Favorable tax regime as an impetus to the development of hard to recover resources

November 28, 2016

Author: Daria Surova, Client Analyst

The current Russian oil and gas tax system was elaborated in the early 2000s. Due to the lack of the tax administration experience in oil production, the government needed a simple mechanism to extract the part of the oil companies’ huge profits. During the period of high oil prices both government and oil and gas business were satisfied by the established tax system that consisted of Mineral Extraction Tax (MET), Export Duty and Income Tax. At that time, the state budget was replenished by increasing oil and gas revenues. The companies also got their part of the margin due to the significant difference between the cost of production and the sale price, which incentivized the development of new fields.  

However, nowadays any initiative of the Russian Ministry of Finance regarding the increase of oil and gas industry tax burden is met with more and more resistance from the companies. In the recent years, such resistance was also joined by the Russian Ministry of Energy, which role is to prioritize the stable development of the industry. Thus, the deterioration of the oil market is not the only point of concern. The reason for such resistance lies in the increase of the hard-to-recover resources in resource structure which extraction becomes more complex and expensive. 

For several decades the domestic oil companies have exploited huge deposits of conventional oil with the cost of production lower than the world’s average. Previously the necessity of investing in technology to develop tight oil resources and exploring new deposits was not so much of a concern. As a result, the rate of depletion of conventional oil turned out to be much greater than expected. This in turn led to the necessity of developing more complicated resources including tight oil. 

According to Rystad Energy, the share of remaining hard to recover oil resources (both discovered and undiscovered) in Russian resources’ structure has reached almost 35% (Figure 1) – this is shale oil, huge volumes of which are concentrated in the world’s biggest shale plays (mainly the Bazhenov and the Domanic formations).  Hence, as of 1 January 2016, the share of conventional oil amounts to slightly more than 60%, considering the fact that part of this oil is located in undeveloped regions like Eastern Siberia, Far East and northern latitudes. In particular, the significant resource potential is located in the Arctic shelf. In 2014, the USA and Europe imposed sanctions against Russia which forbid companies to export certain development equipment to Russia. Both harsh climate and the lack of equipment designed for the development of the Arctic shelf make extensive production practically impossible, at least in the nearest future. 












The government has a real mechanism at hand, applying which it is capable of maintaining the current level of production in the country, making the investments in the oil sector more stable and at the same time doing no harm to budget revenues. Such a mechanism is the tax regime.

At the moment, there are three scenarios of development of the Russian tax system: tax on the financial result (TFR), tax on additional income (TAI) or maintaining the current system (CTS), with all its benefits and preferences.

So far, the current tax reform boils down to extending the list of amendments in terms of granting new exemptions and exceptions to the general regime. The amount of benefits received usually depends on the region of production. If the fields belong to the same oil and gas province, the tax regime treats them identically regardless of the differences in their performance parameters. As a result, for some assets the tax burden is unreasonably low, while other fields remain unprofitable under the tax regime. Thus, the inconsistency of benefits has a negative effect on both production and the state budget, which substantially depends on oil and gas revenues.

However, the current tax system can be replaced by a tax regime, which takes into account the financial performance of production companies. In November 2014, the State Duma introduced the tax on financial result bill. Unlike the Mineral Extraction Tax (MET), TFR levies the profit of the company, not income. Taxable income equals gross revenue less the following deductions: production costs, depreciation, losses incurred in previous income years, taxes (MET is set to zero) and capital allowance, the so-called “uplift”. The uplift provides the reduction of the gross revenue by the value equal to 10% of the initial cost of fixed assets put into production in the current year and is performed during the 4-year period. According to the bill, the rate of TFR is 60%.

Russian Ministry of Finance has elaborated the tax on additional income (TAI) as an alternative to the TFR. According to the TAI bill, its rate amounts to 70%. The tax base is the following: gross revenue from oil sales, reduced by transportation and production costs, export duty, MET and capital expenditures. There is an imposed limit on the amount of deductible costs. In total, they should not exceed 20 USD/bbl in the tax period, including the losses of previous years. The remaining costs are carried forward to be offset by future taxable income. TAI is levied only after all capital costs are paid off and the profitability of the project reaches 6%. Export duty is charged only after the base for TAI becomes positive. The calculation of the MET is also revised: MET rate is 30% of the revenue in the periods when tax base for TAI is equal to zero; then total tax burden of the MET and export duty increase, but should not exceed 40%.

We explore the impact of different tax regimes on the profitability of projects and state revenues using the example of the development of an open acreage, the Bazhenov formation, which is the part of the world’s largest shale formations. The Bazhenov formation is a group of hydrocarbon source rocks that, apart from kerogen, also concludes the light oil of high quality in its layers. The oil saturation reaches 80% in some areas, while its proximity to existing infrastructure can greatly reduce production costs for companies. On the other hand, the oil of the Bazhenov formation is considered to be hard to recover because it lies in reservoirs with extremely low rates of porosity and permeability.

We evaluate the influence of different tax regimes on the profitability of the development of the asset (1) and the relevant present value to the government (2) using production, capital and operating costs profiles modeled in UCube, all under the assumption that production starts in the mid 2020’s.






Table 1 shows the breakeven prices of the asset and the amount of discounted taxes in the breakeven point in different tax regime scenarios:

  • The current tax benefit provides the Bazhenov operators with tax holidays on MET, which makes the asset development profitable at a constant real oil price above 58 USD/bbl. Such a low breakeven price is because the validity of a zero tax rate (15 years from the date of achieving the degree of resources depletion 1%) partially overlaps with the period of the most intensive oil production. The net present value (NPV) of the project reaches its maximum not at the end of the realization, but when the tax holiday ends (figure 2). In other words, it is more expedient for the companies to stop production much earlier, because the continued development decreases the profitability of the asset. This in turn affects the budget revenue that turns to zero after the tax holiday expires. 














Note: Figure 2 and 3 demonstrate current NPV not only for a fixed period, but for any period up to the end of the project’s lifetime. 

  • Transition to the TFR would reduce the breakeven price to 48 $/bbl. The maximum NPV of the project is achieved at the end of its realization. This provides the state budget with tax revenues over a longer period of time. The sum of the discounted revenues of the state in this case is 28 BUSD.
  • In case of transitioning to the TAI, the breakeven point in our example is achieved with the oil price of 55 USD/bbl, which is slightly lower than under the current tax regime. At the same time, the discounted income of the state at the breakeven point amounts to 37 BUSD, almost 2 times higher than under the current tax regime. 














When oil prices are high, the transition to more flexible fiscal instruments is also appropriate. Figure 3 presents the dynamics of the asset NPV over the entire period of its development in our base case oil price scenario.  From the point of view of the company, during the period of high oil prices the most favorable scenario is achieved by maintaining the current tax regime and tax incentives in the form of a zero tax rate. Under the current tax system, NPV and internal rate of return (IRR) of the asset are significantly higher than under the TFR or the AIT (26.7 BUSD and 17.7%, respectively). At the same time, this case can turn unfavorable for the state. Figure 4 demonstrates how the tax burden on the company is changing as the asset develops. In case of the current tax system, the excessive reduction in the tax burden leads to the state losing a fair share of the rental income in the first years, when oil production is the most intensive. 















As a result, the total discounted revenue of the state is the lowest under the current tax regime (figure 5).













TFR and TAI provide less profitability of the asset than the current tax system (16.3 and 13.3 BUSD respectively). However, the asset still remains attractive for development benefiting both the company and the state. This is achieved by the flexibility of the tax system. As it can be seen in figure 4, unlike under the current system, the tax burden largely depends on the profit of the company. Also, the direct linkage of TAI to the IRR allows achieving an acceptable level of tax burden during the early development of the project and helps increasing it after all capital costs are paid off and the company gets a fixed return of 6%.

In case of the introduction of the TFR, the benefit of the company will be higher than when implementing the TAI. However, the TFR has a significant drawback: all risks associated with the exploration and development of fields are transferred to the state. The profits taxation implies that the budget will receive revenue from the oil and gas sector only in case the tax base is positive. Typical for oil market high price fluctuations may lead to instability of government revenues. As for TAI, the risks for the state are reduced. The preservation of the MET allows the state to receive income at the beginning of the development of the field as well as at low oil prices.

According to the conducted analysis, it can be argued that under oil resource structure deterioration the tax system that takes into account the financial results of oil companies is a good alternative to the current tax regime even in high oil price scenarios. This thesis can be confirmed by international experience. According to figure 6, in most countries where more flexible fiscal instruments are used, the share of hard-to-reach and hard-to-recover resources exceeds 50%. Some countries completely abandoned the taxation of income (UK, Norway), while others chose to retain royalty, but lowered its impact by reducing or differentiating its rates (USA, Canada). At the same time, most of the OPEC countries have traditional, highly profitable oil resources. It explains the stability of their fiscal regimes, which are mainly based on taxation of the gross values of the companies.

















The key Russian ministries start recognizing that the permanent increase in tax benefits may no longer be an effective measure that meets the interests of the companies and the state. Under the increasing complexity of production conditions, transitioning to a more flexible taxation system appears to be a rational decision. 



Article Contacts

Daria Surova, Client Analyst
Phone: +7 (499)-391-1783

Julia Weiss, VP Marketing
Phone: +47 48 29 87 61

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