The economic perspective… Government take, profit, and accounting for costs

Introduction

Today’s column along with the next portrays selected aspects of my recent discussion of the fiscal regime in Guyana’s 2016 Production Sharing Agreement (PSA), from the perspective of basic economic principles. I believe this would enhance readers’ appreciation of those issues. In pursuit of this, I shall discuss briefly the following five topics 1) Economic profit, government take and other developmental benefits; 2) accounting for exploration & evaluation costs (EE); 3) reserves estimation & classification; 4) the life cycle of petroleum projects, and 5) tax evasion and avoidance. The first two topics will be considered today.

From the perspective of economic principles, we may re-state the ‘government take’ relation under the PSA 1) economic profit derived by the Contractor (Exxon and its partners) from Guyana’s petroleum operations is equal to the cumulative gross revenues the Contractor receives, less the cumulative gross costs that are incurred, over the full life cycle of the project. This measure represents the operations’ cash flow. 2) Government take (expressed as a percentage), is therefore equal to all government (GoG) revenues derived from taxes/fees/imposts; profit sharing; and benefits, which are earned, if the GoG secured at some point in time, a working interest (as an investor) in the Contractor’s operations, divided by the cash flow (economic profit). 3) Consequently, the Contractor’s take (%) is the residual, or 1- government take (%). 

Based on the above relation, the GoG’s profit share can vary from zero or indeed a negative sum (loss) to very high values, depending on the overall commercial outcome in terms of marketing opportunities, prices, and production costs. The relation does not address the time sequence of the benefits’ flow to either the GoG or the Contractor. Readers should note, however, that despite their different risk-reward profiles, early benefit flows are preferred to later ones by both. Indeed, upfront payments like signature bonuses and royalties find worldwide governmental support.

Development benefits

Last week’s column had introduced economic developmental benefits, apart from the spending of government take, which are embedded in the PSA’s fiscal regime. As shown, these include local content requirements (LCRs); Research & Development (R&D); inter-industry & inter-sectoral linkages; and, the expected income multiplier effects of enhanced public and private spending as the hydrocarbons’ sector develops. Such benefits should contribute to Guyana’s growth in value-added production (GDP), income, economic diversification, differentiation and transformation. Furthermore, as I shall argue in coming columns, public spending from the government’s take is likely to be, by far, the most important contributor to these developmental processes.

Economic profit and incentives

If economic profit is represented by total revenue minus total costs, these total costs would include both monetary and opportunity costs, That is, explicit and implicit costs. It is therefore: “the surplus remaining after the full opportunity costs of all the factors of production have been met” as economics textbooks indicate.

Put this way, economic profit is not the same as accounting profit. Accounting profit, does not deduct the implicit costs, which the Contractor incurs; for example, those incurred by not employing time and own capital in alternative operations. In other words, economic profit measures the incentive the Contractor has to pursue exploration and development of hydrocarbons in Guyana.

Relatedly this also means, from an economic perspective, that accounting profit equals normal profit when economic profit is zero. At that point, accounting profit is not zero. And, indeed, it is possible for economic loss to be accruing to Exxon and its partners, while accounting profits remain positive!

Accounting for costs

A second way in which the perspective of economic principles aids the evaluation of the petroleum industry, lies in the consideration of the costs incurred by the Contractor, in relation to petroleum exploration and evaluation efforts. Such costs are incurred when establishing the technical and commercial viability of Guyana’s hydrocarbons reserves. However, it has been well documented worldwide that accounting for these costs have significant impacts on the economic benefits flowing to the host country. Economists therefore expect, as accountants have indeed traditionally urged: “the accounting treatment of exploration and evaluation (E&E) expenditures … can have a significant impact on the financial statements and reported financial results”. Economists argue this is even more likely where, like Guyana, production activities have not yet begun!

Additionally, economic principles have played a significant role in guiding accounting practice in regards to E&E. Two widely accepted methods have traditionally been applied, namely, the successful efforts (SE) and the full cost (FC) approaches (and their variants). The United States’ Generally Accepted Accounting Principles (GAAP) have dominated practice in this area.

The SE method has been reported as “perhaps … more widely used by integrated oil and gas companies, but is also used by many smaller upstream-only businesses” (Price Waterhouse Coopers (PWC): Financial reporting in the oil and gas industry, 2017). This method allows 1) costs incurred in exploration, discovery and developing reserves to be capitalized on the basis of individual fields; 2) these capitalized costs to be allocated to “commercially viable hydrocarbons reserves”; 3) however, if no commercially viable reserves are found the expenditure is charged to expenses; and 4) these capitalized costs are depleted on a field-by-field basis, as production occurs.

Several companies, however, do utilize the FC method. Here 1) all costs incurred in a country (or a large geographic centre or pool) are capitalized; 2) the costs are depleted on a country (pool, geographic cost centre) as production occurs in this unit; 3) unsuccessful efforts are therefore expensed. And, as a rule, the full cost method permits a greater “deferral of costs during exploration and development and higher subsequent depletion costs.” (ibid, page 15).

Significantly, PWC has reported, as recently as last year, (in the citation above) that: “debate continues within the industry on the conceptual merits of both methods although neither is consistent with the (GAAP) IFRS framework” (page 15).

This Sunday column is not appropriate for exploring these technical details. My main aim is to highlight traditional practice and the fact that these accounting standards are under transition.

Next week I continue examining the three other topics from an economic perspective.

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