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To tax, or not to tax
Published in Al-Ahram Weekly on 08 - 02 - 2007

Hussein Abdallah* debates whether Egypt needs to impose a windfall profit tax on foreign operating oil companies
On 22 November, 2006, the Algerian energy minister notified oil and gas companies in his country that the Algerian parliament passed, on 15 October, an amendment to the oil and gas law, thereby imposing a tax on their windfall profits in view of recent unexpected hikes in oil price. Oil prices climbed from $15-18 a barrel in the 1990s to $25 in 2000-2003. Then again to $36 in 2004, $50 in 2005, and $61 in 2006.
The windfall profit tax would re-establish the balance of contracts concluded between Algeria and the oil companies. It brings back profit-sharing among the two sides to the date when the agreement was first signed. When Algerian oil concessions were negotiated, the prevailing price of oil -- which is one of the fundamental basics -- averaged $18 a barrel. The Algerian windfall profit tax would range between 5-50 per cent, and would be applied when the price of Brent oil passes the $30 level. Each company will be dealt with according to its own circumstances, while the new exceptional tax would provide the Algeria treasury with additional revenues that could help reduce its foreign debt, currently estimated at $5 billion.
Maintaining the initial balance between the host country and the oil-operating companies is an essential principle in the oil industry, considering the fact that an oil agreement usually runs for 35 years. Over such a long period, the underlying conditions may be subject to fundamental changes, therefore it is a legally accepted rule that long-term contracts may be restructured in order to restore the initial balance of the contract. A near quadrupled oil price would, for sure, justify the intervention of the host country to regain its legitimate share of the windfall profit.
Algeria was not the only country to do so. The Venezuelan hydrocarbons law of 2001 linked the production share of the host country directly to the profitability of oil companies operating in Venezuela. Accordingly, the Venezuelan government would obtain 34 per cent of total oil production as a royalty, which is levied by the host country, regardless of the profits or losses made by oil companies. Thereafter, an income tax is levied at the rate of 50 per cent of the companies' net income. To guarantee that oil companies would not benefit alone from unexpected hikes in world oil prices, Venezuelan legislators mandated that the state's total share (royalty plus income tax) be no less than 50 per cent of the oil companies' gross income. This measure guarantees that the state will automatically have a share in any windfall profit that may be realised, due to unexpected rise of oil prices.
With the Venezuelan national oil company holding a majority equity share in all joint ventures, Venezuela, under President Hugo Chavez's government, has regained its sovereign right to direct its oil industry to the benefit of Venezuelan people, and receive its legitimate share of hydrocarbon revenues in the form of royalties, taxes, and equity profits. No company has resisted the reform plans that were initiated by the Chavez regime, which is now starting its third presidential term.
Looking at Production Sharing Agreements (PSAs) in Egypt, one wonders whether they need to be amended or even have windfall profit taxes imposed on operating companies. Usually, a foreign company is contracted for a period of eight years to explore for oil, and pay all necessary costs. In case the exploration efforts strike a commercial oil discovery, the contract is extended for a maximum period of 35 years. A joint venture with the foreign company is established to develop and produce the oil and/or gas, while the foreign partner still single-handedly carries all development and production costs.
When production starts, the foreign partner is allowed to keep up to 40 per cent of total production, valued in dollars at the export price, to be deducted from the remaining cost balance. This is to be repeated, year after year, until his costs are fully recovered. What remains (60 per cent of total production) is divided between the foreign partner and the Egyptian government, as represented by the Egyptian General Petroleum Corporation (EGPC). The foreign partner receives 25 per cent of the remaining 60 per cent (15 per cent of total production) as equity profit and as compensation for assuming the exploration risks. If a foreign company fails to discover a commercial field during the exploration period, it has to leave without recovering any cost. The 75 per cent of the remaining 60 per cent (45 per cent of total production) is the share of the host country, and is received by EGPC.
Since the foreign partner is entitled to one quarter of total production (net of cost recovery), and since the price of oil prevailing at the time of signature is a fundamental element of sharing production, then a sudden unexpected hike in oil prices from $15 to over $60 should raise the questions. Among these is how much windfall profits are made by the foreign partner, once the price of oil is nearly four times what it used to be when the contract was signed? Is it fair for the foreign partner to retain all windfall profits? Or should the host country introduce a special tax to receive its legitimate share of such windfall profits, which were realised regardless of the partner activities and costs?
These questions should be dealt with, considering the very attractive PSAs concluded in Egypt. According to the Egyptian PSA model, foreign operating companies neither pay royalties nor income tax since both are assumed by EGPC on behalf of the foreign companies. Furthermore, Egypt recently amended some PSAs in a manner that would benefit foreign operating companies. The cost recovery share of the foreign partner was reduced from 40 per cent of total production to 30 per cent, while the foreign partner equity share increased from 25 per cent to 35 per cent after cost recovery.
This amendment gives the foreign partner a larger share of production over the entire period of the contract. Meanwhile, the reduction of the cost recovery ratio, under a quadrupling price, would still be more than enough to recover costs in even less time than was originally anticipated. But the increase of equity share, which would last to the very end of the contract period, would make the total profits of the foreign partner much larger, than was the case before the amendment.
* The writer is a consultant on petroleum and energy economics.

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