Oil and Gas Taxation in Romania: a Wandering Path

The Romanian Government has recently submitted the main fiscal measures that are to be implemented starting February 1, 2013. The most significant measures relate to the introduction of new fees in the upstream and midstream sector. The Government’s action was motivated by the need to maintain the budgetary deficit at the level agreed with the IMF and to ensure economic stability. Considering the optimistic forecasts regarding the unconventional gas and oil reserves discovered on the Romanian territory, the measures adopted may result in short term additional revenues, however undermining in the long run the development of the extractive industry.

Towards the end of last year, the previous Government had announced its intention “to tax windfall revenues following the liberalization of gas price, taxes that shall be directed to a special fund and shall address vulnerable consumers”. For the “reform” in the field of oil and gas to be complete, starting 2015, an increase of oil royalties was forecasted, as the effect of the expiration of an agreement between the Romanian Government and one oil operator (Petrom’s privatization agreement). The level of royalties paid by the companies producing oil and natural gas was established (in 2004) at a range of 3.5% to 13.5% of the production, according to the type of hydrocarbon deposits.

Consequently, the Government announced the establishment of a 60% fee on additional revenues obtained following the deregulation of prices in the natural gas sector. According to the agreement signed with the International Monetary Fund and with the European Commission, starting 2013, Romania undertook to liberalize the natural gas price, by gradually waiving regulated tariffs. Government members motivate the introduction of the new fee by the fact that economic operators in the natural gas industry obtain additional revenues from the sale of such gas, as an effect of the deregulation of natural gas prices, without them registering own additional expenses resulting from the activities in question. The Government intends to use revenues from such fee for securing financial aids intended to vulnerable consumers and for the reduction of the budgetary deficit.  

Another fee that shall also be introduced starting February 1, is the fee on “the natural monopoly” applicable to the midstream sector, namely to natural gas and electricity transmission and distribution operators. The additional funds obtained in this respect (the Government estimates an amount of EUR 127.4 million) shall be used for co financing the investment projects financed from European funds. 

According to the Ministry of Public Finances, the fee shall be computed per each MWh for which the natural gas and electricity transmission and distribution services are invoiced. The amount of the fee shall be RON 0.45/MWh (EUR 0.10/MWh[1]) for the energy transmitted to distribution systems, respectively RON 1.25 /MWh (EUR 0.29 /MWh) for the electricity distributed. As for the electricity transmitted only by transmission system, the fee will amount to RON 1.7/MWh (EUR 0.39/MWh). The natural gas and electricity distribution operators whose number of clients does not exceed 100,000 shall be exempted from the implementation of such fee.  The fee shall be valid until December 2014, when the level of oil and gas royalties paid to the state is recalculated.

Eventually, the Government shall also establish a fee intended as a special fee for the production of natural resources other than natural gas, a fee of 0.5% of the turnover of operators in the mining industry. The revenues earned shall also be intended for co-financing investment projects financed by EU funds.   

According to the Ministry of Public Finances, the draft regulatory deed has an insignificant impact on the business environment, the companies being able to handle such fees, since all of them “are making profit”. Unfortunately, most tax burdens ,when not included in a concept or in a more comprehensive policy (with a purpose to compensate by other tax facilities) may only lead to higher budgetary revenues on a very short term, triggering however the strangling of the affected economic sector. Considering that OMV Petrom and ExxonMobil announced a significant gas discovery in the Black Sea production blocks (preliminary estimations placing the natural gas deposit at around 42-84 billion cubic meters, the equivalent of 3-6 times the Romanian annual consumption) and several other major companies, including Chevron, are about to begin the exploration of shale gas reserves, the fiscal “reform” which is on the way of being implemented proves to be rather superficial. Should this approach still be in progress in 2014, when the review of the level of royalties in relation to natural gas and oil production is scheduled, we can only forecast a bleak future for the business environment in the Romanian energy sector.   

It would probably be useful that within the substantiation of the new tax policies in the energy field, the state takes into consideration the practice of certain countries producing hydrocarbons and having hydrocarbon reserves and also the percentage that fees on oil operations bring to each state’s Gross Domestic Product. Our analysis is mainly focused on some European states as well as on Azerbaijan (emerging economy, world number 23 on the list of hydrocarbon producers and a desirable strategic energy partner for Romania). We cannot avoid not mentioning the US as regards the specific manner this country approaches, from the fiscal point of view, an emerging industry such as unconventional gas production.

When dealing with the fiscal efficiency of a tax/royalty a wide array of factors definitely needs to be taken into consideration: commercial hydrocarbon reserves, the regime of fiscal deductions and, generally, the overall fiscal context (fiscal circumscription of oil operations -„ring fence”, reporting losses, the regime of depreciations, fiscal facilities, fees on transactions, withholding tax, customs duties, VAT, excises etc), the overall development level of the country. However, it may be noted that a high taxation rate does not necessarily involve a major contribution of such budgetary revenues to a country’s gross domestic product.

What may be understood from the declarations so far is that the Romanian Government intends to impose a charge on „windfall revenues”. The correspondent in the international practice is „super normal profit tax” or „windfall profit tax”.  Currently, such fiscal practice is fully in force in states such as Venezuela, Algeria, Israel, Kenya, Pakistan, Trinidad Tobago, China, Namibia, Papua New Guinea.

Generally, this taxation system may be defined as a tax on additional profit, charged by a government for oil and gas operations, in case the oil operator reaches a profit margin (due, for example, to fluctuations in oil prices) exceeding the estimations used in assessing the profitability of oil operations during negotiations with the government in question. We speak of a tax that shall be collected when, depending on the cash flow, a certain profitability level (profit margin) is attained.

Which is the oil companies’ profit rate that we speak of? According to the analysis performed by Conoco Phillips and Forbes, during 2006-2010, the profit margin of oil companies was around 6.5%, thus occupying rank 114 of 215 industries, which is not exactly a“windfall” revenue.  When drafting a timely fiscal policy it is advisable not to make the confusion between the gasoline pump price and the profit margin in the upstream sector.  Things go much deeper.

Great Britain experimented with the overtaxation of oil & gas companies’ revenues, by introducing, in 1975, the Petroleum Revenue Tax as a 50 % profit tax, additional to the profit tax applicable to any other British company. This tax was subsequently repealed in 1993 (for the licenses awarded afterwards). In 1995, however, the British oil industry reached a record production level, many analysts attributing these results to the 1993 reapealing of the Petroleum Revenue Tax. The oil & gas production increase also determined a rise in fiscal revenues resulting from the classic profit tax. 

What is interesting is that this taxation system, albeit criticised and subsequently repealed, had acquired the tendency of a balanced fiscal approach, by trying to compensate the direct fiscal burden with a series of facilities, destined to ensure a rapid cost depreciation. These facilities included tax exemptions for low turnover blocks, a clear definition of all deductible costs (including R&D costs), an indefinite carrying forward of losses, from one block to another, the exemption of new blocks from paying the fee,  if such would  prove to have an impact on the economic efficiency etc.

A positive experience from the perspective of assuring a balance in risk sharing between the state and the oil & gas companies, of maintainig an attractive investment climate at the same time with a high although reasonable budgetary collection rate  is the one recorded in the United States. The oil & gas companies that produce hydrocarbons on federal lands pay royalties of 12.5% for the onshore exploitations and 18.75%  for the offshore ones. The royalties level for onshore production (both oil and natural gas) on federal lands was established through the Mineral Leasing Act, in 1920 and hasn’t been changed ever since.

Royalties are one of the largest sources of income for the federal government, the state collecting $86 million/day from rents, bonus fees, royalties and other fees. The largest part of this sum comes from the offshore production, with natural gas delivering 60% of the income from royalties. For onshore lands, natural gas production deliveres 70% of the revenue collected by the Government.

At the same time, the United States provides us with a representative model of a mature fiscal policy in the case of an emerging industry, such as shale gas production: from 2000 to 2006, the shale gas production increased, on average, with 17% per year, and between 2006 – 2010 with 48% per year. This development brought $18.6 billion to the federal, state and local budgets. By 2035, the amount could go up to $57 billion. In Texas, where the largest shale gas production in the United States is registered and where the federal government owns very few mineral rights, the State didn’t increase the royalties’ level once the shale gas production started increasing, but offered fiscal benefits to the oil & gas companies instead. This allowed the deduction of a large part of the drilling and production costs. Thus, the state encouraged and increased the profitability of shale gas production by the incentives granted, which led to a growth of the state’s budget tax revenue. 

The main trend of the last decade in terms of royalties applicable to the upstream industry was constant or rather decreasing (the average being around 20%). As a general rule, a high royalty level is practiced in oil and gas exporting countries. In the states interested in attracting foreign investments, the royalty level is, usually, around 12%. The royalties system needs to be reformed in many countries (including Romania), with a view to ensure a neutral, balanced, competitive approach adaptable to various economic models (for example, with a production volume- based royalty, considering that  investment costs and deposits’ profitability can vary from one block to another, a highly profitable oil & gas company will pay the same royalty quantum as the companies that register higher production costs. This can lead to market and competition distortion).

The purpose of an oil fiscal regime needs to fall under the principle of fiscal „neutrality”, namely, to enable the adoption of economic decisions by virtue of a economic logic and not as a result of a tax.

The increase of the royalties’ level or the enforcement of additional taxes usually leads to capital (and profitable) investments reductions and, subsequently, to a decline in budgetary revenues. The absence of a complex set of rules, measures and fiscal policies intended for: reducing the impact of taxation on the economic environment, encouraging investments, ensuring a balance between the risks took on by the state and oil & gas operators, between private profits and budgetary revenues, will certainly result in a recoil of budgetary revenues. The same endeavour, made notwithstanding the investment costs (which are significantly different in the case of onshore and offshore, conventional and unconventional production), the geologic properties of the deposits(depth, structure, profitability), the price of hydrocarbons on the relevant markets and the multitude of other natural, economic, technical and even accountancy factors , is likely to discredit its economic impact (which needs to be a positive one not just for the state budget, but for all the economic actors).

What’s worth keeping in mind is that both the state and the companies are interested in the distribution of profits. Moreover, what is of an equal importance  but in danger of being disregarded, is the need of maximizing such profits and consequently, budget revenues.       

Laurentiu Pachiu is the Managing Partner and founder of Pachiu & Associates, having over 18 years of experience in the legal business environment. The energy practice initiated by Mr. Laurentiu Pachiu was among the first legal practices of such kind established in the country. The firm developed at the same fast pace at which the Romanian energy market evolved.

He is a graduate of the Diplomatic Academy of the German Federal Ministry of Foreign Affairs. Prior to being a lawyer, Mr. Pachiu was a diplomat of the Ministry of Foreign Affairs of Romania. 

Pachiu & Associates is a leading Romanian business law firm, offering prompt, effective and personalised solutions to all legal matters, with a special focus on the energy field. The Energy Practice Group provides legal support in relation to the planning, implementation and operation of projects in the field of alternative and conventional energy and natural resources in both upstream and downstream sectors. Pachiu & Associates is the only Romanian firm member of Associated European Energy Consultants. More details on: www.pachiu.com