44122 No. 9 Petroleum Sector Briefing Note February 2008 Contracts for Petroleum Development - Part 3 The flows of oil revenues are quite complex. This note presents the results of two hypothetical simulations -- one a progressive production sharing regime and the other regressive -- to illustrate qualitatively how they affect the amount and timing of government revenue and investors' profits. B riefing Notes 7 and 8 [1,2] gave an overview of The two fiscal cases are summarized in Table 1. In different types of contractual arrangements in both cases, for income tax purposes, straight-line de- the upstream petroleum sector and defined key preciation of capital expenditures over five years is payment streams under production sharing agreements assumed and there is no limit on the recognition of ex- (PSAs). This note, the last in a three-part series, pro- penses incurred for petroleum operations, which may vides quantitative examples of how varying fiscal pa- be carried forward from one year to the next until they rameters affect the size and timing of government rev- are fully recovered. For computing the government's enue streams. To this end, the note takes two sets of share of profit oil in production sharing, a ceiling on fiscal parameters--one progressive and the other re- cost recovery is imposed in one case. Smaller payments, gressive--and follows revenue streams over the life of such as surface rental and other fees, are omitted for a contract. simplicity. Two Fiscal Systems The first case considered is regressive: royalty, tax, and production sharing rates do not increase with increas- The simulations take a hypothetical field that, over ing net-of-cost income. There is a signature bonus of 19 years, produces 100 million barrels of oil. The US$20 million, the royalty rate is fixed at 10 percent, production profile (Figure 1), associated costs, and and cost recovery for production sharing is restricted financial flow calculation methodologies are taken to 60 percent in any given accounting period.All these from [3]. The simulation considers both steady oil provisions are designed to ensure early revenue. The price levels and the historical annual price of Brent government receives 70 percent of profit oil.After these crude oil--an important marker crude whose price payments, the contractor pays an income tax of 30 per- movement is taken as a barometer of the overall oil cent on profits derived from the remaining income. market--expressed in 2006 U.S. dollars1 between 1988 and 2006 (Figure 2). The average price in Fig- The second case does not have a signature bonus and ure 2 is $30 a barrel. The first year of operation is has sliding scale royalty and production sharing sched- the year in which the contract becomes effective. ules, the details of which are shown in Table 2. The It is worth noting that the start of production in Fig- royalty rate does not reach 10 percent, the rate set in ure 1 is much sooner than what occurs in practice; case 1, until the extracted oil fetches at least US$25 a the exploration period was shortened for brevity in barrel. As the oil price increases, however, the royalty this note. rate rises with it and reaches a maximum of 40 percent 1 These prices are real pricesadjusted for inflationrather than nominal prices. Although the nominal price of Dubai Fateh crude oil was US$39.50 a barrel in November 1979, markedly lower than the high of US$69.52 a barrel reached in July 2007, in real terms this crude hit the highest in history in November 1979--equivalent to US$90.32 a barrel in 2007 U.S. dollars. The prices in Figure 2 are adjusted for inflation so that past prices shown are higher than the nominal price at each time period (except the price in 2006). 2 Petroleum Sector Briefing Note February 2008 above US$60 a barrel, considerably above that in case price was assumed during the entire life of the con- 1. The government's share of profit oil increases as the tract, and the same calculation was repeated at seven contractor's internal rate of return (IRR) increases. As price levels, ranging from US$20 to $80 a barrel. Briefing Note 8 described, this sliding scale production share makes this PSA a rate-of-return contract. The Figure 3 shows the percentage of net-of-cost income government share is zero if IRR is 20 percent (in prac- that flows to the government. Each price level repre- tice, and especially in new PSAs, the government shares sents a scenario run. Annual revenues were computed production from the outset), and is only 40 percent when using discounted cash flow analysis to take the time IRR is between 20 and 30 percent. The government's value of money into account (see Briefing Note No. share rises rapidly above this threshold, and is as high 7). The discount rate used in this note was 12.5 per- as 90 percent when IRR exceeds 50 percent. In case cent. The percent received by the government was 2, an income tax of 30 percent is paid before profit oil is computed by dividing the aggregate discounted gov- shared. ernment revenues by total discounted receipts from the sale of oil minus total discounted expenditures (that is, Impact of Different Price Levels net income). Constant oil price scenarios It is immediately clear from Figure 3 that the two fiscal Calculations were carried out assuming different con- systems are very different. In case 1, the percent re- stant oil price levels. In each scenario, a constant oil ceived by the government declines with rising oil price, February 2008 Petroleum Sector Briefing Note 3 whereas the reverse is observed in case 2, clearly illus- gressive regime may provide less revenue when times trating that case 1 is regressive, case 2 progressive. are tough--low oil prices, high production costs, or both--but provide more income if the project becomes profitable. Impact on Revenue Flow Figure 5 shows annual government revenues using the oil price history shown in Figure 2. This assumes that the price of oil extracted in this hypothetical field fetches the same price as Brent. There are marked differences between the two cases during the first five years. In the first year, the government receives a signature bo- nus of US$20 million in case 1 but nothing in case 2. The government receives no revenue in year 2, and in practice years of little revenue will last longer than a year. As production starts, government revenue rises more rapidly in case 1, but falls below that in case 2 beginning in year 7. Government revenues in case 1 are more front-loaded. Figure 4 shows the contractor's rate of return, which is a measure of profitability. In case 1, the rate of return Table 3 compares the overall government revenue is markedly lower than that in case 2 at low oil prices, over the life of this oil field at different (constant) oil but the two curves cross near US$45 a barrel above price levels, calculated using discounted cash flow which case 1 gives higher rates of return. That is, case analysis. In case 2, despite being back-loaded, the 1 is unattractive to investors in a low oil-price environ- aggregate revenue is lower than in case 1 below ment but very attractive if oil prices soar. US$40 a barrel, but is 14 percent higher at US$80 a barrel, a highly profitable scenario, The ratio of gov- What these two figures illustrate is that a progressive ernment revenues is higher for a doubling and qua- regime is more likely to assure a reasonable return to drupling of oil prices in case 2. investors even when world oil prices are low (or alter- natively in high-cost fields, such as marginal fields), but limits the amount of profits that the contractor can earn in "good times." Conversely for the government, a pro- Observations The two cases discussed in this note illustrate the type of trade-offs that governments have to consider in set- ting fiscal parameters. So-called regressive parameters are more likely to ensure early revenue as well as mini- mal revenues in adverse circumstances, but also to dis- courage investments, especially in marginal fields. Pro- 4 Petroleum Sector Briefing Note February 2008 gressive regimes may encourage investments in adverse framework and contractual terms in any country. It is situations and also increase government revenues in important to note that, because each project is situa- favorable circumstances, but could delay the arrival of tion-specific, fiscal systems cannot merely be trans- government revenues and reduce them if oil prices fall, planted from one country, area, or project to another; production costs increase, or both. what works well inAlgeria may not work well in Cam- bodia. In this regard, it is important to retain flexibility Table 3 also illustrates that, as one would expect, the in fiscal systems¾capable of adapting to changes in impact of oil price variation on government revenue market conditions, government policy, and geological volatility is amplified if fiscal parameters are linked to and country risks. profitability indices. But it is difficult to try to control revenue volatility by means of fiscal parameters.Arec- ommended approach is to design the fiscal system to References maximize government revenue in the long run, and to use other instruments¾such as oil funds or risk man- [1] World Bank. 2007. "Contracts for Petroleum agement strategies including hedging¾to deal with rev- Development ­ Part 1." Petroleum Sector Briefing Note No. 7, October. enue volatility. [2] World Bank. 2007. "Contracts for Petroleum Development ­ Part 2." Petroleum Sector Briefing Note In all cases, the government's (and the government's No. 7, November. perception of investors') assessment of future oil price [3] Daniel Johnston. 2003. International Exploration movements, production cost escalation, and the field's Economics, Risk, and Contract Analysis. Tulsa, prospectivity (its attractiveness as an exploration tar- Oklahoma: PennWell Corporation. get) will influence how to set fiscal parameters for long- term government revenue maximization. For more information contact: Mr. Bun Veasna This three-part series has had to simplify complex is- Infrastructure Officer sues for the sake of readability and brevity. The long- Email: vbun@worldbank.org or term nature, large upfront investments, and significant Masami Kojima uncertainties surrounding petroleum projects present a Lead Energy Specialist considerable challenge to the formulation of the fiscal Email: mkojima@worldbank.org