Are accountants the most important people in Big Oil?

It’s always been a mystery to me why cost recovery, the process by which oil companies claim back billions of dollars in expenses from the governments of countries where they operate, is not formally part of EITI requirements. If EITI is supposed to capture all ‘material’ revenue flows between the companies and governments, why would it include a signature bonus of $50 million paid by a company to a government, and ignore cost recovery of $500 million allocated back to the company by the same government?

And when you run the numbers, it becomes clear that two major trends in the oil industry in the past 20 years have significantly increased, not decreased, the importance of cost recovery in understanding the financial relationship between IOCs and governments around the world. They are, first, the sharply increased capital requirements of exploration and development – up by 600% in the past 12 years according to the IEA – and second, an increase in assertiveness on the part of governments in the terms of production sharing agreements, which is squeezing the formal ‘profit oil’ part of revenues generated. Oh, and you can throw in Brent stabilising at around $100 a barrel for the past few years – the phenomenal rise in absolute sums changing hands in the marketplace.

Put all those together and the premium on clever accounting has risen massively. Under the EPSA IV agreements in Libya, for example, a company could easily double its effective rate of return by inflating costs by just five percent of gross revenues (I’m not claiming, by the way, that anyone has. I’m just saying).

The principle of cost recovery seems simple enough. Because an oil company has to invest so much to explore and develop oil fields, it needs to get those costs reimbursed before we even get to negotiating a share of profits. The problem is that it’s the profit share that grabs all the headlines. Libya’s latest contract round establishes 92 percent of profits for the government and just eight percent for the companies. Iraq’s service agreements even abolish a profit split for the companies, giving them only a fee per barrel.

After. After costs have been covered.

Costs that reach billions of dollars and which are theoretically 100 percent reimbursable to the company.

Before. Before any profit split.

Contracts establish a hierarchy of revenue flows out of the huge amounts of petrodollars created by scaled oil production and cost recovery for the companies is right up there at the top, just after any royalty systems put in place by the government, and way before profit splits and taxes.

Cost recovery is perhaps the single biggest difference between accounting techniques used around the extractive industries, and business in general. These approved costs are not tax deductible as they would be, for example, for a company making office furniture or running a chain of restaurants. They come before profit, and therefore tax, has even been calculated, and are often much bigger than the profits themselves.

Occasionally disputes over ‘gold plating’, or artificial inflation of costs by companies, surface in media reports – recently in Indonesia and Iraq, for example.

But it’s not until you play with the numbers that the scale of the issue becomes apparent – and the trend towards its increasing importance.

The original model of the Production Sharing Agreements (PSAs) now used widely around the world was first used in Indonesia in the 1960s. These were designed to produce a government-company split of 85/15 – of ‘profit oil’, sales from oil left over after costs of the companies in developing the fields have been reimbursed. Now contracts differ in their terms for cost recovery. Some, including some versions of the Indonesian contract, have capped categories of costs such as “G&A”, General and Administration, things like office space back home and general overheads. Many cap the amount of costs that can be recovered in any given year as a percentage of the value of total production, though they then allow the remainder of those costs to be carried forward to the next year. Again, the principle here is clear and reasonable – the vast majority of huge capital costs are sunk early in the lifetime of a field and companies press to have those costs covered as soon as possible – in the first few years of what might be a generation-long project. But typically such a cap might be 40 percent of gross revenues – the money made by selling all that oil on the market.

So what would happen if a company could ‘goldplate’ costs which were actually 35 percent of gross revenues, say, up to 40 percent? This could be directly fraudulent activity – charging items procured at above their real market price, especially if those transactions were happening between two companies that shares significant cross-ownership (what is known as transfer pricing). But it wouldn’t need to be. It could also very well be – and this might be more pervasive – submitting genuine costs the company incurs at their real rates, but which were not really directly attributable to this project. Otherwise known as living it up. There are many, many grey areas here. How much of the office space in London or Houston was really used for that project in Nigeria? Did that executive really need to travel first class everywhere and shouldn’t he, or at least the company, have paid, in fact, for his sports club membership, the training course for his general professional development, his children to go to private schools?

The ‘take’ is calculated out of profit oil – the money left over after costs have been recovered. But if some more take is concealed within those recovered costs themselves, the numbers start to change fast. In the Indonesian case, a padding of five percent of gross revenues would boost the effective take from 15% of revenues to 23% – an increase in the company’s real rate of return of 53% in fact (23 / 15).

But those figures climb more quickly and steeply to the extent that the split of ‘profit oil’ has been squeezed down in negotiations, as it has been in recent years. And politics play here. Governments need to show dominance over the international oil companies to their domestic constituencies to prove that they’ve move on from the days of the Seven Sisters and Big Oil dominance. Profit split is what is easy to understand and draws all the attention, so driving the company take down is the easiest way to act tough for the home crowd.

So in Libya, with a 92/8 split on profit oil, the same increase in recovered costs of another five percent could more than double the effective take of the company. Even a single percent of increased – gold-plated – cost recovery in terms of gross revenues would equal another 20% on the company’s actual profit margin. Even if it is indirect – levels of staff compensation paid for out of a specific project which add to their general productivity for the company as a whole, an overstated share of actually incurred overheads – global market trends are increasing the incentive to load it all into cost recovery.

To the extent that EITI and other initiatives promote the norm of transparency without actually delving into this area, they also may risk triggering the ‘Bubble Effect’ well known in the counter-narcotics world. Increase surveillance in one country, or one stage in the value chain, or even in this case, one fairly specific interpretation of one stage in the value chain, and you may just squeeze real revenue flows up and down the hierarchy of costs where they will sit undisturbed precisely because public scrutiny is now seen to be honoured.

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