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“The Fuel and Energy Complex Cannot Do without Exploration”

by Alena Lipyavko | Oct 03, 2013

Economics and the Fuel and Energy Complex Today, 20, 2012

Sergey Donskoy, Minister of Natural Resources of Russia, said that he was discussing the idea of introduction of a MET (mineral extraction tax) deduction for exploration expenses in Russia. According to the Minister, the introduction of such a mechanism will allow to create incentives for exploration in Russia. A similar point of view is expressed by industry experts and  legislators.

  On the Brink of Change

The problems of exploration in our country after the reforms of the 90s became chronic. The industry is locked in conditions of chronic underfinancing. The government takes steps to create incentives for exploration, but as always bureaucracy, disagreement between authorities and subsoil users, misunderstanding between authorities themselves on a number of key issues related to geological exploration raises barriers. Change in tax legislation is obviously one of the most important issues in this regard. Fiscal instruments should facilitate growth in the level exploration activity. Eventually, they could allow Russia to achieve the annual oil production target set in its Energy Strategy 2030. Different regulators and companies offer different solutions. However, the scenario developed by the Ministry of Energy implying the introduction (or extension) of tax holidays for new projects remains the central scenario. West Siberia brownfields do not fit this scenario. Unfortunately, progressing depletion of hydrocarbon resources continues. The reserves which are currently being developed were discovered dozens of years ago back in Soviet times. Only four large fields came on stream in 2011 to maintain the current oil production level in Russia. No more than three large fields have been discovered in the last 20 years. Currently, the unallocated fund consists mainly of small and medium-sized fields (Fig.1). They do not have a sufficient number of profitable reservoirs to maintain today’s oil production levels. In addition, we are witnessing a very significant fall in exploration activities. In comparison with Soviet times, exploration has shrunk 5-6 times over the last 20 years: from 5.7 MM m drilled in 1989 to 1 MM m drilled in 2009. The achieved level of exploration maturity of forecasted resources in Russia is extremely low and does not exceed 50%. An inadequate level of exploration activities will result in a decline in oil production in the next 5-10 years. As a result, such decline will lead to a significant drop in the amount of taxes paid by companies into state budgets at all levels, which creates the risk of a certain drop in living standards in our country and the ensuing negative social and political implications. The level of oil production defined in the energy strategy of Russia to 2030 (ES 2030) requires significant investments in exploration. However, de-factor such investments are not being made. If production drops to 350-400 MM tons p.a. (this level can be achieved starting from 2015-2016 if no urgent measures are taken), the budget losses due to the drop in payments (MET, customs duties, profit tax, payroll charges, etc.) from oil companies and related industries and service sectors could amount up to 1.5 trln RUR a year. Underutilization of oil transport facilities due to a decline in production (mainly the newly commissioned pipeline systems BPS and ESPO) will raise the issue of the profitability of these projects and will necessitate an increase in tariffs to maintain the profitability of Transneft. Actually, the deplorable situation in the industry is attributable to the consistent underfinancing of exploration both by subsoil users and other investors. Fuel and energy companies invest less than 100 bn. RUB p.a. to maintain production levels (there is no question of production growth). Only in the last three years has underfinancing of exploration amounted to around 450 bn. RUR. With comparable production, Russian vertically integrated oil majors spend on exploration several times less. According to experts’ estimates, such costs in the Russian oil and energy industry amount to 0.3-0.6% of revenue versus 1-3% in the case of international oil production corporations. The so-called additions in the reserves of oil companies are mainly driven by a re-estimation of previously discovered fields and revision of the oil recovery factor (ORF). Meanwhile, the depletion of reserves at developed fields is already beyond 60%, while it could hit 75% by 2020. Unfortunately, even the actively discussed application of stimulation technologies (WO, fracs, acid treatments, etc.) can provide only short-term relief, which will be followed by a sharp decrease. Based on their impact, such technologies could be compared to artificial stimulators which completely squeeze the resources of the organism, leading to hectic activity and to exhaustion in the end. Despite evident underfinancing, ES 2030 and the master plan for the development of the Russian industry provides for an increase in oil reserves to the tune of 12-14 bn. tons. However, the authors of these policy documents seem to forgrt that it is necessary to bring on stream several large and a dozen medium-sized oil fields p.a. to achieve such high targets. That is why it is advisable to speak of the achievement of these parameters with a lot of circumspection.

Fiscal Issue

 Today many industry experts and analysts express the opinion that only a revision of the Russian tax system can rescue production through the intensification of exploration. Currently, with the help of the mineral extraction tax (hereinafter MET), the government actually takes 70% of the income of oil companies. It is important to understand that MET is a production tax: for this reason, companies pay only so long as they can produce. Nobody talks about production costs, while they continue to increase because Russia ran out of easy oil long ago. In the U.S. and Norway, taxes on oil companies are cut twice: first at the initial production stage and a second time during rehabilitation when companies have to invest in technologies and appropriate wellwork activities to recover well flow rates. Top tax rates in these countries are applied only during production peaks. In the past years, the issue of reforms in tax legislation in the fuel and energy sector has repeatedly come to the fore at the government level. Obviously, there is understanding on the necessity and imminence of changes in this sphere. Moreover, the government makes attempts to create optimum tax instruments which would help facilitate the development of reserves: namely, very recently thee Ministry of Energy offered a zero MET rate for Eastern Siberia and Far Eastern fields, including the Vostochno-Talakanskoye and Alinkskoye fields (developed by Surgutneftegaz), the Yaraktinskoye, Markovskoye, Danilovskoye and Zapadno-Ayanskoye areas that are owned by the Irkutsk Oil Company. It is proposed to extend the tax holidays for these and other projects from 2017 till 2020. In addition, a draft law setting reduced MET and export duty rates for new investment projects for the development of challenging oil has been submitted to the government for review. Exemptions amounting to up to 40% and more on the MET tax will be applied to super-viscous oil and to oil with special physical and chemical properties produced on fields located in Yakutia, the Irkutsk Region, Krasnoyarsk Krai, the Yamal Peninsula and on onshore fields. The Ministry of Energy believes that this will be a significant incentive, noting that tax breaks will allow to attract investments in the development of challenging reserves in an amount of around $US45 bn by 2030. According to representatives of the Ministry, tax revenues from the implementation of these projects could exceed $US60 bn. Implementation of government initiatives in the mid-term according to preliminary data will increase the amount of hydrocarbon reserves by 60-85 bboe, while the added value could amount to $US170 bn.

Exploration As an Obligation

Let's assume that the positive scenario implied by the governmental measures will be implemented. Unfortunately, in the present tax environment, the proposals of the Ministry of Energy can be considered as a half-measure rather than a real solution to the problems in exploration and in the industry in general. First of all, it is necessary to remember that oil companies already enjoy tax breaks in the eastern regions of Russia. Taking this into account, the proposal is designed primarily to simplify the tax break application procedure for each specific project. At the same time, paying attention to the necessity of investments in new projects, the government forgets about the necessity to increase production at the old fields in KhMAO and Yamal (Soviet legacy). Without doing so, it is impossible to cope with the decline in production and shrinking resource base. Also, in the higher echelons of power, periodically the possibility of introduction of an excess profit tax, which implies taxing of profit rather than revenue, is discussed. However, the idea faces strong opposition; namely, the Ministry of Finance which is concerned that such a shift could eat into the government's revenues. It is necessary to remember that an excess profit tax has been successfully in application in Canada and Norway for many years and has never resulted in holes in the budgets of these countries. However, as we know, one man’s meat is another man’s poison… Actually, it is possible that the concerns of the Ministry of Finance are not as groundless as may seem. In Russia, introduction of such a tax is unlikely to lead to fundamental changes or spur growth in exploration activities, which will ensure the required oil production. The idea is pushed by exploration companies, which in turn offer to set compulsory exploration charges for oil companies in the amount of 500 RUB from each ton of produced oil. According to industry experts, these funds could come from two sources: 200 RUB from current MET payments and the other 300 RUB from the increase in MET for the financing of exploration. There are always propositions to introduce an exemption from the mineral extraction tax for oil and gas companies equivalent to the amount spent by a subsoil user to finance exploration conducted in order to replenish resources. The main idea in this case is to make exploration an obligatory cost item for production companies to maintain and increase oil production. Estimates are that it is necessary to invest in exploration at least 250 bn RUB in order to achieve the annual production of 530-550 MM tons set in ES 2030 and to bring on stream several large fields. Companies’ representatives propose the following mechanisms for raising the 150 bn RUB shortfall: 100 bn RUB – additional financing from MET payments collected by the government. 75 bn RUB to be returned to budgets of all levels in the form of taxes from the related industries and services sector. The other 50 bn RUB will have to be paid by subsoil users in addition to the current 100 bn RUR which is annually spent by them on exploration. Most analysts believe that both parties should be interested in this scenario. Application of this scheme will allow the government to collect the planned amount of consolidated budget revenues, and oil companies will be able to avoid a future explosion in expenses related to the need to compensate for budget shortfalls and increase tariffs on the transportation of energy resources. Generally, an investment boom in exploration will allow to arrest the decline in production and create a stock of fields for future generations. However, all these considerations are only theoretical. In practice,  most likely fires will be fought locally according to a set plan. In other words, this could happen only in new regions and on the shelf. The challenging reserves and underexplored ones of Western Siberia brownfields are not mentioned in this context. It means that exploration companies will have to fight for the passing of the respective legal acts. However, what’s inspiring is that some legislators back the idea. For example, Pavel Maslov, Member of the Agricultural and Food Policy Committee of the Federation Council, is convinced that “MET exemptions for companies that spend funds on exploration will provide a significant incentive for exploration and the replenishment of mineral resources in our country.” 

Egor Ushakov