Legislature(2011 - 2012)BUTROVICH 205
02/16/2012 03:30 PM Senate RESOURCES
| Audio | Topic |
|---|---|
| Start | |
| SB192 | |
| Pfc Energy Presentation on Progressive Fiscal Structures | |
| Adjourn |
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
+ teleconferenced
= bill was previously heard/scheduled
| += | SB 192 | TELECONFERENCED | |
SB 192-OIL AND GAS PRODUCTION TAX RATES
PFC ENERGY PRESENTATION ON PROGRESSIVE FISCAL STRUCTURES
3:33:51 PM
CO-CHAIR PASKVAN announced that SB 192 was before the committee
and that PFC Energy would deliver a presentation [on progressive
fiscal structures.]
He related that Alaska has many components to its fiscal system
that are attractive across a spectrum of oil prices. For
example, among the levers are low royalties; 50 percent or lower
than the royalty in North Dakota or Texas. Alaska has attractive
credits, such as a 100 percent deduction for capital
expenditures in the year spent, plus 20 percent credit "on their
bottom line." It's also called the "comparative front end
loading index." Alaska also disproportionately shares in the
geologic risk and is one of the most attractive locations in the
world. Also attractive to investors is the royalty modification
component.
He questioned how Alaska will create a balanced fiscal regime in
order to receive a fair return on its generous capital credits
to investors in the North Slope and on its disproportionate
geologic risk.
^PFC Energy Presentation on Progressive Fiscal Structures
3:37:12 PM
JANAK MAYER, Manager, Upstream and Gas, PFC Energy, introduced
himself as a legislative consultant hired by the Legislative
Budget & Audit Committee to analyze Alaska's current fiscal
structure and any proposed changes to the structure. One of the
requirements is to build a complex model of the current fiscal
structure and of a wide range of existing base production assets
with the potential for new production from new investments.
Another task is to provide presentations to the legislature.
He related that today's presentation will cover three broad
areas: company behaviors and investment decision making, a
conceptual overview of progressivity, and how progressivity
works in other jurisdictions and under ACES.
3:40:50 PM
TONY REINSCH, Senior Director, Upstream and Gas Group, PFC
Energy, said that his focus is on strategy, planning, and
positioning of large international and national oil companies in
the upstream sector of both oil and gas.
He related that PFC has focused traditionally on the area of the
oil and gas sector that has been the weakest in terms of
company, government, and regulator analysis - the areas of
above-ground risk. These are areas such as competitor landscape,
or who owns the resources, political, social, and economic
risks, and policy and regulatory risks. He said that PFC advises
international oil companies (IOC's), national oil companies
(NOC's) and governments on how these risks are unfolding
globally.
MR. REINSCH began by explaining IOC decision making regarding
capital allocation, budget, and long-range planning. He related
that he plans to discuss company behaviors and decision making,
especially regarding investment decisions and decisions on
whether to develop particular resources in the near term or to
postpone development. He said he would also cover key metrics
including return on capital employed (ROCE), net present value
(NPR), and internal rate of return (IRR), as well as
consideration of asset metrics versus portfolio metrics and
differences between integrated versus non-integrated companies.
He said he would conclude with cash flow allocation and the
reallocation of free cash flow within global portfolios as
projects and basins move through various stages of development
to maturity.
SENATOR STEDMAN joined the committee.
3:44:38 PM
MR. REINSCH explained that oil and gas companies follow a
standardized process linking the annual budget cycle to the long
range plan and corporate strategy. They follow an annual process
that is predictable. The timing has to do with filing reports
and drilling seasons.
SENATOR WIELECHOWSKI asked if PFC Energy works with oil
companies and governments.
MR. REINSCH replied that PFC advises international oil and gas
companies, governments, and national oil companies.
He continued to explain the capital allocation cycle within a
given company. The first quarter of the year is spent on
strategy review and updates about where the company is going in
the longer term. That process carries through at the corporate
level for much of the year. The budget cycle begins in the third
quarter and uses the strategies and long-range plan to create
the capital expenditures of the coming budget.
3:47:18 PM
MR. REINSCH explained that slide 4 is an attempt to capture how
companies look at the world during the planning and strategy
process. The process begins with a view of the world they will
be working in; economic markets, energy supply, and geopolitical
considerations, leading to a view on oil and gas prices.
Companies then look at the basins in which they are operating or
may want to operate in the future. Next, they identify blockers,
enablers, gaps, and logjams to being able to accomplish what
they want to, and focus on competitor landscape and markets.
From that analysis, the company targets objectives and
identifies objectives. Finally, the company identifies
strategies and uses the long-range plan to make capital
investments.
He turned to slide 6 to show corporate input assumptions on the
external environment. Companies have business units that manage
operations in specific areas such as the Gulf of Mexico, the
North Sea in the United Kingdom, Alaska's Prudhoe Bay, Eagle
Ford Shale Gas, and Angola's deep water production. The units
are responsible for developing a long-range plan, a five year
plan, and a budget. He continued to say "at corporate, those are
rolled up," leading to a discretionary and non-discretionary
capital budget available for board approval. After the board
approves the budget, capital is allocated, the projects are
approved, and the programs are executed.
3:51:26 PM
MR. REINSCH moved on to slide 8, which depicts the issue of how
to attract capital for a project within a corporate budget.
There are a number of considerations when determining whether an
oil company will position, or continue to invest, in a
particular asset, basin, or country. Some of these
considerations are materiality, total capex exposure, and full-
cycle economics/metrics.
He continued to say that each project is broken down into
discrete investment decisions, in the form of Project Approval
Requests (PAR's), creating a natural "state-gate" for capital
approval and allocation. Each stage-gate creates an opportunity
for the company to continue, amend, suspend, or exit/divest.
Each PAR has an authorization for expenditure (AFE) attached to
it. The sum of the AFE's in any given year is the budget.
3:54:22 PM
He related that slide 9 shows a program with multiple activities
over multiple years. He noted that discretionary capital comes
up for discussion and approval every year.
He discussed how companies measure the performance of their
investments and decide to allocate capital to one activity
versus another - slide 10. Key to measuring performance are
growth, profitability, efficiency, cash flow, and risk.
CO-CHAIR PASKVAN asked if, within any one company's decision-
making process, 100 percent of the project approval request
would not be funded.
MR. REINSCH replied that with $100 oil, many companies were able
to fund all of their projects. Currently, not all activities are
funded. Companies must decide how to balance growth activity,
debt management, and returning capital to shareholders.
3:58:01 PM
MR. REINSCH explained project selections and decision metrics -
slide 11. Energy companies employ a variety of benchmarks or
metrics to rank investment opportunities and to allocate
financial capital. Some of the more common include: pay-out
period, internal rate of return, net present value, recycle
ratio, discounted and undiscounted net cash flow profiles,
maximum negative cash flow exposure, net booked reserves, and
capex/boe or cost per barrel of production capacity.
CO-CHAIR PASKVAN inquired if there was a selection or decision
metric most often used by a resource owner who is attempting to
impose a production tax.
MR. REINSCH said the ranking metric is the internal rate of
return (IRR) because it provides a relative ranking and
allocation across a portfolio of projects. The owner of the
resource would be more interested in the net present value (NPV)
as the ranking metric.
4:02:15 PM
SENATOR WIELECHOWSKI asked if information such as the rate of
return or the net present value is readily available to the
resource owners in the countries PFC Energy has worked in.
MR. REINSCH explained that varies by country and regulatory
structure. He reported that it was surprising to find that in
the least developed jurisdictions, in terms of government
institutional capacity, the standard for regulation and approval
is increasingly becoming the IRR, which the companies are
required to provide.
SENATOR WIELECHOWSKI inquired about the standard or average IRR
for which a project is deemed profitable or should go forward.
MR. REINSCH answered that in countries that are just beginning
oil and gas development, projects have IRR's of greater than 25
percent. IRR's becomes less useful in more mature jurisdictions.
MR. MAYER added that from the government's perspective, IRR's
happen most in the less developed countries that have a strong
national oil company.
MR. REINSCH turned to slide 12 - net present value, which is the
estimated value of a project when all future net cash flows are
discounted to the present at an appropriate rate or discount
factor. He contrasted the advantages and disadvantages of NPV.
The main disadvantage is that it is difficult to rank projects.
He explained slide 13 - internal rate of return, which is the
discount rate that equates all future cash inflows to outflows
at a point in time. He contrasted the advantages and
disadvantages of IRR.
He pointed out that corporations establish a "hurdle" IRR
number. Projects with IRR's in excess of the hurdle rate attract
budget capital, with those below the hurdle rate not funded. He
listed issues with IRR hurdle rates.
4:12:51 PM
SENATOR FRENCH stated the legislature spends a lot of time
guessing what a company's IRR rate is in order to determine if
the state's investments are sufficiently attractive. He
requested an example of what a good IRR rate would be for a
major international oil company.
MR. REINSCH said it varies by company. A good rate would be an
IRR threshold at 15 percent or greater for a domestic
investment, or 20 percent for an international investment.
He explained the third metric, the return on capital employed
(ROCE), as described on slide 15. ROCE means net profit before
interest and taxes, divided by the gross capital employed, times
100. The ROCE indicates how well management has used the
investment made by owners and creditors into the business. He
referred to two charts that depicted ROCE, one of global players
and one of international players.
He said that seldom is a company able to perform at high ROCE
and high growth; they move in and out of those cycles. Upstream
ROCE is higher for the larger companies and is lower for the
intermediate companies because ROCE has a built-in capital bias.
He described some of the issues with ROCE. Initially, ROCE
penalizes an oil company for major capital investments. Once the
projects are in place, there is a bias toward large asset
portfolios due to a material production cash flow.
4:17:57 PM
MR. REINSCH explained why fiscal changes impact project
economics. It is rare to find a company able to perform at both
a high efficiency level, or high ROCE, and a high production
growth level as measured by changes in production. He used as an
example the increase in the United Kingdom supplementary ring
fence charge, where the supplementary profits tax of 20 percent
was increased to 32 percent. The impact was a reallocation of
net cash flow from the contractor to the government with little
or no impact on the development of the basin or the wells that
were drilled. The result was the government gave up a degree of
freedom in dealing with the price cycle. When the price cycle is
down, it is harder to attract capital.
SENATOR FRENCH asked how the deductions and credits work in
Alaska when calculating IRR's.
4:20:27 PM
MR. REINSCH explained that calculating IRR's are part of company
operations that are almost impossible to assess externally.
SENATOR FRENCH suggested that $1 billion would be the figure
used to calculate IRR.
MR. REINSCH agreed.
MR. MAYER added that the modeling work PFC Energy has undertaken
is aimed at looking at the entire base of existing production
for producers on the North Slope, as well as trying to
understand some of the possible new investments, because it is
the interaction of all factors that determines the economics
under Alaska's system. It is important to understand how the
credits play into the equation.
SENATOR FRENCH suggested that the figure of $400 million may
have to be used to calculate the IRR as well.
MR. MAYER agreed there would be an immediate tax benefit on the
$1 billion.
SENATOR WIELECHOWSKI asked for the date of slide 17. He noted
that oil production has increased in the British fields since
2011.
MR. REINSCH reported that the slide was introduced in the spring
or summer of 2011.
He turned to the issue of integration on slide 18. Both
integrations and de-integration are hot topics ever since
Marathon and ConocoPhillips have both de-integrated their
downstream operations from their upstream operations. Both
companies maintain that integration hides value. De-integrated
entities are better capable of developing appropriate strategies
and appropriate execution of those strategies. He said there are
technical drivers for integration; however, the benefits can be
secured through contracts and partner agreements. BP, TOTAL, and
Shell are divesting from Africa in favor of pure play refiners
and marketers.
CO-CHAIR PASKVAN asked what Mr. Reinsch thought about
integration of North Slope crude with the West Coast of the
United States.
MR. REINSCH opined that the maturity of the North Slope and of
the refining and marketing business in North America creates a
situation much like the Canadian oil sands, where the companies
can either integrate refineries with the upstream operations, or
contract with third parties. North Slope crude would fall into
that same category with other crude flows. Incentives to create
artificial barriers have eroded away.
4:28:16 PM
He turned to the issue of basin allocation and free cash flow
distribution. He described Alaska as a harvest area and said he
would discuss what that means regarding global portfolios, as
shown on slide 19. PFC Energy allocates company activities to
particular basins on the basis of whether those basins are core
to the company, and whether their focus area is new venture.
He defined harvest area as an area that produces positive net
cash flow, with investment activity typically at or below
replacement level. Investing is done to maintain the cash flow.
There is a limit to actual or perceived growth. He pointed out
that the oil industry has largely been built up by the
reallocation of free cash flow from one basin to another.
MR. REINSCH defined the "sit and hold" category as an area with
a substantial resource base, but investment has been delayed due
to unattractive fiscal terms or significant above ground risks.
The company may hold large projects in this area but hold back
the pace of investment until the risk factors have been
addressed. He used the changes taking place in Libya, Sudan,
Chad, and Venezuela as examples.
4:31:11 PM
SENATOR FRENCH noted that Alaska appears in the harvest area. He
wondered if jurisdictions cycle in and out of their status and
how quickly that happens.
MR. REINSCH clarified that the chart was not PFC's analysis. He
said that companies do cycle within base allocations in a couple
of ways. Harvest assets for one company can be a growth asset
for another company. Apache is such a company because they take
over assets, such as BP's, and use them for growth. Another
example is the UK's North Sea, which has been in harvest mode
for decades. Chevron built the majority of its Asian portfolio
off of the free cash flow generated from Europe and West Africa,
just as those jurisdictions had been built by the free cash flow
generated from U.S. on-shore assets of Chevron.
SENATOR FRENCH gave a hypothetical example if the UK had decided
to drop their taxes to entice Chevron back into the UK, it
wouldn't have worked. Chevron was focused on a different part of
the world.
MR. REINSCH agreed.
4:34:16 PM
CO-CHAIR WAGONER requested more information about Apache's
takeover of BP's assets.
MR. REINSCH reported that Apache first stemmed the decline of
the 40's Field and then they grew the production. The incumbent
company, BP, had the capability to do the same thing, but they
had better prospects elsewhere.
CO-CHAIR PASKVAN summarized that BP turned to another area of
their diversified portfolio.
MR. REINSCH agreed. BP ended up developing Deepwater in the Gulf
of Mexico.
MR. REISCH turned to a chart on slide 20 that shows, over a
three year period from 2003 to 2005, the sources and uses of
cash flow on a regional basis for the largest international oil
companies. North America and Europe are the largest generators
of net or free upstream cash flow. Sub-Saharan Africa is
beginning to develop as a deep water player.
He related that the second chart shows sources and uses of cash
flow between 2008 and 2010. It shows Sub-Saharan Africa as a net
cash flow generator with the capital going to North America.
There are substantial shifts in how capital is allocated across
portfolios on a global basis.
MR. REINSCH described, on slide 21, Nexen, Inc. as a company
that initially built its North Sea assets from the cash flow
generated out to Yemen, and now the cash flow from Europe is
being used to finance developments in Canada. These moves can be
very rapid.
He discussed ExxonMobil's global areas of upstream operations,
as shown on slides 22 and 23.
4:38:08 PM
MR. MAYER presented the principles of fiscal regime design. He
said he would address the concept of progressivity with emphasis
on progressive versus regressive fiscal regimes, the rationale
for a progressive fiscal regime, how the concept of
progressivity works in a range of other hydrocarbon
jurisdictions, and the problems in the applications of
progressivity. He shared a favorite quote by Jean Baptiste
Colbert, the Minister of Finance under King Louis XIV of France.
Colbert said, "The art of taxation consists in so plucking the
goose as to get the most feathers with the least hissing." In
more contemporary terms, that art of taxation consists in
maximizing revenues, subject to two important constraints,
efficiency and competitiveness.
MR. MAYER said that efficiency is an absolute concept - the
degree of distortion in a taxation regime is something "we can
assess solely in relation to ourselves." There is a need to
examine the incidence of the tax under different price and cost
levels and to understand what components of the underlying
economic activity are being taxed.
He explained that competitiveness is a relative concept and
requires us to examine our attractiveness in comparison to
others. There is a need to understand what other jurisdictions
we are competing with for capital and to understand whose
capital we are competing for, as well as how rates of return for
projects compare to what our target investors can achieve in
other jurisdiction.
He said the goal is to find the intersection between efficiency
and competitiveness, and to find a regime that does not distort
investment with rates that are internationally competitive.
4:44:58 PM
MR. MAYER showed slide 31 which depicts the efficiency of
supply, demand, and price. The graph on the right shows that the
supply curve is a series of various projects, such as five
different classes of oil regimes. The point is that each has a
very different cost structure and very different economic
returns at a given oil price.
He used slide 32 to explain economic rent, the gap between the
cost required to ensure a normal return on capital and the price
received.
He related that slide 33 depicts the impact of a 30 percent
royalty on the five projects. The royalty successfully captures
30 percent of the gross revenues from projects 1 - 4 for the
government. The tax, however, is highly distorting. Project 5 no
longer earns a normal return on capital; if it were a
prospective investment, it would now have negative NPV and would
be cancelled. If the oil price were to fall, the 30 percent
royalty would make further projects non-economic.
4:48:29 PM
MR. MAYER defined relative government take as government take
divided by divisible income. Divisible income is the gross
revenues less cost, including capex and transportation costs.
Government take includes all payments the government mandates in
its function as a sovereign: royalties, land rental fees,
property taxes, production taxes, and income taxes. Government
take does not include amounts the government earns in an
entrepreneurial function.
He turned to slide 35 to depict the relative government take
impact of a 30 percent royalty. The impact of the royalty is
very different across different projects. For project 5, it is
100 percent, but for project 1, it is less than 30 percent. A
fixed percentage royalty is inefficient and highly regressive
with regard to costs - as costs increase, so does relative
government take. Royalties, however, are very simple to
administer.
He noted that more revenue could be created, not by taxing
production, but by the targeting of economic rent.
4:53:54 PM
Mr. MAYER turned to a brief history of production sharing
contracts, as shown on slide 39. He said that ACES is in many
ways a reflection of a recent trend seen in tax/royalty regimes
around the world that have endeavored to capture a greater share
of rent, by replication many aspects of the economics of a
production sharing contract (PSC). Until the 1960's and 1970's,
the global oil industry was dominated by tax/royalty type
concessions for oil and gas production. These were very simple
to administer, and made sense so long as prices were reasonably
low and stable, and oil was easy to produce.
He related that, in many cases, relatively generous terms for
oil companies reflected the colonial-era world in which the
concessions had been set. Rising nationalism in oil producing
countries saw the first moves away from this system. OPEC was
formed in 1960, and Indonesia introduced the first "contracts of
work" with terminology and mechanics very similar to later
PSC's. The 1973 Arab oil embargo sent oil prices from $3 to
$12/bbl, dramatically eroding government take under tax/royalty
systems, as international oil company profits surged. This
resulted in the widespread rescission of existing of concessions
in major oil producing nations and the introduction of PSC's.
4:57:39 PM
MR. MAYER described the structure of a simple PSC - slide 40.
Core to the concept of PSC is the differentiation between cost
oil and profit oil. Cost oil represents barrels of production
required to recover operating and capital costs. The remainder
of production is deemed profit oil.
He related that the Malaysia-Thailand joint development area has
one of the simplest PSC structures anywhere. It is not
regressive with regard to either price or cost. Because it
includes the normal return on capital in the tax base, it is
regressive with regard to economic rent.
He explained that many PSC-type regimes include progressive and
regressive elements. Many such systems incorporate regressive
elements like fixed-percentage royalties. Some regimes add
progressivity to their profit-focused components to compensate
for regressive elements of the regime to achieve a more neutral
outcome. Often application of progressivity has been taken
further, to focus on limiting the share of rent received by
IOC's in high price environments and maximizing relative
government take.
He said that tomorrow's presentation would focus on how
progressivity works in a number of different regimes and how it
includes a range of different metrics. He noted he would also
focus on progressivity under ACES.
CO-CHAIR WAGONER asked whether the presenters could explain
Alaska's total tax system to a new producer who was ready to
invest in Alaska.
MR. MAYER stated that Alaska has a very complex tax system with
different impacts, depending on the existing production base and
the nature of a number of factors. He stressed that a generic
modeling of ACES wouldn't tell the company the reality of the
field for a specific investment.
| Document Name | Date/Time | Subjects |
|---|---|---|
| PFC Energy_Bios2_Feb_2012.pdf |
SRES 2/16/2012 3:30:00 PM |
SB 192 |
| PFC Energy_Senate Resources_Slides_Feb_16_2012.pdf |
SRES 2/16/2012 3:30:00 PM |
SB 192 |