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Is Malaysia’s Rigid Fiscal Regime the Best Recipe for Petronas’ Success?

Daniel Johnston, in his book International Petroleum Fiscal Systems and Production Sharing Contracts dubbed Malaysia as having “one of the toughest fiscal systems in South East Asia” after an extensive research covering 148 oil and gas-producing nations and their respective petroleum taxation systems.

In simpler language, he means that we have the toughest regulations to ensure we get the most from foreign oil and gas operators harvesting petroleum from Malaysian territories.

If this is the case, why are foreign operators like Shell and Exxon still able to find it profitable and attractive to come and develop oil in Malaysia?

Furthermore, national oil and gas corporation Petronas is ranked as one of Fortune’s Global 500 largest and most profitable corporations in the world.  Why do neighboring PTT of Thailand, Pertamina of Indonesia, and PetroVietnam not compare in size and stature albeit having significant oil reserves too?  This brings us to the discussion of Petroleum Fiscal Systems.  Simply having oil and gas reserves alone does not necessarily guarantee success.  What is the role of a robust complementary fiscal system in this success?

How We Started

Bear with me and a bit of history.  Many would have thought that we have been producing oil and gas only since Petronas was founded back in 1974.  This was not the case.  Just like tin and other minerals, our British colonial masters have been plundering our petroleum wealth prior to independence.  Royal Dutch Shell began oil exploration from the coasts of Miri in 1910, and together with Esso, built our first refineries in 1914.  By 1921, we had our very first Esso pump station in Kuala Lumpur.

Post independence, we inherited and continued to use the same concessionary system, awarding further concessions to Shell and Esso for exploring oil and gas off of Malaysian waters.  Under this system, an oil and gas operator is awarded absolute rights over a particular acreage, including the potential reserves that it contains.  Although 100 percent of the developments costs incurred were to be borne by the operator, they have absolute liberty over procurement, contracting and technological decisions, while the local host government has absolutely no say other than a bit of environmental and safety regulations here and there.

The concept works quite similarly to how our highway concessions work.  In exchange for this right, the operator is required to pay royalties and taxes to the government.  The United States, along with 58 other countries in the world, are still using the same concept to this date.

The Introduction of the Petroleum Contracts: Production Sharing Contracts (PSCs)

Tun Abdul Razak and Tengku Razaleigh Hamzah as the founding fathers of Petronas had another vision.   They hoped that Malaysia would not end up like just another rich Arab state purely dependent on its petroleum reserves though lacking on knowledge, technology and competitive edge.  They envisioned a Malaysia that nurtured globally competitive petroleum experts. Is this possible to achieve if we continue to leave the A-to-Z of oil and gas production to foreign experts via the concessionary system, without learning anything from it?

First in use by Indonesia in 1966, it was only 10 years later that we emulated our neighbour and introduced our first PSC replacing the concessionary system.  A PSC essentially embodies the Napoleonic Economy of France, which champions the idealism that mineral wealth should not be owned by few individuals, but rather by the state for the benefits of all citizens.  This became the stepping stone to Malaysia’s own version of PSC, propelling Petronas to the heights it is at today.

The PSC entails a percentage profit share, on top of taxes and royalties, to the local host government, in this case Malaysia, via Petronas.  Its core difference with a concession is that sovereignty over the reserves is still maintained by the host country.

A PSC comes with a cost recovery clause, where the operators can claim its development costs from Petronas.  However, this is capped between 30 and 70 percent of their gross revenue depending on contracts.  Unlike the concession system, we now share the cost burden and get to participate in the oil and gas development of our nation.  A PSC also covers for price hikes! A base price is stipulated at the signing.  In the event of a price hike, the PSC will ensure that the operator only enjoys a small percentage share of the increased profits, while a big portion of the hike goes to Petronas.

Via the PSC, Petronas is able to perform a two-pronged regulatory role.

From the procurement and contracting perspective, the Group Supply Chain Management (GSCM) oversees contract awarding practices where operators are required to award projects only to local companies with Petronas licenses.  The pure intention is for the CAPEX spent to flow into the local value chain as much as possible, containing the activities and value-add within the Malaysian oil and gas industry.  This ensures local companies have the opportunity to grow and develop alongside foreign operators, and thus emerge as globally competitive players themselves.  Unfortunately, this is also how Ali Babas existed and mushroomed.

Governance wise, the Petroleum Management Unit (PMU) is responsible to regulate oil and gas operations.  PMU supervises the legitimacy of cost recovery claims by operators.  It rides on this regulator experience to also audit and learn from various technology and knowledge transfers.  They use the opportunity to allow the skill sets and expertise to permeate through within local industry players for the benefit of the nation.

Credit is most due to PSC when we saw the birth of our very own operator; Petronas Carigali in 1976, a wholly-owned subsidiary of Petronas.  Carigali has experienced marvelous success, benefitting from the said knowledge transfer via joint ventures with foreign operators.  To date, Carigali has even gone solo in various geographical locations in the world.  Local capable talents have also been able to grow and successfully nurtured into reputable oil and gas service providers.  If we were to still use the concession system, would we have the Petronas that we have today?

From PSCs to Risk Service Contracts (RSCs)

Fast tracking to 2012, we find that remaining untapped Malaysian oil and gas reserves dwindling.  A significant proportion of our remaining resources are estimated to yield less than 30 million barrels of recoverable oil.  Profits would be lower as almost the same expensive offshore facilities are needed, but the revenues are lower given the smaller reserves.

Foreign operators are no longer racing to bid for these fields, as risk of non discovery is too high, in which case the prevailing PSC system will not allow them to recover any of the costs.  There are a total of 23 marginal oil fields identified to be developed and an attractive alternative to PSC is needed to entice oil and gas operators.  That saw the introduction of the RSC which specifies upfront an Internal Rate of Return (IRR).  Profit for operators is capped between 11 and 20 percent, in contrast with the empirical average of 10 to 15 percent usually found under the PSC.  Not only that, if the production fail to meet the target, Petronas will still reimburse the cost, hence the “risk is serviced”.

Under the newly proposed RSC for marginal fields in Malaysia, fiscal tax has also been reduced to 25 percent from the 38 percent under the PSC.  Judging from the previous two RSC awards; the spirit behind the RSC is for joint venturing between foreign operators and local players, promoting technology transfer and operatorship exposure amongst local players.  This is the case with the Berantai Field, involving Petrofac-Sapura Kencana, and the Balai Cluster Field involving Roc Oil-Dialog and Carigali.

Via RSC, we may be settling for less profit but the overbearing aim is to attract foreign operators and their expertise to these marginal fields in the first place.  What is important to note is the non-financial benefit that the RSC offers, which enables operatorship experience between foreign and local oil and gas players, in the hope of creating more homegrown oil and gas operators like Petronas Carigali.

If all goes well, will we perhaps see the likes of SapuraKencana, MMHE, Dialog and UZMA Engineering develop into global oil and gas operators, alongside Petronas in Fortune’s 500?

Food for Thought

Malaysia’s own brand of PSC has been pivotal in propelling Petronas to where it is today. Not only did it provide conducive grounds for the national petroleum company to learn and grow, it also allowed Petronas to build substantial cash reserves to acquire foreign oil blocks and begin venturing overseas. Like Exxon Mobil and Shell, Petronas can be considered to have enjoyed “first mover advantage”, entering relatively under-developed markets like Kazakhstan, Sudan and Iraq. Today, more than 40 percent of its revenues come from these international operations.

In oil and gas, even more than other industries, cash and technology are keys to success. The likes of Exxon and Shell are able to continuously sustain their respective competitive advantages through vast investments in cutting-edge research.  Always at the technological forefront, they are able to offer incomparable propositions to foreign governments to meet the most technologically challenging oil fields globally. Can our Fortune-500 star sustain its current success streak, when similar challenging yet rewarding opportunities knock on our doors? Where will we be left, when these under-developed markets themselves caught up and closed the expertise gap? This remains for us to see.

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