Cost recovery is a fundamental part of any basic Production Sharing Agreement (PSA). It is a method which allows an oil company to recover costs from the petroleum produced. The various costs are subtracted from gross production. Onlyafter costs have been recovered is the remaining “profit gas” divided between the company and the Government. Let’s examine the various costs associated with cost recovery.
Exploration Costs
Exploration costs are expenses incurred in the search for petroleum within the contract area. The period of exploration begins with the signing of the contract and includes the discovery of petroleum and its subsequent appraisal, up until the Government approves the first Development Plan. Costs related to exploration can be recovered in the year when commercial production begins. Examples of explorations costs, as set out in Annex C of most contracts, include:
seismic surveys and studies; core hole drilling; labour, materials and services used in drilling wells; and facilities used
solely in support of these purposes, including access roads.
Development Costs
Often called capital costs, development costs are the monies spent to build infrastructure to extract petroleum and send it to the market. Putting in place the capital infrastructure represents the overwhelming majority of the costs of an oil and gas project. Examples of such costs, as set out in Annex C of most contracts, include: drilling and completing wells, the costs of field facilities such as production and treatment units, drilling platforms, petroleum storage facilities, export terminals and piers, harbours and related facilities, access roads for production activities.
Operations
Operating costs start from the beginning of commercial production. Operating costs attributable to petroleum operations
can be recovered in the full amount in the year in which they were incurred. These costs include all expenditures incurred in the petroleum operations, including: operating and maintaining field facilities completed during the Development and Production Operations and producing petroleum and gathering, storing and transporting the petroleum from the reservoir to the delivery point.
Service and Administrative Costs
Service costs are direct and indirect expenditures in support of the Petroleum Operations, including warehouses, offices, vehicles, water and sewage plants, power plants, housing, community and recreational facilities and furniture, tools and equipment used in these activities.
Costs Recoverable with Spec ific Approval and Non- Recoverable Costs
Most costs are recoverable through the normal “cost recovery statement” process, without further approval from
Government. But, there are two important exceptions. First, where services are provided by a company affiliated with the
concessionaire, the charges will be based on actual costs and will be competitive. The charges will be no higher than the
most favourable prices charged by the affiliated company to third parties for comparable services under similar terms
and conditions elsewhere. Second and more importantly, interest, fees and related charges incurred on commercial loans raised by the concessionaire for the Petroleum Operations requires Government approval, though this approval must not
be “unreasonably withheld.” In addition, four specific costs are explicitly identified as “non-recoverable.” These include:
petroleum marketing or transportation costs of petroleum beyond the delivery point; costs of arbitration and the
independent expert; Petroleum Production Tax and Corporate Income Tax; fines and penalties imposed by any public authority in the host country or elsewhere.
Challenges
Now that you have a basic understanding as to the makeup of the cost recovery process, it is crucial to move to another dimension of this topic; that the process for cost recovery provides ample opportunity for companies to inflate expenses. This provides significant challenges for oil rich nations. The higher the cost recovery claims by the company, the smaller the pie to be divided between the company and host country The American state of Alaska provides a compelling example of the technical challenges of securing the full proportion of revenues owed to the Government. According to an analysis undertaken. in 2003, over the 25-year lifespan of the petroleum sector, “one dollar out of every six that Alaska received from its oil development was obtained through legal challenges to the industry’s original payment.”
The majority (90%) of the petroleum production in Alaska, since first exports in 1977, has been controlled by three
companies, now known by the names British Petroleum, ExxonMobil and ConocoPhillips. Over the first 25 years of production, Alaska received approximately $70 Billion in petroleum revenue from royalty payments of 12.5% of the value of the oil, and three principal taxes: corporate income tax, a petroleum production tax, and property tax.
Based on independent analyses and audits, Alaskan officials overseeing the petroleum sector claimed that the
“industry chronically reduced the basis for calculating royalty, severance and income tax payments by underestimating
the market value of a barrel of oil at the point of sale. Overstated pipeline shipping charges (tariffs) had the same result.”
In order to secure what Government officials believed to be a fair share of revenues from this petroleum development, they were forced to take prolonged and intensive legal action against the companies. Between 1977 and 1994, the Alaskan Department of Law reported that it had paid contract lawyers and accounting specialists from 30 different companies a total of more than $217 Million to follow up these legal claims. The money was well spent. Litigation resulted in additional company payments to Government of $2.7 Billon. The issues in dispute were highly technical and, in some cases, based on a legitimate difference of opinion in the interpretation of complex contractual language and taxation law. But, in many cases, the differences were based on outright deceit and fraud. By tracking the export and value of each barrel of oil being exported, Alaskan authorities demonstrated that overall revenues were deliberately
minimized by misrepresenting the actual sale value of oil and by inflating the costs associated with transporting oil by pipeline and tankers. By 2000, litigation had produced an additional $10.6 Billion in revenue, including $6.8 Billion in direct payments for taxes and royalties and an additional $3.8 Billion in increased taxes and royalties related to reassessing pipeline transportation costs. This pattern has continued with an additional $1.7 Billion in oil and gas settlements over the past decade. The figures listed above substantially underestimate the scale of abuse. Many other claims were launched against companies by the Government but were settled ‘out of court’ and are therefore not public.
GUYANA
Oil production is expected to get into full swing by March 2020. That is less than two years away. Guyana does not have all of its measures in place, but Minister of Natural Resources, Raphael Trotman has assured that the Government is doing all that is necessary to ensure that Guyana’s future revenues in oil and gas are protected. In fact, Trotman said that the authenticity of cost recovery claims was one of the main discussions he and others had with the International Monetary Fund (IMF) and its experts. Trotman acknowledged that indeed, several countries around the world; Kenya,
Ghana, the USA and Great Britain, have had struggles with ensuring cost recovery is precise and transparent. The Natural Resources Minister said, “We have turned to some of the best financial experts in the world and they have come, they have done their assessments and they will be guiding us. It is a work in progress and we are doing better by the day.” He also pointed out that the Guyana Revenue Authority (GRA) was able to garner $900 Million in taxes due to its
attentiveness in this regard.
GRA STEPS UP
While Guyana still awaits the establishment of a Petroleum Commission, the Guyana Revenue Authority has stepped
up to the place and has commenced the review of cost recovery claims by ExxonMobil. This was confirmed by GRA
Commissioner General, Godfrey Statia. Statia explained that based on the contractual arrangements, ExxonMobil
is allowed to recover 75 percent of its costs in a given year. He explained that expenses which are not recovered for that
year are carried forward to the following year. Statia said, “So what you need to do is audit those costs… It is important to do a proper audit because failure to do so can have implications for the Government’s cut of the pie. The higher the expenses, the smaller the take could be, so the audits need to be effective. But we have started the review of the costs incurred thus far by ExxonMobil. The audit of the claims by ExxonMobil started last year.”
The Commissioner General said, “You cannot wait until 2020 or for production to start for you to begin reviewing the costs. Until the Petroleum Commission is set up, GRA will continue to review everything that would be going into cost recovery claims. We are looking after taxes. That is why we are monitoring their expenses…” He added, “There were a few things which were identified to ExxonMobil regarding their claims and we have asked them some questions on it. We have collected withholding tax and when production comes, corporation tax will kick in, but it will be subtracted from Government’s share. Our staff is also being trained in cost recovery. We are at the forefront of it.”
IMF URG ES
The International Monetary Fund (IMF) has also urged the authorities of Guyana to commence auditing of all exploration and development costs by USA oil operator, ExxonMobil. The Fund made this known in one of its recent reports on Guyana’s oil sector. This document was handed over to the Government last year. Elaborating further on the matter,
the IMF said that plans to establish a petroleum industry taxpayer unit attached to the large taxpayer office in the Guyana
Revenue Authority should be prioritized. The Fund said that this effort is supported by a consultant from the US Treasury
office of Technical Assistance. The IMF said, “It will be important for this unit to start verifying and undertaking audits of costs incurred during the exploration and development phase, which is getting underway now.
It would be advantageous to establish close working relations between the GRA and the sector regulators (Ministry of
Natural Resources, Guyana Geology and Mines Commission and the prospective Petroleum Commission) to ensure that
the limited petroleum sector expertise in Government is applied most efficiently.” The International Monetary Fund said
the intention is that the Guyana Revenue Authority will be the single revenue collection agency for the petroleum sector.
It opined that this is a reasonable decision given the key role played by the Production Sharing Agreement and the pay-on-behalf arrangement for corporate income tax in existing contracts (this is where the contractor’s income tax bligations are settled from the Government’s share of the profit oil). However, given the limited experience in the GRA with petroleum taxation, the IMF said that there is urgency to develop skills in this area.