The economic literature of ‘investment under uncertainty’ has been used in many different contexts: investment of manufacturing firms, in financial instruments, etc. But perhaps the best application of the theoretical model is related to oil and gas investment. A recent paper, IDB-WP-661, brings these lessons to Trinidad and Tobago, discussing the dos and don’ts of taxation of oil and gas. As it turns out, oil companies crave fiscal stability. In other words, they prefer to have the same tax rates and the same regime over a long horizon or period of time, rather than a lower initial tax rate but uncertainty as to whether it will be changed by the government. Not unlike the decisions individuals make on long-term personal investments such as mortgages.
For example, when you take out a 15-year mortgage on your home, would you rather: (a) pay a guaranteed 5-percent annual interest rate over the full term of the loan, or (b) pay 2.5 percent annual interest rate for three years, then an adjustable rate that will vary between 2.5 and 12 percent–with a likely average of 5 percent. Let’s assume for the sake of this exercise that the adjustable rate would vary in tandem with the international price of oil.
Your decision will depend on many things: Are you planning to sell the house within three years? If so, option b is much better. Do you have good information about the workings of the housing market? Then option b is more advantageous, especially if your mortgage payment is a small share of your income and you like to gamble.
What about the fixed-rate option? If you are committed to staying in the house for at least 15 years, because, say, the neighborhood has good health, education, and infrastructure services, the safe 5-percent fixed-rate option could be the way to go. This route prevents you from being at the mercy of wide oil price fluctuations over which you have no control.
Oil companies face similar choices when investing. Consider an analogy where the bank offering the mortgage is the government of Trinidad and Tobago–which works for the benefit of the population; the house is an exploration field or block, the interest payment is the annual taxes, and you (the prospective buyer) are an international oil company. Moreover, consider that Trinidad and Tobago’s government has to decide whether to offer a ‘fixed rate’ or and ‘adjustable rate’ option, and can only offer one. It has very little information about the elements that go into the oil company’s decision, including cash flow and alternative global equity investments.
In a world of imperfect information and an investment of a horizon of 15 years or more, the government should opt for only offering the ‘fixed rate’ option. Companies that take the ‘fixed-rate’ investment option self-select themselves as long-term investors, so the government knows it is more likely to benefit from a steady 15-year revenue stream without needing to fully understand the reasons behind a company’s decision. The government knows what it will receive and can better plan the financing of its own ‘businesses,’ such as health, education, infrastructure, and skills-training programs.
What aspects of the deal with the government should companies care for the most? At a minimum, they care that the government sticks to its commitment and does not renege on contracts. Furthermore, issues such as spending from the oil revenue on schools, roads, and healthcare would likely be important, as a company’s employees will use such public services for at least 15 years. A skilled local workforce may also be important.
What if the government decided to offer only the ‘adjustable rate’ option? Perhaps the government may believe that a lower tax rate will attract more investors. Certainly oil companies that are cash-strapped may prefer this option, as it will lower the tax bill at least the first few years, and they may like the gamble. Nonetheless, as soon as tax rates change the company is more likely to be the type to cut its losses and moves elsewhere.
An additional issue is that oil fields in Trinidad and Tobago are rich not just in petroleum, but also in natural gas. Transporting natural gas is more challenging and its final use is more varied than for petroleum. Therefore, some of the considerations the investor has to make become somewhat more complicated than the decision described above. Fortunately, the country’s fabulous infrastructure for the marketing and use of natural gas presents an important opportunity for downstream investments as well. Therefore, the government should set the stage for natural gas prices to reflect market conditions and afford an investor fair, attractive rates of return. Moreover, natural gas has the advantage of being a relatively clean fuel, and new technologies are leading to its increased usage.
The new tax regime in Trinidad and Tobago has many of the favorable characteristics of the ‘fixed rate’ option, as in the analogy above, that encourage investors to be there for the long term. However, the government is still working on the challenging area of designing a tax and regulatory regime that can also boost investment and marketing of natural gas. Three policy aspects affecting both oil and natural gas could be improved.
- First, the government should continue to err on the side of offering certainty and transparency of production sharing contracts rather than tweaking tax rates here and there. The latter are unlikely to affect multinational companies’ major decisions.
- Second, government spending needs to be more effective and efficient.
- Third, a correct, fair natural gas price is hard to reach: The government is working on the issue through its upcoming Natural Gas Master Plan. The government should continue to invest in natural gas technologies.
Oil and gas have a very long investment horizon. Creating the right investment environment takes time, but the payoff for the country as a whole may make it more than worth it.
 See the seminal book by Avinash Dixit and Robert Pindyck here.
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