Taxation, Optimization, and Rationalization
Authors: Warren J.E. 
Published: December 2007

Warren, J.E., consultant
SPE Member

Abstract
As exploration continues in frontier areas where adverse environmental conditions are the rule rather than the exception, the petroleum industry is faced with the enigma petroleum industry is faced with the enigma of success; i.e., the need to make development decisions - involving massive capital expenditures - despite technical, economic and political-uncertainties. This decision-making political-uncertainties. This decision-making problem is compounded by the inadequacy of the problem is compounded by the inadequacy of the tax regimes under which management must operate - conventional tax schemes fail to conserve natural resources, they fail to maximize government revenues and they fail to consider the economic risk of-the oil company (operator).
In this paper, three bases for optimizing the design of the production system in a newly discovered field are compared - operator's net cash flow after tax, government take and total net cash flow (all expressed in present-worth, constant dollars). The impact of the tax rate and of the royalty rate on both the optimal design and the specification of a marginal field is also discussed. Finally, a rational tax system is proposed for a specific play - to provide proposed for a specific play - to provide adequate incentives for the operator and to enhance the government take while assuring the recovery of a larger fraction of the reserves contained in the play.
To demonstrate the reasoning underlying the proposed tax system and to illustrate the implementation of the suggested procedure, several numerical examples are presented.

Introduction
The purpose of this paper is to examine the inherent conflict of interest between the government and the oil company (operator) vis "a vis the decision to develop a field in a frontier area. Since the development of productive capacity in such areas requires a timely decision, based on limited and uncertain information, to commit totally to the completion of what may be a multi-billion dollar project, this type of decision represents a unique challenge because there are rarely any case histories or convenient rules-of-thumb which can be used as a crutch. From the operator's point of view, the problem is to determine the probability that the project will satisfy the economic criteria project will satisfy the economic criteria established for the employment of capital and to obtain a measure of the expected economic performance for comparison with alternative projects. On the other hand, the government's goal should be to maximize the public benefit derived from development public benefit derived from development economic rent and resource recovery. Odell and Rosing suggested in their North Sea study that "the conflict of interest be resolved by appropriate government involvement in the decision-taking about the field's development and on the financing of the field's exploitation." In their paper re the effect of petroleum tax on exploration and development, Stauffer and Gault indicated that an "ideal" taxation regime can be specified to maximize government revenues while providing any given level of incentives to the developer. Warren showed the dramatic effect that the form of taxation can have on both the economic criteria and the optimal design for development. Hoyle examined the North Sea and concluded that there are many positive aspects associated with exploration and development in that area and that there are some not-so-positive features - such as the onerous taxation structures and disincentives companies face today. In his review of the status of the Canadian frontier, Taschereau states that "the issue is not whether the oil and gas exist in vast quantities but how much of this tremendous resource will be commercially and technically exploitable".