You don’t know what you’ve got until its modeled

More contract disclosure will not necessarily result in greater understanding of the economic implications of fiscal terms. The terms only become meaningful when their interactions are understood alongside relevant national tax laws and regulations. So to make real sense of the economic implications, the fiscal terms must be considered under varying scenarios of production, price and costs. In other words, they must be modeled. Economic modeling is currently considered an advanced and esoteric pursuit, but we believe that this can be turned on its head: methodologically sound models starting from a pedagogical viewpoint can actually be the entry point to understanding the economic implications of extractives contracts. And, to put the converse case, the transparency community will not succeed in spreading public understanding of what these contracts mean unless this modeling does take place because in the case of complex extractives projects “you don’t know what you’ve got until its modeled”.

 The norm of contract transparency is gaining ground and more contracts governing extractive sector projects are becoming public – through several channels. Some governments have disclosed contracts as a matter of policy. International lenders, including the International Finance Corporation, are encouraging contract disclosure. Smaller, publicly listed companies have long been required to disclose contracts in the United States and Canada if those contracts could affect their share price. And, of course, sometimes contracts end up in circulation after having been informally disclosed, as is the case with the recent Statoil contract amendment in Tanzania.  Many of these contracts can be found on sites including resourcecontracts.org and the Publish What You Pay site Who has published contracts?

 Increased information in the public domain can only be a good thing. But more information does not necessarily mean more understanding. In fact, there is a risk it can result in more confusion, as Michael Jarvis of the World Bank pointed out in a blog post last year.

 In the petroleum sector, public “model” contracts are commonly available. But what is often missing is not the general structure of the contract but the economic terms. Against this background, and coming from a low base of what we might call “contract literacy”, the first response to publication of contracts has been to focus on royalty rates, income tax rates, and possibly the level of government equity participation.

 But what do such headline terms really tell us by themselves? Not much.

 From Contract Terms to Fiscal Regimes

 First, percentages only count against a “tax base.” If a contract contains a 10% royalty, the real question is: 10% of what?

  • Is it 10% of the final sale price, and is the sale price linked to an existing international benchmark?

  • Does the contract allow sales to affiliated companies where the agreed price might be well below market value? If so, is any formula used to establish an “arms length formula” to calculate a notional market value for tax purposes anyway?

  • Is the royalty assessed on a “net-back” price where deductions for transportation and other fees are deducted before the 10% is assessed?

 It quickly becomes clear the 10% royalty alone does not tell us very much at all.

Second, individual terms are like inert chemical elements. We only understand that “compound” that is the contract as a whole when we put them together and watch how they “react” to each other. Tough terms in one part of the contract can easily be offset by big concessions in another. This means reading the fine print in the main contract as well as the annexes. Take just one example: are royalty payments allowed as a deductible cost against taxable income? Sometimes yes, sometimes no. But the difference matters. When a 10 percent royalty is deductible and the income tax rate is 40 percent, the effective tax rate is considerably lower than the stated 40%. In terms of the sums involved in these contracts, that’s big money, enough to spark a public debate if it were explicit. But if it sits quietly as the impact of one term on another inside an obscure contract it can pass unnoticed.

 Third, most contracts are only the final part of the economic picture. They are built on top of other legislation such as corporate income tax laws and broader foreign investment laws. So the contract’s positioning in this larger body of national laws and regulations must be understood. And it is often not just a question of drawing on current legislation. Contract stabilization clauses can mean the tax law back when the contract was signed is relevant, irrespective of subsequent changes. We therefore also need a timeline of all legislation and regulation in force at all stages in the long lifetime of these projects, as Jack Calder points out in the IMF’s new handbook on fiscal administration of extractives.

So the main contract terms are just a first step. We must also consider, at the very least, the tax base, the interaction of the terms, and the broader skein of regulations and laws. Combined, these three elements represent the overall “fiscal regime” governing a project.

 From Static Analysis to Scenario Modeling

Even then, the real economic implications can only be understood in the context of overall project economics.

Of course, full knowledge is only possible when a project is over and the books are closed. But no one wants to wait for, potentially, decades. Politicians need policy options. Publics need answers. The solution is to model a range of future hypotheticals in terms of production, price and project costs.

This inevitably means speculating. In fact, once contracts have been disclosed and the broader tax analysis has been completed, the fiscal terms are the most stable part of any model. Other inputs include estimates of the overall resource base, year-by-year production, future prices, and expenses including exploration, development, and operating costs.

As many of these inputs are often based on educated guesses, economic modeling does not provide a very reliable way of projecting future revenues. But modeling a broad range of scenarios does provide a good sense of how a fiscal regime will work in whatever future scenario ultimately unfolds.

Modeling as an Essential Component of Sector Good Governance

Economic models are in widespread use in behind-the-scenes decision-making by companies and governments. All too often, governments rely on the company’s model during a contract negotiation. Curiously, economic models are not yet part of the extractive sector transparency agenda. In part, this is because the models themselves are almost never publicly accessible. But we suspect that it is also because economic modeling based on elaborate spreadsheets is seen as technical and esoteric – beyond the reach of many of those interested in better management of the extractive sector.

We want to change this. In our next post, we will review the common uses for project economic modeling in the extractive sector as well as some of the private and public organizations that build models. In the current environment, the characterization of models as highly technical and esoteric certainly rings true. These models are forbidding rather than user friendly.

It is easy to build models that are intelligible only to a very few technical experts. But we contend that this complexity is not inherent to modeling. Rather it is because, not surprisingly, existing models have been built by economists for economists.

There’s no doubt that it is easy to get lost when you combine 100+ page contracts with a model spread across multiple sheets in an Excel file. But if we make pedagogy a leading requirement in model design, it should be possible for models to be the best way to see the forest of extractive economics rather than just lots of trees.

Modeling needs to be mainstreamed. Currently, fiscal regime analysis is the precursor to building project models. We want to test the opposite hypothesis:  that models can empower, and provide the best entry point to understand the economic implications of contract terms that are increasingly in the public domain but not often well understood.

In fact, we suggest there really is no alternative. Because when it comes to understanding the economic implications of extractive sector contracts, “you don’t know what you’ve got until its modeled.”

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