Africa Upstream Fiscal Systems Evaluation, Rating, & Analysis

Transcription

1 Africa Upstream Fiscal Systems Evaluation, Rating, & Analysis - ANNEX I: ACRONYMS, DEFINITIONS, & ILLUSTRATIONS Prepared by: Rodgers Oil & Gas Consulting August, 2018

2 Acronyms, Definitions, and Illustrations AD&A Accelerated depreciation and amortization AI Area Incremental refers to contract (area) incremental tax position AMT Alternative Minimum Tax APPA African Petroleum Producers Association APT Additional Profits Tax ARF Alberta Royalty Framework Aver Average Barrows Info Not yet published Barrows Contracts BBCC Barrows Basic Oil Laws and Concession Contracts bbl barrel Bcf billion cubic feet (10 9 ) Bcfe billion cubic feet equivalent Bcm billion cubic meters (10 9 ) Bcmpy billion cubic meters per year (10 9 ) boe barrel of oil equivalent boepd barrel of oil equivalent per day bopd barrel of oil per day Braz Brazil Can Canada CapEx capital expenditure CBM coal bed methane CI Carried Interest CIF Costs, insurance, freight (gas import price) CIT Corporate Income tax CtI Country Incremental Tax Position cons consolidation contr contractor CNOOC Chinese National Offshore Oil Corporation CPO Contractor share of Profit Oil CPR Cost/Price Ratio CPR10 Cost/Price Ratio discounted at a real 10% discount rate CSI Cost Savings Index cum cumulative D&A Depreciation and Amortization D&C drilling and completion DB declining balance for depreciation dev development (of petroleum fields) Disc Discovery DOM Domestic gas price DW Deep Water E East (where the context indicates a geographical location or direction) EMV Expected Monetary Value (EMV10 refers to EMV discounted at 10%) EOR Enhanced Oil Recovery EUR Estimated Ultimate Recovery (of oil and gas from a well or field) Expl Exploration Fed Federal FEEDGAS Gas price delivered at the entry point of an LNG facility. FeLI% Front End Loading Index (GS10% less GS0%) FeLR GS0% before payout FeLRR GS0% before the start of production FOB Free on Board (gas export price) 1

3 FTP First Tranche Petroleum (Indonesia) FUT Anticipated future gas price G&G Geological and Geophysical Costs GOM Gulf of Mexico Gov Government GRSI Government Risk Sharing Index (GS0%(R) less GS0%) GS0% Government Share (undiscounted) (equal to GS0) GS10% Government Share discounted at 10% (equal to GS10) GIS0 Government Income Share (undiscounted) GIS10% Government Income Share discounted at 10% GTS0 Government Total Share (undiscounted) GTS10% Government Total Share discounted at 10% HH Henry Hub (gas hub in North America) HT Hydrocarbon Tax HYPLNG Hypothetical LNG net back Hz Horizontal (in the context of a horizontal well) info information intang intangible asset IOC International Oil Company IRR Internal Rate of Return JV Joint Venture K barrels thousand barrels LAT latest available terms for a fiscal system in a country m3 cubic meter max maximum marg marginal Mcf thousand cubic feet Mcfd thousand cubic feet per day Mcfe thousand cubic feet equivalent per day Mcm thousand cubic meters Min minimum MM $ million US dollars MMbbls million barrels MMboe million barrels of oil equivalent MMBtu million British Thermal Units MMcf million cubic feet MMcfd million cubic feet per day N North (where the context indicates a geographical location or direction) NA Fiscal systems for North American wells NB Net Back NBP National Balancing Point (gas hub in UK) NCF Net Cash Flow NL Newfoundland and Labrador NOC National Oil Company NPV10 Net Present Value discounted at 10% OCS Outer Continental Shelf - (offshore area beyond State waters of the United States) ON Onshore OpEx Operating expenditure Part. participation of a state company PIR10 Profit to Investment Ratio discounted at 10% PNG Papua New Guinea PO Profit Oil Priv Private 2

4 Prof profit Prop Proposed PRT Petroleum Revenue Tax PSC Production Sharing Contract, or PSA Production Sharing Agreement RSC Risk Service Contract S South (where the context indicates a geographical location or direction) SA Stand Alone Tax Position SevT Severance Tax SL straight line for depreciation SS sliding scale SW Shallow Water tang tangible asset th m3 thousand cubic meters Tcf Trillion cubic feet Tcfe Trillion cubic feet equivalent UDW Ultra-Deep Water UR Un-Risked US United States Vt Vertical W West (where the context indicates a geographical location or direction) WD Water Depth WELLH Regulated wellhead gas price WFSG (1997) World Fiscal Systems for Gas (1997) WFSO (1997) World Fiscal Systems for Oil (1997) WFSOG (2012) World Fiscal Systems for Oil and Gas 2012 WI Working Interest WTI West Texas Intermediate crude oil Also see Definitions Below. A sample cash flow is presented at the end of this section to illustrate key economics concepts and analysis procedures. 3

5 Carried Interest (CI): refers to a situation where one joint venture company, typically the state company (commonly referred to as the NOC National Oil Company), does not contribute its full share of costs. The NOC is therefore referred to as being carried by the private investor companies. Constant Dollars: also commonly referred to as real dollars. See Monetary Units. Costs: Costs are defined as technical costs, in order to distinguish between costs attributed to the fiscal system, and to differentiate other cost concepts; specifically, opportunity cost and sunk cost. Fiscal costs are included as payments to governments/resource owners. Also see Fiscal Costs. Technical costs are the project capital (CapEx) and operating (OpEx) expenditures. Cost/Price Ratio (CPR): This is the ratio of total capital and operating costs per barrel (Mcf or BOE) divided by the price on an undiscounted real basis. For instance, a cost of $32 per barrel and a price of $80 per barrel yields CPR of 40%. The lower the CPR the more attractive the project prior to taking government share into account. CPR10 - this is the CPR discounted on a real 10% basis. Cost Savings Index (CSI): the per-dollar share of cost saving retained by the investor. Also see Price Maximizing Index. The CSI indicates how much is retained by the investor if the investor manages to save $1 per barrel in costs. Also see Gold Plating. From an international perspective the following overall scale could be applied: Table Cost Savings Index Guideline (US $ per US $ saving) Very Good > $ 0.50 Good $ $ 0.50 Average $ $ 0.30 Poor $ $ 0.20 Very Poor $ $ 0.10 Neutral $0.00 Gold Plating < $

6 Country Incremental (CtI): Country incremental refers to a scenario where the investor in a given project can benefit by using project costs to reduce existing taxable income from already producing oil and gas property in the host country. This means that costs can be deducted for tax purposes based on the various depreciation provisions, on the assumption that there is sufficient positive taxable income. Where expenditures are 100% deductible as incurred, such as certain exploration costs, the investor benefits from the immediate reduction of tax payments in the year such investments are being made. Contract Area Incremental (AI): Typically, petroleum royalties and other sector-specific fiscal levies are assessed (ring-fenced) at the individual well or field level, particularly under concession systems. By contrast, many production sharing contracts apply to the entire contract area. This means that field economics may be different than contract area economics. This applies most specifically to incremental investments within the contract area and where the fiscal terms are based on the entire contract area, not just on a given field within a contract area. Fiscal systems where the rates are fixed or otherwise do not vary with production (typically daily or monthly), with cumulative production, or with costs, generally do not need special fiscal consideration when making incremental investment decisions. In these cases, with two exceptions, there would be no difference between the contract incremental results and those for the stand alone or country incremental scenarios. The exceptions are for signature bonuses and area rentals. Whether for concessions or contracts, the signature bonus and rentals related to the total exploration area do not require additional bonuses or rental payments for further exploration within the area. These levies would therefore be ignored when considering incremental investments within the same contract or concession area. Production Based Bonuses and Royalties: If a contract or concession calls for production bonuses, these bonuses are typically dependent on the level of daily or cumulative production. For example, the initial field within a contract area may be required to pay $10 5

7 million when production reaches 5,000 bopd and a further $5 MM at the 15,000 and 25,000 bopd production thresholds. If these production thresholds relate to the entire contract area, and the existing field is already producing 5,000 bopd, a new or incremental field would be required to pay $5 MM when its production reaches 5,000 per day, not at the 10,000 per day lever required for the first field. Profit Petroleum and Profit-Based Systems: If the profit oil/gas under PSC s is determined field by field, no special contract incremental calculations are necessary and the country incremental results can be used. If the contract states that the profit oil/profit gas calculations are to be done on a total contract area basis, a special contract incremental analysis is again required. Both the costs and production for the new field will be added to the already existing cost and production in order to determine the total cost petroleum and profit petroleum. In this case, the characteristics of the field that is already producing in the contract area have a significant impact on the profitability of the incremental investment. Incremental cost oil can now be recovered from the revenue attributed to the existing production. This provides a benefit similar to tax consolidation under the country incremental tax position as costs can be recovered from the existing field(s) before the start of the production from the new field(s). This typically improves the IRR significantly. This consolidation effect however is limited where the contracts have low cost petroleum limits. In this case, there may be little incremental costs that can be recovered from existing production. With cost-based systems such as those where the rate is based on a threshold rate of return (ROR) or R-factor, an incremental investment may delay the time when the initial investment is required to pay a higher rate as a result of reaching the threshold ROR or R- Factor. Alternatively, if the top rate is already in effect, incremental production from a new investment could be subject automatically to the top rate. The combined effects of the 6

8 earlier cost recovery but the higher profit petroleum rates may cause the overall profitability to increase or decrease depending on the effect of the two countervailing factors. In general, for incremental fields in the same contract or concession area, which are ringfenced to the contract area, the ROR for the incremental fields will be higher, the undiscounted GS% will be lower, and the NPV10 may be higher or lower, depending on the circumstances around the balance between earlier cost recovery and higher rates. Discount Rate: the rate of return that represents the investor s expected return from comparable alternative investments, more specifically, from the next-best alternative investment. The rate incorporates three components inflation, opportunity cost, and time-related risk. It is common practice in the upstream oil & gas sector to use a real-dollar discount rate of 8% to 10%. The discounted value, alternatively referred to as the present value or net present value, is determined with the following equation. PV = FV / (1 + r) ( t 0.5) Where: FV = Future Value (also referred to as nominal dollar value); PV = Present Value; r = the discount rate; t = number of time periods = Ey Sy +1; Ey = End Year; and, Sy = Start Year. Note: this formula represents mid-year discounting (also see Nominal Dollars), where distinction is made between values at the start of the year versus those at the end of the year. This is a simplifying concept to avoid the impractical challenge of trying to estimate changing values on a daily or even monthly basis. An even more practical application, and the one most commonly, if not always, applied, is to assume that all values are estimated at the mid-point of the year. This means that the constant (0.5) value in the formula s exponent is not required and that the t parameter is defined simply as Ey Sy so that no discounting occurs in/for the first year of the cash flow. 7

9 Economic Rent: Economic rent is the key concept underlying how governments go about determining the level or magnitude of the government share. This is the share remaining after the investor has recovered all costs, including a competitive rate of return. Costs include those for investment (including exploration) and project operations (including transportation). In the context of economic rent, costs also include estimates for risk, and uncertainty. Figures 3.1 illustrates. Figure 3.1 Illustration of Economic Rent Explanation: The towers or stacked bars in the chart illustrate the cost components of a low-cost project (left bar) and a high-cost project (right bar).1 These costs equate to the minimum price that producers need in order to produce quantity-levels Q1 to Qn-1. The aggregate quantity from all of the projects between Q1 and Qn-1 represents, for example, the total production needed to meet the world s demand for oil. Adding the costs for a large 1 Cpx = Capital Costs; ROR = Rate of Return; Opx = Operating Costs; Rsk = Risk; Un = Uncertainty; FTax = Federal Tax; LTax = Local (Provincial or State) Tax; SB = Signature Bonus; Roy = a variety of special fiscal instruments collectively referred to as Royalties for this illustration. 8

10 number of projects enables the construction of a smooth curve. This is the supply curve (S), representing the cost of supplying the world s oil from a multitude of different sources. When the demand for oil is matched with the supply, the oil price is then determined. Since the price has to be sufficient to attract the last supply project needed in order to meet the total demand, the other projects will receive a price that is higher than their costs. Economic rent is the difference between the price for which the resource is sold (illustrated by the intersection of the supply (S) and demand (D) curves. This would be price P2 if there were no supply restrictions. Comparison of the stacked bars with the price (P1) indicates that the costs of some projects leave no economic rent and thus no room for royalties or, in some cases, even income taxes. Other, lower cost, projects enjoy a surplus, thereby leaving room for royalties and taxes and other fiscal levies such as signature bonuses. References to Hotelling Rent and Ricardian Rent identify a conceptual distinction between: (a) rent due to lower costs/better quality projects (Ricardian Rent) and (b) that from scarcity (Hotelling Rent) as reflected in higher prices caused by restricting production from Qn to Qn-1 in the chart, and represented by the rectangle area abcd. 2 The restricted production causes price to increase from P2 to P3. These distinctions are important in designing the specific fiscal instruments that may be applied. Ricardian rent, for example, might accrue to a low cost conventional onshore development whereas a high cost frontier deep water or Arctic development may not yield any rent. A source of scarcity rent the Hotelling portion of the overall economic rent for example, results from the supply restrictions implemented by the Organization of Petroleum Exporting Countries (OPEC). 2 After economists David Ricardo ( ) and Harold Hotelling ( ). 9

11 The concept of economic rent finds practical application in the notion of divisible income. While the overall government share may reflect two different basic considerations; i.e., the recovery of costs and economic rent, it is the overall share that oil and gas companies have to take into account when making investment decisions. As already identified, divisible income is defined as project revenue less capital or investment costs and operating costs. To square the theoretical concept of economic rent with divisible income it is necessary to recognize that the producer s share needs to include an allowance for a return on investment, as well as for risk and uncertainty.3, 4 Expected Monetary Value (EMV10): Also referred to as the risked NPV10, EMV10 is the discounted project Net Present Value from a success case, weighted by the probability of success, less the discounted NPV from the unsuccessful case, weighted by the probability of failure. Effective Royalty Rate (ERR): The real-dollar resource owner revenue divided by project gross revenue. This is the FCI expressed as a percent. Escalation: Escalation refers to the increase in prices or costs over time, including any increase due to inflation. Fiscal Cost Index (FCI): The real-dollar resource owner revenue expressed on a per-unit basis (government revenue divided by production). Front-End Loading Index (FeLI%): The FeLI% measures the impact of front end loading. It is calculated as the discounted government share less the undiscounted share typically 3 Economists distinguish between two types of risk time related and non-time related. Time related risk is reflected by discounting the project s cash flows at the investor s required rate of return. Non-time related risk refers to the risks for example, that project parameters such as recoverable reserves and costs will not be as expected. This type of risk is assessed through the application of probabilistic analysis such as that reflected in monte carlo simulations and expected monetary value (EMV) analysis. 4 It is common practice to report government shares on a real-dollar non-risked and non-discounted basis. It is understood that the developer s share reflects components for rate of return, risk, and uncertainty. 10

12 GS10% less GS0%. The FRI has a different impact on very profitable projects than on marginal projects. The GS10 is higher because of front end loading than the GS0 because the early payments weigh very heavily when discounted at 10%. The difference in percent depends very much on the nature of the cash flow, the costs and the prices. A GS0 of 65% is a rather typical level for many fiscal systems. This means that a difference of 20% between the GS10 and GS0 would place the GS10 at 85%. This would imply an IRR somewhat over 10% and therefore, and therefore would be a high percentage difference. Although largely arbitrary, a difference of 20% can therefore be said to be representative of strong front end loading for the particular fiscal system for the particular economic conditions. A difference of 5% would be weak front end loading. The following comparative scale may be used the fiscal system may be considered to be: Front end loaded, when GS10 > GS0; o Strongly front end loaded system, when GS10 minus GS0 is higher than 20%; o Average front end loaded system, when GS10 minus GS0 is higher than 10% and less than or equal to 20%; o Weakly front end loaded system: when GS10 minus GS0 is higher than 5% and less than or equal to 10%; Neutral, when GS10=GS0 (0% to 5% may be considered neutral); and, Back end loaded, when GS10 < GS0. Front-End Loading Ratio (FeLR): Front End Loading means that that the government has a tendency to take its revenues early in the cash flow. For instance, with fiscal instruments such as bonuses, rentals, property taxes, and ad valorem royalties. The FeLR is the undiscounted real-dollar government share before payout. A high FeLR indicates that the government receives a significant share of the revenues before the investor has achieved payout. This share can be measured by the ratio of the GS0 up to payout divided by the GS0 for all years of the cash flow. If this ratio is higher than 0, the fiscal system is front end loaded, if it equals 0 the system is neutral and if it is less than 0 the system is backend loaded. 11

13 Front-End Loading Risk Ratio (FeLRR): The FeLRR is similar to the FeLR but is measured before the start of production, when investor risk may be considered to be greatest. Gold Plating: Some international fiscal systems have so-called gold plating. This refers to systems where the investor actually loses value by being more efficient. These are usually systems based on an IRR sliding profit scale. Such systems over-burden the investor in case of higher levels of profitability. This means that it is in the interest of the investors to promote higher costs in their operations. This is of course not a sensible policy. Sound fiscal systems should encourage cost savings in order to create a healthy oil industry based on innovation and cost competitiveness. Government Risk Sharing Index (GRSI): The GRSI indicates the degree that a government participates in the sharing of geological risk through the fiscal system. The GRSI is measured by deducting the GS0% from the Risked GS0% (GS0%(R)). Usually, the fiscal system results in a higher Risked GS0 than Un-risked GS0. Bonuses and rentals during exploration load the exploration costs with government share. Also slow depreciation for taxes put a time value differential on exploration costs incurred and tax deductions obtained. It is possible to have a neutral GRSI in case of a perfectly neutral tax system whereby the corporate income tax features an immediate 100% write off for all expenditures. It is also possible to have a negative GRSI, where the government loses proportionately more in tax in case of a dry hole. This is the case for instance, if the government provides exploration tax credits. 12

14 The GRSI is based on the weighted average across all fields such that GRSI = weighted average GS0%(R) less weighted average GS0%. The following comparative scale may be used the fiscal system may be considered to be: Strongly Risk Averse when GS0%(R) GS0% is greater than 10%; Average Risk Averse when GS0%(R) GS0% is between 5% and 10%; Weakly Risk Averse when GS0%(R) GS0% is between 0% and less than 5%; Neutral, when GS0%(R) = GS0% (GS0%(R) less GS0% is equal to 0%; and, Risk Supportive when GS0%(R) less GS0% is less than 0%. Government Share (GS0%): The share of project cash flows going to government is seen as government take (GT), from the investor s point of view. GT0% is also referred to as government share (GS0%). GS0% is the share of divisible income going to resource owners from all fiscal levies, including bonuses, royalties, property taxes, and corporate income tax. Divisible income is simply defined as the gross revenues less all capital and operating expenditures on a cash flow basis. Government share is also referred to a resource owner share. The label GS0% signifies the percentage share based on undiscounted real dollar values. The government share can be determined at various discount rates. It is common practice to express the S in terms of undiscounted real dollars. Other discount rates are also used; for example, 10%, representing the investor s discount rate or cost of capital, and 5%, representing the government s cost of funds. The following calculation illustrate the GS% calculation: Gross Revenues less: Capital Expenditures Operating Expenditures equals: Divisible Income less: Payments to Government equals: Net Profit $20 million $5 million $3 million $12 million $9 million $3 million In this example, the GS% is $9 million divided by $12 million, or 75%. 13

15 Inflation: refers to a general and sustained increase in prices and costs. There can also be cost and price decreases deflation. Inflation is not the same as escalation, which refers to an increase in prices and costs, including that for inflation. Escalation is typically sector or project specific and occurs over a specific and shorter time period. Marginal Net Present Value per Barrel (MNPV/bbl): MNPV/bbl is the difference in perbarrel NPV10 for a high reserves case versus that for a small reserves case as per the following expression: MNPV/bbl = NPV10/bbl High NPV10/bbl Low The MNPV10 per bbl measures the extent to which the fiscal terms encourage oil and gas companies to present a development plan that would help ensure the highest possible recovery of resources. A MNPV10 of $1/bbl may be considered weak. Maximum Sustainable Risk (MSR): used to determine the Maximum Probability of Failure (MPF) - the maximum probability of failure that a project can withstand before the EMV becomes negative. MSR = 1 + [NPVS / Absolute Value of the NPVF]: Where: NPVS = NPV for the success case; and, NPVF = NPV for the failure case; Related components are: MPS = Maximum Probability of Success = 1 / MSR MPF = 100% - MPS Monetary Units: refers to whether or not costs and prices include escalation over time. Prices with escalation included are referred to as being in nominal dollars. Escalation includes two components one for general inflation and one for a change in relative value. Real dollar results are calculated by removing the inflation component from the nominal results. When the full escalation is removed, the results can be said to be expressed in constant dollar terms. See the following note: 14

16 Note: It is common practice to not distinguish between real dollars and constant dollars; thus, real dollars are also referred to as constant dollars and vise versa constant as real. Net Cash Flow: Project revenue less costs typically expressed as: NCF = GR TC = NBR CapEx OpEx = OprInc FC Gov Where: GR = Gross Revenue TC = Transportation Costs NBR = Netback revenue CapEx = Capital Costs OpEx = Operating Costs OprInc = Operating Income or Divisible Income FC = Financing Costs Gov = Payments to Governments NCF per barrel (or Mcf or BOE): This is the undiscounted Net Cash Flow on a per-barrel (Mcf or BOE) basis. This is a good indicator of cash generation and also of long term profitability. Net Present (NPV10): The Net Present Value (NPV) discounted at 10% is the total of the discounted net cash flow. NPV is based on the project net cash flow (NCF) through the following equation: NPV10 = NCFt / [(1 + dr) t ] Where: t = the number of time periods dr = the discount rate, typically 10% The NPV10 is an important indicator of the size of the profits to be made with the investment. It is also a good indicator of the value of the oil or gas reserves that might be discovered or developed. NPV10 per bbl (or Mcf or BOE): The NPV10 is divided by the cumulative production in barrels per oil field and cumulative production in Mcf for gas fields. Often barrels of oil equivalent will be used. The NPV per barrel or Mcf or BOE is a good indicator of which 15

17 projects have the most profitable barrels, regardless of whether the well or field is large or small. In case of state participation on a carried interest basis, the oil production is based on the total reserves, not just the reserves owned by the investor. Nominal Dollars: refers to costs and revenues with escalation (including inflation) included. Based on real dollars, nominal dollars are determined as per the following formula: FV = PV x (1 + i) ( t 0.5) Where: FV = Future Value (also referred to as nominal dollar value); PV = Present Value; i = the rate of escalation (normally inflation); t = number of time periods = Ey Sy +1; Ey = End Year; and, Sy = Start Year. Note: this formula represents mid-year escalation (also see Discounting), where distinction is made between values at the start of the year versus those at the end of the year. This is a simplifying concept to avoid the impractical challenge of trying to estimate changing values on a daily basis. An even more practical application, and the one most commonly, if not always, applied, is to assume that all values are estimated at the mid-point of the year. This means that the constant (0.5) value in the formula s exponent is not required and that the t parameter is defined simply as Ey Sy so that no escalation occurs in/for the first year of the cash flow. Opportunity Cost: the cost of forgoing the next-best investment opportunity. By convention, opportunity cost is reflected in the discount rate. 16

18 Payout: the time (usually expressed in years) from production start to cost recovery. The equation is: ( n n GPR t COST t ) 0 t1 t1 where: t = time period n = number of periods GPR = Gross Project Revenue at the point of sale COST = TC + OC + IC + FC + GOV and: TC = Transportation Cost (part of netback price) OC = Operating Costs IC = Investment Costs FC = Payments to the financial community GOV = Payments to governments. Price Maximizing Index (PMI): the per-dollar share of an increase in price that is retained by the investor. Also see Cost Savings Index. The PMI indicates how much is retained by the investor if the investor increases its revenues by one dollar. Fiscal systems should provide an encouragement to investors to obtain the highest prices in arm s length transactions. If the investor retains less than $ 0.10 of every dollar increase in price, the incentive can be considered weak. Under strongly price progressive systems, the PMI could be zero or negative. Profit to Investment Ratio (PIR10): discounted NCF / discounted CapEx. This ratio is also expressed in terms of risk with the CapEx including only those costs before production start (Risk CapEx) or in terms of only the Exploration Costs (Exploration Risk CapEx). PIR10 is a measure of capital efficiency, providing a good indication of the profit margin to investors. Progressivity: Progressivity is contrasted with Regressivity. It refers to the change in government share for a given change in price, volume, or costs. Fiscal systems are characterized as price progressive or volume progressive if the government share increases when price or volume increase. For costs the system is progressive if government share increases as costs decrease. Also see Regressivity. 17

19 There is no firm rule to determine the degree of progressivity or regressivity. Operationally a range of change can distinguish between neutral and progressive or regressive, with the degree of progressivity or regressivity being characterized as low, medium, high, or extreme based on international reference and experience. Measurement can be constructed so that a positive change signifies progressive while negative change signifies regressive. The following scales are modeled: A neutral progressivity outcome would be produced for example by a fiscal system that includes only corporate income tax and where all costs are expensed immediately from the date incurred. Systems with front-end levies such as fixed ad valorem royalties and particularly signature bonuses, are typically regressive. Most USA fiscal systems are regressive. Progressive systems tie the fiscal share to project profitability. 18

20 Progressivity/Regressivity is typically considered for four situations: (i) across type-well/field EUR (FPI-EUR); (ii) price changes only (FPI-Price); (iii) volume changes only (FPI-Vol); and, (iv) cost changes only (FPI-Cost). While the degree of progressivity is an important consideration in fiscal system design, care should be exercised with this indicator as it depends only on Government Share and therefore is greatly influenced by project viability and by the level of divisible income for the cases used in its calculation. Rate of Return (ROR): This is more accurately, the Internal Rate of Return (IROR or IRR), signifying that it is specific (internal) to the project cash flow and that it is equivalent to the discount rate that will result in a project net present value that is exactly equal to zero. IRR is determined on the total capital invested. The IRR should not be confused with accounting rate of return which is based on depreciated costs (not cash costs) and is more appropriately applied to the entire firm and for a specified time period (typically one year), rather than to the full cash flow for a given project. IRR is a measure of capital efficiency or earning power. IRR does not provide insight into the size of the profits or the potential long term asset growth. Real Dollars: Real dollars are also commonly referred to as constant dollars. Also see Monetary Units and Nominal Dollars. Regressivity: Fiscal systems are characterized as price regressive or volume regressive if the government share decreases when price or volume increase. For costs the system is regressive if government share decreases as costs decrease. Also see Progressivity. Ring Fenced: Refers to area for which a project is defined and from which costs and revenues are eligible. For example; a contract area may include several fields. In cases where the costs and revenues from one field may not be considered in determining the fiscal obligation from another field, these payments are said to be ring fenced to the field. 19

21 Stand Alone: The stand alone scenario contemplates that the investor is making its first investment in the country. The investor does not yet have production or other sources of income. Therefore, investments in exploration and development of oil and gas wells or fields cannot be deducted for corporate income tax purposes in the year that these investments are being made. Tax losses have to be carried forward until revenues from production permit the deduction of these costs. Sunk Cost: Past costs or the costs that have already been spent and, therefore, considered sunk as they should not affect a go-forward investment decision. Time Value of Money: refers to the preference to receive money earlier rather than later or to pay costs later. TMV involves consideration of inflation, opportunity cost, and risk. Supply Price: See Unit Technical Cost (UTC). Standard Deviation (SD): The standard deviation is the square root of the variance (V) of the various NPV outcomes from the mean EMV, calculated as follows: SD = V where: V = [(NPVi EMV) 2 ] x Probi Unit Fiscal Cost (UFC): UFC refers to the total undiscounted real-dollar net payments to government divided by total production. This indicator permits direct comparison with the UTC and with the commodity price. 20

22 Unit Technical Cost (UTC): UTC refers to the undiscounted per-unit cost. UTC can be extended to incorporate discounting to reflect opportunity cost and time-related risk. Discounted UTC (UTC10) is also called the supply price, identifying the minimum price required to determine project break even. UTC is calculated as per the following equation: UTC = n t1 n t1 Costs t /(1 r) ( t1 0.5) Quantity t /(1 r) ( t1 0.5) Value to Risk Index (VRI): VRI is calculated as EMV10 / the Standard Deviation from the associated NPV10 values. VRI is a relative indicator. A higher VRI indicates lower risk as reflected in a narrow range of NPVs. Therefore, maximizing the value of the VRI maximizes the EMV at the lowest risk. The VRI is a particularly powerful ranking indicator; however, caution must be exercises as it is very much influenced by the probability distribution underlying the EMV determination. NOTE: The calculation of the EMV and standard deviation (SD) needed for determining the value to risk index (VRI) are quite difficult to illustrate. The tables below assists by identifying the process used for determining the intermediate values, first for the EMV and then for the standard deviation. Working Interest (WI): is contrasted with carried interest, referring to the situation where a joint venture company contributes its full share of costs from the beginning of exploration. 21

23 Illustration of EMV Calculation Used in VRI Determination 22

24 Illustration of Standard Deviation Calculation Used in VRI Determination 23

25 Sample Cash Flow Illustration and Commentary Explanation of the profitability indicators and government share is provided with the help of the Sample Cash Flow below. The Sample Cash Flow (see table below) illustrates a small investment project that starts in 2017 and generates 30,000 barrels of oil over a three year production period ending in Start Year of the Cash Flow. The first step in the analysis process is to select the start year of the cash flow. This could be the current year for a project that is supposed to start in the current year. It could also be a future year, if a project is supposed to start in the future. It can also be a past year, for instance, if the cash flow relates to a project that is already underway. Base Year. The next step is to determine the Base Year. This is the year for which the Present Values are calculated. The Base Year is the year for which real-dollar (also referred to as constant-dollar) cash flows are determined. If the cash flow relates to an actual project, one would usually select a Base Year for which cost and price data are known or can be estimated on the basis the available data. For a scenario analysis, the Base Year could be any year. Costs and Prices are typically inputted as they would apply to the Base Year; that is, in Base Year values, not considering any escalation and inflation. For example, if the analysis were being undertaken in 2017 the costs and prices would be expressed in current (2017) year terms. Assumptions would then be made for applicable escalation and inflation. Usually the Base Year and the Start Year of the Cash Flow are the same year. However, the Base Year can be earlier or later than the Start Year. For the sample cash flow the Base Year and the Start Year are the same year, The Sample Cash Flow is based on mid-year value inputs, meaning that all escalation and discounting is from the mid-point of one year to the mid-point of another year, with no escalation or discounting for the cash flow Start Year. Base Year Cash Flow. Once the Base Year is selected, the next step is to prepare all the input data for the cash flow. This means all Capital and Operating Expenditures as well as the Oil Price and Gas Price, and the Fiscal Terms. All cash flow inputs are typically prepared in Base Year values. In developing the project cash flow and cost estimates, accounting depreciation or amortization should not be used. Capital expenditures (sometimes abbreviated as Capex ) are for items such as wells, pipelines, field facilities, etc. (sometimes abbreviated as CapEx ). The company also pays for operating expenditures; e.g., for items such as labor costs, insurance, etc. (sometimes abbreviated as OpEx ). 24

26 Fiscal Terms. The fiscal terms also need to be determined. These can be thought of as the cost to the project from the application of government/resource owner fiscal levies such as taxes, royalties, and fees for resource access. Viewed from government s perspective the fiscal levies represent the costs to society of providing goods and services such as transportation infrastructure as well as fire and police services. In the Sample Cash Flow, it is assumed that in 2017 a signature bonus of $100,000 needs to be paid and that in the following years a 15% royalty payment to Government is required. Important Note: While it is customary to express all inputs in Base Year values, all subsequent calculations need to first be performed in Nominal dollar terms; that is, with escalation included. Cash flows are then typically converted back to real dollars for analysis and reporting. Nominal Cash Flow (also called Current Dollar Cash Flow). While analysis inputs may be in real or constant dollar terms, all economic calculations need to be made in nominal or current dollar terms. This results alternatively in the Nominal Dollar or Current Dollar Cash Flow. The reason why calculations have to be first performed in nominal or current dollar values has to do with the treatment of costs for certain fiscal calculations, most notably, corporate income tax. To make the Nominal Cash Flow, one needs to estimate the escalation rates. These are the increases (or decreases) expected to take place from year to year in the oil and gas prices and in the capital and operating costs. If the cash flow contains a further breakdown of capital costs and operating costs one may estimate escalation rates for each component, such as exploration expenditures, labor expenditures, etc. The escalation rates reflect the market forces for the individual components of the cash flow. For instance, in areas of low unemployment and a tight labor market, labor cost escalation may be strong. Under high unemployment it may be weak. Escalation rates do not have to be constant per year, they can change from year to year. For instance, one might estimate that exploration expenditures will decrease between 2017 and 2018, but will increase thereafter. While there is normally in reality a different annual escalation rate for each cost and price component, it is common practice to apply a constant escalation rate for all years for all components. This is a simplifying assumption used to help identify and illustrate important cash flow impacts without the complicating influences of changes in costs and prices. The impacts of differing escalation rates are then addressed through cost and price sensitivity analyses. In the Sample Cash Flow, escalation rates are assumed to be 5% per year for the oil price, 2% per year for the capital expenditures and 4% per year for the operating expenditures. The goal of establishing the Nominal Cash Flow is to create a cash flow with the best estimate of the dollars as they will be actually received and paid in the years these receipts and payments occur. For instance, the sample cash flow assumes that the nominal oil price 25

27 in the year 2020 will be $ per barrel based on 5% per year escalation. This means that the company can expect to receive $ 347, in gross revenues during that year. In that same year, it will pay $ 168, in operating costs. Sometimes analysts like to estimate some or all nominal values directly. For instance, a company may have made direct estimates of the oil prices for future years, for instance $ 50 for 2017, $ 65 for 2018, $ 68 for 2019 and $ 70 for In this case, these actual estimates of nominal future values would be input in the Base Year Cash Flow and the escalation would be set at 0%. In fact, one could skip the Base Year Cash Flow and estimate all the revenues and costs of the entire Nominal Cash Flow directly. This however is not typical as base year cash flows provide important context for comparisons and establishing a point of reference for considering revenues and costs. Commentary on the Nominal-Dollar Sample Cash Flow: In total, the gross revenue receipts for the entire project are estimated at $ 1,953, In 2017 the company pays $ 350,000 in capital expenditures to get the project started. In 2018, it is estimated that another $ 306,000 will be paid. In 2019 another $ 104,040 is estimated to be paid. The estimated capital expenditures are in total $ 760, The operating expenditures are estimated to be in total $ 486, The gross revenues minus the capital and operating expenditures represents the project cash flow before payments to, or from, government. This cash flow is sometimes also referred to synonymously as net income, net revenue, operating revenue, or operating income. There terms however can be confusing as they do not indicate if the cash flow is for the entire project or just that for the investor or company. It is useful, therefore, to refer to this result as the Project Cash Flow. Because the Project Cash Flow is divided between the investor and government(s) this result is also referred to as the Divisible Income. Divisible income is an important reference for the Government Share calculations. The sample project cash flow shows that, if the company did not have to make payments to government(s), it would have a final cash flow of $ 706, by the end of the project in This value is determined as follows: $1,953, less $ less $486, However, the government requires a series of payments. In 2017 the company must pay a $ 100,000 signature bonus. Thereafter, the company must pay to government a 15% royalty, which is calculated as a percentage of the gross revenues. This means that the Project Cash Flow has to be reduced by $ 393, to reflect the total payments to government. Net Cash Flow (NCF (nominal)). The project cash flow before government minus the payments to government results in the net cash flow for the company (also abbreviated as NCF (nominal)). 26

28 Total Cash (nominal) or NPV0 (nominal). The nominal company net cash flow reflects the total cash flows in, or out, of the company during each year. In 2017 this is a negative of $ 450, However, by the end of 2020 the company will have accumulated a net positive of $ 313, This is the total net cash generation from the project the total net cash to the company after paying all costs and government fiscal obligations. The NCF is also sometimes referred to as the undiscounted net present value (NPV) or the NPV discounted at zero percent (NPV0). GS0 (nominal). It is now possible to calculate the nominal undiscounted government share (also abbreviated as GS0 (nominal)). This is the share that the government share is of the Divisible Income. This is calculated as the total payments to government divided by the total Divisible Income expressed as a percentage, or $ 393, divided by $ 706, times 100% or 55.61%. The government share reflects the fiscal burden on the investor. From a government perspective, it reflects the revenue benefit of the project to the government. Real Cash Flow (sometimes also called Constant Dollar Cash Flow). The real dollar cash flow is expressed in Base Year values, thereby adjusting the nominal cash flow for inflation. The purpose of calculating the Real Cash Flow is that management of companies and governments are interested to know the real value of the cash flow in order avoid making decisions based on cash flows that are distorted by inflation. This becomes particularly important when the cash flows occur over a long timeframe. Inflation is the loss of purchasing power of the currency. Even with modest inflation rates, long-term cash flows of 30 years or more tend to show very high values on a nominal basis which largely reflects the inflation component and is therefore disorienting for decision making. It is important to compare projects based on dollars of a constant purchasing power. In particular, if international projects are being compared, in different currencies with different inflation rates, over different time horizons, it becomes very important to compare the real cash flows. The Sample Cash Flow assumes that the inflation rate is 3% per year relative to the previous year for all years in the future. This means that a basket of goods and services which cost $ 1,000,000 in 2017 will cost $ 1,092,727 in the year 2020 (1.03 ( ) x 1,000,000 = $ 1,192,727). In other words, in order to calculate how much an amount in 2020 is worth in terms of the value of dollars in the year 2017 one needs to divide the year 2020 amount by or multiply the amount by a the corresponding discount factor of The Discount Factor is the reciprocal of the inflation factor (1 / = ). This is called the discount factor for that year. The discount factor for the year 2017 is In other words, this year is not discounted, because it is not escalated as it is the Base Year and all cash flows are assumed to be valued at the mid-point of the year. This means the real cash flow is measured in 2017 dollars. The discount factors for each year can be found in the Real Cash Flow section of the Sample Cash Flow table. As inflation increases the discount factor becomes less and less for each year. In the year 2018, the discount factor is divided by 1.03 or In 2019 the discount factor is

29 The real cash flow is calculated by multiplying the nominal cash flow with the inflation related discount factor for each applicable year. For instance, the nominal gross revenues of $ 945, received in the year 2018 are only worth $ 917, in constant 2017 dollars. This is calculated by multiplying $ 945, with Similarly, the oil price of $ in 2020 is only worth $ in real 2017 dollars. In this way, the entire cash flow can now be corrected for inflation. For instance, the oil price of $ in 2020 is only worth $ in real 2017 dollars. It can be noticed that, compared to the Base Year Cash Flow, the oil price in 2020 is higher (63.56 vs ). This means that the Sample Cash Flow assumes that the oil price will increase in real terms, as reflected in a 3% inflation rate assumption compared with a 5% per year assumed increase in the oil price. Government share (real) (GS0 (real)). The total project cash flow (the Divisible Income) in real dollars is $ 654, The total government revenues in real dollars is $ 378, This means that the government share (abbreviated as GS0 (real)) in real 2017 dollars is 57.85%. In other words, the government receives 57.85% of the Divisible Income, or revenues after costs. The higher government share in real terms (57.85% vs, 55.61%) is in part due to the high $ 100,000 bonus in 2017 (the first year of the cash flow), and the fact that the royalties of 15% increase along with the gross revenues which increase 5% per year. Generally, the fact that costs occur before revenues can be earned results in the real and discounted government shares being higher than the corresponding nominal dollar share. Total Cash (real) or NPV0 (real). The real dollar Total Cash to the company is $ 276, Discounted Real Cash Flow. For shareholders to be interested in making investments, the project must be profitable. This means the capital invested in the project must contribute to the growth of the company. This means shareholders and company management like to see their money back plus a certain minimum growth target for the cash contributed. For instance, the growth target could be 8% per year on a real basis. Analysts can now determine whether a cash flow meets the grow target by discounting the real cash flow with a discount rate of 8% per year to determine the Present Value of the amounts for each year. This follows the same discounting procedure as that used to adjust for inflation. For instance, in year 2020 the discount factor associated with an 8% per year growth requirement is All values in this year must be multiplied by this discount factor. The table provides the discount factors for each year. For instance, the real gross revenues of 2018 of $ 917, need to be multiplied by This means the 8% discounted Present Value of these gross revenues in the year 2018 is reduced to $ 849, in the Base Year 2017 values. Discounted Government Share (GS8 (real)). The 8% discounted Divisible Income is now $ 533, The 8% discounted payments to government are now $ 345, This means that the 8% discounted real government share is now 64.78%. From the shareholders and management perspective, the discounted government share (not the 28