In the past, I have given my in-depth perspectives on cost recovery and Domestic Market Obligation (DMO). In this article, I would like to discuss one of the most common incentives given in the Indonesian PSCs, the Investment Credit (IC).
The PSC has fixed terms on profit split for oil and for gas, well defined accounting terms, and likewise with the applicable corporate tax rates which is based on the prevailing tax regulation at the signing date of the PSC. Other variables to project economics such as petroleum reserves and prices are mostly given or environmental. The headroom left for improving project economics for the contractor is hence by granting special incentives. Without the incentives, some project may not be economic for the contractors to proceed with development which would only lead to stranded reserves generating no value to both parties. Special incentives shall be negotiated, agreed, and approved in advance along with POD approvals and project sanctioning.
Incentives are granted after careful consideration and evaluation. The discussions and negotiations can sometime be very tough as some of the variables are based on future assumptions of recoverable reserves, rates and timing of production volumes, costs, and prices which definitely most of the time are subjective. Disagreements happen all the time. It is true that once the project is complete and the field has been producing for a number of years, then when you’d look back you would probably realize that a previously agreed and applied incentive was probably insufficient to help project economics or on the other hand probably had not even been required at all given the other variables have all changed favorably.
There are several types of incentives usually granted for a development project. Investment credit is one of them, typically included in the PSC contract itself:
CONTRACTOR may recover an investment credit amounting to twenty seven point zero zero zero zero percent (27.0000%) of the capital investment cost directly required for developing Natural Gas production facilities of any field out of deduction from gross production before recovering Operating Costs, commencing in the earliest production Year or Years before tax deduction (to be paid in advance in such production Year when taken).
The applicability of investment credit for development of fields other than those fields which are referred in to the first plan of development shall be proposed by CONTRACTOR for approval by BPMIGAS based on the economics of such development. BPMIGAS shall not unreasonably withhold its approval to such investment credit.
The first clause is clear that IC is given at a certain rate (can vary from PSC to PSC, within the range of 17% to 27%) applicable to the development capital expenditures related to oil or gas production facilities (including the tangible portion of well costs). This means that IC is in reality an uplift to capital investments, on which you can essentially recover more than what you actually spend for development. This is similar to uplift on development cost recovery in PSAs in other countries such as Angola (50%), with a big difference on the tax implications (we will see that later below).
The other term related to IC is the fact that it should be claimed in the first year of production (or the first years of production, in the case that gross revenue after FTP in the first year is not sufficient to recover the whole amount of IC) before recovering operating costs, hence it should be applicable after FTP but before recovery of other cost recoveries (current year non capital costs, current year depreciation, and deferred unrecovered costs).
The unique (but very detrimental to contractor’s project economics) characteristics of IC is the fact that it’s recoverable but taxable at the same time when claimed/taken. This in truth significantly reduces the bottom-line uplift factor. For example, in a PSC where the profit split is 15% after tax and the tax rate is 48%, then the bottom line additional cashflow for the contractor is merely 37% of the amount of IC taken (52% from the gross IC after 48% tax, less the unfavorable impact on contractor’s profit share after tax of 15%). In a PSC where the profit split after tax is 40% (typical for gas in a frontier area), the bottom line additional cashflow for the contractor is so small at only 12% of the gross IC claim (52% from the gross IC after 48% tax, less the unfavorable impact on contractor’s profit share after tax of 40%).
Let’s see an example below where in one case there’s no IC granted as compared to another where $1,000 of IC is claimed under exactly the same variables of volume, price, and cost recovery. The profit split for the contractor before tax is 76.9% or 40% after tax rate of 48%.
As we can see, the bottom line impact on contractor’s cashflow is merely $120, which is 12% of the $1,000 gross IC claimed. Again, this is caused by the fact that IC has two implications: (1) it increases contractor’s recovery by $1,000, but taxable at 48% leaving us with only $520; (2) it reduces the gross profit to be split by $1,000 of which the contractor’s unfavorable share is negative 40% or negative $400 after tax.
The first example above is of course applicable only in the case when the first year production volume, price, IC, and cost recovery are all such that there’s enough left for profit share. In reality, a new and first project in a PSC always accumulates significant amount of deferred unrecovered costs being carried forward, causing the early years of production to have no equity to be split at all as the whole revenue left after FTP is consumed for cost recovery. In this situation, claiming IC in the first year (or years) of production will actually put the contractor in an unfavorable cashflow position for the year as total contractor’s entitlement volume would still be the same (the recovery of IC simply would only shift the recovery of deferred unrecovered costs to the following year) but the contractor then has to pay the taxes on IC immediately.
Let’s see the second example where typically the first years of production are solely used to recover deferred unrecovered costs.
The total favorable impact on the contractor’s cashflow is also $120, but the time lag between the two cashflow events is now 4 years apart. In the first year, cashflow with IC is lower by $480 which is caused by the 48% tax payments on the $1,000 IC claimed. Meanwhile, cashflow in the fourth year is higher by $600, caused by the delayed deferred unrecovered cost of $1,000 (which in turn adds contractor’s share from cost recovery of $1,000 partially offset by the negative impact on profit share after tax of $400). The $480 downside on cashflow for the first year is indeed lower than the $600 upside on cashflow in the fourth year, but the $120 delta is so small that when it’s discounted the incremental impact on contractor’s NPV is actually negative by $27 !
This is exactly what I mean by the title of this article that investment credit could become a disincentive rather than an incentive if the project is such that: the time lag between first production until the project starts generating equity profit to be split takes several years (due to high unrecovered costs, low volume, and or low price), the tax rate is high, and the profit split for the contractor is also high (causing the negative offsetting impact on profit share being high as well). If the impact on project NPV is negative, then what’s the point of claiming the incentive ? It completely escapes the concept of incentive in the first place. The weird thing about this strange phenomena of IC is that the bigger your profit share, then the less favorable the impact of IC on cashflow and NPV (as I said above, for a 15% after tax profit split the cashflow impact is 37% while for a 40% split the cashflow impact is merely 12%). Even worse, the bigger the investment credit, then the worse your project NPV will be: for example if in the last example the IC is for $2,000 then the negative cashflow in the first year will be $960 while the positive impact on cashflow in the fourth year will be $1,200 for a net positive cashflow of $240 (which is double than when IC is only for $1,000), but the incremental impact on project NPV will be negative by $53 (which is about double the negative incremental NPV of $27 when IC is only $1,000).
What makes more economic sense is the option to defer IC claim to the year when the project starts having equity profit to be split, hence the time lag between tax payment on IC and the aditional cashflow will no longer exist. The IC deferral will not change the total net additional cashflow, but the incremental project NPV definitely will be better with IC as compared to without IC. This option as I understand used to be available with special approval from Pertamina (BPPKA/MPS), but in reality there’s no legal contractual ground to that practice as the PSC clearly stipulates that IC has to be taken in the first year of production.
Conclusion: IC is probably the strangest incentive ever given in any PSC system in the world. This incentive could be good for project economics, but could be bad in certain situations. First of all, the fact that it’s taxable in itself significantly reduces the uplift factor. Then the stipulation that the claim and the tax payment should be done in the first year of production makes it worse to the extent it could become a disincentive. Nowadays, high oil price in itself is somekind of an incentive already for project development, but certain gas projects with contracted fixed price to domestic market may still need special incentives to be economic for proceeding with development. Interest Cost Recovery (ICR) is a far superior incentive relative to Investment Credit, but it’s rarely (if not never) granted within the last few years. ICR is applicable to the unrecovered balance of the gas investment, yielding a much bigger effective uplift factor, and is cost recoverable but not taxable in itself. If ICR is out of reach while IC is a disincentive, then the contractor has limited or no room to mitigate investment risks with regards to (argueably unknown future) volume, costs, and price.