“Turning petro dollars back on: a game theory approach
I appreciate the opinion written by Prasodjo et. al on October 4, 2011 (link above), in general, the opinion is interesting, however, I would like to share some critical comments.
My understanding from your opinion is that the royalty (and tax) system is better than the Production Sharing Contract (PSC), in the view of game theory. It seems that it is mainly caused by the cost recovery issue.
It is not true to divide the component of PSC simply into two categories: cost oil and profit oil. In most PSC (Including Indonesian PSC), there are three categories, First Tranche Petroleum or FTP (which is similar to royalty in other PSC model, please note that many PSC systems also apply royalty), profit oil and tax. While, in the Royalty tax system, the government only receive two types of payment, namely: Royalty and tax. Therefore, it is obvious that in the royalty and tax system, the government will not get a share of profit (profit oil).
In my opinion the conclusion of the opinion is vague simply due to misunderstanding in seeing what is cost recovery. This simple illustration below hopefully clarify:
Let’s assume that I and a friend open a business venture, let say “fried banana” with fifty : fifty scheme, if the cost of fried banana is 100, while the selling price is 150, then we will make a profit of 50. Each of us will get 25. How about 100?. This will also return to us (in the language of the PSC, we conducted a "cost recovery"). Of course, it is not make any sense if we are each investing 50, in the end, we only have the right to claim 25. This is not business, but community service.
The simple illustration above shows that in any type of business, there must be a "cost recovery". The difference is that, for non-PSC business, we can immediately claim such costs from revenue (such as illustration of "fried banana" above). Meanwhile for PSC business, we can not directly claim cost that we have spent, because it first must go through government for approval.
In general, the main goals of business are seeking a profit, not only recover the cost. If this is the case (only recover the cost), it is clearly better to put the money in the bank and earn interest. In oil industry, there is a time lag between expenditure and resulting revenue (could be 5-7 years from the money that we spent at the exploration stage, until the first production, of course if there is discovery). In addition, there is no interest earned from cost recovery. Therefore, it is misguided (and a bit funny) if anyone thinks that the oil companies aim is only looking for cost recovery.
If the oil company use the royalty tax system, they can simply deduct their cost from their revenue. It is worthy to note that the main idea behind the birth of PSC is the “government control”. In the royalty tax system, the government control’s will be minimized, it is difficult to understand the hypothesis mention that the oil company will be more cost efficient if they operate using royalty tax than PSC. To the best of my knowledge, there is no single paper/study support that hypothesis.
Let’s have another illustration: as we know, BP has many upstream operations around the world, with many types of contract: some are PSCs, other Royalty/taxes or may be service contract. I doubt if BP management treat their cost policy differently simply because one use PSC and other use Royalty/tax. In other words, it is ridiculous if BP instruct not to aware about cost with the PSC system since it has cost recovery mechanism. Because they know, the higher the cost the lower their share of profit oil.
In Indonesia, the concept of royalty/taxes is nearly similar to what we have used in the mining sector, how do we know that the companies in this sector conduct better cost efficiency?. In fact, since there is less supervision in the royalty/tax system than PSC, the possibility to do “unnecessary investment” may be higher, this will have an impact to lower taxable income, in the end, government will receive lower taxes.
Although, mathematically, it is always possible to design the same level of government take for both PSC and royalty/tax, in the case that the objective is to have higher government take, then it can achieved easier using PSC.
Any model has shortcoming, PSC is not an exclusion; it is not necessary means that replacing PSC with the new models automatically solves the problem. I am a bit concerned with the statement made by some observers that we are unable to manage the cost recovery so that we have to find other models without dealing with this (cost recovery) mechanism. The fact that there are unique risks and rewards in oil and gas industry, the end result of the new model that is introduced may produce less government share compare to the existing PSC model.
The issue of adopting a new model is also a hot issue in Brazil. Differ from Indonesia, the Brazilian government proposes to switch to production sharing contract (PSC) instead of its current system (royalty/tax) for potentially world-class discoveries in Santos pre-salt basin. Santos pre-salt basin is very important for Brazil oil industry, these projects will bring Brazil from net oil importing to a net oil exporting country.
Worldwide trends for the last decade show that terms and conditions in oil gas contracts are becoming more sophisticated, in the context of project economics, whatever the model selected, it may be the best from the perspective of the country (of course, one country may adopt some type of models depending upon the geological and other factors). For example, in Russia, majority of their contract models are royalty taxes with greater state participation for their national oil companies, surely this will provide the bigger share of profit to the country as a whole. My observation shows that the royalty taxes is only effective if the National Oil Company (NOC) involved in the block with significant share. If there no involvement of NOC or NOC has only minor share, The PSC is more effective as a tool to capture the economic rent.
Let me conclude my comment, the selection of model contract should be considered on case by base basis since there is a diversity of project risks (deepwater, mature field, marginal field, EOR project, new blocks offered, etc), therefore: a one-size-fits-all model does not exist.
*) Disclaimer: The views presented in this comment represent my personal views