Introduction to Upstream Oil and Gas Training I4TH 16TH May 2013, Intercontinental Hotel, Nairobi

Risk and financial analysis in Exploration and production

Fiscal analysis

Philip M. Tsar
(Petroleum Engineer National Oil Corporation - Kenya)
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Scope

Fiscal analysis, Structure of fiscal regimes, Severity and efficiency of fiscal regimes, Incremental effects of fiscal regimes & Revenue Sharing

Background & Introduction

Background of Legal and Regulatory Framework

Kenya has been exploring for oil since 1937 Current framework (Petroleum Act and Model Production Sharing Contract (PSC)) was developed prior to discoveries; Model PSC is oil-centric 2012 discoveries in Turkana and gas-prone offshore highlighted need to modernize existing framework GoK and World Bank engaged Hunton & Williams and Challenge Energy (Consultant) to review and provide guidance for updating the existing framework

1. Fiscal Considerations Progressive Fiscal Regimes

A progressive fiscal regime is one where the States share of a projects profits increases as the projects profits / rate of return increases.

State share of total benefits

Project profitability

Fiscal Considerations Fiscal Instruments

A range of fiscal instruments exist:

Corporate Income Tax Windfall / Special Petroleum Taxes

Royalties (although often not viewed as a tax)

Bonuses (not a tax but can be used in combination with above) Production Sharing (consistent with existing PSC)
Daily Rate of Production Rate of Return R-Factor

Fiscal Instruments
Benefits Drawbacks

CIT

Familiar for both parties Profit based

Can be varied by the State so may increase Investor risk perception Requires additional instruments

Windfall SPT

Can be complex Progressive therefore increasing the reduces impact on administrative burden Investor decision making Can be subsequently modified by the State Flexible therefore so may increase protects State Investor risk perception
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Fiscal Instruments

Benefits

Drawbacks

Regressive Does not factor in Contractors costs Immediate income for the State Simple administration Delays cost recovery for Investor

Royalties

Potentially complicates double taxation relief administration

Limited flexibility

Fiscal Instruments

Benefits

Drawbacks

Bonuses

Guaranteed State income

Increases Contractors project risk where exploration uncertainty exists

Productio n Sharing

Progressive therefore reduces impact on Investor decision making Double taxation relief Flexible therefore protects administration State Immediate income for the In order to be stable, State must evaluate rates and Reduces the number of bands carefully before fiscal instruments required PSC/PSA is signed Stable environment for Investors

Sharing Mechanisms

Some specific benefits and costs of each method of production sharing are outlined below (in addition to those listed on the previous slide):
Benefits Drawbacks

Not based on project profitability

DROP based on profit hydrocarbon s

Relatively simple to calculate and administer

Low volumes but high prices can limit State share

Requires accurate volumes

Sharing Mechanisms

Benefits

Drawbacks

Based on direct measure of project profitability

Rate of Return

Potentially no different treatment of oil and gas Same rates can be applied to onshore and offshore projects Considers the time value of money

Acceptable rates of return may vary dramatically between investors and concept less simple than volumes or R-Factor may complicate negotiation Sensitive to timing of costs Requires effective cost audits to be performed regularly

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Sharing Mechanisms

Benefits

Drawbacks

Based on direct measure of project profitability No different treatment of oil and gas required

R-Factor

Same rates can be applied to onshore and offshore projects Conceptually simple: once revenues > costs, taxation increases

Does not directly consider the time value of money (although this can be factored in through the cost recovery cap) Requires effective cost audits to be performed regularly

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Wider Fiscal Issues

Capital Gains Tax ensures where value is added by international Investors, the Kenyan State will receive a share of the benefit. Transfer of interest via the sale of non-resident Company shares does not appear to be directly addressed by the 9th Schedule of the ITA. Clarity in relation to the pay on behalf scheme.

Withholding Tax protects against interest / dividend stripping by non-resident companies. Interest stripping can result in income being paid to nonresident companies via interest repayments (profits can be removed by excessive repayments). Dividends paid to non-resident parent companies can help owners realise an investments value whilst avoiding CGT.

VAT on sale to domestic end users reasonable (consistent with HFO) but research required into VAT on LNG sales.

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Fiscal Instruments Best Practice

Best practice:

A progressive fiscal regime, as this is a highly desirable feature for the Investor, balancing taxation of profits against the projects profitability. Use of production sharing (most progressive / flexible) either the R-Factor or ROR methods would be broadly appropriate. An R-Factor approach why?

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Why R Factor?

Under the R-Factor, profit hydrocarbons are allocated using a measure of project profitability, therefore highly progressive and flexible (captures windfalls but also reduces taxation for marginal investments).
The DROP method does not specifically include costs when determining the profit hydrocarbon share so provides limited relief for marginal projects. The DROP method requires additional instruments to effectively capture windfall situations.

With the R-Factor it is possible to use only one method of taxation reducing the administrative burden.
Some form of windfall tax is required under the DROP method.

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Why R Factor?

Stable as the State does not need to alter the terms agreed with the Investor if the project turns out to be more or less profitable than expected.
Including a windfall tax to support the DROP method may increase uncertainty for investors / reduce stability if possible that rate may be modified in subsequent periods by future Governments.

Can be tailored to specific situations if required (such as extremely long project timelines which may require the cost recovery cap to be increased) the same is true for DROP.

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Why R Factor?

Calculated using basic cash flows therefore simple to calculate the R-Factor, but also relatively simple to audit costs incurred.
DROP requires volumes to be measured accurately which can be more complicated. DROP may under-tax profitable fields with low production volumes

Consistent terms for oil and gas, as well as onshore and offshore developments may help to reduce the administrative burden when implemented.
DROP requires different terms or at least some form of conversion of gas volumes into oil equivalents or vice versa.

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Other Best Practices

It is in good order that:

The current VAT treatment is maintained for oil and gas developments, however research is required into the treatment of LNG exports. WHT should only be charged at generally applicable rates. A specific study into the appropriate rate of WHT to be levied on interest and dividend payments to non-residents should be performed. Revision of Schedule 9 of the Income Tax Act to remove any uncertainty over how gains are taxed, and how these gains interact with the PSC framework.

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Thank you!!

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