Gov­ern­ment take, profit, and ac­count­ing for costs

Stabroek News Sunday - - REGIONAL NEWS -

In­tro­duc­tion

To­day’s col­umn along with the next por­trays se­lected as­pects of my re­cent dis­cus­sion of the fis­cal regime in Guyana’s 2016 Pro­duc­tion Shar­ing Agree­ment (PSA), from the per­spec­tive of ba­sic eco­nomic prin­ci­ples. I be­lieve this would en­hance read­ers’ ap­pre­ci­a­tion of those is­sues. In pur­suit of this, I shall dis­cuss briefly the fol­low­ing five top­ics 1) Eco­nomic profit, gov­ern­ment take and other devel­op­men­tal ben­e­fits; 2) ac­count­ing for ex­plo­ration & eval­u­a­tion costs (EE); 3) re­serves es­ti­ma­tion & clas­si­fi­ca­tion; 4) the life cy­cle of petroleum projects, and 5) tax evasion and avoid­ance. The first two top­ics will be con­sid­ered to­day.

From the per­spec­tive of eco­nomic prin­ci­ples, we may re-state the ‘gov­ern­ment take’ re­la­tion un­der the PSA 1) eco­nomic profit de­rived by the Con­trac­tor (Exxon and its part­ners) from Guyana’s petroleum op­er­a­tions is equal to the cu­mu­la­tive gross rev­enues the Con­trac­tor re­ceives, less the cu­mu­la­tive gross costs that are in­curred, over the full life cy­cle of the project. This mea­sure rep­re­sents the op­er­a­tions’ cash flow. 2) Gov­ern­ment take (ex­pressed as a per­cent­age), is there­fore equal to all gov­ern­ment (GoG) rev­enues de­rived from taxes/fees/im­posts; profit shar­ing; and ben­e­fits, which are earned, if the GoG se­cured at some point in time, a work­ing in­ter­est (as an in­vestor) in the Con­trac­tor’s op­er­a­tions, di­vided by the cash flow (eco­nomic profit). 3) Con­se­quently, the Con­trac­tor’s take (%) is the resid­ual, or 1- gov­ern­ment take (%).

Based on the above re­la­tion, the GoG’s profit share can vary from zero or in­deed a neg­a­tive sum (loss) to very high val­ues, de­pend­ing on the over­all com­mer­cial out­come in terms of mar­ket­ing op­por­tu­ni­ties, prices, and pro­duc­tion costs. The re­la­tion does not ad­dress the time se­quence of the ben­e­fits’ flow to ei­ther the GoG or the Con­trac­tor. Read­ers should note, how­ever, that de­spite their dif­fer­ent risk-re­ward pro­files, early ben­e­fit flows are pre­ferred to later ones by both. In­deed, up­front pay­ments like sig­na­ture bonuses and roy­al­ties find world­wide gov­ern­men­tal sup­port.

De­vel­op­ment ben­e­fits

Last week’s col­umn had in­tro­duced eco­nomic devel­op­men­tal ben­e­fits, apart from the spend­ing of gov­ern­ment take, which are em­bed­ded in the PSA’s fis­cal regime. As shown, these in­clude lo­cal con­tent re­quire­ments (LCRs); Re­search & De­vel­op­ment (R&D); in­ter-in­dus­try & in­ter-sec­toral link­ages; and, the ex­pected in­come mul­ti­plier ef­fects of en­hanced pub­lic and pri­vate spend­ing as the hy­dro­car­bons’ sec­tor de­vel­ops. Such ben­e­fits should con­trib­ute to Guyana’s growth in value-added pro­duc­tion (GDP), in­come, eco­nomic di­ver­si­fi­ca­tion, dif­fer­en­ti­a­tion and trans­for­ma­tion. Fur­ther­more, as I shall ar­gue in com­ing col­umns, pub­lic spend­ing from the gov­ern­ment’s take is likely to be, by far, the most im­por­tant con­trib­u­tor to these devel­op­men­tal pro­cesses.

Eco­nomic profit and in­cen­tives

If eco­nomic profit is rep­re­sented by to­tal rev­enue mi­nus to­tal costs, these to­tal costs would in­clude both mon­e­tary and op­por­tu­nity costs, That is, ex­plicit and im­plicit costs. It is there­fore: “the sur­plus re­main­ing af­ter the full op­por­tu­nity costs of all the fac­tors of pro­duc­tion have been met” as eco­nom­ics text­books in­di­cate.

Put this way, eco­nomic profit is not the same as ac­count­ing profit. Ac­count­ing profit, does not deduct the im­plicit costs, which the Con­trac­tor in­curs; for ex­am­ple, those in­curred by not em­ploy­ing time and own cap­i­tal in al­ter­na­tive op­er­a­tions. In other words, eco­nomic profit mea­sures the in­cen­tive the Con­trac­tor has to pur­sue ex­plo­ration and de­vel­op­ment of hy­dro­car­bons in Guyana.

Re­lat­edly this also means, from an eco­nomic per­spec­tive, that ac­count­ing profit equals nor­mal profit when eco­nomic profit is zero. At that point, ac­count­ing profit is not zero. And, in­deed, it is pos­si­ble for eco­nomic loss to be ac­cru­ing to Exxon and its part­ners, while ac­count­ing prof­its re­main pos­i­tive!

Ac­count­ing for costs

A sec­ond way in which the per­spec­tive of eco­nomic prin­ci­ples aids the eval­u­a­tion of the petroleum in­dus­try, lies in the con­sid­er­a­tion of the costs in­curred by the Con­trac­tor, in re­la­tion to petroleum ex­plo­ration and eval­u­a­tion ef­forts. Such costs are in­curred when es­tab­lish­ing the tech­ni­cal and com­mer­cial vi­a­bil­ity of Guyana’s hy­dro­car­bons re­serves. How­ever, it has been well doc­u­mented world­wide that ac­count­ing for these costs have sig­nif­i­cant im­pacts on the eco­nomic ben­e­fits flow­ing to the host coun­try. Econ­o­mists there­fore ex­pect, as ac­coun­tants have in­deed tra­di­tion­ally urged: “the ac­count­ing treat­ment of ex­plo­ration and eval­u­a­tion (E&E) ex­pen­di­tures … can have a sig­nif­i­cant im­pact on the fi­nan­cial state­ments and re­ported fi­nan­cial re­sults”. Econ­o­mists ar­gue this is even more likely where, like Guyana, pro­duc­tion ac­tiv­i­ties have not yet be­gun!

Ad­di­tion­ally, eco­nomic prin­ci­ples have played a sig­nif­i­cant role in guid­ing ac­count­ing prac­tice in re­gards to E&E. Two widely ac­cepted meth­ods have tra­di­tion­ally been ap­plied, namely, the suc­cess­ful ef­forts (SE) and the full cost (FC) ap­proaches (and their vari­ants). The United States’ Gen­er­ally Ac­cepted Ac­count­ing Prin­ci­ples (GAAP) have dom­i­nated prac­tice in this area.

The SE method has been re­ported as “per­haps … more widely used by in­te­grated oil and gas com­pa­nies, but is also used by many smaller up­stream-only busi­nesses” (Price Water­house Coop­ers (PWC): Fi­nan­cial re­port­ing in the oil and gas in­dus­try, 2017). This method al­lows 1) costs in­curred in ex­plo­ration, dis­cov­ery and de­vel­op­ing re­serves to be cap­i­tal­ized on the ba­sis of in­di­vid­ual fields; 2) these cap­i­tal­ized costs to be al­lo­cated to “com­mer­cially vi­able hy­dro­car­bons re­serves”; 3) how­ever, if no com­mer­cially vi­able re­serves are found the ex­pen­di­ture is charged to ex­penses; and 4) these cap­i­tal­ized costs are de­pleted on a fieldby-field ba­sis, as pro­duc­tion oc­curs.

Sev­eral com­pa­nies, how­ever, do uti­lize the FC method. Here 1) all costs in­curred in a coun­try (or a large geo­graphic cen­tre or pool) are cap­i­tal­ized; 2) the costs are de­pleted on a coun­try (pool, geo­graphic cost cen­tre) as pro­duc­tion oc­curs in this unit; 3) un­suc­cess­ful ef­forts are there­fore ex­pensed. And, as a rule, the full cost method per­mits a greater “de­fer­ral of costs dur­ing ex­plo­ration and de­vel­op­ment and higher sub­se­quent de­ple­tion costs.” (ibid, page 15).

Sig­nif­i­cantly, PWC has re­ported, as re­cently as last year, (in the ci­ta­tion above) that: “de­bate con­tin­ues within the in­dus­try on the con­cep­tual mer­its of both meth­ods although nei­ther is con­sis­tent with the (GAAP) IFRS frame­work” (page 15).

This Sun­day col­umn is not ap­pro­pri­ate for ex­plor­ing these tech­ni­cal de­tails. My main aim is to high­light tra­di­tional prac­tice and the fact that these ac­count­ing stan­dards are un­der tran­si­tion.

Next week I con­tinue ex­am­in­ing the three other top­ics from an eco­nomic per­spec­tive.

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