FISCAL REGIME

The objective of host governments should be to design a fiscal regime that maximizes their 'Take' while ensuring that contractors are satisfied with the returns they receive from investing in high-risk exploration and oil projects. The return on investment should be sufficiently attractive to incentivize risk-taking, while also allowing the government to secure a significant portion of the profits.

Methods such as bonuses, royalties, profit oil, and taxes can be employed to extract rent. If the government seeks to avoid any risk, it may opt for a substantial signature bonus. Conversely, if the government is willing to assume some risk, it might prefer a profit-sharing and tax-based mechanism to extract rent.

Contractors generally disfavor paying bonuses and royalties as these are not tied to profits. Royalties and bonuses render the fiscal system regressive, meaning the lower the project profitability, the higher the government take. Conversely, a progressive regime implies that the government's take increases in proportion to the project's profitability. In a progressive scheme, taxes or levies that benefit the government are applied further downstream from gross revenues.

'Take' refers to the distribution of profits between the government and the Contractor, expressed as percentages. Contractor take is defined as the portion of the project profit that the Contractor is entitled to, specified as a percentage. Government take is the remaining portion of the project's profit after the Contractor take has been allocated. Together, the Government take and Contractor take constitute the total project profit.

A basic valuation of reserves can be made using the ‘take’ statistics. According to Daniel Johnston, proved, developed, producing (PDP) reserves are worth 50% to 66% of crude price multiplied by contractor take, assuming no major sunk costs for cost recovery. Proved, undeveloped (PUD) reserves are usually worth less than half of PDP reserves.

Governments aim to maximize economic rent from petroleum projects, although designing an equitable fiscal regime for both government and investors is challenging. Governments seek to maximize their take, boost the economy, and sustain exploration and development activities by attracting investments from private domestic and international firms. Oil companies aim to maximize profits by finding and producing oil and gas at the lowest cost. Thus, the fiscal system must allow fair returns to both parties without overburdening administrative processes.

A country's fiscal regime depends on geological prospects and investment risks. Riskier countries typically have less strict fiscal regimes, while those with high rewards impose tougher conditions. For example, Saudi Arabia's government take is very high at 90%, but the rich geological potential compensates investors for this harshness.

There are fundamentally two types of fiscal regimes: concessionary (also known as royalty/tax) and contractual. The primary distinction between these regimes is the ownership of mineral rights. All other fiscal regimes are variations of these two principal types.

Concessionary systems allow private ownership of mineral resources. Generally, the government (except in the USA where individuals own mineral rights) who owns the minerals under concessionary systems transfers its rights to the company receiving the license to operate. The company becomes the owner and pays royalties and taxes to the government for the right to exploit and own those minerals.

Under contractual systems, the government retains ownership of the minerals but grants licenses to oil companies to explore, develop, and produce petroleum resources on its behalf. The companies share the profit or production/revenues from the sale of oil and gas according to the PSC or Service Contract. This is similar to sharecropping; sharecroppers work on land they do not own, invest their time and money in producing crops, and share profits with the landowner. In most contractual systems, facilities built by the contractor oil company eventually become state property (excluding leased equipment).

Service contracts and Production Sharing Contracts (PSC, also called PSA for production sharing agreements) are examples of contractual fiscal regimes. The difference lies in whether the contractor receives compensation in cash or kind (crude). In a PSC, the contractor receives a share of production and takes title to the crude at the point of export.

In contrast, in service/risk service agreements, the contractor gets a share of profits, not production. Some service contracts allow contractors to purchase crude from the government at a discount, resulting in eventual title to some crude. Therefore, segregating fiscal regimes based on crude ownership may not be effective, as both concessionary and contractual systems can have similar economics depending on the design of the regime.