reading

Contents

Cover

Praise

Series

Title Page

Introduction

About the Authors

Acknowledgements

Chapter 1: Introduction to Tax and Royalty Regimes

1.1 INTRODUCTION

1.2 INFLATION AND DISCOUNTING: TIME VALUE OF MONEY BASICS IN THE CONTEXT OF UPSTREAM PETROLEUM MODELING

1.3 INTRODUCING BASIC COMPONENTS OF UPSTREAM PETROLEUM CASHFLOW UNDER A SIMPLE TAX AND ROYALTY REGIME

1.4 ANOTHER (IMPORTANT) MULTIPLIER – INTRODUCTION TO MODELING COMMERCIAL BEHAVIOR WITH THE ECONOMIC LIMIT TEST

1.5 CHAPTER MODEL HOUSEKEEPING NOTES

1.6 CHAPTER MODEL ASSUMPTIONS

1.7 PRE-ELT CALCULATIONS

1.8 ELT CALCULATION AND ROLE IN ECONOMIC MODELING

1.9 POST-ELT CALCULATIONS

Chapter 2: Tax Consolidation and Incremental Value

2.1 TOM AND CARMEN MIX LOVE AND MONEY: A ROMANTIC INTRODUCTION TO FISCAL CONSOLIDATION

2.2 PETROLEUM TAX AND ROYALTY REGIMES: “RINGFENCING” VS. CONSOLIDATION

2.3 RINGFENCING, CONSOLIDATION AND INCREMENTAL VALUE

2.4 RINGFENCED VS. CONSOLIDATED INCREMENTAL VALUE MODEL: ASSUMPTIONS

2.5 RINGFENCED VS. CONSOLIDATED INCREMENTAL VALUE MODEL: CALCULATIONS

2.6 MODEL RESULTS AND ANALYSIS

2.7 Exercise – Try Modeling Scenario 2 Yourself

2.8 INCOME TAX CONSOLIDATION AND INCREMENTAL VALUE (INTERACTIVE ANALYSIS)

Chapter 3: Royalties

3.1 INTRODUCTION

3.2 ROYALTY BASED ON COMMODITY PRICES

3.3 ROYALTY BASED ON LENGTH OF PRODUCTION

3.4 ROYALTY BASED ON PERIOD-END CUMULATIVE PRODUCTION

3.5 ROYALTY BASED ON CUMULATIVE PRODUCTION THROUGHOUT THE PERIOD

3.6 ROYALTY RATES BASED ON THE PRODUCTION RATE

3.7 ROYALTY BASED ON PRICE AND PRODUCTION RATES (VERSION 1)

3.8 ROYALTY BASED ON PRICE AND PRODUCTION RATES (VERSION 2 – BASED ON CANADA’S NEW ROYALTY FRAMEWORK)

3.9 ROYALTY BASED ON A MEASURE OF CUMULATIVE PROFITABILITY: THE “R-FACTOR”

3.10 ROYALTY BASED ON A MEASURE OF CUMULATIVE PROFITABILITY AND COMMODITY PRICES – CANADIAN OIL SANDS

Chapter 4: Bonuses

4.1 INTRODUCTION

4.2 COMMERCIALITY BONUSES

4.3 BONUSES PAYABLE AT FIRST COMMERCIAL PRODUCTION

4.4 CUMULATIVE PRODUCTION BONUSES

4.5 BONUSES BASED ON THE CUMULATIVE VALUE OF PRODUCTION

4.6 BONUSES BASED ON THE PRODUCTION RATE FOR A SPECIFIED PERIOD

Chapter 5: Abandonment

5.1 INTRODUCTION

5.2 LUMPSUM ABANDONMENT PAYMENTS

5.3 EQUAL ABANDONMENT CONTRIBUTIONS MADE OVER THE PRODUCTION PERIOD

5.4 UNEQUAL ABANDONMENT CONTRIBUTIONS, BASED ON ANNUAL PRODUCTION AS A PERCENTAGE OF ULTIMATE PRODUCTION

5.5 EQUAL ABANDONMENT CONTRIBUTIONS, STARTING WHEN DEPLETION REACHES A SPECIFIED THRESHOLD

5.6 EQUAL ABANDONMENT CONTRIBUTIONS STARTING FROM A SPECIFIED NUMBER OF PERIODS BEFORE ECONOMIC PRODUCTION ENDS

5.7 EQUAL ABANDONMENT CONTRIBUTIONS STARTING WHEN THE PRODUCER CHOOSES

5.8 MULTIPLE METHODS, USING WHICHEVER ONE MAKES ABANDONMENT CONTRIBUTIONS START EARLIER

5.9 ABANDONMENT CONTRIBUTIONS WHICH EARN INTEREST (SINGLE RATE)

5.10 ABANDONMENT CONTRIBUTIONS WHICH EARN INTEREST (VARIABLE RATES)

Chapter 6: Introduction to Production Sharing Contract-Based Fiscal Regimes

6.1 OVERVIEW: PSCs AS A SPECIALIZED REVENUE SHARING FRAMEWORK

6.2 LOOKING AHEAD: ROAD MAP FOR THIS AND THE NEXT CHAPTERS

6.3 SIMPLE EXAMPLE OF PSC REVENUE DISTRIBUTION

6.4 SIMPLISTIC (SINGLE-YEAR) MODEL REVENUE DISTRIBUTION CALCULATIONS, INCLUDING COST OIL DETERMINATION

6.5 INTRODUCING “ENTITLEMENT VOLUMES”

6.6 SIMPLISTIC, MULTI-PERIOD PSC MODEL: THE CALCULATION OF COST OIL

6.7 TOPIC IN DEPTH: CONTRACTOR ENTITLEMENT

Chapter 7: More Realistic PSC Modeling

7.1 INTRODUCING A MORE REALISTIC PSC MODEL

7.2 ARRIVING AT OUR “CORE” PSC MODEL

7.3 “UPLIFTS” TO COST OIL

Chapter 8: PSC Regime Variations

INTRODUCTION

8.1 PSCs WITH EXPLICIT INCOME TAX PROVISIONS

8.2 PROFIT OIL SHARING BASED ON COMMODITY PRICES

8.3 PROFIT OIL SHARING BASED ON THE PRODUCTION RATE

8.4 PROFIT OIL SHARING BASED ON CUMULATIVE PRODUCTION

8.5 INTRODUCTION TO PROFIT SHARING BASED ON A MEASURE OF CUMULATIVE PROFITABILITY: THE “R-FACTOR”

8.6 R-FACTORS AND THE “GOLD PLATING” EFFECT

Index

Discmaterials

WILEY END USER LICENSE AGREEMENT

“This is a book no deal team should be without. It is a must for those involved in upstream oil and gas transactions, planning, budgeting, investment appraisal and portfolio management. Its step-by-step approach cuts through complexity, making it comprehensive and understandable by a wide range of users with a wide range of abilities. It can be used as a textbook, an introductory primer or as a handbook that you can dip in and out of or read cover to cover.”

Michael Lynch-Bell, Senior Advisor, Oil & Gas, Ernst & Young LLP; ex-officio Chairman, UN Expert Group on Resource Classification

“This book is a terrific addition to the existing literature on the subject, and will be invaluable to a wide range of professionals, from Energy Ministry staff through NOCs to energy company economists, advisors and consultants. By far the best way to understand all the subtleties of fiscal regimes is to build one's own models of them, and then to play ‘what if?’ games with them. This is what the book encourages, by being set out so clearly and well, and a thorough study will take the reader from beginner to near expert status.”

Graeme Simpson, Honorary Professor in Petroleum Geology / former Professor of Energy Industry Management, the University of Aberdeen, Scotland; former Business Manager, Exxon

“This book is both a reference for the various types of fiscal regimes and a how-to guide for spreadsheet modeling. Practitioners at every level will find it to be a valuable resource.”

Dan Olds, Senior Vice President – International, Ryder Scott Petroleum Consultants / Past President, Society of Petroleum Evaluation Engineers

“This book gives a comprehensive and in-depth discussion of petroleum economics. It provides a step-by-step guide to understanding fiscal models similar to what many residential courses offer. The excel sheets and formulas are extremely helpful for the novice and users of economic software such as PEEP to start modeling fiscal regimes. As an experienced economist, the book has helped fill gaps in my knowledge and I would personally recommend it as a reference guide for those in commercial disciplines in the industry.”

Aditya Mukherjee, Economics Analyst, Global New Business Development, Hess Services UK Limited

“Kasriel and Wood have produced a monumental set of materials for understanding how to model and analyze the impacts of upstream petroleum fiscal terms on project economics. Unique to their approach is a step-by-step guide on using Microsoft Excel that provides users with a kind of x-ray vision into the complex and sometimes unanticipated outcomes associated with various sorts of taxes, royalties, and production sharing contracts. It is a brilliant practitioner's guide to the subject.”

Graham A. Davis, Professor, Division of Economics and Business, Colorado School of Mines

“I find the book a great tool for anyone who intends to initiate his/her career into the world of petroleum economics. Furthermore, I think experienced economists should always have this book on their desk for quick consultation/reference as it is very comprehensive around the modeling of oil and gas deals. This book is a must-have in every economists book shelf!”

Germán Beckmann, Business Analyst, Premier Oil PLC

“This book will be a useful, practical tool for the petroleum economics practitioner. Practitioners will find the practical spreadsheet tips, delivered in an easy-to-read, conversational style, particularly helpful.”

Roy Kelly, Managing Director, Kerogen Capital

“This book fills a gap in the existing literature - a valuable work for anyone confronted with the complexities of Upstream Petroleum Fiscal and Valuation Modeling. I am impressed by the quantity of data and detailed explanations that guide the reader through the calculations. I really appreciate the authors' step-by-step approach which makes for a practical ‘hands-on’ tool that can be easily adapted to ones' own need”

Nadine Bret-Rouzaut, IFP School, Director of the Centre for Economics & Management, Professor, Upstream management

“This is a very enlightening textbook on Petroleum Economics. It puts a lot of financial decision making in the oil industry in perspective. The descriptions of typical economical terms such as Royalty, Abandonment and Production Sharing Contracts (PSC's) are very well explained and come to life with the abundance of examples. A must-have for every E&P professional.”

Michiel Stofferis, Field Reserves Manager, CEPSA

“In this book Kasriel and Wood lay bare the complex world of petroleum fiscal systems. By leading the reader through carefully worked examples, supported by extensive Excel documentation, they share their experience to create a resource useful to the beginner and the experienced practitioner alike. Building from first principles they lay the foundation for an understanding of the differing systems in use today, whilst also acknowledging the likelihood of evolution and the need for flexibility in application.”

Dr Julian A. Fennema, Lecturer in Petroleum Economics, Institute of Petroleum Engineering, Heriot-Watt University

“Kasriel and Wood have pulled together a comprehensive, well thought through and clear guide to the topic of Upstream Petroleum Fiscal and Valuation Modeling. Their use of explanation, examples and reference material makes it a very accessible guide for both beginners and experienced practioners alike. This is a very useful addition to the repertoire of writing in this area.”

Tom Morris, Commercial Manager, Cairn Energy

“This clearly written, well-organized book is a valuable tool to assist governments in fiscal design and to assist investors and financiers to determine and analyze government take and its effect on the rates of cost recovery and overall profitability.”

Owen L. Anderson, Eugene Kuntz Chair in Oil, Gas & Natural Resources, George Lynn Cross Research Professor, The University of Oklahoma College of Law

“Upstream Petroleum Fiscal and Valuation Modeling in Excel by Ken Kasriel and David Wood presents a carefully worked out set of examples that deal with a complex topic of importance for all who are engaged in the oil extraction business. The chapters lend clarity to a variety of complex topics, each of which is explained clearly and illustrated with an appropriate Excel spreadsheet. This book will prove invaluable to industry participants and analysts.”

Simon Benninga, Author, Principles of Finance with Excel / Visiting Professor of Finance, Wharton School, University of Pennsylvania / Professor of Finance, Faculty of Management, Tel Aviv University

“This book is one of the most comprehensive I've read, that provides a generic illustrative roadmap for evaluating fiscal systems in all their intricacies that will no doubt become the reference material for those involved in understanding, applying and negotiating global fiscal systems.”

Gerry F. Donnelly, Director, Institutional Research, FirstEnergy Capital LLP

Registered office
John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom

For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please see our website at www.wiley.com.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher.

Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.

Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The publisher is not associated with any product or vendor mentioned in this book.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with the respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. It is sold on the understanding that the publisher is not engaged in rendering professional services and neither the publisher nor the author shall be liable for damages arising herefrom. If professional advice or other expert assistance is required, the services of a competent professional should be sought.

Library of Congress Cataloging-in-Publication Data

Kasriel, Ken, 1965-
Upstream petroleum fiscal and valuation modeling in Excel : a worked examples approach / Ken Kasriel, David Wood.
pages cm
Includes index.
ISBN 978-0-470-68682-9 (hbk.) – ISBN 978-1-118-53768-8 (ebk.) – ISBN 978-1-118-53769-5 (ebk.) – ISBN 978-1-118-53770-1 (ebk.)
1. Petroleum industry and trade–Valuation. 2. Microsoft Excel (Computer file) I. Wood, David. II. Title.
HD9560.5.K37 2013
665.50285′554–dc23
2012050120

A catalogue record for this book is available from the British Library.

ISBN 978-0-470-68682-9 (hbk) ISBN 978-1-118-53768-8 (ebk)
ISBN 978-1-118-53769-5 (ebk) ISBN 978-1-118-53770-1 (ebk)

Cover images reproduced by permission of Shutterstock.com
Trial Crystal Ball software provided with permission from the Oracle Corporation.

Introduction

The fiscal share, or “take,” from an upstream petroleum project is one of the key factors determining its profitability, from the perspective of both the investors and host country governments involved. This “take” is determined not just by tax rates, but also by a number of other mechanisms (i.e., those covered in this book)1 which collectively make up a country's fiscal regime (also called “fiscal system” or “fiscal design”).

In a business which ultimately is not about producing petroleum, but rather about making money from doing so, fiscal design is all-important:

Even assuming commodity prices are high, the fiscal regime can turn oil and/or gas fields with great underlying technical strengths (high volumes of petroleum, low costs), and thus the potential to generate significant underlying (i.e., pre-fiscal) cashflow, into an emphatically bad deal for the producer, if the fiscal rules channel too much cashflow to the state.
For governments, understanding how their fiscal systems “behave” under different macro-economic and project-specific conditions is essential, if they are to successfully walk the line between maximizing state revenue and deterring investors.
The detailed calculation of investors' and governments' shares – which is imperative in understanding the true value of petroleum production projects – is the subject of this book.

Fiscal systems are often complex, due not only to the number and/or nature of the mechanisms they use, but also to the high levels of uncertainty that permeate the upstream oil and gas industries, as seen in volatile prices, and in the typically wide ranges of possible reserve sizes, production rates, and costs which characterize exploration, development and production projects.

Whereas the characteristics of each specific oil and gas field (i.e., its location, depth, reservoir and petroleum quality and reserves) are outside the control of governments and investors, these parties do have it within their power to discuss and negotiate fiscal terms, and governments can set and change them via laws and regulations.

History shows that the parties spend significant time and effort in negotiating fiscal issues and trying to optimize overall designs, and that the results have a major influence on investments being made, delayed, abandoned or avoided altogether.

Consequently, the ability to model fiscal devices and understand their impact on value to the respective parties is essential. This is the focus of our book, which takes both investor and government perspectives.

***

Our aim is not to provide a complete and up-to-date, country-by-country upstream petroleum fiscal “encyclopaedia.” That would be huge, and quickly go out of date:2

Each of the approximately 100 or so countries which explore and/or produce petroleum has its own fiscal system, and sometimes more than one – certain governments have different regimes, depending on where a project is or when permits were first awarded.
Fiscal systems, moreover, tend to evolve over time, as:
- economic conditions change;
- significant discoveries are made (e.g., Brazil's “pre-salt” discoveries, as we write this, are prime examples);
- new technologies open up new petroleum provinces with specific challenges that require new fiscal incentives (e.g., deepwater, unconventional oil and gas);
- provinces mature and yield smaller, more marginal fields (e.g., the North Sea); and
- governments change, or change their minds, due to political developments, upheavals, populist pressures, etc.

Despite this dynamism (which some might also call “flux”), often governments do try to design fiscal systems which are stable. To be stable, they need to be flexible, taking into account a wide range of potential economic and technical scenarios, so that the resultant fiscal “takes” vary according to a project's profitability (or lack thereof).

This flexibility, however, often leads to complexity. For example, a simple, single rate of royalty, tax or production share is usually inadequate to respond to changing conditions. Therefore, these fiscal devices are quite often expressed as formulas.

There are very many specific, often mutating fiscal formulas in use globally, but ultimately these are variations of a relatively small number of generic types of formulas. These are the focus of this book. There are less than 20 individual generic fiscal devices in common use. Different countries will “tweak” these and/or use different combinations of them. Thus the large number and variety of international fiscal systems used are like many sentences, using what is actually a relatively small, masterable “vocabulary list.” Our choice of generic examples in this book is designed to give you this vocabulary.

Thus, to be of most immediate, practical use – without requiring at least annual revisions (and to keep it smaller than a telephone book) – this book provides what is lacking in the field, in our view: that is, detailed explanations of how these generic formulas are calculated, and how they cause fiscal systems to “behave” when input assumptions change.

You can learn from other sources, for example, that a country has scrapped its “cumulative production-based tangible capex depreciation uplifts” and is rolling out a new “profit oil sharing scale determined by a linear R-factor scale, with contractor shares ranging from 90% and 10%.” But knowing this is not the same as understanding what these changes mean in plain English, how to model them, and their impacts on fiscal take and valuation.
This book equips the reader to understand such specific fiscal devices via transparent, well-explained spreadsheet examples, in a structured, layperson-friendly manner, which show how their generic counterparts are calculated and modeled in detail. In other words, it shows you how to make sense of and use country-specific fiscal information once you get it.

***

Fortunately, understanding, calculating and modeling petroleum fiscal designs is not rocket science, nor does it require the detailed technical knowledge involved in the geology or engineering aspects of the oil and gas industry.

The concepts behind most individual fiscal devices are usually reasonably straightforward. When, however, they are combined into multi-faceted fiscal systems and/or shrouded in fiscal and contractual jargon, they can appear to the layperson as mechanisms with many, strangely named “moving parts” which work together in ways that are far from obvious.

The key principles and methods can be learned from this book by readers with a rudimentary knowledge of spreadsheets and discounted cashflow principles. No oil and gas background is assumed. The book makes great efforts to be accessible to laypeople, while at the same time being of practical use to an array of readers, including intermediate to experienced petroleum hands. Thus it is a both a “hands-on,” step-by-step course for start-to-finish readers, as well as a practitioner's reference.

The book uses Microsoft Excel as its calculation “engine.” One reason is that Excel is widely used. The transparency of its calculations, moreover, makes it a very effective teaching and communications tool – clearly written models can indeed be worth (at least) a thousand words.

Many upstream petroleum companies use proprietary fiscal computer models, some of them frustratingly opaque “black boxes” which give answers that are difficult, or impossible, to check. Even if you are obliged to use a “black box” model, understanding how the detailed fiscal calculations are done in Excel, in our experience, is a great advantage when using most fiscal modeling applications. Nothing is worse than being asked to explain why a change in input assumption X leads to a Y% change in result Z, without knowing why, and without being able to know why. “This is just what the black box says” is an answer that will not inspire confidence in you as an analyst.

Excel has evolved over the past decade with the release of new and more powerful and versatile versions. In this book we provide explanations of how to perform relevant tasks in Excel 2003, Excel 2007 and Excel 2010, and cashflow models and other examples in formats which will work in all of these versions.

All calculations use “unhidden” cell formulas in our models. Much of this book is devoted to explaining these formulas. At times the discussion is dense – you probably will not be reading this book in a beach chair – but to ease understanding we tend to avoid large formulas, instead usually breaking them into smaller steps to aid understanding. Step-by-step explanations are written in plain English, with new terms clearly defined. We do not do any calculations inside Visual Basic for Applications (VBA) macros. We do, however, use Excel's VBA to make navigating and interrogating the models easier.

There is much more to Upstream Petroleum Fiscal Cashflow and Risk Modeling in Excel than just the physical book. In a sense, the Excel files on the disk play the lead role, with much of the text written to accompany them. The disk contains over 120 Excel files and more than 400 pages of PDF supplements and appendices covering the calculation and/or extended analysis of certain fiscal mechanisms. We have chosen to farm out some portions of the book to PDFs, both for formatting reasons (to be able to use color and larger images, e.g., clear model screenshots and charts) and to provide important material without disrupting the flow of chapters.

***

This book assumes you are willing to learn by getting your hands dirty – expect to spend much of your time with both the book open and the computer on. At times viewing on a larger, desktop monitor might even be helpful. Practice exercises at various points in the chapters pose problems relating to specific techniques for you to solve. Both hints and complete solutions are provided in auxiliary Excel files. There are also frequent solved exercises and interactive graphics designed to prompt and answer “what-if?” questions.

Discounted cashflow methods are standard in calculating the time value of money. Taking time value into account is crucial for oil and gas projects which involve both large, upfront capital investments and revenue streams that do not materialize until many years later, but which might last for decades. Thus when valuing oil and gas assets and evaluating the performance of petroleum fiscal systems, it is discounted post-tax cashflow calculations which usually matter most to oil companies, investors, analysts, third-party advisors and governments.

We use net present value (NPV) as our primary discounted cashflow performance indicator, but also calculate other useful economic yardsticks and other upstream petroleum-relevant benchmarks in our multi-year cashflow models.

Uncertainty and risk are crucial attributes of petroleum projects. They need to be considered when valuing projects and evaluating fiscal designs. Although they are not the main focus of this book, we do illustrate the use of Oracle's Crystal Ball add-in for Excel to add a probabilistic dimension to a few examples. We explain why probabilistic analysis can often improve our understanding of how a fiscal system or specific fiscal device performs over a wide range of input values, and how Crystal Ball lets us do this. Refer to the last page of this book for instructions on how to obtain the trial version of Crystal Ball which Oracle has kindly provided.

For those who “do not read manuals (or textbooks),” at least read the “ReadMe” file.

Some readers might prefer to dive straight into the spreadsheet models and examples, and then consult the text as needed. We strongly suggest that such readers – as well as everyone else, in fact – first take a few minutes to read the file “Spreadsheets_ReadMeFirst.pdf” on the disk, which covers some important Excel-related housekeeping items.

While we have made every effort to eliminate typos and other errors in the text, supplements and Excel files, some might have slipped through. For corrections to any such mistakes found since publication, visit the “Errata” tab of the webpage, http://eu.wiley.com/WileyCDA/WileyTitle/productCd-0470686820.html. (Should you find any, please let us know via the email address ken_kasriel@yahoo.com. We regret that we cannot commit to answer all correspondence.).

Those fortunate enough to be involved in the negotiation and formulation of petroleum fiscal designs, and/or in modeling their impacts on investment value, already know that it is an intellectually challenging and rewarding undertaking, involving many skilled and persuasive individuals, with diverse perspectives on what constitutes true value. This undertaking is greatly enhanced by the ability to personally build models that can quickly evaluate subtle changes to fiscal devices within an existing regime, in a comprehensive and accurate way that can be easily presented and interrogated. Good luck with your fiscal modeling endeavors!

1. As seen in the Contents, these include royalties; bonuses; rentals; depreciation of costs; tax allowances and incentives; ringfencing and consolidation of tax losses; cost recovery and profit sharing mechanisms; and the funding of decommissioning (abandonment) costs.

2. Some such comprehensive information is in fact already available, for example, from the websites of governments which make this material public; from specialist consultancies, for a fee; and in free summaries, from sources such as the annual Ernst & Young Global Oil & Gas Tax Guide, available from www.ey.com.