energy In recent years, a number of Latin American countries have experienced

Transcription

1 Challenges of Designing an Optimal Petroleum Fiscal Model in Latin America Roger Tissot In recent years, a number of Latin American countries have experienced drastic changes in the fiscal structures of their petroleum sectors. These changes resulted in significant rent increases by host governments but also declining investments in exploration. Lowered exploration activity reduces the ability to replace hydrocarbon reserves. As shown in Figure 1, 1 Latin American reserves have increased by a modest.7 percent per year since Figure 1. Latin American Petroleum Reserves and Percent Change 2% energy Billions of barrels % 1% 5% % 5% 1% 15% working paper October 21 2% Oil reserves Percent change in oil reserves Figure 2 shows the change in oil reserves in the main oil-producing countries of Latin America (Bolivian data represents natural gas reserves measured as barrels of oil equivalent) between 24 and 28. Except for Brazil and Venezuela 2 the rest of the region presents stagnating or declining reserves. 1 Source: BP Energy Journal statistics. The drop in oil reserves in 1998 is due to re-evaluation of reserves in Mexico. 2 We excluded from the graph Venezuela s oil reserves for visual purposes. Venezuelan reserves in 24 were 79.7 bb barrels, and in 28 they increased to 99.4 bb barrels, not including the massive reserves from the Orinoco belt, which could be as high as 2 bb barrels or more according to government data and the U.S. Geological Survey. As shown in Figure 3, oil prices in 24 began a constant climb that peaked in the summer of 28 when they surpassed $14/barrel. Oil-producing countries, conscious of past price booms and busts, were initially reluctant to modify contractual terms. 3 Eventually 3 Venezuela changed its contractual terms in 21 only three years after President Hugo Chávez was elected. Chávez s drive for a different contractual model was motivated by political strategy centered on maximizing returns from a close cooperation within OPEC. That led to higher oil prices, more control over the NOC, and leveraging of the massive Orinoco oil projects as a tool for foreign policy influence and local industrialization development. However, despite tightening terms, the Chávez administration did not enforce them during the low oil price period. Most of the resource-nationalist changes have been adopted since 24. Roger Tissot, a distinguished economist, is an independent consultant who focuses on Latin America s energy policy, markets, and strategy, advising mostly Canadian and international oil and gas companies.

2 The more dependent the government is on NOC revenues, the less independence the NOC is granted. Billions of barrels Figure 2. Changes in Hydrocarbon Reserves in Latin America Mexico Argentina Brazil Colombia Ecuador Peru Trinidad & Tobago Bolivia* *Bolivian data represents natural gas reserves measured as barrels of oil equivalent Figure 3. Brent Spot Price U.S. dollars per barrel /1/99 6/18/99 5/26/2 11/17/2 5/4/21 12/3/99 1/19/21 4/5/22 9/2/22 3/7/23 8/22/23 2/6/24 7/23/24 1/7/25 6/24/25 12/9/25 5/26/26 11/1/26 4/27/27 1/12/27 3/28/28 9/12/28 2/27/29 8/14/29 1/29/21 6/18/21 governments started to change terms believing that price increases were structural. The rise in oil demand from industrializing countries, particularly China and India, plus growing pessimism vis-a-vis the industry s ability to supply more oil, sparked a trend toward high oil prices. Since that summer, prices have experienced a severe downgrading adjustment followed by a slow movement upward. The ability to replace hydrocarbon reserves is influenced by the level of investment in exploration activities. Governments have two options: 1. invest directly in exploration activities or 2. ask private companies to invest In the first case, the ability of the entity usually the national oil company (NOC) to make investments is dependent on the skill level of the country s workforce, the government s financial capabilities and its aversion to risk, and the NOC s level of financial and strategic independence from other government authorities. Political authorities tend to be risk averse, preferring to use scarce financial resources for projects aimed at improving social conditions or economic development. Political ideology and constituency preferences also influence investment. The NOC has to compete with other government authorities for the funding to make its investments. The more dependent the government is on NOC revenues, the less independence the NOC is granted. In this case, the NOC is more likely to be risk averse, focus most investments on sustaining production from existing wells, and implement only modest exploration activities in the most prospective areas. 2 Challenges of Designing an Optimal Petroleum Fiscal Model in Latin America

3 Figure 4. Family of Petroleum Fiscal Models Pure Service Contracts Contractual Risk Service Contracts Sometimes NOCs manage to achieve significant independence from the government despite being the authorities main source of cash. However, the sustainability of NOC independence hinges upon the: 1. NOC s ability to meet the government s financial needs 2. Capacity to produce and replace reserves efficiently 3. Endorsement by the top political authorities of the NOC s strategic activities If these conditions are not met, what often results is a cash-starved and risk-averse NOC unable to carry on exploration alone. The other option then is for governments to offer development rights via a concession to international oil companies (IOCs) or to partner with them in exchange for a share of the production or the profits. The option selected is defined by the government s choice of petroleum fiscal models. It is often said that there are as many petroleum fiscal models as there are oil plays in the world. However, most of the models can be arranged into the family of models presented in Figure 4. 4 Family of Petroleum Contracts Profit Sharing Agreements Concessionary over a period of time and for an agreed level of activity. The difference in these systems is mainly the mechanics of risk and reward sharing between the contractor and the government. 5 Therefore, the choice of a fiscal system is often a signal by the government to the investors regarding the level of risk and reward the government is willing to offer them. The design of the optimal fiscal model has profound implications. It defines how the petroleum rent is shared by the government and the IOCs. Oil rents are the main source of government revenue and exports; thus, fiscal models have a direct impact on the macroeconomic indicators such as fiscal and trade balance. Finally, fiscal models impact the country s level of exploration activity and, therefore, the country s ability to replace reserves. Government Questions when Designing a Fiscal Model In designing a fiscal system, a government has to answer the following questions: What is the effect of the fiscal regime on oil and gas output? Does it discourage the development of marginal fields? Does it influence the pace of development? Does it favor early abandonment? Is it insensitive to oil/gas price and It is often said that there are as many petroleum fiscal models as there are oil plays in the world. The family of models represents legal contracts or agreements covering rights granted 4 Daniel Johnston, International Petroleum Fiscal Systems and Production Sharing Contracts (Tulsa, OK: PennWell Publishing Company, 1994) M.A. Mian, Saudi Aramco, Designing Efficient Fiscal Systems (presentation, Society of Petroleum Engineers Hydrocarbon Economics and Evaluation Symposium, Dallas, TX, March 9, 21). Inter-American Dialogue Energy Working Paper Roger Tissot 3

4 Figure 5. Regressive and Progressive Petroleum Fiscal Models Risks caused by changes in contract terms are considered unacceptable by IOCs. Regressive Front-end Loaded Signature bonuses Import duties, VAT Royalty Production bonuses Cost oil limits Payout time Neutral Back-end Loaded Income Taxes Carried government participation Resource rent tax Base Exploration Development Production Abandonment Production starts cost variations? In other words, how flexible, neutral, and stable is the fiscal regime? 6 A flexible fiscal regime is one where the government will have an adequate share of the rent at different levels of profitability. The difference between flexible or inflexible regimes depends on the moment of payment. The more back-end loaded the regime is that is, the further down payments are made after revenues are generated the more flexible the model would be. Flexible models offer a greater degree of stability since as market conditions change, their flexibility reduces the need for renegotiation. However, the main challenge of these systems is the difference in the discount rate of the company and the social discount rate of the government. Governments with high social discount rates would prefer frontend systems. Neutral fiscal regimes are those that neither affect investment behavior in favor of or against oil exploration activities nor distort resource allocations. A tax is defined as neutral when it leaves the pre-tax ranking of possible 6 Silvana Tordo, Fiscal Systems for Hydrocarbons, Design Issues, working paper no. 123, World Bank, Washington, DC, Based on Pedro Van Meurs seminar, World Petroleum Fiscal System, designed by author. investment outcomes equal to the post-tax ranking. 8 Governments desiring to improve the geological knowledge of their country will offer a series of tax incentives aimed at reducing exploration risk for the IOCs. In some cases, governments may subsidize certain activities directly. Exploration subsidies could result in inefficiencies as IOCs invest in exploration mostly because of the subsidy benefit, as opposed to expectations of a commercial discovery. One of the main concerns for IOCs is the stability of contracts. Oil projects are long-term ventures with significant upfront costs and high levels of uncertainty when it comes to cash- flow expectations. Oil prices are volatile, and reserve levels and production profiles can also vary significantly. Those are risks IOCs are willing to assume. Risks caused by changes in agreed contract terms are considered unacceptable by IOCs. However, by the nature of the investments, IOCs are also subject to obsolescence bargaining, 9 and, as external 8 Tordo, Fiscal Systems for Hydrocarbons, Design Issues, Obsolescence bargaining is a term coined by Raymond Vernon and assumes that investors have limited influence on the investment environment ex post because the sunk costs associated with start-up shift the bargaining position to the host government. 4 Challenges of Designing an Optimal Petroleum Fiscal Model in Latin America

5 conditions change or new information regarding the geological potential of the country is available, governments are motivated to revise agreements. Companies with large stranded costs invested in the country are reluctant to leave the project, opting instead to accept the new terms demanded by governments. Companies in that situation, however, would also reduce or cancel new investment programs in the country. A fiscal regime is defined as stable when it does not change over a certain period of time or its changes are predictable. Royalty/taxbased regimes have an intrinsic instability since governments cannot deny future administrations the right to legislate taxation. From that perspective, contractual regimes are more stable since income taxes are often paid by the government on behalf of the IOC. IOCs can demand stabilization clauses. Included in the agreement between the government and the IOC, these clauses guarantee the terms of the agreements will remain stable. Examples of stabilization clauses are: 1. The agreement between the IOC and the government takes the form of law and any future legislation that impacts the IOC would require a change in the general legislation. 2. The government recognizes an economic balancing provision. For example, if a change in the tax regime is later legislated, an automatic change in the clauses of the contract is adopted to ensure the IOC the expected returns agreed to under the original terms and conditions of the contract. 3. The contract includes renegotiation clauses that modify the initial agreement when certain events take place. A common risk mitigation feature is IOCs demand for access to international arbitration in case of a legal dispute with the host country. During the 199s, a period characterized by low oil prices and governments desire to attract private investments, governments agreed to bilateral trade agreements that tend to supersede local legislation. Governments also agreed to international arbitration in case of disputes. In recent years, a number of Latin American countries have moved away from international arbitration, often seen as biased in favor of IOCs. This perception of bias may have more to do with the motivation and resources of both participants. Large IOCs have broad financial capabilities and access to sophisticated expertise; they also tend to be more focused. Governments often have fewer financial capabilities and their focus and expertise are limited often by the frequent rotation of key government officers in charge of the hydrocarbon portfolio. Mechanics of Different Fiscal Models The first petroleum contracts were concessions that included vast tracks of land, in some cases entire countries. Resource owners were entitled only to a small fee from the production of oil. IOCs had complete control of the operations and decisions regarding output. Royalties were usually a small fixed percentage of output. When prices were low, producers could curtail output without any penalty but causing significant harm to the income of producing countries. The de-colonization process of the 195s and 196s in the Middle East brought significant changes to the concessionary model. The advent of independent companies weakened the oligopoly of the Seven Sisters. New contractual terms were negotiated, first by granting higher royalties to host countries. Eventually, oil-producing nations wanted to secure more direct control over operations. Indonesia developed in the 196s what became known as the Profit Sharing Agreement (PSA). Some countries even closed their sector to Large IOCs have broad financial capabilities and access to sophisticated expertise; they also tend to be more focused. Inter-American Dialogue Energy Working Paper Roger Tissot 5

6 Bonuses increase exploration and production costs, discourage riskaverse investors and shorten the life of a project. IOCs activities or permitted only a modest participation through service contracts. 1 Concessionary Agreements Under a concession agreement, the IOC is granted the exclusive right to explore and produce in the concession area. The IOC is entitled to ownership of all hydrocarbons produced at the wellhead, minus a royalty payment. Below-ground reserves are owned by the government in most cases. 11 In exchange for the exclusive right to produce hydrocarbons, IOCs are charged a royalty and income taxes. Other forms of government payments are common in concession systems, including bonuses, rentals, special petroleum taxes, windfall profit taxes, property taxes, and export duties. The royalty can be provided in cash or kind to the government. Title expires at the end of the concession period, and usually all assets transfer to the government. IOCs are also responsible for abandonment costs. Following is a list of the main sources of rent capture common in a concession system. Bonuses. Bonuses are usually paid by the IOC at the time a contract is signed. They are often a biddable variable. Bonuses are the most regressive of rents since they are paid before any investment has been made. Governments like bonuses because they provide an early income and require minimum administrative controls. However, bonuses increase exploration and production (E&P) costs, tend to discourage risk-averse investors (usually small 1 It is important to note that Mexico closed its door to IOCs in However, by then the super majors had focused on Venezuela and, as Venezuela s resource nationalism resulted in constant demands for higher government take, on the Middle East. By the time the Middle East nationalization occurred, contrary to Mexico, the Middle East was the largest and most prolific supplier of oil worldwide. 11 The United States and the United Kingdom are the rare cases where ownership of the resource is granted below ground. companies), and usually shorten the economic life of a project. Royalties. Royalties are usually a charge on volume produced or on the value (add-valorem royalty) of production or export. Royalties are considered a regressive form of rent capture since they are charged at the gross production level. To reduce regression, governments can apply sliding-scale royalties based on production levels, sale values, water or well depth, or R-Factors. 12 According to Manzano and Moldani, 13 a royalty regime performs poorly in capturing rents during a period of increasing oil prices. As oil prices rise, a set royalty rate captures less rent than a set income tax rate. Royalty rates are typically lower than income taxes. If a government wants a specific share of the profits, leaving aside behavioural changes, it needs a higher income tax than a royalty rate. Consequently, when prices rise, the share of the government in the increased price is lower with a royalty. An important amount of rents thus remains with the producer, and these rents are pro-cyclical. 14 Moreover, if IOCs expect prices to increase, they may want to postpone production since the net present value of the royalty is expected to decline if prices are expected to rise. 12 R-Factors are based on an ancient and fundamental payout formula. An R, which stands for ratio, will be a function of X divided by Y. X is defined by accumulated receipts actually received by the contractor less tax. Y is defined by accumulated capital expenditures (capex) and operating expenditures (opex). The R-Factor is calculated in each accounting period; once a threshold is crossed, the new tax rate R=X/Y will apply in the next accounting period. X=Contractor cumulative receipts (after tax). Y=Contractor cumulative expenditures. At payout R=1. From Daniel Johnston, International Exploration Economics, Risk, and Contract Analysis (Tulsa, OK: PennWell Publishing Company, 23). 13 Osmel Manzano and Francisco Monaldi, The Political Economy of Oil Production in Latin America, Economía 9.1 (28) Ibid. 6 Challenges of Designing an Optimal Petroleum Fiscal Model in Latin America

7 Figure 6. Royalty Regime for the Oil Sector in Latin America 15 Country Argentina Bolivia Colombia Ecuador Mexico Trinidad & Tobago Venezuela Royalty rate on production 12% for the local government 199: 18% on new fields, 5% on old fields 24: 18% 2% on old fields, variable 8 25% on new fields Variable % depending on field conditions President Correa s administration has submitted changes to the fiscal model. The new model in Ecuador is a service contract in which companies pay 25% income tax, and 25% retention from gross revenues. N/A Royalties negotiated by contract 199s: % depending on field Post 2: 3% on traditional fields, 2% on Orinoco Present: 33% Governments like to use royalties because they provide certainty and are easy to calculate, collect, and monitor. This has been suggested as one of the main culprits of fiscal instability in Latin American petroleum contracts in the last decade. As shown in the following table, most Latin American petroleum fiscal models charge a royalty on production. If set too high, royalties shorten the economic life of a project, resulting in higher levels of oil left underground. Since royalties increase the marginal cost of producing oil, they also discourage investments in marginal fields. These are fields that, on aggregate, could make an important contribution to the overall production and export potential of a country but, more importantly, have an important impact on the level of FDI, employment, and local government revenues. Governments like to use royalties because they provide some certainty in revenues and are easy to calculate, collect, and monitor. Income Tax. Income taxes are usually levied on oil and gas companies, in some cases at rates higher than the income tax charged to other types of companies. A fixed income-tax rate tends to be regressive since the charge in 15 Ibid. percentage terms remains the same at different levels of profitability. To make the income tax more progressive, such as when projects profitability increases due to rising prices, governments could link income taxes to crude oil prices or sales value. On the other hand, if a government wants to provide incentives to E&P activity, it could allow for an accelerated recovery of exploration and development costs. Accelerated cost recovery brings forward payback for the investor and, possibly, retirement of debt. It can therefore reduce both investor risk and tax-deductible interest costs; it also facilitates project financing. 16 However, to protect the tax base of the country, governments will impose limits or restrictions on the use of debt financing to avoid erosion of earnings by companies from payment of interests abroad. Income tax paid to the producing country is often deducted in the IOC s home country. In 16 Emil M. Sunley, Thomas Baunsgaard and Dominique Simard, Revenue from Oil and Gas Sector: Issues and Country Experience, Fiscal Policy Formulation and Implementation in Oil Producing Countries, (ed. J.M Davis, R. Ossowski and A. Fedelino, Washington, DC: International Monetary Fund, 23). Inter-American Dialogue Energy Working Paper Roger Tissot 7

8 To protect their tax base, governments will impose limits on the use of debit financing to avoid erosion of earnings by companies from payment of interests abroad. the absence of an income tax, the IOC may be subject to a higher tax rate in its home country. Consolidation and Ring-fencing. A fiscal system s attractiveness to IOCs can be affected by the level of consolidation or ring-fencing allowed in the producing country. Ring-fence refers to the delineation of taxable entities. When ring fence applies, at contract area or project level, income derived from one area/ one project cannot be offset against losses from another area/project. 17 Ring-fence matters. Without it, tax obligations to governments can be deferred by companies that undertake a series of new projects. Their new investment expenditures can be deducted from profits earned on other ventures. This encourages existing operators to invest in the country but discriminates against new entrants. Resource Rent Tax. Resource rent tax ties taxation to profitability, making the tax system less distortive for investors. The resource rent tax is imposed only if the accumulated cash flow from the project is positive. In its purest form, taxes are deferred until all expenditures have been recovered and the project has yielded a predefined target return. Then a very high marginal tax is applied to all subsequent operating revenue. 18 Negative cash flows are accumulated at an interest rate that, in theory, should equal the investor s opportunity cost of capital. Resource rent tax has theoretical appeal since it captures rents over and above the company s opportunity cost of capital, and it is perceived as being more stable since it automatically increases the government s share in highly profitable projects. 19 However, the design, 17 Tordo Silvana, Fiscal Systems for Hydrocarbons, Design Issues P Tordo, Fiscal Systems for Hydrocarbons, Design Issues, Sunley, Baunsgaard and Simard, Revenue from Oil and Gas Sector: Issues and Country Experience, 16. implementation, and monitoring of resource rent tax is particularly difficult due to the complexity of allocating the proper discount rate. The government has access to the rent only when a targeted payback or rate of return has been reached. Calculating the proper discount rate is particularly difficult. If the discount rate is too high, it is possible that the resource rent tax will not apply; if it is too low, the tax will deter investors. Indirect Taxes. Indirect tax refers to valueadded tax (VAT) and import and/or export duties. Import duties apply to all material and equipment imported into the country, usually as a mechanism to protect the local industry. Due to the capital-intensive nature of oil exploration activity, import duties can be regressive. Governments would often exempt companies from import duties during the exploration phase as a mechanism to encourage E&P investments. VAT is usually charged on a destination basis. Imports are charged a VAT but exports are not. Since most of the oil in producer countries is exported, VAT calculations and charges are complicated. The taxpayer is in a constant process of claiming its VAT paid. For that reason the majority of countries exempt the VAT on oil-exporting projects. Surface Taxes. These are taxes paid on the basis of the size of the area under lease. The goal of a surface tax is to prevent IOCs from hoarding land without investing. Another mechanism used by governments is to force companies to relinquish a percentage of the leased area after a period of time. Work Commitments. Work commitments are mandatory investments the contractor must make when granted a lease. These are usually measured in units, for example, kilometers of seismic data acquisition, numbers of wells to be drilled, etc. Because of the high costs involved with drilling exploration, work commitments tend to have a significant impact on the project economics of an oil investment. 8 Challenges of Designing an Optimal Petroleum Fiscal Model in Latin America

9 Governments that want to increase the geological knowledge of the country designate some areas as hot and put more emphasis on work commitments in them. However, excessive focus on work commitments could result in an inefficient allocation of resources as companies bidding for an area would offer a higher level of work than technically required. Contractual Systems (PSAs, Service Contracts) Profit-sharing agreements were a preferred option for rent capture in several developing countries that are oil producers. It offered them a mechanism to assert their sovereignty and allow their gradual entry into the complexities of oil E&P activities. However, there is no intrinsic reason to prefer a tax/royalty regime to a PSA regime since the fiscal terms of a tax/royalty regime can be replicated in a PSA regime, and vice-versa. 2 PSAs can deliver the same results in terms of government and company take, or earnings from the agreement, as concession systems. The main difference between the two systems is that under a PSA, the ownership of the resource remains with the state, and the oil and gas company is hired to explore and produce hydrocarbons. Usually the company referred to as the contractor assumes all the exploration costs in return for a share of the production. Contractual agreements grant ownership of the share of the oil to the contractor at the delivery point. The typical PSA consists of an agreement between the government, represented by the local NOC, and the contractor. If exploration is successful, a pre-negotiated share of the production is given to the contractor in compensation for the risks and technical and 2 Sunley, Baunsgaard and Simard, Revenue from Oil and Gas Sector: Issues and Country Experience, 163. financial services provided. The contractor is entitled to recover capital and operating expenditures from production; this is what is defined as cost oil. Often governments will impose a limit on how much contractors are entitled to recover. The limits discourage contractors from gold plating, or excessively increasing costs. This is perhaps one of the main challenges of PSAs, since it requires a sophisticated level of understanding of petroleum activities in order to properly monitor IOCs cost reports. What s left after subtracting the cost of oil from the total output is known as profit oil. The percentage split of profit oil is often a biddable item, or set up by legislation. In most cases, the NOC assumes all the abandonment costs. In a PSA, the contractor usually is not taxed because it has no ownership of the resource. However, the income generated from the share of profit oil is subject to income tax. A more restrictive agreement is the Risk Service Contract (RSC) in which the contractor finances and carries out petroleum operations and receives a fee for its services in kind. 21 The fee usually allows for the recovery of all costs and includes a profit component. Governments may also want to participate in an oil venture through state equity. In this case, the government may offer a working interest as it becomes a partner in a joint venture with other investors. The government may also enter as an equity partner only after a discovery is made, letting the private company assume all the exploration and development costs and risks. In some cases, governments may assume some of those costs if a discovery 21 Humphrey Onyeukwu, Fiscal Regimes in a Volatile Oil Price Era: What Options Exist for Balancing the Interest of the Resource Country and Investor Company? (presentation, Society of Petroleum Engineers International Oil and Gas Conference, Beijing, China, June 8, 21). 22 Adapted from Tordo, Fiscal Systems for Hydrocarbons, Design Issues, 1. PSAs can deliver the same government and company take, as concession systems. Inter-American Dialogue Energy Working Paper Roger Tissot 9

10 Figure 7. Main Differences between Concessionary Agreements and PSAs 22 Petroleum fiscal models should be simple, reduce costs, and maximize production. Concessionary System PSA Ownership of the national mineral resource Held by sovereign state Held by sovereign state Title transfer point At the wellhead At the export point Company entitlement Gross production royalty Cost oil/gas + profit oil/gas Entitlement percentage Typically 9% Typically 5% to 6% Ownership of facilities Held by company Held by NOC/government Management and control Typically less government control More direct government control and participation Government participation (working interest) Not likely Likely Ring-fencing Less likely More likely is made. Finally the government can have a carried interest in which it pays its equity share from its share of oil output. There are different motivations for participating directly in a project. If the project is successful, direct participation can offer an attractive cash flow to the government and help with industrial growth and human and physical capital development. In some cases, however, direct participation can have a significant impact on the government budget. Designing an Optimal Fiscal Petroleum Model Some countries have been very successful at increasing their hydrocarbon reserves, capturing a high rent for the government, attracting a strong level of investment, and offering an attractive rate of return to investors. While it would be tempting to copy the fiscal models of successful countries, a successful fiscal model must first reflect the political, social, and economic characteristics of the host country. In some countries, because of history, concessions to IOCs may be seen as highly controversial. In other countries, securing new reserves in order to postpone the need to import oil would be a sufficient incentive to allow IOCs participation under attractive fiscal conditions. The main challenge in the design of an optimal fiscal system is the alignment of the government s and the IOC s differing, and sometimes diverging, objectives. The government s main objective is to maximize the value of its petroleum resources while attracting sufficient IOC interest for investing in E&P activities. An IOC s objective is to ensure that the rate of return of the capital employed is consistent with the project s risk and with the strategic objectives of the corporation. 23 It is, nevertheless, possible to develop a list of best practices that governments should consider when designing fiscal models. Models should: 1. Aim for simplicity. Simple models reduce administration and monitoring costs for the government. They offer more accurate projections of the expected value of the project. Simpler models also reduce the opportunity for contractual disputes and increase transparency regarding government revenues. 2. Encourage cost reduction. Cost recovery is an important feature of fiscal models. In order to avoid inefficient practices such as gold-plating, fiscal models should encourage cost reduction behavior but not to the extent of encouraging poor safety or environmental operating standards. 23 Tordo, Fiscal Systems for Hydrocarbons, Design Issues, Challenges of Designing an Optimal Petroleum Fiscal Model in Latin America

11 Billions of barrels Figure 8. Mexico Oil Reserves and Production Oil reserves bb barrels Oil production MBD 4,5 4, 3,5 3, 2,5 2, 1,5 1, 5 Millions of barrels per day Mexico has one of the most restrictive fiscal systems in Latin America. 3. Encourage maximization of production. Fiscal models should encourage companies to carry out their investments as soon as possible and to develop the fields so as to maximize production without damaging the reservoir or endangering the environment. A Brief Look at the Latin American Experience Latin America has experience with a variety of petroleum fiscal models. This reflects not only the diversity of resources available in the region but also changing economic conditions and political ideologies. Latin America s oil industry started with traditional concession systems but, due to its Spanish legacy, it inherited a long tradition of state ownership of the mineral rights, although there have been short periods of private mineral ownership. 24 A key feature of Latin America is the early creation of NOCs. 24 Bernard Mommer, Petroleo Global y Estado Nacional, (Caracas: Ediciones Comala.com, 23) 79. The long tradition of state ownership of minerals was not disturbed by the wars of independence. On the contrary, it was reinforced with the French Revolution. However, Mexico in 1884 included oil and coal as exclusive private property rights. The privatization of Mexican oil would end only in 1917 with the adoption of a new constitution. Mexico Mexico has one of the most restrictive fiscal systems in Latin America. Pemex, the NOC, pays out more than 6 percent of its revenues in royalties and taxes, leaving very little for E&P activities. Pemex used creative accounting techniques to increase its level of debt in order to finance some of its production and basic exploration activities. IOCs are not allowed to operate in Mexico except as service contractors for a fee paid in cash. In 28 the government approved a series of reforms aimed at improving Pemex s cash flow and attracting more investors to the oil sector under a service agreement with Pemex. The new contracts offer some cost recovery incentives to contractors. Mexico s oil production and reserves are declining fast, and the country is at risk of becoming a net oil importer. Most future oil reserves are located in the deepwater Gulf of Mexico. Pemex faces enormous challenges if it wants to develop those reserves alone. First, it has only limited experience in offshore drilling, most of it in shallow waters. Second, its role as the government cash cow has made it a company starving for resources. Offshore deepwater development is a particularly expensive venture, requiring massive capital. With Inter-American Dialogue Energy Working Paper Roger Tissot 11

12 Unlike Mexico s contentious nationalization of the industry, Venezuela s nationalization was relatively amicable. economic uncertainty and elections looming in the next couple of years, the current government appears reluctant to reduce its dependency on Pemex oil rents and increase taxes on other economic activities. In light of the recent oil spill in the Macondo well in the Gulf of Mexico, it is expected that governments will tighten regulations and, therefore, increase the cost of E&P activities in the gulf. Nationalist forces may argue that IOCs do not a guarantee safe exploitation of the resource, even though thousands of deepwater wells have been drilled worldwide. Local communities would also demand state-ofthe-art regulation, increasing the cost of doing business and the time required for permits. Forecasting Mexico s oil production is beyond the purpose of this paper. However, in the short to medium term a reversal of the current decline is unlikely unless there is a major redesign of Mexico s petroleum legislation in order to allow greater participation by IOCs. A return to petroleum-importing may be the detonator that finally frees political forces to open upstream activities in Mexico. Venezuela Venezuela nationalized its oil industry in 1973 and set up a new NOC: Petroleos de Venezuela (PDVSA). Unlike Mexico s contentious nationalization of the industry, Venezuela s nationalization was relatively amicable. PDVSA was granted the monopoly of all E&P activities. The former foreign operators maintained the same operating structure but under a new owner (the government of Venezuela), and foreign cadres were kept on as advisers and consultants. This beginning helped PDVSA develop a unique corporate culture, in tune with its private sector roots and the cultural differences of its previous owners. This new culture was reflected in the new family of companies forming PDVSA. 25 The NOC fought hard against political interference. Through its own corporate promotion mechanism known as the meritocracy, it established an esprit de corps that worked against political interference. In the mid 199s, Venezuela opened its oil sector to IOC participation under service contracts. 26 The reason for this opening was twofold: to hedge the risk and cost of developing the expensive reserves of the Orinoco belt and to increase production from marginal fields that, because of their size, were unattractive to PDVSA. The government offered a royalty incentive for companies bidding in the Orinoco fields, charging for a limited period of time (eight years) a royalty of 1 percent. IOCs responded enthusiastically, oil production increased rapidly, and new reserves were discovered. The wrongly named re-nationalization of the oil industry by the Chávez administration reversed most of these policies. However, Venezuela did not close the door to foreign oil companies participation. Under the current model, IOCs form joint ventures with PDVSA, which retains majority equity and is the operator of the project. Because of financial difficulties at PDVSA, however, the NOC has secured part of its equity in some of these projects in exchange for future oil production to be delivered to the partners. 25 The main companies were Lagoven, Corpoven, and Maraven, all under the umbrella of PDVSA 26 The current administration challenged the legality of the service contracts, describing them as de facto concessions 12 Challenges of Designing an Optimal Petroleum Fiscal Model in Latin America

13 12 Figure 9. Venezuela Oil Reserves and Production 4, Billions of barrels 3,5 1 3, Oil reserves bb barrels Oil production MBD 2,5 2, 1,5 1, 5 Millions of barrels per day It is unlikely that PDVSA, marred by financial problems and political interference, will be able to reverse the trend in production decline. Venezuela s oil production has been in constant decline since 2. The reduction in production was first due to Chávez s desire to comply with Venezuela s OPEC quotas, a marked difference from the previous administration, which focused on production growth and a higher share of the U.S. market. Production has also been affected by the strike at PDVSA that resulted in the dismissal of a large number of employees, many of them with sophisticated technical expertise. Finally, production has been affected by the diversion of funds from oil activities to politically motivated projects. Today PDVSA is the largest supplier of food in the country. In recent years, most of the attention in Venezuela has focused on the repositioning of the Orinoco belt. After ending previous agreements with the IOCs 27 and requiring the companies to accept new terms and conditions, the government divided the Orinoco oil belt into four large areas: Boyacá, Junín, Ayacucho, and Carabobo. Some NOCs were invited to participate in the development of the fields, first by helping evaluate the reserves then as minority partners. The strategy clearly showed the government s interest in favoring Latin American NOCs, some of which do not have the technical or financial capabilities to produce heavy crude oil. It also strengthened new relations with countries such as Russia (an important supplier of military equipment and technology) and Iran (an important member of OPEC and, since the Iranian Revolution, a foe of the United States). Of particular importance to PDVSA is access to the Chinese market and Chinese capital. Chinese oil companies have become an important source of financing for cash-strapped PDVSA; the financing comes in exchange for future oil production. Venezuela s oil future depends on the ability of the foreign NOCs and those IOCs that have accepted the new terms to successfully invest and expand output. It is unlikely that PDVSA, marred by financial problems and political interference, will be able to reverse the trend in production decline. However, since PDVSA is the operator of all projects in Venezuela, it remains to be seen if the new joint ventures will meet the company s ambitious goals without giving foreign partners a larger control over the operations and, perhaps, migration toward some sort of PSA. 27 In the 199s, four heavy crude oil projects were signed with PDVSA: Hamaca (Conoco, Chevron); Cerro Negro (Exxon, BP), PetroZuata (Conoco), and Suncor (Total, Statoil). Inter-American Dialogue Energy Working Paper Roger Tissot 13

14 The challenge ahead is for Brazil to manage its new oil wealth while avoiding common mistakes that come with windfall revenues. Billions of barrels Figure 1. Brazil Oil Reserves and Production Oil reserves bb barrels Oil production MBD 2, 1,8 1,6 1,4 1,2 1, Millions of barrels per day Brazil Brazil s oil production has increased constantly over the last twenty years. As shown in the graph above, reserves have also increased. The data do not include the huge offshore reserve discoveries from the pre-salt 28 oil fields. Those discoveries will permit Brazil petroleum independence and allow it to become a large future exporter of hydrocarbons. In 1994, Brazil ended the monopoly of its NOC, Petrobras, and returned to a concession model. Since enacting that new fiscal model, Brazil has held ten bidding rounds attracting strong interest from IOCs. However, in 28, as a result of the discoveries made by the consortium led by Petrobras, BG Group, and Galp Energia in the pre-salt area, the government suggested changes in the fiscal model. 28 Pre-salt refers to an aggregation of rocks located off the Brazilian coast and with potential to generate and accumulate oil. It was called pre-salt because it sits under an extensive layer of salt which, in certain areas of the coast, can be as much as 2, meters thick. The pre expression is used because these rocks were deposited before the salt layer. The total depth of these rocks the distance between the surface of the sea and the oil reservoirs under the salt layer can be as much as 7, meters. Source: questions-answers/ The government cited new geological information in justifying the changes from the concession system to PSAs in the pre-salt area. With lower exploration risks, the government chose to increase its access and have greater control over the development of the resource. The new model, which applies only to the pre-salt area, makes Petrobras the operator; IOCs are minority equity partners. A new NOC is also participating, not as an operator but as an entity in charge of protecting the nation s interests, according to government comments. Brazil s oil policies have been highly successful at increasing reserves, production, and allowing the government to capture a share of the petroleum rent. Because of Brazil s economic diversification, however, the economy is not dependent on the rents generated by Petrobras and/or the IOCs. The challenge ahead is for Brazil to manage its new oil wealth while avoiding common mistakes that come with windfall revenues, mistakes such as those affecting Mexico in the 198s after the discovery of the massive Cantarell oil field or Venezuela during the high oil price shocks of the 197s, the early 198s, and the last oil boom of The new contractual agreement can be seen as a setback from a competitive model as it strengthens state-owned corporatism. This could not only erode the efficiency of 14 Challenges of Designing an Optimal Petroleum Fiscal Model in Latin America

15 Billions of barrels Figure 11. Argentina Oil Reserves and Production Oil reserves bb barrels Oil production MBD 1, Millions of barrels per day Argentina s natural gas reserves and production have also collapsed. Petrobras but also increase the government s dependency on the NOC s rents. Although the government appears to be inspired by the Norwegian model which tends to favor conservation 29 over production it is unclear whether what is good for Petrobras is also good for Brazil. In fact, Petrobras already has a strong monopolistic power in other areas of the hydrocarbon value chain in Brazil, resulting in high costs for consumers (natural gas, for example) and exposing the company to further political influence. However, the pre-salt discoveries are of particular importance not only because of their size but also because they have the potential to transform Brazil from a net oil importer to a large exporter of hydrocarbons. Petrobras rents will have a significant impact on Brazil fiscal and trade balances. How the NOC manages these challenges will define the outlook of Brazilian petroleum. Argentina Unlike Brazil, Argentina s oil reserves and production have been in a steady decline since 21, following rapid growth for most of the previous decade. Although some basins in Argentina are considered mature, the drastic change in the production and reserves profiles is not just the result of reservoir depletion. Changes in the petroleum fiscal model are also responsible. Argentina adopted one of the most liberal fiscal models in Latin America in the 199s. That included privatization of national oil company YPF. But, in 22, the government imposed a 25 percent export tax on oil, eroding IOCs interest in continued investment in exploration. Argentina s natural gas reserves and production have also collapsed, as evidenced in the following graph. The country s gas crisis has a bigger impact than the inability to export oil. Natural gas accounts for more than 5 percent of Argentina s primary energy consumption. Moreover, Argentina s gas crisis spilled into Chile when Argentina stopped exporting to its neighbor. In recent months, the government has reacted to the rapid decline of production and reserves by adopting a gas plus program, which basically offers better prices to producers of new natural gas discoveries and unconventional gas. Although the gas plus program is a step in the right direction, the energy crisis can be addressed by simply removing price controls and barriers to IOCs. 29 Conservation of the petroleum resource through a controlled pace of development. Inter-American Dialogue Energy Working Paper Roger Tissot 15

16 Colombia s petroleum reserves are relatively modest and unlikely to last long. Trillion cubic feet Figure 12. Argentina Gas Reserves and Production Gas reserves Tcf Gas production bcfd Billions of cubic feet per day Colombia Colombia s oil reserves and production saw rapid growth in the early 199s when the government offered an attractive fiscal model that resulted in an increase in exploration activity and the discovery of the Cusiana oil field, which followed the earlier Caño Limón field discovery. As a result, Colombia tightened the rules and adopted a PSA model, significantly increasing the government take. However, the move coincided with a collapse in oil prices and rapid deterioration of security conditions. Investments in E&P by IOCs disappeared, and the local NOC, Ecopetrol, proved ineffective at replacing reserves. Facing the possibility of the country becoming a net oil importer and the dire fiscal situation and trade balance consequences of that shift the government of former president Álvaro Uribe changed the petroleum fiscal regime, returning to the concession system, ending the monopoly of Ecopetrol, and reducing the government take. Since then, Colombia has attracted substantial investments in exploration and production. Oil output is at record highs of 8, b/d, although no major oil discoveries Billions of barrels Figure 13. Colombia Oil Reserves and Production Oil reserves bb barrels Oil production MBD 1, Millions of barrels per day 16 Challenges of Designing an Optimal Petroleum Fiscal Model in Latin America