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Draft

TAXATION OF NATURAL GAS PROJECTS

Graham Kellas

September 25, 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 It is work in progress: please do not
cite without permission.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 International
Monetary Fund, its Executive Board, or its management.
www.woodmac.com

Taxation of Natural Gas Projects

Graham Kellas
Wood Mackenzie Ltd.

IMF Resource Tax Conference


Washington DC, September 2008

Delivering commercial insight to the global energy industry


Introduction The taxation of gas production is varied around the
> world and often highly complex. There are normally
several links in the value chain between producer
and consumer and each link seeks a share of the
economic rent generated.

Gas prices are often established in other countries


or regulated for domestic consumers. This presents
a variety of issues and choices which need to be
addressed in the fiscal regime.

This presentation identifies the topics involved and


highlights some of the different policies being
pursued.

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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 Projects
Natural Gas Value Chain

Price / Price / Price / Price /


Market Price
Rent? Rent? Rent? Rent?

Re-gasification
Re-gasification
Gas
Gas Processing
Processing // // distribution
distribution //
Pipeline
Pipeline Transportation
Transportation Consumer
Consumer
Production
Production liquefaction
liquefaction power
power
generation
generation

Mid/downstream Regime
Upstream 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 Projects
Natural Gas Value Chain
The chain can be ‘segmented’ – i.e. different ownership of each link – or ‘integrated’ – i.e. the
same 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 as
possible - although currently they are almost universally increasing
• export prices normally significantly higher and agreed under long term sales contracts, often
with some linkage to oil prices
Another distinction = costs
• export of gas normally incurs significant additional processing and transportation costs
In a segmented chain, ‘arm’s length’ agreements will tend to dictate the price and level of
economic rent achieved in each link
Government may own one or more links of the chain and remove any economic rent from its
links (e.g. early Indonesian LNG plants)
Where there is common ownership but differentiated tax systems for each link, there are no
‘arm’s 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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Natural Gas Projects
Defining the taxable entity

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 subject
only to standard corporate income tax
• major projects, such as greenfield LNG plants, may also receive fiscal incentives such as tax
holidays
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/downstream
Only 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 common
ownership, the project is ‘segmented’

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Natural Gas Projects
Upstream vs mid/downstream vs integrated taxation
Common ownership of upstream and mid/downstream operations and differentiated tax
systems 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
• Snøhvit LNG (Norway) – onshore operations are liable to 28% corporate tax but not the offshore 50% special
tax. All offshore operations are consolidated for tax purposes and investors preferred the entire Snøhvit LNG
project to be treated as offshore - with accelerated depreciation - and receive immediate tax relief at effective
78% 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 JV’s oil operations and
receive 85% tax relief, with upstream gas profits (which are minimal) taxed at 30%

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Natural Gas Projects
Segmented taxation example: Malaysian LNG

PLANT
GATE

UPSTREAM DOWNSTREAM
TAX SYSTEM TAX SYSTEM

Source: Wood Mackenzie’s LNG Service


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Natural Gas Projects
Integrated taxation example: Yemen LNG

INTEGRATED
PSC TERMS

Source: Wood Mackenzie’s LNG Service


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Natural Gas Pricing & Taxation
Subsidised prices or Government Take?

Domestic gas pricing and fiscal policies must be


developed simultaneously 9
8
• Subsidised consumer prices can often render 7

projects uneconomic 6

5
Gas price too low

Govt Take / Company Profit

US$/mmbtu
4 Dow nstream Costs
• Fiscal terms need to be adjusted to take this 3 Upstream Costs
Consumer Price
into account 2
1

-
• Regressive fiscal terms (i.e. revenue rather -1

than profit based) can be particularly harmful -2


Dom estic Export
So urce: Wo o d M ackenzie
in a low price environment
In extreme cases, government may have to 6
Government Take too high
5
subsidise producers as well
4

• e.g. Nigerian domestic prices have been so 3 Company Profit

US$/mmbtu
Government Take
low that only oil producers who receive 85% 2
Upstream Costs

tax relief on capital costs (but pay 30% tax on 1 Maximum Dow nstream Price

gas profits) can supply gas economically -

-1

Government must decide between subsidising -2

consumers and collecting fiscal revenue So urce: Wo o d M ackenzie

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Natural Gas Pricing & Taxation
Deriving tax prices from final market price

Major challenge for taxation of export projects Consumer Price


• ensure the country netback is fair (gas sales agreement)
• 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 reflect
numerous factors, so prevailing price for one contract may not be relevant
to current market conditions – e.g. price floors and ceilings often apply
• contract prices should reflect and/or be linked to established spot market
prices (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 wellhead
or somewhere in between
• LNG delivery to to consumer involves shipping, re-gasification and
delivery to market
• Integrated project owners may control each of these links and have an
interest in moving economic rent to lowest-taxed link
• Tanker freight rates are quoted and can be benchmarked against internal
charges to project Export Price
(basis for taxation)
• Pipeline tariffs could refer to established FERC/NEB regulations in US
and Canada (based on cost recovery plus regulated return)
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Natural Gas Pricing & Taxation
Example 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

Assess basis differentials Calculate average


for each area basis differential
over relevant
across the 2010
timeframe
-2020
-
W
timeframe

Assess pipeline
Assess average Calculate appropriate
connections around
each area
pipeline lengths pipeline tariff X

Pipeline losses C

Assess regas projects Assess capex & opex Calculate appropriate


Define 3 -4 general Assess typical scale of
regas areas in final
GOMmarket
under development or
with a high probability regas projects
based on published regas tariff for notional Y
data terminal
of development

Define average
distance to Regas losses B
notional terminal

Calculate appropriate
Analysis of reasonable
shipping assumptions
shipping tariff to
notional terminal
Z

Boil off A
Source: Wood Mackenzie
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Natural Gas Pricing & Taxation
Sharing in trading upside
Buyer takes delivery of LNG on
FOB basis at the LNG plant
Buyer agrees FOB contract price
Market A Market B
with producers based on netback
$8 /mmbtu $12 /mmbtu
from sales price in Market A on
expectation that cargoes will be
delivered to Market A
Buyer realises Market B is paying
premium (e.g. $4 /mmbtu) and
diverts cargo to Market B
Buyer gains entire upside unless
sales agreement specifically
provides for sharing any gains
Producing
FoB contract pricing formula
Country
could provide a price “floor”,
based on Market A, but if the
realised price is greater then the
difference is shared

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Natural Gas Pricing & Taxation
Upstream natural gas prices
Government owns gas and only reimburses costs, e.g. Algeria, Oman, UAE
Government establishes prices for royalty/taxation purposes e.g. Alberta’s “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 of
pricing 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/downstream
operations (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 proxy
transfer price is required

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Natural Gas Pricing & Taxation
Establishing a proxy upstream price: example
Australia’s residual pricing mechanism establishes a transfer price for integrated LNG
projects which shares the “value gap” between upstream and downstream operations
Upstream is subject to Petroleum Resource Rent Tax (PRRT), mid/downstream is not

LNG price

Capital annuity on downstream


capital (including risk premium)

Downstream operating costs


Gas Transfer Price

Netback

GTP

Cost Plus
Upstream operating cost

Ongoing capital costs


Capital annuity on upstream changes GTP over time
capital (including risk premium)

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


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Differentiating Fiscal Terms
Gas 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 Terms
Gas vs Oil - 2

Increasing trend toward linking fiscal take to project profitability enables the same fiscal
terms 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 gas
production (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 that
the 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 strong
rationale for upstream and mid/downstream operations to be segmented
Where ownership of upstream and mid/downstream operations is the same, a proxy transfer
price needs to be established
Alternative approach is to have a separate tax regime for integrated gas projects and treat the
entire 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 agreed
market 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 terms
linked 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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Appendix
Global LNG Projects

Snohvit
Shtokman

Sakhalin 2
Sakhalin
Kenai

Qatargas
Iran LNG Qatargas-2
Pars LNG Qatargas-3
Persian LNG Qatargas-4

Algeria LNG RasGas


Marsa El Brega
Skikda Rebuild RasGas II
Marsa El B. Exp. ADGAS
Arzew Exp. RL 3
Damietta
NLNG Base Arun
Damietta Exp. OLNG
NLNG Expansion
Atlantic LNG 1 ELNG 1 Brunei
NLNG Plus Qalhat
Atlantic LNG 2 ELNG 2
Delta Caribe LNG NLNG 6 Yemen LNG Tangguh
Atlantic LNG 3 NLNG VII+ Tangguh Exp.
Peru LNG Atlantic LNG 4 MLNG Bontang
Brass LNG
Train X Angola LNG PNG LNG
OK LNG EG LNG MLNG Dua
Nigeria Flex EG LNG 2 MLNG Tiga

North West Shelf


Pluto Darwin Curtis
Gorgon Ichthys Gladstone
Scarborough Browse GLNG
Wheatstone Greater Sunrise Sun LNG
Gorgon Expansion

Supply - Existing Supply - Under Construction Supply - Proposed Regas - Existing Regas - Under Construction Regas - Proposed

Source: Wood Mackenzie’s LNG Service


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Contact

Graham Kellas
VP, Energy Consulting
T: +44 203 060 0452
E: graham.kellas@woodmac.com

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