Upstream Petroleum Fiscal and Valuation Modeling in Excel

Chapter 1

Introduction to Tax and Royalty Regimes

1.1 Introduction

1.2 Inflation and Discounting: Time Value of Money Basics in the Context of Upstream Petroleum Modeling

1.3 Introducing Basic Components of Upstream Petroleum Cashflow Under a Simple Tax and Royalty Regime

1.4 Another (Important) Multiplier - Introduction to Modeling Commercial Behavior with the Economic Limit Test

1.5 Chapter Model Housekeeping Notes

1.6 Chapter Model Assumptions

1.6.1 Assumptions: General Remarks

1.6.2 Assumptions: Time and the Time Value of Money

1.6.3 Assumptions: Commodity Prices14

1.6.4 Assumptions: Production Profile

1.6.5 Assumptions: Capex

1.6.6 Assumptions: Opex

1.6.7 Assumptions: Abandonment

1.6.8 Assumptions: Royalty

1.6.9 Assumptions: Rentals

1.6.10 Assumptions: Bonuses

1.6.11 Assumptions: Income Tax and Related Items

1.7 Pre-ELT Calculations

1.7.1 Pre-ELT Calculations: Opex and Capex Timing/Inflation

1.7.2 Pre-ELT Calculations: Bonus and Rentals

1.7.3 Pre-ELT Calculations: GOCF

1.8 ELT Calculation and Role in Economic Modeling

1.9 Post-ELT Calculations

1.9.1 Post-ELT Calculations: Abandonment

1.9.2 Post-ELT Calculations: Depreciation

1.9.3 Income Tax: Basic Concepts and Calculations

1.9.4 Returning to Main Model - Post-ELT Calculations: Income Tax

1.9.5 Post-ELT Calculations: NCF and Discounting

1.9.6 Post-ELT Calculations: Financial Metrics

1.9.7 Post-ELT Calculations: Volumetric Outcomes

1.10 Multivariable Sensitivity Analysis Using a Two-Way Data Table

1.11 The ELT - Questions to Consider

1.12 Review Exercise: Key Calculations

1.1 INTRODUCTION

In this book, we treat two principal types of upstream petroleum fiscal regime (a collection of individual fiscal devices, such as taxes):

• Tax and Royalty regimes are introduced here.
• The other major kind, known as a Production Sharing Contract (PSC) regime, is covered in Chapters 6, 7 and 8.
• The intervening chapters treat individual fiscal devices which are often used in either type of regime.

As the name implies, the main (though not necessarily only) sources of revenue for a government using a Tax and Royalty regime are income tax - payable on profits, if these occur - and royalties, which are usually payable as a percentage of revenue (almost always) whether the project is profitable or not.

Fiscal regimes based on royalties and taxes are a cornerstone of how governments extract their economic rent - here, meaning share of revenue - from petroleum producing properties. Such regimes, which are also commonly referred to as concessionary or mineral-interest arrangements, were the only fiscal regimes, or "fiscal designs," used, until PSCs were introduced in the mid-1960s.

In fact, in the early days of the petroleum and mineral extraction industries, a royalty was the only fiscal device applied that provided a state with any share of project revenue.

Land rentals, bonuses (both also introduced in this chapter) and income taxes were soon added, to increase the government's economic rent, or "fiscal take" (using "take" as a noun, to mean what revenue the government "takes"). As oil prices soared in the 1970s, governments saw their bargaining power grow at the expense of international oil companies, and introduced other supplementary or "special" petroleum taxes to capture "excess" profits.

Today, concessionary systems with two or more layers of taxation in addition to a royalty are not unusual. Typically there is also a complex set of tax allowances, credits and other incentives designed to encourage investors to invest in high-cost and risky projects. Most OECD countries have concessionary fiscal designs based on a combination of royalty and tax fiscal devices, as do some developing countries.

Our Approach in This Chapter

To keep things simple for the main example model in this introductory chapter - the discounted cashflow model found in the file "Ch1_Tax_and_Royalty_Model.xls" - we use simplified (though still realistic) royalty and tax rates, which are the same every year. Be aware, however, that the rates for income tax and - as we will see in Chapter 3 - royalties can vary over time, according to sophisticated formulas which make them flexible over a wide range of economic and production situations.

In this chapter we concentrate on the most common concepts and components of a basic (but reasonably typical) hypothetical tax and royalty regime, illustrated in a simplified (but reasonably granular) multi-year Excel fiscal model. This approach highlights:

• how various fiscal devices in many tax and royalty regimes are typically applied;
• the input assumptions required; and
• the allowances and deductions used in their calculation.

We include both an abstract-style summary and a flowchart-style "map" of our model for reference as we work through it, section by section.1

We will also pester you from time to time, asking you to make changes in the model and to decide whether the results make any sense. The ultimate goal of the model is to show how changes in the fiscal regime affect the hypothetical government's and investor's discounted net cashflows, the sum of which equals their net present values (NPVs).

To ensure readers understand both basic and certain nuanced concepts and calculations relating to NPV, we include an introductory section on the time value of money - discounting and inflation - and why they are important in valuing upstream petroleum properties. Even if you are already familiar with discounted cashflow valuation, this section should be worthwhile for you at least to skim, to see which calculation approaches we have adopted as standard in this and other chapters.

Basic key upstream-specific model inputs are introduced in layperson's terms.

We also introduce some useful Excel techniques for making models easier to navigate and view, and ask "what-if?" questions, using interactive charts which show how specific fiscal devices and other key upstream input assumptions impact investor and government cashflow.

This chapter explains the need for, and the calculation of, an economic limit test (ELT), which establishes when a project ceases to be profitable and therefore should be abandoned. The ELT thus determines when production should permanently stop (or be "shut-in") and when the site should be cleaned up and restored, by decommissioning wells and facilities. The ELT is critical in optimizing future cashflow.

Sensitivity analysis is often required to establish the impacts on NPV of ranges of uncertain input variables. Spreadsheet "spinner" controls can help make it easy to change variable settings. Excel also provides a one-way and two-way "Data Table" feature, which is more useful and powerful for showing the effects of many different variable settings in a single view. We demonstrate these tools in this chapter's main example model.

1.2 INFLATION AND DISCOUNTING: TIME VALUE OF MONEY BASICS IN THE CONTEXT OF UPSTREAM PETROLEUM MODELING

Introduction

In upstream petroleum fiscal and valuation modeling, there are three considerations which determine whether an oil or gas field is potentially a promising investment. Failure in any one area negates the strengths of the others. These areas are:

Because we do not intend this book to be a complete course in petroleum economics - a field which actually brings in a lot of detail from other disciplines within the industry - we treat items 1 and 3 above only in overview. We shall address item 1 later in this chapter. We address item 3 here.

We introduce the time value of money in this section through examples which completely ignore the fiscal issues to which most of the rest of the book is devoted. This is deliberate, in order to isolate for examination:

• the unique "distortions" which the time value of money can have on the value of an oil or gas project to an investor and/or host government; as opposed to
• the (usually) unrelated distortions which...