Lebanon’s Offshore Natural Gas: The Importance of Two Decrees

After some years of careful planning, in 2013 Lebanon was on the verge of launching an auction for the first licensing round in relation to its offshore natural gas potential. Two decrees, one related to the division of the Lebanese economic exclusive zone (E.E.Z.) into 10 blocks, and one related to the exploration and production agreement (E.P.A.), i.e., the petroleum contract that Lebanon wants to sign with the international energy companies interested in Lebanon’s hydrocarbons, were the prerequisite for the auction. Unfortunately, the government has never approved these two decrees, and the auction has been postponed since then. The aim of this paper is to analyze the importance of these two degrees with a particular attention given to the E.P.A. degree with its related fiscal issues.

If the two above-mentioned decrees are not passed because there are some doubts about the economic side of the development of an offshore natural gas sector in Lebanon, this kind of substantiated opposition is perfectly acceptable and could be logic (of course, it needs an explanation). But, if the two decrees do not advance for political reasons, this does not serve the long-term interests of Lebanon.

With reference to block delineation, an important consideration is that a government has never to award all of its offshore and/or onshore territory for exploration and exploitation simultaneously; this rule is particularly true when a government is awarding unexplored acreage with many unknown factors involved. In fact, especially when dealing with frontier territory, designing immediately an almost perfect contractual framework with its related fiscal terms is practically an impossible task, so it’s much safer for a government to award its territory in a gradual manner utilizing for every new award the information obtained through the previous exploration and production agreements (E.P.A.s).

The petroleum literature well explains that there is no ideal block size; in general, a block size is defined according to:

A) Geology

B) Location

C) Competition

D) License duration and

E) Relinquishment rules

Lebanon has opted to sign Production Sharing Contracts (P.S.C.s). The slides below provide some details concerning the structure of today’s general P.S.C.s. The scheme released by the L.P.A. shows that Lebanese P.S.C.s are well in line with the most basic form of a classic P.S.C., which has four components as shown by the table below.

THE FOUR MAIN COMPONENTS OF A CLASSIC P.S.C.
Royalty In Lebanon: it’s fixed by legislation
Cost Recovery In Lebanon: biddable
Profit Petroleum In Lebanon: biddable
Tax In Lebanon: it’s fixed by legislation

STATE PARTICIPATION

In addition to the four mentioned components, the O.P.R.L. Art. 6 (State Participation), affirms that the state maintains the right to carry out or participate in petroleum activities. Apparently, the state participation option will not be part of Lebanon’s first licensing round. So, presently, there is no state participation in the E.P.A. at the time of award, but, the state or any entity owned by the state could in the future become a right holder pursuant to additional assignment rules, and early termination and forced assignment rules. At the time of this writing, state participation has yet to be defined. And, until now, petroleum literature has not been able to demonstrate that direct state participation provides some additional benefits that could not be achieved from taxes — many a time states decide to participate on the ground of non-economic considerations, e.g., control, technology transfer, national pride. For sure, for a state, state participation augments administrative complexity and risk, while for the investing I.O.C.s, it represents a cost and sometimes the implementation of suboptimal decisions concerning the hydrocarbons development. So, for a country as small as Lebanon, the benefits of establishing a national petroleum company are not so evident.

Summing up Lebanon’s proposed E.P.A. should consist of four or five elements.

THE FISCAL TERMS

In light of the presence of a royalty, some commentators see the Lebanese P.S.C. as a hybrid between a concession and a P.S.C. This is an opinable point of view because most of modern P.S.C.s have a royalty included. Moreover, governments have the objective of maximizing the value of government revenues in their petroleum arrangements with I.O.C.s. and they can reach this goal through whatever petroleum arrangement they decide to sign: concession, P.S.C., and service contract.

The E.P.A. seems to primarily recall the definitions set forth in the O.P.R.L. and the P.A.R. So, as defined in Art.1 of the O.P.R.L., the E.P.A. is “[a]n agreement concluded between the State and no less than three Right Holders”. A right holder can be a single company or a group of companies in which at least one meets the prequalification eligibility criteria set forth in the Pre-Qualification Decree. One of them is the operator (with at least a 35 percent participating interest, while non-operators have a minimum 10 percent participating interest), responsible for carrying out day-to-day activities, although all right holders are jointly and severally liable for their obligations. The idea of an unincorporated joint venture (U.J.V.) is quite common in petroleum ventures.

According to the information concerning the E.P.A. posted online by the L.P.A., right holders may explore for petroleum during a five-year exploration phase, which is divided into two periods respectively of three years and two years. This exploration phase may be extended up to 10 years with the approval of the council of ministries. This timeframe, apart from the distinction of the five-year exploration phase into two periods, is in line with the text of the O.P.R.L.

With reference to the percentages for acreage relinquishment, the legislation envisaged for Lebanon follows current practices with P.S.C.s: an initial period of five years (divided into two sub periods of three years and two years like in Lebanon) extendable for two additional years up to a total of seven years. In fact, in Lebanon, at the end of the first period, right holders will relinquish 25 percent of the block, and, if later there is an extension to the exploration phase, they will add an additional 25 percent relinquishment (at that point relinquishment will amount to 50 percent).

According to the L.P.A., for natural gas there will be a royalty with a flat rate at 4 percent — instead, with reference to oil, Lebanon wants to implement a flexible royalty rate between 5 percent and 12 percent in relation to a sliding scale linked to daily oil production.  Some analysts deem the royalty rate for gas as too low, while others would like to avoid completely the royalty, which of course is a regressive instrument. Indeed, these are two opposite points of view. But the reality is that they both probably misread the overall structure of a petroleum contract — in this case a gas contract. A royalty is surely regressive (regressivity is intrinsic to the concept of royalty no matter how we may formulate it), but it serves the purpose of a government that wants to obtain a cash flow soon — and Lebanon needs to obtain some profits quite early. At the same time, because this royalty is not very high (it’s true that it’s a natural gas royalty and not an oil royalty, which is always higher) so it’s not an excessive fiscal burden for the I.O.C.s that want to invest in Lebanon. But, as usual, when drafting a petroleum contract every single element has to be aligned with all of the others. A perfect royalty rate does not exist, and analysts should evaluate a royalty rate in relation to the other parameters present in the contract. What matters is the final result.

The L.P.A. says that “a percentage (determined by bidding) of the oil and gas is allocated to the Right Holders to reimburse their costs”. Also this element is the kernel of a P.S.C. After paying the royalty, the next application of the production is given to the contractor in order to recover its costs. Usually, there is an upper limit (a.k.a. ceiling), let’s say for instance 40 percent of production, which may be used every year for cost recovery. At least, the contractor’s costs include all capital costs (CAPEX) and the annual operating costs (OPEX) — let’s put aside other elements as interest on debt and investment credit. Without an upper limit I.O.C.s could quickly recover their costs and have a reduced payback period, but, at the same time, this would run counter the interest of the hosting government, which would see its initial revenues postponed to a later time. A cost recovery limit is less regressive than a royalty.

In Lebanon, every quarter, profit petroleum, i.e., the production not otherwise allocated to cost petroleum and/or royalty, will be evaluated on a biddable sliding scale that is related to profitability (an R-factor for the immediately preceding quarter).

Investors like a sliding-scale profit-petroleum split indexed on an R-factor, and they would probably like it more if this was indexed on the rate of return of the investment because it could accommodate concepts like the time value of money. An R-factor permits investors to reduce the risk of the project thanks to the introduction of flexibility in the fiscal structure of the contract. In Lebanon, the R-factor is calculated in accordance to the formula:

Cumulative Cash Inflow / Cumulative CAPEX

In any quarter, cumulative cash inflow corresponds to:

Profit Petroleum + Cost Petroleum – Operating Expenses

The following table shows the percentages of profit petroleum implemented in relation to the R-factor.

LEBANON’S R-FACTOR
R-Factor Government’s Profit Petroleum Percentage Right Holders’ Profit Petroleum Percentage
< than or = to 1 A% 100% – A%
> than 1 and < than RB See the formula below 100% – % determined in the formula below
= to or > than RB B% 100% – B%

From the table above it emerges that when the R-factor is greater than 1 and less than RB, the percentage of profit petroleum pertaining to the state will be calculated according to the following formula:

Government’s Profit Petroleum Percentage = A + [(B – A) . (R – 1) / (RB – 1)]

Carole Nackle (July 2015) correctly pointed out that:

It is unusual to see the minimum profit sharing biddable especially since it can lead to a wide range of minimum government takes, thereby increasing the administrative burden and complicating revenue forecasting. Lebanon can improve its system by fixing the lower band of its share of profit petroleum and allowing companies to bid for two more upper tiers. The advantage of this approach is that it ensures a minimum government share of profit petroleum, rather than solely relying on the bidding process.

Yes, a biddable minimum profit-sharing percentage means that for every signed E.P.A. there could be a different minimum profit-sharing percentage. Administratively speaking, especially for a country new to the petroleum business this could create a real mess. Instead, an already decided minimum percentage could give more stability to the country’s revenues.

The future E.P.A. has necessarily to clarify the rate of the Corporate Income Tax (C.I.T.). The L.P.A. in a simplistic manner affirms that right holders must pay all the Lebanese taxes. It’s possible that Lebanon will use also the general income tax, which has a 15 percent rate, but until now it is not clear what the L.P.A. and the Ministry of Finance will decide. Again, administratively speaking, it’s easier for a country to manage a single general C.I.T. for all the business sectors than to manage the general C.I.T. together with a specific petroleum C.I.T. If the C.I.T. is fixed, corporate taxes are relatively regressive, i.e., their burden stays the same notwithstanding different rates of profitability.

So, in Lebanon, two out of four of the P.S.C. main components, are biddable, i.e., the cost recovery limit and the profit sharing. Lebanon has decided to have also a biddable work program. Work program bidding is primarily used for affecting the quality and level of exploration in an area. It’s a means in order to control that the I.O.C.s work on time and with good quality results. Of course, excessive working commitments on the shoulders of the I.O.C.s risk increasing excessively the extraction cost of every single unit. It’s also not advisable that companies propose grandiose working programs, not related to an efficient exploration, because, in doing so, they will add relevant costs to the project in the end reducing the quantity of available profit petroleum. In general, after a while, an excessive working commitment forces the parties to the contract

CONCLUSION

If Lebanon desires to move on with its offshore gas potential it has to approve quite soon the two decrees. In specific, the decree related to Lebanon’s E.P.A. is of paramount importance for the interested I.O.C.s in order to understand whether it may make sense for them to invest in Lebanon.

 

Author: Alessandro Bacci