Oil, Gas and Resources: Designing Winning Fiscal Regimes

Published on: 12/06/2012
Posted on: 12/14/2012
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Professor James Smith of SMU Cox has been asked to work on a vitally important 21st century problem by the International Monetary Fund (IMF). In an age of concern over resource sustainability, his new research could hold a key to keeping economies moving in a way that helps the resource-fortunate country and the private investor come together. His practical, working model attempts to find the best type of fiscal regime to develop natural resources. He also shows that all extraction is not equal.

Professor James Smith of SMU Cox has been asked to work on a vitally important 21st century problem. In an age of concern over resource sustainability, his new research could hold a key to keeping economies moving in a way that helps the resource-fortunate country and the private investor come together. The International Monetary Fund (IMF) is the supreme agency putting this knowledge to work.

In Africa, says Smith, this type of analysis is vital because of the "disproportionate impact that extractive industries have on national wealth." So the IMF came to Professor Smith to provide his version of a model that could analyze and determine what the most effective type of tax system was or could be developed to upgrade abilities of developing countries to benefit from their natural resources.

Smith set about to create a model that shows how the various amounts of taxes taken by the government would impact the incentives for firms to locate, develop and monetize a given natural resource, whether oil and gas, or even minerals under a variety of fiscal regimes.

The IMF is the de facto watchdog over the global economy to a degree, and countries' financial affairs. It is a banker of last resort for some countries, offering a lifeboat to those in crisis — the 1997 Asian financial crisis and now first-mover Eurozone crisis countries like Greece. A significant activity of the IMF on the ground is their technical assistance missions; the organization advises governments, treasuries and regulatory agencies in Asia, Latin America and Africa how to best manage their fiscal house in terms of taxes, revenues, accountability and corruption, to name a few key policy areas.

In oil and gas development, different forms of taxation have a variety of different impacts on the margins of development. Smith explains, "The model reveals what happens to exploration, to the timing of initial development, and the scope of development given a particular type of tax regime. The research helps answer the question: Will we have a full-fledged operational plan to use these minerals as appropriately as possible, or are there insufficient incentives that will cause firms to hold back at a given amount of taxation or royalties?"

Said another way, the model attempts to find the best overall approach, which lets the government take its share, while creating incentives for the industry to do a complete job of utilizing the resource. Smith notes that the trick is to let both parties win through fiscal design. This work for the IMF has a definitive end game—helping developing countries help themselves.

A Model for Progress
This innovative model accounts for the investor’s simultaneous consideration of all of the major factors that affect the decision to invest. It examines how an extractive enterprise would adjust the intensity of exploration, the timing and intensity of initial development, the timing and intensity of enhanced recovery (EOR), and eventual abandonment of the field when facing real-world tax regimes. The research illustrates how the government receives its share of revenue, but at the same time, how taxation impacts the investor's decision to change their plan to avoid taxes or minimize their burden. Most of the literature on the topic has overlooked this important point.

While this is a highly complex optimization problem, the model is also quite simple and user-friendly; Smith offers it in Excel. His approach fills a gap in earlier models and scenarios analysis. Enhanced recovery of oil and gas today is an extremely significant element of the latest oil and gas development environment, which earlier models lack. Smith’s model incorporates tax impacts on both primary and enhanced recovery. New technology has allowed for a doubling of resource extraction compared to even a decade ago. "The techniques of primary recovery  — drilling in the optimal location, and the pressure of the well that drives recovery — has historically recovered a third of the oil in place," Smith explains. "By injecting fluids and other recovery methods and other innovative technologies like horizontal drilling, you almost double the recovery. If you think the government is getting a third of the recovery, they are now getting twice as much. That's a lot of incremental value, but it won't be recovered if there is not an incentive for private investors."

Primary investment is easy, Smith notes. "Secondary recovery is very dependent upon technologies and the information about the underlying resource reservoir such as the physics or the properties mapping out the heterogeneity of the deposit," he says. "It is not an easy task; much of this decision is dependent upon how heavy handed the taxation is, but light-handed taxation leaves the money on the wrong side of the table."

The research begins by showing the optimal extraction rate versus the timing of transition to EOR operations for the benchmark field, illustrating how each of the tax regimes influences it. The research covers nine different types of tax policies used by governments, from royalties to production sharing contracts to resource rent regimes. Smith finds that under all fiscal regimes, the availability of more effective EOR technology tends to reduce the initial rate of extraction but accelerate the transition to enhanced recovery operations; more of the resource is left for the later enhanced recovery phase.

Smith relayed that the resource rent tax system allows for a more optimal development of resources. "The resource rent system (RRT) clearly does the best job with resource development. It is also one of the most innovative and recent forms of tax regime." According to Smith, this methodology came along in last 25 years, both pioneered and used in Australia. It is not universally used however; production sharing regimes and contracts are the dominant form of tax system applied. In this style of system, the investor recovers the costs of what is produced, and the rest is considered 'profit oil' where government receives the additional profit oil proceeds and the investor might share, likely on a sliding scale. Often this is skewed to the government's benefit.

All extraction is not equal
The research offers insight into drilling unconventional resources like oil sands, deepwater and Arctic resources. Also important is the diligence with which the investor carries out the plans. "If a firm is licensed with the rights to produce a resource, the government wants it to be produced, not sit on it and wait for prices to rise," explains Smith. "High cost resources are vulnerable to this diligence problem, and a careless application of taxes would cause investors to delay although the government wants to proceed." Smith cites disputes between government and investors that are not working fast enough in Iraq, Russia, China, and Latin America.  Argentina recently nationalized YPF, the largest oil player in the country. This conflict happens with high-cost deposits that have thin profit margins. "If they had a high profit margin, investors would jump in today," concludes Smith. "As margins begin to become narrower, the subtlety of a tax system can create a wedge that pits government and investor against each other in terms of most favorable development time."

Iraqi oil fields are considered a last frontier, according to Smith. "They are giant oil fields which are easy to produce, unlike deepwater or Arctic resources. The fields are literally below your feet." The Iraqi government uses a services contract, which is very stringent, without private participation on excess resource recovery.  Smith characterizes potential reserves in Africa " as being in a different league in terms of the potential oil reserves to be developed, particularly offshore. The resource potential is big (though not the Middle East) but much of it located in deep water, which is expensive and risky."

When considering future growth, Smith says the market "is well supplied but there will be greater demand." We will be looking to all types of supply and different sources or substitutes. When asked about Arctic development, he notes, "The operational and technical requirements are different there. If an iceberg comes along, the firm must disengage drilling equipment, and move off location, and then move back on with numerous challenges. There are tighter windows to even produce; then there is the environmental question. Plans take longer to be approved. Society has to understand it is going to be very expensive to use those resources. If there is something cheaper, let's use those instead."
Importantly this model is a practical, working model to find the best type of fiscal regime to develop natural resources. Smith makes a significant advance with his contributions toward better resource utilization that can benefit emerging and developing economies, their citizens and resource markets.

The IMF working paper "Modeling the Impact of Taxes on Petroleum Exploration and Development" by James Smith, Cary M. Maguire Chair in Oil and Gas Management is available at: https://www.imf.org/external/pubs/cat/longres.aspx?sk=40122.0

See a literature review about earlier research in this field. http://www.imf.org/external/pubs/cat/longres.aspx?sk=40150.0

Written by Jennifer Warren.

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