The importance of royalty
In the last column which appeared on August 17, I indicated that I would touch next on royalty in petroleum contracts. The concept of royalty under Guyana petroleum laws gained some prominence when the Minister of Natural Resources had succeeded in negotiating an increase in the royalty rate from 1% to 2%, in each case expressed as a percentage of crude oil produced and sold. In fact, the Model Petroleum Agreement provides that royalty would be paid in kind and at the delivery point which is defined as the “fob point of export in Guyana, either offshore or onshore, which shall be agreed by the oil company and the Minister.
Royalty is not peculiar to any particular type of petroleum agreement which broadly can be one of the concessionary system or the contractual system. In other words, royalty can feature in the concession system or the contractual system. Recall that under the concession system, the host country may be paid a signing bonus, royalties based on production and taxes on taxable profits.
Concessions are recorded as the oldest form of petroleum contracts but these are more recently referred to as the Royalty Tax System. Generally, a royalty tax regime can be made up of a combination of three elements: a royalty to secure a minimum payment, the regular income tax applicable to all companies and a resource rent tax which is aimed at capturing a large share of the profits.
Under the Production sharing contract model, the host country retains title to the petroleum until it is produced and ready for export or distribution at the wellhead at which point the Government and the contractor each takes its share which compensates the contractor for its risks, reimburses it for its expenses for exploration, development and production and for its share of profits. It is not unusual to find that under this model, a signing or signature bonus may also be payable, as well as production bonuses at various thresholds of production.
Royalties are also common to production sharing contracts although there are arguments against them under any system. Since such a payment comes off the gross income or barrels of oil produced they are a disincentive to production particularly in relation to marginal fields and it is perhaps why royalty payable under section 45 of the Petroleum Exploration and Production Act may be remitted in whole or in part under section 49 after consultation with the Minister of Finance. The Model Agreement seems to favour the production sharing contract arrangement under which all the risks are borne by the contractor who is allowed to deduct his expenses before sharing what is called profit oil.
The key similarities and differences between the Production Sharing Contract and the Taxation-Royalty Contract are as follows:
Production Sharing Contract Taxation-Royalty
Royalties √ √
Cost oil √ x
Profit oil √ x
Share of production √ x
Tax on profits x √
It is doubtful that there is such a concept of a fair rate of royalty. In fact, the better question is what is a fair return to the contractor and the host country given that in the first case the contractors bears all the risks while in the case of the host country, the country is giving up a non-renewable resource and expects to get a fair rent.
Royalty rates for countries not signed to a Production Sharing Agreement can range from as much as 33% in Venezuela or 30% in Bolivia to 2% in Guyana; profit share to the Government under a production sharing agreement may be as high as 75% based on the scale of production; taxes on income can be actual or deemed, as in the case of any company benefitting from the modification under section 51 of the Petroleum Exploration and Production Act; there can be a host of miscellaneous payments and bonuses; and in the case of a production sharing contract there can be a cap on cost oil from 60% to 90%.
Host governments must avoid being seen as greedy, as Indonesia and Mexico learnt to their cost. While existing licensees may be forced to take a reduced income, it will become difficult to attract other investors. At the same time petroleum companies must also avoid gouging and a reputation for taking advantage of their financial power. Readers may want to determine for themselves what a fair take is but are cautioned that rates vary wildly among petroleum producing countries.