Royalty

There can be an element of maintenance costs that is fixed and an element which is variable. Fixed maintenance costs cover routine maintenance such as regular maintenance on safety valves which must be carried out irrespective of the rate of production. There also can be an element of maintenance costs which is variable. This arises from the fact that certain items of equipment can need more maintenance as the production rate increases. Also, royalties which cover the cost of purchasing another company s process technology may have different bases. Royalties may be a variable cost, since they can sometimes be paid in proportion to the rate of production. Alternatively, the royalty might be a single-sum payment at the beginning of the project. In this case, the single-sum payment will become part of the project s capital investment. As such, it will be included in the annual capital repayment, and this becomes part of the fixed cost. 

Keywords economic model, shareholder s profit, project cashflow, gross revenue, discounted cashflow, opex, capex, technical cost, tax, royalty, oil price, marker crude, capital allowance, discount rate, profitability indicators, net present value, rate of return, screening, ranking, expected monetary value, exploration decision making. 

Once production commences (possibly 3-8 years after the first capex) gross revenues are received from the sale of the hydrocarbons. These revenues are used to recover the capital expenditure (capex) of the project, to pay for the operating expenditure (opex) of the project (e.g. manpower, maintenance, equipment running costs, support costs), and to provide the host government take which may in the simplest case be in the form of taxes and royalty. 

Host Government Fiscal system - tax rate - royalty rate - royalty in kind (e.g. oil) - company status (e.g. newcomer) - project status (e.g. ring fenced)... 

The fiscal system set by the host government determines the method by which the host nation claims its entitlement to income from the production and sale of hydrocarbons. The simplest fiscal system is the tax and royalty scheme, such as that applied to income from production in the UKCS (United Kingdom Continental Shelf). 

Royalty is normally charged as a percentage of the gross revenues from the sale of hydrocarbons, and may be paid in cash or in kind (e.g. oil). The prevailing oil price is used. 

In addition to royalty, one or more taxes may be levied (such as corporation tax and/or a special petroleum tax). 

Prior to the calculation of tax, certain allowances may be made against the gross revenue before applying the tax rate. These are called fiscal costs and commonly include the royalty, opex and capital allowances (which is explained later in this section). Fiscal costs may also be referred to as deductibles. 

Royalty is charged from the start of production, but tax is only payable once there is a positive taxable income. At the beginning of a new project the fiscal costs may exceed the revenues, giving rise to a negative taxable income. Whether the project can take advantage of this depends upon the fiscal status of the company and the project. 

Figure 13.4 Split of the barrel under a typical tax and royalty system...

The project cashflow s constructed by performing the calculation for every year of the project life. Atypical project cashflow is shown in Figure 13.9, along with a cumulative cashflow showing how cumulative revenue is typically split between the capex, opex, the host government (through tax and royalty) and the investor (say the oil company). The cumulative amount of money accruing to the company at the endof the project is the cumulative cash surplus or field life net cash flow. 

While tax and royalty fiscal systems are common, another prevalent form of fiscal system is the Production Sharing Contract, in which the investor (e.g. oil company) enters into an agreement with the host government to explore and potentially appraise and develop an area. The investor is a contractor to the host government, who retains the title of any produced hydrocarbons. 

Typically, the contractor carries the cost of exploration, appraisal and development, later claiming these costs form a tranche of the produced oil or gas ( cost oil ). If the cost oil allowance is insufficient to cover the annual costs (capex and opex), excess costs are usually deferred to the following year. After the deduction of royalty (if applicable) the remaining volume of production (called profit oil ) is then split between the contractor and the host government. The contractor will usually pay tax on the contractor s share of the profit oil. In diagrammatic form the split of production for a typical PSC is shown in Figure 13.11. 

PSCs are agreed with a schedule for exploration, appraisal and development, and production periods. During these times the terms of the PSC are usually fixed, thus reducing some of the uncertainties associated with tax and royalty systems where the royalty and tax rates may vary over the field lifetime. 

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Every iadustry has its owa sease of what a reasoaable royalty might be. Whereas earned royalties are usually based oa aet sales, a very rough rule of thumb is that an earned royalty reflects approximately 25% of profits earned on the particular technology. Minimum royalties are often based on one-fourth to one-thind of a conservative projection of sales. 

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