Oil production needs boosting, not slowing down

Prime Minister Yuriy Yekhanurov of Ukraine has described the 2006 budget as a socially balanced development budget. But there are grounds for questioning this statement. Development is somewhat hindered in Ukraine. Arguments to support this claim can be found even in this year’s budgeting process, particularly in the explanatory memorandum to the Law of Ukraine “On Amendments to the Law of Ukraine ‘On the State Budget of Ukraine for 2005’ and to Certain Other Laws of Ukraine,” as well as in the 2006 draft budget. These documents indicate that as of August 2005 the royalty rate for oil production has already been raised by 83.3 percent (from UAH 300 to UAH 550 per ton) versus an oil price increase of only 49 percent. The government proposes raising the royalty rate for the year 2006 to UAH 876.17 per ton. Experts believe that such an approach might eventually result in a situation where the size of royalties will exceed the supernormal profit of oil and natural gas producing companies. This would pose an obstacle for the development of their facilities and infrastructure, substantially undermining financial stability in the oil and gas sector.

ANALYSIS

We must also take into account the fact that royalty rates for oil and natural gas condensate, established each year under the budget laws, are constantly rising. To illustrate, the royalty rate for oil production is currently 32 times the 2001 rate. The royalty rate for natural gas condensate is now 5.3 times the 2004 rate.

An analysis of state budget revenue from royalties for produced oil and condensate suggests that their volume is constantly growing. But does this facilitate a more effective operation of producing companies? Does this promote growth of budget receipts? The fact is that higher royalties and corresponding payments to the budget are at odds with the economic significance of royalties and only result in the reduction of capital investments in production. Moreover, leading financial experts say that such abrupt and economically unjustified royalty rate hikes may eventually cause a state budget shortfall stemming from dwindling tax payments as a result of abnormally high royalty payments.

A RETURN TO EGALITARIANISM?

The mechanism of determining the amount of royalties for oil and gas (multiplying the royalty rate by the volume of mineral resources produced during the fiscal period) does not incorporate a differentiated approach toward determining the amount of royalties depending on the geological properties of deposits (depth of extraction and daily yield). As a result, companies that exploit more profitable deposits and have lower production costs pay the same royalty rate per ton of oil or condensate as companies with much higher production costs. For example, the cost of producing a ton of oil in Boryslav, Lviv oblast, where most deposits have been largely exhausted, is much higher than in Okhtyrka, Sumy oblast. Thus, the current undifferentiated approach results in the reduction of capital investments at enterprises with higher costs of oil production, which in turn creates a braking trend in production.

Moreover, oil and natural gas are nonrenewable natural resources whose depletion during the exploitation of deposits gives rise to the need to use special instruments for taxing income from their sales. For this very reason the international oil and natural gas industry uses royalties calculated as the difference between the value of produced hydrocarbons and the costs of their production. The costs are calculated as the sum total of expenses on production, geological prospecting, and drilling, combined with a percentage of profit that is standard for this sector. The remainder is paid as royalties. In general, royalties are synonymous with supernormal profit and cannot exceed it. In all civilized countries the purpose of royalties is to channel part of the supernormal profit of oil producing companies into state coffers. Supernormal profit can grow as a result of rising oil prices or declining costs of oil production and sales.

INTERNATIONAL EXPERIENCE

According to international experience, the mechanism of calculating royalties should consider geological conditions (depth of deposits and average daily yield) and oil prices. France, much like Ukraine, does not have large deposits of hydrocarbons and uses a scale of rates to determine the size of royalties, which is tied to production volumes. The scale ranges from 0 percent (for yields below 1,000 barrels per day) to 12 percent (for yields exceeding 6,000 barrels per day).

Moreover, in calculating the size of royalties, France deducts from it all costs of production, transportation, etc., and also uses tax deferments (or tax discounts to offset the loss of value resulting from the depletion of mineral resources). At the same time, the company retains 50% of its supernormal profit to continue exploratory drilling.

When calculating the size of royalties, the US and Canada also take into account such factors as oil yield per well and deposit, the stage of development of deposits, and the market price. Royalty rates for most deposits in the US vary within a range of 0.5 to 12.5 percent. The governments of these countries offer significant tax concessions, including a reprieve from royalty payments for low-yield wells with yields below five barrels per day and for companies that use new methods for increasing the yield from wells.

Great Britain levies a tax on income, and the object of taxation is the supernormal profit of oil and natural gas producing companies, which is determined from the profitability of individual deposits.

Russia, another country with tremendous oil reserves, determines the rate of tax on the production of mineral resources based on a coefficient that reflects the dynamics of world prices.

Thus, international experience shows that payments for produced hydrocarbons should be established in the form of tax rates relative to the value and quantity of hydrocarbons and based on normative (differentiated, depending on geological conditions of deposits) royalty rates that take into account current price levels. Notably, over the last 5 to 10 years there has been a discernible downward trend in the volume of royalty payments. Moreover, higher royalty rates are normally used in oil- exporting countries. Yet even in most of these countries royalty rates do not exceed 20 percent. For most oil importing countries, especially those interested in attracting foreign investment in projects to exploit and develop their deposits, these rates do not exceed 12.5 percent. Proceeding from the economic significance of royalties, one may expect higher budget receipts from royalty payments only where supernormal profits of oil and gas producing companies are rising in connection with growing prices, the reduction of oil production costs and sales, or in connection with growing output volumes.

However, the average price of oil produced in Ukraine in 2005 rose by a mere 2.6 times compared to the average price in 2002, whereas the 2005 state budget envisions 8.5 times higher receipts from royalty payments as compared to 2002. Meanwhile, major companies in Ukraine have not seen any reductions in oil production and sales costs or any major increases in output.

PLUS TAX PRESSURE

In determining royalty rates, the government has overlooked the tax pressure on oil and gas producing companies. Whereas in 2002 companies paid 1.53 hryvnias in taxes per each hryvnia of net income, in the first half of 2005 this figure rose to 1.88 hryvnias. For example, the amount of taxes and duties paid by Ukrnafta to budgets of all levels accounted for 40 percent of its sales in the first half of 2005, whereas in 2002 this figure was only 25 percent. This figure is expected to increase significantly in the second half of 2005. Overall, royalties paid in 2005 will be ten times the amount of royalties paid in 2002.

This year’s repeated increases in the royalty rate for oil and gas producing companies — to UAH 300 in January-July, UAH 550 as of August, and UAH 876.17 in the 2006 draft budget — add significantly to the tax burden. This may lead to profit reductions at such companies, which in turn will adversely affect the size of dividends collected by the state. Furthermore, the declining financial performance of Ukraine’s oil- and gas-producing companies not only reduces their investment attractiveness, but also damages Ukraine’s investment image.

It is a mistake to think that constantly growing royalty rates can help increase budget revenues. In reality, this growth can stall the development of Ukraine’s oil and gas production sector. It will also significantly reduce the amount of financial resources that companies spend on exploration and developing new deposits. Oil and gas production on Ukrainian territory will become unprofitable, which in turn will cause a general reduction in tax receipts from this sector.

HOW IT SHOULD BE

Experts point out that royalty payments for oil and gas have a direct impact on the future development of the oil and gas sector. For this reason the approach to calculating the royalty rate should be balanced and reasonable, and should be determined by a special law. Taking into account international experience and the economic significance of royalty payments, experts at branch institutions have proposed acceptable mechanisms for calculating royalty payments, which incorporate such factors as volume of produced oil and its average price at the London Exchange throughout the fiscal period.

Using the London Stock Exchange oil price as a factor for calculating the amount of royalty payments will ensure additional budget receipts, because the price of oil in the international market is constantly fluctuating, and experts predict that this trend will continue. Commonwealth Bank has estimated the 2006 sale price of a barrel of oil at a minimum $75.3, Merrill Lynch & Co. brokers at close to $69.4, the Bloomberg agency and the brokerage firm Goldman Sachs Group Inc. at a minimum $63.3, and the analytical research institute ZEW at a minimum $65.4. Thus, in 2006 world oil prices will be at least $67 per barrel, or UAH 2,470 per ton.

The proposed royalty rate of 30 percent was determined on the premise that the government, as the owner of mineral resources, is entitled to some of the supernormal profit that a producing company receives as a result of rising oil prices and/or declining costs of oil production and sales. Given the oil price of UAH 2,470 per ton, the cost of oil production (including the standard income rate for the sector and mandatory payments) will be UAH 1,124 and the supernormal profit will amount to UAH 1,346. Experts suggest that producing companies should keep 45 percent of the supernormal profit, while channeling 55 percent into the state budget.

If the oil price exceeds the forecasted UAH 2,470, establishing the royalty rate as a percentage of the supernormal profit will ensure a proportional increase in budget revenues (this will be impossible if the draft budget is adopted in its current wording). Thus, if the government embraces the proposed mechanism for calculating the amount of royalty payments, this will ensure stable budget revenues even in situations where sales of produced oil are suspended in auctions, because royalty payments will not depend on domestic oil prices.

AN EVEN BETTER OPTION

However, the proposed approach does not take into account geological conditions of oil deposits, namely well depth and average yield. For this reason experts have developed another, somewhat more complex, mechanism of calculations that envisions a royalty rate of 9 percent, a base weighted-average well depth of 2,655 meters, and a base weighted-average oil yield per well of 3.6 tons per day, and takes into account the actual average depth of wells in a deposit, the actual average oil yield per well in a deposit, and the actual average production rate per well (determined on the basis of a monthly production report). Economic performance indicators at different deposits are to be leveled off using the ratio between the base weighted- average depth of wells and the actual depth of wells in the deposit, and the ratio between the actual average oil output in the deposit and the base weighted-average output of oil per production well.

This way it is possible to differentiate the approach to determining the amount of royalties. After all, using the above ratios can balance out economic factors of production, depending on the geological factors of deposits.

Where oil is produced at depths exceeding the base depth, the production depth adjustment ratio makes it possible to reduce the size of royalties, since the production conditions are more complex and extracting oil from greater depths entails more capital investments and costs. Where oil is extracted from lesser depths, this ratio increases the size of royalties in view of the more favorable conditions for the production of oil, a lesser need for capital investments, and smaller costs.

The adjustment ratio for the volume of oil produced in one day makes it possible to level off geological factors through the use of economic factors: where greater volumes than the base daily volume are produced, it means that there are sufficient oil reserves for production, so the company can afford to pay more royalties. Where oil production volumes drop below the base level, companies will have to pay fewer royalties, since the low output volume means that either this particular deposit is depleted or there is a need for additional capital infusions.

This approach to determining the amount of royalties will boost the profitability of oil production and stimulate both the development of new deposits and higher output at deposits with complex production conditions and depleted reserves. In other words, this approach reflects the economic significance of royalties as confirmed by international experience.

The introduction of a 9-percent royalty rate will enable companies to retain 45 percent of their supernormal incomes, while channeling 55 percent into state coffers. While incorporating global trends of oil price formation and geological conditions of deposits, this calculation mechanism is simple enough to use for determining both the company’s expected revenues and future state budget receipts.

INCIDENTALLY

In the first nine months of 2005 the Open Joint-Stock Company Ukrnafta paid over two billion hryvnias (UAH 2,094,000,000) to all levels of budgets. This represents an increase of UAH 1,157,500,000, or 123.6 percent, from the same period in 2004 (UAH 936,500,000). According to Ukrnafta’s press service, most of this amount is royalty payments, which have risen by almost 3.5 times over one year from UAH 160 in 2004 to UAH 550 as of August 2005 (to UAH 300 over January-July 2005).