How do we get that 20% Royalty without Upsetting the Oil Cart?

That 20% Oil Royalty has to come from Somewhere.

So I did the math.

How do each of the current players divide the spoils so that the states can get their 20%? You can just look at this graph, but you really need to read on to understand how the production sharing regime regime works and the assumptions I have made. 

I’ve been against an increase in oil royalty ever since Pakatan Harapan (and PKR before that) mooted the idea. Coming from the industry, I’ve witnessed the fine balance between the need to produce oil and gas and the increasingly high costs in doing so as we hit harder to reach oil and marginal oil fields. Instead, the government should retain the current royalty levels and pay the oil producing states a percentage through a federal-state agreement. This way, Petronas and the oil companies are kept whole.

Benefits to a national or state economy don’t come through the royalty payments. Rather it’s the knock on effect to the economy through contracts awarded to local service providers. See how Terengganu benefits from having Kertih (mainly Exxon) and Kemaman Port to service the platforms offshore. Instead of clamouring higher royalty payment, the state would do much better in ensuring that the port delivers good service to attract higher output, and with it, more jobs. We can see how the low oil price impacted the Malaysian marine and offshore construction industry, with many people laid off. The focus needs to be on ensuring continuous development offshore so that Malaysian companies benefit. If foreign oil companies are deterred because their profits are carved out and given to the state, they will stop investing. Who loses? The state.

What is a Production Sharing Contract?

If the costs outweigh the benefits - an oil company is not incentivised to go get that hard to reach oil. Oil production is a long term game. It takes years from the point of taking on an oil block until oil production. For gas, it’s even longer. You need to find a long term buyer and as this means construction of long pipelines to shore to reach that buyer, you need to lock in your buyer even before you construct the pipelines. In Malaysia of course, you only have one buyer - Petronas. This gas buyer monopoly is common in many countries.

As we’ve pretty much used up our easy to reach shallow and abundant oil, what we are left with is oil in deepwater and smaller pockets of oil. It is hardly worth building platforms for little pockets and deepwater (over 1000 feet and mainly in Sabah) requires the more sophisticated and expensive platforms and oil rigs.

Malaysia adopted the Indonesian concept of the Production Sharing Contract (PSC). This means that the owner of the oil and gas remains with the government. Through the Petroleum Development Act (PDA), the government appointed Petronas as the owner. In O&G parlance, we call Petronas the major resource holder. Petronas enters into contracts, the PSC, with the oil companies. This is where the royalty percentage is set out, not the PDA as new Economic Minister, Azmin Ali seems to believe.

So if the government wants to increase the royalty percentage, it can do so through any new PSC. It cannot change existing PSCs unilaterally. Do we have new PSCs in the offing? Well some small ones, and old oil fields where older PSCs are near expiry. Neither are particularly attractive and are unlikely to attract large returns in an uncertain oil price environment.

According to EIA, Malaysia has 0.6% of the world’s gas reserves and a mere 0.2% of the world’s oil reserves. 3.6 billion barrels of proved oil reserves as at January 2017. This is why Petronas which once had an ambitious 1:1.2 replacement ratio target (replace every 1 barrel of oil produced with 1.2 barrels of reserves) had to go overseas for its long term viability. Unfortunately money which could have been reinvested was milked by the previous government through high dividends and oil and gas subsidies for domestic consumption.

Here’s how the revenue is split under the PSC regime

• 10% Royalty to Government

When a barrel of oil is sold, the first 10% is skimmed off as royalty and paid to the government. Ideally half of this 10% is given to the state government. Terengganu contested this sometime back and finally the government said, ok, we will pay you that 5% as “wang ehsan” (contribution). Instead of giving it directly to the state, a company was formed: the Terengganu Investment Authority, later named 1MDB. Yes, 1MDB started as Terengganu’s oil money which the Terengganu rakyat never saw.

• 50% Cost Oil to the Operator

The oil company would have sunk a great deal of investment by the time first oil comes along. The PSC allows them to recoup the costs each quarter and it’s normally capped at 50%. It could be higher in the case of deepwater or gas as costs are higher or incurred for a longer period before commercialisation. The nature of costs allowed to be covered are tightly monitored by Petronas. For instance, payments are to contractors licensed by Petronas and in accordance with a strict procurement process. Unapproved costs cannot be recovered. Costs are likely to be higher than 50% and are rolled over to the next quarter. It can be years before an asset is cost current.

This ensures that oil companies are incentivised to continue investment.

• 40% (or higher) Profit Oil is divided between Operator and Petronas

The balance left over after Royalty and Cost Oil deductions is Profit Oil. If an operator’s Cost Oil is approved up to 50%, then the balance is 40%. It is higher if the Cost Oil is less than 50%.

Typically the split would be 50:50. So we’d expect the operator to receive 20% right? Well that profit is taxed at 38% - the Petroleum Income Tax. And here’s some more news. A foreign oil company will not have 100% rights over an oil block. Petronas awards oil blocks with the requirement that its upstream arm - Petronas Carigali - holds equity. So if Carigali holds 50% interest in a block, here’s what the split looks like:

• Government: 10% Royalty + 15.2% (38% tax of 40% Profit Oil) = 25.2%
• Petronas (including Carigali’s share): 18.6% (30% Profit Oil less 38% tax) + 25% Cost Oil = 43.6%
• Foreign Oil Company: 6.2% (10% Profit Oil less 38% tax) + 25% Cost Oil = 31.2%

If we were to remove costs, this is the take away of each entity: Government: 25.2%, Petronas: 18.6% and Foreign Oil Company: 6.2%

Petronas has been paying significant dividends to the government every year. in 2016, just as the oil price was dropping, 20% of Malaysia’s revenue came from Petronas. It is expected to pay RM19 Billion in 2018. But can it maintain high dividend and tax payments if a portion of its profits are carved out as royalty?

What did PH promise exactly?

In its manifesto, as part of Promise 3: Sharing the nation’s wealth in a targeted and equitable way PH stated:

“Oil and gas-producing states will be given royalty or its appropriate equivalent value. The cruelty of UMNO and Barisan Nasional that have been denying these payments based on political leanings will be stopped immediately. 

The Pakatan Harapan Government will increase the royalty payment to Sabah and Sarawak, and other oil producing states, to 20 percent or of its value equivalent, so that the respective states can take over and fund more of their own development activities.”

Currently Royalty is 10% and it’s not clear how much of that goes to the states - wang ehsan or by any other name. This sounds like PH promised to double the royalty and give it all to the states. 

So let’s see what the math looks like with 20% royalty skimmed off the top.

Applying 20% Royalty

• 20% Royalty to the Government (all goes to state, nothing left for Federal)
• 50% Cost Oil (assuming this stays the same)
• 30% (min) Profit Oil shared with Petronas and subject to 38% tax

Let's bring out the calculator:

• Government: 20% Royalty + 11.4% (38% tax of 30% Profit Oil) = 31.4%
• Petronas (including Carigali’s share): 14.5 (22.5% Profit Oil less 38% tax) + 25% Cost Oil = 39.5%
• Foreign Oil Company: 4.65% (7.5% Profit Oil less 38% tax) + 25% Cost Oil = 29.65%

If we were to remove costs, this is the take away of each entity:

This can impact the government’s take away in annual dividends from Petronas. The Federal government will no longer receive royalty but rely on petroleum tax reduced by 3.8%.

The Federal Government takes the greatest hit (almost 14% reduction) followed by Petronas (4.1% reduction) and the oil company (2.1% reduction).

Would a company consider investing with 4.65% profit? This doesn’t take into account the high risks involved if an oil block is less profitable than originally envisaged. Also, some operators have experienced millions of costs denied as non cost recoverable. This eats into their profits.

When 20% is out of the Profits

Let’s ignore the broad wording of the PH manifesto for a moment and consider the new interpretation. The 20% is out of profits. Technically speaking, this would be 20% of Profit Oil and not Royalty at all.

Let’s do the math anyway.

• 10% Royalty to the Government 
• 50% Cost Oil

40% (min) Profit Oil split 3 ways:

• 20% to State Government
• 40% to Petronas
• 40% to Operator (split 50:50 between Foreign Oil Company and Petronas Carigali)

We will assume the State Government is not taxed.

Bring out those calculators! If I got it wrong, let me know - I'll plead I'm a lawyer and can't count.

• Government: 10% Royalty + 12.6% (38% tax of 32% Profit Oil) = 22.26%
• State Government: 20% of 40% = 8%
• Petronas (including Carigali’s share): 14.88% (24% Profit Oil less 38% tax) + 25% Cost Oil = 39.88%
• Foreign Oil Company: 4.96% (8% Profit Oil less 38% tax) + 25% Cost Oil = 29.96%

If we were to remove costs, this is the take away of each entity: Federal Government: 22.6%, State Government: 8%, Petronas: 14.88%, Foreign Oil Company: 4.96%

Conclusion

Scroll back to the top to compare the three scenarios.

If we consider the fact that the 20% to State can only apply to new PSCs which are mainly for less attractive oil fields, we may drive away investors. When we consider the revenue that the government (state and federal) receive - not just from the PSCs but from the supporting industry, it could drop in the long term.

As I said earlier, this new fiscal regime cannot be imposed on existing PSCs. The question is whether oil companies would want to sign up for new blocks at such unattractive rates. If they don’t it may be left to Petronas Carigali to develop the blocks - and Petronas suffers. Alternatively Petronas does not hold any interest through Petronas Carigali or does so with very minimal interest, say 10 or 15%. Another incentive would be to reduce the petroleum income tax, but this impacts Federal government revenue. All these playing around with numbers becomes zero sum game. It could very well result in minimal bottom line change. It’s all about the Federal government handing some of its oil revenue to the states.

If this is a Federal - State issue where the states are demanding their share, then give them an allocation out of what the Federal Government receives. Perhaps all of the 10% royalty and a percentage of the petroleum tax collected. Don’t dig into Petronas’ and the oil companies’ share. 

Animah Kosai, a former general counsel in the oil and gas industry formed Speak Up to support organisations in enabling their employees to speak up on wrongdoing. She also writes and speaks on corporate whistleblowing, harassment and sexual harassment. See www.speakupatwork.com. Follow Animah on LinkedIn, Twitter and Facebook.