Can fiscal policy help the oil industry to ‘do a Leicester’?

In a number of recent industry conferences I have presented this slide.

Leicester City have won the English Premier League, against all the odds and with an eighth of the budget of the pre-season favourites, Manchester City. I link this 'tale of the unexpected' to one of the strongest emerging trends in petroleum fiscal policy today: reducing cost recovery. Governments are telling the oil companies that they need to 'do a Leicester'. That is, maintain (or even improve on) their best performance – investment, production – but at a fraction of the cost.

This follows a decade of severe cost inflation that has created an atmosphere of mistrust in many countries. Companies argue that cost increases are a result of simple supply/demand economics and need to be recovered first from revenue. Governments believe the companies, in cahoots with suppliers, simply increase costs to absorb any price windfall and minimise government revenues.

As a result, governments have been increasing their scrutiny of budget proposals and audits of expenditure claims. This occurs most often in production sharing contracts (PSCs) and service contracts, where governments normally have to approve budgets prior to expenditure. The increased scrutiny creates tension and frustration and results in delays to investment. A 'lose-lose' situation, in other words.

So, the issue of cost recovery is firmly under the fiscal policy spotlight. From exploration to decommissioning, governments want companies to deliver at a lower cost. And companies want governments to stop interfering and let them get on with business. The solution beginning to gain popularity is relatively simple: remove cost recovery from the equation.

India recently introduced a new fiscal policy for the future award of marginal field licences. For many years, India has employed a traditional PSC, with production first allocated to cost recovery then remaining production ('profit oil') is shared between the company and government. Under its new revenue sharing mechanism (RSM), companies will bid for a simple share of revenue. How much profit companies can generate from that revenue while fulfilling their contractual work commitments is up to them. This model is also an option in Indonesia for coal bed methane investments.

When compared with the traditional net revenue sharing mechanism, these gross revenue sharing schemes protect the government from any cost overruns in the project. And as the government is no longer picking up the tab for higher costs, it does not need to scrutinise the budgets.

Under the gross PSC terms, when prices change, both the company and government share in the upside or downside. But if costs are higher, this only reduces the company's margin, not the government's revenue. On the flipside, if the company can reduce its costs, it does not have to share any of the additional profit with the government. All of which sounds like a 'win-win' situation, right?

Maybe. But maybe not. India's RSM is effectively a royalty and royalty systems are the oldest, simplest fiscal terms around. They are relatively easy to administer and they ensure a share of revenue for government from day one of production. But if the rate is too high, companies may not have sufficient revenue to recover costs and make a return. If the rate is too low, and projects are clearly highly profitable, the government may be accused of not getting its fair share.

Using sliding scales that link the revenue share (or royalty rate) to the price level or production rate, or both, as some countries already do, would at least partly address this situation. The government's share of revenue from smaller projects, and all projects under lower prices, would be reduced. This approach also incentivises companies to impose stricter cost controls on larger projects, and all projects under higher prices.

The downside, from a company's perspective, is that the government could receive its highest share of revenue in the first years of production. This delays cost recovery, making project economics less attractive and, potentially, unable to meet hurdle rates of return.

As English football teams enter the summer break, team owners are trying to work out how they can 'do a Leicester' next season. Host governments want to motivate oil companies to do something similar: produce more, at a much lower cost. India believes that removing cost recovery provisions and focusing on revenue-sharing is the way to achieve this. Certainly, removing the need for cost approval and bottlenecks would be welcomed by all involved. But only if the rates and mechanics of the revenue sharing system are right, will a true 'win-win' solution emerge.