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Diplomica Verlag

Petroleum Fiscal Systemsand Contracts

Muhammed Mazeel

Muhammed Mazeel Petroleum Fiscal Systems and Contracts ISBN: 978-3-8366-3852-4 Herstellung: Diplomica® Verlag GmbH, Hamburg, 2010 Dieses Werk ist urheberrechtlich geschützt. Die dadurch begründeten Rechte, insbesondere die der Übersetzung, des Nachdrucks, des Vortrags, der Entnahme von Abbildungen und Tabellen, der Funksendung, der Mikroverfilmung oder der Vervielfältigung auf anderen Wegen und der Speicherung in Datenverarbeitungsanlagen, bleiben, auch bei nur auszugsweiser Verwertung, vorbehalten. Eine Vervielfältigung dieses Werkes oder von Teilen dieses Werkes ist auch im Einzelfall nur in den Grenzen der gesetzlichen Bestimmungen des Urheberrechtsgesetzes der Bundesrepublik Deutschland in der jeweils geltenden Fassung zulässig. Sie ist grundsätzlich vergütungspflichtig. Zuwiderhandlungen unterliegen den Strafbestimmungen des Urheberrechtes.

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Petroleum Fiscal Systems and Contracts

CONTENTS

1 CLASSIFICATION OF PETROLEUM FISCAL SYSTEMS....82 PROJECT EVALUATION ....................................................373 CONTRACTS .......................................................................444 GOVERNMENT AND OPERATOR TAKES, COSTS AND

TAXES..................................................................................695 PROJECT ECONOMICS .....................................................826 FINANCE............................................................................1067 TAXES................................................................................1218 FIELD DEVELOPMENT PLANNING .................................1419 GEOPOTENTIAL OF THE GLOBAL EXPLORATION

MARKET ............................................................................15510 DIFFERENT TYPES OF PETROLEUM FISCAL SYSTEMS

............................................................................................15911 HIGH RISK COUNTRIES...................................................290REFERENCES ..........................................................................362APPENDICES ...........................................................................364

Petroleum Fiscal Systems and Contracts

FIGURES Figure 1.1 Classification of petroleum fiscal systems 8Figure 1.2 Detailed classification of petroleum fiscal systems 10Figure 1.3 Typical project contract conditions 11Figure 1.4 Example concessionary system flow diagram 14Figure 1.5 Example calculation of government and contractor take

15Figure 1.6 Basic equations for royalty/tax systems 16Figure 1.7 Concessionary system structure from the oil company

perspective 17Figure 1.8 Basic equations for contractual systems 19Figure 1.9 Example production sharing contract flow diagram 20Figure 1.10 Production sharing contract structure from the

contractor’s perspective 21Figure 1.11 Sample rate of return contract cash flow projection 23Figure 1.12 Sample sliding scale royalty 26Figure 1.13 Joint venture structure with a PSC 33Figure 1.14 Typical joint venture in Russia 35Figure 1.15 Three phase technical assistance contract (TAC) 36Figure 2.1 Allocation of revenues from production 42Figure 2.2 Tax Base Spectrum 43Figure 4.1 Government and Contractor take 71Figure 4.2 Division of the costs and profit 71Figure 4.3 Changing fiscal terms 72Figure 5.1 Profitability measures 88Figure 5.2 Sensitivities of fiscal model 91Figure 5.3 Influence diagram for typical stages in project

development 92Figure 5.4 Value of information to demonstrate commerciality 94Figure 5.5 Value of information for development optimization 95Figure 5.6 Comparing options 96Figure 5.7 Project definition 98Figure 5.8 Cost probability curves 100Figure 5.9 Accuracy of estimates through project development

101Figure 6.1 Hierarchy of legislation and contractual agreements 107

Petroleum Fiscal Systems and Contracts

Figure 7.1 UK tax regime 123Figure 8.1 Legal framework 142Figure 8.2 PDO approval flow chart 145Figure 8.3 PDO approval administrative process 145Figure 10.1 Azerbaijani fiscal regime 174Figure 10.2 Dubai fiscal regime 201Figure 10.3 Egypt fiscal regime 207Figure 10.4 Example Iraqi service contract 228Figure 10.5 Ireland fiscal regime 232Figure 10.6 Libyan fiscal regime 235Figure 10.7 Malta fiscal regime 242Figure 10.8 Morocco fiscal regime 246Figure 10.9 Norway fiscal regime 260Figure 10.10 Russian fiscal regime 267Figure 11.1 Plentiful reserves in Iraq - oil comes to the surface in

many places 291Figure 11.2 Location of auctioned licenses (map printed in The

Wall Street Journal) 323Figure 11.3 Oil refinery near the village of Taq Taq in the

autonomous Iraqi region of Kurdistan 332Figure 11.4 Production profile example for West Qurna 1 340Figure 11.5 Comparison of Bid and Peter Wells' estimates of most

likely production profile for West Qurna 1 341Figure 11.6 Iraqi crude oil production 343Figure 11.7 Crude price variation 348Figure 11.8 Cash flow for the TSC for West Qurna 1 (after Peter

Wells) 357Figure 11.9 Cash flow for the KRG PSC for West Qurna 1 (after

Peter Wells) 357Figure 11.10 Relative sensitivity of the TSC and the KRG PSC to

oil price (after Peter Wells) 358

Petroleum Fiscal Systems and Contracts

TABLES Table 4.1 Contractor take, cost recovery limits and government

participation rates 74Table 5.1 Present value of one time payment 87Table 9.1 Recoverable conventional oil by region 156Table 9.2 Examples of block sizes worldwide 158Table 11.1 Main commercial terms of the Shamaran PSC for

Pulkhama oil field (after Peter Wells) 338Table 11.2 Comparison of main terms of the TSC and the KRG

PSC (after Peter Wells) 356

Petroleum Fiscal Systems and Contracts

ACKNOWLEDGEMENTS I would like to thank all the people who gave me their time and their views on this book. I am particularly grateful for the helpful suggestions, reviews and comments received from Rod Searle and many others. This book is the result of long years of work and experience in different countries and fields. Special thanks are due to my small family for the support to continue to write books and publications which comes exclusively from them. The revenue from this book will be donated to the sick cancer children and help organizations.

Dr Muhammed Mazeel

Petroleum Fiscal Systems and Contracts

INTRODUCTION This book has been written for those interested in petroleum taxation and international negotiations, and the way to carry out successful exploration and development projects. It examines the petroleum fiscal systems that apply in different countries across the world and how these systems govern the economics of exploration and development for oil and gas. Examples are included to give the reader a wide perspective on the implementation of fiscal systems. The petroleum fiscal system for a country is a combination of the taxation structure established by legislation, together with the contractual framework under which an international oil company operates with the host government. Fiscal systems vary widely between countries and in some countries there is more than one system. The taxation structure may, for example, include royalty payments. The contractual framework may be based on concessionary arrangements or on service and production sharing agreements. The different types of fiscal system are classified and the factors in these systems that govern exploration and development economics are identified. The practical aspects of petroleum taxation and the relationships between oil companies and governments are examined in detail in a chapter that focuses on the resultant contractor and government take under different fiscal regimes. This book also provides descriptions of how exploration development project economics are calculated and how projects are planned and financed. Legal and operational aspects of contractual and fiscal terms are also considered. Topics are addressed from both industry and government viewpoints to give an understanding of the aims and concerns of both sides. Much of the material provided here was inspired by questions most frequently asked on the subject. The best answers are supported with specific examples and many of these are used throughout the book.

Petroleum Fiscal Systems and Contracts

The summaries and analyses of various fiscal terms and contract conditions are believed to be accurate, and every practicable effort has been made to gather up-to-date information about the current conditions in the countries cited. Examples of fiscal terms used here are drawn from numerous public sources. Confidential information has been carefully excluded. A glossary is provided to help with industry jargon and non-standardised terminology which can obscure some of the simple concepts covered in this book.

Petroleum Fiscal Systems and Contracts

1 CLASSIFICATION OF PETROLEUM FISCAL SYSTEMS

Petroleum fiscal systems whereby the owner of mineral resources receives levies from the extraction company can be classified into two main categories These are concessionary systems and contractual systems as shown in Figure 1-1.

Petroleum Fiscal Systems

Contractual SystemsConcessionary Systems

Production Sharing Agreements

Risk Service Agreements

ServiceAgreements

Pure Service Agreements

Figure 1.1 Classification of petroleum fiscal systems (Ref. 7) In most countries, except the United States of America, the owner of the mineral resources is the government. In the USA, the owners are private individuals or companies that pay taxes on production to the state. Worldwide, every country has developed its own petroleum fiscal systems to be applied. Under concessionary systems, the government will transfer title of the oil and gas to a company if they are produced. The producing company then pays royalties and taxes. Contractual systems are in most cases either production sharing agreements or service contracts. The private companies under

Petroleum Fiscal Systems and Contracts

contractual systems have the right to receive a share of production or revenues from the sale of oil and gas in accordance with a production sharing agreement (PSA) or a service agreement (SA). The state companies either self produce or share the production and selling of the oil or gas. Revenues then flow into the finance ministries’ treasuries. In most contractual systems, the facilities installed by the contractor within the host government’s territory become the property of the state either as soon as they are landed or upon start up or commissioning. Sometimes, the asset or a facility does not pass to the government until the expended costs have been recovered. This transfer of title for asset facilities does not apply to leased equipment or to equipment brought in by service companies. The difference between service contracts and production sharing contracts depends on whether the contractor receives compensation in cash or in crude. Under a production sharing agreement, the contractor receives a share of production and hence takes title to this crude. In a concessionary system, the transfer of title occurs at the point of export instead of at the wellhead. In a service contract, there is no issue of title since the contractor gets a share of profits rather than production. Under some service agreements, however, the contractor has the right to purchase crude from the government at a discount. Despite the differences between the systems the same economic results are achieved. When the contractor is paid a fee for conducting exploration and production operations, then this system is a risk service contract. The difference between risk and pure services contracts depends on whether there is a fee on the profits or not. The pure service contract is without risk in exploration and development. Consequently, this is usually used by conservative nationalised companies or by states that have capital but are lacking in technology and management capability.

Petroleum Fiscal Systems and Contracts

The different fiscal systems are further illustrated in Figure 1-2, showing the differing points of transfer of title and methods of remuneration.

Concessionary(Royality/Tax) Systems

at the wellhead (1)

Contractual BasedSystems

Service AgreementsIn „Cash“(2)

Production Sharing Contracts„Titel“ to Hydrocarbons at the Export Point (1)

In „Kind“ (2)

Hybridsa Flat Fee (pure) (3)

Risk ServiceProfit (Risk) (3)

PeruvianType

Division of „Gross

Production“

IndonesianType

Division of „Profit Oil“

EgyptianType

Unused CostOil as seperate

category

Pure Servicea Flat Fee (Pure) (3)

„Titel“ to Mineral

Resources: (1)

„Reimbursement“and

„Remuneration“ is (2):

Service-„Remuneration“

Is based upon: (3)

Characteristics:

Classification of Petroleum Fiscal Regimes

Figure 1.2 Detailed classification of petroleum fiscal systems (Ref. 7) In addition to the concessionary and contractual systems, which are the two most used systems, there are some further variations that could be considered as types of fiscal system. The joint venture is a variant fiscal/contractual system. It is used where the national company and contractor company establish a working interest arrangement. This is found in both concessionary and contractual systems. Technical assistance contracts (TACs) are sometimes used for enhanced oil recovery (EOR) projects or restoration and redevelopment managed under a production sharing agreement or a concessionary system.

Petroleum Fiscal Systems and Contracts

• Area Bonus• Duration Government participation• Relinquishment Ringfencing• Exploration Obligation/(Work Commitment) Cost Recovery• Royalty C/R Limit• Depreciation Profit Oil Split• Special Deductions R-Ratio• Tax Credit Domestic Market Obligations• Taxation

Petroleum Asset Profile

Typical Contract Conditions

ClosureProductionDevelopmentExplorationLease Post-Closure

Start of Production

RecoveryEnd of Production

Lease is returned

Petroleum Fiscal SystemsRelatively Regressive Systems(High Royalties, Bonuses, Low CostRecovery Limit, Ring Fencing,…)

Relatively Progressive Systems(Income Tax and Royalty linked to Volume or Value of Production, Government take linked to Production or Return on Investment,…)

Discourage investment Encourage investment

Figure 1.3 Typical project contract conditions (Ref. 15)

Petroleum Fiscal Systems and Contracts

CONCESSIONARY SYSTEMS Under a concessionary system, the state government grants a Concession or License to an international oil company (IOC) or a consortium which gives rights for a fixed period to explore for and produce hydrocarbons within a certain area (License Area or Block). The IOC may be required to pay a signature bonus or a license fee to the government to secure the Concession or License. Thereafter, the government will obtain compensation usually through royalty and tax payments when hydrocarbons are produced. Concessionary systems are used by around half of the countries worldwide including the US, UK, France, Norway, Russia, Australia, New Zealand, South Africa, Colombia, and Argentina. These countries have fiscal regimes which vary widely in terms of royalty and tax rates, tiers of taxation and other features such as incentives to promote investment. Examples of how concessionary arrangements work through paying royalties and taxes to the state in different tiers are shown in Figures 1-4 to 1-6. The first point of government tax may be royalty in the start as in Figure 1-4. This may be followed by local and federal level taxation on income after allowing for operating costs, depreciation, depletion and amortisation. The cash flow projection and the calculation of the net present value (NPV) and internal rate of return (IRR) of a project needs to take account of the full range of royalties and taxes to be applied. Calculation of Government and Contractor Take The concession agreement determines how profits will be shared between the government take and the contractor’s take. The balance between these is critical for investment in exploration and development activities. Figure 1-4 shows a typical model of how revenue is distributed under a simple concessionary system. Royalties, deductions, and taxation are subtracted sequentially. The royalty, in this case 40%

Petroleum Fiscal Systems and Contracts

of the gross revenues, comes right off the top. The balance remaining after royalties is the net revenue. Certain deductions of contractor’s costs are allowable from the net revenue. These deductions include operating costs (Opex), depreciation, depletion, and amortisation (DD&A) and intangible drilling costs (IDCs). Most countries follow this DD&A format but will allow different rates of depreciation or amortisation for various costs. Some countries are liberal in allowing capital costs to be expensed. Revenue remaining after royalty and deductions is called taxable income. In this example, it is subjected to two layers of taxation with 10% provincial tax and 40% federal tax. Since provincial tax is deductible against federal tax, the overall effective tax rate is 46%. After tax deductions, the contractor share of profit is USD 6.48, making a share of gross revenues of USD 18.48. This equates to a contractor take of 47%. The profit in this example is USD 28 (USD 40 gross revenues minus USD 12 costs). This is different from contractor’s profit margin, which in this example is 16.2% (USD 6.48/USD 40).

Petroleum Fiscal Systems and Contracts

CONCESSIONARY SYSTEM FLOW DIAGRAM One Barrel of oil = 40 USD Contractor Share Royalties and Taxes 40% Royalty USD 16 USD 24 (Net Revenue) Deductions for Operating costs (Opex), Depreciation, Depletion and Amortisation (DD&A), Intangible Drilling and Development Costs (IDCs), etc.) USD 12 USD 12 (Taxable Income) Provincial Taxes for example 10% USD 1.2 USD 10.8 Federal Income Tax for example 40% USD 4.32 USD 6.48 Net Income after Tax __ USD 18.48 USD 21.52 47% 53% Figure 1.4 Example concessionary system flow diagram Figures 1-5 and 1-6 further outline terminology and the hierarchy of arithmetic for calculating contractor cash flow. This example gives more of a financial perspective. The cash flow projection is based on the assumption that some classes of capital cost are intangible and are immediately deductible whilst tangible capital costs are depreciated over five years. The development example in Figure 1-5 is for a field with 50 MMbbl of recoverable oil. Total capital costs (Capex) are USD 174 million and estimated operating costs during the life of field (Opex) are USD 300 million. Production of the field is expected to generate gross revenues of

Petroleum Fiscal Systems and Contracts

USD 2 billion based on an oil price of USD 40 per barrel. Calculation of the respective takes comes from the cash flow projection. The government take of 52% is derived from 40% royalties plus 20% tax on net profit.

Figure 1.5 Example calculation of government and contractor take

Gross Revenues USD 2 billion Total costs - USD 474 million Total profit USD 1.526 billion Royalties 40% USD 610.40 million Taxes 20% USD 183.12 million Contractor take USD 732.48 million Contractor Take 48% (732.48 ÷ 1.526) Government Take 52%

Petroleum Fiscal Systems and Contracts

Basic Equations for Royalty/Tax Systems Figure 1-6 sets out the basic equations for calculating net cash flow under a royalty/tax fiscal system. Gross revenues = Total oil and gas revenues Net revenues = Gross revenues – royalties Net revenue (%) = 100% - Royalty rate (%) Taxable income = Gross revenues - Royalties - Operation costs – Intangible capital costs Deductions - Depreciation, Depletion and Amortisation (DD&A) – Investment credits (if allowed) - Interest on financing (if allowed) – Tax loss carried forward - Bonuses Net cash flow = Gross revenues (after tax) - Royalties - Tangible capital costs - Intangible capital costs - Bonuses - Taxes

Figure 1.6 Basic equations for royalty/tax systems (Ref. 7, 8, 9, 10)

Petroleum Fiscal Systems and Contracts

Figure 1.7 Concessionary system structure from the oil company perspective

CONCESSIONARY SYSTEM STRUCTURE OIL COMPANY PERSPECTIVE Terminology USD/bbl Royalties, Costs, and Taxes Wellhead price USD 40 -USD 16 40% Royalty Net revenue USD 24 - USD 2.4 10% Provincial taxes - USD 6 Operating costs - USD 1.8 General and administrative costs USD 13.8 Before - tax operating income - USD 6.20 Depreciation, depletion and amortisation Before - tax net income USD 7.6 -USD 0.608 8% State income tax USD 6.992 USD 2.38 34% Federal income tax After - tax net income USD 4.62 +USD 6.2 Depreciation, depletion and amortisation - USD 2.5 Tangible capital costs After - tax cash USD 8.32

Petroleum Fiscal Systems and Contracts

PRODUCTION SHARING CONTRACTS Production sharing contracts or agreements (PSCs or PSAs) give an international oil company (IOC) or consortium exploration and production rights for a fixed period in a defined Contract Area or Block. The IOC bears all exploration risks and costs in exchange for a share of the oil or gas produced. Production is split between the parties according to formulae in the PSC that may be fixed by statute, negotiated, or secured through competitive bidding. If the IOC does not find a commercial discovery, there is no reimbursement of costs by the government. The advantage to the host government of this system is that the government will generally receive a large share of the oil or gas. This can be sold and the revenue used according to the government’s development programmes and economic needs. Following the introduction of PSCs in Indonesia in the mid 1960s, they are now also used in Malaysia, India, Nigeria, Angola, Trinidad, the Central Asian Republics of the Former Soviet Union, Algeria, Egypt, Yemen, Syria, Mongolia, China, and many other countries. Essentially, control of the oil remains with the state. National companies are maintained to manage the resource whilst the contractors have execution responsibility. Contractors are required to submit a programme and a budget to be approved by the national company. The type of contact depends on the level of reserves and political economic aims of the host government. It is important to note in such contracts both the level of percentage of recovery of costs and also the way in which the exploration or development costs may be recovered. If there is costs recovery before sharing of production, the contractor is allowed to recover the costs out of net revenues. The costs recovery limit is the only true distinction between concessionary systems and PSCs. The amount of revenues remaining after royalty and cost recovery, is termed profit oil or profit gas. This is the equivalent of taxable income in a concessionary system. Within the service agreement, it would be termed the service fee

Petroleum Fiscal Systems and Contracts

rather than profit oil or gas. The contractor share of profit oil or gas is taxed at the rate of sharing. Basic Equations for Contractual Systems Figure 1-8 sets out the basic equations for calculating net cash flow under a product sharing contractual system (Ref. 7,8). Gross revenue = Total oil and gas revenues Net revenues = Gross revenue – Royalties Net revenue (%) = 100% - Royalty rate (%) Cost recovery = Operating costs “Cost oil” + Intangible capital costs + DD&A (including abandonment costs) + Investment credits (if allowed) + Interest on financing (if allowed) + Unrecovered costs carried forward Profit oil = Net revenue – Cost recovery Contractor profit oil = Profit oil x Contractor percentage share Government profit oil = Profit oil x Government percentage share Net Cash flow = Gross revenues (after tax) - Royalties - Tangible capital costs - Intangible capital costs - Operating costs + Investment credits - Bonuses - Government profit oil - Taxes Taxable income = Gross revenues - Royalties - Intangible capital costs - Operating costs + Investment credits - Government profit oil - DD&A (including abandonment costs) - Bonuses (Not always deductible).

Figure 1.8 Basic equations for contractual systems

Petroleum Fiscal Systems and Contracts

The example in Figure 1-9 illustrates the way in which the contractor and government shares may be calculated in a production sharing contract.

Figure 1.9 Example production sharing contract flow diagram Contractor Take In Figure 1-9, with one barrel of oil worth 40 USD, the total profit is USD 16. Considering the 20% royalty, profit oil split, and taxation, the contractor share of profits is 20%, or USD 3.2. The presence of a cost recovery limit forces some profit sharing under all circumstances where production is achieved.

PRODUCTION SHARING CONTRACT FLOW DIAGRAM

One Barrel of Oil = USD 40Contractor Share Government Share 20% Royalty USD 8 USD 32 Cost Recovery [Operating Costs, Depreciation, Depletion and Amortization (DD&A), Intangible Drilling and Development Costs (IDCs) ] USD 16 40% (Limit) USD 16 Profit Oil Split

USD 6.4 40%/60% USD 9.6 (Taxable) - (USD 2.56 ) Taxes 40% + USD 2.56 USD 19.84 USD 20.16 49.6% 50.4%

Petroleum Fiscal Systems and Contracts

PRODUCTION SHARING CONTRACT STRUCTURE CONTRACTOR’S PERSPECTIVE

Terminology USD/bbl Royalties, Costs, Taxes and Sharing Wellhead price USD 40 -USD 8 20% Royality Net revenue USD 32 1 Local taxes (usually)

Cost recovery - 6 Operating costs - 1.8 General and administrative costs - 6.2 Depreciation, depletion and amortization Total cost recovery USD - 14 Profit oil USD 18 Sharable Government share (60%) - USD 10.8 60%/40% Split in favor of Government Contractor share (40%) USD 7.2 -USD 3.6 50% Income tax After-tax net income USD 3.6 + USD 6.2 Depreciation, depletion and amortization - USD 2.5 Tangible capital costs After-tax cashflow USD 7.3

Figure 1.10 Production sharing contract structure from the contractor’s perspective Cash Flow Projection In the cash flow projection example illustrated in Figure 1-11 the calculation of government and contractor takes can be seen. It is necessary to define the royalty, cost recovery limit, DD&A, profit oil split and taxes. The gross revenues, less the total costs, then gives the total profit, less the government profit oil and taxes. The results are the respective contractor take and government take.

Petroleum Fiscal Systems and Contracts

The PSC terms include: Royalty = 0% Cost recovery limit = 40% DD&A = 5-year straight-line decline (SLD) Profit oil split = 30% for the contractor Taxes = 40%. The development costs are all capitalised, and depreciation starts when production begins. The last column, net cash flow, is the undiscounted cash flow. A Production Profile B Oil Price C Gross Revenue = A x B D Intangible Capital Costs E Tangible Capital Costs F Operating Costs G Bonuses are not cost recoverable but are tax deductible H Depreciation of tangible Capital Costs: 5-Year Straight Line Decline I Contractor Cost Oil = D + F + H, if C is greater than zero: Up to a maximum of 60% of C J Total Profit Oil = C – J K Contractor Profit Oil = J x 35% L Tax Loss Carry Forward (see the Bonus G Column) M Income Tax 45% = [(K) – (L)] x 45% if (K) – (G) – (L) > (zero) then [(K) – (G) –(L)] x 45%, otherwise zero N Contractor After–tax Net Cash Flow = (C) -(D) –(E) – (F) – (G) –(J) + (K) –(M)

Petroleum Fiscal Systems and Contracts

Figure 1.11 Sample rate of return contract cash flow projection

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Petroleum Fiscal Systems and Contracts

Basic Elements There are two basic elements in the production sharing fiscal structure. The first is the operational element and the second is the revenue or production sharing element. Each of them have national legalisation and contractual aspects. The national legalisation aspects such as government participation, mediation, insurance and ownership transfers are unchangeable in the operational period, as are revenue factors (royalties, taxation, depreciation rates, investment credit and domestic obligations). The contract conditions, however, are negotiable. For example, the oil ministry can negotiate the split of oil but cannot negotiate the tax rate which is fixed. The oil companies are able to negotiate the structure of production sharing contracts. Negotiable aspects include the area of lease, work commitment, commerciality, renouncement, bonus payments, cost recovery limits, and production sharing percentages. Work commitments are generally defined in terms of kilometres of seismic data to be acquired and the number of wells to be drilled. There are some cases, however, where only seismic commitments are defined and drilling is optional. Bonus Payments Cash bonuses are sometimes paid upon finalisation of negotiation and contract signing, or these will be paid when production reaches a certain cumulative level. Sometimes part of the costs of equipment is calculated as a bonus. Production bonuses may be payable at the start of production or when a certain level of accumulated production is achieved.

Petroleum Fiscal Systems and Contracts

Royalties The basic concept of royalties which is similar under all fiscal systems is that royalties are taken straight off the top of gross revenues. Many production sharing contracts (PSCs) do not have a normal royalty because of the ownership issue. Payment of royalty implies ownership on the part of the royalty payer but in a PSC the contractor has no ownership at this stage. The primary reason that this terminology is used is because of the hierarchy of the arithmetic associated with royalties. Where PSCs do include a royalty, this can typically range as high as 15%. A PSC royalty is treated just as it would be under a concessionary system; it is the first calculation made. The royalty level is clearly very important and rates above 15% may be considered by the contractor as excessive. Governments may now scale royalties accordingly to the field size since it can be inefficient and counterproductive if royalties are set too high. Sliding Scales A characteristic encountered in many petroleum fiscal systems is the sliding scale (or progression of steps) used for royalties, taxes, and various other items. The aim is to create a flexible system with sliding scale terms so that as production rates increase, government take increases. Terms can be set appropriately for the development of varying sizes of field. Some contracts will provide flexibility through a progressive tax rate. Others will tie more than one variable to a sliding scale such as cost recovery, profit oil split, and royalty. The most common approach is an incremental sliding scale based on average daily production. The following example, Figure 1-12, shows a sliding scale royalty that steps up from 5% to 15% on portions of the daily production rate. If average daily production is 20,000 bopd, the aggregate effective royalty paid by the contractor is (10,000 bopd at 5% + 10,000 bopd at 10%).

Petroleum Fiscal Systems and Contracts

Sample Sliding Scale Royalty Average Daily Production Royalty First Part Up to 10,000 bopd 5% Second Part 10,001 - 20,000 bopd 10% Third Part Above 20,000 bopd 15%

Figure 1.12 Sample sliding scale royalty (Ref. 7) Production levels in sliding scale systems must be chosen carefully. If rates are too high, then the system effectively does not have a flexible sliding scale. In some situations steps of 50,000 bopd can be too high or conversely 10,000 bopd steps may be too low. The choice should be determined by the anticipated size of discoveries.

Petroleum Fiscal Systems and Contracts

SERVICE CONTRACTS

Many service agreement are identical to PSCs in all but the method of payment, either by production sharing or profit sharing. Many service agreements, however, have unique contract elements that are used in calculating the service fee.

Pure Service Contracts A pure service contract is one where the contractor carries out exploration and/or development work on behalf of the host government for a fee and the contractor bears no exploration risk. This kind of contract is not used widely but may be used sometimes, typically in the Middle East, where the state has substantial capital but seeks only expertise. Examples exist in Iran, Saudi Arabia, the Philippines and Kuwait. The pure service contract is similar to contracts used in the oil service industry with companies such as Halliburton and Schlumberger where the contractor is paid a fee for performing a service. Examples are contracts placed for drilling services, development services and some exploration services. Drilling service contracts may be let as pure service arrangements e.g. whereby the contractor is paid on a footage basis while drilling and on an hourly basis for completion and testing operations. Risk Service Contracts A risk service contract is radically different from a pure service contract and bears little similarity to an oil service industry service contract. Under a risk service contract awarded by a host government, the contractor provides all capital associated with exploration and development of petroleum resources, bearing all the exploration risk. If exploration is successful, the contractor is allowed to recover costs through sale of the oil or gas and also receives a

Petroleum Fiscal Systems and Contracts

fee based on a percentage of the remaining revenues. This fee is often subject to taxes. As well as bearing exploration risk, the contractor does not get a share of production. However, although there is no production sharing or profit oil, the contract terms allow the contractor a share of revenues similar to that derived from a share of production in a PSC. The host government maintains ownership of the hydrocarbons produced and the contractor does not acquire any rights to oil and or gas unless the contractor is paid its fee in kind as oil or gas. The contractor may also be given preferential rights to purchase production from the government.

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