An Empirical Analysis of the Fiscal Regime for Exploration ... · • Prices are set according to the fiscal regime governing a producing field • The fiscal regime has evolved over

Out of Gas:

An Empirical Analysis of the Fiscal

Regime for Exploration in India

Anupama Sen

JUNE 2014

IAEE INTERNATIONAL CONFERENCE, NYC

Senior Research Fellow, Oxford Institute for

Energy Studies, United Kingdom

1. Natural Gas in India

2. Conceptual Literature on Resource Taxation

3. Empirical Literature

4. Method

5. Analysis

6. Results

7. Observations & Conclusions


Outline

• Gas forms 11% of India’s primary energy consumption • Relatively ‘young’ but growing sector

• India’s gas reserves – 0.7% of world reserves

– Range of estimates

– Mostly offshore

• Consumption • 60 Bcma (20-30% LNG)

• 70% used in power generation, fertiliser industry, household use, transportation

• Policy on gas • Substitute for coal, naphtha, fuel oil

• Security of supply / mitigating energy shortages

• Environment


1. Natural Gas in India


Electricity

Other Energy Industry Own Use

Manufacturing Industries

and Construction

Transport Residential Other

Total CO2 Emissions from Fuel

Combustion

OECD 4,007 558 1,423 2,699 797 1,408 10,096

UK 2,873 519 822 1,919 1,325 1,643 7,776

USA 7,448 845 1,893 5,229 1,038 1,897 17,312

India 748 52 342 138 64 108 1,388

China 2,659 205 1,734 382 225 416 5,395

Brazil 230 129 585 852 87 194 1,989

Africa 414 39 138 215 56 104 910

Middle East 2,715 786 1,577 1,651 623 829 7,559

Per Capita Emissions by Sector, 2010 (kg of CO2 per capita)

Source: IEA (2008)

Potential for gas in electricity and transportation

• Prices for domestically produced gas are controlled • To keep prices to consuming sectors low

• Prices are set according to the fiscal regime governing a producing field • The fiscal regime has evolved over time; thus multiple pricing mechanisms

• India’s 1999 liberalised upstream fiscal regime • Prices based on an ‘S curve’ formula with a cap and ceiling

• SP = $2.5 + (CP – 25) 0.15+ C

• Five year reviews

• Formula rendered redundant by high oil price – Ceiling of $60/bbl breached very early on

– Review of pricing currently underway; proposals to link it to Henry Hub, NBP and Japan LNG


Pricing


India Gas Price vs International Benchmarks

Source: BP Statistical Review; Govt of India

Henry Hub

India LNG Imports

• Liberalised regime launched in 1999 • New Exploration Licensing Policy

• Based on a Production Sharing Contract (PSC)

• Hybrid system (royalty + taxes on ‘rent’)

• Main features 1. Royalty

• 10%, 5% for first 7 years

2. Cost recovery • Opex, capex & royalty up to 100% pa

3. Profit Sharing • Based on a R-factor, or the ratio of cumulative income to cumulative capital

expenditure.

• Two tranches, 1.5 and 3.5. Shares in-between worked out using an extrapolation formula Z = a + [(b-a)*(X-1.5)/2]

4. Corporate Income Tax • 30-40%

5. Minimum Alternate Tax • 18.5% of ‘book profits’ if IT payable is < 18.5% of ‘book profits’


Fiscal Regime for Gas


Gross Production

Total Profit Oil

Cost Recovery

Taxable Income

Contractor Take

Royalty

Government

Share

Government Take Tax

(+) (+)

(-)

(-)

(+)

(+)

(-)

Contractor Share

Graphical Illustration of PSC Regime

• Production • Large initial increase (2009) followed by dramatic decline in production; currently a

third of original targets

• Driven by private sector

• NOC production has remained stagnant

• No significant new discoveries since 2004

• Investments • Down from $4.7Bn in 2007 to $1.6 Bn in 2013

• Arbitration & delays • Companies accused of gold plating in the R Factor

• Alleged loss of revenues to exchequer

• Proposed Policy Solution • Replace the PSC regime with a simple Revenue Sharing Contract (RSC) Regime

• Eliminate royalty, cost recovery and profit sharing (R Factor)

• Companies simply share a percentage of their revenues from day 1 of production

• Production slabs pre-specified by the government. Percentage revenue shares biddable by companies at the time of the auction rounds


Performance of India’s Fiscal Regime


Drop in Production Increase in Consumption & Imports

Source: BP Statistical Review, PPAC India (2013/14)

Performance …(contd)

What to Tax - The Base

• Net income / rent / liberal regimes – Pure rent = surplus or financial return

not required to motivate economic

behaviour

– Supply price of investment = costs of

capital and operation plus risk premium.

Lower supply price, higher rent. Risk

premium affected by policy

– Zero marginal fiscal take

– Requires information on production

volumes, costs, prices, investments

• Gross income / proprietorial

regimes – Positive marginal rent, reservation

ground rent, and excess profits

– Information on prices and volumes only

• Mommer (1999), Baunsgaard

(2001), Hotelling (1931)

How to Tax - The Instruments

• Net Income /rent – Resource Rent Taxes (R Factor, Rate-

of-Return), Progressive Profits Taxes, Corporate Income Tax, VAT

• Gross Income – Royalties, Bonuses, Fixed Fees,

Minimum Work Programs

• Other – Government equal partner

Government/NOC equity participation, Brown Tax (

– Most systems use a ‘hybrid’ or combinations of both elements

2. Conceptual Literature on Resource Taxation

Royalties Corporate

Income Tax

Resource Rent

Tax

Brown Tax

Production

Sharing

Royalty rate =

cost oil cap

Tax rate =

government

profit share

Paid Equity Tax rate =

equity share

Carried Interest Tax rate =

equity share

Target real rate

of return =

interest rate

Concessional

Equity

Tax rate = share

of initial

concessional

investment

Tax rate =

equity share

Target rate of

return =

interest rate


Source: Baunsgaard (2001)

Equivalencies in Fiscal System Design

• Desirable features of a fiscal system (Nakhle, 2008) – Efficiency

– Neutrality

– Equity

– Sharing of fiscal risk

– Simplicity

– Stability of fiscal terms and of revenues

• Trade-offs between features – Neutrality trades off with efficiency and with revenue generation

– Neutrality trades off with simplicity

– Equity trades off with simplicity and efficiency

– Stability trades off with fiscal risk sharing

• Selection of instruments is contingent upon the government’s objectives in fiscal system design


Desirable Features & Tradeoffs

• PSC regime analogous to rate-of-return system; RSC regime to price cap system

– PSC (RoR) necessitates information on volumes, costs, prices and investment

– RSC (Price Cap) necessitates information only on volumes and prices

• Under a price cap type system, the government will most likely need to accept a lower overall expected level of taxation and lower take but stable (yet lower) revenues

– Conversely, investors face greater risks in sinking investments into difficult (offshore) areas

• In utilities and resource taxation price cap systems almost always revert towards rate-of-return (Tapia, 2012; Helm, 2010; Liston, 1993)

– The setting of appropriate caps ultimately necessitates information on cost functions

– Governments may therefore be compelled to intervene ex post

– There is a case for incorporating RoR elements into fiscal design ex ante


Analogies with Price Cap versus RoR Regulation


Static Models: Discounted cash flow models using

data on production, costs & prices

under a high, medium and low case

scenario. Fiscal terms used to

compute economic measures. One or

more of these are held constant to

observe the effect of changes in the

others. Results anchored to initial

conditions employed. Restrictions on

graphical representation of

multidimensional data.

Key Studies:

• Goldworthy and Zakharova (2010)

• Johnston (2003)

• Dongkun and Yan (2010)

• Daniel and McPherson (2010)

• Nakhle (2008)

• Tordo (2007)

• Al-Attair and Alomair (2005)

• Dharmadji and Parlindungan

(2002)

• Iledare (2001)

System Measures:

• AETR, IRR, sensitivity analysis

• AGR/ERR, savings index, take stat

• Government take, front loading

index

• METR, AETR, NPV

• NPV, IRR, take

• NPV, IRR, take

• E&P costs

• Contractor take, IRR, NPV

• Prices, production, NPV, take

Meta Models: A cash flow model of the system

constructed and parameters of the

system are defined and bound

through design intervals based on

historical data or reasonable

assumptions combined with the given

parameters in the fiscal system.

Parameters of the system sampled

from the design space and evaluated

in the cash flow model. The results of

the model and system parameters

are then analysed and a linear model

is constructed from the generated

data.

• Kemp and Stephen (2011)

• Hong and Kaiser(2010)

• Adenikinju and Oderinde (2009)

• Iledare and Kaiser (2006)

• Kaiser and Pulsipher (2004)

• Prod, costs, invest., tax revenues

• NPV, IRR, GT, CT

• NPC, IRR GT CT

• NPV, IRR, GT CT

• NPV, IRR, GT, CT

3. Empirical Literature

•


4. Method

Static Analysis

•


Meta Modelling

• Static DCF model constructed for India’s PSC regime

• Inputs

– Price

– Fiscal terms: royalty, cost recovery ceiling, corporate income tax, minimum

alternate tax, share of profits from production to the government at the lower and

upper tranches of the R-Factor investment multiple, and the contractor and

government discount rates

• Inputs are applied to a real (representative) offshore gas field in India

• We obtain a set of economic measures

– Present value of cash flows to the contractor and government (NPGc, NPVg), the

internal rate of return (IRR) and the discounted contractor and government take

(NPVct, NPVgt)


5. Analysis

Parameter Name Measures

Recoverable Reserves 11 tcf

Field Life 33 years

Total Capex $14.78 bn

Full Cycle Opex $0.76 /Bcf

DCF Model Inputs and Project Parameters

Key Project Parameters

Inputs (Fiscal Terms)

Inputs Units Varnames Numbers

Price $/MMBtu P 4.20

Royalty Rate % Roy 5, 10

Cost Recovery Ceiling % CR 80

Corporate Income Tax % CIT 34

Minimum Alternate Tax % MAT 18.5

Government Profit Share

at Lower R Factor (<1.5)

% IM1 0.3

Government Profit Share

at Higher R Factor (>3.5)

% IM2 0.8

Contractor Discount Rate % Dc 15

Government Discount

Rate

% Dg 12


Set of Economic Measures

Economic Measures Results

NPVc $ 1,213 Mn

NPVg $ 3,298 Mn

IRR 22%

NPVct 27%

NPVgt 73%

DCF Model Results

• Assumption variables

• P, Roy, CR, CIT, IM1, IM2, Dc, Dg.

• Forecast variables

• NPVc, NPVg, IRR, NPVct, NPVgt.

• A design space is constructed for each assumption variable

• Based on reasonable assumptions or historical data (fit to

distribution)

• 100, 500 and 1000 trial simulations of the assumption

variables

• Obtain corresponding forecast variables


The Meta Model – (1)


Parameter Design Space

Price LN (3.05, 16.75)

Royalty Rate U (0.05, 0.20)

Cost Recovery Ceiling U (0.10, 1.00)

Corporate Income Tax U (0.30, 0.40)

Government Profit Share at Lower

R Factor (<1.5)

U (0.10, 0.90)

Government Profit Share at Higher

R Factor (>3.5)

U (0.10, 0.90)

Contractor Discount Rate U (0.12, 0.40)

Government Discount Rate U (0.07, 0.12)

Design Space for Meta Model

• Dependent variables:

• NPVc, NPVg, IRR, NPVct, NPVgt

• Independent variables:

• P, Roy, CR, CIT, IM1, IM2, Dc, Dg

• The dataset generated mimics time-series data. We test for

stationarity

• We are interested in the relative influence (elasticity relationships) of

indepvars upon the depvar.

• We estimate the following equation for depvars NPVc, NPVg, IRR, NPVct,

NPVgt:

• L.φ (f, F) = k+ βL.P+ βL.Roy+ βL.CR+ βL.CIT+ βL.IM1+ βL.IM2+βL.Dc+ βL.Dg +ε

• We test for serial correlation and use robust standard errors.

• The coefficients stabilise at around 500 trials


The Meta Model – (2)


Same procedure for Revenue Sharing Contract (RSC)

Inputs Units Varnames Numbers

Price $/MMBtu P 4.20

Corporate Income Tax % CIT 34

Minimum Alternate Tax % MAT 18.5

Revenue Share at Tranche ‘A’ % RA 9

Revenue Share at Tranche ‘B’ % RB 13

Revenue Share at Tranche ‘C’ % RC 16

Revenue Share at Tranche ‘D’ % RD 25

Contractor Discount Rate % Dc 15

Government Discount Rate % Dg 12

Inputs (Fiscal Terms)

Parameter Name Measures

Recoverable Reserves 11 tcf

Field Life 33 years

Total Capex $14.78 bn

Total Opex $8.8 bn

Production

Slabs (Bcf)

Govt Revenue

Share

A 0 - 73 9%

B 74 - 1,825 13%

C 1,826 - 2,920 6%

D > 2,921 25%

Key Project Parameters Production Slabs

Source: Kelkar Committee Report, 2013


Economic Measures Results

NPVc $ 5,047 Mn

NPVg $ 6,053 Mn

IRR 91%

dCT 54.53%

dGT 45.47%

Set of Economic Measures

Parameter Design Space

Price LN (3.05, 16.75)

Corporate Income Tax U (0.30, 0.40)

Revenue Share at Tranche ‘A’ U (0.01, 0.50)

Revenue Share at Tranche ‘B’ U (0.01, 0.50)

Revenue Share at Tranche ‘C’ U (0.01, 0.50)

Revenue Share at Tranche ‘D’ U (0.01, 0.50)

Contractor Discount Rate U (0.12, 0.40)

Government Discount Rate U (0.07, 0.12)

Design Space for Meta Model


φ (f, F) = k+ βL.P+ βL.Roy+ βL.CR+ βL.CIT+ βL.IM1+ βL.IM2+ βL.Dc+ βL.Dg +ε

Trials k βL.P βL.Roy βL.CR βL.CIT βL.IM1 βL.IM2 βL.Dc βL.Dg R2 Adj R2 F Stat DW

L.NPVC 100

500 1000

2.21(4.73)

0.52(1.42) 2.31(1.0)

0.15(0.03)+

0.14(0.01) +

0.10(0.01) +

-0.03(0.52)

-0.20(0.18) -0.27(0.11) *

0.25(0.37)

0.01(0.13) 0.33(0.09) +

-2.51(2.22)

0.34(0.87) -0.35(0.57)

-0.67(0.35)

-0.68(0.13) +

-0.48(0.08) +

0.51(0.37)

0.04(0.13) -0.11(0.08)

-2.43(0.62)+

-2.88(0.20) +

-2.37(0.14) +

0.77(1.46)#

-0.63(0.44) -0.05(0.29)

0.53

0.58 0.53

0.43

0.57 0.53

6.15+

45.17+

75.86 +

2.5

1.9 2.0

L.NPVG 100

500

1000

6.51(0.96)

6.36(0.38)

7.24(0.34)

0.13(0.01) +

0.12(0.003) +

0.10(0.002) +

0.08(0.11)

0.15(0.05)*

0.07(0.04) #

-0.13(0.07) *

-0.15(0.03) +

-0.05(0.03) #

0.27(0.49)

0.61(0.22) +

0.59(0.18) +

0.38(0.08) +

0.27(0.03) +

0.31(0.01) +

-0.01(0.07)

-0.001(0.03)

0.0001(0.03)

-0.15(0.14)

-0.03(0.05)

0.004(0.05)

-1.85(0.29) +

-2.17(0.12) +

-1.85(0.10) +

0.83

0.78

0.73

0.82

0.77

0.73

55.44+

214.02+

333.58+

2.0

1.9

2.0

L.IRR 100

500

1000

-3.51(5.24)

-4.50(1.61)

-2.50(1.19)

0.20(0.10) +

0.19(0.01) +

0.13(0.01) +

-0.12(0.57)

-0.10(0.21)

-0.32(0.14) *

0.54(0.41)

0.20(0.14)

0.63(0.11) +

-2.53(2.46)

0.84(0.94)

-0.11(0.68)

-0.22(0.38)

-0.32(0.15)*

-0.07(0.10)

0.45(0.41)

0.04(0.15)

-0.14(0.10)

0.15(0.69)

-0.28(0.23)

0.26(0.17)

0.59(1.62)

-0.83(0.51)

-0.08(0.35)

0.59

0.52

0.50

0.52

0.51

0.49

8.21+

35.41+

66.39 +

2.4

1.8

2.0

L.NPVGT 100 500

1000

0.05(0.14) 0.20(0.06)

0.12(0.04)

-0.001(0.001) +

-0.004(0.0005) +

-0.002(0.002) +

0.03(0.02) 0.01(0.01)

0.02(0.01) +

-0.01(0.01) -0.02(0.01) +

-0.02(0.003) +

-0.03(0.07) 0.01(0.03)

0.03(0.02)

0.03(0.01) #

0.05(0.01) +

0.04(0.003) +

-0.001(0.01) -0.003(0.01)

-0.002(0.003)

0.09(0.02) +

0.08(0.01) +

0.07(0.01) +

-0.05(0.04) 0.01(0.02)

-0.02(0.01)*

0.33 0.38

0.31

0.28 0.37

0.30

5.69+

37.02+

55.65+

2.4 2.0

1.9

L.NPVCT 100

500 1000

-6.55(3.85)

-6.90(1.08) -5.58(0.71)

0.05(0.02)*

0.05(0.01) +

0.03(0.004) +

-0.14(0.42)

-0.32(0.14)*

-0.34(0.08) +

0.32(0.30)

0.15(0.10)

0.39(0.06) +

-2.89(1.81)

-0.45(0.66) -0.73(0.40) #

-1.15(0.28) +

-0.99(0.10) +

-0.90(0.06) +

0.48(0.30)

0.05(0.10) -0.002(0.003)

-2.59(0.51) +

-2.86(0.15) +

0.07(0.01) +

2.18(1.19) #

1.43(0.34) +

-0.02(0.01) #

0.51

0.65 0.31

0.42

0.64 0.30

5.94+

61.08+

55.65+

2.5

2.0 1.9

Results from all simulations-PSC Regime

+Significant at 1%, *Significant at 5%, # Significant at 10%, Standard errors in parentheses

6. Results


L. φ (f, F) = k+ βL.P+ βL.Roy+ βL.CR+ βL.CIT+ βL.IM1+ βL.IM2+ βL.Dc+

βL.Dg+ε

L.NPVC L.NPVG L.IRR L.NPVGT L.NPVCT

k 0.52

(1.42)

6.36

(0.38)

-4.50

(1.61)

0.20

(0.06)

-6.90

(1.08) βL.P 0.14**

(0.01)

0.12**

(0.003)

0.19**

(0.01)

-0.004**

(0.0005)

0.05**

(0.01) βL.Roy -0.20

(0.18)

0.15*

(0.05)

-0.10

(0.21)

0.01

(0.01)

-0.32*

(0.14) βL.CR 0.01

(0.13)

-0.15**

(0.03)

0.20

(0.14)

-0.02**

(0.01)

0.15

(0.10) βL.CIT 0.34

(0.87)

0.61**

(0.22)

0.84

(0.94)

0.01

(0.03)

-0.45

(0.66) βL.IM1

-0.68**

(0.13)

0.27 **

(0.03)

-0.32*

(0.15)

0.05 **

(0.01)

-0.99**

(0.10) βL.IM2 0.04

(0.13)

-0.001

(0.03)

0.04

(0.15)

-0.003

(0.01)

0.05

(0.10) βL.Dc -2.88**

(0.20)

-0.03

(0.05)

-0.28

(0.23)

0.08**

(0.01)

-2.86**

(0.15) βL.Dg -0.63

(0.44)

-2.17**

(0.12)

-0.83

(0.51)

0.01

(0.02)

1.43**

(0.34) R2 0.58 0.78 0.52 0.38 0.65 Adj R2 0.57 0.77 0.51 0.37 0.64 F Stat 45.17** 214.02** 35.41** 37.02** 61.08** Durbin Watson 1.9 1.9 1.8 2.0 2.0 Trials 500 500 500 500 500

**Significant at 1%, *Significant at 5%, Standard errors in parentheses

Results – PSC Regime


Results – RSC Regime

φ (f, F) = k+ βL.P+ βL.RA+ βL.RB + βL.RC + βL.RD+ βL.CIT+ βL.Dc+ βL.Dg +ε

L.NPVC L.NPVG L.NPVGT L.NPVCT

k 3.55

(0.14)

7.24

(0.05)

0.23

(0.06)

-3.46

(0.19)

βL.P

-0.014

(0.01)

0.01

(0.01)

4.42E-05

(0.01)

-0.02

(0.02)

βL.RA 0.011

(0.01)

-0.003

(0.004)

-0.003

(0.004)

0.01

(0.01)

βL.RB -0.25**

(0.01)

0.27**

(0.004)

0.10**

(0.0040

-0.42**

(0.01)

βL.RC -0.01

(0.01)

0.003

(0.001)

-0.0004

(0.006)

-0.01

(0.01)

βL.RD -0.001

(0.01)

-0.004

(0.004)

-0.003

(0.004)

0.001

(0.01)

βL.CIT -0.30**

(0.08)

0.45**

(0.04)

0.16**

(0.04)

-0.60**

(0.12)

βL.Dc -2.32**

(0.02)

0.01

(0.01)

0.44**

(0.01)

-1.88**

(0.03)

βL.Dg -2.32**

(0.02)

-1.15**

(0.02)

-0.20**

(0.02)

0.97**

(0.06)

R2 0.97 0.94 0.87 0.93

Adj R2 0.97 0.94 0.97 0.93

F Stat 1816.7** 1015.650** 414.46** 776.67**

Durbin Watson 2.0 2.0 1.93 2.0

Trials 500 500 500 500 **Significant at 1%, *Significant at 5%, Standard errors in parentheses

• Variables that have significant effects across all economic indicators:

PSC Regime

– Price

– Share of profits to the government at the lower tranche of the R factor

(‘trigger tranche’)

• Coefficients larger than price

• Variables that have significant effects across all economic indicators:

RSC Regime

– Share of revenues to the government at the first production slab (‘trigger

slab’)

– Corporate income tax

– Government discount rate

• ‘Trigger tranche’/ ‘trigger slab’ reflect rate-of-return characteristics


7. Observation & Conclusions

• The results for trigger tranche/trigger slabs in the PSC/RSC system are indicative of rate-of-return influences on the fiscal system – With a RSC, it could deter investment in difficult (offshore) areas as there is

less traction in the system to offset investor risk

• The government’s objective in fiscal design appears contrary in the RSC: it desires higher production and higher (and earlier) revenues, but there is not enough traction to offset the higher risks that come with it

• Alternatively, it could explicitly incorporate the rate-of-return element into fiscal system design – This could be done through retaining the PSC, but adding an element of

cost uplift, for instance

– It could also be done through designing a rate-of-return based tax combined with corporate income tax and/or royalties, instead of a RSC

• Areas for further work; RoR systems; testing functional relationships further


Observations & Conclusions (2)


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End

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NPVc

NPVg

IRR

NPVct

NPVgt

PSC Regime Price

Trigger tranche

(large)

Discount rate (c)

Price

Trigger tranche

Royalty

Cost recovery

Corporate

income tax

Discount rate (g)

Price

Trigger tranche

Price (negligible)

Trigger tranche

(large)

Royalty

Discount rates

Price

Trigger tranche

Cost recovery

Discount rate (g)

(all negligible)

RSC Regime Trigger slab

Corporate

income tax

Discount rates

Trigger slab

Corporate

income tax

Discount rate (g)

No significant

results

Trigger slab

Corporate

income tax

Discount rates

Trigger slab

Corporate

income tax

Discount rates

Significant Variables Compared

Variable ADF Stats (at levels) Order of Integration

NPVC -22.50+ I(0)

NPVG -23.36+ I(0)

NPVGT -22.47+ I(0)

NPVCT -22.47+ I(0)

P -23.25+ I(0)

Roy -20.92+ I(0)

CR -22.02+ I(0)

CIT -23.28+ I(0)

IM1 -20.82+ I(0)

IM2 -22.76+ I(0)

Dc -22.64+ I(0)

Dg -21.97+ I(0)

Critical Value at 1% -3.443228




Stationarity Tests

+Significant at 1%

PSC Regime


Variable ADF Stats (at levels) Order of Integration

NPVC -24.37+ I(0)

NPVG -22.13+ I(0)

NPVGT -23.45+ I(0)

NPVCT -23.45+ I(0)

P -23.25+ I(0)

RA -19.50+ I(0)

RB -22.29+ I(0)

RC -21.20+ I(0)

RD -23.56+ I(0)

CIT -21.65+ I(0)

Dc -24.63+ I(0)

Dg -22.85+ I(0)




RSC Regime

+Significant at 1%

Documents

An Empirical Analysis of the Fiscal Regime for Exploration ... · • Prices are set according to the fiscal regime governing a producing field • The fiscal regime has evolved over