CHAPTER VII

OIL AND GAS FISCAL REGIME

The international petroleum industry involves tremendous wealth and power. In

many countries petroleum, whether exported or imported, dominates the economy.
Natural resources are the crown jewels. Few industries combine such a dramatic
contrast between risk and reward. Countries with petroleum resources carefully guard
this wealth. Petroleum taxation is a vital aspect of the industry. Geological, engineering,
and financial principles are universal, yet in the realm of taxation, there is added
dimension. The subject is so important that understanding at least the basics is
mandatory.

Learning Objectives:

By the end of this chapter, students will be able to:

1. Explain the petroleum fiscal system and its classifications.

2. Identify the factors that govern oil and gas exploration.
3. Identify the status of the Philippines' petroleum fiscal regime system.
4. Discuss the existing petroleum service contracts of the Philippines.

Introduction

The petroleum fiscal regime of a country is a set of laws, regulations and

agreements which governs the economical benefits derived from petroleum exploration
and production. The regime regulates transactions between the political entity and the
legal entities involved.A commercial or legal entity in this context is commonly an oil
company, and two or more companies may establish partnerships to share economic
risks and investment capital.

Although petroleum, oil and gas, and hydrocarbons are not technically mineral
resources, the term mineral rights is used to denote rights to exploit oil and gas
resources from the underground. Onshore, in United States, the landowner possesses
exclusive rights for mineral rights, elsewhere generally the state does.For this reason,
the fiscal regime of US is divergent from that of other countries. The petroleum licensing
system of a country may be considered interwoven with the fiscal regime, however, a
licensing system has its distinct function: to grant rights for petroleum exploration and
production to commercial entities.

CONTRACTOR TAKE: THE COMMON DENOMINATOR

Division of profits boils down to what is called contractor and government take.
These are expressed as percentages. Contractor take is the percentage of profits to
which the contractor is entitled. Government take is the complement of that. Contractor
take provides an important comparison between one fiscal system and another. It
focuses exclusively on the division of profits and correlates directly with reserve values,
field size thresholds, and other measures of relative economics.

GOVERNMENT OBJECTIVES
The objective of a host government is to maximize wealth from its natural
resources by encouraging appropriate levels of exploration and development activity. In
order to accomplish this, governments must design fiscal systems that • Provide a fair
return to the state and to the industry
• Avoid undue speculation
• Limit undue administrative burden
• Provide flexibility
• Create healthy competition and market efficiency

The design of an efficient fiscal system must take into consideration the political
and geological risks as well as the potential rewards. Malaysia has one of the toughest
fiscal systems in southeast Asia. But Malaysia has good geological potential. Many
companies would love to explore in Malaysia, and the government knows this.
Governments are not the only ones who draw the line between fair return and rent. The
market works both ways.

GOVERNMENT OBJECTIVES
The objective of a host government is to maximize wealth from its natural resources by
encouraging appropriate levels of exploration and development activity. In order to
accomplish this, governments must design fiscal systems that
• Provide a fair return to the state and to the industry
• Avoid undue speculation
• Limit undue administrative burden
• Provide flexibility
• Create healthy competition and market efficiency

OIL COMPANY OBJECTIVES

The objectives of oil companies are to build equity and maximize wealth by
finding and producing oil and gas reserves at the lowest possible cost and highest
possible profit margin. In order to do this, they must search for huge fields.
Unfortunately, the regions where huge fields are likely to be found are often
accompanied by tight fiscal terms. The oil industry is comfortable with tough terms if
they are justified by sufficient geological potential.

CLASSIFICATION OF PETROLEUM FISCAL SYSTEM

Governments and companies negotiate their interests in one of two basic
systems: concessionary and contractual. The fundamental difference between them
stems from different attitudes towards the ownership of mineral resources.
In most countries, except the United States of America, the owner of the mineral
resources is the government. In the USA, the owners are private individuals or
companies that pay taxes on production to the state.
 Figure 1. Classification of petroleum fiscal systems

CONCESSIONARY SYSTEMS
Concessionary systems, as the term implies, allow private ownership of mineral
resources. The United States, of course, is the extreme example of such a system
where individuals may own mineral rights. This concept of ownership comes from
Anglo-Saxon legal tradition. In most countries the government owns all mineral
resources, but under concessionary systems it will transfer title of the minerals to a
company if they are produced. The company is then subject to payment of royalties and
taxes.
 Under a concessionary system, the state government grants a Concession or
License to an international oil company (IOC) or a consortium which gives rights for a
fixed period to explore for and produce hydrocarbons within a certain area (License
Area or Block).
Under a concessionary system, the title to hydrocarbons passes to the investor
at the borehole. The state receives royalties and taxes in compensation for the use of
the resource by the investor. Title to and ownership of equipment and installation
permanently affixed to the ground and/or destined for exploration and production of
hydrocarbons generally passes to the state at the expiry, or termination, of the
concession (whichever is earlier). The investor is typically responsible for abandonment.

CONTRACTUAL SYSTEMS
Contractual systems are in most cases either production sharing agreements or
service contracts. Under contractual systems the government retains ownership of
minerals. The private companies under contractual systems have the right to receive a
share of production or revenues from the sale of oil and gas in accordance with a
production sharing agreement (PSA) or a service agreement (SA). The state companies
either self produce or share the production and selling of the oil or gas. Revenues then
flow into the finance ministries’ treasuries.
In most contractual systems, the facilities installed by the contractor within the
host government’s territory become the property of the state either as soon as they are
landed or upon start up or commissioning. Sometimes, the asset or a facility does not
pass to the government until the expended costs have been recovered. This transfer of
title for asset facilities does not apply to leased equipment or to equipment brought in by
service companies.
The difference between service contracts and production sharing contracts
depends on whether the contractor receives compensation in cash or in crude. Under a
production sharing agreement, the contractor receives a share of production and hence
takes title to this crude. In a concessionary system, the transfer of title occurs at the
point of export instead of at the wellhead. In a service contract, there is no issue of title
since the contractor gets a share of profits rather than production. Under some service
agreements, however, the contractor has the right to purchase crude from the
government at a discount. Despite the differences between the systems the same
economic results are achieved.
When the contractor is paid a fee for conducting exploration and production
operations, then this system is a risk service contract. The difference between risk and
pure services contracts depends on whether there is a fee on the profits or not. The
pure service contract is without risk in exploration and development. Consequently, this
is usually used by conservative nationalised companies or by states that have capital
but are lacking in technology and management capability.
PRODUCTION SHARING CONTRACTS
Production sharing contracts or agreements (PSCs or PSAs) give an
international oil company (IOC) or consortium exploration and production rights for a
fixed period in a defined Contract Area or Block. The IOC bears all exploration risks and
costs in exchange for a share of the oil or gas produced. Production is split between the
parties according to formulae in the PSC that may be fixed by statute, negotiated, or
secured through competitive bidding. If the IOC does not find a commercial discovery,
there is no reimbursement of costs by the government.
The advantage to the host government of this system is that the government will
generally receive a large share of the oil or gas. This can be sold and the revenue used
according to the government’s development programmes and economic needs.
Following the introduction of PSCs in Indonesia in the mid 1960s, they are now also
used in Malaysia, India, Nigeria, Angola, Trinidad, the Central Asian Republics of the
Former Soviet Union, Algeria, Egypt, Yemen, Syria, Mongolia, China, and many other
countries.
Essentially, control of the oil remains with the state. National companies are
maintained to manage the resource whilst the contractors have execution responsibility.
Contractors are required to submit a programme and a budget to be approved by the
national company. The type of contact depends on the level of reserves and political
economic aims of the host government.

SERVICE CONTRACTS
 Many service agreements are identical to PSCs in all but the method of payment,
either by production sharing or profit sharing. Many service agreements, however, have
unique contract elements that are used in calculating the service fee.

Pure Service Contracts

A pure service contract is one where the contractor carries out exploration and/or
development work on behalf of the host government for a fee and the contractor bears
no exploration risk. This kind of contract is not used widely but may be used sometimes,
typically in the Middle East, where the state has substantial capital but seeks only
expertise. Examples exist in Iran, Saudi Arabia, the Philippines and Kuwait.
The pure service contract is similar to contracts used in the oil service industry
with companies such as Halliburton and Schlumberger where the contractor is paid a
fee for performing a service. Examples are contracts placed for drilling services,
development services and some exploration services. Drilling service contracts may be
let as pure service arrangements e.g. whereby the contractor is paid on a footage basis
while drilling and on an hourly basis for completion and testing operations.

Risk Service Contracts

A risk service contract is radically different from a pure service contract and
bears little similarity to an oil service industry service contract.
Under a risk service contract awarded by a host government, the contractor
provides all capital associated with exploration and development of petroleum
resources, bearing all the exploration risk. If exploration is successful, the contractor is
allowed to recover costs through sale of the oil or gas and also receives a fee based on
a percentage of the remaining revenues. This fee is often subject to taxes.
As well as bearing exploration risk, the contractor does not get a share of
production. However, although there is no production sharing or profit oil, the contract
terms allow the contractor a share of revenues similar to that derived from a share of
production in a PSC. The host government maintains ownership of the hydrocarbons
produced and the contractor does not acquire any rights to oil and or gas unless the
contractor is paid its fee in kind as oil or gas. The contractor may also be given
preferential rights to purchase production from the government.

RISK FACTORS IN OIL AND GAS EXPLORATION

1. Political Factor
The primary way that politics can affect oil is in the regulatory sense, but
it's not necessarily the only way. Typically, an oil and gas company is covered by
a range of regulations that limit where, when and how extraction is done. This
interpretation of laws and regulations can also differ from state to state. That
said, political risk generally increases when oil and gas companies are working
on deposits abroad.
Oil and gas companies tend to prefer countries with stable political
systems and a history of granting and enforcing long-term leases. However,
some companies simply go where the oil and gas is, even if a particular country
doesn't quite match their preferences. Numerous issues may arise from this,
including sudden nationalization and/or shifting political winds that change the
regulatory environment. Depending on what country the oil is being extracted
from, the deal a company starts with is not always the deal it ends up with, as the
government may change its mind after the capital is invested, in order to make
more profit for itself.

2. Geological Risk
Many of the easy-to-get oil and gas is already tapped out, or in the
process of being tapped out. Exploration has moved on to areas that involve
drilling in less friendly environments, such as on a platform in the middle of an
undulating ocean. There is a wide variety of unconventional oil and gas
extraction techniques that have helped squeeze out resources in areas where it
would have otherwise been impossible.
Geological risk refers to both the difficulty of extraction and the possibility
that the accessible reserves in any deposit will be smaller than estimated. Oil and
 gas geologists work hard to minimize geological risk by testing frequently, and so
it is rare that estimates are substantially "off." In fact, they use the terms
"proven," "probable" and "possible" before reserve estimates, to express their
level of confidence in the findings.

3. Price Risk
Beyond the geological risk, the price of oil and gas is the primary factor in
deciding whether a reserve is economically feasible. Basically, the higher the
geological barriers to easy extraction, the more price risk a given project faces.
This is because unconventional extraction usually costs more than a vertical drill
down to a deposit.
This doesn't mean that oil and gas companies automatically cease
operations on a project that becomes unprofitable due to a price dip. Often, these
projects can't be quickly shut down and then restarted. Instead, O&G companies
attempt to forecast the likely prices over the term of the project in order to decide
whether to begin. Once a project has begun, price risk is a constant companion.

4. Supply and Demand Risks

Supply and demand shocks are a very real risk for oil and gas companies.
As mentioned above, operations take a lot of capital and time to get going, and
they are not easy to shut down when prices go south or to ramp up when they go
north. The uneven nature of production is part of what makes the price of oil and
gas so volatile. Other economic factors also play into this, as financial crises and
macroeconomic factors can dry up capital or otherwise affect the industry
independently of the usual price risks.

5. Cost Risks
All of these preceding risks feed into the biggest of them all: operational
costs. The more onerous the regulation and the more difficult the drill, the more
expensive a project becomes. Couple this with uncertain prices due to worldwide
 production beyond any one company's control, and you have some real cost
concerns.
This is not the end, however, as many oil and gas companies struggle to
find and retain the qualified workers that they need during boom times, so payroll
can quickly rise to add another cost to the overall picture. These costs, in turn,
have made oil and gas a very capital-intensive industry, with fewer players all the
time.

PHILIPPINE RISK SERVICE CONTRACT

The language of the Philippine contract is identical to that of most PSCs with the
exception of the Filipino Participation Incentive Allowance (FPIA). The FPIA is part of
the service fee, and it is based on gross revenues just like a royalty except that it goes
to the contractor group. The FPIA, based on a sliding scale, can get as high as 7.5% if
Filipino participation is 30% or more onshore. Offshore, 15% Filipino participation will
qualify for the FPIA.
The Philippine contract has a 70% cost recovery limit, and profit sharing is
60%/40% in favor of the government. The contractor 40% share of profits is not subject
to taxation. The contractor’s taxes are paid out of the government share of profit oil.
Calculation of the contractor entitlement under the Philippine contract is based on the
following assumptions.

EXISTING SERVICE CONTRACTS IN THE PHILIPPINES

1. SERVICE CONTRACT 38 - MALAMPAYA PROJECT
Project Location:
Offshore Palawan
JV Partners and Percent Equity
Shell Philippines Exploration BV (SPEX)45%
UC3845%
PNOC EC10%

Project description
● SC 38, which is situated in offshore northwest Palawan, was awarded to Shell
Philippines Exploration B.V. (SPEX) on 11 December 1990. The block currently
covers an area of around 830 sq. km. First gas from the Malampaya Deepwater
Gas-to-Power Project flowed to the platform in October 2001.
● PNOC EC holds 10% participating interest with SPEX (Operator) and UC38
which each hold 45%.
● Since it began commercial operations in 2001, the Malampaya project has
produced cleaner-burning natural gas which supplies five power plants in Luzon,
namely: Sta. Rita (1,000 MW), San Lorenzo (500 MW), Ilijan (1,200 MW), San
Gabriel (414 MW), and Avion (97 MW).
● The total government share from the revenues of the project as of December
2020 was at US$11.9 billion. In addition to the government’s 60% share in the
net revenues, the project also reduces oil imports, ensuring a more stable supply
of cleaner energy from an indigenous resource and meeting up to 20% of the
country’s energy requirements.

2. SERVICE CONTRACT NO. 75 – NORTHWEST PALAWAN

Project Location:

Northwest Palawan Basin

JV Partners and Percent Equity
PXP Energy Corp. (Operator) (formerly Philex Petroleum)50%
PNOC EC35%
PetroEnergy Resources Corporation15%

Project description
● SC 75 was a successful joint bid of Philex Petroleum (now PXP Energy),
PetroEnergy, and PNOC EC for Area 4 under the 4th Philippine Energy
Contracting Round. The service contract was awarded by the DOE on 27
December 2013. It covers an area of 6,160 km2 in the offshore Northwest
 Palawan Basin with water depths at 1,000 to 2,600 m. It is located west of SC 58
and north of SC 63.

Brief Background
● The SC 75 Consortium conducted 2D seismic acquisition survey in 2014 and
acquired about 2,235 km of 2D seismic data over the block. It also acquired
2,337 km gravity and magnetic data aside from the reconnaissance satellite
gravity data. These data were all processed and then interpreted to determine
the prospectivity of the block.

● On 9 September 2015, DOE granted force majeure to SC 75’s work

commitments under Subphase 2 effective December 2015 until the date when
DOE notifies PXP Energy to resume its petroleum exploration-related activities.
The force majeure was lifted by the DOE on 14 October 2020. PXP
communicated with the DOE regarding the lifting of the suspension and
constraints to fulfil the commitment under Sub-Phase 2 given the pandemic
situation and continuing security concerns in the West Philippine Sea.

SERVICE CONTRACT NO. 74 – NORTHWEST PALAWAN

Project Location

Northwest Palawan Basin

JV Partners and Percent Equity
PXP Energy Corp.(Operator)(formerly Philex Petroleum)70%
Philodrill Corporation25%
PNOC EC5%

Project description
● SC 74 was awarded by the DOE to joint bidders Pitkin Petroleum Limited (Pitkin)
and Philodrill Corporation on 13 August 2013 during the 4th Philippine Energy
Contracting Round. The Service Contract covers an area of 4, 268 km2 in the
offshore Northwest Palawan Basin with water depths ranging from less than 10
 m to about 200 m. It is about 278 km southwest of Manila and approximately 150
km. northwest of Puerto Princesa, Palawan.
● PNOC EC acquired its 5% participating interest from Philodrill which was
approved by the DOE on 5 November 2015. Philodrill, which originally held 30%,
now has 25% interest in the block. On 5 April 2016, DOE approved Pitkin
Petroleum’s transfer of its 70% interest and operatorship to PXP Energy Corp.
(formerly Philex Petroleum).

Brief Background
● Geological and geophysical studies, including purchase of 3D seismic data and
reprocessing of selected 2D seismic data, were conducted as part of the initial
commitment for the service contract. In 2016, about 1,600 km of 2D seismic data
covering the block was acquired through a DOE-CGG multi-client seismic survey
and processed together with gravity and magnetic data. Interpretation of the data
was completed in 2017 and is currently integrated with the gravity-magnetic
interpretation. Evaluation of the Linapacan-A and Linapacan-B oil discoveries
were also undertaken for possible commercial development.

● SC 74 under Sub-Phase 3 was granted extension by the DOE until 12

September 2021, due to the force majeure conditions citing the negative impact
of the COVID-19 pandemic.

SERVICE CONTRACT NO. 59 – WEST BALABAC

Project Location
Offshore Southwest Palawan
JV Partners and Percent Equity
PNOC EC100%

Project description
● DOE awarded SC 59 to PNOC EC on 13 January 2006. It covers an area of
14,760 km2 and located in offshore Southwest Palawan, north of the deep-water
gas discoveries in offshore Malaysia.
 ● PNOC EC holds 100% participating interest and operatorship.

Brief Background
● In 2006, PNOC EC acquired about 2,000 km of 2D seismic data to promote the
area. In 2009, BHP farmed-in acquiring 75% working interest and operatorship.
BHP has been operating the Service Contract since then, until they withdrew in
2013. As part of their commitment, BHP acquired 3,000 km2 of 3D and 5,000 km
of 2D seismic data. Their seismic program, one of the largest by a single
company in the Philippines, resulted in several drillable targets.

● All seismic commitment under SC 59 have been complied with, including the
3,000 km 2D acquired by PNOC EC in 2016. The 2016 2D data includes gravity
and magnetic data. These data are intended to identify shallow-water drilling
targets to complement the deepwater prospects.

● In 2018, DOE approved the suspension of SC 59’s work obligations in SC 59

based on force majeure, until the resolution of the West Philippine Sea maritime
dispute. During the suspension PNOC EC continued its technical evaluation of
the block with the interpretation of 2016 MC2D data. The interpretation resulted
in the identification of several prospects and leads in the shallow water area.

● DOE lifted the force majeure on 14 October 2020. PNOC EC is currently

discussing with DOE to grant additional time to fulfil its outstanding commitment.