Investment Credit – An Incentive Which Can Backfire As a Disincentive

Bit by bit, one by one, I would like to discuss in this Forum some of the basics of the Indonesian PSCs. By no way I have the intent to preach and teach the visitors of this site, I just want to give you different perspectives to the foundations of the terms and concepts in the Indonesian PSCs. Discussing recent issues and developments surrounding the industry is definitely important and “fun”, but discussing the basics should also be useful as from time to time we have to go to the basics to help iluminate or even resolve the current issues.
Without Incentives, It's Just A Phantom Platform in The Mist

Without Incentives, It's Just a phantom platform in the mist

 

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.

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7 responses to “Investment Credit – An Incentive Which Can Backfire As a Disincentive

  1. B.A.D,
    As always great posting. That makes me want to share my opinion to enhance my knowledge and learn from master like you.
    IMHO, on every investment analysis that we make, we need to come up with different scenarios. From best scenario, medium and worst scenario. Each given the weight and conditions for analysis. The numbers that you show will illustrate the scenario in which the IC will do more harm to project. But, at the same time we also need to calculate the best scenario in which IC gives the best impact (such as recovering it fully at year 1).
    When you do the calculation for the weighted average impact to the project given the different scenarios, IC will overall still give improvement to project.
    If the weighted average still provides negative (incremental) NPV, then the project itself may not be financially feasible and it is not because of the IC.
    Also, many of the projects that require IC are expansion in nature. The existing block usually already has enough production. The project that asks for IC is an incremental to the existing. And as long as it is still within the same block, it can always cost recover against the existing block (correct me if I am wrong in this).
    Thus, in most of the cases, the scenario that you described is unlikely to happen. Since the block already has enough revenue to cover both the cost recovery and IC.

    Overall, IC still provides great “incentive” for PSC contractors to reach out for projects that are inherently negative NPVs without IC. But still at the end, the conditions, scenarios and other assumptions during analysis will determine the outcome of the project outlook.

    As always looking forward to your excellent enlightenment 🙂

    Cheers.
    W.

  2. Wolvie,

    The example I put forward in the article is based on true real cases (of course all the numbers are just make up numbers). Since IC is mostly stipulated in the PSC agreement itself, it is applicable to the very first field development in the PSC, hence this illustrated situation is very real. Note that the past practice to somehow have partially delayed claim of IC was offered because we did (and still do) have this situations to sort out. Oil&GasLover probably can share his insights on this very true (yet strange) story.
    I agree that essentially IC is an incentive, but its feature is such that there are cases where not claiming would be better than claiming it. In reality, there’s no way you will know for sure whether not claiming will be better than claiming, as the actual volume, rate, price, and costs could change favorably or vice versa. It is indeed an (unnecessary) dilemma for the contractor to take. All the extra hassles and economic risks for what’s supposed to be an incentive (which by definition should always give you better economics in all possible situations) .

    Regards,
    B.A.D.

  3. .A.D. & Wolvie,

    Your views on I/C and its applications are really informative and inspiring. I had nothing important to add until you mentioned my name. Thank you, I thought I’ve been forgotten since for sometime I’ve been away from this site.

    I agree with you guys, I/C is basically an incentive but it might also be disinsentive in certain situations especially when it is applied on the first fields generating lower revenue compared to its costs. PSC anticipates this condition by putting the word ‘may’ instead of ‘shall’ in I/C clause. It is the contractor’s discretion to take or not to take such an incentive. Most contractors choose to take the I/C despite the field’s production level and price might still be in doubt. The decision has to be made in the first year of production by claiming the I/C in that year, unless the contractor not interested to claim it. We know there will be cash outflow implication for tax.

    Yes, additional cash flow may reach 37% when sharing splits are 85/15 at 48% of tax. Thefore there is no I/C available in PSC operating in deepsea or or frontier area with 60/40 splits.

    One thing that I’ve been wondering is about the ‘ringfence’ of I/C claim. What I believe is that I/C is claimable only to the respective field instead of the contract area. Precisely, the claim shall not exceed the field’s revenue after FTP. It simply because the I/C is dedicated to and should be taken from such field development, otherwise it will jeopardizing the gov’t income derived from other field(s). I/C is intended to give more revenue for contractor from the developing field. I know this is not what happening in practice. I still have that question.

    Regards,
    Oil&gaslover

  4. B.A.D. , Sorry I mistyped your nick name it should start with “B”, and one more, there is ‘http://FTP’ printed in blue unintentionally, it should be read ‘FTP’
    thx
    Oil&gaslover

  5. Oil&gaslover

    I don’t want to disclose my true identity, as that should be even more “shocking” than Peter Parker, Clark Kent, or Bruce Wayne publicly declaring their identities as Spiderman, Superman, and Batman, but my pseudonym as B.A.D is actually my real initials as my name actually appears on my passport, it just happens to read as an opposite of good. There you go, I’ve given you the clue to crack the secret identity of the mistery man.
    Don’t worry about mistyping ….. it’s your insights and contribution that count.
    B.A.D.

  6. Mr B.
    im a newbie in this oil industry, is there anyway i could email you, coz i got a few question i wanna ask.

    Thanks…

  7. All,
    Where is everyone???
    I am back ….

    W.

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