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Petroleum Economics

by
Dr.Thitisak Boonpramote
Department of Mining and Petroleum Engineering
Chulalongkorn University

Concepts of Tax Treatment for Expenditures


under
the royalty/tax regime

After-tax Cash Flow


The key point is that since taxes are a cash outflow of a project, our
economic analyses must reflect the after-tax cash flow of a project in order
to achieve a true reflection of the cash flow patterns.
Tax laws are imposed for revenue generation. However, a secondary
purpose is that of social legislation. The laws are very complex with many
exceptions. However, this section attempts to capture the fundamental
concepts.
In a sense, the government shares in every profitable venture through the
taxation of a portion of the profits. The contra is also true if the individual or
corporation has other profit generating activities to offset the loss in a
venture.

CAPEX vs. DD&A


A key point to remember is that capital expenditures (buildings,
machinery, etc.) are not deductible as operating expenses, but rather
are recovered through DD&A.

A second key point to note is that DD&A when considered as a tax


deduction results in less taxes and therefore is a source of cash flow to
match the cash outflow when the investment is made.

Issues
The investment in a well of $1,000,000 may be partly
depreciated (tangible) and partly amortized (intangible.) The
rules (i.e. calculation procedures) for these two types of
systematic expensing may be different depending on the
standards set by either the financial or the tax model
employed.
The use of DD&A in a financial model is intended to give a
realistic view of the financial viability of a project or firm by
accounting for costs that are intended to benefit the future.
The use of the both financial model and cash flow model
should give a better view of financial viability than either model
alone.

Review of DD&A
1. Depreciation- the systematic expensing (i.e. treated as an immediate
deduction against revenue) of the cost of a tangible asset. A tangible
asset is something that has a physical presence such as a flowline,
wellhead or tanker.
2. Depletion-the systematic expensing of the cost of a natural resource.
For instance, if a company buys oil reserves the cost of these reserves
may be expensed in a systematic way, over the years, using depletion
methods.
3. Amortization- the systematic expensing of the cost of an intangible
asset. An intangible asset is one that has no physical presence. An
example might be the labor cost of installing oilfield equipment. The
equipment itself is tangible, but the labor has no physical presence after
the equipment is installed.

Operating Cash Flows


Cash Flows from Operations
Recall that:
Operating Cash Flow = EBIT Taxes + DD&A
Net Capital Spending
Dont forget salvage value (after tax, of course).
Changes in Net Working Capital
Recall that when the project winds down, we enjoy a return of net
working capital.

Tax Calculation

Taxable Income = Revenue Royalty - OPEX DD&A

DD&A

These deduction allowances are non-cash charges that make cash flow
differ from profit or net income in any given year

Tax

=
% of CAPEX
(Depend on Type of Assets & Government Rule)

Tax Rate * (Taxable Income)

Cash Flow vs. Profit


It is important to realize that Net Cash Flow is usually not the
same as Net Income in any given year due to DD&A and
other tax deductions.
However, total Net Cash Flow equals total Net Income over
the life of the project. Checking this equality is an important
tool in validating an evaluation model.

Cash Flow vs. Profit

Cash Flow vs. Profit

Depreciation Concepts

Depreciation

Depreciation is defined as the loss in service value over time.


Thus from a physical standpoint it can be associated with physical
deterioration and obsolescence. In addition, the loss in service value could
be based upon remaining useful life in terms of number of units left to be
produced.
This technique would recognize that the economic life of an asset is less
than the physical life.
We normally think of depreciation from the accounting standpoint which
is the systematic allocation of the cost of an asset (less its salvage value)
over its useful life.
Depreciation is based upon historical cost accounting or original cost
accounting.

Depreciation
The key point to remember about depreciation from an
economic analysis standpoint is that you must separate
book depreciation (accounting depreciation) from tax
depreciation.
Our object in economic analysis is to get to the cash
flow stream.
Only tax depreciation causes cash flow.
If book depreciation is used, deferred tax is needed for
adjustment the cash flow.

Depreciation, Book Value and Salvage

Book value is the remaining unallocated cost of an asset or:

Book Value =

Historical Cost - Accumulated Depreciation

Cost Basis =

Historical Cost (includes freight, labor, site preparation)

Depreciation Methods
A. Straight line: use for financial/book accounting
Accelerated depreciation: use for tax accounting such as:
B. Sum of years digits
C. Declining balance
D. Unit of production

A. Straight Line Depreciation

Annual Depreciation = Historical Cost - Salvage Value


Useful Life

Most often used in book depreciation where the object is to minimize depreciation
expense in order to maximize net income.
Tax depreciation is normally not based upon straight line depreciation since other
methods will generally maximize tax depreciation expense which tends to minimize
taxes payable.
Straight line depreciation results in a constant depreciation expense each year

An example for the straight line method


Original basis = $100,000
Assumed life of asset = 5 years
Year

Basis at start of year Systematic expense Basis at end of year


1
$100,000
$20,000
$80,000
2
$80,000
$20,000
$60,000
3
$60,000
$20,000
$40,000
4
$40,000
$20,000
$20,000
5
$20,000
$20,000
$0

Each year a constant factor, f, was multiplied by the original basis to determine the
systematic expense for the yearly period.

An example for the straight line method


In the case of the straight line method this factor was:
f = 1/Assumed life of asset. f was constant at 0.2 in this example.
Note that all of the basis was expensed at the end of five years. If the asset
life is terminated earlier than assumed the usual procedure is to expense
the remaining basis immediately. For instance, if the assets life was
terminated during the third year, then the remaining basis of $60,000 may
be expensed. If the asset is then sold, proceeds from the sale will likely be
treated as revenue. Financial profit will be the difference between the
revenue and the remaining basis.
The timing of revenue and expensing of the basis may , in practice, vary
somewhat from firm to firm according to the rules adopted by the firm and
in accordance with generally accepted accounting practices.

Straight Line Method for 500 million with 5 years

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B. Sum Of The Years Depreciation (SOYD)


This is a form of accelerated depreciation which results in higher
depreciation expense in early years and lower depreciation expense in
later years, based upon the sum of the useful years digits:

Sum = Useful Life x (Useful Life + 1)


2
Example: Useful Life 5 Years

Sum = 5 (5+1) = 15 or 5+4+3+2+1 = 15


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Sum of the Year Digit for 500 million with 5 years

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Declining Balance Method


Declining Balance This method is computational slightly more complex
than the straight line method. It involves expensing a constant fraction, f, of
the remaining basis each period.
Two variations of this method are: single declining balance and double
declining balance.
The single (100%)declining balance uses the factor
f = 1/Assumed life of asset
and the double (200%) declining balance uses the factor
f = 2/Assumed life of asset
Note again that these factors are applied to the remaining basis, not the
original basis as was the case in the straight line method.

An example for the single declining balance method


Original basis = $100,000
Assumed life of asset = 5 years
Year
1
2
3
4
5

Basis at start of year Systematic expense Basis at end of year


$100,000
$20,000
$80,000
$80,000
$16,000
$64,000
$64,000
$12,800
$51,200
$51,200
$10,240
$40,960
$40,960
$40,960
$0

Note that the systematic expense for the final (fifth) year should have been $8,192.
If the formula, Basis at end of year =f*Basis at start of year were to continue without
interruption then the basis would never be completely expensed (i.e. reach the value of
zero.).
However the final years systematic expense is an exception and all the remaining basis is
expensed during the final year in the assets life.

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C. Double Declining Balance Depreciation (DDB)


This is one of the few methods which does not take the salvage
value directly into account. It also is an accelerated method.
Most property except certain used property and real estate has
been accorded the treatment of double declining balance which
may be stated as:

DDB =

2
Useful Life

x Historical Cost - Accumulated


Depreciation

A constraint is that the accumulated depreciation cannot exceed


the historical cost less salvage value.

An example for the double declining balance method


Original basis = $100,000
Assumed life of asset = 5 years
Basis at start of
Year year
Systematic expense Basis at end of year
1
$100,000
$40,000
$60,000
2
$60,000
$24,000
$36,000
3
$36,000
$14,400
$21,600
4
$21,600
$8,640
$12,960
5
$12,960
$0
$12,960

This is a more rapid expensing of an asset than the single declining balance method.

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D. Unit of Production
this method allows for the systematic expensing of the cost of oil and gas
reserves. Thus it is primarily a depletion method. It differs considerably
from the above systematic expensing methods in the way the factor, f, is
computed.
In this case f = (production during the year)/(reserves at the start of the
year)

UOP
Used in situations where the loss in service value is more closely
related to use or number of units produced rather than time.
Most commonly associated with machinery and equipment
involved in producing natural resources where the physical life of
the equipment exceeds the economic or production life of the
natural resources.
Example:

The total reserves of a gas field are 10 billion cubic


feet. If 30% of the gas is produced the first year the
depreciation expense would be equal to 30% times the
historical cost less the salvage value. Similarly in
future years. Results in a matching of depreciation
expense to actual production.

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UOP example
Original basis = $100,000
Assumed life of asset (in this case, the natural resource)= 5 years
Reserves at the start of the first year= 10,000 STB
Production = amounts given in the table below
Year

Basis at
Systematic
Basis at
Reserves at Year's
Reserves at
start of year
expense
end of year start of year production end of year
1
$100,000
$20,000
$80,000
10000
2000
8000
2
$80,000
$30,000
$50,000
8000
3000
5000
3
$50,000
$25,000
$25,000
5000
2500
2500
4
$25,000
$10,000
$15,000
2500
1000
1500
5
$15,000
$15,000
$0
1500
1500
0

Reserves re-evaluation
The last example assumed that reserves were not adjusted from year to
year. If reserves had been adjusted then the systematic expense schedule
will change. Nevertheless, the factor, f, will still be calculated in the same
way. To show how adjustment of reserves influences systematic expenses
well use the following scenario:
Scenario
An oil companys engineering department has adjusted reserves at the end
of the second year to reflect the results of a new engineering study that
showed reserves had increased by an additional 2,000 STB. To simplify
the example, well assume that production rates remain the same. This
increases the reserve life beyond five years and will leave an unexpensed
basis at the end of that time

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Reserves re-evaluation example


Here is the resulting table. The numbers in bold type have changed from the previous
table.
Year

Basis at
Systematic
Basis at
Reserves at Year's
Reserves at
start of year
expense
end of year start of year production end of year
1
$100,000
$20,000
$80,000
10000
2000
8000
7000
2
$80,000
$30,000
$50,000
8000
3000
$17,857
$32,143
7000
2500
4500
3
$50,000
$32,143
$7,143
$25,000
4500
1000
3500
4
$25,000
$10,714
$14,286
3500
1500
2000
5

Note that the first change in systematic expense took place in year three. In the first
example the year three value of f was 2500/5000 = 0.5. In the second example the year
three value of f changed to 2500/7000 = 0.35714.

Comparing of 3 methods

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Depreciation For Tax Purpose (Thailand I)

All pre-production expenditure, except tangible assets, is capitalized at


the beginning of first production and amortized at a rate of 10% p.a.
All tangible assets acquired in the pre-production period are capitalized
effective start of production and are depreciated at 20% p.a.
As from the beginning of the first production,
- all operating expenditures, geological and geophysical survey and
study costs and all intangible drilling costs are fully expensed in the
year incurred.
- all tangible assets (excl. land and buildings) and tangible drilling costs
(e.g. wellhead equipment and tubing) are capitalized and depreciated at
20% p.a.
- permanent buildings are depreciated at 5% p.a.
- no depreciation is allowed on land.
- concession payments are amortized at 10% p.a.

Depreciation For Tax Purpose (Thailand III)


Fiscal Income: Fiscal Income equals Gross Income minus
Allowables.
Allowables: Allowables for PITA purposes include concession
payments, production bonuses, exploration costs, production drilling
costs, other capital cost items, operating costs, Royalty, Special
Remuneration Benefit (SRB) and losses carried forward.
All pre-production expenditures, except tangible assets are
capitalized at the beginning of first production and amortized at a
rate of 10% per annum.
All tangible assets acquired in the pre-production period (capital
expenditure) are capitalized at the effective start of production and
are depreciated at 20% per annum.

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Depreciation For Tax Purpose (Thailand III) cont.


(l) Exploration Costs
It is assumed that 95% of the exploration costs incurred in the fiscal year
relates to intangible assets. Cost incurred after first production can be
directly written off for PITA purposes. The remaining 5% - tangible cost - is
amortized at 20% per annum after first production.
(2) Production Drilling Costs
It is assumed that 80% of the production drilling costs incurred in the
fiscal year relates to intangible assets. Cost incurred after first
production can be directly written off for PITA purposes. The remaining 20%
- tangible cost - is amortized at 20% per annum after first production.
PITA Liability: PITA liability is 50% of the Fiscal Income. If PITA liability is
negative then losses may be rolled forward for a maximum of ten years.
Losses may not be carried backward.

Deferred Tax Concepts

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Tax Accounting vs. Book Accounting Concepts


The appropriate accounting rules are standardized within a
country for determining the corporate profit for purposes of
reporting the financial condition of the company to its
shareholders includes the calculation of income tax liability
shown on the income statement.
That value is not the actual amount of income tax paid, but
following the matching principle it is the amount of tax due on
the profit earned that year.

Tax Accounting vs. Book Accounting Concepts


Tax laws rarely coincide with accounting procedures, so the
actual amount of income tax paid is frequently less than is
shown on the income statement with the difference carried to
the balance sheet as a future liability (deferred income tax).
When the rules differ between tax and financial accounting it
becomes necessary to maintain more than one set of
accounting records. Thus, profit for paying income tax may not
be the same as the profit reported to the shareholders.

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Book (Financial) Accounting


Net Income - earnings after recognition of revenues less operating expenses,
book depreciation, and the book tax provision.
Revenues - value of product sales or services rendered.
Operating Expenses - salaries, product materials, rent, etc.
(Remind that capital expenditures and dividends are not operating expenses.
Book Depreciation - systematic allocation of original cost over the useful life
of the asset.
Book Tax Provision - tax rate times income before taxes.

Relationships in Book Accounting


=
=

Revenues
Operating Expenses
Depreciation (Book)
Income Before Taxes
Book Tax Provision
Net Income (NIAT)
Key Comment:
NIAT does not equate to cash flow from operations.

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Tax Accounting
Revenues - generally similar to book revenues. We assume no difference.
Operating Expenses - generally similar to book definition. We assume no
difference.
(Book Depreciation - no such term in tax accounting.)
Tax Depreciation capital expenditure allocation of tax basis.
Tax Basis - historical cost of asset less any accumulated tax depreciation.
(Net Income - no such term in tax accounting.)
Taxable Income - revenues less operating expenses less tax depreciation.
Current Taxes Payable - taxable income times tax rate.

Relationships in Tax Accounting

=
x
=

Revenues
Operating Expenses
Tax Depreciation
Taxable Income
Tax Rate
Current Taxes Payable

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Deferred Taxes
Deferred income taxes is a concept associated only with the
book or financial accounting. It is not a tax accounting concept.
Tax accounting computes an income tax payable. It is payable
for and within the current year.
Book accounting computes a provision for income taxes as a
reduction of net income. Thus, the book provision for income
taxes is based upon book depreciation and will differ from current
taxes payable if book and tax depreciation are not equal.
The difference between current taxes payable and the book
tax provision is known as deferred taxes and thus is important
in tracking cash.

Example I : Deferred Tax


Revenues
Operating Expenses
Depreciation
Taxable Income
Income Before Taxes
Current Taxes Payable (50%)
Book Provision (50%)
Net Income

Tax
10,000
2,000
8,000
4,000
4,000

Book
10,000
2,000
8,000
2,000
6,000

NOTE:
Tax rate of
50%
assumed.

2,000
3,000
3,000

Thus, our book provision for income taxes is 3,000 while our current taxes
are 2,000. The difference of 1,000 is known as a deferred tax.
The meaning of a deferred tax is that it represents a tax on current book
year earnings that will be paid in a future year.
The deferred tax could alternatively be computed as the difference in tax
and book depreciation (4,000-2,000) times the tax rate (50%).

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Example II: Deferred Tax


Assume the following depreciation schedules for book and tax
purposes for a $10,000 asset:
Year
1
2
3
4
5
6
7
8
9
10

Tax
Depreciation

Book
Depreciation

Difference

800
1,400
1,200
1,000
1,000
1,000
900
900
900
900

1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000

(200)
400
200
(100)
(100)
(100)
(100)

10,000

10,000

-0-

Tax
Rate
46%
46%
46%
46%
46%
46%
46%
46%
46%
46%

Deferred
Tax

Accumulated
Deferred Tax

(92)
184
92
(46)
(46)
(46)
(46)

(92)
92
184
184
184
184
138
92
46
-0-

-0-

Comments on Deferred Example


1.

The deferred tax in the first year is negative meaning that the current
taxes payable to the government are higher than the book income tax
provision.

2.

Over time the exact same amount will be taken for tax depreciation as
taken for book depreciation.

3.

Since the statement in 2. is correct, it follows that over time the


accumulated deferred tax will become zero.

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Example: Cash Flow Calculation with 2 approaches


Assume $10,000 Investment,
5-year straight line book depreciation ($2,000 each year)
Tax Depreciation:

$1,500; $2,200; $2,100;


$2,100; $2,100

Revenues:

$5,000/year

Operating Costs:

$1,000/year

Tax Rate:

46%

1) Tax Accounting Approach: use tax depreciation


Time
0
Cash
Flow

= - Investment = -10,000

Year
Year
Year
Year
Year

1
2
3
4
5

Taxes (IRS) = [Rev - Op Costs - Tax Depr] x Tax Rate


[5000 - 1000 - 1500] x 46% = 1150
[5000 - 1000 - 2200] x 46% = 828
[5000 - 1000 - 2100] x 46% = 874
[5000 - 1000 - 2100] x 46% = 874
[5000 - 1000 - 2100] x 46% = 874

Year
Year
Year
Year
Year

1
2
3
4
5

Cash Flow = Revenues - Op Costs - Taxes (IRS)


5000 - 1000 - 1150 = 2850
5000 - 1000 - 828 = 3172
5000 - 1000 - 874 = 3126
5000 - 1000 - 874 = 3126
5000 - 1000 - 874 = 3126

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2) Book Accounting Approach: use book depreciation


and deferred tax adjustment
Time 0 Cash Flow = - Investment = -10,000
Net Income = Rev - Op Costs - Book Depreciation - Taxes (Book)
Taxes (Book) = [Rev - Op Costs - Book Depreciation] x Tax Rate
Year
Year
Year
Year
Year

1
2
3
4
5

Taxes (Book)
[5000 - 1000 - 2000] x 46% = 920
[5000 - 1000 - 2000] x 46% = 920
[5000 - 1000 - 2000] x 46% = 920
[5000 - 1000 - 2000] x 46% = 920
[5000 - 1000 - 2000] x 46% = 920

Year
Year
Year
Year
Year

1
2
3
4
5

Net Income
5000 - 1000 - 2000 - 920 = 1080
5000 - 1000 - 2000 - 920 = 1080
5000 - 1000 - 2000 - 920 = 1080
5000 - 1000 - 2000 - 920 = 1080
5000 - 1000 - 2000 - 920 = 1080

2) Continue with deferred tax calculation

Deferred Taxes = (Tax Depr - Book Depr) x Tax Rate


Year 1
(1500 2000) x 46% = (230)
Year 2
(2200 2000) x 46% = 92
Year 3
(2100 2000) x 46% = 46
Year 4
(2100 2000) x 46% = 46
Year 5
(2100 2000) x 46% = 46
-0- (always sums to zero!)

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2) Continue with deferred tax adjustment

Cash Flow = Net Income + (Book Depreciation + Deferred Taxes)


Year 1
Year 2
Year 3
Year 4
Year 5

1080 + 2000 + (230) = 2850


1080 + 2000 + 92 = 3172
1080 + 2000 + 46 = 3126
1080 + 2000 + 46 = 3126
1080 + 2000 + 46 = 3126

Note that the cash flows are identical in each period regardless of
approach! Must be true in all cases.

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