Operating Costs and Paying the Government (5) James Henderson November 2022 The Economics of Energy Corporations (2) Outline of the course Overall objective – understand how senior management use economic models to make investment decisions 1.Introduction to key themes in the global energy market 2.Introduction to financial modelling as a management tool 1.Understanding some key concepts 3.Starting two models for an oil and a gas field – revenues and prices 4.Inputting the costs – capital expenditure 5.Operating costs and paying the government 6.A power plant – a buyer and seller of energy 7.Calculating a discounted cashflow 1.Why is it important 2.How is it used to make decisions 8.Testing the investment decisions: running some numbers under different assumptions 9.Answering your questions Increasing interaction between prices of hydrocarbons Operating Costs Key Assumptions • •Lifting costs – getting the oil out of the ground –Electricity –Rig costs –Employment costs • •Transportation – moving the oil to market –Pipeline distance and tariffs –Shipping costs and distance –Truck or rail freight – •Operating taxes –Royalties –Export tax –Production sharing agreement –Other local taxes – Contrasting operating costs Saudi Arabia •Huge reserves located in close proximity •Potential for large synergy benefits •Relatively benign operating environment •Low costs per barrel North Sea •Tough environment •Remote location •Relatively small reserves •Higher costs per barrel Contrasting operating costs North Sea •Tough environment •Remote location •Relatively small reserves •Higher costs per barrel Lifting Costs •Generally calculated by local experts with knowledge of specific environment •If a general assumption is needed, then company or country metrics can be used Oil is a global commodity •Oil is traded in multiple directions across the globe •Much of the trade originates from the Middle East and flows West and East •Prices are set relative to a set of global benchmarks Figures in mmt Trade routes key Liquid market helps security of supply Benchmark prices Shipping lanes key – control of large navies South China Sea Malacca Straits Gulf of Hormuz Russia’s huge pipeline system •text Oil tanker and the Panama Canal •text Transportation Cost •Main driver of cost is distance •Mode of transport also important – onshore pipelines versus offshore tankers •Most expensive is rail or truck transport, due to lower individual volumes Gas transportation can get complex •Gas is also transported by pipeline and ship • •Pipelines have dominated, but LNG is globalising the gas market • •Liquefaction and regasification then become an integral part of the value chain • •Costs are increased, but new markets can be accessed • •From a modelling perspective, LNG plants are included in capex, while shipping and regas costs are generally included in transport • •Shipping tariffs are based on journey time (days) multiplied by freight rates, which can vary significantly over time Gas trade flows (bcm) •Gas trade flows via two transport methods – pipeline and LNG •Historically pipeline flows have dominated, leading to regionalisation •LNG is now turning gas into a more global commodity Shift in trade mechanism making gas more like oil No global liquidity yet Large lot sizes Expanding LNG infrastructure Pipelines provide security and risk – point to point link is very strategic Long Distance Pipeline Yemen Liquefaction Facility LNG Tankers LNG tanker freight rates •Significant volatility driven by LNG demand and ship-building investment LNG Import and Regas Terminal Jurong Island, Singapore Taxation Tax and Royalty Regime • •The most common tax regime includes operating taxes and profit tax • •Operating taxes are normally taken from revenues –Export tax (on export revenues only) –Royalty (on all production) –Specific local or regional taxes (for regional government support) – •Revenue taxes are simple to collect, but can be penal because they do not take investment costs into account • •Sometimes governments alleviate the risks of revenue taxes by introducing a sliding scale relative to the oil price Types of taxes •Export Tax –Normally a % of export revenues –Occasionally banded by oil price ranges –Focus tax on premium market and prices • •Royalty –Ensures that government gets a minimum amount of revenue –Can be a % of overall revenues or a fixed amount per barrel of production –Very regressive, as takes no account of cost recovery, but very easy to collect to favoured in countries with dubious accounting regulation • •Regional taxes –Levied by local governments to support regional infrastructure –Often used to fund schools, hospitals etc. –Can be open to significant negotiation • •Corporate Tax (Profit Tax) –Levied after all costs have been taken into consideration (including other taxes) –Often a complex calculation, but does allow for reclaiming of expenses The Key is Cost Recovery •Can you get your money back before you start paying higher taxes • •The sooner you recover your money the better for your project economics • •Revenue taxes do not allow for cost recovery • •Depreciation offers some element of cost recovery in a tax and royalty scheme • •Another term for it is “cost oil”, which is used in Production Sharing Agreements (PSAs) Depreciation •Depreciation is an allowance against profit tax • •An accounting calculation to reduce “pre-tax profits” • •Has no cash impact • •Reduces corporation (profit) tax and effectively allows cashflow to the company to be increased • •Encourages a faster recovery of costs, although not perfect • •PSA Cost oil has the same impact, and is a subject of fierce negotiation • Production Sharing Agreements •Specific tax and legal regimes for individual projects – •Negotiated with government before first investment is made – •Legally guaranteed for the life of a project (although this is not always the case) – •Normally based on a split of cost oil and profit oil, although can also include a royalty payment •Cost oil allows the company a larger share of revenues until costs are recovered – •Profit oil is the split of revenues after costs have been taken into account – it tends to increase in importance once costs have been recovered – •Governments sometimes also demand a royalty in order to guarantee a minimum amount of revenue immediately