In the absence of the explicit ring-fencing of costs, the Guyana 2016 Production Sharing Agreement (2016) has provoked unqualified and perhaps even one-sided condemnation. The argument has been that this constitutes a fatal weakness of the contract, and, consequent to that, “proof of poor negotiation” capability. Even the IMF seems to be heading in this particular direction, despite the fact that otherwise, the IMF has championed caution on this matter, and indeed resisted any rush to judgment on the ring-fencing of costs.
The predicted outcome of the adverse effect of there being no ring-fencing, may very well turn out as accurate. This, however, cannot be established a priori. It can only be established definitively, after a case study of the operations of Guyana 2016 PSA is conducted sometime post-2020. As of now, despite the pretensions of the advocates for ring-fencing their claims must remain speculative, and by no means a foregone conclusion. In this matter, therefore, the informed reader needs to beware of all claims of certainty of outcomes for Guyana’s 2016 PSA. At this stage, this is premature, based on the uncertainties and risks facing that PSA, and indeed all petroleum contracts designed to operate in a world in which future uncertainties and risks are inextricably imbedded.
As promised last week, today’s column starts with a further discussion as to whether the absence of ring-fencing of recoverable costs in the Guyana 2016 PSA, should be condemned as fatal, and rejected a priori, without deeper and more analytic evaluation than that which has appeared in the local media thus far.
What is ring-fencing?
Definitions of ring-fencing are quite straightforward. Thus, the IMF (2001) concisely defines it as “a limitation on consolidation of income and deductions for tax purposes across different activities or different projects undertaken by the same taxpayer.” Alternately, D N Meehan (Baker Hughes, 2011) states, “ring-fencing is simply the level at which each fiscal or administrative component is to be calculated or administered”.
In the petroleum sector, ring-fencing can range from the whole country as a unit in which the Contractor operates, right down to a specific “field/deployment” area for which recoverable cost is determined as a fiscal item in the contract-agreed fiscal package. In practice, the ring-fencing concept has been used also in a wide range of business sectors, particularly banking and finance, following on the 2007-8 financial crisis.
To be expected, there are wide variations in the types of ring-fencing arrangements inserted into petroleum contracts. Generally, industry analysts seek to grade these variations in terms of their “restrictiveness”. This usage permits the highlighting of the basic consideration: in the absence of ring-fencing, Contractors are able to deduct exploration and development expenditures from each new project against income from those projects already generating taxable income. Further, as petroleum areas mature (because they are mined out), this discourages new investors entering the sector. Particularly, if those investors do not have income against which they can deduct their exploration and development expenditure.
I have not come across a single serious contribution to the analysis/evaluation of ring-fencing, which while stressing its merits, did not immediately seek also to qualify their claims through stressing the pitfalls and dangers of ring-fencing costs. The Natural Resources Charter poses the dilemma in an important publication: ‘The Challenge: The Double-edged Sword of Ring-fencing’.
From this title it is clear that, while large amounts of capital expenditures are immediately deductible, thereby making it possible to delay paying income taxes for many years, ring-fencing is one way of limiting income consolidation for tax purposes. However, it is further stressed that: “Despite widespread use, ring-fencing must be approached with caution.” The caution is that it can deter further exploration and development expenditures, because these are now less profitable than without ring-fencing, thereby limiting the future tax base.
In a case study evaluation of Ghana’s PSA, (Getting a Good Deal: Ring-fencing in Ghana) under lessons learned, Readhead advises: “while ring-fencing may be a necessary safeguard against tax base evasion, Government’s must consider the various trade-offs when deciding to ring-fence and if so, how tightly the ring-fence should be drawn”.
Turning to the public debate on Guyana’s 2016 PSA, it has been observed time and again this has suffered from grave overreach, as well as exaggerated pretensions of certitude, based on suppression, (whether accidental or otherwise), of the cautions stressed in the literature. This has led some to see in this behaviour, part of a deliberate pattern, with mischief as its chief intent. Similarly, others attribute this defect to ignorance or incompetence. Personally, I find it hard to believe that anyone could court such dismissals on matters of grave importance not only to them, but to the citizenry of Guyana at large.
After all, most of the topics covered in the debates to date, have transformative potential for Guyana in its coming time of oil and gas production and export. In the face of this prospect, there have been far too many mis-specifications, (intended and unintended). These important debates have ranged across topics such as the likely state of the world’s petroleum market circa 2020, the sovereign wealth fund, membership of the Extractive Industries Transparency Initiative (EITI), building a local oil refinery, local content provisions, the management/governance of the coming petroleum sector and the likelihood of, and protection against, environmental dangers and mishaps.
The major conclusion I would stress is that topics such as those covered today, do in their essence, speak to trade-offs facing the Principal (State) and Agent/Contractor (Exxon and its partners). The Principal owns the petroleum wealth and the Contractor principally explores for, finds, and operates the production-distribution-and sale of the discovered reservoir. These interests might converge, (for example, in seeking maximum ‘finds,’) but they also might diverge or even conflict (for example, on the distribution of the benefits of this yield).
To ring-fence is, therefore, neither unambiguously beneficial to the Principal (State) nor the Agent (Exxon and partners). There is a trade-off, where the correct choice is a matter of balance. This may lead to lower revenue in the short to medium term, but nevertheless stimulate investment flows into Guyana’s petroleum sector over the long run. That is, Resource Revenue Timing: Now or Later, as it was indicated last week.
Next week’s column starts with presenting the major policy trade-offs in PSAs.