Best of the worst?

By Jocelyn Edwards 

IMF report praises Uganda oil contracts, warns of loses

Uganda’s contracts for foreign oil exploration, or the incomplete details known of them, have been largely criticised by observers.  But at least one analysis concludes they are favourable.   That is the determination of an International Monetary Fund (IMF) report on Uganda’s agreements with oil exploration companies exposed now in The Independent for the first time.

Perhaps one of its most significant points, the IMF also recommends full disclosure of the contracts and any payments that the government receives from oil. Almost a year after huge oil discoveries were announced Ugandans still have not seen the secret contracts in full.

Dated February 15, 2008, the report was undertaken following requests by President Yoweri Museveni and then Finance minister Ezra Suruma for the IMF to provide advice on the economic costs and gains from the petroleum sector in Uganda.

The 2008 report obtained by The Independent sheds new light on Uganda’s Production Sharing Agreements (PSAs), as the contracts with the oil companies operating in the country, are called.

The report reveals information about the PSAs signed later between the government and the dominant oil exploration companies like Tullow Oil Plc of the UK and Heritage Oil Plc also of the UK, the two companies with the largest stakes in oil in the country.

It suggests that contrary to previous media reports, the country’s contracts are relatively positive for the country.

The IMF finds that Uganda has favourable terms compared to other African countries as a result of what it considers relatively high royalty interest rates- fees that the oil exploration companies pay to the government for their percentage of future gains- and government shares of oil profits.

This is a dated analysis however.  It is  largely based on Uganda’s 1999 Model PSA, which was written before large volumes of oil were discovered in order to attract companies to invest in oil in Uganda and provide a framework for the writing of actual contracts with those companies.

Furthermore, report’s evaluation  of actual contracts was done when ‘the scale of potential recoverable reserves in Uganda remain[ed] uncertain,’ before Tullow and Heritage announced finds that brought confirmed reserves in the country up to two billion barrels.

Today, Uganda is poised to become one of Africa’s oil heavy weights.

While the contracts may have been comparatively good for a country desperate to attract investment and exploration to the country, they seem less suitable for the nation now.

The Permanent Secretary for Energy, Fred Kabagambe-Kalisa, has said, without providing any evidence, that subsequent PSAs are much better with government share of oil profits possibly ranging from 81-86%.

While making several recommendations on how to improve future contracts, the IMF admits at least one major flaw with the current PSAs.  They do not take into account the effect that oil prices will have on profits made by companies if those prices go up.

They wrongly assume that the profitability of the projects is only be determined by the volume of production.  Under the contracts, royalty rates and government share of profits are determined by number of barrels produced per day.  As a result, the government’s share of profits goes up as the number of barrels produced increases.

As a result of not considering rises in price, the government risks missing out on a huge share of profits that could be made if oil prices continue to soar in the coming decades.

In order to rectify this problem, the IMF recommends changing the way that the government’s share is calculated to take into account the effect of oil prices.  On the flip side, it recommends reducing ‘fiscal burden’ on less profitable projects in order to encourage investment in the country.

Unfavourable comparison?

The government’s lack of transparency over the PSAs has led to speculation that their terms might represent an embarrassingly raw deal for the government relative to other countries. However, comparing the government’s earnings under Uganda’s PSAs with those in various other countries around the continent, the report finds that only in Angola and,  on some measures, Sudan does the state capture more.

‘Uganda has been successful in securing very favourable terms in its initial PSAs,’ the IMF says.

‘Government take,’ or the amount earned by the government under its PSAs is the sum of the royalties levied on oil, the state’s share of profits made by the companies and corporate taxes.  Under the 1999 model PSA, royalty rates range from 5 to 12.5% and government share of oil profits ranges from 50% to 85%.

Significantly, however, the figures in the actual PSAs are not necessarily as high.  Under the Tullow 2001 contract, the government share of profits maxes out at 65% at 40,000 barrels per day or more.  Income tax is set at only 30%, on the low side for African countries that use PSAs.

The report points out that the governments of Namibia, Ghana, Mozambique, Tanzania, Madagascar, Mauritania, Kenya and others all take away less than Uganda under their PSAs.  However, while these may have been worthwhile comparisons when the report was written in 2008, their validity today is questionable.  In fact, few of the countries the IMF report mentions have any discovered oil.  The others named all have much smaller reserves than Uganda and therefore have never been in a position to demand favourable terms.

Of the few oil producing countries used as comparators, Mauritania and Ghana are fingered as getting a smaller share than Uganda.  However, Mauritania’s oil reserves have been estimated at 300 million barrels on the high side.  Ghana’s have been projected at 2 billion barrels but oil discovery is farther along there than here in Uganda, where exploration has just begun.  Only a third of the licensed land has even been explored in Uganda and some analysts put the amount yet to be discovered at 6 billion barrels. That would put it above Chad on the African continent as an oil producer.  Such a wealth of resources means that the country’s contracts should be compared to the likes of Libya, Equatorial Guinea and Chad.  One cannot merely compare Uganda’s contracts to the worst of the worst and conclude that they are the best.

Missing Out

In accordance with earlier analysis by various groups, the report finds that a major downside of the PSAs for the government of Uganda is that it will loose out on a huge share of profits from rising oil prices. The structure of the contracts leaves that as economic rent for the oil companies.  In fact, ‘the government take, undiscounted, decreases as the oil price increases under the existing fiscal regime.’  In other words when the oil companies are making the most money, the government’s share of their profits actually goes down.

There are several flaws in the PSAs that contribute to this problem.  Under the model, royalty rates are calculated according to the number of barrels produced per day, with rates increasing as the number of barrels produced increases.  Unfortunately, the model assumes that higher profitability is correlated directly with higher production.  If the price of oil doubles but the number of barrels stays the same, the share taken by the government does not change.

Similarly, the model uses number of barrels per day to determine the splitting of oil profits between the government and oil companies.  Increasing levels of production yield increasing shares of profit for the government.  Again, this assumes that the companies profits depends only on the number of barrels produced, failing to take into account the effect of higher prices.

As a result, the government share, of oil revenues tops out at around 75% at about $100 per barrel.  This means that whether oil is selling for $100 or $200 the government will take the same share, leaving the rest of the profits for the companies.  This an especially salient problem given projected oil prices for the coming decades; official US government energy statistics set prices at US$110 per barrel in 2015 and US$130 in 2030. The December 2008 price is around US$ 70 per barrel.

That Uganda’s PSAs fail to take advantage of rising economic rent has been a subject of criticism by other analysts as well.  A 2008 report by the Norwegian Agency for Development Co-operation (NORAD) delivered an unequivocal warning to the government.  The Ugandan government’s model PSA ‘cannot be regarded as being in accordance with the interests of the host country.

The enormous increase in oil prices during the last five years have fully demonstrated the need for production sharing models that adequately protect the interests of the host country by securing the economic rent for the country,’ said NORAD.

Elsewhere countries have started to move towards more progressive fiscal regimes that take into account higher oil prices. Different methods have become prevalent in Russia, the Caucasus and Central Asia, in Africa, and to some extent, in South East Asia, according to the IMF.

In Africa, Cameroon, Mozambique, Angola and Tanzania have all started to employ some form of profit sharing that uses account oil prices to calculate the split between government and industry.  In such countries, governments manage ‘to capture a higher share of returns at higher profitability levels.’

The report highlights one further provision that is particularly advantageous for companies and disadvantageous for the government.  Unlike most countries, Uganda allows companies to claim interest and other financial charges on loans incurred in development as recoverable costs.  Most contracts internationally do not include such clauses.  Calling the provision ‘generous’ to the companies, the IMF recommends getting rid of it.

‘Burden’ on Companies

While taking too little profit from highly profitable projects, the IMF report also suggests that the government takes too much in other cases.  In particular, the fiscal burden on marginal projects is too high, it says, worrying that the unprofitability of such projects will discourage international investment.  The IMF points to high royalty rates and government profit oil shares as responsible for these perceived flaws.  Together they create a ‘heavier fiscal burden’ than companies may be willing to shoulder to invest in Uganda.

Furthermore, the IMF suggests that the limit on recoverable costs that can be claimed in anyone year is too low and recommends raising it from 50% to between 70% and 80% of that year’s revenue.  Limits on the costs that can be claimed ‘put greater pressure for allowing the contractor to recover costs adjusted, in some way, for the time value of money.’  Increasing the limits would allow companies to recover their investments earlier in their projects.

Need for Transparency

Looking at the IMF analysis of Uganda’s contracts with the oil industry reveals a mixed picture of the government’s terms with the oil companies.  While the report paints a positive picture of the deals in comparison to other African nations, that does not necessarily mean that they are the best.  Futhermore, assessment of the PSA terms for highly profitable projects suggests that Uganda could miss out on significant revenues.

Perhaps the most important recommendation from the IMF has nothing to do with numbers or formulas for profit splitting however.  The report points out that the government of Uganda has made a commitment to the Extractive Industries Transparency Initiative in its National Oil and Gas Policy.  Futhermore, it makes its own stance on openness in industry clear; the fund ‘favours publication of mining and petroleum agreements as means to improve transparency and accountability.’  Elsewhere, in its 2007 ‘Guide on Resource Revenue Transparency,’ the fund suggests that openness by government on the payments it receives is the only way for countries to avoid the so-called ‘resource curse.’

While some information on the PSAs has trickled out in the form of third party analysis of the contracts, this report included, the people of Uganda still have not seen the documents in full.  It’s time for the government to make them public so that their effects on the state can be comprehensively accessed.