Economic Problems Related to Oil and Gas Exploration 9789814377676

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The Institute of Southeast Asian Studies

Established as an autonomous organisation in May, 1968, the Institute of Southeast Asian Studies is a regional research centre fOJ: scholars and other specialists concerned with modern Southeast Asia. The Institute's research interest is focused ·on the many-faceted problems of modernization and development, and political and social change in Southeast Asia. The Institute is governed by a twenty-four-member Board of Trustees on which are represented the University of Singapore and Nanyang University, appointee$ from the Government, as well as representatives from a broad range of professional and civic organizations and groups. A ten-man Executive Committee oversees day-to-day operations; it is ex officio chaired by the Director, the Institute's chief academic and administrative officer.

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Economic Problems Related to Oil and Gas Exploration

by

M. Mainguy

Research Notes and Discussions Series No. 1 Institute of Southeast Asian Studies Price:

S$6.00

Publications Review Conunittee Professor Kernial

s.

Sandhu (Chairman)

Dr. Corazon M. Siddayao (Co-ordinator) Mrs. CoP. Chin Dr. Huynh Kim Khanh Mrs. P. Lim Pui Huen Mr. M. Rajaretnam Mrs. Christine Tan

Maurice Mainguyus Eaonomia ProbZems Related to Oil and Gas Exploration is the first in the Researah Notes and Discussions series published by the Institute of Southeast Asian Studies. The author took his first degrees in Physics, Biology and Geology in the University of Paris and graduated in i939 from Ecole Nationale Superieure du Petrole in Strasbourgc He has served as Adviser to the Committee for Coordination of Joint Prospecting for Mineral Resources in Asian Offshor·e Asia (CCOP-East Asia) since 1967. His publications include "Regional Geology and Petroleum Prospects of the Marine Studies of Eastern Asia," in UNDP/CCOP, TeahniaaZ Bulletin, No. 3, May 1970.

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The Institute publishes books and papers from time to time in t;he following series: BOOKS/MONOGRAPHS: specialized studies on topics relating to Southeast Asia. SOUTHEAST ASIAN AFFAIRS: an annual review of significant political, economic and social developments in the region, with emphasis on the ASEAN countries. Contents include analyses in depth of topics of regional concern and of specific issues on a country-by-country basis. FIELD REPORTS: studies embodying the results of, and based exclusively on, the Institute's research programme; OCCASIONAL PAPERS: professional papers issued periodically on a variety of topics of regional interest; RESEARCH NOTES AND DISCUSSIONS: contributions which represent the tentat.ive results of ongoing research, and of discussions, printed for the purpose of st.imulating further t.hought on specific subjects. TRENDS IN SOUTHEAST ASIA:

papers and proceedings of

2'rends seminars held on individual Southeast Asian countries; INTERNATIONAL CONFERENCES: publications based on proceedings of International Conferences sponsored by the Institute itself or in conjunction with other organizations; CURRENT ISSUES SEMINARS: publications growing out of the Institute's Current Issues series of seminars, the objective of which is

to bring together knowledgeable and lnterested people Lo discuss topics of current concern and impc.rLance to tJ:"le reg10n,

SOUTHEAS'T ASIAN PERSPECTIVES~ aimed at wider ci.:r ct~latic:.n cf Southeast. Asian tJ:unking" t.hese pub 1 icat lens are origina~ contributions in English of Southeast As1ans or translat1ons of their sign1-f1cant papers and monog.rapr~s appear1ng in one of the local or national languages of the r:eg1on; ORAL HISTORY PROGRAMME~ publl-CatJ.ons based on the cra.J.. memcirs of persons who have made notable cont.:clbt:d. io:r~ to, or have first-hand information to impart on, certain aspects of the development of Singapore and Malaysia; LIBRARY BULLETINS: papers on Southeast A.sian libra.ti.anshi.p and blbliogLaphy,

Diraco.:.or 15 December 1976

Institute of Southeast Asian Studies

CONTENTS Page I:

GENERAL DISCUSSION

1

Introduction

1

Taxation of Producer's Surplus

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Return on a Risk Investment

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Costs

II:

III: IV: V:

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Returns

14

Risks

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Summation

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APPLICATION TO ASIA

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Potential

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Costs

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Returns

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Risks

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CHINA'S POTENTIAL

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THE FUTURE OF OIL AND GAS IN EAST ASIA

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EPILOGUE

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I:

GENERAL DISCUSSION

Introduction Oil and natural gas have been known since antiquity, but these subtances only acquired economic value in the latter half of the past century. This occurred with the advent of their industrial use and the development of technological capacity to discover and produce large accumulations that could ensure relatively continued supply (compared to small seeps which our ancestors explo1-c.ed for artisanal uses}. Advances in exploration and production techniques have also led to a considerable decline in the cost of production of crude oil and natura! gas, thus sparking the tremendous growth of the industry. However, despite the considerable improvements in exploration techniques and technology, the rate of success in exploration has changed very slightly since oil became a commercial commodity, The notion of the success rate will be discussed later, but it can be stated at the outset that a rate of 10% (1 successful well out of 10 wildcats) , often presented as a so-called world average, can be misleading. Even in certain regions, that are rather prolific, this rate is far from g·enerally attained. The world "exploration" itself, for which oil prospecto:rs demonstrate a predilection, conjures an image of a perilous adventure in uncharted lands rather than a normal industrial

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At the outset, gasoline was a worthless by-product, The development of the petroleum industry is associated with that of the internal combustion engine and, originally, with the automobile industry, lndusLrial markets were subsequently developed, together with domE:stic. heating and air conditioning, Anxiet.y about an oil shortage which occasionally grips the industrial world generally gives rise to accelerated exploration effort and oversupply. In order to protect their national industry, the United States set impo·rt quotas in 1959, causing the collapse of Middle East oil prices and providing an impetc.s for the speedy re::::overy of Lhe European and Japanese economies - rapid bu'C. vulnerable because based exclusively on o~l, As a defensive reflex, the producing countries created OPEC (Organ~zation of Petroleum Exporting Countries) in 1960o This organization grew in strength, deriving its force from thE. fragile growth of industrialized nations,

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and commercial activity capable of be1ng subjected w1th The explorer acceptable precision to economic analysis. anticipates rewards from his expedition: when the King of Spain financed the quest of Christopher Colu1~us, he anticipated gold and spices; seeking India, he discovered America. Oil prospectors sometimes end up with sim1lar results; hence, the potash mines of Alsace, in northeastern France, were discovered while searching for oil, and ten years or so later, a borehole intended to reach an extension of the potash deposit gave rise to the discovery of a small oilfield. Estimating the value of a petroleum explora~ion project entails a series of operations. First, hydrocarbons Then they must be discovered, where nature deposited them< must be transported to the point of consumption, and refined into commercially useful products that can be sold in the F1nally the overall operation markets where they are needed. The fluid nature of oil requires a must produce a profit. specially adapted transportation network. This need becomes more pressing as oilfields are chiefly situated at. Furthermore, g:t~eat dist.ances from centres of consumption. It must be 011 cannot be employed as it is found" fractionated, and each fraction pur1f1ed, sometimes even drastically mod1.f1ed, to obtain usable products of constant quality, the so-called 11 standard" products. 2 Natural gas requires fewer conversions, except for the fractlon used for petrochemicals, but its overseas transportation J.s more difficult and more costly than that of crude 011, whether by land or by sea, The selling price of a crude 011 depends on its composition and on the value of the products which can be derived from it. The price of natural gas is based on its heating value, which can be lowered by the presence of inert gases (C02, N2, etc,) c

There are other problems related to the economics of pe-c:roleum explorat1on that. are not dealt with 1n this One may ask whether transportat1on should cursory review. precede conversion, or v1ce versa; in other words, whether the refining industry should be placed near production

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This was observed from the start by Rockefeller, who created th£ Standard Oil Company, which was subsequently broken up by region as a result of antitrust suits by the Uc S. Government.

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areas, as in the beginning, or near markets, reflecting current practice. Producing countries would like to recover the value added by conversion: this viewpoint is debatable 3 0

A second problem arises - the problem of allocating the producer's surplus between the public and private sectors; it must be emphasized that such a problem is totally independent of the need for the existence of a surplus. Taxation of Producer's Surplus The problem mentioned above, that of the distribution of producing surplus or profits, cannot be neglected in any economic analysis of exploration projects" For convenience, this problem will be discussed first. To state the problem in terms of sharing a surplus assumes that petroleum production is only subject to a tax on profits, in other words, that one first determines the value of the surplus (actual receipts less expenses) , and that one then sets a tax rate applicable t.o the profits thus Computation of receipts, once quantities sold calculated. and selling prices are known, appears to be a simple matter. However, when oil becomes abundant relative to demand (see foot.note 1) , prices drop and calculation of taxable profits become less determinatec Normally, the market mechanism is essentially triggered final consumer stage or in the product market, with the at repercussions on the price of the raw material, crude oil, sold in the world market.4 In a large number of consuming

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The decision to transpcrt crude oil to market locations for refining is relatively recent. It dates from the 1950s with the development of huge oil tankers (see Bart Collins, "Energy and New Business Opportunities, 11 Financial Times Conference on Southeast Asia Shipping, Singapore, June 1975) and fairly rapidly became debat.able in r:he 1960s, However, refining and conversion are marginally profitable, and the bulk of the value added by downstream operations occurs at the marketing level,

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Owing to technical difficulties and the cost of its maritime transport, no real world gas market exists today.

4 countries (e.g., countr1es 1n Europe and Asia), the selling price of a wide range of products lS fixed by the government; the tax on light products, where consumption is almost price-insensitive, is usually considerable, Nevertheless, both the price of crude petroleum and products, in constant value terms, declined during the 1960so The integrated, major oil companies have a certain freedom in setting the price of crude oil sold by the production subsidiary to the refining subsidiary, and thus in shifting profits upstream or downstream. While they tend to allocate a major portion to the upstream or producing stage, a practice which slowed down the decline in crude oil selling prices, this did not completely prevent such price from dropping. Gradually the host governments adopted the method of comput1ng profits, not on the basis of actual selling price, but on a fictitious selling price or the posted price. The posted price was in1tially determ1ned by negotiat1on between the oil companies and the governments of producing countr1es (among which the most important formed the Organization of Petroleum Export1ng Countries (OPEC) in 1960, see footnote 1); subsequently, it was unilaterally se-c by t.b.e government, This amounted to replac1ng a tax on profits with a tax on production. In effect, this is a tax charged per barrel, at a f1xed level, irrespective of the true profit derived from the sale by the company. 5 In addition to this tax on production, the producing countries levy a royalty at the source. This is a legacy of Anglo-Saxon la'g, in which the owner of the land also owns the subsoil. But, because he generally lacks the technical and financ1al capability to exploit the subsoil he ass1gns it to an operator who grants him, in exchange, a share of the products extracted from the subsoil. By collecting this royalty, the state acts more in the capacity of the owner of the land than a tax collector. The royalty, levied at the well-head, or as soon as the 5

The original posted price was nothing but the label placed by a tradesman on a product signifying: I wan-e to sell this product at such a price - and am prepared to bargain. It soon became the reference basis for levying of taxes. Nevertheless: contracts do exist in which the reference value is the reaiized sales price; in this case, the tax is actually a tax on profits, and not a tax on production.

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A fundamental discussion of the Anglo-Saxon philosophy behind royalty payments may be found in "The Angla-Saxon Land Law t" Essays in AngZo-Saxan LOJJJ (South Hackensack, New Jersey: Rothman Reprints IDC.o •

1972c)

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oil has left the ground, was originally considered as a tax advance, and was offset against the total taxes levied on profits.? It was thus treated as an operating expensef stressing its aspect as a tax on production, which can be justified theoretically by the fact that it is applied to nonrenewable resources, The overall arguments concerning the tax on profits are placed within the framework of conventional licence contracts. These contracts are gradually being abandoned in favour of joint ventures associating the producing country and the contractor, such as the production-sharing contract developed by Indonesia. This type of contract has already been subjected to a thorough examination in the publicat~ons of the Institute of Southeast Asian Studies (ISEAS); its use is becoming widespread in Asia, and 1t guarantees an acceptable profit to contractors, as well as stable, good overall relations between contractors ar.d governmental and administrative bodies. Agency contract_s only assign to contractors the role of operator appointed on behalf of the state company, the risks incurred being remunerated by a reduced price sales contract covering a portion of productiono Return on a Risk Investment The evaluation of an exploration operation ul1:imately falls within the overall context briefly described aboveo For any industrial operation, it is necessary to compare the anticipated return on the initial investment 1 the expected return being itself encumbered with tax charges to varying degreeso However, in oil exploration, an additional factor is involved, the risk factoro While it is t.rue that every industrial venture incurs a risk, the risk of a manufacturing company is relatively

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Most contracts provide for the State co take in kind, and to sell for its own &ccount, the production fraction making up thE: royalty, The State can only gain from this clause if prices are higho

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Robert Fabrikant ~ Legal Aspects of Prcduction Shar•ing ContY•acts in Indonesian Pe-troleum IrLdustry, Field Report Series No, 3, l97..L

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minor compared to that of a company exploring for oil and gas. For any industrial company, the major risk is commercial: the product, after manufacture, may sell poorly, or at an excessively low price. In general, in the case of mining exploration, especially petroleum exploration, the risk is one of failure to find the product, and this risk is very great. The cycle of petroleum operations begins by a random operation, exploration, to be succeeded by industrial operations, where the risk factor is diminished: development, production, refining; the risk increases again in conversion, and the cycle ends with marketing, where it reaches a random level, as at the startc However, the seller can act on the buyerr whereas the prospector is impotent in relation to nature. There are therefore three factors - costs, returns, risks - to be considered in oil/gas exploration. Costs. Exploration in an unknown region starts with a general survey. Much use is made of the methods of aerial reconnaissance, which are rapid and reasonably cheap. These provide general views which are invaluable for an understanding of the geological structure of basins 9 likely to contain oil, Measurements by airborne magnetometer provide an idea of the thickness of the sedimentary series and the main deformations of the basement. 10 Aerial surveys can be supplemented by geological surveys in the field, which, in equatorial forest zones, combine excessive cost with dubious results. Gaps still exist in the geological chart of Borneo, Irian, Mindanao, and no single Southeast

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The anomalies in the terrestrial magnetic fields are measured by towing a highly sensitive magnetometer behind an aircraft, A magnetometer can also be towed behind a ship. Sedimentary series are rocks resulting from the transformation, through a long period of time, at relatively low temperature, of old deposits: sands, shales, limestones. These deposits store up organic matter derived from the remains of marine or lake animal and plant debris" Bacterial fermentation processes transform this organic matter into hydrocarbons (oil and gas) which flow through the porous rocks and accumulate above water (which is heavier) in the upper zones of beds deformed during folding phenomena,. The succession of different sedimentary rocks in a basin is called "stratigraphic section,"

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Asian country has been completely covered by a large-scale geological survey. Gravimetric measurementsll are sometimes undertaken on land. Advances in airborne magnetometers and in the quality of photographic documents obtained by satellites have led to a renovation of geological notions concerning vast zones which were, until relatively :r:ecently, considered as not worth prospecting, such as certain internal basins of Central Africa. The cost of an airborne magnetometer survey amounts to a few US dollars per mile, and a satisfactory geological picture can be obtained by a general survey with flight paths at five or ten-mile intervals, provided that they are correct.ly oriented. Because photogeology and field geology are obviously unfeasible at sea, airborne magnetometer surveys are widely resorted t.o for offshore exploration, and almost all the marine zones of Southeast Asia have been covered by ~irborne magnetometer as part of the operat.ions of the CCOP. 1 However, a fundamental difference exists between exploration strategies at sea and on land. The selsmic operationsl3 naturally follow aerial reconnaissance and field surveys. On land, it is always difficult to compile satisfactory networks of seismic lines; houses, crops, roads, and dense

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Anomalies in the earth 1 s gravitational field are measured, Interpretaticn is a highly complex matter.

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The Committee for Coordination of Joint Prospecting for Mineral Resources in Asian Offshore Areas (CCOP) created in 1966 with~n the framework of ECAFE (now ESCAP), originally composed of four countries - Japan, South Korea, Taiwan and the Philippines - now includes nine countries: Japan, South Korea, the Philippines, Vietnam, Cambodia, Thailand, Malaysia, Singapore and Indonesia. Sinc.e 1972 it has benefited from the ba~king of a project of the United Nations Development Programme (UNDP)o

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This method involves the determination of an image of the structure of the subsoil by producing an acoustic wave in the ground. Initially produced by an explosive, such waves are now produced with various means of creating a ground concussion: weight dropping, sustained acoustic waves reflected by the beds of the sedimenr.ary series capable of reflecting the waves, on a series of receivers (geophones) preferably aligned in a straight line,

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forests obstruct work. The upper portion of the ground is altered to a variable depth (weathered zone); in principle, it is necessary to bury the explosive charge underneath the weathered zone and, in order to statistically eliminate the interference created in this zone, irrespective of the concussion source, to increase the number of recording geophones and of the shots (multiple coverage). The movement of these shooting and recording systems raises practical problems in any type of environment. These problems, which are relatively minor in desert zones and savanna, become formldable in thickly populated regions and dense equatorial forest. The cost of a survey by seismic reflection can amount to serveral thousand US dollars per mile; in extreme cases, it can exceed US$10,000 per mile, not including the cost of interpretation. Processing designed to eliminate interference from raw recordings can cost about US$400 to US$500 per mile; interpretation is then carried out by experts, and its cost is difficult to estimate, such cost depends mainly on the geological complexity of the reglon and on ~he body of data likely to guide the expert in his work. At sea, the matter takes on a completely different complexion. Ecological constraints (in respect of marine fauna) and requirements pertaining to technical efficiency converge in this case. Explosives are dispensed with and replaced by acoustic wave propagation sources which are apparently weaker, but which can be multiplled ad infinitum: gas or air gun, electrical sparks (sparker methods), implosions (flexichoc and vaporchoc) . It is also easy to tow a line of geophones behind a ship, without t,he need for a large team of workers to install, remove and transport them, The monthly cost of a marine team amounts to about US$250,000 - in other words, about the same order of magnitude as the cost of a full-scale land survey teamc However, the output of a marine team is far greater than that of a land team: about l, 500 miles per month at, sea, as compared with 60-100 on land.l4 As a result, the cost per mile recorded only amounts to a few hundred US dollars at sea, frequently less than the cost of laboratory processing. Even the latter item is cheaper for marine seismics than for land seismics. There is no need to l4

For example, in 1975, onshore seismic operations represented 75% of the total cost of seismic operations of the Elf-Aquitaine group, but produced only 16% of total mileage produced. The cos~ on land was between US$2,000/mile and, in rainy forest areas, US$15,000/mile and offshore it varied between US$140 and US$540/mile.

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eliminate the effect of the weathered zone; on the other hand, it is necessary to eliminate the multiple echoes between the seabed and the surface. One may conclude from this cost comparison, and particularly from the rapidity of execution, that marine seismics will frequently be employed as a major survey method. Furthermore, it is possible to further simplify the recording techniques, driving costs down even more with less overall data being acquired. Within the framework of the work programmes of the CCOP, the seas bordering the countries of Southeast Asia have been covered by general reconnaissance seismic surveys, the results of which have been published in the Technical Bulletin of the CCOP and in the Bulletin of the American Association of Petroleum Geologists (AAPG) .L 5 These surveys enabled the pinpointing of potential oil-bearing basins in the region and plott.ing of their approximate limits. They are inadequate for a sufficiently precise determination of zones of interest, and this task must be handled by the oil companies In zones which have never been exploied, a themselves. group of oil companies sometimes carries out a joint survey covering the entire zone in question. Sometimes a seismic contractor carries out a speculative survey on his own It initiative, for subsequent sale to the oil companies. a provides magnetometry airborne that above stated was statisfactory survey pattern with profiles at five to This remark also applies to seismic ten-mile intervals. surveys; however, in the latter case, shooting always In takes place along a network of orthogonal lines. detail work, the average spacing of seismic lines may reach one mile or less. Once the interpretation has been made, a detail survey often leads to another. Whatever the outcome, no positive information confirming the presence of oil or gas in a region can be One often reads obtained except by the drilling of wells. in the press that "proof has been obtained [sometimes adding that all the experts are categorical on the matter]

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Marine seismics are easier to record and interpret ~n de;eper waters. Shallow water seismics, performed in swamps &nd deltas which are often favourable petroleum zones, are far more costly per recorded and interpreted miie than deep water seismic.s ~ but are nevertheless cheaper than land seismics.

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that. a major oil-bearing basin - comparable to the Middle East - exists in such and such a region 11 , whereas not a single well has been drilled; assertions of this type are absolutely undeserving of credence. An oil expert will never assert the presence of oil, and will be even less inclined to provide figures, as long as no well has been drilled; he will only state that the general conditions are more or less favourable. On the other hand - we shall return to this later - he will not be discouraged after one or even many dry holes. The drilling of a well will not immediately follow the survey campaign (even without accounting for the time required to obtain a mining licence) The interpretation of this survey will have attracted attention to certain structural zones which will be covered by a detail survey, in order to provide the best location for the first well, It sometimes happens that: certain seasons - such as the monsoon in Southeast As1a - are unfavourable to field and offshore work, introducing an additional interval between general and detail surveys. The cost of drilling, unlike the costs of seismics, are far higher at sea than on land, The daily rental of a drilling installation on land, capable of drilling to a depth of 3,500 metres (about 12,000 feet) amounts to about US$5,000 in 1974 prices. At sea, the cost depends on the type of support for the drilling unit (which is identical to t.hat employed on land to drill to the same depth). The daily rental of the 1nstallation capable of drilling at sea (drilling unit mounted on a marine support) varies from US$12,000 for units mounted on swamp barges to US$40,2~0 for ultramodern self-contained dynamic positioning units, capable of dri~ling in more than 200 metres of water, A jack-up rig,l' capable of drilling in a maximum 16

A dynamic pos~t1.oning machine includes a very precise satellite locaLing syst:em, which constantly gives the difference between the actual pos~tion of the ship and its initial position vertically above the borehole, It also includes two or more propellers at the ends of the machine, actuated by independent motors, which automatically receive movement instructions to correct this difference from the computer which calculates the difference,

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A jack-up drilling system is a self-elevating platform, The legs rest on r.he sea floor, and the position of the pladorm along the legs is adjusted tc the water depth by use of screw jacks.

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of 60 metres of water, will cost between US$15,oo2 and US$20,000 per day. A modern semisubmersible rig, 8 capable of drilling in depths up to 200 metres, will cost a daily rental of more than US$30,000 (see Table 1)