Past few weeks has witnessed debate amongst policy makers, economists, and political fraternity alike on justification for levy of windfall tax on oil and gas businesses.
It is important for the legislature to examine various parameters prior to making any hasty decision, since precedents and current situation suggest that it could be a ‘knee-jerk’ reaction.
Whopped economic rationale for levy
The term ‘windfall’ means an exceptional situation, good fortune and is primarily attributable to gains in situation of ‘legacy’. Similarly, windfall tax represents a levy on an unexpectedly large profit, especially one regarded to be excessive or unfairly obtained. The origin of windfall profits tax traces its roots to the United States legislating an excise levy on the production of crude oil.
Introduced in 1980 on increased profits that accrued following the deregulation of US price controls on crude oil, the levy was repealed in 1988. The US government enacted the legislation as part of compromise between the Carter Administration and the Congress over decontrol of crude oil prices.
The levy was imposed on the difference between the market price of crude (referred to as removal price) and a statutory 1979 base price, adjusted quarterly for inflation and state taxes.
Crude is the most important traded commodity and unlike other traded commodities its demand and supply are subject to geo-political vagaries and hence inherently susceptible to a price variation. The added feature being that its availability is not as widely scattered as other natural resources.
One of the unfortunate fall outs for such levy could be the effect of reducing domestic supply of crude below what the supply would have been without the tax. For India, the tax would enhance production cost, possibly reduce domestic production, enhance dependence on imports and the final nail in the coffin, discourage domestic and foreign investment in hydro-carbon production and refining capacity.
Since the repeal in 1988, the US government is debating reimposition of tax and recently, Presidential hopeful Obama has called for windfall taxes on oil. However, with primary season in the US, the political debate can be highly pitched and one need not take this debate at face value. In any case, the windfall tax on petroleum refining goes against the grain of oil economics.
The fact of the matter is that gross refining margins do not necessarily fluctuate in the manner crude prices do. Given the competitive nature of refining business and the fact that there is global shortage of refining capacity (an important factor attributable to high crude and petroleum product prices), improvement of margins is attributable to enhanced productivity and efficiencies.
For India, we are in a decontrolled environment, at least, insofar as marketing of petroleum products is concerned. The government has the ability to juggle with fiscal levies and determine final price of petroleum products to meet the dual objectives of fiscal discipline and political acceptance.
Economics of oil production could go haywire
No policy maker will deny our serious attempts to attract private investment in the hydro-carbon sector. Our production sharing contracts (PSC) – an agreement between the Indian government and oil entrepreneurs provide for inbuilt mechanism to deal with any significant upside in oil prices and/ or oil reserves. Take for instance, the PSCs that India has signed with private and public sector oil companies.
Under the sliding scale formula, the government gets a higher share of profit oil on the basis of investment multiple achieved by the entrepreneur. To illustrate, if the investment multiple is less than 1.5, the government is entitled to 25% and the entrepreneur 75% of petroleum profit. Similarly, as the investment multiple increases to 3.5, the government’s share is enhanced to 50% and the entrepreneur share reduced to 50%.
The investment multiple is expressed by dividing net income by investments. Hence, as crude continues to soar, investment multiple moves up and so does government’s share in profit oil. Hence, the government is extracting its pound of flesh under the current PSC regime. Not to forget, the royalties levied by central and state government under PSC are on ad-valorem basis.
Now, to levy a windfall tax seems unreasonable besides reneging on contractual obligation. All PSC’s besides being placed before both the houses of parliament are ‘grandfathered’, which tends to protect the interest of an entrepreneur from any subsequent levies. Hence, even if such tax is levied, the entrepreneur would pass the cost to the Government by way of reduced profit petroleum (government’s share of profit).
In summary, a combination of reduced profit petroleum and sliding scale formula ensures that the government will collect from the right hand and pay from the left hand.
Oil and gas production in 21st century — a new paradigm
If one witnesses the trend of vertically integrated oil and gas business model, it is noticeable that new investments occur only when oil prices move up.
Further, exploration and production in deep waters, which justify significant scalable investments, has become order of the day. A combination of both factors would mean that the current business model is relatively risky than ever before. The situation in India is not dissimilar, wherein recent rounds of oil concessions suggest more emphasis on deep sea water blocks.
Some notable facts need deeper reflection:
a. India is neither a material oil producer nor Indian companies have gained from rising global prices.
b. We will discourage long term investment and our chances of successful discoveries would be further compromised if fiscal regime is not transparent.
c. If volatile oil prices stabilise in the short term (which seems to be the case), how will we deal with such levies.
To say that the recent rise in crude oil would result in windfall to producers is probably not fair unless India was a net exporter. At best, the rewards could be attributed to high risk assumed by investors.
Why are we ignoring the fact that high crude prices means increased share of government profit oil, higher rate of federal, state and local taxes and royalties.
If commodity price variation is subject to windfall levy, we should consider similar levies for other commodities like iron, steel or gold. This would result in an absurd situation from tax economics perspective.
How are other jurisdictions dealing?
Besides US, wherein the debate hasn’t gathered momentum, UK as a major oil producing nation has history of imposing a supplementary charge of 10% only on the ring fence profits. In the past, UK has attempted windfall tax on very specific businesses and targeted privatised utilities.
The rationale being subsequent deregulation has given rise to windfall profits. Insofar as Canada is concerned, experts believe that it would be political suicide. In the 70’s, an attempt to change energy taxation (but no windfall tax) met with criticism and to wisper in Calgary (Canadian centre for oil and gas) would be viewed as disaster. In May 2008, Venezuela, a major oil exporting nation approved law on special contribution paid by companies exporting or transporting natural or upgraded liquid hydrocarbons.
Indonesia, in turn has not considered any proposal to levy tax. Hence, current global regime even in most oil producing and exporting nations does not favour such levy.
In conclusion, its fair to say that we need to be watchful about potential pitfalls to India and what other energy starved economies are doing. Singling out this industry will further deepen low investor confidence and frustrate investors, as is borne out from recent response by bidders for oil concessions.
The author is a Partner with BMR Advisors. Views expressed herein are personal
