The oil royalty conundrum

Distribution of oil wealth is a contentious issue. Azam Aris looks at a possible solution.

Azam Aris, fz.com 

A FEW weeks ago, an ex-colleague who is now working with a foreign embassy sent me several questions about Malaysia's oil royalty. The issue, she added, was of interest to them. 

 

I did not ask why that was so but I guess it is the job of an embassy to get as much information as possible on socio-economic and political matters that could have an impact on the country it represents. 

 

The oil and gas industry worldwide, including here in Malaysia, attracts a lot of investments from multinationals (MNCs). Nearly all the big petroleum players are doing business here, with super majors like Exxon-Mobil, Shell and Conoco-Phillips awarded offshore exploration and production blocks.

 

The industry also attracts its fair share of controversy – ranging from human rights and environmental issues to the fair distribution of oil wealth by the central government in places like Nigeria, Sudan and Indonesia's Aceh province.

 

Distribution of the oil wealth, which is related to the royalty, has been an issue in Malaysia since 2000 when the federal government directed the national oil corporation, Petronas, to stop payments to the Terengganu government, which was then controlled by opposition party PAS.

 

On Jan 22, the Kelantan government – also controlled by PAS – filed an application for a court injunction to prevent Petronas from paying the state's "share" of the royalty to the federal government. Petronas and the federal government say Kelantan is not entitled to the royalty - which is the subject of another court case.

 

Kelantan had in fact mooted the idea of a G5 – to include the four other oil-producing states of Terengganu, Sabah, Sarawak and Pahang, all controlled by the ruling Barisan Nasional – to make a united stand when negotiating oil royalty.

 

It may all be a bit complicated for uninitiated readers. I will try to shed some light on the issue based on the questions asked by the foreign embassy. Of course, these are my personal views.

 

How is the royalty from Petronas to the states calculated?

 

First and foremost, get hold of the Petroleum Development Act (PDA). It is the Act that governs the oil and gas sector and Petronas' role as custodian of the country's hydrocarbon resources. 

 

The oil companies are just contractors and Petronas is the owner of the blocks awarded. The oil companies sign a production-sharing contract (PSC) with Petronas. The PSC stipulates the sharing of the resources among the federal government, states, Petronas and the oil companies.

 

In simple terms, this is how the royalty works for the first-generation PSCs, based on the gross production of crude oil or gas. 

 

Let's assume that gross production of crude oil is 100 barrels. Of this, 10% or 10 barrels are set aside as payment for royalty. The federal and state governments where the oil is produced get five barrels (or 5%) each. Oil companies are then allowed to claim a recovery cost up to a maximum of 20 barrels (or 20%) – considered "cost oil". The remaining 70 barrels (or 70%) – "profit oil" – are split in the ratio of 70:30 in favour of Petronas.

 

That's the basic formula. As oil and gas extraction becomes more difficult, with exploration moving into deeper waters, the percentage of cost oil and profit oil are increased in favour of the contractors. But the royalty remains at 10% – 5% each for the federal and respective state governments. Payment is made twice a year by Petronas straight into the state's coffers.

 

Are states eligible for royalty if the oilfields are situated more than three nautical miles from shore? Did the three-nautical-mile condition only come up after Kelantan made a claim on the Joint Development Area (JDA) in the overlapping waters of Thailand and Malaysia?

 

Almost all offshore oil and gas fields in the country – whether in Terengannu, Sabah or Sarawak – are more than three nautical miles from shore. They all get their royalty. 

 

The PDA 1974 was crafted in the spirit of sharing revenue between the federal and state governments. There wasn't any issue until 1999, when PAS took control of the Terengganu government. The federal government, as the sole shareholder of Petronas, decided in 2000 that payment to the state government should stop. Part of the royalty – known as wang ehsan or goodwill money – was then channelled to federal-based agencies in the state.

 

PAS then took the federal government and Petronas to court. One of the main defences was that the Terengganu government was not entitled to royalty as the oilfields were not within the state's waters as they were more than three nautical miles from shore and thus belong to the federal government. So, based on the same argument, Kelantan too is not entitled to the oil royalty.

 

But if that were the case, Sabah and Sarawak should similarly not be entitled to the royalty. However, the federal government's counter argument was that oil was first discovered in Sarawak and Sabah during British rule and that they were governed by a different set of rules. 

 

How is wang ehsan calculated for Terengganu?

 

It should be based on the same formula as the PSC. But since the case was taken to court and was still pending then (PAS filed suit as the ruling state government and not as the political party), the federal government cannot give back the royalty back even though the state government returned to Umno's control in 2004. 

 

So wang ehsan became a permanent arrangement until the Umno state government officially dropped the case. So since Petronas can't pay the royalty to the state government, it now gives Terengganu's 5% share to the federal government to manage it for the state. But the Terengganu government, now under Umno, has reported that the wang ehsan it gets does not exactly tally with the 5% royalty the state is entitled to.

 

Are the royalties to Sabah and Sarawak paid directly to the state by Petronas or via the federal government?

 

The PSC and PDA apply. Petronas pays directly to both state governments twice a year. 

 

Do the PSC companies also pay oil royalty? 

 

The PSC and PDA also apply here. This means that under the PSC they sign with Petronas, 10% of the gross production goes to royalty payments – 5% each to the state and federal governments – if oil or gas is discovered. Payment will be made by Petronas. 

 

Do the oil companies that have PSCs with Petronas also pay other taxes?

 

Yes, they pay Petroleum Income Tax (PITA) – for which the rates are higher than the normal corporate tax. However, PITA is only applicable to exploration and production companies operating in the upstream sector. In the downstream sector, oil companies – for example, the retail/marketing arm of Shell – pay the normal corporate tax. That is the basic tax structure. 

 

As for the states themselves, what do they want? Kelantan wants its share of royalty which it claims it is entitled to and says the PDA does not discriminate when it comes to paying opposition-controlled state governments. 

 

In the process of executing the PDA, Petronas/federal government had signed a vesting deed with all state governments, noting their entitlement to royalty payments if oil or gas is discovered.

 

Terengganu, which is now under Umno, no longer wants the oil revenue to be paid in the form of wang ehsan – although it has not announced it officially. It wants to revert to the days before 2000 when the royalty went straight into the state's coffers.

 

For Sabah and Sarawak, the BN state governments have no reason to complain as Petronas pays the royalty payments promptly. But there have been suggestions from them about a higher share. The opposition, as part of its political campaign, has said it will increase royalty for all-oil producing states to 20%. It considers the move feasible but the federal government claims it will only bankrupt Petronas.

 

My view is this: At the moment, the royalty cannot be increased to 20% as it is governed by the PDA. Any changes would need an amendment to the Act. One also has to take into account that the existing PSCs that Petronas has signed with the MNCs – stipulating a royalty of 5% to the states – are still intact. 

 

But is it possible to pay oil-producing states 20% of the oil revenue without putting a severe strain on the finances of Petronas and the federal government? Yes, but there is a caveat.

 

Here is how it could work. 

 

At the moment, all the states (and that should include Kelantan) get 5% royalty. If the federal government gives up its share, then the state's royalty is increased to 10%. The remaining 10% could come from the oil revenue that the federal government gets – dividends from Petronas, PITA, corporate tax and export duties – which totalled RM56.4 billion in 2011. 

 

For the oil-producing states, the caveat is that the federal government has to compensate for the shortfall in its revenue. So, if they get higher royalty paid directly to the state governments, they can manage their own revenue and prioritise their development according to their needs. But they should also get much less development funds from the federal government. This would, in turn, allow the federal government to channel the bulk of its revenue and development expenditure to the non-oil producing states.