Designing Efficient Hydrocarbon Fiscal System for Somalia


The oil industry is currently experiencing a period of uncertainty. Investors are nervous about the recent oil price crush, which has dropped from around $100 to $60-a-barrel in the space of a few months. Predictions for next year range from $60-80, and investments that were made at $100-a-barrel don’t seem so profitable at $60. It is also unclear if or when oil prices will recover, as an oversupply of crude oils has largely been cited as the main cause for the price meltdown. Cost cutting will likely take on higher priority in the oil industry at least for the near future, and high cost projects such as deep-water drilling may not be feasible. Projects with sunken-costs will likely be safe. However, new opportunities on the drawing boards will be re-examined to account for lower prices.

Given these uncertainties, it is perhaps fitting to examine the levers state policy makers and investors rely on when it comes to designing Fiscal regimes, which are essentially oil profit-sharing-agreements. This is especially relevant for East Africa which has recently seen a surge in both oil and gas exploration and discoveries. This region is generally in urgent need of economic development, and many see natural resources as quick means for improving living standards. However, with oil prices approaching multi-year lows, attracting investors may become more difficult than it has been for a while.

The past two years have seen renewed interest from major oil and gas companies to explore Somalia for hydrocarbon resources thanks to the recent successes in East African explorations and the emerging political stability in the country. Soma Oil and Gas successfully completed an offshore seismic survey in June 2014, acquiring 20,500 km lines of 2D seismic data. This has provided further evidence of the country’s improved security, and the potential for starting exploration activities along Somalia’s large off-shore seabed. Other governments in the region are also competing for capital and technology to develop their hydrocarbon sectors. Somalia’s government is tasked with assessing its position in the region and formulating an appropriate fiscal policies to facilitate the development of the country’s under-explored hydrocarbon potential.

The main objective of oil companies is to maximise shareholder value whereas the government is primarily concerned with maximising its share of the profit. Since the objectives of the oil companies and the government does not typically necessarily align, it is prudent to identify likely sources of future conflicts and write a comprehensive contract which addresses the concerns of both parties. One of the objectives of the current Somali government is to establish government owned profit sharing model which will form the basis for future negotiations with oil companies. The following some-what academic piece aims to provide an overview of the key features of hydrocarbon fiscal regime.

The challenge of developing an effective fiscal system is ensuring that the risks and rewards associated with the whole lifecycle of hydrocarbon exploration, development and production are catered for adequately. This essentially entails that the rewards offered should be proportional to the risks taken by the stakeholders. The oil and gas industry is characterised by high risks and long project cycles, where risks and revenues can change substantially over time. An efficient fiscal system should offer enough flexibility to accommodate changes in operating condition, such fluctuation in commodity prices, and reduce the need for costly renegotiations.

In constructing a fiscal system a State has to consider the effects of different systems and features on expected cash-flows, impact on the pace of development, and sensitivity to prices and cost variations, as well as the relative value it offers to interested investors.

Given the varying circumstances and objectives of different countries, the legal and fiscal systems are generally tailored to address the risks and exposures host governments and investors expect. For example, the fiscal regimes developing countries such as Mozambique and Somalia employ to meet their pressing cash-flows, economic, welfare and infrastructure development needs, can be considerably different to that of a more established countries like Norway or UK.


 

Typically fiscal systems will contain some of the following features:

Royalty

Royalties are a cash flow or in-kind payment (oil or gas) to the government at the point of resource extraction. Royalty payments are typically tax deductible for oil companies. However, if royalties are only linked to the level of production and not the price, then it offers the government a cash-flow stream that can shielded against price fluctuations.

Bonuses

Fiscal regimes frequently contain signature, production and discovery bonuses to be paid by the oil companies. The signature and discovery bonuses are one-off payments to the government made at the time the contract is signed or when a commercially viable discovery goes into the development phase. While production bonuses are paid when production reaches pre-specified levels, and hence can become a good cash flow source for governments provided production levels are met.

Cost Recovery

The costs associated with production is known as the cost oil. Typical oil costs include operating costs, depreciation, depletion and amortisation which are carried forward and recovered by oil companies in the production phase. In some instances the contracts also include uplifts, which enable the oil companies to recover investment costs. Uplifts are generally not tax deductible. The cost recovery limit plays an important factor in the state’s receipts, especially for marginal fields.

Profit-Oil

The portion of production remaining after royalties and cost recovery is referred to as the profit oil, and is split between the government and the oil company at a pre-agreed ratio. For the oil company exploration cost oil are generally sunk costs which can only be recovered at the production phase so it is their advantage to have high cost recovery limits, while represents a liability for governments as it reduces their share of profit-oil.

Income Taxes

Oil companies’ share of the profit oil may be taxed as a corporation income tax, which further increases a government’s take from the profit oil. There are, however, cases in which governments decide to wave the income tax for a number of years starting from the production phase (tax holiday) to incentivise and attract investment.

Contract Duration

Typically a minimum period is specified for the exploration period with the possibility of extensions agreed beforehand. The production period starts when a commercial discovery is declared and a work programme has been agreed. Depending on the contract exploration and production phases are either set as fixed durations or the whole contractual agreement has a specific duration. For example, the contract could state that the exploration period is five years with the possibility of extension by a further two years, while the production period is 20 years. Alternatively, the contract period could be 30 years with a maximum exploration period of five years.

Relinquishment

It is common for all or part of a contracted area to be relinquished after a set time period, if the oil company has not discovered or met its obligations, usually agreed as an investment on seismic and a minimum number of exploration wells. It is also typical for the oil company to relinquish its rights over a fraction of its contracted area after the exploration period, and focus on the areas it considers more promising.

Commercialism

The definition of what it means for an oil field to be commercially feasible has to be also agreed between the parties. The costs associated with different fields can vary considerably, and oil companies will have more incentives to produce from field with low operating cost for low cost recovery limits, while fields with high operating costs reduce the state’s share of gross production when high cost recovery limits are used. It is common for the government to set a standard for what it deems commercially feasible, such as a minimum limit on its share of gross production from any given field.

Work Programme

The start of the production phase entails a work programme which concerns the oil company’s commitments to the operational aspects of production as well as the local and wider community. Issues ranging from seismic, drilling, information sharing, financial duties, and employment of a local workers are included in the work programme.

Sliding Scales

To enable further flexibility within the fiscal systems, sliding scales linked to production or costs are used in the formulation of fiscal regimes. This allows governments and investors to scale their share of production and profits depending on the operating conditions, and expected production and cost levels. Sliding scales need to be carefully analysed, as changes in some of the parameters, such as royalties, taxes or oil prices, can significantly tilt the balance in favour of one of the parties.

Contract Types

Given the complexities involved in this process, numerous legal systems encompassing at least some of these contractual features are used to address the needs of states and investors. These frameworks generally come under the concessionary or contractual umbrellas. In both systems, oil companies commonly assume the investment and technical risks associated with exploration, development and production, and are compensated according to the risk level. The differentiating factor between these systems relates to the ownership of the natural resources.

In a contractual system ownership of equipment and installation permanently affixed to the ground for the exploration and production of hydrocarbons generally passes to the state immediately, while the oil company receives a share of the production. Typically legal responsibility for abandonment lies with the state under a contractual system unless provisions are made within the contract.

In concessionary systems the title to the natural resources pass to the oil company and the state receives taxes and royalties as compensation. Ownership of the equipment and installations passes to the state only after expiration of the contract. Legal responsibility for abandonment lies with company in this system.


 

Supporting investment

Companies seek investment opportunities that suit their corporate strategies and risk-return profiles. The initial decision to invest and the subsequent allocation of capital are greatly influenced by the content of existing legal provision and fiscal terms.

Governments needs to come up with appropriate fiscal regime to convert its policy into economic signals to the market and influence investment decisions. Several countries have used fiscal regimes to support the development of their oil sector. For example, fiscal regime revisions from 1991 onwards appear to have contributed to the exploration and production expansion in Angola’s deep water prospects.

Some estimates puts Uganda’s exploration and development cost at $5–13-a-barrel. Assuming a cost of $10-a-barrel, an oil price of $60 per barrel and production of 1 million barrels per day. Even under a conservative 50% profit share for the government would yield an income of approximately $9 billion per year.


References:

  1. Gelb, Alan, Kai Kaiser, and Lorena ViƱuela, 2012, “How Much Does Natural Resource Extraction Really Diminish National Wealth? The Implications of Discovery,” Working Paper No. 290, Center for Global Development, July 9.

  2. http://af.reuters.com/article/somaliaNews/idAFL6N0T848020141118

  3. Kirsten Bindemann, “Production Sharing Agreements: An Economic Analysis”, Oxford Institute for Energy Studies, WPM 25, Oct. 1999

  4. Silvana Tordo, “Fiscal Systems for Hydrocarbons”, Design Issues, World Bank working paper no. 123, 2007

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