The new reality: Determining realistic offshore licensing terms

Most national oil company (NOC) officials and oil ministers agonize over how to attract exploration investment capital. It is not a simple matter. And the issue seems to have gotten more challenging.

Typically, NOC officials have mandates from a prime minister or parliament to provide "competitive" or "comparable" fiscal terms for their country. But with this mandate comes a common curse – lackluster interest, or worse, less-than-lackluster interest. There have been more and more "failed" license rounds in the past few years. For a NOC, there are few things more horrifying – it's like throwing a party, but nobody shows up.

If a government is satisfied with the amount of exploration and development activity in its country, the fiscal terms are appropriate. This is the acid test; however, it is nearly impossible to find anyone happy with the level of exploration activity in their country.

The reason is that fiscal terms are generally too tough relative to the associated geopotential. Many oil company personnel attribute this to greedy governments. While there are certainly a few glistening examples of greed at high levels, that is not the real reason. The are two much more legitimate reasons:

• In the past 20 years, most basins have matured dramatically, and future discoveries will be an order-of-magnitude smaller than early discoveries
• Fiscal terms have been pushed to the limit. This situation is the result of over two decades of overbidding for exploration rights and licenses around the world.

During the 1980s in particular, companies started to get concerned. Discoveries were not as frequent, nor were they as large as anticipated. Exploration is risky business, and disappointing results are expected. The problem reoccurred year after year. Something was definitely wrong. In the late 1980s and early 1990s, most oil companies conducted post-mortem analyses of past exploration efforts.

The findings from the numerous studies performed during these years were extremely consistent. We had systematically overestimated recoverable reserves for exploration prospects, and we were overly optimistic in our estimates of the probability of success. This shortcoming alone was sufficient to grossly distort the thousands of bids and negotiations of the past few decades. But, we were also overly optimistic in our oil price estimates. These over-expectations have had a profound influence on the universe of fiscal terms that exists today. The distortion from over-optimistic bidding is one-sided and created heavy pressure toward tougher and tougher terms.

This pressure is mitigated somewhat because each year 20 to 30 countries announce incentives and/or improvements to their systems. But these improvements are usually negligible compared to the ever-deteriorating prospectivity – almost always a case of too-little-too-late.

Once the industry realized that over-optimism was so pervasive, there were dramatic efforts to fix the problem. But the over-optimism is just a symptom of a more serious disease. The fabric of the problem goes deeper. It is a function of the internal corporate competition for funds amongst geoscientists and project groups.

One major oil company in the early 1990s made policy-level changes because it had lost hundreds of millions in the exploration end of the business. The new policy was characterized by two key features:

• No more high-risk exploration (where probability of success is estimated at less than 20%)
• For exploration risk analysis, cash flows would be discounted at 15%.

The new exploration hurdle rate was 15%. After a few years under the new policy, exploration success rates had gone up to around 45%. The company proudly proclaimed this achievement publicly as investor relations personnel must do; however, it was generally acknowledged internally that the company had not actually managed to achieve the 15% internal rate of return. In fact, they knew they were not "adding value." This meant that the hundreds of millions of dollars spent under the new policy represented "loss of value." Any large oil company employee can identify with stories like this. It is extremely frustrating trying to succeed in the petroleum exploration business.

So what is a government to do? If it wants to accelerate exploration activity, it must offer something better than "competitive" or "comparable" terms. To do that, the government typically must "fix" the terms and allocate licenses on the basis of work-program-bidding or negotiated work programs deals. And the terms must be fixed at a level significantly lower than what might otherwise be considered "competitive."

The UK sector of the North Sea became the most active offshore province in the world in the early 1990s because the government dramatically reduced the government take. Most other governments were shocked to see how little the UK government was reaping with its single 30% tax that existed throughout the 1990s. But the hyperactivity that resulted from this fiscal structure created thousands of direct oil industry jobs in the UK and many more ancillary jobs, creating benefits that go beyond direct taxes or royalties on petroleum. The problem is the benefits are difficult to measure. Because of this, it is usually difficult for a government to contemplate large reductions in taxes, royalties, or fiscal terms of any sort for the petroleum industry.

Unless a country has spectacular geology, it takes some fairly dramatic fiscal changes to gain the industry's attention. With the super maturation of most of the basins on this planet, we approach a new reality. Fiscal terms that exist today for the most part were crafted in another era. Most provinces do not require the financial and technical muscle of a major oil company. There will be more opportunities for the smaller, more efficient independent oil companies, but they need better terms if governments want to see robust exploration activity. It won't be easy, but it could be exciting. I'm optimistic.

Daniel Johnston
Daniel Johnston & Co. Inc.

This page reflects viewpoints on the political, economic, cultural, technological, and environmental issues that shape the future of the petroleum industry. Offshore Magazine invites you to share your thoughts. Email your Beyond the Horizon manuscript to William Furlow at [email protected].