C ’ OUNTRIES EXPERIENCE WITH THE ALLOCATION OF PETROLEUM EXPLORATION AND PRODUCTION : RIGHTS STRATEGIES AND DESIGN ISSUES World Bank Working Paper- Draft Silvana Tordo with the collaboration of David Johnston and Daniel Johnston June 2009 World Bank Working Paper- Draft. This paper is a work-in-progress, and this draft version has been published to inform the public debate on good practice in the allocation of petroleum exploration, development and production rights. A revised version of this paper will be published in October 2009. Additional examples or references, where these will add to the strength of the paper, are welcome. For further information on this paper please contact the author at [email protected] . Abstract Governments often pursue a variety of economic, social and political objectives through their allocation policies that go beyond the maximization of the net present value of the economic rent. There is little empirical documentation on the design and relative effectiveness of alternative systems for the allocation of petroleum exploration, development, and production (E&P) rights and their policy implications. This paper analyzes the available evidence on the advantages and disadvantages of various practices used by petroleum producing countries to allocate petroleum E&P rights, and draws conclusions about the design of E&P allocation systems. We find that the optimal allocation policy depends on a range of country specific and exogenous factors. Bur despite the variety of factors influencing optimal design, most countries use similar solutions. In particular, when auctions or administrative procedures are used, most governments opt for simple simultaneous multi-object sealed-bid rounds. While this may appear to be paradoxical, there is a practical explanation. It is true that more complex bidding forms might increase rent capture at bidding. However, the potential marginal gain is often limited, owing to most E&P projects’ high level of uncertainty and risk. In addition market mechanisms, such as joint bidding and secondary markets, and the fiscal regime are widely used in the petroleum sector to correct inefficiency at the time of allocation. This paper aims to provide a framework for policy discussion while leaving implementation issues for subsequent papers. Copyright © 2009 The International Bank for Reconstruction and Development/The World Bank 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved. This paper is an informal document intended to improve the understanding of the factors that affect the efficient and transparent allocation of petroleum exploration, development, and production rights and their relative importance for policy makers. The manuscript of this paper has not been prepared in accordance with the procedures appropriate to formally edited texts. Some sources cited in this paper may be informal documents that are not readily available. The findings, interpretations, and conclusions expressed herein are those of the author(s) and do not necessarily reflect the views of the International Bank for Reconstruction and Development or the World Bank and its affiliated organizations, or those of the executive directors of the World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. This paper may not be resold, reprinted, or redistributed for compensation of any kind without prior written permission from the World Bank. For free downloads of this paper or to make inquiries, please contact: Oil, Gas, and Mining Policy Division The World Bank 2121 Pennsylvania Avenue, NW Washington, DC, 20433 Telephone: +1-202-473-6990 Fax: +1-202-522 0395 E-mail: [email protected] Web: http://www.worldbank.org/noc. Table of Contents Abbreviations and acronyms ______________________________________________ vi Executive summary ____________________________________________________ viii Conclusions _______________________________________________________________ xii 1. The exploration, development, and production of petroleum resources ________ 1 1.1 Uncertainty and risk: Key elements of petroleum exploration, development, and production _________________________________________________________________ 1 1.2 The decision to explore for petroleum resources ___________________________ 3 1.2.1 Exploration and inter-temporal depletion policies ________________________________ 3 1.2.2 Exploration and inter-generational equity ______________________________________ 4 1.2.3 Exploration and the maximization of the resource rent _____________________________ 4 1.3 Who carries the risk of exploration? _____________________________________ 6 2 Alternative approaches to the granting of petroleum exploration, development, and production rights ____________________________________________________ 8 2.1 Legal regimes for petroleum E&P _______________________________________ 8 2.1.1 Concessions ______________________________________________________________ 9 2.1.2 Production sharing contracts _______________________________________________ 10 2.1.3 Service agreements _______________________________________________________ 10 2.2 Fiscal regimes for petroleum E&P _____________________________________ 11 2.2.1 Taxation instruments and methods ___________________________________________ 11 2.2.2 Comparison of key fiscal elements of concessions, PSCs, and SAs ___________________ 13 2.3 The allocation of petroleum E&P rights _________________________________ 14 2.3.1 Open-door systems _______________________________________________________ 14 2.3.2 Licensing rounds _________________________________________________________ 15 2.3.3 Biddable or negotiable factors ______________________________________________ 18 2.3.4 Some countries’ experience _________________________________________________ 22 3 The design of appropriate allocation systems ____________________________ 29 3.1 Allocation system objectives ___________________________________________ 30 3.1.1 Consistency with petroleum sector policy ______________________________________ 31 3.1.2 Selecting the most efficient operator __________________________________________ 32 3.1.3 Keeping compliance and administrative costs down ______________________________ 34 3.1.4 Minimizing distortionary effects _____________________________________________ 35 3.1.5 Addressing market deficiencies ______________________________________________ 37 3.2 Key issues in allocation systems design __________________________________ 39 3.2.1 Open-door systems or licensing rounds? _______________________________________ 39 3.2.2 Auctions or administrative procedures? _______________________________________ 39 3.2.3 Which form of auction is more likely to lead to higher bids? _______________________ 40 3.2.4 Are planning and commitment important? _____________________________________ 41 3.2.5 What really matters for the design of licensing rounds? ___________________________ 44 3.2.6 What does this mean in practice? ____________________________________________ 47 4 Conclusions ______________________________________________________ 49 Appendix I – Life cycle of a typical oil and gas project ________________________ 51 Appendix II – Main fiscal instruments: Advantages and disadvantages __________ 52 iii Appendix III – World average fiscal terms __________________________________ 54 Appendix IV – Select countries’ experience _________________________________ 55 Australia _________________________________________________________________ 55 United Kingdom ___________________________________________________________ 59 United States ______________________________________________________________ 64 Brazil ____________________________________________________________________ 70 Mexico ___________________________________________________________________ 77 Yemen ___________________________________________________________________ 83 Appendix V – Allocation systems design: Example ___________________________ 88 Glossary _____________________________________________________________ 89 References ___________________________________________________________ 93 iv Tables Table 1 – Objectives of fiscal systems_______________________________________ 11 Table 2 – Fiscal elements of petroleum agreements ____________________________ 13 Table 3 – Overview of allocation systems in select countries ____________________ 23 Table 4 – Alternative bid design ___________________________________________ 65 Table 5 – Overview of Brazil’s licensing rounds ______________________________ 74 Table 6 – Bidding rounds summary ________________________________________ 80 Table 7 – Biddable parameters ____________________________________________ 85 Boxes Box 1 – Licensing policy as a means to promote local content ___________________ 33 Box 2 – Tax implications of the transfer of E&P rights _________________________ 33 Box 3 – Administrative complexity _________________________________________ 34 Box 4 – Examples of bidding parameters ____________________________________ 34 Box 5 – Minimum bidding requirements _____________________________________ 35 Box 6 – Excessive royalty rates ___________________________________________ 35 Box 7 – Over-sized work programs ________________________________________ 36 Box 8 – Fiscal incentives to cost saving _____________________________________ 36 Box 9 – Information and risk perception ____________________________________ 37 Box 10 – Joint bidding or a forced marriage? ________________________________ 38 Box 11 – Example of sequential auction _____________________________________ 41 Box 12 – Issues with the planning of licensing rounds __________________________ 42 Box 13 – Changing the rules of the game ____________________________________ 43 Box 14 – Reserve prices _________________________________________________ 46 Box 15 – Transparency mechanisms________________________________________ 46 Figures Figure 1 – Allocation policy flow chart _____________________________________ 30 Acknowledgments This paper presents the results of a study aimed to collect information on countries’ experience with the allocation of petroleum exploration, development, and production rights. The paper was undertaken and written by Silvana Tordo (lead energy economist—Oil, Gas, and Mining Division, the World Bank). Input was provided by petroleum sector expert consultants David Johnston and Daniel Johnston. The comments of peer reviewers Alan H. Gelb (director, Development Policy) and Robert W. Bacon (consultant, Oil, Gas, and Mining Division), both with the World Bank; Clive Armstrong (lead economist, Oil, Gas, Mining and Chemicals, International Financial Corporation); Charles P. McPherson (senior adviser, Fiscal Affairs Department, International Monetary Fund); Willy Olsen (consultant); and Kjell J. Sunnevåg (senior adviser, Norwegian Competition Authority) are gratefully acknowledged. Comments were also provided by Robert M. Lesnick (adviser, Global Gas Flaring Reduction Initiative, Oil, Gas, and Mining Division, the World Bank) The author wishes to particularly thank Wayne W. Camard (senior economist, Africa Department, International Monetary Fund) for his helpful comments and suggestions during the preparation of this paper. Special thanks also go to Fayre Makeig and Stephen Spector for their editorial suggestions. Finally, the author owes a debt to Professor Paul Kemperer, Oxford University, whose theoretical and practical work on auctions provided inspiration for this paper. v Abbreviations and acronyms Technical terms: CIT Corporate income tax E&P Exploration, development, and production EPC Engineering, procurement, and construction ERR Effective royalty rate FPWC Financed public works contract GoM Gulf of Mexico GTL Gas-to-liquid JVs Joint ventures LCV Local content vehicle LNG Liquified natural gas LPG Liquid petroleum gas MOU Memorandum of understanding NPV Net present value OCS Outer Continental Shelf PRRT Petroleum resource rent tax PSA Petroleum-sharing agreement PSC Petroleum-sharing contract RJBL Restricted joint bidders list R-factor Ratio-factor RoR Rate of return SA Service agreement SLD Straight line decline UKCS U.K. Continental Shelf USGoM U.S. Gulf of Mexico Government agencies and other entities: AAPG American Association of Petroleum Geologists ABARE Australian Bureau of Agricultural and Resource Economics ANP Agencia Nacional do Petróleo (Brazil) API American Petroleum Association ARC Aden Refinery Company (Yemen) BERR U.K. Department for Business, Enterprise & Regulatory Reform CNPE Conselho Nacional de Política Energética (Mexico) CRE Comisión Reguladora de Energía (Mexico) compraNET Government Procurement Electronic System (Mexico) DECC Department of Energy and Climate Change (U.K.) DOI Department of the Interior (U.S.A.) EIA Energy Information Administration (U.S.A.) MMS Minerals Management Service (U.S.A.) MoM Ministry of Oil and Minerals (Yemen) vi MRC Marib Refinery Company (Yemen) PEMEX Petróleos Mexicanos (Mexico) PEPA Petroleum Exploration and Production Agency (Yemen) PETROBRAS Petróleo Brasileiro (Brazil) SEC Security Exchange Commission (U.S.A.) SECODAM Secretaría de Contraloría y Desarollo Administrativo (Mexico) SENER Secretaría de Energía (Mexico) SHCP Secretaría de Hacienda y Crédito Público (Mexico) SPE Society of Petroleum Engineers WPC World Petroleum Congress YC Yemen Company YGC Yemen Gas Company YOC Yemen Oil Company YOGC Yemen Oil and Gas Company YPC Yemen Petroleum Company vii Executive summary Petroleum has become an integral part of today’s global economy and a key component of many national economies. Hence, the presence of petroleum in meaningful quantities can have important economic, developmental, and strategic consequences for a country. While a country’s petroleum resource base is a gift of nature, translating this resource into saleable crude oil requires investment and effort. Whether governments choose to invest directly or allow private investors to do so, their primary concern should be to maximize the social benefits derived from the exploitation of the resource base. In practice, however, defining what constitutes maximum social welfare is essentially a political question, which helps explain the variety of objectives pursued by governments over time. In order to exploit their natural resources efficiently, many governments rely on private oil companies. Governments have a challenging task in deciding which companies should be awarded the exclusive rights to explore, develop, and produce their resources, and on what conditions such rights should be awarded. There is little empirical documentation on the design and relative effectiveness of alternative systems for the allocation of petroleum exploration, development, and production (E&P) rights and their policy implications. This paper analyzes the available evidence on the advantages and disadvantages of various practices used by petroleum producing countries to allocate petroleum E&P rights, and draws conclusions about the optimal design of E&P allocation systems. The first crucial set of decisions a government faces is whether or not to explore for petroleum, at what pace to explore, and who should undertake such exploration. There are several reasons why policy makers should promote oil and gas exploration:  Exploration provides information on the existence, likely size, and distribution of petroleum reserves, which can be used to guide the definition of efficient inter-temporal depletion policies;  Better knowledge of the size of petroleum reserves provides an input for the design of sustainable macroeconomic policies and for improving inter- generational equity through the choice of current consumption rates;  Information about an area’s geological potential affects the perception of geological risk and related market interest in—and competition for—E&P rights in the specific area; and  Improved knowledge of the geological potential of an area allows the government to design appropriate strategies for the promotion and licensing of petroleum E&P rights, including delineation of blocks to be licensed, licensing procedures, and licensing terms that reflect the risk profile of the specific areas. Clearly, exploration generates valuable information for policy makers, investors, and the public at large. Who should undertake the risk of exploration, and in what measure, is another important policy decision. Companies hedge against risk by investing in a diverse viii portfolio of projects—often in several countries—and by involving partners. Countries rarely have the same ability to diversify their petroleum investments. Hence, often governments hedge against exploration risk by transferring part of it to private oil companies through contract and fiscal system design. Indeed, the uncertainty and risk that characterize petroleum E&P activities pose special challenges to the design of efficient allocation policies. At the time of allocating exploration rights, neither the resource owner nor the investors know whether oil or gas will be found, in what quantities, at what cost it will be produced, and at what price it will be sold. Moreover, the resource is non-renewable, and a large portion of the total risk is project specific. For these reasons, even if a hypothetical social welfare function could be determined with precision, the uncertainty surrounding the existence and value of petroleum resources makes their management a complex endeavor. Risk is not, however, the only challenge that governments and investors must face. Exploration and development activities require specialized, high-tech equipment and skills that are often not available in the host country, and are, in any case, limited in quantity. Capital investment is usually high and the largest investments occur several years before production. As a consequence, governments and investors are much more likely to observe higher levels of activity (and ultimately faster economic growth and higher profits) if they can spread their investment over several projects through partnering with other market participants. For governments, this strategy translates into the need to design efficient policies for the allocation of petroleum E&P rights to investors. Countries allocate petroleum E&P rights in various ways; some use different forms of public tenders or licensing rounds, others use direct negotiation, and most use a combination of these systems. The conditions for award can vary substantially: some countries adopt rather rigid systems with very limited biddable items that affect the sharing of the rent between investors and owner of the resource; others award rights on the basis of work programs; in others, ―everything is negotiable.‖ Poorly conceived legal, regulatory, and fiscal frameworks may lead to inefficiency and loss of economic rent, which may not be mitigated through the allocation system. The most common allocation systems and biddable parameters include cash bonuses, work programs, royalties, and profit shares. Bundle bidding—that is, linking access to petroleum resources with downstream or infrastructure investments—is also used, particularly in developing countries. In this paper, allocation systems are grouped into two categories: (i) open-door systems (E&P rights are allocated as a result of negotiation between the government and interested investors through solicited or unsolicited expression of interest); and (ii) licensing rounds. Two types of licensing rounds can be identified: (i) administrative procedures, in which E&P rights are allocated through an administrative adjudication process on the basis of a set of criteria defined by the government; and (ii) auctions, in which rights go to the highest bidder. In open-door systems, the criteria for award are often not pre-defined and known to market participants; the government retains considerable discretionary power and flexibility in awarding E&P rights. Open-door systems are likely less competitive than licensing rounds and are generally considered less transparent and more vulnerable to corruption. Such systems can, however, be made ix