Review of fiscal terms for oil and gas industry

 Michael McKernan analyses the implications of the recent review of fiscal terms for the oil and gas exploration industry.

Ireland’s regime for promoting and subsequently taxing private sector oil and gas exploration – Ireland’s ‘fiscal terms’ – has recently been reviewed and changed. This follows the appointment by the Department for Communications, Energy and Natural Resources (DCENR) of UK specialists Wood Mackenzie, in 2014, to assess whether or not Ireland’s fiscal terms were ‘fit for purpose’ and to make appropriate recommendations for change. The Government, which has accepted all of the Wood Mackenzie recommendations, hopes that the changes will underpin the success of the current 2015 Atlantic Margin Oil and Gas Licencing Round, which is due to complete in September of this year.

Background

The current regime for oil and gas exploration fiscal terms was last reviewed in 2007 and there has been a growing consensus that the State has not done as well as it should have, financially, from the package since that time. Indeed with generous tax allowances granted, private E&P companies have been able to recover most of their upfront investment costs before the State has seen any significant revenue. Also, in addition to very low pre-production receipts, the State has often seen relatively low returns during production even on highly profitable commercial fields.

So the task facing the Wood Mackenzie consultants was to find a way where the State, on behalf of citizens, could earn a higher return on a valuable national asset while keeping Ireland competitive – i.e. without discouraging private sector interest in E&P investment in Ireland.

Wood MacKenzie approach

The Review commenced with some cold recognition of the overall position of Ireland in the international league of oil and gas exploration countries. Although there are some positive estimates of the potential resources around Irish shores, very little is proven, and over the past few decades Ireland has converted a very low proportion of exploration activity into commercial production. Therefore Ireland has to be regarded as a relatively high risk (and high cost) country and needs to have fiscal terms which reflect this reality and which are competitive with peer countries. This means terms competitive with countries such as Newfoundland and Portugal and Morocco, rather than terms modelled on the larger take enjoyed by say, the UK or Norwegian governments, where the E&P industry is mature and there is a high success rate. The Review therefore benchmarked the impact of proposed changes against nine of Ireland’s competitors.

Licencing

The review proposed no significant change to Ireland’s existing overarching licencing system – the three tier system of prospecting options, exploration licences and production licences. There were also no major changes proposed to the conditionality of those licences including the built-in requirements to carry out certain phases of work within set timeframes. Most importantly the consultants recommended that whatever changes were proposed to the system of royalties, to increase the State share, they should not be made retrospective and should apply only to new licencees. This would give regulatory certainty in a relatively risky environment.

New fiscal terms

Under the 2007 regime, the Government’s ‘take’ is comprised of a corporation tax of 25 per cent applied on profit across the board, supplemented by a Profits Resource rent Tax (PPRT) which ranges from 0 per cent on the least profitable field to a maximum of

15 per cent on the most profitable ones. Profitability is determined according to a set ‘profit ratio’ calculated as a function of revenues against costs for a given field (see Table 1). Also capital costs can be depreciated on a 100 per cent first year allowance basis which significantly lowers taxable profits until the company has recovered its outlay. The corporation tax and PPRT are simply added together and this means that in total, the State’s take, from producing fields, varies from a 25 per cent effective rate to a maximum effective rate of 40 per cent. This maximum rate has been criticised as being far too low, particularly on the most profitable fields. Indeed a Joint Oireachtas Committee had previously examined Ireland’s fiscal terms and had proposed a maximum rate of 80 per cent.

Petroleum Production Tax

The major change under Ireland’s new fiscal terms is the replacement of PPRT by a new Petroleum Production Tax. (PPT) The new PPT is to be levied on a similar overall basis to PPRT in that the rate applicable is higher the higher the profitability of the field. However the previous ‘profit ratio’ is replaced by an ‘R’ factor. However although, like PPRT, PPT is a field tax, the new tax is levied before the application of corporation tax (a company wide tax) and this has the effect of stopping company losses elsewhere being used to dampen taxable profits. It also has the effect of making the ‘R’ factor a bigger number than the ‘profit ratio’ it has replaced – ensuring a higher tax take for the State. This is illustrated in Table 2 below. The other impact of PPT is that the State gets its share earlier and the calculation is made on a continuous pro-rata basis rather than the four levels of the old system.

The result overall is that the State’s share increases in most instances (although it can be slightly lower in the case of the least profitable fields) and the new maximum effective rate rises from 40 per cent to 55 per cent. Although this is well short of the Joint Oireachtas Committee’s recommended maximum, the Review concludes that “Investor returns are reduced…but exploration prospects with a robust EMV (estimated market value) should not be deterred by the new terms. The Government share is increased, compared to current terms, but remains competitive within the peer group”

Fiscal terms aside, the Review, cognisant of the overall state of the public finances in Ireland and the low Government appetite for risk, did not recommend any change to the degree to which the Government itself might takes up equity interests in E&P activity. However it did recommend that the Government should ‘investigate’ the possibility of a National Oil Company (NOC) model which has found favour in some of Ireland’s peer countries.

Meanwhile attention will be turning to the outcome of the ’2015 Round’ in September coming for the first signs of any impact of Ireland’s new fiscal terms.