09 Mar Australia’s Incredible Shrinking LNG Royalty
This week‘s post is from my colleague and friend John Bland, on the topic of taxes and royalties in Queensland‘s emerging LNG export industry.
Oil prices have been on a tumble for several months now. Since contracted LNG is often priced with reference to oil (unlike LNG available on the spot market, which is based on what buyer and seller agree), it means LNG prices are also falling. But what about the taxes that Australian governments collect from the gas sector? Will those taxes be less than planned?
Before digging into the question of oil, gas, taxes and royalties, it is useful to consider in general the taxes that impact on the oil and gas sector in Australia. No prizes for guessing that it is a complex area, but thankfully, there‘s no quiz at the end.
Step 1 – Tax any income
Like every other company in Australia, gas companies have to pay tax on their taxable profits at the rate of 30%. This is a tax levied by the Federal Government.
Tax trivia: did you know that the Federal Government took sole responsibility to levy income taxes in Australia in the 1940‘s? Prior to that the states and the Feds all levied income taxes, so the Australian tax world today is actually much simpler than it could have been.
Step 2 – Tax any excess profits
However gas companies don’t finish their tax obligations with just a corporate income tax. The Federal Government also levies the Petroleum Resource Rent Tax (PRRT), which is designed to tax the ‘rents’ or economic profits associated with gas extraction. Economic profits are the super profits that resources companies sometimes benefit from when commodity prices soar on high levels of demand. Profits for PRRT purposes are calculated on a very different basis compared with how profits are computed for accounting or corporate tax purposes. PRRT is levied at the rate of 40% of these economic profits, with an allowance made for the PRRT paid when calculating normal corporate taxes (See? I told you it was complex).
Until 2012 the PRRT applied only to offshore oil and gas projects, but from 1 July 2012 the regime was changed so that it applied to onshore projects such as the coal seam gas in Queensland. The Feds also decided to apply the PRRT to some projects that were originally excluded, such as the North West Shelf project off WA.
Step 3 – Throw on a royalty
But wait, there’s more. The Australian states retain their taxing powers, and one of these is the ability to charge royalties for natural resources extraction. This is a legacy of Australia’s past as a continent comprised of separate and sovereign colonies. Federation in 1901 divided the revenue raising powers between the new Commonwealth and the States, and not surprisingly there has been a confusing array of charges at different levels of government ever since.
In some countries, such as the US, the private landowner also owns the rights to the resources under the land – think Jed Clampett and the Beverley Hillbillies! In Australia, Canada and probably a few other former British Commonwealth countries, these rights vest in the States, with some indigenous royalties in some cases also payable to traditional owners.
There is also a valid question of whether a resource royalty is a tax at all, as it is a payment to an owner (the relevant State) for the right to extract the resources. For simplicity let’s assume that economically the royalty serves as a tax in that it is a payment to government that impacts on the gas company’s results.
Change it up
State royalties vary across the states and may be different again depending on the nature of the resource, but I would like to look at the royalties charged for gas extraction in Queensland, as the epicentre of Australia’s onshore gas projects. Queensland levies a royalty of 10% of the wellhead value of gas extracted in the State. Sounds simple, but it can be a fiendishly difficult task to identify the notional value of the gas at wellhead (i.e., where gas comes out of the ground) when:
a) there is an integrated processing and supply chain downstream before the gas gets sold, and
b) what does get sold is LNG that has been loaded onto a ship, but what comes out of the ground is coal seam gas (consisting of methane, some water and CO2).
Not only is the resource in a different physical state at the wellhead, it is about 800 kilometres away from the port of export, so there are still lots of costs to be incurred in getting the gas sold that have a bearing on its value (but let‘s save that discussion for another day).
Oops. Did we miscalculate?
As we know, LNG is generally sold based on oil prices, typically applying a percentage of an oil index price such as Japan Customs Cleared (JCC) Crude or Brent Crude. So it should come as no surprise that when the oil price drops, as has happened throughout the second half of 2014, the reduced price works its way up the chain to impact on the wellhead value used for royalty calculations, the economic profits for PRRT and the taxable income for corporate taxes. Triple Whammy. So as well as hitting the gas companies hard, the oil price crash also hits the Feds and the Queensland State government hard.
When the Queensland Treasury released the Mid Year Fiscal and Economic Review in December 2014 we got an idea of what it meant for government revenues. For the 2014-15 year the Treasury had reduced gas royalties projections from $AU199M to $71M. This represents a 65% reduction in projected gas royalty revenue. Remember this is the first year of production and the first gas from Queensland was only shipped in December 2014. If the oil price does not recover, then applying that reduction to the forward estimates for gas royalties would mean Queensland‘s gas royalty revenue projections may need to be reduced by $1.06B up to 30 June 2018.
Federal government expectations on collections of PRRT and corporate taxes from the gas players will also need to be managed. PRRT collections are based on super profits and when the oil price, and therefore the connected LNG price, drops it is the economic profit that is directly reduced, as the fixed returns in the chain remain largely the same. Similarly corporate taxes, is levied on overall taxable income, and reducing revenue means reducing profits.
State and federal budgets relying on #LNG revenue collections to cover spending may need to rethink their forecasting.
The other variable at work in LNG pricing is the foreign exchange rate. Oil, and hence LNG, is typically transacted using US dollars, in common with many resource commodities around the world. So even if the oil price stays down, there could be some upside from any drops in the value of the Australian dollar against the mighty greenback. Certainly this has been happening over the last 6 months with the Aussie dollar now below US80c rather than at or near parity. However the so-called currency wars are continuing with many countries using their exchange rate as an indirect tool for domestic growth.
The excess oil supply and resultant price drop mean challenging times for gas producers, but it doesn’t end there. Governments also have much revenue at risk in this environment. Where it will all lead is, as always, unpredictable.
What to do?
In the same way that market discipline is being imposed with ruthless effectiveness on the oil and gas companies and their suppliers, governments everywhere need to revisit their revenue playbook and realign to our new reality.
Reset the revenue models
These low oil prices could certainly fall further and could stay depressed for some time. Revenue models need to be updated to reflect these new price curves. Spending plans that were linked directly to royalties need to be pulled back. With overall government revenues to be lower than expected, by as much as $1b over the next 3 years in Queensland alone, governments need to modify their spending plans.
Strive for stability
Resist the temptation to rewrite the revenue playbook (the royalty rules, thresholds and rates). Industry places a high value on a stable fiscal environment because it removes future volatility from the business.
Spend to the low side, bank the rest
One of the key lessons from Norway, Alberta and Saudi Arabia is the importance of building a sovereign wealth fund. Those countries most insulated from the pressures of low commodity prices are those that exercise spending restraint when blessed with hydrocarbon riches. When oil prices return, governments would be wise to adjust spending plans to the low end of the commodity price curve and bank the high side for a rainy day (like today!).