Oil royalty: Was it 20 pct of production, or profit?

In its election manifesto, Pakatan Harapan had promised to pay 20 percent royalty to oil-producing states so that states could fund more of their own development.

But was it 20 percent of nett production or nett profit? That was the question that arose in Parliament this week.

In this instalment of KiniGuide, we look into oil-royalty payments and what the law says about it.

Who pays oil royalty and why?

Under the Petroleum Development Act 1974 that established Petronas, Petronas is supposed to pay the federal government and any relevant state government “cash payments as may be agreed between the parties concerned.”

This is in exchange for having the states surrender its oil and gas rights over to Petronas, which is otherwise the state’s prerogative under the Federal Constitution.

Under agreements signed with each state, the rate was set at five percent of the value of the petroleum “won and saved” onshore and offshore of the relevant state, and is payable annually. The law defines petroleum as both oil and gas.

“Won and saved” is a technical term, but essentially refers to gross oil and gas production.

Who gets the money and how much?

Malaysia’s oil-producing states are generally considered to be Kelantan, Terengganu, Pahang, Sabah, and Sarawak, since these are the states nearest to the oilfields.

According to latest figures available from the Energy Commission, crude oil production in Malaysia in 2016 was 234,395,000 barrels, while natural gas production was 62,723 kilotonnes of oil-equivalent.

Petronas’ annual reports state that its cash payments to the state and federal governments that year amounted to RM7.1 billion, which would have included royalties for both oil and gas.

However, the Federal Government under the previous administration had contended that no oil had been found in Pahang, Kelantan and Terengganu, and thus Petronas is not legally obliged to pay royalty to these state governments.

This is because under the Territorial Seas Act 2012, territorial waters is defined as the sea within 12 nautical miles (22.2 kilometres) of the coastline, except for purposes of the Petroleum Development Act where it is defined as three nautical miles (5.6 kilometres).

Offshore oil platforms off the East Coast are beyond that three-nautical mile limit, and in some cases are hundreds of kilometres from the shore.

The Federal Government collects oil royalties from these offshore oilfields instead, including those on continental shelves rather than territorial waters, but in practice also pays wang ehsan (consolation money) to the state governments.

When an oil field was found off Bertam in 2012, for example, the then prime minister Najib Abdul Razak announced that the Pahang government would be entitled to up to RM100 million in annual payment.

This is despite the fact that it is located 120 kilometres from Pantai Geliga in Kemaman, Terengganu, and 160 kilometres from the coast of Kuantan. The two states have since been embroiled in a dispute over their maritime boundaries.

How does Pakatan Harapan promise to change this?

This is outlined under “Promise Three” of the Harapan manifesto, which promised to share the nation’s wealth in a targeted and equitable away.

The relevant paragraphs read: “Oil and gas-producing states will be given royalty or its appropriate equivalent value. The cruelty of Umno and Barisan Nasional that have been denying these payments based on political leanings will be stopped immediately.

“The Pakatan Harapan government will increase the royalty payment to Sabah and Sarawak, and other oil-producing states, to 20 percent or of its value equivalent, so that the respective states can take over and fund more of their own development activities.”

It should be noted that the manifesto makes no reference on how the 20 percent figure will be calculated, which led to the belief that the five-percent figure in existing agreements would simply be raised to 20 percent.

How are things turning out?

While fielding questions about Harapan’s oil royalty promise at the Dewan Rakyat on July 19, Prime Minister Dr Mahathir Mohamad mentioned that the 20 percent royalty will be calculated based on profit.

“It is not only the right of Kelantan or Terengganu. It affect all areas, all states that produce oil. Profit […] 20 percent of profit. Thank you,” he said, according to the Hansard.

In response, Sarawak Chief Minister Abang Johari Openg said he would seek clarification about the prime minister’s statement.

"We will get an explanation because royalty and profits are not the same,” he said.

Terengganu Menteri Besar Ahmad Samsuri Mokhtar said the state government will studythe matter and would only agree to it if it benefits the state.

Kelantan Deputy Menteri Besar Mohd Amar Nik Abdullah rejected the proposal outright, and instead demanded for five percent royalty that is paid based on oil production.

“In our opinion, the royalty should not be paid based on profits, as production is more important.

“If oil prices or sales are high, we could get a lot, but if the prices or sales are low, we could get only a little (if oil royalty is based on profits).

“But even if we are only given five percent based on production, we would receive no less than RM700 million a year,” he said.

For the record, Kelantan had previously received oil royalty payments, but the payments ceased after PAS took over the state in 1990. Mahathir was the prime minister at the time. In 2000, the Federal Government under Najib began making wang ehsan payments to Terengganu while Kelantan began receiving these payments in 2010.

On July 25 this year, Economic Affairs Minister Mohamed Azmin Ali countered that Petronas would have to cease operations if it has to pay a 20 percent royalty if it is calculated based on production rather than profit.

However, he promised to discuss the matter with oil-producing states.

Profit or production – What difference does it make?

The profitability of an oil-extraction venture depends heavily on the global price of crude oil, and how much it costs to extract it.

Oil from land-based shallow oil fields like those in Saudi Arabia is among the cheapest to extract, while extracting oil from shale such as in the US and deep water such as in the Atlantic Ocean are among the most expensive.

Malaysia’s oil fields typically fall in between these two extremes, being located predominantly in shallow waters. According to a PricewaterhouseCoopers report in April 2015, the minimum break-even point for Malaysian oil producers is between US$55 to US$60 per barrel.

This means that if Petronas is required to pay royalty based on oil production profits, state governments will earn nothing until oil prices rise above the break-even point.

If oil prices are high and soar above US$75 to US$80 per barrel, however, state governments stand to earn more under the profit-based scheme than the current scheme that pays five percent royalty based on production.

At US$80 per barrel, oil royalties would have been US$4 per barrel under the current five percent production-based formula, or about US$4 to US$5 per barrel under the proposed 20 percent profit-based formula.

The profit-based formula is even more profitable compared to the production-based formula if oil prices soar higher.

On the other hand, the present production-based formula requires Petronas to make payments regardless of whether it is profitable to produce oil or not.

This provides a smaller but arguably steadier source of income for governments as long as the oil fields don't become so unprofitable that they are shut down.

The Brent Crude price is currently about US$74, but the actual price for Malaysian crude oil will vary even from one oilfield to another. According to a notification gazetted by the Royal Customs Department on July 17, for example, Tapis Blend is valued at RM306.28 per barrel, while Bertam Crude is valued at RM323.03 per barrel.

Crude oil prices are also highly volatile and sensitive to global political and economic developments. - Mkini