A balancing act: getting fiscal terms right

At the beginning of December 2016, opportunities in 30 licensing rounds are being considered by exploration companies. We know of at least 37 more that are planned to open within the next 18 months. It’s becoming a crowded market.

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Governments have a strong influence on the business environment in which exploration will be conducted. And this will have a big influence on the success or failure of attempts to lure new investment. Providing exploration companies with access to available data, making minimal financial demands during the exploration phase and establishing clear and stable, regulatory and fiscal systems will all increase the appeal of new investment opportunities.

A balancing act

The industry is stressing the need for governments to establish fiscal terms that are “predictable and internationally competitive” and to create a “competitive tax and fiscal environment”. But are they listening?

Governments first need to ask who they are competing with? While there are many opportunities for explorers, they do not all look alike. A government can’t influence the geological potential of the areas they offer, so they need to be aware of how the industry perceives the areas offered. How good are the rocks?

Getting the terms right

Companies may accept tough fiscal terms if the acreage is deemed low risk and offers very high geological potential. Some of the forthcoming Iranian opportunities may fit this description but few others will. So most governments will have to carefully balance their desire to get a fair share of potential future revenues with the companies’ need to generate positive, risked returns from exploration investment. This makes matching the terms with prospectivity a key consideration.

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Finding the right approach

Pitching the terms at the right level can be a precarious business. Set the terms too low and the Government Share may not appear fair if large discoveries are made and/or prices return to high levels. This could prompt retroactive changes to terms and create an environment of fiscal instability. But demand too much and companies will not turn up, wasting the government’s time, money and reputation in a failed licensing round.

Bidding fiscal terms

Some governments try to get round this by making a key element of the fiscal terms a bidding variable. Mexico, for example, makes licence awards based on the royalty or profit share rates that are bid for different blocks. This can establish the true market rate for the areas, but it can also carry risks.

Beware over-bidding

Some companies may bid unrealistic rates in order to secure the licence, with a view to re-negotiating them later. Or they may have simply not done any economic assessment. Either way the government has a dilemma: accept the highest bid and expect to have to re-licence or ne-negotiate later because the terms will not support economic development of discoveries. Or refuse the high bid and award to a company with a lower, workable bid. The latter is difficult to explain to the public, which may well cry foul and accuse the regulator of corruption. And the process gets more complex when multiple variables are included as bid items, as they have been in several African countries.

Does transparency constrain flexibility?

The alternative is to bring discussions about the fiscal terms behind closed doors. This allows the government to negotiate a deal with the company it likes best for each block. This might follow an open licencing process where companies have to meet certain criteria and minimum commitments on future work. The preferred company is then invited to negotiate a commercial agreement. Or the government can simply enter direct negotiation with interested companies from the outset. However, this is the least transparent approach.

Adjusting to a new transparency

Of the 148 jurisdictions reviewed in our recently published fiscal study, half award licences through bid rounds, 30% directly negotiate terms with companies and the remainder operate a combination of the two policies. Public scrutiny of commercial agreements has increased in recent years and transparency has become a goal for many governments. But this also creates hurdles to  getting the right terms.

Fair share, prospectivity, costs, transparency, competitiveness. All have to be considered when deciding on a licensing and fiscal policy and there are pros and cons to each approach. Those that get the balance right will be the winners.

If you would like to learn more about our recent fiscal multi-client study, please get in touch.

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Graham Kellas has 30 years experience in analysing global petroleum fiscal systems. He heads Wood Mackenzie’s fiscal research and has written several multi-client studies, analysing and comparing global fiscal systems. Graham has advised many governments on fiscal policy; most recently Colombia, Ireland, Newfoundland & Labrador and South Africa. He has also assisted many oil companies during debates with governments on appropriate fiscal terms (e.g. Nigeria and UK). Graham has wide experience delivering training courses in petroleum economics and fiscal analysis around the world and is a regular speaker at industry conferences.

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