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HANS HENRIK RAMM

Changing the Rules of the Game to Unlock More Value

Offshore Northern Seas Conference 28 August 2002, Stavanger

There is a lot of discussion about creating more value from the NCS, most of it about what we could call "self-improvement". This is important and demanding, but mostly uncontroversial. The intention of this paper is to focus on some of the more controversial aspects.

The Ministry of Petroleum and Energy has presented two future scenarios. The "erosion" scenario ends with an accumulated oil & gas production of approx. 7 bn Sm3 toe by 2050, while the "long range" scenario at that time passes 12 bn, and still growing. Current NPD assessment of total extractable resources has a mean value around 14 bn.

The MPE says we have a choice between the two scenarios, but doesn't specify its nature, except that it requires "an aggressive" policy. It is easy to imagine that a reason for this evasion is that the most important choices are controversial, which means they are even more important, since the implication is that failure to make the right decisions would mean that around half of the resources would remain in the ground forever.

It is therefore of utmost importance to investigate further what these decisions are.

If framework conditions had been aligned with commercial investment requirements, there would have been no need to make choices. With the exception of the postponement of certain exploration areas pending further environmental studies, there are few major regulatory obstacles left. While improvements are still possible, the industry's experience is that the MPE is fairly responsive to regulative reform. It doesn't look like this has much to do with the dramatic choice the MPE is referring to.

What remain are economic incentives. It may be unpleasant for politicians to discuss tax breaks for the assumed affluent petroleum industry, but it can't be ignored that the NCS must be competitive and that companies won't invest unless there is sufficient reward for capital, knowledge and risk.

In particular, we need better incentives to develop new technology and other knowledge required to find and develop the second half of the resource base. These relate to demanding deep-water projects, enhanced recovery, smaller fields, tail-end production and so on. This is clearly stated in the report from OG21, a cross-discipline R&D study group appointed by the MPE.

The report presents us with an even larger upside if we invest in knowledge. In addition to the NCS potential, there are also vast opportunities in technology export and downstream value creation.

In short, it is about making optimal use of the knowledge today embodied in the Norwegian petroleum cluster, and developing it further. Properly managed, this cluster can move on into other energy sectors and even quite new or different industries, creating value even beyond possible resource constraints. It is already a main industrial locomotive for Norway, and represents a demanding customer base that, for one example, the information and communication industry would have problems living without.

The total R&D effort is inadequate, in particular the state's contribution. It is reasonable that the state contributes much more, since it takes the lion's share of the profits anyway. But calling for increased government R&D funding only touches the surface of the problem. We cannot avoid the fact that oil companies and suppliers alike need sufficient post-tax profits to justify the investment and renew both financial and knowledge capital.

Four major trends combine to change the rules of the game.

1) The continuing opening of previously closed host countries increases demand for oil companies' services, and therefore enables these companies to choose projects meeting their full post-tax profit requirements. Even traditionally low-cost onshore producers now require the best efforts of advanced international oil companies to overcome new technological challenges.

2) Modern industrial society is rapidly becoming highly knowledge-intensive. Many markets, and certainly offshore E&P, are not any more governed by economic rules developed by observing supply and demand for generic products. Companies differ strongly on efficiency and can demand company-specific compensation. The differences are related to technology, organisation and other knowledge. This invalidates classic capital value theory and requires the introduction of new parameters like knowledge capital and knowledge returns.

3) The restructuring within the international petroleum industry includes focusing on core competence, outsourcing, and creating worldwide organisations for rapid duplication of leading knowledge. Suppliers are given more responsibility for technology, and value creation takes place in a limited number of local clusters where close ties develop between petroleum companies and suppliers, and knowledge building is enhanced by internal information float.

4) The Norwegian Continental Shelf is entering a mature stage, where new projects cannot be expected to yield much resource rent. Knowledge capital must substitute resource capital to recover remaining resources, by pushing limits for commerciality. Risk/reward relationships change when upside scenarios cover a narrower range. Financial volume is required to justify the effort. A larger diversity of players is required for development of smaller reservoirs, tail-end production etc.


Norway needs to understand these trends, and take appropriate action to meet them. The choices that must be made to unlock remaining value and move beyond the NCS are therefore related to allowing sufficient post-tax returns to cover employment and renewal of knowledge capital, as well as financial capital for all required players, and to ensure that the Norwegian petroleum cluster can defend and improve its position as one of the main international hubs for knowledge building.

The current petroleum tax system has developed through history with main features fairly constant for many years. With the exception of the CO2 tax, it is a company based net profit tax system with a 50% special tax designed to collect resource rent, on top of the 28% company tax. Apart from expenses and depreciation, the only shelter against special tax is an uplift calculated as 5% of investment costs for 6 years. A uniform 6-year depreciation rule is beneficial for large projects with long investment life, but the benefits dwindle with shorter project life and of course become liabilities for investment in use less than 6 years.

To the extent depreciation can be seen as a shelter, all sheltering is therefore dependent on physical investment cost. No allowance is made for employment of knowledge capital.

A major part of the effort to unlock more value is about reducing costs, in particular investment costs. Production facilities become lighter and cheaper. But this doesn't happen by itself. Knowledge capital has been applied.

What happens is therefore that knowledge capital crowds out the investment in fixed assets that is the basis for calculating special tax shelters. Sheltering loses value, and knowledge rent is taxed at 78% at par with resource rent. This is equivalent to an automatic tax increase as the relationship between financial and knowledge capital changes.

Historically, authorities have tried to strike a pragmatic, equitable balance between government take and company profits, notwithstanding system properties. Therefore, we cannot know for sure at what point in time the automatic increase will push returns in general below acceptable limits, but since there has been no fundamental change for many years, it is likely that this line has been passed already.

Over-taxation of new projects will therefore increase, representing a serious and growing obstruction for necessary new technology and value creation from frontier and mature areas alike.

This will, of course, for a time not be evident from companies' total results, since most companies have income from past investment in major resource rent producing fields. It is however clear that Norwegian subsidiaries find it increasingly difficult to justify investment in new E&P activities in Norway to their mother companies, as indicated by the poor interest in the 17th Round.

There is, however, another factor that probably contributes to disguise these effects and postpone warning signals to the authorities: The fact that the supply industry with some exceptions has unacceptably low returns on capital, far below normal returns on financial capital. This means negative returns on knowledge capital.

If this is due in part to underpayment rather than lack of efficiency, it represents a non-sustainable improvement of field economics that postpones visible effects of over-taxation of oil companies.

There are several patterns that do suggest that this is in fact the case:

* The exceptions to the general low-profit picture are mostly suppliers with worldwide organisations that are in a position to choose the best projects.

* Average profitability for offshore suppliers is much lower than for other Norwegian industries, the opposite of what one intuitively would believe about an industry living in proximity to the "rich" petroleum companies

* It is also much lower than for similar non-Norwegian suppliers.

* There is a strong tendency of erosion of Norwegian ownership within the offshore supply industry, contrary to Norwegian industry in general, where cross-border movements of equity capital seem to be fairly balanced.


All of these seem to indicate a lack of ability by home market dependent offshore suppliers to compete or negotiate sufficient rewards from their customers.

It is not hard to identify possible structural causes for this. Operatorships on the NCS are strongly concentrated to the two large Norwegian companies. This creates high dependence and unbalanced negotiating power.

Bidding for EPC contracts normally takes place at a time when scope of work isn't fully known. Change orders often have to be implemented before it is clear who is responsible for the costs, leaving large unassigned costs for later negotiations. In case of legal conflict, oil companies are in a much better position than suppliers to wait for settlement.

The merger between Aker and Kvaerner may redress some of the unbalance, but similar effects could then appear further down the supply chain. New model contracts have been designed or are in the pipeline to correct many of the other problems. Kon-Kraft (the Norwegian parallel to Pilot) is continuing to work on internal cluster cooperation and problem solving. Much depends on the oil companies' will to implement changes.

In general, however, this market is to a large extent characterized by negotiation economy and interdependence. Pricing of contracts is much more complicated than choosing the lowest bidder, since bidders rarely offer the same product, since there are many trade-offs between capex and opex, since actual performance may be more important than bids, and so on. Oil companies and suppliers are also entwined in other relationships such as R&D projects, long-term contracts, venture companies, discussions about ownership to technology etc.

The same interdependence that can enable oil companies to take out short-term price benefits is, however, also the very reason why they should not.

One obvious answer to this problem is that suppliers should internationalise.

For some, this solution is not available, since products and standards often are particular to the NCS.

For most, however, internationalisation is definitely an answer. But it isn't easy. It requires a lot of specialised knowledge and experience. The institution Intsok has the responsibility to assist suppliers in this respect.

But again, we can't avoid looking for more fundamental obstacles. Today, internationalisation requires more than traditional marketing efforts. If you have a leading technology product, you need to sell large volumes over a short time, before it becomes state-of-the-art. This requires access to international marketing organisations.

There has been a lot of attention to suppliers piggy-backing on oil companies to other regions. This has given only limited results, but remains an argument for increasing operator diversity and good framework conditions for internationals.

International market access can also be obtained through cross-border mergers.

This is a vital point, since mergers also often are necessary to renew the knowledge base and retain technological leadership, but only when synergy effects go beyond mere administrative savings, and actually unite relevant knowledge bases into a more advanced whole. This limits the choice of good candidates.

Norwegian-owned companies are, however, handicapped in this restructuring process. The value of Norwegian companies is, according to some studies, as a general trend discounted by 40-50% compared to equally profitable non-Norwegian companies. One of the reasons is assumed to be the thin Norwegian equity capital market. These uneven terms of trade tend to discourage management and owners from taking proper action in time.

In the offshore supply industry, this is made even worse because of poor profitability. The record shows a large number of Norwegian offshore technology companies sold to foreign interests, and very few Norwegian acquisitions.

In many cases, such sales are correct and successful, but it cannot be healthy that an uneven playing field has decisive influence on the outcome, and that Norwegian ownership to technology is systematically eroded. The fact that tradition-rich Kvaerner was only hours away from being sold to Russian capital should alone have been a loud warning signal.

Whether or not international ownership is good for the individual company, eroded Norwegian ownership means that too little of the cash flow from advanced technology sales is recycled back to Norway to be employed for new technology development. It is also likely that many crucial knowledge-carrying functions in the long run will follow ownership out of the country.

This provides evidence for the existence of a "home market trap" that actually also is a "technology and knowledge trap", since it seems to be difficult both to internationalise and to create knowledge synergy effects without giving up local ownership. It is hard to believe that the supply industry part of the Norwegian cluster can function properly for long without a strong engagement of Norwegian capital that also is able to take the industry abroad.

The consequences could be damaging both for customers and society as a whole. There are many reasons why oil companies are better off with a local industry focusing on the particular needs and properties of the NCS, and why the knowledge exchange won't function well without a cluster of competent players in proximity to each other.

More important, Norwegian society as a whole has invested a lot in developing this cluster. It is Norway's most important cluster, and the only industry we have operating in the higher levels of international technology development.

So far, I have shown that there is both analytical and empirical evidence to support two conclusions:

* That oil companies are over-taxed, that over-taxation will increase, and that it is directly discouraging knowledge creation

* That Norwegian suppliers are caught in structural relationships eroding profits and ownership, and hence the knowledge/technology base.


Whether there is a causal relationship between these two points is a more complex discussion. But both demand immediate attention whether they are related in a causal relationship or not.

I think we can agree that the erosion we observe in the supply industry should make authorities rely less on their inclination to postpone tax reform until it is evident that oil companies have lost interest. There are certainly plenty of other early warning signals around. There is an increasing frequency of major oil companies opting out of licensing rounds, and others submitting rather conservative applications. Also, we are far away from that aggressive drive to dig deeper in mature areas that is required to unlock remaining value there.

We should also agree to work for a wide acceptance of the general interdependence within the cluster, and for the need to reward knowledge rent created by all commercial players, and that unreasonably high oil company taxation is hardly fit to create a good climate for this.

Finally, we should observe that diversity among operators, already crucial for creativity, is vital also for the supply industry. This is among the reasons why a Statoil/Hydro merger is a bad idea, and why internationals should be awarded a larger share of the operatorships.

***

I would also like to suggest some guidelines for a petroleum tax reform designed to improve risk reward and provide incentives to develop knowledge and technology for the future, without damaging past investment.



Reducing the special tax is not the solution. This follows already from pure political considerations: All immediate revenue loss would benefit producing fields, when politicians will want to focus their effort on the future. Sheltering future investment will not require any immediate revenue loss at all. If successful it will enhance state revenues in the long run, as more value is created.

More important, a special tax reduction wouldn't solve the real problem, which is that knowledge returns should not be taxed above company tax at all. This is generally accepted for normal rent on financial capital, which is why there is sheltering against special tax already. The rapid emergence of knowledge rent simply means it must be treated the same way.

Knowledge economy is an emerging discipline, currently mostly driven by the need to disclose and verify more about a company's future earnings potential for the market than what is available in traditional financial reporting, to avoid observed problems like increasing advantages for inside traders, underestimation of emerging technology companies and overestimation of companies with good PR departments and high media profile (like Enron).

Some work has also been done on the relationship between knowledge building and fiscal systems, but predominantly with respect to individuals. Most researchers seem to agree that progressive taxation is a strong disincentive. There has been very little attention to company tax, since it is very rare to find progressive company taxation. It should, however, be even more obvious that progressive taxation has the same effect on companies, since knowledge return per definition is return above average.

The Norwegian petroleum tax system is a progressive company tax system, where income above shelters is subject to a special tax to capture resource rent. Our challenge is therefore to separate three kinds of rent. This is particular to host countries with resource-based knowledge industries, using a net income tax system to capture resource rent. There are not too many such countries in addition to Norway - perhaps the UK after recent tax amendments.

While improved theory on separating knowledge rent from resource rent would be highly welcome, and absolutely a subject for Norwegian researchers, it is neither necessary nor possible to wait for new economic science. What we need is an additional shelter against special tax, designed as a reasonably good proxy for knowledge rent.

Without going into details, it is my opinion that the best option is to add an allowance for production from new investment, combined with "grandfathering" of old investment. Production allowance has been used before in the Norwegian petroleum tax system, and is therefore a well-known element. I also believe we can approximate the necessary size of the allowance, such as by using available methods for benchmarking knowledge capital.

With sufficient sheltering, the rest of the system, including rules for depreciation and consolidation, can follow the onshore company tax system. I see this as necessary to unlock remaining value in mature areas, where the activity will look much more like normal industry, for which fiscal and other barriers between onshore and offshore activities are serious obstacles. We should also consider simply declaring mature areas as zones exempt of special tax.

Finally, there is the matter of improving the Norwegian capital market. We need more private Norwegian risk capital for emerging venture companies and for taking more mature companies abroad. The beginning of this story is about finding ways to privatise some of the state's vast savings in an equitable and responsible manner, and certain other fiscal issues. The rest is outside the scope of this paper.

To summarize: The Ministry of Oil and Energy has made it clear that we need to make some serious choices, but it hasn't specified what they really are about. My contribution to this is that we need to analyse and amend both fiscal framework conditions and internal cluster relations, if we want to encourage the technology and knowledge development needed to unlock the value between the MPE's two scenarios, and to move further to the visions of OG21 and beyond.


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This page last updated 17 October, 2010.