Introduction
To round off my evaluation of Guyana’s emergent oil and gas sector in its very first year, I shall report in coming columns on the Inter-American Development Bank’s (IDB) Technical Note, IDB-TN-1994, published August, 2020 and entitled, ‘Traversing a Slippery Slope: Guyana’s Oil Opportunity.’ The Note’s Abstract states that it has four areas of focus: 1) the country context; 2) the petroleum sector’s fiscal mechanism and projected revenues; 3) hurdles to constructing an effective governance regime for the sector; and 4) “new” policy perspectives on oil revenues utilization for sustainable development.
I encourage all readers to peruse this well constructed Note closely for themselves. My focus here is principally on item 2 listed above, as this is the area of my Sunday columns immediate concern for assessing the impact of the 2020 general crisis on Guyana’s emergent petroleum sector. Today I report on the fiscal mechanism; and, in the coming columns, I report on the Note’s modeling of prospective Government Take (revenues).
I report on the fiscal mechanism following the sequence in the report; namely, the legal framework; royalties; cost recovery; profit sharing; ring fencing; and, taxation.
Framework
The report locates the fiscal mechanism of current PSAs in the laws of the 1980s; particularly the Petroleum (Exploration and Production) Act, 1986. This was enacted at a time when risk and uncertainty flourished; and therefore, attracting investors was the foremost concern. As the Note observes, laws and regulations were framed in highly discretionary terms, leaving applicable fiscal imposts to be defined in specific PSAs or effectively on, a case- by- case basis. Not surprisingly, the legal framework’s primary focus is on exploration and development activities.
Since then, Guyana’s hydrocarbons have been largely de-risked and the Note consequently recommends that “the authorities should consider reforming and modernizing the legal and fiscal framework of new investments in the sector.” This is in my view a non-contentious recommendation. However, based on the Nobel Prize winning economic theory of incomplete contracts, I have argued earlier in these columns that the reforming/ modernizing pressures are indeed endemic to all PSAs; and arise, independent of the public postures of Parties to a given PSA. This outcome requires that the Parties continue to rationally pursue their differing goals and objectives.
Royalties
Readers are aware a royalty rate of 2% ad valorem is applied in the Stabroek PSA. This percentage though varies across PSAs. The royalty rate is levied on “the gross value of all oil and gas produced and saved from the contract area.” The Note supports the view that 2% is quite modest; with its main advantage being that it provides an early dependable source of Government Revenue.
The Note supports the line of reasoning that argues oil and gas royalties are insensitive to cost of production and profitability. Indeed, they operate as implicit depletion policies because they raise the marginal cost of output and, therefore, reduce the array of feasible projects! Guyana’s comparatively low royalty rate, however, minimizes these inhibiting effects.
Cost recovery
As readers are aware, the cost recovery limit under the Stabroek PSA is 75%. And, the profit oil left to be distributed when this limit is reached is 25%, which is then split 50/50, or 12.5% each. If recoverable cost does not reach this limit, then the profit oil left to be split 50/50 increases. Of note, if the 2% royalty discussed in the previous section is added the combination yields 14.5%, whenever the recoverable cost limit applies.
The IDB Note observes that exploration and development costs can be fully expensed for cost recovery. And, “if cost oil is less than recoverable costs in a given period unrecovered costs can be carried forward without interest … or limitation.” The Note further directs readers to Annexes in the various PSAs which provide the applicable cost recovery rules particularly for depreciation, services provided by affiliates and financing costs.
Special attention is paid to the treatment of interest expenses, which as the Note indicates favours the contractors and risks the abusive use of debt and therefore, loss of Government Take. It is general practice for PSAs to disallow or cap interest expenses but the Stabroek PSA permits these to be recovered if they are consistent with market rates. There is clearly scope for contract improvement in this area that is aligned with widespread accounting practice.
Profit
The Stabroek PSA’s fixed 50/50 profit split is atypical in the sense that it is insensitive to changing profitability in the sector. As the Note observes, typically, PSAs profit split is based on formulae that are responsive to some combination of prices, production, productivity, revenues and costs. Moreover, governments’ share is also greater, reaching as high as 80% to 90%.
Such arrangements befit a risky frontier investment play. Today, however, they are somewhat anomalous, principally because since then with 10 billion barrels of oil equivalent, Guyana’s hydrocarbons sector has been effectively de-risked. However, the 2020 general crisis (particularly its pandemic dimension) has plunged the global oil and gas industry into a downward spiraling struggle for markets and investment flows. In light of this, my recommendation is that Guyana should play smart and avoid at this juncture placing unintended constraints on any of its prevailing sources of competitive advantage.
Ring fencing
Simply put, the main concern is that the Stabroek PSA shares profit oil on a field-by field basis over the contract area, while simultaneously permitting the contractor to allocate cost oil in the PSA contract area to any field! This asymmetric feature is highlighted in the Note, as it can result in lowering Government Take obtained from contractors with several fields and differing development phases, like Stabroek itself.
Taxation
This section treats with the Stabroek PSA permitting government’s profit oil/gas to cater for the contractor’s income tax obligations in its pay-on-behalf mechanism. It ring-fences the contract area for this purpose thereby offering fiscal stability and perhaps dis-incentivizing income tax evasion and avoidance. In truth however, such an outcome is really contingent on the quality of financial governance.
Conclusion
Next week, I conclude discussion of the fiscal mechanism and move on to address the IDB estimate of Government Take.
