By Blessing James Laburta
member countries to cease control of the petroleum industry from the IOCs and vest same in the NOCs; with very limited participation rights granted to IOCs . Statistics have shown that NOCs account for 25 out of the 50 best oil companies in the world . More so, the control of 90% of global petroleum reserves and more than 70% of petroleum production worldwide are traced to NOCs .Table 1 below gives a summary of SP in PPCs :
Source: Charles Mcpherson: State Participation in the Natural Resource Sectors: Evolution, Issues and Outlook.
KEY:
* : Countries with potentially large, medium and long-term petroleum revenue
CI : Carried Interest
WI : Working or Paying Interest
F : Free Equity
* : Countries with potentially large, medium and long-term petroleum revenue
CI : Carried Interest
WI : Working or Paying Interest
F : Free Equity
TYPES OF STATE PARTICIPATION IN PETROLEUM OPERATIONS
There are various forms of SP in petroleum operations. The rationale for adopting a particular form of SP by each country depends on its unique circumstances. However, each form of SP has a tax equivalent which has been argued as achieving the desired result of SP in petroleum operations (fiscal equivalent argument). The forms of SP adopted by PPCs include:
i) EQUITY FOR CASH ON PRIVATE INVESTOR TERMS
This is also referred to as working interest participation. Here, the State acquires equity on the same basis as any other private investor in a Joint Venture (JV).Such equity is acquired either by a pro rata contribution to exploration, development and operating expenditures, consequently levying on the State the same cost as other JV partners or the State joining the JV at a later stage, upon the payment of a premium to the other partners as a compensation for the risk earlier incurred . SP in this form has similar features to a Brown Tax (BT).Countries which have exercised this option include Venezuela, Columbia, Kyrgyzstan, Norway and Ghana .
ii) PAID EQUITY ON CONCESSIONAL TERMS
SP in this form occurs only at a later stage of petroleum operations (e.g. Development Phase).However unlike the working interest participation ,the State is only obliged to pay its share of future expenditures and may or may not be obliged to reimburse its share of past exploration expenditures . The State also has the privilege of not paying any premium for exploration risk incurred by other partners. This arrangement is equivalent to a BT at a rate representing the actual share of expenditures on the project paid by the State, plus an Income Tax (same as profit tax) at a rate representing the share of initial risk expenditures which the State is not obliged to pay .
iii) CARRIED INTEREST WITH REPAYMENT
As the name implies, the State is ‘’carried’’ through the exploration and development phases of petroleum operations by the private investors who lend money to the State to pay its cost of participation . Subsequently, the State repays its cost of participation for the exploration, development and production phases out of its share of future revenues from petroleum operations. Carried interest resembles a loan to the State and attracts a rate of interest. The State only receives revenue upon repayment of its cost of participation and interest. A Resource Rent Tax (RRT) has the same financial effect as a carried interest .
iv) TAX SWAPPED FOR EQUITY
SP in this form involves the State exchanging a tax entitlement for an equity share or vice versa . This is possible in Countries where taxes are imposed by contract and not by legislation. Tax swapped for equity has the same economic properties like the carried interest .
v) EQUITY IN EXCHANGE FOR NON-CASH CONTRIBUTION
In this case, SP is obtained ‘’in return for the provision of infrastructure or other project assets without further charge, in recognition of past work on a project at the Government’s risk and expense or in return for the grant of mineral rights’’ .The difficulty with this arrangement is the valuation of contribution . However, its economic properties are similar to the BT.
vi) FREE EQUITY
Free equity participation involves the grant of an equity interest to the State without any direct compensation to the Investor . Though referred to as ‘’free equity’’ it may result in an offset of some of the investor’s fiscal obligations. It has the same economic effects as a Standard Company Income Tax or perhaps a Dividend Tax . Guinea and Ghana have exercised this form of SP.
v) PRODUCTION SHARING
Production sharing is similar to free equity participation since the State is provided with an equity share income after cost recovery by the investor who bears the exploration risk .The production left after cost recovery is shared on a pre-determined basis between the parties, with the State’s share increasing at higher rates of production . Production sharing has an economic effect like a progressive corporate income tax. Table 2 below shows the various forms of SP and tax equivalents :
ADVANTAGES OF STATE PARTICIPATION IN PETROLEUM OPERATIONS
For most countries, the rationale for SP is due to its advantages which include: the need to assert sovereignty and control over petroleum operations, efficient exploration of petroleum resources, security of supply for the domestic market, safety and environmental matters, risk sharing, transfer of technology, training and employment as discussed in the previous section of this article .
DISADVANTAGES OF STATE PARTICIPATION
SP has the following disadvantages:
i) CASH-CALL DEFAULTS AND COMMERCIAL INEFFICIENCIES OF NATIONAL OIL COMPANIES (NOCs).
SP through an NOC is an extremely expensive venture in view of the capital intensive nature of petroleum operations. Enormous budgetary demands for funding by NOCs usually compete with funding for other social and infrastructural requirements such as health, transportation and education. Often, cash call funding for petroleum operations are delayed due to such competition resulting in huge financial loses . For instance, Nigerian National Petroleum Corporation’s (NNPC) annual JV cash call obligations for the past 5years is estimated at $3billion - $3.5billion and a disputed estimate of $500- $1billion cash-call arrears for the period 1994-1999 remains unpaid.
Except for a few exceptions; most NOCs in comparison to IOCs are commercially inefficient and as a result have incurred losses which have depleted Government revenue . A recent audit of Indonesia’s NOC, Pertamina revealed a loss of over $2 billion each year which is an amount equivalent to 10% of the national budget . Similarly, NNPC is estimated to have incurred losses of between $800 million and $1billion annually .
ii) GOVERNMENT INTERFERANCE
NOCs are viewed as instruments of State Policy in petroleum operations. This notion has promoted Government interference in NOC operations which has in most cases crippled the commercial objectives of NOCs and reduced them to mere ‘’Government cash-cows’’ . An instance is the deliberate confiscation of PEMEX’s income by the Government through taxes and forcing the company to negotiate its budget on an item-by-item basis with the Ministry of Finance . NNPC had in the past operated without a Board of Directors for 10 years due to the political interest of Government for control . Government interference has remained a hurdle to the smooth running of petroleum operations through SP.
iii) INVESTMENT RISK
An intrinsic feature of petroleum operations is the risk associated with its various phases, from exploration to production . SP therefore implies that the State is exposed and vulnerable to such risk in an amount commensurate with its equity participation. Consequently, unsuccessful petroleum operations result in a waste of scarce public funds which could have been utilized for infrastructural development.
iV) CONFLICT OF INTEREST
In most PPCs, Government policy for petroleum operations are formulated and implemented by NOCs giving rise to a potential conflict of interest with respect to the dual role of participant and regulator vested in the NOC .
A drawback arising from such conflict of interest is the preferential treatment of NOC operations at the expense of other industry players e.g. granting of choice acreages, discretionary waivers on development approvals, unwarranted preference to local enterprises affiliated to NOC for the supply of goods and services in the guise of promoting local capacity . In Indonesia and Angola, tensions have arisen between IOC operators and NOCs due to delays and increased cost as a result of distortions in procurement processes . These increased costs represent a reduction of IOC profit and Government revenue.
CHINWE'S NUTSHELL:
Sequel to the first part of this article- Government Petroleum Operations- State Participation VS Taxation & Regulation- on which option should be preferred for state participation in petroleum operations is this analysis by Blessing on the different forms through which Governments seek to capture their fair share of the fiscal benefits in the extractive industry, with reference to countries in which they are currently practiced. What is your take on this issue? Is State participation in the petroleum industry more disadvantageous than it is beneficial to it? Have a good read. Contributions and insights more insights on this issue are welcome.
[1] Brown Tax is levied as a fixed percentage of annual net cash flow of a project. When net cash flow is positive, firms pay tax but when negative firms receive a subsidy from the Government.
[2] Resource Rent Tax was introduced by Garnaut and Ross (1975).It is a modified form of a Brown Tax but instead of paying tax credits in years with negative cash flows, the Government allows it to be carried forward and deducted from positive cash flows in later periods.
[3] Corporate Income Tax is levied on corporate net income. In most countries, it allows current expenses, interest expenses and historic cost depreciation, to be deducted.
[7] Standard Corporate Income Tax has the tax effect of Free Equity except to the extent that book and tax depreciation rules diverge and that profit are retained rather than used for dividend distribution.
[8] The economic effect of production sharing is the same as that of a company income tax with progressive rates for higher bands of profit.
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