Mexico Round 1 Fiscal Terms:

The Incentive for Gold Plating

Page 1 of 12

What is Gold Plating?

For a petroleum fiscal system to be successful, there must be an
alignment between the goals of the host country and the petroleum
companies carrying out exploration and production.
An example of alignment is that both the host government and the
investor benefit if a petroleum company carries out its operations
in an efficient manner at the lowest cost per barrel. This means
more revenues for the host country and more profits for the
investor.
Therefore, under a well designed fiscal system the benefits of
higher efficiency and lower costs are shared. The investor
should receive a share of the cost saving in the form of more
cash per barrel. There is no incentive to lower costs if the
government taxes away all of the additional revenue.

Pedro van Meurs: Risk of Gold Plating in Round 1

January 24, 2015

Page 2 of 12

What is Gold Plating?

Misalignment occurs when the fiscal system is designed in such a
way that the investor receives less cash if operations are more
efficient. Such a system creates an incentive for the investor to
manage the operations in such a way that costs are higher than
necessary and operations are inefficient.
This behavior is called gold plating.
Gold plating is incentivized by fiscal systems that have sliding
scales that disproportionately increase with higher levels of
profitability (IRR). Gold plating is avoided with moderate
increases of the profit share to Government, such as from 20% to
30%. An increase to 80%, in contrast, would bring about
misalignment of interests.
A fiscal system that incentivizes gold plating is detrimental to
the host country in two ways: 1) total profits to be shared are
less because of the higher costs; and 2) paradoxically, the oil
company receives more cash out from lower profits.
Pedro van Meurs: Risk of Gold Plating in Round 1

January 24, 2015

Page 3 of 12

Mexico Round 1 Fiscal Terms

At present, the Mexico Round 1 Fiscal Terms illustrate the
potential for severe gold plating.
This will be demonstrated with a calculation example in the
following slides.
The Round 1 Fiscal Terms include a Profit Share for the
Government (called Contraprestacin). The terms related to this
Profit Share are based on the IRR. The incentive for gold plating
may be seen in the sliding scale related to Profit Share. See Annex 3
of the Model Contract (pp. 64-77):
http://ronda1.gob.mx/Contratoindividual.pdf

Pedro van Meurs: Risk of Gold Plating in Round 1

January 24, 2015

Page 4 of 12

Example of Gold Plating

The example uses a 10 million barrel field in shallow water
producing oil over 7 years. The oil price is assumed to be $ 80 per
barrel. The start of the cash flow is assumed to be 2014 and the
start of production is in 2022.
It is assumed that the company made a bid of an 80% profit share
to the contractor reducing to 16% as per the Annex 3 formulas of
the Model Contract based on the IRR range from 15% to 30%.
This means the profit share to the Government goes up from 20%
to 84%.
Two cost scenarios are compared: $ 30 per barrel vs. $ 15 per
barrel.

Pedro van Meurs: Risk of Gold Plating in Round 1

January 24, 2015

Page 5 of 12

Gold Plating Demonstration

Incentivizing gold plating
Yearly IRR
35.00%
30.00%

IRR

25.00%

20.00%
15.00%

$30

10.00%

$15

5.00%

0.00%
2022

2023

2024

2025

2026

2027

2028

Years

The IRR of the $ 15 per barrel cost case increases much faster than the $ 30 per
barrel cost case during the 7 year life of the field.

Pedro van Meurs: Risk of Gold Plating in Round 1

January 24, 2015

Page 6 of 12

Gold Plating Demonstration

Share to Government (%)

Yearly Profit Share (%) to Government

100.00%
90.00%
80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%

$30
$15

2022

2023

2024

2025

2026

2027

2028

Years

Due to the higher IRR, the percentage share of the profits to Government
increases much faster under the $ 15 per barrel cost scenario.

Pedro van Meurs: Risk of Gold Plating in Round 1

January 24, 2015

Page 7 of 12

Gold Plating Demonstration

Yearly Amount of Profits to Government

Profits to Gov ($ mln)

140.00
120.00
100.00

80.00
60.00

$30

40.00

$15

20.00
0.00
2022

2023

2024

2025

2026

2027

2028

Years

Due to the higher share to Government, the amount of the profits payable to
Government is much higher under the $ 15 per barrel cost scenario.

Pedro van Meurs: Risk of Gold Plating in Round 1

January 24, 2015

Page 8 of 12

Gold Plating Demonstration

Yearly Cashflow
150.00
100.00

50.00
0.00
-50.00
-100.00
-150.00
-200.00

$30

2028

2027

2026

2025

2024

2023

2022

2021

2020

2019

2018

2017

2016

2015

$15

2014

Yearly Cash Flow ($ mln)

200.00

Years

The increase in payments to Government is much higher than the cost savings
between $ 30 and $ 15 per barrel costs. Therefore the total cash to the
Contractor is less under the $ 15 per barrel scenario.
Pedro van Meurs: Risk of Gold Plating in Round 1

January 24, 2015

Page 9 of 12

Gold Plating Demonstration

Cashflow Distribution ($ mln)

Less cash to the investor in a lower-cost project

1200.0

1000.0
800.0
CashtoComp

600.0

PaytoGov

400.0

Opex

200.0

Capex

0.0
$30

$15
Costs/bbl

The chart illustrates how the oil company ends up with less cash, if the
company is more efficient and manages to reduce costs from $ 30 to $ 15 per
barrel. The reduction is very significant. Therefore the Mexico Round 1 fiscal
terms pose the risk for severe gold plating.
Pedro van Meurs: Risk of Gold Plating in Round 1

January 24, 2015

Page 10 of 12

Gold Plating Demonstration

NPV10 ($ mln)

Motivating the higher-cost project

100.0
90.0
80.0
70.0
60.0
50.0
40.0
30.0
20.0
10.0
0.0

NPV10

$30

$15
Costs/bbl

The Net Present Value discounted at 10% (NPV@10%) is actually higher for the
$ 30 per barrel scenario and therefore in this case a $ 30 development plan may
be more attractive to the investor than a $ 15 plan.
Pedro van Meurs: Risk of Gold Plating in Round 1

January 24, 2015

Page 11 of 12

Solution for going forward

It is relatively easy to modify the fiscal terms in such a way that
the incentive for gold plating is eliminated.
The IRR based feature and the formulas in Annex 3 can be
maintained. However, the emphasis on the profit share based on
this feature should be reduced. Less profits should be collected
from this feature for Government.

In order to maintain attractive revenues for Government, an

additional feature can be introduced based on a profit share with a
sliding scale based on the level of daily production.
This is a standard feature in the majority of the production sharing
contracts around the world.
In total, the system should be designed in such a way that it is
competitive with fiscal systems of other countries, for similar
shallow water circumstances, over a wide range of cost and price
assumptions.
Pedro van Meurs: Risk of Gold Plating in Round 1

January 24, 2015

Page 12 of 12