Friday, 19 June 2009

Is Ireland "giving away" its resources?

An article in today's Irish Times raises a popular issue in certain Left of centre circles in Ireland.

This revolves generally around the licencing and leasing arrangements for oil and gas exploration in Irish Atlantic waters and more specifically as they related to the Corrib gas field.

The premise, as outlined in the article, by a Left wing activist academic at UCD, is that Ireland, often in contrast to other jurisdictions:

  1. Takes no equity stake in these projects
  2. Will impose no royalties on revenues from commercially exploited discoveries
  3. Applies a lower tax rate to the commercial activities of the exploration and extraction companies
  4. All of the above applied up until the 1980s

Let's consider those one by one and then take in the big picture.

  1. Ireland indeed takes no equity stake in any companies. Neither does it provide any capital to such endeavours, nor does it assume any risk of failure. There are some estimates that approximately €2 billion in exploration and development costs have been expended through failed exploration in the last 30 years in 140 different ventures. Irish tax payers have not had to underwrite any of that.
  2. Ireland does not impose any royalties on oil or gas revenues. Royalties are but taxes, levied on revenues. They make sense and work well when, in an uncertain venture, the potential costs of producing the revenue stream can be quite well estimated in advance. There is only one decent example of a successful energy extraction operation off the Irish Coast. That is in Kinsale, which is off the South coast. There is no other and nothing off the West coast where the Corrib field is located and other exploration is likely. When a company is facing an exploration project and has little idea of how much it might cost to extract any find, a tax on revenues (before any costs are allowed) can make the project appear unfavourable on financial terms - in fact any such company might find that the combined royalties plus development and extraction costs exceed the revenue.
  3. Tax rates on energy extraction leases are levied on a scale that starts at 25% of earnings and increases to 40% as profit margins increase. This makes sense as it circumvents the cost uncertainty issue outlined above, but it also provides an effective "optional" royalty payment. That is, if costs are lower (or indeed if oil/gas prices rise) the tax rate goes up. So this does in fact allow some form of royalty factor, which kicks in if the project achieves an outcome at the more favourable range of potential outcomes.

    Also consider, when looking at that 25-40% corporate tax rate - which will apply to an earnings stream that might not eventuate after €100m of costs - that the rate that applies to any other company in Ireland is 12.5%. Google, Dell, Intel and many other large companies channel massive amounts of revenue through Irish domiciled companies. They pay 12.5% tax on profits (and usually far, far less). This places things in perspective.
  4. The final criticism is that Ireland once had royalties, higher taxes and equity stakes in ventures in the 1970s. Well, yes it did. But also understand that the only other major oil or gas discovery occurred in 1971, at Kinsale Head. Nothing of commercial significance since then.

    Of course the Kinsale find led exploration companies to fancy their own chances of making a viable discovery, culminating
    in 1978 14 exploratory and 8 appraisal and development wells were drilled. Even by the mid 1980s there were 24 exploration licences on issue. But there was no other discovery and interest, understandably, dropped off. Face it, who wants to invest tens of millions of Euros (Punts at the time) in a venture that looks increasingly unlikely to yield anything, but would attract royalties, a 50% tax rate and a dividend payment to an equity partner (who provided no risk capital) in the remote chance that it did? Of course it makes no financial sense and companies went elsewhere. By 1992 there was only 4 exploration licenses on issue.

    It is clear the the risk/reward ratio was far too unfavourable and a major factor in that was the large financial return being demanded by the Irish Government. So there was clear need to reform the system and address that risk/return trade-off.

    Hence the revision of terms and hence the response from the industry that saw those 4 exploration licenses in 1992 rise to 35 in 1997. If you want economic benefits from resources, you need people to go find and develop them, so this was successful. But there was ongoing exploration failure and exploration dwindled again before further reform promoted some more exploration. Among those ventures was the Corrib field.

The final strand of the article is the insinuation that this area of government policy was victim of the well documented political corruption that was occurring at the time. That can be neither confirmed nor disproved at present. It is certainly not outside the realm of possibility. However, we don't need to resort to such theories to justify the more favourable regime in place in Ireland today.

And it bears thinking a little more deeply about the economic nature of exploration of this kind. It is a feature of the uncertainty that surrounds potential future revenue streams (if any) and costs, combined with the sunk nature of a substantial proportion of those costs (i.e. exploration and development costs that would be lost in a failed venture) that allows governments around the world to take a higher or lower share of any realised earnings. At one end of the spectrum, it is almost impossible not to strike oil in Saudi Arabia, it is easy to extract and of a known quality. The Saudi authorities are able to impose very high effect royalties and tax rates in that case (essentially because the exploration and development adds a much smaller proportion of the final economic value). Or, indeed the authorities could retain the risk themselves, knowing that there is a high chance of success and higher certainty of revenue streams and costs.

Similarly for late development Norwegian and British exploration in the North Sea. Once large scale deposits of oil are found and quantified, governments can raise their economic interest without scaring off investors. So it was in the North Sea.

Ireland, unfortunately is at the other end of the scale. Not only is there significant uncertainty, but there is now a very long track record of low success rates. The opposite to the experience in the North Sea decades ago and hence the ability to impose higher effective tax revenues or royalties or equity deals has dwindled also.

Is Ireland being "robbed" of its resources? It wouldn't appear so. Test the theory yourself. Place your brand new 52" LCD High Definition television on the front lawn overnight. See if it is still there in the morning. So it is with natural resources and the people of Ireland aren't exactly beating off "thieves" intent on walking off with an easy prize.

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