Source: Lebanese Center for Policy Studies
Executive Summary
Markets largely dictate how the relationship between international oil companies and host states will play out, with governments attempting to ensure they receive a ‘fair share’ of petroleum revenues. But with no clear definition of what a fair share is, particularly in relation to changes in oil prices, the perception of a fair share remains under near constant review. This results in a pendulum effect, whereby changing market conditions can place either governments or companies in more advantageous positions in negotiations. In terms of policy-making by the Lebanese government, these dynamics suggest that existing market conditions should be taken into consideration when launching the country’s first licensing round but this does not necessarily mean that the government should wait for oil prices to recover to pre-2014 levels, as that might take a while to happen. The fiscal regime should be internationally competitive and balanced.
Introduction
The relationship between host governments and companies—the two key stakeholders in the oil and gas sector—is rarely static. It alternates between sweet and sour depending on several factors. Chief among them is the price of oil, which is the most obvious trigger behind a modification of the upstream fiscal regime that defines that relationship. According to Stevens et al (2013), more than thirty countries revised their petroleum contracts or entire fiscal regimes between 1999 and 2010—a period which witnessed major oil price changes.At its simplest, governments most of all want a fair share of the proceeds from the exploitation of a nation’s oil and gas resources, hand in hand with commitments from investors to invest in exploration and development of an indigenous resource. Around the world, the concept of a ‘fair share’ is imbedded in governments’ objectives in relation to the sector, with the fiscal regime being the means to secure that share. The UK government’s objective is ‘to obtain a fair share of the net income from those resources for the nation, primarily through taxation’. In Liberia, ‘the fiscal regime shall create incentives for responsible investors while providing a fair and equitable return to’ the country.
There is no clear definition of what represents a fair share and it is seldom that both government and industry agree for long about whether a fiscal regime is fair or not
In practice, however, achieving that objective is rarely simple. There is no clear definition of what represents a fair share and it is seldom that both government and industry agree for long about whether a fiscal regime is fair or not. The dynamics of oil price volatility ensure that views of what constitutes a fair share constantly change. While a government take—the total share of government revenues from a project’s net cash flows—of 50% to 60% might be acceptable with oil prices at $60 per barrel (/bl), it is unlikely to be the view when the oil price shoots up above $100/bl. Consequently, the issue is controversial and governments keep the question of a fair share under almost constant review.
This brief will unpack these concepts by first reviewing changes in government policy vis-à-vis changes in the oil market. It will then explore the cycle with which states had discouraged private investment and then tried to entice oil companies to invest, depending on the oil price. It then discusses additional factors that should be taken into consideration along with the oil price. The brief concludes with the implications for Lebanon, specifically with respect to the country’s first licensing round and how the government should design its fiscal regime considering the current state of the oil market.
Notable Trend
High oil prices have typically led to higher taxes, contract renegotiations, tougher regulations, and in extreme cases expropriation and nationalization as host governments demand a bigger share of the perceived higher profitability of the industry. Such developments are often notable in countries where the fiscal regime does not automatically capture additional rents accruing from higher prices.
High oil prices have typically led to higher taxes, contract renegotiations, tougher regulations, and in extreme cases expropriation and nationalization ...
From 2002 to 2008, oil prices were on an upward trend, rising from $26 to $100/bl over that period (figure 1). In parallel, in Angola, Argentina, China, Ecuador, India, Kazakhstan, Libya, Nigeria, and the United States (Alaska), governments tightened the fiscal regime that applies to oil and gas, on the grounds that they were not receiving their fair share of the increasing profitability from the sector. According to The Economist (2007), the then surge in oil and gas prices presented a shift in the global balance of power away from companies to host governments. Consultancy firm Wood Mackenzie (2008) described those developments as the ‘fiscal storm’.
The reaction across oil producing countries varied from straightforward increases in existing tax rates, to the application of new taxes and increasing the share of national oil companies, to the expropriation of assets. All these measures fall under the umbrella of ‘resource nationalism’, albeit of differing degrees. Resource nationalism refers to government interventions, either through the direct exercise of discretionary powers or ownership of a natural resource, theoretically to increase the benefit of a nation as a whole.
The UK government, for instance, increased the rate of one of its oil tax instruments—the Supplementary Charge Tax (SCT)—from 10% to 20% in 2006, and then again to 32% in 2011. In 2006, Algeria introduced a new hydrocarbons law that imposed a new windfall tax of up to 50% on profits when oil prices top $30/bl and fixed the rate of participation of Sonatrach to a minimum rate of 51%. Algeria also enacted additional foreign investment rules in 2009 and 2010, further restricting imports and foreign investment. In an extreme case, in 2007, the government of Venezuela replaced all the then-existing terms with new contracts and imposed a majority equity share of 60% for its national company, PDVSA. In this case, late Venezuelan President Hugo Chavez confronted the industry with an ‘accept it or leave it’ offer. Companies like ExxonMobil resorted to the international arbitration court to resolve the matter.
Cyclical Policy
According to Clarke and Cummins (2012), resource nationalism is perceived as cyclical. When oil prices decline, companies are enticed to return to states which had sought to discourage private investment.
The subsequent dramatic fall in oil prices during the financial crisis in 2008, combined with funding restrictions, generated different reactions in some oilproducing countries and raised companies’ hopes for more attractive terms. Former CEO of BG Frank Chapman stated in 2009 that resource nationalism was on the decline, arguing that ‘governments the world over now need investment more than ever… They know capital is in short supply the world over, they know they are competing with other countries for capital, and they know the value investors place on stability and sanctity of contracts’ (Ward 2009, 33). Indeed some countries relaxed their fiscal terms. Even in Venezuela, officials began soliciting bids from Western oil companies, promising them access to some of the world’s largest petroleum reserves.
... resource nationalism is perceived as cyclical. When oil prices decline, companies are enticed to return to states which had sought to discourage private investment
The industry’s hope for better terms was, however, short lived. As oil prices recovered in 2010 and continued to increase, the Financial Times published an article in 2012 entitled ‘2012: the year of resource nationalism?’, questioning whether 2012 would be the year host governments move toward securing greater rewards from their oil and gas sector. This was triggered by the decision of then Argentinian President Cristina Fernández de Kirchner to nationalize YPF, an oil company owned by Spain’s Repsol, justifying her actions as a victory for ‘energy sovereignty’ (The Economist 2013).
Since summer 2014, the global oil market has entered a new phase—a period of low oil prices, which fell from highs of $100/bl to less than $40/bl. This has, once again, raised the question of whether petroleum fiscal policy will enter a phase of leniency. According to Ernst & Young (2015), ‘over the last decade, and especially in the last five years, governments of exporting countries around the world have gradually introduced or adjusted their fiscal regimes to capitalize on the high oil price environment. The dramatic oil price drop exposed the vulnerabilities of many of these tax structures and is forcing jurisdictions to focus on revising them.’
Swinging Pendulum
The price level plays a significant role in determining the degree of bargaining power each party has at the negotiating table. Typically, when oil prices are high, governments have the upper hand. When the price moves in the opposite direction, the pendulum swings in favor of companies. That said, the reaction to falling prices is not as visible as the impact of higher prices; it tends to be slower and more erratic. In general, during periods of low oil prices there is a limited scope for higher taxation but a reversal of opportunistic tax increases may be necessary to ensure that a competitive fiscal regime remains in place. However, it can take many years for a country to reverse fiscal policies in order to attract new investment (Nakhle 2010). The fall in oil prices since mid-2014 has pushed some governments to go in the opposite direction. This is, however, most notable in countries which have been struggling to increase production and attract investment, and/or that rushed to significantly tighten their fiscal terms and limit foreign oil companies’ access to their oil reserves during periods of high oil prices. Low oil prices exacerbate an already dire situation and prompt anxious governments to implement drastic measures to stop conditions from worsening further.
Typically, when oil prices are high, governments have the upper hand. When the price moves in the opposite direction, the pendulum swings in favor of companies
Kazakhstan recently reduced its tax on exports of oil. Brazil put a new oil royalty on hold while the Canadian province of Alberta decided not to raise its royalty rate (The Economist 2016). Colombia introduced fiscal incentives for new developments (Kellas 2015). In the North Sea—a mature province where production peaked and has been on a declining trend and where costs are high—the impact of low oil prices is most visible. In 2015 and 2016, the UK government announced several measures in an attempt to compensate for shrinking profitability, including a permanent reduction in one of the tax instruments—the so-called Petroleum Revenue Tax (PRT) from 35% to 0%—and a reduction in the SCT from 20% to 10%, a U-turn on the policy introduced ten years ago. By the same token, in its 2016 budget, the Norwegian government proposed a reduction in the corporate income tax rate by 2% to 25%. However, in order to safeguard the stability of the fiscal regime, which is of paramount importance to Norway, the government announced a corresponding increase of the Special Petroleum Tax rate by 2% to 53%. Interestingly, although they share the same sea, the UK and Norway have followed disparate policies; the UK fiscal regime has been revised repeatedly since the beginning of oil operations in the province, while the Norwegian system is one of the most stable regimes in the world.
Opposite Reaction
These changes, however, do not necessarily mean companies are going to see ‘a race to the bottom’. Some countries have resisted relaxing their fiscal terms; others are even going in the opposite direction. This is usually the case in countries where opposition to private ownership of oil is particularly pronounced, meaning companies are unlikely to expect any sympathy, and in fact could be blamed for shrinking public finances. Also, in countries where governments are highly dependent on oil and gas revenues and therefore feel cash poor when oil prices are low, there may be demand for higher tax rates (Kellas 2015). Russia is one example. Short of cash, the government announced in January 2016 that the tax breaks many fields enjoy would be cancelled.
Tightening the fiscal regime during periods of low oil prices is a rather short-sighted policy focused on maximizing short-term revenues. But it can, and often does, backfire
Tightening the fiscal regime during periods of low oil prices is a rather short-sighted policy focused on maximizing short-term revenues. But it can, and often does, backfire. The impact of such changes on production and investment can materialize later, as often there is a lag between the change in fiscal terms and their subsequent impact in the longer term. As such, even when oil prices recover, countries where policies have not fostered private investments are unlikely to benefit from the investment boom that typically accompanies high oil prices. Such governments may even be forced to soften their stance and offer concessions, even during periods of high prices.
As a consequence of its unattractive fiscal policy during the last decade, Algeria had no other choice but to relax its fiscal regime despite the high price of oil. In 2013, the Algerian government revised its hydrocarbon law and provided additional tax incentives to encourage activities related to shale and other unconventional oil and gas, as well as to those involving small fields; deposits in underexplored areas, including offshore fields; and fields with complex geology and/or those lacking infrastructure.
... a country with high prospectivity and a large reserve base is in a stronger position than a country where the geological risk remains high
According to Kellas (2015), the impact of fiscal changes is largely visible through exploration, which is ‘the most discretionary area of company spending and one of the first areas to be cut back when times are tough—it is also where the competitiveness of fiscal terms has the greatest impact’. This is particularly true if production contracts include stabilization mechanisms, which come in different forms, but their main objective is to lock in fiscal terms for the duration of a project and guarantee that the fiscal terms will not be altered during the project’s life cycle. Contractual stabilization mechanisms therefore secure, for investors, the basis on which investment decisions are originally made (Mansour and Nakhle 2016).
A tightening of the fiscal terms during periods of low oil prices will put additional pressure on companies to revise and even cancel some of their capital expenditure plans. The decline in the price of oil since summer 2014 has led to more than $380 billion in capital spending cuts on sixty-eight existing oil and gas development costs worldwide (Ausick 2016). In such an environment companies therefore become more selective in terms of where to allocate their limited financial resources. In this respect, low oil prices give oil companies stronger bargaining power at the negotiating table.
Additional Factors
Of course, any generalization should be treated with caution. While the oil price is the principal driver behind governments changing heart, it has to be considered in line with other important factors.
For instance, a country with high prospectivity and a large reserve base is in a stronger position than a country where the geological risk remains high.
Similarly, the availability of infrastructure (or lack of it) will encourage (or discourage) investors. For instance, Cyprus has almost no infrastructure for the exploitation of existing and potential discoveries. Consequently, the exploration activity level remains rather modest in the island’s waters compared to Egypt, where exploration activity has remained relatively strong.
Today, Lebanon is in a weaker position than it was a few years ago or as compared to its neighbors
The power and financial health of a national oil company will also determine whether the government will adopt a more welcoming attitude toward investors. A major energy reform was passed by the Mexican government in December 2013. The reform changed the constitution which, for seventy-five years, prohibited private investment in the oil sector since Mexico’s President Lazaro Cardenas nationalized the industry in 1938. The new reform ended the monopoly of the heavily indebted state oil company, Petroleos Mexicanos (Pemex), which had the exclusive right to explore, produce, refine, and process oil and gas.
Also, one must consider the way a petroleum fiscal regime is designed. Profit-based regimes typically adjust automatically to changing circumstances including variation in oil prices. Such regimes are called progressive because they vary in tandem with projects’ profitability, unlike regimes which are largely revenue based. Also, under contractual arrangements— whether a production sharing agreement or even more so a service agreement— the government is more exposed to the oil price risk compared to concessionary regimes where companies take the full price risk.
Iraq, for example, uses service agreements whereby the contractor receives a fixed remuneration fee on barrels produced—the service fee—which is a maximum of $2/bl, irrespective of what the oil price is, for contracts signed during the first two tenders in 2009 and 2010. From the government’s perspective, such contracts are a mixed blessing. On the one hand they generate more than a 90% share of a project’s value going to the government. On the other hand, they fully expose the government to the oil price risk, which is most visible when prices fall. This is particularly notable in a country like Iraq where dependence on oil is among the highest in the region, with the sector providing more than 90% of government and export revenues. Following the fall in the oil price, the Iraqi Ministry of Oil revised the terms of some contracts in an attempt to soften the financial burden on government finances.
Implications for Lebanon
The above ‘tour du monde’ shows that the oil price level plays a significant role in determining the bargaining power host governments and companies have.
Today, Lebanon is in a weaker position than it was a few years ago or as compared to its neighbors. The lack of any discoveries, absence of infrastructure, political stalemate, delay in decision making, and security risk—all of which were present before the oil price collapsed—translate more unfavorably in a low oil price environment from the government’s perspective. Such a reality should be taken into consideration when launching the country’s first licensing round.
Chasing the price of oil is a burdensome and inefficient strategy as oil is an internationally traded commodity where short-term price volatility has been the norm and is likely to remain so
This, however, does not necessarily mean that the government should wait for oil prices to recover as that might take a while to happen. But it emphasizes the importance of the fiscal regime design. Lebanon’s fiscal regime should be internationally competitive and balanced in a way that provides sufficient incentivesfor companiesto satisfy their risk-reward requirement without putting the government at a disadvantage when oil prices increase. A progressive regime can achieve these aims especially since it can adjust automatically to changing circumstances. Chasing the price of oil is a burdensome and inefficient strategy as oil is an internationally traded commodity where short-term price volatility has been the norm and is likely to remain so.
Authored References
Ausick, P. 2016. ‘Which Oil Companies Are Cutting Capex Most?’ 24/7 WallSt., January 14.
Clarke, M., and T. Cummins. 2012. ‘Resource Nationalism: A Gathering Storm?’ International Energy Law Review, Issue 6.
Kellas, G. 2015. ‘Do Lower Oil Prices Lead To Lower Oil Tax Rates?’ Wood Mackenzie, 8 December.
Mansour, M., and C. Nakhle. 2016. ‘Fiscal Stabilization in Oil and Gas Contracts: Evidence and Implications.’ Oxford Institute for Energy Studies, January
Nakhle, C. 2010. ‘Petroleum Fiscal Regimes: Evolution and Challenges’, in Philip Daniel, Michael Keen and Charles McPherson (eds), The Taxation of Petroleum and Minerals: Principles, Problems and Practice. IMF, Washington.
Papchenkova M., and D. Pinchuk. 2016. ‘Russian Finance Ministry Readies for Fight with Big Oil over Tax.’ Reuters, 29 January.
Minto, R. 2012. ‘2012: The Year of Resource Nationalism?’ Financial Times, 18 January.
Stevens, P., J. Kooroshy, G. Lahn, and B. Lee. 2013. ‘Conflict and Coexistence in the Extractive Industries.’ Chatham House.
Ward, H. 2009. ‘Resource Nationalism and Sustainable Development: a Primer and Key Issues.’ Working Paper, iied.
Non-authored References
‘Barking Louder, Biting Less.’ 2007. The Economist, 8 March.
Energy Information Administration (EIA) www.eia.gov.
Ernst & Young. 2015. ‘Global oil and gas tax guide 2015’, EY http://www.ey.com/GL/en/Industries/Oil---Gas/EY-2015-global-oil-andgastax-guide.
‘Flogging a Dead Cow.’ 2013. The Economist, 27 July
HM Treasury. 2014. ‘Review of the oil and gas fiscal regime: Call for evidence,' UK.GOV.
KPMG. 2015. ‘Norway: Budget 2016, petroleum tax proposals, interest deduction rules Norway: Budget 2016, Petroleum tax, Interest Deduction.’ 8 October.
‘Oiling the Wheels.’ 2016. The Economist, March 19.
Republic Of Liberia. 2012. ‘National Petroleum Policy.’
Wood Mackenzie. 2008. ‘Fiscal Storms Perspective.’ May.
This article was originally published by the Lebanese Center for Policy Studies.