Distortionary effects of a production-sharing fiscal system in a sequential modular offshore petroleum project

Abstract

This research examines the distortionary effects of a discovered and undeveloped sequential modular offshore project under five different designs for a production-sharing agreement (PSA). The model differs from previous research by looking at the effect of taxation from the perspective of a host government, where the objective is to maximize government utility over government revenue generated by the project and the non-pecuniary benefits to society. This research uses Modern Asset Pricing (MAP) theory, which is able to provide a good measure of the asset value accruing to various stakeholders in the project combined with the optimal decision rule for the development of the investment opportunity. Monte Carlo simulation was also applied to incorporate into the model the most important sources of risk associated with the project and to account for non-linearity in the cash flows. For a complete evaluation of how the fiscal system affects the project development, an investor's behavioral model was constructed, incorporating three operational decisions: investment timing, capacity size and early abandonment. The model considers four sources of uncertainty that affect the project value and the firm's optimal decision: the long run oil price and short-run deviations from that price, cost escalation and the reservoir recovery rate. The optimizations outcomes show that all fiscal systems evaluated produce distortion over the companies' optimal decisions, and companies adjust their choices to avoid taxation in different ways according to the fiscal system characteristics. Moreover, it is revealed that fiscal systems with tax provisions that try to capture additional project profits based on production profitability measures leads to stronger distortions in the project investment and output profile. It is also shown that a model based on a fixed percentage rate is the system that creates the least distortion. This is because companies will be subjected to the same government share of profit oil independently of any operational decision which they can make to change the production profile to evade taxation.