[ 2014-12-10 ]

The oil price crush and oil frontiers: The stakes and the escape strategy for Ghana
The black gold is under severe pressure which has
been blamed on several factors including
increasing US domestic oil production, increasing
shale production, Saudi’s strategy to maintain
its market share, and low demand for oil in the
Euro Zone and Asia. Oil prices have crushed as a
result, reported at a five year low of US$66 per
barrel of Brent Crude Oil and $65 per barrel of
WTI.

The effects of the crush have been two folds.
First, it has put pressure on the budgets of oil
producing countries compelling them to cut
spending and reviewing benchmark oil prices.
Second, it has put pressure on the investments of
oil companies forcing increased discussions for
mergers, acquisitions and slushing of planned
exploration spending. These effects have greater
implications for the oil and gas industry in
particular, as well as for the whole world.
Frontier countries such as Ghana that have built
higher expectations of the promise of oil are not
spared. Particularly, some of the oil frontiers
are developing new petroleum laws and are divided
between the objectives of maximizing revenues or
attracting investments. The oil crush therefore
provides important lessons for these countries to
appreciate the current and future implications of
their policies and to be able to address them.

Ghana and the Oil Price Crush

Ghana’s parliament is about to consider a new
Petroleum Bill to repeal the old PNDC Law 84,
which has governed the oil and gas sector since
1984. The Bill seeks to increase the fiscal rates
as well as introduce new fiscal terms. For
example, the Bill increases carried participating
interest from the current contractual 10% on
exploration and development to a minimum of 15%.
The new terms introduced in the Bill are capital
gain tax and bonuses.

There is no doubt that with proven commercial
reserves and commencement of commercial
production, Ghana’s risk profile has reduced
significantly and should position the country to
demand more for its oil and gas resources.
However, given that more than 70% of Ghana’s
hydrocarbon basins remain unlicensed, one wonders
whether Ghana’s strategy to generate more
revenues from the few exploration areas in future
is unlikely to adversely affect its objective of
attracting investments upstream. The oil crush
therefore provides space for Ghana and other oil
frontiers to reconsider their strategies in a way
that balances their revenue capture objectives
with investment objectives.

Oil prices affect oil investments in many ways

Project economics based on the Net Present Value
of future revenues is an important benchmark
deriving investment decisions. Kosmos Energy for
instance estimated its revenues for the Ghana
Jubilee Project based on the 12-month un-weighted
arithmetic average of the first-day-of-the-month
price for the preceding twelve months, adjusted
for anticipated market premium. With actual prices
falling three years after the estimation, current
revenues are already adversely affected. Therefore
in spite that Kosmos recorded a net income of $137
million in the third quarter of 2014, this was
much lower than the $215 million recorded same
time in 2013. One of the major reasons for the
decline in revenues is the decline in the
company’s realized price from $112.52 in the
third quarter of 2013 to $95.26 same time in 2014.
Oil prices are now below $70 per barrel, and the
effect could be more serious by end of the year.

Also, oil companies suffer from asset valuation
for the purpose of borrowing to finance
investments. The oil crush no doubt has negatively
impacted on oil companies to the extent that some
are writing down the carrying value of their
assets. This further reduces their bank-borrowing
base as price assumptions regarding future oil
revenues change, undermining their ability to
repay their debts. They lose their negotiation
strength as well. The overall effect of the crush
if extended over a longer period could reduce
upstream investments greatly.

Already, Tullow Oil is going through many
challenges although they may all not be attributed
to the current oil price crush. Tullow oil shares
have been reported to have lost by 43% since the
start of the year due to lack of big exploration
success and its failure to secure a deal to sell
down part of its stake in the Ghana TEN project.
Tullow’s market capitalization has therefore
fallen from more than £11bn in 2011 to £4.4bn,
prompting speculations of a possible take over by
some of the big companies. In July 2014, Tullow
reported a net loss for the first half of the year
after writing off more than $400m in exploration
costs. It is also reported to be planning a cut in
its 2015 spending from between $800 million to $1
billion annually over the past two years to $300
million due to worsening market conditions largely
attributed to the oil crush.

Will the Ghana TEN project suffer?

The Jubilee fields continue to produce quality
crude oil increasing marginally annually. Ghana
and its partners are however very hopeful of
increasing production when the TEN project is
completed by 2016. But all may not be well as
project economics begin to realign to market
conditions.

It has been reported that TEN project economics
was based on an oil price of $80 per barrel. With
oil prices below $70 per barrel, industry watchers
are skeptical about the schedule of the TEN
project. Tullow Oil has assured that it would
apply a greater share of its capital in 2015 to
its core oil projects in West Africa including the
Ghana TEN project estimated to cost the project
partners $4.9 billion and expected on-stream in
2016.

However, this is at the expense of other projects
in other countries. Tullow Oil has operations in
Kenya, Uganda and Mauritania. It is not clear yet
however, what the strategy of its partners in the
project will be as uncertainty about market
conditions continues.

It is still good news that the Operator of the
project, Tullow Oil and GNPC consider the project
a high priority for them given that they both need
higher production levels to meet financial
commitments in other projects. Tullow for instance
has largely funded some of its Africa’s
operations with revenues from Jubilee, whilst GNPC
has outlined ambitious investment projects to
position itself as a major player in the industry.
However depending on how long the oil crush holds,
circumstances may warrant a review of plans by the
partners.

Ghana Government Revenues Falling

The oil crush increases the economic cost of the
financial budgets of producing countries. The
effects on the budget however differ by country.
The Table below shows break-even oil prices
required to balance the budgets of some producing
countries.

Table 1: Break-even price for balancing the Budget
of Selected Oil Producers

Producer

Oil price to balance Budget

Kuwait, Qatar and the United Arab Emirates

$90 per barrel

Iran

$136 per barrel

Venezuela and Nigeria

$120 per barrel

Russia

$101 Per barrel

Although the Government of Ghana has already
estimated down its 2015 oil price to $93 per
barrel from a realized price of $107 per barrel in
2014, the effect of the price crush may not affect
Ghana much. Unlike the countries referenced above,
Ghana does not heavily depend on oil revenues to
finance its budget.

With average oil production of 100,000 barrels,
annual oil revenues have risen from $444 million
in 2011 to $709 million in 2013. By end of third
quarter 2014, oil revenues stood at $780 million,
about 1% of GDP and expected to end the year at
1.2% of GDP according to the Government’s 2015
Budget and Economic Policy Statement. The
projections for 2015 is put at $1.2 billion but
this is unlikely if the trend in oil prices
continue into next year (See Figure 2 for Jubilee
Oil Price Trend). Also, importing all of its oil
consumption, the Government’s Budget will get
fiscal relief through a reduction in petroleum
price subsidies.

However, it is important to recognize that major
capital projects in Ghana are being financed from
oil revenues given that the bulk of the
government’s budget goes to wages, goods and
services. For instance, of the total budget of
GHC5.8 billion for the Ministry of Education in
2014, capital budget was only GHC276 million of
which oil revenues constituted GHC103.5 million.
Similarly, of the total capital budget of GHC233.6
million for the Ministry of Food and Agriculture,
oil revenues were GHC52.1 million. For the same
year, 78% of the capital budget for the Ministry
of Fisheries and Aquaculture came from oil
revenues. Furthermore, Government’s new
Infrastructure Investment Fund (GIIF) relies on
25% of the oil revenues allocated to the annual
budget; and any drastic fall in revenues could
affect the investment plan of the government.
Thus, in spite of the modest levels of oil
revenues, it has become a major source of
financing the Government’s capital budget. In
this case, the oil price crush could greatly
affect the development fortunes of the country.

Addressing Budgetary Effects

There are measures the Government of Ghana can
fall on to address the budgetary effects of oil
the current oil price crush as well as future
ones.

First, the common practice during unexpected price
crush is to reduce spending. This measure however
affects welfare as planned social investments
often suffer in favour salaries and emoluments.

Second, depending on the size of oil reserves and
given the level of capacity, increasing oil
production is the preferred measure. However,
Ghana’s reserve replacement is very slow and
therefore this measure can be sustained only when
there are many successful discoveries and
significant investment in the development of new
discoveries.

Third, the behavior of oil prices is cyclical. It
is therefore important to save against downward
price risks. The Government must seek to grow the
Ghana Stabilization Fund by investing it in
instruments abroad and deploying it to balance the
budget in times of price crush. The current set up
of the Stabilization Fund is unlikely to address
these risks as the size of oil revenues to the
Budget increases due to the more discretionary and
non-scientific determination of the maximum cap on
the Fund. This is fueled by the fact that
Government’s budgetary plans are based on
short-termism whilst significant oil price cycles
are short to medium-term.

Addressing Investment Effects

On holding current upstream investments and
attracting new ones, Government must institute
market-based policies that could attract
investments in a market that is becoming more
fluid and where profits are under serious threat.
Government can start this by passing an investment
friendly petroleum law, which will not only be
attractive but also protective of investments.
Some of the proposals for the consideration of
Government are:

i. Creating a fiscal system that automatically
results in a higher government-take under higher
oil prices and lower government-take under lower
prices. Ghana has additional oil entitlement in
its fiscal regime and this must be encouraged.
Government should however model it to be more
progressive and not regressive. This is more
preferable to investors than blanket taxes.

ii. Creating a mechanism for reviewing contractual
terms when there is a significant change in oil
prices that could likely cause economic
disequilibrium. The most preferred method for
determining this is based on the rate of return.
That is, when the rate of return at any time falls
below the project rate of return, a review might
be warranted.

iii. Using the bid system for new acreages to
increase or decrease fiscal terms to reflect price
movements at the time of negotiating contracts.

iv. Providing fiscal incentives when there is a
price crush to keep contractors in operations and
thereby maintain jobs. For instance, the British
Government has announced a decrease in corporate
taxes from 32% to 30%, effective Jan 1, 2015, to
encourage production during the current price
crush.

Source - Dr. Mohammed Amin Adam

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