Investment Allocation with Capital Constraints. Comparison of Fiscal Regimes.

• Author: Osmundsen, Petter

1. INTRODUCTION

   The article addresses capital rationing in the petroleum sector, i.e., the fact that oil companies limit or cut their investment budgets. Our definition is that a company rations capital when profitable projects, measured at the company's cost of capital, are not sanctioned. An equivalent formulation is that the oil company sets a required break-even price that is lower than its expected oil price.

   There is always some extent of capital rationing in the oil industry. The rationing was reinforced in 2014 and still in effect, due to a drastic reduction in the cash flow of the oil companies, following a steep decline in the oil price and high cost as a result of an unprecedented long boom period.

   Capital rationing has large effects of the petroleum industry and society at large. Our focus will be on effects on tax design. When designing a petroleum taxation system, resource governments make assumptions on oil companies' investment behaviour. To obtain the best outcome in terms of government revenue and production, the assumption on behaviour must be adequate. One might think that tax competition is less relevant to the petroleum industry, since the oil and gas resources are by nature immobile and often subject to government regulation and taxation. However, successful exploration, development and production of oil and natural gas depends on crucial inputs from competent oil companies and oil service companies. These are typically international companies and highly mobile.

   Obviously, it is also important to know details on capital rationing for suppliers to the oil industry and for oil consumers. To estimate future demand from the oil companies, suppliers need to understand the actual investment process in the oil companies. The same applies to oil consumers, oil investments have a large effect on oil prices, though with a considerable time lag in offshore projects due to project execution time.

   Resource extraction countries compete to attract the best or the most adequate oil companies, i.e., there is tax competition. The general tax competition literature assumes that the aim of company investment decisions at all points in time is simply to realise every project with a positive after-tax net present value (NPV), unless they are mutually exclusive. See, e.g., Olsen and Osmundsen (2011), Kind et al. (2005), and Haufler and Wooton (1999). However, tax competition is often exacerbated by capital rationing. Countries then struggle to attract investment from limited company investment budgets. The assumption made in the current literature precludes a vital element in tax competition. Capital rationing amplifies the intensity of tax competition. In addition, the capital rationing metrics applied by multinational companies alter the nature of the localisation game.

   Petroleum taxation literature has a broader perspective than the general tax competition literature, see Daniel et al. (2015) and Glomsrod and Osmundsen (2005) for a particular focus on politically stable states. The objective of resource governments is often broader, not only including tax revenue but also concerns of security of supply, see Nakhle (2007). Oil companies consider taxation in their localisation decisions, but also the size of the remaining resource base (Sassoon, 2003). Kemp (1992) undertakes a comparative study of the petroleum fiscal systems in the UK, Norway, Denmark and the Netherlands. Nakhle (2008) evaluates different types of petroleum tax systems and evaluates how different tax systems might have worked out over time, had they been left unchanged, how they affect different field sizes and what impact different crude oil price levels have had. Osmundsen et al. (2015) discuss optimal tax design and oil companies' treatment of tax depreciation in NPV analysis. Kemp (1994) analyses petroleum tax systems designed to cope with lower oil prices. Helliwell et al. (1982) analyse taxation of oil and gas revenues in Canada, the U.S., the UK and Norway.

   The challenge of optimal tax design when companies ration capital is of relevance in many industries. We apply a case from the petroleum sector, where a volatile oil price imposes dramatic capital rationing at times. According to Wood Mackenzie Ltd, (1) because of the slump in prices, the oil and gas industry will cut USD 1 trillion from 2015 to 2020 from planned spending on exploration and development. Worldwide investment in the development of oil and gas reserves will be cut by 22 per cent, or USD 740 billion. A further USD 300 billion will be eliminated from exploration spending over the same period. Oil companies may ration capital even when the oil price is rising, since they know from experience that overly rapid growth leads to lower quality, inadequate project management and cost overruns (Osmundsen et al (2006)).

   Several reasons may prompt companies to delay or refrain from investing in projects with a positive NPV. In the situation of oil price reductions, oil companies have cut investment budgets in response to a dramatic reduction in cash flow owing to an oil price reduction which reached 70 per cent at the most. Since companies prefer to fund a considerable part of new investment from their cash flow, they therefore cut capital spending. They are reluctant to cut back on dividends promised to shareholders and are careful not to increase debt levels due to credit rating concerns and fear of financial stress. Another main reason for refusing to sanction projects with positive NPVs, which does not relate to the market or to any financial position the company might occupy, is the organisational aspect of using resources other than financial ones in an optimal way. In other words, the decision may be linked to capacity constraints with regard to experienced project personnel and managers. Given continued low prices and great uncertainty about the future level of oil prices, this tightening of investment requirements may be the only way to avoid large losses. It is also a signal to the organisation that it needs to find new technical solutions which may reduce costs and make projects more robust at lower price levels. Large nonlinearity from possible losses probably exists, and is perceived much greater than losses from not sanctioning projects with positive NPVs based on very uncertain expected prices. This may make it appropriate for companies to delay or refrain from sanctioning projects with positive NPVs.

   Several studies compare different upstream petroleum fiscal systems, but without accounting for capital rationing-e.g., Blake and Roberts (2006). Not much can be found in the academic literature on capital rationing. Instead, it largely addresses the evaluation of investment projects involving both uncertainty and flexibility (see, e.g., Bjerksund and Ekern, 1990). The focus here is on an investment opportunity where the deferrable investment decision may be made contingent on future information emerging about the risky output price. Decision criteria take the form of adjusted breakeven prices (BEPs). The real option approach is relevant in the current situation, where an increase in oil price volatility may call for investment deferral. The Norwegian-based oil company AkerBP in 2016 announced that new projects must satisfy a BEP of USD 35 per barrel (/bbl), while most analysts estimate a real oil price of USD 60/bbl or higher. A large difference in project value exists between an expected price scenario of USD 60 per barrel and the AkerBP sanction criterion of a BEP below USD 35/bbl. Where projects with a positive NPV at the expected price of USD 60/bbl are concerned, the option value of waiting (based on common oil price models) would normally only justify a minor part of this project value difference. The remainder represents capital rationing. Although deviations of this magnitude are not unheard of in the real options literature, see, e.g., section 6.2.B in Dixit and Pindyck (1994), this theory does not, according to our reference group, play a vital part in decisions on offshore petroleum projects. The dramatic fall in oil prices has prompted the oil companies to impose strict capital constraints, with cancellations and delayed project decisions as the result. In Norway, for example, Statoil as operator for the Snorre Extension and Johan Castberg oil projects in 2016 again postponed a green light on the grounds that it needs to undertake additional optimisation and evaluation.

   Oil companies are required to report their future price assumptions in their annual account. Combined with their statements on BEP requirements, we get an indication of capital rationing at the company level. BP indicates on pg. 130 in their annual report (2) a long-term oil price level of USD 75/bbl, and has communicated a BEP requirement of USD 35-40/bbl. (3) On pg. 150 in Statoil's annual report (4) we learn that it expects a long-term oil price in the range USD 75-80 per barrel. By 2016 the company had cut its investment by 50 %. On its Capital Market Day in June 2015, Statoil made particular mention of the need for projects to have a positive NPV at USD 50 per barrel, and reported this year that it has lowered the break-even price for five projects starting up in the next five years to an average of USD 27/bbl. (5) ENI reports a USD 7 billion divestment target in the period 2016 to 2019 and has cut the breakeven oil price to USD 27. (6) Chevron has cut investments by USD 5 billion since 2014 and is planning to make even deeper cuts. (7) The priority is to cover its dividend payments from free cash flow.

   For a discussion of current issues pertaining to petroleum investment projects in the absence of capital constraints, see Osmundsen et al (2015). The investment decision when some constraint exists becomes rather more complicated than accepting all projects with an NPV greater than zero (Ingersoll and Ross, 1992). Myers (1974) showed that the weighted average cost of...