A summary of my thoughts on the oil contractBy Tarron Khemraj On In Business Review |
There have been several lofty predictions of gross revenues that the Guyana government is likely to receive. For example, Rystad Energy recently announced that the government will earn over US$100 billion in oil revenues from the Stabroek block alone. However, it is important to note that the gross oil revenue the government is expected to earn will be realised over different time periods across a 20-plus year period for each project or well. Therefore, the gross revenue has to be a present value calculation, which involves a discount rate. We do not know what rate of discount was used to calculate the present value aggregate revenues, which are then partitioned for recouping fixed and operational costs, as well as determining the profit share of oil company and the Guyana government.
Given the uncertainty surrounding the discount rate, time dimension and cost recovery parameters – all of which will determine the government’s gross revenue – I do not find the aggregate prediction to be helpful, particularly from an annual budget planning perspective. The Guyana government will have to determine how much revenues it is likely to receive on a monthly and then annual basis. This number and the revenues from general taxation will then guide annual expenditures, which we all hope will tie into a long-term cohesive vision.
If there is persistent under-realisation of the government’s projected annual revenues compared with what is actually paid to it by the oil companies, then this would be an indication that there is some kind of serious underpayment. Hence, this is the underlying reason why I always prefer to look at expected revenues on a monthly basis. There is enough information in the production sharing contract to make this assessment and determine where the underpayment exists.
Doing so would require being aware of two regimes. The first regime (regime 1) is the period over which there will be cost recovery of the pre-contract, exploration costs, and other fixed costs outlined in Annex C of the contract. In regime 1, which is made up of multiple monthly time periods, the operational costs are to be considered as well. However, it becomes interesting when or if cost recovery ends. The contract specifies cost recovery as the recouping of the fixed costs (pre-contract, exploration costs, development costs, etc.).
The issue of the rate of royalty has been discussed extensively by several observers. However, there is another important matter which has not attracted enough attention. We can continue to quarrel over the rate of explicit royalty; however, a serious problem of the present contract is there is no time period when cost recovery ends. Ring fencing of the fixed costs is related to the time issue. The fixed costs – pre-contract, development, exploration and others – from one project can in theory be claimed as part of the fixed cost in another project (say a post-Liza 1 or Liza 2 project). In other words, cost recovery of fixed costs can take a very long time to complete.
An important aspect of the cost recovery in regime 1 is the 75% cap. Recent letters in the press have asked on what quantity is the 75% applied. The answer is in the contract. The 75% cost recovery is on the average market price for a given month. This should ostensibly be a good thing since the oil company cannot recover more than 75% of the market price worth of fixed cost in any given month. This is not necessarily the case for two reasons: (i) there is no time dimension or ring fencing of the recovery of fixed costs; and (ii) one can show using some high school mathematics that Guyana can make more money if the locals can get the oil companies to pin down an average (or unit) cost per barrel of extraction. The cost recovery cap of 75% appears, in my opinion, to be a mathematical ruse. As a general rule, oil companies do not like to discuss average cost of production, although there are a few estimates relating to the Guyana discoveries floating around. The IMF thinks it is around US$20 per barrel and one estimate of the operating cost (variable costs alone) I have seen from Hess has it as US$9 per barrel.
This takes us to the second regime – regime 2. In this regime, the oil company has recovered all its fixed costs and only now needs to recover its operating cost each month. We know from our Microeconomics or Cost Accounting class that the profit earned on a widget is the market price of the widget minus the cost to produce the widget. What if this widget is a barrel of crude oil off the shores of Guyana? The profit per barrel of oil has to be the market price (P) minus the cost to extract a barrel (C); profit = P minus C.
The profit per barrel of oil in regime 1 is the same, except that the cost of production is not the overall average cost but 75% of the market price in a given month. In other words, during cost recovery the cost per barrel of oil in any month is 0.75 multiplied by P. In other words, unit cost = 0.75P. We also know there is a 2% royalty and a 50% profit sharing agreement.
These legal aspects of the production sharing contract can be distilled into a simple algebraic expression that determines how much (in each month) the Guyana government is likely to get during cost recovery. This expression is 0.02P + 0.5(0.98P – 0.75P) = 0.135P. In other words, the Guyana government will receive 13.5% of the market price of a barrel of oil for any given month during cost recovery. This also implies that
although the legal royalty is 2%, the effective (or implicit) royalty is 13.5% during regime 1. Of course, if one wants to know the gross revenue that the Guyana government is expected to receive in a given month, one has to multiply 13.5% by the market price of said month and the total barrels produced in same month.
Once we exit cost recovery, the average cost is now mainly operating or variable costs. As noted above, this cost is quite low by international standards – thus making regime 2 a much better scenario for Guyana. I will not do the numerical simulations here as this column is probably getting unwieldy for readers. I will definitely do this in a future essay. It should be noted, however, that the 13.5% effective royalty in regime 1 and the likely higher elective royalty in regime 2 do not consider the expected cost if there is an oil spill, expected legal jeopardy oil companies could face in the future for global warming, and the marketing fee Guyana will pay to sell its share of crude oil.
There has been much discussion of renegotiation of the contract. However, we should know – as all business owners do – that an explicit royalty is akin to a tax on production. Any business focusing on its shareholder wealth maximisation – as ExxonMobil clearly does – will reassess production levels if the tax on production rises. If the royalty rises, the oil companies will certainly arbitrage production and spread production out over places where the tax rate is the lowest. The oil companies will not stop production in Guyana, but they will certainly have to reassess how profitable is the investment relative to other places. The tax on production clearly influences the discounted cash flow and hence the net present value of existing and future wells.
I have noted in the past that Guyana will not make a lot of money on the percentages or rate of profit share and royalty, but on volume of production. If the optimism is realised such that 600,000 plus barrels are produced per day, then Guyana will receive a substantial amount of money each year, even with 13.5% elective royalty under binding cost recovery. For example, at US$50 per barrel average price for a year and 600,000 barrels per day, the Guyana government will receive around US$1.5 billion in annual revenue under regime 1. The number is significantly higher if we assume average cost of US$20 per barrel – regime 2.
I strongly believe evading the natural resource curse, even partially, depends on completely rewriting the constitution for shared governance, space for third parties, electoral reform, direct election of MPs, jettisoning of the list system, and others. There will be a lot of money for a tiny population, but most will be wasted under present governance structure.
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