Petroleum Taxation

Sharing the Oil Wealth: A Study of Petroleum Taxation Yesterday, Today and Tomorrow

Carole Nakhle

• Publisher: Taylor & Francis
• Year: 2008
• Print ISBN: 9780415541909
• eBook ISBN: 9781134080328
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Petroleum taxation is the universal instrument through which governments seek to determine the crucial balance between the financial interests of the oil companies and the owners of the resource. This book addresses how governments have and continue to approach this problem, the impacts of different policy choices and how these are being adapted to

1 Petroleum taxation

Art and science

1.1 INTRODUCTION AND APPROACH

This work seeks to offer to the reader a comprehensive and up-to-date analysis of petroleum taxation and its impact. Round the world petroleum taxation is the principal mechanism for sharing hydrocarbon wealth between host governments and investors and has, in particular, been a central feature of both UK fiscal policy and UK energy policy since the early nineteen-sixties and pre-dates this for many long established provinces.

However, the analysis and commentary go beyond the UK scene and examine both the theoretical background to petroleum taxation and the many varieties of taxation that can be, are, or indeed might have been, applied in any country or oil province.

Petroleum fiscal regimes consist of a variety or mixture of tax instruments. Essentially the most popular choice is between Tax and Royalty regimes (T&R), predominant in OECD countries and Production Sharing Contracts (PSCs) typically favoured by developing countries. Thus the UK, for example, operates a concessionary regime, companies being entitled to the ownership of the oil extracted. By contrast a country like Azerbaijan applies a contractual regime where the government retains the ownership of the resource. The book reviews the two most common types of fiscal regime which operate all round the world and looks at their main strengths and weaknesses.

In addition, the book explains how many of the world’s fiscal regimes can be evaluated quantitatively and develops a general cash flow model that can be applied to each country’s circumstances. This procedure is then applied (as an example) to six countries—the UK, Norway and Australia, where concessionary regimes apply, and India, China and Iraq, which have contractual regimes.

Specific focus is given to the UK North Sea and its fiscal history because the lessons from this regime, which has been one of the world’s most unstable and frequently altered regimes, are generally relevant to oil production and applicable world-wide. The UK North Sea and indeed the whole North Sea province play a highly important part in Western Europe’s energy supply. The North Sea provides an interesting example of how fiscal terms can and do change through the lifetime of a province (from high production to maturity and decline), and in tune with changes of policy approach and in particular changing oil prices (from very high in the nineteen seventies and early eighties to low levels in the nineties and back to high points in the new century).

The uniqueness of oil taxation when compared to the taxation of other commodities lies in the oil industry’s special characteristics, e.g. the significant contribution oil makes to numerous national economies, the high operating and development costs, high uncertainty in exploration activities, volatility of oil prices, and the maturity of certain oil provinces such as the North Sea.

These all add challenges to both the government and the industry. Consequently, the field of oil taxation requires specific knowledge by any regulator. A study such as this can therefore hopefully yield new insights into the investment decision process and the way it is influenced by the different oil industry fiscal packages and regimes to be found today around the globe. Others are still in the making. It is hoped that the messages from this work can also aid decisions for changing or creating new fiscal regimes, such as that struggling to emerge in Iraq, where future change is clearly and urgently needed, but can only come about in practice at a pace dictated by the rate of improvements in the security situation.

National tax policies can greatly influence the petroleum industry long-term global sustainability. The research in this book has been carried out against the background of a helpfully timely feature, namely the current maturity of the UK North Sea province. The larger fields (such as Forties, Brent and Ninian) were discovered in the early phases of exploration and brought into production between 1975 and 1979. Fields found during subsequent periods have become progressively smaller. This fact vividly illustrates further the significance of taxation in its effect on the trade-off between the opposing viewpoints of the government and companies. As the great French finance minister, Jean-Baptiste Colbert, observed ‘the art of taxation consists in so plucking the goose as to obtain the largest amount of feathers with the least possible amount of hissing’,¹ to which a modern commentator has added ‘it is also important not to frighten away the geese so that they lay no eggs, golden or otherwise, let alone present themselves for plucking.’

As world oil demand continues to climb inexorably, driving oil prices to levels well beyond predictions of only a few years back, the importance of heeding these adages increases. It is the tax authorities above all who can determine how much hissing there will be, how many golden eggs will be laid now and how many more will be laid in the future. They need to get it right.

1.2 PURPOSE OF THIS BOOK

The message of this book is that petroleum taxation is a decisive factor in oil and gas investment decision making and ultimately will have a material impact on basin production. At a time when oil prices are high and countries and companies want to maximise revenues from the oil and gas sectors, the design of fiscal regimes is a critical factor in shaping perceptions of basin competitiveness. All round the world many countries are seeing their production aspirations undermined, and in some cases production declining, because their fiscal terms are poorly designed for the character and features of the province in question.

Since there is no objective yardstick for sharing economic wealth between the various interests involved in petroleum activity, controversy and tensions will always prevail between investors and the host government. A trade-off is bound to exist, since both government and oil companies want to maximise their own rewards. Tax rates that are set too low leave the government, the owner of the resource, a small and inequitable portion and are unlikely to be sustainable. Yet, if tax rates are too high, investment will be discouraged, not only in new projects, but in sustaining the capital investment required to maximise future value added from existing operations.

The exploration and exploitation of oil require significant financial resources that can exceed the capability of most of oil producing countries. This becomes more than ever the case as deeper and more remote wells are drilled. The ever higher risks involved, as a result of geology and oil price volatility, make a purely national approach to the exploitation of petroleum increasingly outdated. It follows that exploration and exploitation activities present delicate legal, technical, financial and political problems and any solution requires a balancing act between the respective interests of the producing countries and the oil companies.

But despite the competing objectives of both government and oil companies, a balance can still be reached. The right choice of fiscal regime can improve the trade-off between each party’s interests. A small sacrifice from one side may be a big gain for the other.

There is no final, fixed or universal solution to the ever-changing and evolving set of problems and challenges which oil industry taxation presents. But the aim in the following pages is to suggest how a balance can be most effectively sought and how the inevitable adjustments which are constantly needed to secure that balance can best be devised and applied.

1.3 CONTENTS OF THE BOOK

Our subject—the pattern and impact of petroleum taxation round the globe—is approached by first, in Chapter 2, examining the theoretical background to petroleum taxation then, in Chapter 3, making an in-depth analysis of some of the principal fiscal packages that have been applied around the world. Chapter 3 compares six internationally representative petroleum fiscal regimes; UK, Australia, Norway, Indonesia, China and Iraq. Chapter 4 looks at the UK experience and case in detail, together with the many controversies and policy attitudes surrounding this subject.

In Chapters 5, 6 and 7, we then move on to predominantly technical issues. Chapter 5 develops a cash flow model for each of the six selected countries, further highlighting the complexities behind petroleum taxation. Chapter 6 covers the impact of different fiscal packages on selected oil fields’ profitability and government revenues under different price scenarios. It also evaluates the possible outcomes of previous fiscal rates and structures, had they still applied today, and researches the way in particular in which the designers of the UK’s petroleum fiscal regime and its subsequent amendments have affected the trade-off between the UK government and the oil companies. Particular attention is paid to the question of how differing tax regimes might have worked out through time, had they been left unchanged, how they affect different field sizes and what impact different crude oil price levels have had, and might have had, on the overall results.

Chapter 7 examines alternative possible methods for evaluating oil projects’ profitability and revenue outcomes. By applying hypothetically different accounting conventions to the various examples selected it enables the reader to judge how significant these different techniques have proved, and would have proved useful to both oil companies’ and government’s appraisals, estimates and decisions. The choice of financial evaluation technique is of particular significance to both oil companies and government. An inappropriate technique can generate a misleading figure for profitability and taxable capacity leading, in turn, to incorrect decision making and an inappropriate assessment of a particular fiscal structure or instrument. In addition, major controversy still surrounds the choice of an appropriate evaluation technique.

Chapter 8 sets these detailed considerations of petroleum taxation in the broader political and attitudinal background from which they originate and by which their shape is heavily influenced. A final Chapter 9 summarises the main findings and conclusions of the whole book.

2 The taxation of oil

Theoretical background

A good tax—principle and characteristics of an effective tax system

2.1 GENERAL APPROACH

This chapter addresses the basic principles underlining petroleum taxation. It looks at the elements and qualities required for an ideal oil tax system, and examines the extent to which the various instruments discussed in previous studies match up to these basic criteria for an ideal system.

The basic proposition underlying petroleum taxation is easily stated. It is to acquire for the state in whose legal territory the resources in question lie, a fair share of the wealth accruing from their extraction, whilst encouraging investors to ensure optimal economic recovery of those hydrocarbon resources. However this general statement leaves all the key questions to be answered. What is fair? What is a share and of what total stream of output and income? At what point in the extraction and production process is the state’s take to be levied?

These issues, and many others, arise in almost all taxation policy activities. But in the case of petroleum they assume a special character and complexity. Of central relevance are the uncertainties associated with petroleum geology, the specific characteristics of individual oil fields and the possibility of reinvestment. The costs of petroleum projects tend by their nature to be incurred up front. The time lags can be considerable, often of many years and even decades, from the initial discovery of oil or gas reserves to the time of first production. Such characteristics impose numerous difficulties in the design and implementation of an appropriate tax system aimed at achieving a balance between both government and industry objectives.

In the case of minerals in the ground, and petroleum in particular, governments and state authorities see themselves as the legal owners of these resources and therefore fully entitled to collect a revenue stream from what they own. This ownership status can be translated into policy in a variety of ways. One traditional method has been to charge royalties on all units extracted, regardless of associated costs or actual net revenues—a method understandably unpopular with the industries incurring the costs and likely to act as a strong deterrent to investment and production. In the high noon of socialism the leading authoritarian countries, notably the former Soviet Union, bypassed the ownership and taxation issues by maintaining total state ownership of oil producing activities, by ignoring normal profit criteria and the true cost of capital, and by siphoning off surpluses, often on an arbitrary basis—with of course a damaging impact on the flow of investment.

Most common, and the main focus of this work, (but by no means free of arbitrary political influences), are patterns which recognize oil enterprises as separate entities with proper accounts and are taxed at arm’s length, without the state’s underlying assumption of ownership rights (and therefore rights to participate in the benefits) being in any way surrendered.

Governments of oil producing countries face important challenges when designing a tax system that meets two fundamental objectives; namely to ensure a fair share of revenues for themselves whilst simultaneously providing sufficient incentives to encourage investment. These two objectives are often competing rather than complementary. The need for balance between taxpayer and tax-levying authority is unavoidable but hard to achieve in practice particularly at times of volatile prices. A fair share at $20/barrel may be seen as unfair at $40/barrel. In the petroleum case, as in others, tax rates that are set too high will eliminate field value and create investment disincentives; hence both the producer and the government are left with nothing.

The general proposition is well illustrated by the concept of the Laffer Curve, which illustrates the trade-off between tax rates and tax revenues. As Professor Arthur Laffer famously maintained, governments can maximize tax revenue by setting tax rates at an optimum point. Lowering tax too much will produce less revenue but setting the tax rate too high—beyond the optimum level—can decrease revenue as well. When the Laffer doctrine was applied during the first Reagan Administration in the US it was found that lower taxation increased the tax flow from higher tax bracket earners. The same outcome occurred in the UK when top tax rates were dramatically lowered in Margaret Thatcher’s first administration (1979–83). But pressed beyond its limits the Laffer curve can be counterproductive. When the same medicine was applied to the much larger standard rate brackets, both in the US and the UK, the outcome was a marked decline in total revenues, leading, in the American case, to a dramatic widening of the annual budget deficit.

Nevertheless, confirmation of the validity of the Laffer lesson in a reverse sense—that higher taxes do not always increase revenues—can be detected in UK government North Sea tax policy. In 2002, the UK government introduced a 10 per cent supplementary charge on top of the standard 30 per cent corporation tax and in 2005, doubled the charge to 20 per cent. The latter changes to the North Sea tax regime were introduced in order, it was hoped, to maintain a balance between oil producers and consumers, by promoting investment and ensuring fairness to taxpayers in view of the significant increases in oil prices and the upwards shift in expectations of the medium term outlook for future oil prices.¹ The UK governm...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• List of variables
• List of figures
• List of tables
• Foreword
• Preface
• Acknowledgments
• 1 Petroleum taxation: art and science
• 2 The taxation of oil: theoretical background
• 3 Comparing fiscal regimes
• 4 The UK petroleum fiscal regime
• 5 The economics of petroleum projects
• 6 Regimes and outcomes
• 7 Other financial evaluation techniques
• 8 Sharing the oil wealth: the political and social contexts
• 9 Sharing the wealth: the way forward
• Notes
• Glossary
• List of Acronyms
• Appendices
• References