Thursday, July 10, 2008

Recent fears around decreasing levels of natural oil reserves in the United States have resulted in crude oil prices rocketing to their highest ever recorded levels. In the face of these fears, the South African government seems to be disincentivising investment in the offshore oil and gas industry through some less than favourable terms in the fourth draft Petroleum Resources Royalty Bill. This Bill was published on 3 June 2008 and is open for technical comments until 11 June 2008. It appears that this final draft could have serious and detrimental consequences on the industry.

Prior to the commencement of the Mineral Petroleum Resources Development Act (the “MPRDA”) South African offshore oil and gas exploration and production was governed by the so-called OP26 agreements.  The great advantage of these agreements was that they contained various provisions which facilitated legal, financial, customs and economic stability, including fixed royalty rates.

In May 2004 the OP26 regime was replaced by the MPRDA, which gave the holders of the OP26 rights until 30 June 2007 to apply for conversion of their rights.  If they failed to do so, these rights ceased to exist. These converted rights would be subject to the provisions of the MPRDA and the OP26 agreements would no longer apply. Although all eight OP26 right holders applied timeously for the conversion of their rights, only PetroSA was successful and could reach an agreement with government regarding the terms and conditions of the exploration and production rights applied for.  PetroSA is the state’s national oil company.  The remainder of the holders are from the private sector, with only one being a South African company.

During the drafting stages of the Royalty Bill, the industry raised concerns in relation to negative effects that the Bill may have on their investments and operations.

The primary concern raised by the industry was that the Bill moved away from fixed royalty rates towards formula based royalty rates. It is commonly accepted that fixed royalty rates promote financial certainty and as a consequence attract investors. As such, the Industry proposed that royalty rates be fixed between 1,5% and 3% as contemplated in the second draft Bill as well as in the OP26 agreements.  Despite these concerns the fourth draft Bill has continued to use the formula, with some minor changes. On the one hand, these changes favour the industry since they ensure lower royalty rates during times of low levels of profitability and higher rates during times of higher profitability.  On the other hand, the maximum royalty rate specified in the fourth draft Bill is 5%, approximately 1 to 2% higher than the royalty rate stipulated in the OP26 agreements.  Even though the revised formula is an improvement on the previous draft Bill, the overall royalty rates might be higher than before. It is at this stage unclear whether the Industry will be able to absorb these higher costs.

The legal, financial, operational, customs and economic guarantees made by government under the OP26 regime are not honoured in the fourth draft Bill. National Treasury incorrectly stated in the submission to the Portfolio Committee of Finance on 13 May 2008 that “[m]ost of the provisions of the OP26 agreements have now been incorporated into the tenth schedule [of the Income Tax Act]”.  The tenth schedule is limited to tax related matters only, and provides the Minister of Finance with discretion to enter into an agreement guaranteeing that the provisions of schedule 10 will remain in force for the duration of a participating company’s rights. The Minister of Finance has already entered into two of these agreements and the Industry anticipate that he will continue to do so but he is under no obligation to do so.
Similarly, the fourth draft Bill seems to provide for fiscal stability in relation to royalties. It allows the Minister of Finance to enter into an agreement with a right holder guaranteeing that the formula in section 4 of the Bill will not vary for the duration of the right. One should not be mislead by this section however since it does not provide for fixed royalty rates but only for a fixed formula. Royalty rates may still vary in terms of the formula.
 In conclusion, it seems that few of the comments by the industry were considered favourably.  With all the negative impacts of the draft bill in mind, it will be interesting to see whether the remainder of the OP26 right holders will pursue their negotiations with government regarding the terms and conditions of the rights they applied for and whether this final draft of the Bill have the desired effect or negate any further exploration and production operations.

Lizel Oberholzer is a senior associate at Bowman Gilfillan