30795607 Taxation of Natural Gas Projects Wood Mackenzie

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TAXATION OF NATURAL GAS PROJECTS

Graham Kellas

September25, 2008

This paper was prepared for the IMF conference on Taxing Natural Resources: New

Challenges, New Perspectives, September 25-27, 2008. It is work in progress: please do not

cite without permission. Views expressed here should not be attributed to the InternationalMonetary Fund, its Executive Board, or its management.


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Delivering commercial insight to the global energy industry

Taxation of Natural Gas Projects

Graham KellasWood Mackenzie Ltd.

IMF Resource Tax ConferenceWashington DC, September 2008


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IMF Resource Taxation Conference 2008 - 2


The taxation of gas production is varied around theworld and often highly complex. There are normallyseveral links in the value chain between producerand consumer and each link seeks a share of theeconomic rent generated.

Gas prices are often established in other countriesor regulated for domestic consumers. This presentsa variety of issues and choices which need to be

addressed in the fiscal regime.

This presentation identifies the topics involved andhighlights some of the different policies beingpursued.

Introduction>


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Contents

Natural gas projects

natural gas value chain

defining the taxable entity

upstream vs mid/downstream vs integrated taxation

Natural gas pricing & taxation

subsidised prices or Government Take?

deriving tax prices from final market prices upstream natural gas prices

Gas vs oil fiscal terms

Implications for fiscal policy

Appendix: Global LNG projects


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Natural Gas ProjectsNatural Gas Value Chain

GasProduction

GasProduction

Processing /

liquefaction

Processing /

liquefactionPipelinePipeline TransportationTransportation ConsumerConsumer

Price /Rent?

Price /Rent?

Price /Rent?

Market Price

Re-gasification

/ distribution /

power

generation

Re-gasification

/ distribution /

power

generation

Price /Rent?

Upstream Regime

Mid/downstream Regime

Note: number of links in each chain depends on the project (e.g. gas may be sold directly to consumer after processing)


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Natural Gas ProjectsNatural Gas Value Chain

The chain can be segmented i.e. different ownership of each link or integrated i.e. thesame companies own the entire chain

Most integrated projects are either LNG exports or domestic power generation (IPP)

Major distinction between domestic and export sales = prices

domestic energy prices in developing countries are normally regulated and kept as low aspossible - although currently they are almost universally increasing

export prices normally significantly higher and agreed under long term sales contracts, oftenwith some linkage to oil prices

Another distinction = costs export of gas normally incurs significant additional processing and transportation costs

In a segmented chain, arms length agreements will tend to dictate the price and level ofeconomic rent achieved in each link

Government may own one or more links of the chain and remove any economic rent from itslinks (e.g. early Indonesian LNG plants)

Where there is common ownership but differentiated tax systems for each link, there are noarms length prices and proxy transfer prices need to be established

The alternative is to treat the entire project as the taxable entity


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Elements of the fiscal regime may only apply to specific links in the chain

Mid/downstream elements tend to be treated as general industrial projects and are subjectonly to standard corporate income tax

major projects, such as greenfield LNG plants, may also receive fiscal incentives such as taxholidays

Upstream production tends to be subject to more complex fiscal terms

bonuses, royalty, production sharing, windfall profits taxes

corporate income tax may also be payable or replaced with a special petroleum profit tax

oil and gas production may be treated separately or together for tax purposes

individual licences or fields may be ring-fenced for elements of the fiscal regime

The fiscal take tends to be much higher from upstream than mid/downstreamOnly projects which have a fiscal ring fence around the entire project are truly integrated -if different tax systems apply to upstream and mid/downstream then, even with commonownership, the project is segmented

Natural Gas ProjectsDefining the taxable entity


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Natural Gas ProjectsUpstream vs mid/downstream vs integrated taxation

Common ownership of upstream and mid/downstream operations and differentiated taxsystems creates an incentive to manipulate transfer prices and keep as low as possible government needs to carefully monitor proxy transfer prices

Alternative of including mid/downstream with upstream is rare because:

only really works if all gas supplies come from a single source (e.g. field or licence/contract area)

difficult to apply if upstream producers are also selling gas to other projects

downstream cost recovery will delay higher government take from upstream

There are some examples:

Rasgas LNG (Qatar) development of North Field gas subject to consolidated royalty/tax regime Yemen LNG all gas comes from Block 18 PSC area and special PSC terms apply to gas production with

downstream costs included in cost recovery

Snhvit LNG (Norway) onshore operations are liable to 28% corporate tax but not the offshore 50% specialtax. All offshore operations are consolidated for tax purposes and investors preferred the entire Snhvit LNGproject to be treated as offshore - with accelerated depreciation - and receive immediate tax relief at effective78% rate from oil revenue, even though future profits will be liable to tax at the 78% rate

North West Shelf LNG (Australia) mid/downstream costs included in the upstream ring fence for royalty,excise and tax purposes

Okpai IPP (Nigeria) all capital costs are allowed to be consolidated with the Eni JVs oil operations andreceive 85% tax relief, with upstream gas profits (which are minimal) taxed at 30%


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Natural Gas ProjectsSegmented taxation example: Malaysian LNG

Source: Wood Mackenzies LNG Service

UPSTREAMTAX SYSTEM DOWNSTREAMTAX SYSTEM

PLANTGATE


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Natural Gas ProjectsIntegrated taxation example: Yemen LNG


INTEGRATEDPSC TERMS


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Natural Gas Pricing & TaxationSubsidised prices or Government Take?

Domestic gas pricing and fiscal policies must bedeveloped simultaneously

Subsidised consumer prices can often render

projects uneconomic

Fiscal terms need to be adjusted to take thisinto account

Regressive fiscal terms (i.e. revenue ratherthan profit based) can be particularly harmful

in a low price environment

In extreme cases, government may have tosubsidise producers as well

e.g. Nigerian domestic prices have been so

low that only oil producers who receive 85%tax relief on capital costs (but pay 30% tax ongas profits) can supply gas economically

Government must decide between subsidising

consumers and collecting fiscal revenue

-2

-1

-

1

2

3

4

5

6

7

8

9

Domestic Export

US$/mmbtu Govt Take / Company Prof it

Downstream Costs

Upstream Costs

Consumer Price

Source: Wood M ackenzie

Gas price too low

-2

-1

-

1

2

3

4

5

6

US$/mm

btu

Company Profit

Government TakeUpstream Costs

Maximum Dow nstream Price

Source: Wood M ackenzie

Government Take too high


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Major challenge for taxation of export projects

ensure the country netback is fair

there is a very limited number of reported global FoB gas prices

also normally very few, if any, comparable projects in-country

most export sales are under long term contracts and terms can reflectnumerous factors, so prevailing price for one contract may not be relevantto current market conditions e.g. price floors and ceilings often apply

contract prices should reflect and/or be linked to established spot marketprices (e.g. Henry Hub), less differentials

Establishing deductible costs between final market and export prices

Buyer may pay for gas when it receives it, for final use, or at the wellheador somewhere in between

LNG delivery to to consumer involves shipping, re-gasification anddelivery to market

Integrated project owners may control each of these links and have aninterest in moving economic rent to lowest-taxed link

Tanker freight rates are quoted and can be benchmarked against internalcharges to project

Pipeline tariffs could refer to established FERC/NEB regulations in US

and Canada (based on cost recovery plus regulated return)

Natural Gas Pricing & TaxationDeriving tax prices from final market price

Consumer Price(gas sales agreement)

Export Price(basis for taxation)


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Natural Gas Pricing & TaxationExample methodology for defining the netback price for an LNG project

FOB Price = Henry Hub Price x (100-(A+B+C))% (W+X+Y+Z)

A+B+C = losses (c. 5%-10% of loaded volumes); W+X+Y+Z = tariffs

Define 3 -4 generalregas areas in GOM

Assess basis differentials

for each area

Assess regas projectsunder development orwith a high probability

of development

Assess typical scale ofregas projects

Assess capex & opexbased on published

data

Calculate appropriateregas tariff for notional

terminalY

Define averagedistance to

notional terminal

Assess pipelineconnections around

each area

Calculate average

basis differentialacross the 2010 -2020timeframe

W

Assess averagepipeline lengths

Calculate appropriatepipeline tariff

Regas losses

Analysis of reasonableshipping assumptions

Boil off

Calculate appropriateshipping tariff tonotional terminal

X

B

Z

A

Pipeline losses C

Define 3 -4 generalregas areas in final market

Assess basis differentials

for each area

Assess regas projectsunder development orwith a high probability

of development

Assess typical scale ofregas projects

Assess capex & opexbased on published

data

Calculate appropriateregas tariff for notional

terminalY

Define averagedistance to

notional terminal

Assess pipelineconnections around

each area

Calculate average

basis differentialover relevant timeframe- W

Assess averagepipeline lengths

Calculate appropriatepipeline tariff

Regas losses

Analysis of reasonableshipping assumptions

Boil off

Calculate appropriateshipping tariff tonotional terminal

X

B

Z

A

Pipeline losses C

Source: Wood Mackenzie


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Natural Gas Pricing & TaxationSharing in trading upside

Market A$8 /mmbtu

Market B$12 /mmbtu

ProducingCountry

Buyer takes delivery of LNG onFOB basis at the LNG plant

Buyer agrees FOB contract pricewith producers based on netback

from sales price in Market A onexpectation that cargoes will bedelivered to Market A

Buyer realises Market B is payingpremium (e.g. $4 /mmbtu) anddiverts cargo to Market B

Buyer gains entire upside unlesssales agreement specificallyprovides for sharing any gains

FoB contract pricing formulacould provide a price floor,based on Market A, but if therealised price is greater then thedifference is shared


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Government owns gas and only reimburses costs, e.g. Algeria, Oman, UAE

Government establishes prices for royalty/taxation purposes e.g. Albertas select prices

Spot markets: currently US, Canada and UK and beginning to develop in Europe

Gas price formulae are established in upstream contract, e.g. Egyptian PSC

Consumer contracts

normally 20-30 years with volume and price commitments this is the most common form ofpricing for direct sales to consumers in developing countries

consumer contracts for export sales are normally agreed with the plant owners and the

upstream share of the price (i.e. netback) needs to be established

Consumer price netbacks

upstream receives final sales price less regulated tariffs/tolls payable to mid/downstreamoperations (e.g. Indonesia, Trinidad (Atlantic LNG 2/3/4))

upstream receives a fixed % of FOB sales price (e.g. Nigeria LNG)

upstream and downstream agree sharing of final sales price (e.g. Trinidad (Atlantic LNG 1))

If upstream and mid/downstream owners are the same but tax rules are different, a proxytransfer price is required

Natural Gas Pricing & TaxationUpstream natural gas prices


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LNG price

Capital annuity on upstream

capital (including risk premium)

Capital annuity on downstream

capital (including risk premium)

GasTransferPric

e

Netback

GTP

Cost Plus

Upstream operating cost

Downstream operating costs

Source: Australian Government (Department of Resources, Energy & Tourism)

Ongoing capital costschanges GTP over time

Natural Gas Pricing & TaxationEstablishing a proxy upstream price: example

Australias residual pricing mechanism establishes a transfer price for integrated LNGprojects which shares the value gap between upstream and downstream operations

Upstream is subject to Petroleum Resource Rent Tax (PRRT), mid/downstream is not


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Differentiating Fiscal TermsGas vs Oil - 1

Upstream gas project economics are normally much less robust than oil

lower prices per boe (either domestic regulations or export netbacks)

higher transportation costs

longer, flatter production profiles (which impacts the present value of future production)

To compensate, many governments offer fiscal incentives to gas

lower royalty rates (e.g. Nigeria, Tunisia, Vietnam)

higher cost recovery ceilings and/or profit shares (e.g. Egypt, Indonesia, Malaysia) lower tax rates (e.g. Nigeria, Tunisia, Papua New Guinea)

exemption from certain oil taxes (e.g. Trinidad & Tobago (SPT))

Alternative approach is to levy additional taxes on export sales to reduce incentive to export

e.g. Argentina, Russia

Where local gas prices are not regulated, fewer (if any) incentives offered

e.g. USA, Canada, Norway, UK

can create problems if a divergence between oil and gas prices emerges


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Differentiating Fiscal TermsGas vs Oil - 2

Increasing trend toward linking fiscal take to project profitability enables the same fiscalterms to apply to oil and gas

automatically provides lower take from less valuable projects and vice versa

Major issue in differentiated fiscal regimes is the treatment of liquids associated with gasproduction (condensate) treat as oil or gas revenues?

high liquids content reduces breakeven gas prices and can often make or break gas projects

very high taxation (i.e. oil rates) on condensate can nullify this e.g. recent changes in taxation

proposed for North West Shelf gas project in Australia particularly important issue when gas is associated with oil production

Many PSC regimes only include terms for oil; gas will be subject to separate agreement

if gas is associated with oil, it may be delivered to government for free, with upstream

development and operating costs recoverable from oil revenues

non-associated gas will be subject to separate agreement and government may argue thatthe existing PSC owners have no rights at all to gas discoveries


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Conclusions and implications for fiscal policy

Domestic gas pricing and fiscal policies must be developed simultaneously

If upstream and downstream fiscal regimes are different which is normal there is a strongrationale for upstream and mid/downstream operations to be segmented

Where ownership of upstream and mid/downstream operations is the same, a proxy transferprice needs to be established

Alternative approach is to have a separate tax regime for integrated gas projects and treat theentire project as the taxable entity

Role of national oil company normally very important as it may have different equity interests

in upstream and mid/downstream

In integrated export projects, government needs to closely monitor and benchmark agreedmarket prices and costs in each link of the chain to ensure taxable income is fairly calculated

Government and producers should aim to share in realised market prices which are greater

than expected needs to be addressed in gas sales agreements

Gas projects may require more attractive fiscal terms than oil projects - although fiscal termslinked to project profitability could apply to both

Where liquids are taxed at a higher rate than gas, it is important to consider how condensate

is treated if liquids, then higher tax revenue, but also a higher price will be required for gas


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AppendixGlobal LNG Projects


Regas - ExistingSupply - Existing Supply - Under Construction Regas - Under ConstructionSupply - Proposed Regas - Proposed

Kenai

Peru LNG

Atlantic LNG 1

Atlantic LNG 2

Atlantic LNG 3

Atlantic LNG 4

Train X

Algeria LNG

Skikda Rebuild

Arzew Exp.

Iran LNG

Pars LNG

Persian LNG

Snohvit

NLNG Base

NLNG Expansion

NLNG Plus

NLNG 6

NLNG VII+

Delta Caribe LNG

EG LNG

EG LNG 2

Marsa El Brega

Marsa El B. Exp.Damietta

Damietta Exp.

ELNG 1

ELNG 2

Angola LNG

Yemen LNG

ADGAS

OLNG

Qalhat

RasGas

RasGas II

RL 3

QatargasQatargas-2

Qatargas-3

Qatargas-4

a a n

Sakhalin

Arun

MLNG

MLNG Dua

MLNG Tiga

Brunei

Bontang

Tangguh

Tangguh Exp.

North West Shelf

Pluto

Gorgon

Scarborough

Wheatstone

Gorgon Expansion

Darwin

Ichthys

Browse

Greater Sunrise

PNG LNG

Shtokman

Curtis

Gladstone

GLNG

Sun LNG

Brass LNG

OK LNG

Nigeria Flex


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30795607 Taxation of Natural Gas Projects Wood Mackenzie

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