April 25, 2011

Maximizing the Value of Oil Resources in the MENA Region: The Critical Role of Petroleum Fiscal Systems

The question of how much oil the world will need to meet demand in the coming years is the subject of considerable debate and uncertainty. There is, however, general consensus about the fact that OPEC’s role in supplying world markets will increase as non-OPEC supplies reach their peak, and that much of the required increase in production capacity will come from the countries of the MENA region. The addition of future production capacity, which will involve greater technological difficulty, will require investment of hundreds of billions of dollars. Meeting this challenge will require national oil companies (NOCs) and international oil companies (IOCs) to combine their skills, capabilities, and resources in long-term partnerships.

With oil prices once again having breached US$100 per barrel, the debate over future oil supply and demand balances is growing ever more intense. On one side are warnings of an oil price spike by 2015, and on the other a belief that the markets are currently, and will remain, well supplied. Amidst a wealth of analysis, both sides agree on one thing: OPEC’s role in supplying world oil markets will increase as non-OPEC oil supplies peak in coming years.

Over the past decade, growth in non-OPEC oil production has been largely driven by the countries of the former Soviet Union. In contrast, many established non-OPEC oil producers have experienced significant production declines. “With production from existing fields declining by an average of about 5 percent each year, the International Energy Agency (IEA) expects non-OPEC oil supply to peak around the middle of the coming decade. Consequently, the agency predicts that OPEC’s contribution to global oil markets will rise from 42 percent in 2011 to 52 percent in 2035—a level not seen since the early 1970s,” said Dr. Raed Kombargi, Partner Booz & Company.

With the world economy emerging from a punishing recession, estimates for oil demand growth—and the amount of related investment required—remain hugely uncertain. OPEC estimates new oil production capacity investments will range between $180 billion and $430 billion between now and 2020, depending upon the growth outlook for the global economy. “Even so, the recovery in oil demand that began in 2010 means spare capacity is increasingly being used. Industry analysts predict that spare capacity will tighten to about 2 million barrels per day between 2013 and 2015—a level comparable to the 2006–2008 period, when oil prices spiked from $30 per barrel to $145 per barrel,” said Asheesh Sastry, Principal Booz & Company.

The countries of the MENA region will continue to lead in establishing new oil production capacity. With a trend toward increasingly complex and challenging developments, the addition of new capacity is likely to place greater demands on NOCs. The expected challenges include: the development of less productive, more complex reservoirs, the development of heavy and sour oils, the development of smaller, less promising fields, improved oil recovery, enhanced oil recovery and increased project complexity.

Against this backdrop, OPEC countries and their NOCs are grappling with the dilemma of how to plan capacity additions in the face of market uncertainty and greater technical difficulties. Successfully managing these challenges will require deeper collaboration between NOCs and IOCs, founded on a complementary set of goals and targets. “It will be critical for MENA governments to tailor their petroleum fiscal systems to adequately align NOC and IOC objectives, one hand ensuring that countries maximize the value of their resources and capture any upside and on the other hand guaranteeing acceptable returns for their IOC partners to stimulate technology deployment and investment,” said David Branson, Executive Advisor
Booz & Company.
 
Petroleum fiscal systems fall under three main categories. Each system has its own distinctive terminology and mechanism for the division of revenues between the host government/NOC and the IOC.

A. Royalty/Tax (Concession) Systems: The key feature of the royalty/tax system is that title to produced hydrocarbons transfers to the IOC at the wellhead, which gives the IOC the right to dispose of its equity share of hydrocarbons produced.

B. Production Sharing Agreements: Under a production sharing agreement, an IOC acts as a “contractor” to the NOC; title to hydrocarbons may or may not be transferred to IOCs and certainly not at the well head.

C. Service Agreements: Under Service agreements, an IOC acts as a contractor to the NOC and receives a predetermined fee for a defined activity. Title to hydrocarbons remains strictly with the host government.

Despite the key philosophical differences between the systems, they increasingly share a number of fiscal, economic, accounting, and financial features that have blurred the distinction between them. Today, each system borrows elements from other systems, including such common features such as state participation, bonuses/royalty payments, cost recovery and profit-sharing.

IOCs increasingly view production sharing agreements as offering a fair basis for their investment, as the agreements generally align the goals of the NOC (e.g., resource and operations ) with those of the IOC (e.g., access to volume and price upside, reserves booking). In contrast, royalty/tax and service agreements generally do not offer this level of alignment, as the distribution of risks and benefits can be perceived as favoring one of the parties. Irrespective of the choice of fiscal system, NOCs are considering a number of guiding principles in designing and implementing appropriate fiscal systems:

  • Establish a basis of competition that ensures the host government will achieve its production and recovery goals while extracting maximum value from its hydrocarbon resources, benefiting from any upside as well
  • Ensure that the IOC receives a fair share of the rewards commensurate with the characteristics of the opportunity and the specific technical and non-technical risks the IOC will likely face.
  • Provide a stable and predictable system that offers a long-term basis for investment and is able to adapt to unexpected technical challenges and outcomes.

Countries in the region that fail to design their fiscal systems appropriately may still attract outside investment, but they risk forming business relationships that are short-lived. The partnerships that persevere will be the ones that are formed through a mutual understanding of what it will take to make both sides prosper. That middle ground will differ from country to country. “There is more than one way to achieve a proper balance, but with these principles and lessons in mind, MENA governments will be one step closer to attracting the partners they will need to maximize the value of their natural resources and position the region to meet and capitalize on the world’s ever-expanding energy demand,” concluded Kombargi.