Rene Roger Tissot

Comments to Seminar Institute of the Americas

0.000

50.000

100.000

150.000

200.000

250.000

300.000

350.000

1989M1 1997M5 2005M9 2014M1

Inde

x Pr

ice

Period

Mineral and Energy Prices Index IMF

Minerals index price Energy Index price

https://www.imf.org/en/Research/commodity-prices

The end of commodity price super cycle: Short term impacts: (-) Growing fiscal deficits (-) Painful fiscal adjustment (-) Lower GDP growth (-) Delay in investments (-) Exchange rate depreciation, inflation (+) Lower/end of fuel subsidies (?) Political vulnerability? Transition of power? Repression?

https://www.imf.org/en/Research/commodity-prices

Extractive Industries Importance

Essential to the economies of at least 81 countries

Half of the world population

25% of the world’s GDP

69% of the world population living in extreme poverty are in countries dependent on E.I.

4

Source: https://www.worldbank.org/en/topic/extractiveindustries/overview

The Problem: It has not happened

• On average resource rich

countries grown at lower rate than resource poor

• & Tend to have lower Human Development Index

0

0.5

1

1.5

2

2.5

3

3.5

4

Resource poorlarge country

Resource poorsmall country

Resource richlarge country

Oil Exporter

Gro

wth

of G

DP p

er c

apita

PC GDP growth 1960-1990 PC GDP growth 1970-1993

5

Explaining The Resource Curse

• Economic analysis: Dutch disease

• Governance analysis: impact of rents on institutions. Weaken democracy. Impact varies by type of commodity

• Economic Geography analysis: Disconnect between resource and

society

6

• Nation wealth: • Natural capital • Produced capital • Human capital • Net Foreign Assets

• Economic development is strongly correlated to the composition of its wealth.

• Challenge of EI: • Recover a rent from private

operators • Invest in wealth creation assets

0.14

0.47 0.41

-0.02

0.28

0.03

0.7

-0.001

-0.2

0

0.2

0.4

0.6

0.8

1

Produced K Natural K Human K Net ForeignAssets

Wealth of nations by Type of Asset 2014 Low Income Countries High income OECD

Petroleum Value Chain

(10)

-

10

20

30

40

50

60

70

2020 2025 2030 2035 2040

Mill

ion

of b

arrle

s oil

equi

vale

nt

Oil Production Consumption Oil Exports

Depletion-led Development Transition Dependence

Unsustainable

Data adapted from http://openoil.net/public-interest-modeling-sprint-2016/

Based on Paul Stevens “Role of Oil and Gas in the Economic Development of the Global Economy”. Book: Extractive Industries, Addison & Roe

Economic Rent Landlord gains

Cost

Volume Q*

P*

Supply

Demand

Economic Rent

Economic Rent of Natural Resources

0

20

40

60

80

100

120

140

Russ

ia a

rtic

Euro

pe b

iodi

esel

Euro

pe e

than

ol

Cana

da sa

nd

Braz

il of

fsho

re

USA

sha

le

Braz

il et

hano

l

USA

dee

pwat

er

Ango

la o

ffsh

ore

Nig

eria

dee

pwat

er

Ecua

dor T

otal

Vene

zuel

a To

tal

Russ

ia o

nsho

re

Kaza

khst

an T

otal

Nig

eria

ons

hore

Om

an T

otal

Qat

ar T

otal

Iran

Tota

l

Alge

ria T

otal

UEA

Tot

al

Iraq

Tota

l

Saud

i Ara

bia

Tota

l

US$

/bar

rel

Marginal production cost US$ 2014

Marginal production cost Oil price

Profit for the government Profit for the company

Production costs Development costs Exploration costs

Rent

Cost: View of the government

Rent: Excess of revenues after all costs of production, discovery and development and a normal profit have been included

Source: https://knoema.com/vyronoe/cost-of-oil-production-by-country Source: Fiscal regimes for extractive industries: design and implementation IMF 2012

• Objective of a Petroleum Fiscal regime: Fair share…?

• There are no economic indicators defining fairness resulting in controversy.

• Economic theory has attempted to suggest an “optimal level of taxation”

Optimal Taxation Level, Laffer Curve

Tax Rate %

Low High

Tax Collection $

Optimal Tax

Laffer curve from the Right

Laffer curve from the Left

Critical issues of Extractive Resource Taxation

• Size of rents • High level of uncertainty • Asymmetric information • High sunk costs=> inconsistency

problem • Role of MNC and SOE • Market power • Exhaustibility

The Challenge of a Good Tax System

Different objectives

• Maximize NPV and rent capture

• Other objectives: • Energy security • National sovereignty • Industrialization • Income distribution • Geopolitical influence • Social development

• Diversity objectives=> contradictory policies?

• Maximize value of shareholders

• Increase reserves (book reserves)

• Substitute produced reserves Positive cash flows

• Strategic opportunities for future growth

• Portfolio diversification • Stakeholders wellbeing?

Government Oil Corporation

• Strategic Choices: • Go alone • Private

ownership • State/NOC and

IOC cooperation.

Source: Paul Stevens A Methodology for assessing the performance of national oil companies

18

Price $50 Production: 10 Mill b Total Revenue $50*10= $500 Capex $150 Opex $100 Profit Split $500-($150+$100)= $250 Assumption: Payments to the government (bonus, royalties, taxes) =$150 Profit: $250-$150=$100 Government Take:$150/$250= 60% Corporate Take 40% If Corporate Take ↑ when profits ↑ => Progressive model If Corporate Take ↓ when profits ↑=> Regressive model

Profit Split

CAPEX

OPEX

Fiscal Models

19

Royalty/Tax Systems

Contractual Based

Systems

Service Agreements

Production Sharing

Contracts

Pure Service Hybrids Gross

Production Profit oil Risk Service

Source: Daniel Johnston International Exploration Economics, Risk and Contract Analysis. 2003

Regressive Neutral Progressive Pay at the beginning Pay with production

Licence Exploration Development Production Abandonment

Bonus Royalty Taxon imports, VAT

Impact on investment

Income tax

Production Bonus

Government share

Caps on cost of oil

Resource Tax

Production starts

Fiscal Regimes: Regressive vs Progressive

$

t Regressive

It is paid before the company knows if it can recuperate capital invested.

Progressive

Government and Company share the risk

Concessions Royalty/Tax

• Exclusive right to exploit the resource

• Old concession used to control large areas.

• Modern concessions: smaller areas, shorter period of time, relinquishments, and specific working programs.

• Company assumes exploratory and development risks

• “In situ” oil is property of the state, but property of oil at the wellhead is transferred to the company.

• Assets of the company in the concessions is transferred to the government when project ends.

• Company is responsible of the abandonment costs and environmental restauration.

21

Share

$ Gob. IOC

Revenues 20

Royalty 12.5% 2.5 2.5

Income 17.5

Deductions (capex,opex) 5.65 5.65

Taxable Income 11.85

Special petroleum tax 25%

2.96

Income Tax 35% 3.11

Net Income After Tax 5.78 5.78

Division gross revenues 8.57 11.43

Take 8.57/(20-5.65)=60%

(5.78/(20-5.65)=40%

Daniel Johnston, “International Exploration Economics, Risk and Contract Analysis

Royalties • Royalties are an attractive mechanism to capture rents as revenue is received as soon as

production starts. They are also easy to administrate • Royalties ensure companies make a minimum payment • However raise the marginal cost of extracting oil=>can deter investors if they are too high, or

reduce development of “marginal fields” • Royalties are a regressive form of capturing rent=> They are based on gross revenues • Royalties can also lead to premature termination of production=> deter from more complex

forms of production (EOR, etc) • They are usually calculated over volume produced or”ad valorem”=>value of the oil extracted

(F.O.B. export price netting back costs) • Royalty payments are only a deductible expense in determining taxable income in the home

country and are not allowed as a foreign tax credit against the home country’s tax credit

Income Tax • Income tax is another form of capturing revenue from oil E&P. • Countries often provide incentive to E&P by allowing exploration costs to be

recovered immediately and allowing accelerated recovery of development costs • Accelerated costs recovery=>reduces investor payback time=> reduces investment

risk • To protect tax base countries may place limits on use of debt=> avoid “earning

stripping” through payment of interest abroad • To avoid transfer pricing between companies=>tax authority should have the power

to adjust income and expenses where under or overpricing between related companies resulted n lowering taxable profit

• Ring-fencing=>limitations on consolidation of income and deductions for tax purposes across different activities or projects. Some countries ring-fence individual contracts, others overall oil and gas activities. Companies may want trough transfer pricing shift profits from more profitable activities to less ones impacting the country’s tax base

• As projects mature, absence of ring-fencing discriminates against new entrants which have no income to deduct E&P expenditures

Resource tax • Resource tax attempts to provide the government with an

appropriate economic rent while minimizing distortion for investors

• Resource tax applies only if accumulated cash flow from the project is positive

• Early negative cash flows are accumulated at an interest rate (company’s opportunity cost of capital)

• Resource tax require each project to be ringfenced • Intellectually the resource tax is an attractive option but it is not

very common.=> • Difficulty to design=.what discount rate to use? If rate is too high there will

be no resource tax revenue, if it is too low the tax will deter investors • It could produce perverse incentives for for companies to avoid tax

payments • Difficult to administer and control

• Bonus payments

• Ring fencing/consolidation

Consolidacion

Ring Fencing

Contractual Regimes

• PSA

• Service Contracts

PSA

• Assume average full time cost (Opex, Capex) is $5.65

• Royalty come at the top

• Before sharing production the operator is allowed to recover costs of net revenues.

• The contract may place an upper limit on how much costs a company can deduct. In this example 50% of total costs.

• P/O Split: Revenues remaining after royalty and Cost Recovery are referred to as Profit Split. At this level the income is not taxable because the operator does not own the production yet.

Share

$ Gob. IOC

Revenues 20

Royalty 10% 2 2

Income 18

Cost Recovery Limit 50%

5.65 (assumed costs)

Profit Oil split 40% cont/60%gov

12.35 7.41 4.94

Income tax 30% 1.48 (1.48)

Net Income 3.46

Share 10.89 3.46

Division gross revenues

(2+7.41+1.48) =10.89

(5.65+4.94-1.48) =9.11

Government Take 10.89/(20-5.65)=76%

=3.46/(20-5.65)=24%

Service Agreements • Under a S.A. the government hires the company to perform

exploration and/or production services within a specified area for a specific period of time

• Companies are compensated by a fixed or variable fee. • The government maintains ownership of the petroleum all the time,

whether “in situ” or produced • The company does not acquire any right over petroleum, except if the

contract stipulates that fees can be paid “in kind” or grant a preferential right to purchase a share of the production from the government

Other taxes • Indirect taxes=> Often indirect taxes are ignored in the analysis

of petroleum policies but play an important role in the fiscal regime

• In theory, the sector should be treated equally to any other economic activity but often in this area oil investment are treated differently

• Import duties=> due to the K intensity of the investments, often oil companies are exempted from import duties

• VAT=> Usually a very important source of fiscal revenues for developing countries, it is very complex to administer in the case of oil activities=>very large sums paid and then reimbursed. It is easier to grant an exceptions

• Export duties=>Often aimed at taxing windfall gains, to substitute income taxes

Other sources of income/control • Local content requirements

• Company must acquire in the local market a % of its procurement.

• A % of the company workforce must be local

• Sales to the domestic market • Company must sale a % of its production to the domestic

market at prices set by the government (often below international market prices)

• Technology transfer • Company must develop training program for local workforce • Company transfers all assets at the end of the project to the

government

Transfer pricing

• Transfer price mechanism affect revenue in oil/gas activities: • Creative use of price hedging by firms involving transactions between

related parties • Above market interest rates or highly leveraged debt financing • Excessive management fees, deductions from or consultancy costs • Domestic shell firms lending capital => interest deductions

Fiscal Stabilization Clauses

• Drivers of Fiscal Instability • Why companies want FSC? • Stabilization mechanisms

• Classical: Freezing clauses • Modern • Limited freezing • Economic Equliibrium • Hybrid

• Classical out of favor • Modern: Difficult to administer, complex

Importance of Institutions:

• Quality of institutions matter in the design and effectiveness of petroleum fiscal policy.

• Latin America has a large diversity of fiscal regimes reflecting differences in governance, political preferences, and geological characteristics.

• If the government decides to exploit the resource two key strategic options:

• Revenue focused approach

• Value creation approach

The central difference between the Revenue-focused and ICV-focused approaches lies in the fact that the latter sacrifices short-term value with the aim of achieving greater development in the long run.

Local Content Policy: Local content is the extra value that an extraction project brings to the local, regional or national economy beyond the resource revenues, achieved by leveraging on the extractive value chain.” (The Natural Resource Governance Institute, 2015) Drivers for local content requirements:

• Increase Value Added through • Economic Diversification • Discovery of new products

• Correct Market Failures • Speed Learning curve • Capture productive externalities • Infant industry

Extractive Transparency Industry Initiative

Governance model: “collaborative” Started by Western countries and their civil society: voters and customers Membership voluntarily

Governments

Civil Society EI Enterprises

36

Extractive Transparency Industry Initiative

Companies report payments made to governments Governments report payments received from companies Standards and Verification process

37

EI firms disclose

payments

Government discloses receipt of

revenues

Independent Administration

Reconciles payments

Oversight by Multi-stakeholder group

EITI Country Report

Extractive Transparency Industry Initiative

• Benefits • Governments: signal good governance, reduce country risk Enterprises: Good corporate social responsibility, Level the playing field

38

Limitations of EITI

Focus on revenues and not on expenditures

Narrow definition of payments.

Avoided put blame on EI firms or western countries

Ignored firms Tax evasion efforts (Transfer payments)

The key problem:

Weak civil society in resource rich countries => Transparency without accountability

39

Transparency is a necessary but an insufficient condition to avoid the resource curse in resource rich countries Post-globalization world: Global governance fatigue How to strengthen local civil society?