W4_John Bwala_Choosing Petroleum Fiscal System

W4_John Bwala_Choosing Petroleum Fiscal System

By John Bwala on November 16, 2012

Problem statement

In the Nigerian Oil and Gas Industry, couple with the recent passage of the Nigerian Content Development and Monitoring Board (NCDMB) Act, a lot of indigenous oil and gas Companies have acquired marginal fields relinquished by the oil majors.  An indigenous company B, who acquired OPL 001, is not quite sure of the fiscal policy to adapt. In Nigeria we have three different types of fiscal policy which a prospecting oil company can adapt if it meets the requirement, therefore which one of these fiscal policy fit company B? This question has been answered in my week 3 (W3) posting.

The next question is, will applying External Rate of Return on the profit from the Concessionary (Sole Risk) Contract, a wise decision for company B?

Alternative Solution

Below are the three (3) types of petroleum fiscal model which company B will like to consider in an effort to determine the one that is most profitable:

1. Concessionary contract

·         Sole Risk

·         Joint venture

2. Production Sharing Contract

3. Service contract

Concessionary Contract:-

The concessionary contract is of two types:

Sole Risk:

·         The Operator owns 100% of the concession; (Government is not a partner)

·         Concession Owner pays Taxes and Royalties to the Government

Joint Venture:

·         The National oil company is usually  not an Operator and generally holds 50% and above

·         The partners in the JV have undivided interests and contribute by cash-call to the JV OPEX and CAPEX expenses. The partners share oil and gas production according to their equity interest.

·         The JV is Unincorporated and governed by a joint operating agreement (JOA) between the Parties.

Production Sharing Contract:

·         Government owns the concession

·         The Partnering Company is the Operator

·         Governance is by the Management Committee (MACOM)

·         The Operator (Contractor) funds all OPEX and CAPEX and assumes all pre-production risk.

·         Reimbursement of Operator’s cost depend on production

Service contract:- Service contract cannot be applied here since Government National Oil Company is not interested in acquiring marginal field.

Note: Government also is not interested in founding another JV agreement.

Selection Criteria

1.      Taxes

2.      Net Present Value (NPV)

3.      Internal Rate of Return (IRR) which is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero.

Analysis and Comparison of Alternatives

Below is the analysis of the percentage of the Company B and Government take home for both Concessionary and Production Sharing Contract (PSC) agreement.

Concessionary System (Sole Risk) Flow Diagram

To make it simpler an average barrel of oil = $85.00 was used.

	One Barrel of Oil = $85.00
Company Share		Government (National Oil Company)
	Royalty 15%	$12.75
	$72.25
$35.00	Deductions (Operating cost etc.). No   Limit
	$37.25
	Provisional Taxes (10%)	$3.73
	$33.52
	Federal Income Taxes (35%)	$11.73
$21.79	Net Income to the Company after Tax
$56.79	Total Income to company and Govt.	$28.21
66.81%		33.19%

Production Sharing Contract (PSC) Flow Diagram

To make it simpler an average barrel of oil = $85.00 was used.

	One Barrel of Oil  = $85
Company Share		Government (National Oil Company)
	Royalty 10%	$8.50
	$76.50
$34.43	Cost Recoverable   (Operating cost, DD&A etc.) 45% only
	$42.10
$16.83	Profit Oil split (40/60%)	$25.27
($5.89)	Federal Income Taxes (35%)	$5.89
$45.34	Total Income to Company and Govt.	$39.66
53.34%		46.66%

The tables below shows how the NPV and the IRR were calculated and also it shows company verses Govt. NPV

This formula can be used to calculate IRR,  0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n

Where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n, respectively; and

IRR equals the project's internal rate of return.

However a general rule of thumb is that the IRR value cannot be derived analytically. Instead, IRR must be found by using mathematical trial-and-error to derive the appropriate rate. For this solution IRR were calculated with business calculators and spreadsheet programs.

Concessionary System (Sole Risk) Contract

Company takes 66.81%, while Govt. takes 33.19% of every barrel of oil produced.

Company planned to spend $400,000,000

Discounted Rate of 12%

Time Period (T)	Total bbl produced per annum	Average price of oil in a year	Discount Rate (DR)	DR + 1	(DR + 1) ^ T	NPV of Cash Flow{Cash Flow / (DR +1)^T}
						Company ($)	Govt ($)
0			0.12	-	-	(400,000,000)
1	3,000,000	$85.00	0.12	1.12	1.12	152,112,053.60	75,566,517.86
2	3,200,000	$90.00	0.12	1.12	1.25	153,930,240.00	76,469,760.00
3	3,100,000	$87.00	0.12	1.12	1.41	127,791,893.60	63,484,702.13
4	3,000,000	$88.00	0.12	1.12	1.57	112,342,929.90	55,809,936.31
5	2,900,000	$86.00	0.12	1.12	1.76	94,672,806.82	47,031,738.64
NPV						240,849,923.90	318,362,654.90
IRR						20%

Production Sharing Contract

Company takes 53.34%, while Govt. takes 46.66% of every barrel of oil produced.

Company planned to spend $400,000,000

Discounted Rate of 12%

Time Period (T)	Total bbl produced per annum	Average price of oil in a year	Discount Rate (DR)	DR + 1	(DR + 1) ^ T	NPV of Cash Flow{Cash Flow / (DR +1)^T}
						Company ($)	Govt ($)
0			0.12	-	-	(400,000,000)
1	3,000,000	$85.00	0.12	1.12	1.12	121,443,750.00	106234821.4
2	3,200,000	$90.00	0.12	1.12	1.25	122,895,360.00	107504640
3	3,100,000	$87.00	0.12	1.12	1.41	102,026,936.20	89249659.57
4	3,000,000	$88.00	0.12	1.12	1.57	89,692,738.85	78460127.39
5	2,900,000	$86.00	0.12	1.12	1.76	75,585,204.55	66119340.91
NPV						111,643,989.60	447,568,589.3
IRR						10%

Selection of the preferred alternative (W3 blog posting):-

From the analysis above Company B have higher NPV and IRR from the Concessionary (Sole Risk) Contract compare to the Production Share Contract at the same terms and condition. Therefore Company B will be better off with Concessionary (Sole Risk) Contract than PSC.

Eternal Rate of Return (ERR)

This is where the W4 blog posting analysis started and it is based on concessionary Contract alternative chose by Company B in the previous analysis.

To determine if the available External Rate of Return is worth investment by Company B, the below formula can be used:

Where

Cj= denote initial cost of investment alternative j

Rj= denote net revenue received from investment j during period t

i = External rate of return

r = reinvestment rate for positive cash follows in period t. Normally r= MARR since MARR reflects the opportunity cost for money available for investment

Using the data from the concessionary sole risk table ERR can be calculated as follows

Therefore

640,849,923.9 (F/A, 12%, 5) - 400,000,000(F/P i, 5)

From the factor table (F/A, 12%, 5) = 6.3528

Therefore

640,849,923.9(6.3528) – 400,000,000(F/P, I, 5) = 0

(1+ i)⁵= (4.07x10⁹/400x10⁶

(1 + i)⁵ =   (4.07x10³/400)

(1 + )⁵ = 10.175

i = 5.90%

I = 6% < MARR = 12%

Hence, decision is economically is wrong

Selection of the preferred alternative (W4 blog posting):-

From the analysis above Company B has higher NPV and IRR from the Concessionary (Sole Risk) Contract compare to the Production Sharing Contract, given the same terms and condition. Therefore Company B will be better off with Concessionary (Sole Risk) Contract rather PSC and stick to the income based on IRR of 20% rather ERR of 6%. That is the choice of ERR is a wrong economic decision.

Performance monitoring and post-evaluation of results:-

The field needs to be evaluated properly in order to weigh the risk involve whether Company B can afford to bear it.

Company B must continue to negotiate with the government to keep the fiscal policies favorable for investment.

The Contractor must persuade the government (National Oil Company) to sign the signature bonus with stabilization clause.

Company B should be watching out for an attractive ERRs before going to invest in an external venture.

References:

Johnston Daniel. International petroleum fiscal systems and production sharing contracts (Tulsa, Oklahoma : PennWell Books, c1994), pp. 29 – 48.

Sullivan, W. G., Wicks, E.M., & Koelling, C.P. (2009). Engineering economy and design process. In M.J. Horton (Ed.), Engineering economy (15^th ed.) (Chapter 5) (pp. 222)

Chan S. Park. Fundamentals of Engineering Economics (Third Edition) (Chapter 7) (pp. 280 – 293)

1993 PSC Agreement (Nigeria) clause 8 (Recovery of operating costs and crude oil allocation) subsection f.

Web Publications

Nigerian content development and monitory board act retrieved from http://www.ncdmb.gov.ng/index.php/nc-act

Investing answer retrieved from http://www.investinganswers.com/financial-dictionary/investing/internal-rate-return-irr-2130

External Rate of Return (ERR) retrieved from http://www.me.metu.edu.tr/courses/me443/Assets/lecture%20notes/ME443_CH3.pdf