Grupo de Economia da Energia

Prices, costs and new regulatory framework for oil

In oil on 25/04/2011 at 00:30

By Thales Viegas

The production sharing agreement, in Brazil, changes significantly the role of costs and prices in oil activity regulation. First, costs have become the decisive factor for determining the surplus oil to be shared. Second, the price of oil may not only be a reference to the monetization of oil for each agent involved, that is, the price which pays the oil purchased by agent. It can also influence the magnitude of the sharing, if the price is a variable in the calculation that defines the percentage of surplus for the government. In some countries, to share profit oil with the government depends upon the price of oil. That is, the higher the price of oil, the greater the government’s portion for the profit oil.

By deduction, the production sharing agreement may fix the involvement of government in production, but also can allow it to alternate according to contract items previously agreed. Given the centrality of price and cost variables, the following analyses attempt to explain the interdependent dynamics of these two items.

By adopting the production sharing agreement in Brazil, it is important to consider the relationship between price of oil and costs in the oil chain. Oil is one of the most important commodities in the global economy. Its price influences the cost structure of many industries, either under basic raw material or energy source. These inflationary effects also affect the supply chain of the oil industry. Inflation may be even more generally when there is a general rise in price of commodities, as found mostly in 2000s.

The growth of emerging economies was the main driver for increasing demand and prices of such goods. This rise in price of commodities was fed back by financial market speculations, which caused price bubble. In 2007, before the first signs of the credit crisis, beginning in 2008, price of commodities dropped quickly. The price of oil was affected in mid-2008. However, after the initial moments of the economic cycle, price of commodities raised consistently.

In the particular case of oil, exploration has been moving to geological frontiers where it is harder to find oil and the required investments are higher. Thus, the highest price, the greater the investment. This intensifies the demand for capital goods and specialized services and increases the cost of investments. This was the inflationary trajectory of the sector in the last decade. The following Table shows a comparison between the evolution of the average profit per barrel (blue) and costs per barrel (yellow) of the major oil companies in the 2000s. Profit per barrel shows price of oil.

Table 1: Production Costs per Barrel and Profit per barrel of Major Oil Companies

(Price per barrel of oil equivalent in U.S. dollars)


Source: Evaluate Energy

The interdependence between costs and prices in the industry can be expressed as follows. The increase in costs also results upward pressure on prices. So, higher prices encourage investments, which increase the demand for scarce resources – rigs and specialized personnel. We have to mention that these two inputs tend to be the main obstacles of the world offshore production in the coming years.

Given this lack of resources, not even the drop in price of oil in 2008 was able to reduce consistently the costs of investment and production of hydrocarbons. Except for 2009, operating costs per barrel have increased steadily over the past 10 years. In the second half of the 2000s the level of investment by oil companies grew much more financially than physically. This frustrated the expectation of growth in production of many of them over the period.

Under these conditions, companies had difficulties to promote organic growth. In that decade, more than a quarter of reserves developed by the major oil companies were the object of acquisition. Remember that this occurred in a scenario of rising price of oil, when the cash flow of these companies was solid and growing. The problem is price of oil can vary quickly and intensely, differently for the costs, so that prices of equipment and services do not always drop at the same rate and speed as price of oil. The drop tends to be smoother. This time gap impacts the profitability and ability of companies to invest in the future.

The regulatory agency has the challenge of balancing the gains from extraordinary high price of oil, and these companies need to raise cash to invest even at rising costs. Especially, in the production sharing agreement, the government imposes limits on costs that are subject to appropriation by the consortium. Thus, if the government adopts mechanisms for capturing exceptional income arising from higher prices and profitability via price cap, for example, with a limit on cost recovery, we must balance these two limits in order to make practical exploration and production projects.

The advent of the crisis in the Arab world increased instability and prices in world oil market. If on one hand the immediate profitability of oil production tends to increase, a rapid rise in prices, on the other hand, it can reduce demand and misrepresent the agents’ calculations who invest based on long-term horizons.

Under these conditions, it is convenient for Brazilian government to reflect on the implications of prices and costs in its regulatory framework. The new regulatory model introduced new problems to be faced. The first of them refers to the correct definition of recoverable costs (limits), which will probably be subject to thorough review. Accumulation of costs at the beginning of the project involves a major impact on the discounted cash flow. And, at the end of the production curve, the revenues impact lesser on results. Thus, as reasonable strategy, the government would establish an escalation of production sharing, where its share in it would be smaller in the beginning and growing over time. The appropriation of the exceptional income from the oil activity must be done in order to avoid unbalancing the economically and financially the contracts and the attractiveness of investments.

Under these conditions, two aspects have to be observed. The first one is that the reference price for preparing the discounted cash flow – used in the analysis of investment projects – can not rely on temporary and misrepresented price levels. Upon drafting the contract, it is desirable that the government does not rely on extreme price scenarios when performing the calculations to define its participation.

The second one is associated with a possible use of mechanisms to capture exceptional income associated with price fluctuations or profitability. As costs are not constant, it seems to be more rational some criteria consider revenue and costs, not only one of them. Thus, if the government take is from profitability, the government could increase its share as price of oil increase and at the same time allow companies to reinforce their cash flows to enable them to invest in less favorable periods of price of oil. The adoption of the ratio between revenues and costs as the criterion of profitability seems to be an efficient and easy mechanism by those involved in production and regulation of the activity.

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