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For flexible production sharing

25 August 2011
by Luiz Antonio Lemos, Luis Antonio Menezes da Silva & Marcelo Romanelli de Oliveira

Although the Brazilian Production Sharing Agreement Law was promulgated last year, the criterion for defining the government’s share of profit oil (the share of oil production allocated to the federal government) continues to be a mystery. This is highly relevant to the industry because it will affect the feasibility and stability of the PSA regime.

It would be reasonable for the Ministry of Mines and Energy (MME) to follow the worldwide trend and not adopt a fixed percentage for government’s share of profit oil, but rather to adopt progressive criteria, under which the sharing would vary based on project profitability. The latter course would provide greater flexibility to the fiscal regime.

The flexibility of a fiscal regime refers to the capacity of the model to adapt itself to international oil and gas market volatility, not only from the viewpoint of commodities price instability but also regarding the costs associated with a project. The concept of flexibility is inherent to a progressive fiscal regime. In short, a fiscal regime is flexible when the increase in profitability triggers an increase in government take and when a decrease of profitability reduces this take.

E&P projects may last several decades, while an inflexible fiscal regime may become obsolete in a few years. This suggests that in the absence of a flexible regime, the relationship between the state and investors will, at some point in the project’s life, become impaired.

Currently, about 70% of the world’s fiscal regimes adopt a certain element of progressivity. Based on this, it is expected that the MME may adopt a so-called sliding scale to provide some level of progressivity to the sharing. Through this system, the percentage of oil that will pertain to the government shall vary according to project profitability, the latter being inferred on the basis of such variables as level of output, the R factor (the ratio between the cumulative income/cumulative expenditure), price per barrel or rate of return. In the event progressivity is used, one question remains: which of these variables will MME adopt?

Sliding Scales

Production-based sliding scales are the forerunners and by far the most widely used tool to assign progressivity to PSAs. They were first used in the 1970s and 80s in countries like Nigeria, Sudan and Morocco. Despite being commonly employed, the major shortcoming of production-based sliding scales is the assumption that there is a direct relationship between level of output and profitability. This assumption may lead to economic distortions.

The second-most-popular sliding scale is the one based on the R factor. There are variations of the R factor but it is generally determined by the ratio between cumulative income and cumulative expenditure: the greater the R factor, the greater the government’s share of profit oil. This system represents an evolution beyond those based only on output level, as it is able to reflect the effects generated by the most significant industry variables – project costs and price per barrel.

The most efficient sliding scale is that based on rate of return, because this most accurately estimates project profitability. The rate of return is able to reflect not only variations in output level, price of oil and costs, but also timing and cost of capital. Despite the efficiency of this method, return-based sliding scales are rarely used due to their complexity and high administration costs. They are found in the former Soviet republics and in African countries such as Angola, where the government’s share of profit oil may range from 30% to 90%.

Last and rarest are sliding scales directly linked to oil price. Trinidad and Tobago, for example, adopts as a parameter the price associated with the daily average output level. The flaw in this system is the assumption that an increase in price necessarily implies an increase in project profitability.

With all these possibilities, the MME needs to be strategic. The criteria ultimately chosen to determine Brazil’s share of profit oil will be crucial to the success of the production sharing regime, not only from the viewpoint of attractiveness at auction, but also to ensure that Brazil realizes a fair share of the wealth that these projects generate throughout their lifetimes.

Source: Brasil Energy