Government take and the 2016 PSA: Misleading metric

Rational incentive

Based on the economics Nobel Prize winning theory of “incomplete markets”, my previous column posited that, the Parties to Guyana’s 2016 PSA have a rational incentive to re-negotiate the contract, if underlying conditions of the country’s petroleum sector drastically change. This holds true, in spite of declarations by the Parties not to re-open negotiations. The reason for this is that, from the oil companies’ perspective, their goal is to optimize profits for their shareholders, based on their global portfolio of assets and “risk-reward preference function”. The Government of Guyana’s (GoG) perspective at the project level is on whether the financial/social benefits derived from the sector are consistent with its risk level and the preference function it has set itself.

In this context, the performance outcome that matters most to the GoG, is the division of profits between the Contractor and itself. GoG share is known as the “Government take”. I had briefly referenced this metric in the conclusion to last week’s column. That take is the product of a negotiated outcome.

Government take

The take therefore, is not an economic statistic but a fiscal metric. When employed by serious analysts, they define it in order to avoid ambiguity. The metric is also recognized as a preliminary reference, when assessing governments’ negotiations effort. Additionally, analysts admit that: “comparing the take of different projects and/or different countries is a very difficult and often misleading exercise”.

Many considerations account for this complication, one of which I had provided last week. There are other such considerations: 1) to ensure Government take is accurately measured at the project/country level, analysts have also to forecast accurately, expected cash flow for the project (that is, ex ante), or 2) if this is done after the project/country experience is ended (that is, ex post) data which are typically kept confidential for commercial reasons, would have to be forthcoming.

Definition

Energy analysts define government take “as the percentage of the petroleum pre-tax project’s net cash flow adjusted to take into account any form of Govern-ment participation. The take can be calculated in discounted or undiscounted value”. S. Tordo (2007), Fiscal Systems for Hydrocarbons – Design Issues, (World Bank Working Paper 123) The discount rate employed, reflects the time value of money. (That is an amount of money today is worth more than the same amount paid one year into the future). Typically, the discount rate used is the interest rate ruling in private markets. For governments however, future benefits are discounted by the social discount rate. This rate is not objectively determined in the market place.

Meanwhile, oil Contractors use economic indicators to evaluate projects. Readers are aware that the private sector measures project performance by 1) the Net Present Value (NPV) of the project’s cash flow (that is, the present value of the expected cash flow of a project, after discounting the future cash flows) 2) the Internal Rate of Return (IRR) which indicates the relative attractiveness of projects or 3) the Profitability Ratio (PR), which is the ratio derived from dividing the NPV with total capital invested in a project. This indicator reveals the profitability of each unit of money spent worldwide by the Contractor, thereby aiding the selection of projects.

Alternative definitions

Another perspective on government take might help readers’ appreciation of this fiscal metric. Some economists conceptualize fiscal systems and oil contracts through their functioning in a global petroleum market. Scores of governments are involved in selling oil contracts. And, similarly, scores of companies are involved in buying these contracts. Supporting these sales/ purchases are a large number of available oil fields/reserves. Governments’ take arises from the balancing of the demand and supply for these oil fields/reserves. The “price” obtained for any given field/ reserve is determined by the resolution of demand and supply, resulting in a “price” or government take. In effect therefore, that price is the “total effect of the fiscal system on the cash flow of an oil field or country’s reserves” (World Bank, Note 46, ‘Fiscal System For Oil’), 1995.

At the time the World Bank Note was published, the estimated world average government take was 64 per cent. The take ranged from a low of 25 per cent (Ireland) to 95 per cent (Yemen). The modal take ranged between 40 and 85 per cent.

Limitations

As a performance indicator of the fiscal regime, government take has several limitations. First, (like the Guyana 2016 PSA), take is not ‘neutral’ in regard to the impact of oil price changes on it. Govern-ment take will, in all likelihood, vary with both crude oil prices and Contractor profits. Given this, profits, prices, and therefore production and costs should be measured over the “life cycle” of the oil field, if they are to be relied on. Second, a similar “non-neutral” situation exists for the production of crude oil.

Thirdly, because it is the full life cycle of any oil field (project) that has to be considered, readers should bear in mind that this could last for several decades! This makes estimation hazardous. It also makes the time sequence of the profit-flow relevant to the outcome. This consideration relates to the concept of the time value of money introduced above. Because of this factor, economists and accountants have evolved a preferred measure to Government take  ̶ the Effective Royalty Rate (ERR). The ERR measures Government take after taking into account clearly defined accounting periods.

Zero-Sum Game?

Industry analysts often take great care to ensure that divisions between Governments take and Contractor’s profit are not represented solely as a Zero-Sum Game. That is, one in which one party gains only at the expense of the other. As we saw, the Contractor focuses on the NPV, IRR or PR and therefore, it is in practice possible for the value going to both groups to rise, if market conditions favour this outcome.

However, this does not mean there is zero likelihood of a zero-sum game. No! This potential resides in the timing of returns. Both Government and the Contractor may strive for early returns. Typically, Government spending needs for public goods and services are urgent. Investors also want to get their returns early. This competition can lead to a zero-sum game, but this may not always be the case!

Next week, I continue this discussion.

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