I GEOL. CROAT . 49/2 183 - 187 1 Tab. I I ZAGREB 1996 I Professional paper The Petroleum Fiscal Regime and Oil Company Status Boro VLASI<': and Hrvoje LIPOV AC Key words: Transition, Exploration contract, State leg­ islature, Fiscal terms, Licence. Abstract In {he foreseeable future the Republic of Croatia wi ll be inc luded in lhe market economy as a consequence of recent widespread socia l changes . The oi l il1cillslry will also be a ffected by these changes, inevitably becoming a part of the wider markel, and it will have 10 adjust its business practice accordingly . To facil itate the inevitable lransilion of INA into a modern and profitable company, capable of su rvival in the market, it is necessary 10 create favourable business envi ronment s for possi bl e eco nomic grow th and development. As a nrs( step towards this goal it is neces­ sary for the state o f Croat ia to adjust its legal sys tem to be compatible wi th those prevaili ng in the market economy. There arc several differe nt !ega I approaches in world prac tice specific for a particular country, and one has to take 1hem into consid­ eratio n while creating lega l relat ions in thc oil industry in Croatia. Here it comparison is made between the present legal stat us in Croatia and some of the o thers abroad. An op timal solution is proposed from the viewpoi nt of the company dealing with the o il industry. 1. INTRODUCTION Oil production in Croatia is declining remarkably as a consequence of a lower replacement rate of reserves. The natural decli ne of remaining reserves as a conse­ qucnce or oi l deplc li on, is partly slowed down by the introduct ion or secondary recovery methods. However, the bes t replacement of reserves are new d iscoveries, because on ly on newly discovered pools can various technological applications give optimal results using human and techno logica l resources. Lengthy discussi ons havc already taken place in the compan y as to the reasons ror the delay of reserve replaccment, whether it was the inefficiency or explo ­ ra tion, the delayed introduction of new exploration tech nologies (modern seismic equ ipment, informatics, 3D scismic and so on) or maybe insistence of intensive exploration in mature basins where major discoveries or new rese rves cannot be expected. 'WHITE & GEH ­ MAN (1979) investigated the remaining potential of mat ure basins, and showed that after the first di scover­ ics in a gi vcn basin , larger fi elds arc then discovered lNA -Naftaplin, Subiceva 29, HR 10000 Zagreb, Croatia. PROCEEDINGS quickly, but any remaining fields are more numerou s but with less reserves. Analysis of the company's suc­ cessful discoveries produces the same sce nario . The assesment of the cause of decay of successfu lness in exploration will enable the right strategic deci s ions to be made. The earlier prevailing opinion of INA was that increased accomplishment of the company would be achieved by improved technology and better expert ise. Although these factors are relevant in the oil industry, the natural conditions of the area where the technology and knowledge are applied are even more important. In the Panonian Basin, there is a real possibility of finding new reserves , examination of remai ning potential reserves indicates that it is not possib le to find suffi cient quantiti es of new reserves to replace thc reserves decline. There has been no change in strategy requi red to look for new exploration opportunities. Such a change l11 ust now occur under less than per­ fect condit ions dur ing a recess ion in the oil indust ry and after a war. The present status of the oil market strongly influences the potential entrance of foreign investors into oil exploration in Croatia. Since rest ructuring of the oil industry in Croatia has not yet taken place, and the government control s both natu ra l resou rces and INA, (the only oil producer in the country, state owned), there is an opportunity to reshape the oil business so that it is compatible to other oil producing co untries . More inves tment is now required for prospects abroad and foreign in ves tors must be attracted to the Croatian oil industry. This requires Croat ia to develop a clear legislative system and become competent in cu r­ rent world practice, thus provid ing the stab le opera­ tional condi tions attractive to such investors. The aim or the paper is to compare the Croatian lega l system as app lied to the oil industry with the legislalUre in coun­ tri es where we have somc cxperiencc. These are not only countries where we have participated in ex plo­ ration, either as an operator or as a partner. Confiden­ tiality res tricts this analysis to generalities, precluding disclosure or detailed inrormation. 2. THE ROLE OF THE STATE The fi scal regime is one of the mos t important fac ­ tors in creating a business environment toget her with political and natural factors. A fiscal regime is a collee- 184 tion of conditions which a host country demands an oil company to fulfill in cxchangc for thc right to undcr­ take cxploration and production of oil and gas in a lim­ itcd arca of its tcrritory. The precise nature of these condit ions depends on Illany factors, of which thc following arc somc of thc most important: - prospcctivity of the exploration area; political risk in the country; - competitivness of the oil industry comparcd to other industries; - macro economic policy of the country; - general status of developmcnt of the country. Depending on thc asscssment of the above factors, a host country will create its fiscal policy, and prescribe under which conditions it will temporarily give explo­ ration rights on part of its terittory. It is important that the above fac tors are objectively assessed and balanced with fiscal measures, i.e. the fiscal regime must be such that exploration projects arc suffic iently attractive for pot ential investors (or comparable with others available on the market) . It also must protect the interest of the host country, in other words it must enable the country to participate advantageously in ruture production. The host country can claim its share in different ways, dircctly or through an agency, or through a national oil company by: - royalty; - production sharing; - profit sharing; income taxes; profit taxes; - additionaltaxcs (cxport quotas etc.); - bonus paymcnts. The country legally defincs, most often by a Petro­ leum Law, thc basic terms which are applied to thc whole count ry. Some of the above parameters are nego­ tiable, and they are usually stip ulated in thc bidding for an exploration area. The negotiations arc held between an oil compa ny and the govern ment representativc (government agency, national oil company and some­ times ministry for natural resou rces). It is important that once agreed contracts are unchanged during the whole life of the project, as this provides security. In many cases the law is changed sllccessively depending on changes of the country's policy or prospectivity of exploration area, but once signed agreements, remain empowered until the end of the project. 3. TYPES OF THE AGREEMENTS IN THE EXPLORATION AND PRODUCTION OF orLAND GAS The types of agreements can be divided into two mal11 groups: Geologia Cwatie:t 49/2 - Royalty(Tax Agreements or Concession Agreements - Production Sharing Agreements or Contracts Royalty/Tax Agreements or Concession Agree­ ments are such agreements where the government or country transfers the title of mineral resources to the company, and the company is subject to tax and royalty payments. This kind of agreements is becoming obso­ lete, and more rarely used. Production Sharing Agreements - the great major­ ity of current agreements in the countries that arc major oil producers, are production sharing agreements. A basic difference between this type of agreement and a concess Io n agreemelll is ownership o f mineral resources. In this type or agreement the government reta ins the ownership of minerals , while the oil compa­ ny invests money in exploration, development and sur­ face facilities taking the risk. The oil company on the other hand is allowed a certain percentage or oil or gas for cost recovery (cost oil) and fo r profit (profit oil). All equipment and objects included in the agreement become the ownership of the host country immediately after sign ing the agreement or after starting production. Heavy service equ ipment for drilling and wcll opera­ tions are exc luded . The company has a right to cost recovery for that purpose. There arc many additiona l detail s in differcnt agreements which, for example, specify the right to interests on invested capital, amorti­ zation, rate of cost recovery and others. Besides production sharing agreements there are variants when the host country through its agency o r national company forms a joint company for exp lo­ ration and production financing, taking a certain per­ centage of working interest, i.e. join t venlLtre agree­ ments. Such a company is subject to all the lega l regu­ lations in the host country. Along with these basic items which define the rela­ tionship between the owner of the mineral resources and a foreign company, (sometimes rcferred to as the contractor), the agreement contains additional content s including a work program, ent itlement to the data coor­ dinates of the area covered by the agreement, relin­ quishment after a certain phase, duration of the agree­ ment , rcporting of financial issues etc. At the same time the obligations of the country or a national oil company are defined, including access to data, assistance during agreement implementation , nomination of authorised representatives, project supervision, cost control etc. The agreement usually defines a myriad of other de tails which enable operations to be carried out with­ out any misunderstanding, but they don't determine the attractiveness of a country for investment in oil and gas exploration and production. Some countries, especially those in transition from a socialist to capitalist system, treat their own oil compa­ nies differently to fore ign ones. Some countries, e.g. Italy, in past years, had exploration areas exclusively reserved for AGIP, Albania for Albpetrol, etc. The national oil companies of some other countries also act YlasiC & Lipovac ' Illc 1\:ll"Olculil Fiscal Regime and Oil Company Status STRUCTURE OF THE CONCESSION TYPE OF AGREEMENT GROSS INCOME COUNTRY ROYALTY (usually 12.5 %) EXTRA PROFIT TAX INCOME TAX COMPANY CAPITAL EXPENDITURES. OPERATI NG COSTS NET CASH FLOW FOR THE COMPANY STRUCTURE OF THE PRODUCTION SHARING AGREEMENT COMPANY TAKE Cost oil for: • explorat ion • development · investment Profit oil or gas for company income tax - capital expenditures operating expenditures GROSS INCOME BY PROJECT ROYALTY COST OIL PROFIT OIL = NET CASH FLOW FOR THE COMPANY COUNTRY TAKE Profit oil for country as operators, as well as taking eare or the organisation and superv ision of exploration and production of for­ eign companies, e.g. Sonalraeh in Algeria, NOC In Libya, and to some extent SONANGOL in Angola. 4. CROATIAN LEGISLATURE The rights and obligations of a company and an individual person engaged with exploration are deter­ mined by the Mining Law, published in "Narodne novinc" , Zagreb, on May 26, 1995 . Accord ing to this Law, all organ ic and inorganic mineral resources arc SOME COUNTRIES WITH CONCESSION TYPE AGREEMENTS ABU DHABI ALGERIA (unlil1991) ARGENTINA (1990) FRANCE IRELAND MOROCCO NORWAY PAKISTAN THAILAND TUNISIA (special Iype) UK 185 considered mineral resources owned by the Republic of Croatia. The law also defines all technical and legal details related to obtaining licenses for oil and gas exploration and production, but less so to business activities themselvcs. One of the provisions of the Min­ ing Law is the obligation to usc a part or any income (minimum 3%) earned from the sale of minerals, for mineral reserves exploration. A mineral royalty (com­ pensation for the exploration of mineral resources) is 2.5%, and represents the revenue of the Republic of Croatia which is assigned to municipalities or c ities. The Croatian Government establishes the amount of compensation/royalty percentage. Also "If a mining company or an individual person owns the discovered reserves of mineral resources classified as A+B cate­ gories for exploration, they are not obligated Lo allocate Cunds for exploration in the following 25 years." This docs not reveal what kind of production is involved. A "Licence for exploration or exploitation of miner­ al resources can be granted to a company located in the Republic of Croatia and registered for the performance of such activities (in further text mining company) and to citizens which arc cngaged in this economic activity with their own work registered in the Republic of Croa­ tia (in futher lext individual entrepreneur)". A licence for oil and gas exploration and exploitation is grantcd by the Government of the Republic of Croatia. Licences cannot be transferred to another physical or legal per­ so n without permission of the authority who granted them and cannot be the subject of bankruptcy or liqui­ dation. The law imposes limi ts on certain exploration rights 111 a glvcn area. Besides these provisions which have been sligh tly elaborated, the law defines the right to mineral resources exploi tat ion. It is granted to a mining compa­ ny or an individual enterpreneur if they have earlier performed exploration activities in this arca. SOME COUNTRIES WITH PRODUCTION SHARING AGREEMENTS ALBANIA ALGERIA (aller 1991) ANGOLA EGYPT (since 1986) GABON INDIA INDONESIA LIBYA MALESIA MALTA NIGERIA SYRIA TURKMENISTAN VIETNAM UZBEKISTAN JEMEN Furthermore, the law provides for the manner, con­ ditions and rights concerning mineral resources explo­ itation, managing and recording of reserves, necessary techni ca l documentation, land-reg istry of exploration areas and exploitation fi el ds, the required professional and other capacities of workers, safety measures, super­ vision and finally, penalty measures. Several articles of the law anticipate the preparation of several by-laws such as: "By- law on the contents of an annual program of exploration, the procedure of the application for cxploration liccnce, and the details of the licensing procedure", " By-law on the contents of the application for ex ploitation licence" etc. The by-law on the cont ent s of an annual program of explorat ion , the procedure of the applicat ion for exploration licence, and content s of the reports on performed exploration activities, dctermines the terms for submittal of annual reports and plans , contents of the application for licence, etc. Furthermore, thi s by-law estabLishes some very important parameters related to exploration rights, such as li cence duration/validity (3 years), work pro­ gram, exploration area, and deviation from the under­ taken obligations of work program during application for ex ploration rights. There is no time duration of pro­ duction rights. Art. no. IS of the above by-law is very interesting and reads as follows: The size of exploration area is determined according to/based on: - planned exploration activi ties on the basis of which reserves of mineral res ources can be estab li shed belonging to at least category C; - (the amount 01) available financial funds; - obligation to carry out planned exploration activities at the lates t within a period set in the art. 13, line I or Ihis by-law. It can be observed from the above that the legislator who prescribed the reg ulations and obli gations related to oil and gas exploration and production, did not take into account world practice existing in the oil industry. Most countries have a special law covering this branch of industry owing to the fact that the oil industry is sig­ nificantly different from all olhers, a lthough it can be agreed that it is most similar to other mining activities. If we wish to summarize the fiscal regime in the Republi c of Croatia accord ing to the Mining Law , it could be expressed as: Co mpany obligation: - to offer a minimal work program; - to provid e necessary financial funds (there is no indication of how it is going to be checked); - to provide adequate means of production; - company alone proposes the area of their interest. Oncc the company has been granted an explorat ion licence, their obligation is to: Geologia Cro:l1ica 49/2 perform operations envisaged in the annual work program; - report on plan realisation; - report on invested fund s; - make a final report; - continually report on the di scovery of new hydro- carbon reserves (which is prescribed by a totally dif­ rerenl by-law). Once there is a discovery of hydrocarbon reserves, the company is obligated to: - provide a licence for the fi eld exploitation; - the exploitation licence is gran ted conditionally by technological and personnel suitability; - there is no time limit for the licence; - company status towards the state is not defined . Although the Mining Law docs not explieitely state it, the total rcvcnue shou ld be divided in the follow ing way: - TOTAL REV ENUE ( FROM OIL AND GAS PRODUCTION AND SALE) - 2.5 % OF TOTAL REVEN UI3 FOR TI-IE STATE, LOCAL SELF~MANAGEMENT - 3% OF TOTAL REVENUE FOR THE PURPOSE OF EXPLO- RATION or UNDISCOV[RED RESERVES - CAPITAL EXPENDITURE - OPERATING EXPENDITURE - TAX INCOME 25% ~ NET CASII FLOW Table l shows the com pari son between the state's take and the oil company' s take in different types or agreements. It is obvious that an oil company's take in Croatia, for one field yielding 10 mil. tons, and under the afore­ mentioned conditions, is sign ificantly higher than in any other country, thc contracts of which we were able to use [or comparison. Consequently, a conclusion can be drawn that our present legal system insufficienLiy protects the state interests in the case of forcign compa­ nies entering direclly into agreement with thc sta le. 5. CONCLUSION According to the above analysis we may conclude that the existentlegisiature in the Republic of Croatia is not transparent enough, and that it cannot serve as the basis for sign ing one of the known types of contract with the clearly defined rights and obl igations of the state on one side, and th e oil company on the other. Practically, the state cannot protect its interest without the strong presence of a national oil company, which need not aJways be acceptable to a foreign company as a potential inves tor. YI;liii~ & Lipov;lc: '!lle Petroleum riseal Regime and Oil Company Status Cro.ati.an T.ax Regime Compulsory Explorat ion Expendi tu res 3% Optional Exploration Expenditures 32% Capilal Expenditures 20% Operating Expenditures 10% Royalty (2.5% of Revenue) 3% Tax (35% of Profit) 11% Net Profit 21 % Structure or Typica l Concession Type Tax Regime Compulsory Explorat ion Expenditures 3% Optional Exploration Expenditures 32% Capi181 Expenciitu res 20% Operating Expenditures 12% Royahy (8- 16% or Revenue) 8% Tax (35-50% of Profit) 9% Net Profit 16% Structure of' Typical Production Sharing ConI ract Cost Oil (30-80%) State Profit Oil (40-90%) Company Profit Oil (1 0-60%) Tabte t Comparison of different lypes of tax reg imes . 50% 40% 10% The law does not de fine how to obtain an explo­ ration area. There is no bidding procedure whereby the bes t offers cou ld be se lccted . The law determines the percentage of total revenue for investment in explo­ ration, but it is not ag reed on how much should be in vested in an exp lorati on area. The tim e limit for investment in exploration , which is not determined by the law, but by a by-law, is only 3 years - for the cycle of geo logy-geophys ics, exp loration and drilling. The law does not define the period of production rights. In other words, accordi ng to thc current law, the state can­ not ge t an income from oil adequatc to the practice in ot her oil and gas producing countries, but at the same time it does not clearly guarantee to an oil company any safety of long term investment. Considering the interes t of a Croatian oi I company undertakjng exploration abroad, it is obvious that a dol­ lar invested in Croatia brings considerably morc return than a dollar invested abroad, with the same geological and polilical ri sk, the same reserves and the same work co nditions. Under the same contractua l conditions the percentage of net present value belonging to a company deducted from net present value per project, ranges from 1:3 to 1:2. Conseguent ly, the probab ility of oil discovery or the size of an expl oration area abroad, should be in a reverse relat io nship in favour of the international project if we want to invest in this project. In order to formulate a decision on selecting a pro­ jec t for investm ent , one sho uld carefully com pare all avai lable projects using available economic and techni ­ cal parameters. One should choose the proj ec ts that indicate the fastest return on investment and the highest profit. 6, REFERENCE WHITE, D.A. & GEHMAN , M. (1979): Method s o f est imating oi l and gas resourees.- AAPG Bulletin, 63/ 12,2183-2 192. 'RS Geologia Croatic:l 49/2