Revisiting Government Take & Reserves Reporting in the face of much Noise and Nonsense Part 1

Introduction

As readers are aware, I usually indicate well beforehand the topics I intend to address over an extended period, going forward. Rarely do I get diverted from this course. Recently however, several readers have been pleading that I quickly re-visit my previous contributions on Guyana Government Take and reported reserves discoveries under the ruling Production Sharing Agreement, PSA. I accede to this request and in the coming weeks I shall attempt a highly condensed, but hopefully robust, summary of my previous columns on this topic over several years.

In addressing Government Take in my Chapter entitled ‘Guyana and the Advent of World-Class Petroleum Finds” in the edited Volume on Caribbean Economy, 2020 [Professor Loomey, ed. Routledge], I have indicated the massive importance of Government Take; “it determines the size of Government spending”. Its importance therefore should not be understated. Further the IDB, in its 2020 study of Guyana’s Oil Opportunity, pointed out that Government Take “is an essential tool for the comparison of fiscal regimes in the extractive sector.” The IDB also took the opportunity to identify Government Take’s similarity to the average effective tax rate, AETR.

In my Volume of Articles, entitled Guyana’s Petroleum Road Map 2019/2020, I have sought to contextualize Government Take. There I noted that the literature deems Government Take an accounting/financial ratio or “fiscal metric”. That is, government’s revenue share from oil projects’ net cash flow. However, from an economic perspective, this fiscal metric is indeed a gross measure. It is clearly not “net benefit” arrived at after taking fully into account “government contingent liabilities for petroleum production, such as environmental, social, and other costs”.

For purposes of this re-visit of Government Take, I start again from the very conception of PSAs.

Intellectual Origins

About five years ago I introduced readers to PSAs by labelling them as social constructs, which originated from three tributaries of intellectual inquiry; namely, legal, behavioral economics, and institutional theory. Legally, PSAs have evolved from French Napoleonic traditions of granting individuals State-owned property rights to develop for the benefit of all citizens. This legal construct initiated in agriculture; notably, in landowner ─ farmer ─ tenant ─ sharecropping arrangements. This is perhaps the oldest form of “risk capital with a dual nature”. That is, with rights to explore for and produce, while cooperating among parties to a contract [State and private, or their respective designees].

Behavioral economics originates in risk-reward theorems and the analysis of these trade-offs. This analysis has contributed immensely to the proliferation of PSAs due to its emphasis on “expected rewards” vs “investment risk”. Petroleum exploration is reputed to be one of the riskiest investments, worldwide. The general principle that applies is: “potential returns must rise if risks increase”.

Institutional theory, the third intellectual tributary, centres on principal-agent relations. Here the State is Owner of the hydrocarbon resources and foreign oil company, FOC, is the Contractor (Agent). The Contractor explores for hydrocarbons and if successful manages their production. This theoretical field has generated several well-known theorems such as: 1) contract completeness/ incompleteness; 2) asymmetric information flows (information failure); 3) insider trading; 4) moral hazard; and 5) agency costs.

PSA Dynamics

Given the prevailing noise and nonsense two features of PSAs should standout for citizens. One is they guarantee States sovereign right over their resources. And, second, they pose no “financial risks” to States simply because the Contractor is legally expected to provide capital for exploration and start-up, as well as technology and know-how to produce/distribute/market the petroleum as stated in the PSA. Obviously, a good outcome for this principal-agent relation is one where the State (Principal) maximizes revenue collections over the short run and simultaneously stimulates profitable FOC (Agent) investments over the long run.

Furthermore, certain contract outcomes are necessary, if not sufficient; for example, the contract should be: 1] comprehensive, given the uncertainty; 2] driving competitive outcomes by fostering innovation and cost efficiency; 3] considered by both principal and agent, as a dynamic document, which will be adapted if circumstances change significantly; and 4] situated in a fiscal environment such that, after trade-offs, both the State (Principal) and FOC (Agent) find it acceptable for going forward, without significant disagreements.

Energy economists constantly remind us of an irreversible secular technical condition that governs the dynamics of the petroleum industry. That is, hydrocarbon resources are ultimately finite and the effect of this finiteness is captured in the theorem of the “energy return on investment, EROI”. EROI quantifies the amount of energy required (barrels of oil, worldwide) to produce more energy. The industry rule-of-thumb is, overall, it took one barrel of oil to produce 100 barrels in the middle of the 19th century. Nowadays though, overall, it takes as many as 5-15 barrels of oil to produce 100 barrels of oil. Obviously, among other things, this signifies a secular decline in crude oil quality. If true, this would have serious long-run consequences for the economics of petroleum and hence, contracts for their exploration and production.

NOC and the GoG may, under the contract, create a joint committee to monitor operations of the undertaking.

Conclusion

PSAs or contracts have been, from the time of their earliest introduction to the oil and gas sector, subjected to in-depth critical analyses and/or evaluations; from economic, legal, and institutional perspectives.

Next week I continue the presentation, focusing on this aspect.