OTC-29568-MS

Impacts of Fiscal Systems on Oil Projects Valuation

Rodrigo Dambros Lucchesi, Oil & Gas Consultant

Copyright 2019, Offshore Technology Conference

This paper was prepared for presentation at the Offshore Technology Conference held in Houston, Texas, USA, 6 – 9 May 2019.

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Abstract
Despite increasing demand for cleaner energy around the world, oil is still the main global energy source
and this scenario will not change in the short term. Together with natural gas, they supply 57% of world
primary energy demand (BP, 2018). Therefore, if a country wants to benefit from having its hydrocarbon
reserves developed to generate wealth, it is crucial to enable economic conditions for such. This study aims
to show the impact that distinct fiscal systems adopted by each country can have on the valuation of an
oil field and its commercial feasibility, from an international oil company perspective. Fiscal terms define,
among other things, how revenue from oil production is shared between operators and the host country.
To investigate such topic, a deepwater offshore oil development project was valuated using discounted
cash flow method. Sixteen scenarios were created, considering a combination of four distinct field sizes
under four fiscal systems, selected from some of the world's top oil producing countries. For each scenario,
internal rate of return (IRR), which indicates the project's economic return for the operator, and government
take (GT), which indicates how much of the oil revenue is directed for the host country, were calculated.
Findings show very distinct results in each scenario, with IRR for operators ranging between 8 and 21%
and government take between 57% and 84%. Considering that project returns should always be higher than
a company's capital cost, in some scenarios the discovery would not be declared commercial. Results also
show that, in general, large oil development projects in countries with tax/royalty system present a higher
return for the operators, while production-sharing contracts tend to generate a higher government take. This
shows that the same oil field, under same geological conditions, can offer very different economic returns to
the operators and host governments, depending on the fiscal system in place. In some cases, the fiscal system
has such an impact on the economic feasibility of the project, that it may even prevent the discovery to be
declared as commercial and, therefore, not be developed and booked as proven reserves. The main takeaway
of this study is that understanding fiscal systems is an essential tool for operators to properly evaluate its
projects and one of the most important features governments can adjust to attract private investment to their
oil industries.

Introduction
Despite all the advances achieved so far on the environmental challenges to reduce CO2 emissions, world
energy consumption is still concentrated on fossil fuels such as oil, gas and coal. Due to physical and
economic limitations, renewable energy will not substitute oil and natural gas consumption in the short-
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term, in fact fossil fuels will most likely remain the main energy source for the next decade or two. In the
past two years, oil has accounted for 34% of primary energy consumption in the world energy matrix, or
57% when combined with natural gas (BP, 2018)
Therefore, if a country wants to benefit from having its oil and gas reserves developed to generate wealth
to its society, it's crucial to enable economic conditions for such, by understanding and designing fiscal
terms that promote a fair economic return for oil companies venturing in its territories.
The main goal of this study is to compare and analyze the impacts different fiscal systems have in the
economic attractiveness of an E&P project from the oil company point of view, as well as to understand
how the government take changes accordingly.

Statement of Theory and Definitions

Fiscal systems, in the oil industry, are the set of legal, contractual and tax aspects governing oil operations
in a given sovereign country or state (Johnston, 1994). One of the purposes of the fiscal system is to define
how the petroleum rent will be shared among oil producers and governments. (Lucchesi, 2011). They play
a key role in the relationship between both sides, since it establishes rights and duties for the companies
engaged in exploration and production (E&P) activities in a given country.
The two main kinds of fiscal systems adopted in the oil industry worldwide are the Tax/Royalty system
and the Production Sharing Contract, each one with its own rules and modus operandi:

Tax/Royalty
The Tax/Royalty system (also called Concession system) grants the oil companies the rights to explore and
produce oil in a determined area (also called block or lease) awarded by the host country, for a specific
time, under its own risk and expenses. In case of success, they have the ownership of the oil produced for
which they have to pay, in exchange, royalties and other compensations. Examples of countries that use Tax/
Royalty system include United States, United Kingdom, Norway and Brazil (in some areas), among others.

PSC
In the Production Sharing Contract (PSC) system, the mineral resources belong to the State and the operator
receives a portion of the oil production as a compensation for its investments and work. The PSC, as the name
says, requires the sharing of the produced oil between the host country and the operators. First, the operator
uses some of the production to recover its costs like exploratory expenses and production investments ("Cost
Oil"). PSC usually defines a ceiling, a maximum share of the production that can be used for cost recovery
each year. Then, the remaining production is shared between government and the oil companies, according
to pre-established factors. This share of the production is called "profit oil". From its share of profit oil,
companies still have to pay income taxes and other fees, according to each contract. Most PSC's also charge
royalties from the operators, usually a fixed percentage of the gross income.
In this system, the host country has a bigger role in the conduction of E&P activities, taking part in the
decision-making process with the operator, either by having a National Oil Company (NOC) as a partner in
the joint-venture, or by having government members with seats in the operating committee which manages
the projects. Another important difference is that, by the end of the contract and, therefore, production phase,
all facilities and infrastructure will remain in place and become property of the government, having the
operator only the right to use it during production phase (Johnston, 1994).

Government Take
One indicator often used to compare fiscal systems from different countries and test how much wealth from
the oil and gas exploration is captured by the host country is the Government Take (GT). The most common
way to estimate it is by using the formula:
GT = Government collection / (Government collection + Operator net profit)
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Where government collection includes royalties, signing bonuses, taxes, profit oil sharing (in PSC
systems), among others. This number can be used to broadly compare different fiscal systems and gives an
idea of how much of the oil revenue is being captured by governments, although it does not address other
aspects of fiscal systems, such as timing of collection, risk sharing between companies and governments,
among others.

Methodology
In order to properly compare the fiscal systems impact on an oil project, a simulator was designed to conduct
the economic valuations under different scenarios. The valuation was executed using the Discounted Cash
Flow (DCF) method, in which all project's revenues and expenses are projected on a yearly basis and then
indicators like the Internal Rate of Return (IRR) and Government Take (GT) are obtained.
The IRR is a common financial parameter used by corporations to compare and decide between capital
projects. It is the discount rate that makes the net present value (NPV) of all cash flows from a particular
project equal to zero. In other words, if the internal rate of return on a project is greater than the company's
cost of capital, then the project adds value to the company and should be pursued. Conversely, if the IRR
on a project is lower than its cost of capital, then the best course of action may be to reject it because it will
destroy value of the company. (Investopedia, 2018).
Despite the uncertainty that is typical of long-term projects, especially in the oil business where it is hard
to predict relevant inputs such as future oil prices, the valuations were done in a deterministic approach,
rather than the more usual stochastic one. That is because the goal was to compare different fiscal systems
and not to obtain a risk free estimate of return.
Variables such as oil price, capex and opex were considered using current trends in offshore production.
The oil price used in this study was $ 72.52/bbl, which was obtained by the average Brent price of a 6-month
period between February and August 2018, when the valuations were done (EIA, 2018). As for the time
span of the valuation, cash flows were estimated for 20 years, considering 5 years of exploration activities
and 15 years of production.
Then, a standard fictitious offshore oil development project was valuated in sixteen different scenarios,
generated by a combination of four different field sizes (100, 250, 500 and 1,000 million barrels of
recoverable reserves) and four distinct countries’ fiscal systems (two Tax/Royalty and two PSC systems).
Table 1 shows the sixteen scenarios:

Table 1—The sixteen scenarios valuated

The four fiscal systems chosen to be tested in this study represent actual systems currently in place in four
of the ten largest oil producing countries, and are considered open markets, i.e. that occasionally promote
bidding rounds and/or allow IOC's to operate. Since it is not the purpose of this paper to compare countries
and rank them in any way, but only to understand the differences that exist worldwide, the countries’ names
are not disclosed here.
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The main features used to represent each of the fiscal systems in the economic valuation, which were
in effect at the time this study was written, for a deepwater offshore oil development project, are shown
below at table 2:

Table 2—Main features of the four fiscal systems

For each of the sixteen scenarios the corresponding field size and fiscal terms features were applied at
the cash flow simulator, together with the other standard inputs (oil price, capex, opex, etc) so the valuation
could be computed, and IRR and GT outputs obtained.

Results
The table 3 presents the results of IRR and GT obtained for the sixteen scenarios evaluated:

Table 3—Internal Rate of Return (IRR) for the sixteen scenarios

Considering a typical cost of capital of 10% for oil companies, the first thing the results from the table
above indicate is that, among the sixteen scenarios, two would be considered uneconomic for having an
IRR below 10% (marked in red), and two would be considered marginal, with an IRR around 10% (marked
in yellow). The other fourteen scenarios present returns comfortably above the required cost of capital and
therefore could be approved as having a positive economic return for the oil companies.
Another observation is that the same project's returns can vary greatly moving from one system to another,
with differences of up to 80% in the case of 1 billion barrels oil field, comparing T/R 1 (IRR of 21.1%)
and PSC 2 (IRR of 11.7%).
The figure 1 below shows the same data from the table above in bars to help the comparison between
the fiscal systems. One immediate and intuitive conclusion is that, in general, the larger the oil field is, the
larger the rate of return for the operators, all else equal. Another takeaway is that Tax/Royalty 1 is the best
fiscal system for operators in all scenarios, while PSC 2 is the worst one. But the two other systems change
positions in the rank depending on the field size.
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Figure 1—IRR by field size and fiscal system

For the three smaller oil fields (100, 250 and 500 million barrels), production under PSC 1 is more
profitable than under Tax/Royalty 2. But when the reserves grow to 1 billion barrels, PSC1 becomes more
onerous and less profitable than Tax/Royalty 2. That is due to the fact that PSC1 is a progressive system,
which means that the government set it in a way that the more profit the project generates, the larger their
share will be, making the operator profit rate still increase, but a lower rate. While Tax/Royalty 2, as most
of royalty-based systems are, has flat rates that do not change with the size or profitability of the project.
Simulations in lower oil price ranges (U$60/bbl and U$50/bbl) presented similar behaviors from the fiscal
systems. Return rates are naturally lower but, in general, follow the same hierarchy. The only exception
noticed was that returns on T/R 2 system were significantly lower than PSC1 returns in all field sizes, even
in the 1 billion barrels reserve. Such behavior can be explained by the fact that royalty charged on T/R 2,
as presented on Table 2, has a percentage share and a "per barrel" share which, the lower the oil price is,
the higher it impacts on the project revenue.
The table 4 shows the Government Take (GT) outcome from the valuation performed in the sixteen
scenarios. Like the IRR results, it changes significantly according to the field size and the fiscal system in
place, although not as much as the IRR, varying from 57% to as much as 84%.

Table 4—Government Take (GT) for the sixteen scenarios

It is interesting to notice that, the larger reserves are, the higher government take is in PSC systems,
while it decreases in Tax/Royalty systems. Again, that indicates that PSC's are usually progressive systems,
providing host countries a larger share of the revenue on the more profitable projects. The rationale behind
it is that after a certain threshold where operator has already paid back its investments and risk taking and
made some profit, government wishes to benefit more from the production of its mineral resources.
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On the other hand, the GT decrease for larger reserves in Tax/Royalty systems does not mean that the
government collection is smaller. Instead, it is the operator's profit that increases proportionately more than
the government's, reducing, then, their share of project's total available revenue. The explanation is that,
since most Tax/Royalty systems do not institute higher tax rates for higher profits, operator benefits from
having, in larger oil fields, a larger revenue in comparison to its costs.

Conclusion
As the results show, economic return from the development of a given oil field can vary greatly from one
country to the other, according to the fiscal system in place. Indeed, in the scenarios valuated, IRR varied
from 8 to 21%. In some cases, the differences in return are so significant that the same oil field would be
declared commercial in one country but not in another. Due to the way they are structured, PSC systems
usually present lower returns for the companies and a higher government take than the Tax/Royalty systems,
but this can not be extrapolated as an immutable fact. Furthermore, PSC systems are usually present in
countries with lower geological risks and more abundant oil reserves, which still attracts oil companies
despite the not so favorable fiscal terms.
The scenarios evaluated also show that, even though PSC systems are usually more onerous to oil
companies than Tax/Royalties, it is possible to have situations where the opposite is true. Considering how
the production sharing works, a smaller oil field may have a higher share of its revenue being used as cost
oil, which belongs 100% to the operator, leaving a smaller portion of the production to be shared with the
government as profit oil. Here, the cost recovery ceiling aspect makes a difference. The higher the ceiling,
the higher share of initial production will be used to operator recover its costs, leaving less for government
collection in the first years of production.
Designing fiscal systems is a government's responsibility, so it is ultimately up to them deciding what
share of its fossil fuels wealth they want to retrieve as a compensation to its society, from the exhaustion of its
mineral resources, as long as they provide a fair payback to oil companies in exchange for their investments
and work. In theory, countries with higher geological risks or which want to attract foreign investment to
explore its resources, should reduce its take on the revenue sharing, to foster interest from oil companies.
In a broader perspective, harsh fiscal systems throughout the world can prevent more oil from being
discovered and declared as reserves. After all, as the simulation shows, the same oil field can have positive
or negative financial impact, depending on where it is discovered.
The main takeaway from this study is that understanding fiscal systems and how they impact oil projects’
revenue is mandatory for oil companies to properly evaluate its projects and perform economic risks
assessments. It is also a very important discipline to be understood by policy makers in oil producing
countries, so they can help attract private investment without compromising more than enough from its
society's wealth. Harsh fiscal systems in countries with moderate to high geological risk will prevent
companies from exploring, and even if they do, some discoveries won't be commercial, therefore won't be
developed and generate wealth for its society.

References
BP. 2018. Statistical Review of World Energy. http://www.bp.com/statisticalreview
EIA. 2018. Europe Brent Spot Price FOB. https://www.eia.gov/dnav/pet/hist/rbrteD.htm
Investopedia. 2018. Internal Rate of Return. ttps://www.investopedia.com/walkthrough/corporate-finance/4/npv-irr/
internal-rate-return.aspx
Johnston, D. 1994. International Petroleum Fiscal Systems and Production Sharing Contracts. Pennwell Publishing
Company, Tulsa, OK.
Lucchesi, R.D. 2011. Fiscal Systems for Petroleum Exploration and Production in Brazil and in the World. UFRJ, COPPE.
http://antigo.ppe.ufrj.br/ppe/production/tesis/rodrigo_lucchesi.pdf