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Romania’s Black Sea gas: when geologic bonanza meets above ground chaos

The story of Romania’s offshore gas reserves has received significant attention since 2012, the year of the biggest discovery in the Romanian segment of the Black Sea. However, this success found Romania quite unprepared for a new hydrocarbon boon. Successive governments dragged their feet on the key issue of mineral resource taxation, time was wasted, while a coherent government policy on the stewardship of Romania’s mineral resources has yet to be formulated. The text captures in broad strokes some of the main underlying causes that lead to the situation in which Romania finds itself today, with FIDs in the Black Sea under threat of not being taken right before the Black Sea gas production should start. Who is to blame?

Context

The first relevant natural gas news in the Romanian offshore segment date back to 2007-2008, when Sterling resources (now Black Sea Oil and Gas, BSOG) has discovered the Ana and Doina gas fields (10 Bcm). This was followed by other subsequent gas discoveries, the most notable of which is the Domino-1 gas find in 2012 (42- 84 Bcm initial estimate) and the Lira-1X find by Lukoil in 2015 (30 Bcm initial estimate). Exxon and Petrom have since conducted the most extensive seismic data acquisition campaign in the Romania Black Sea without however making big public announcements. So, it took ten years after the first gas discovery by Sterling and six years since the first significant gas find (Domino-1), for Romania to put in place a dedicated framework for offshore oil and gas development. The Law on certain measures necessary to be implemented by the petroleum agreements titleholders regarding the offshore petroleum perimeters, largely known as the Offshore Law, is a much needed piece of legislation which details the process and sets the ground rules for the new offshore development. This law has been the object of hot debates over the past few months, but one if its most contentious aspects is taxation, not so much the issue of royalties for new offshore production as “THE” most important question of all – whether a windfall profit tax (WPT) should apply to the future Black Sea production or not. The draft proposed by the Senate in fall 2017 exempted the Black Sea operators from it altogether (Art. 18) and granted a fiscal credit for everything paid in excess from what this law stipulates (Art. 19). The version adopted by the lower Chamber of Parliament in July 2018 leaves Art. 18 as before (royalties stay the same as when agreements were signed, exemption from the windfall profit tax in spite of the current laws that exist in this regard). However, Art. 19 introduces a separate (new) windfall profit tax for offshore gas production only, with a rate ranging from 15% to 50% depending on the level of gas price. At the moment of writing (mid-September 2018) this is still an unfolding story as the law was sent back to Parliament for reexamination by the President of Romania, and has yet to be approved.

Asymmetric information: the cost countries pay for incompetence

In 2004, the year when Petrom was privatized, Romania adopted a new Petroleum Law no. 238/2004, in which the level of royalties for gas ranged between 3.5% and 13% (designed during and in preparation for a low oil price environment). As a condition for Petrom’s privatization, these level of royalties were frozen at this level for 10 years (fiscal stability clause) in the privatization contract of Petrom. However, this is the period when the oil market started its rebound and prices shot up considerably (to as much as 140 USD/bbl in 2008). During this exact period Romania was prevented from changing its petroleum fiscal level. With an outdated (and unadjusted to market realities) petroleum fiscal system in place, Romania missed out on the opportunity to tax the surplus revenues during most of the peak oil and natural gas period (2004- June 2014) having no windfall profit tax in place whatsoever until 2013 – when a provisional  such tax was introduced (but for natural gas only). Knowing that in 2014 the freeze expires, and in spite of the significant public interest in this matter and repeated calls to revise the level upward in order to ensure a fair share for the Romanian government, the latter took no credible steps to engage experts, initiate a much needed discussion or analyze options on the table and scenarios of taxation. More shocking still, the responsibility over this very important matter is split between various institutions with no one specifically in charge of this issue. The Energy Ministry and the National Agency for Mineral Resources (NAMR) have repeatedly declined responsibility and accountability on this very topic and pointed to the Finance Ministry as the competent authority. Meanwhile, the petroleum companies have organized in two industry associations (ROPEPCA – representing the onshore producers and, RBSTA – representing the offshore producers) and have tried to coordinate, engage and lobby repeatedly the government on this very important topic. They have talked with different ministers and prime-ministers, but each time it seems the result was the same: public nodding and assurances that investor’s interest will be taken into account, followed usually by government re-shuffle, appointment of different officials with whom the discussion had to start anew.

New petroleum royalties: much ado about nothing

In 2010, NAMR organized its last known tender for petroleum concessions (the last such tender that took place in Romania for oil and gas). Consequently, all the agreements that have been signed based on that tender (including for Black Sea perimeters) have locked in the level of royalties stipulated by the legislation at the time (the old royalties). Starting with 2013, NAMR has repeatedly said that it plans to organize a new tender (the XI round) for 28 perimeters (6 of which offshore). However, Romanian experts (myself included) have drawn attention to the fact that if such a new tender is organized before the royalties’ framework is updated, it wouldn’t make much sense coming up with new royalties after that, because all the petroleum concession agreements will have been already concluded. Moreover, lawyers specialized in Romania’s petroleum law underscored many times a provision which exists in these agreements which, once signed, do not allow any subsequent changes to the terms, except if they are more favorable for the company or if both parties agree to the change. This leaves the Romanian state with no legal avenues to revise the terms which means that NAMR (the designated custodian of Romania’s mineral resources) must be very careful what it signs beforehand, since there is no clause allowing the unilateral review of royalties once the agreement is signed.

Ioana Petrescu, a holder of a PhD degree in economics from Harvard University (2008) and a former Finance Minister in the third Ponta cabinet (March-December 2014) publicly referenced the existence of a World Bank study commissioned by the government of Romania on how the royalties framework may be changed to reflect a more fair split between the government and private sector take of the petroleum rent. During her tenure at the Finance Ministry, technical consultations were conducted with Washington, IMF, and Israel’s Finance Minister, who even sent their top specialist professor Eytan Sheshinski to Bucharest.[1] With a PhD in Economics from MIT, Eytan Sheshinski headed the committee on taxation of Israel’s new found offshore resources and another committee on taxation of all other natural resources and his recommendations were adopted by the Knesset and became laws (‘Sheshinski 1’ and ‘Sheshinski 2’).[2]

Now, back to Romania. Nor this initial World Bank study, nor the royalties’ draft on which Petrescu and her team worked was ever made public. Everyone was expecting the government to present its new oil and gas taxation framework in early 2014, then by the end of 2015. Yet, it was only in October 2017 that the Ministry of Economy (so, not the Finance Ministry) put up for public debate a draft law on a new system for oil & gas royalties (the “Draft Royalties Law”). It did not propose changes in the taxation of onshore production, nor did it propose dramatically different fiscal provisions for the offshore production. For instance, the royalties proposed for offshore natural gas had a 10% fixed component (irrespective of the volume extracted) and 2-3% variable component. So, it wouldn’t have been a radical change from the maximum rate that currently applies for natural gas production (13%). The draft introduced also a provision allowing the government to review the level of royalties at NAMR’s request, on the basis of an economic opportunity analysis. However, the draft didn’t go any further and was withdrawn soon after.

By the time the Romanian government came up with a proposal for new royalties, the market changed, and countries willing to attract investors were providing incentives by lowering taxes (post–June 2014 environment meaning lower oil prices worldwide). Ultimately, the idea of putting in place new royalties was abandoned, as the current levels (the ones designed in 2004) seem suitable and attractive enough for the current price environment. We came full circle – by the time Romania’s government designed new royalties, there was no need for them anymore. Timing is everything!

Windfall profit tax (WPT)

Despite being one of the few natural gas producing countries in Europe, Romania did not have until 2013 a windfall profit tax. Communist education did not provide classes on petroleum taxation in its curricula, so the transition period caught Romania completely unprepared to defend its national interest and lacking in expertise that would have allowed it to design a suitable petroleum taxation system. Government Emergency Ordinance (GEO) 7/2013 introduced for the first time such a tax on the industry. Designed initially for two years only, it was prolonged subsequently each year, until, in March 2017 the government adopted a law making it permanent:  Law 73/2018. Slightly different than its initial form (60%) introduced by GEO 7 in 2013, the WPT now had two levels: a 60% rate for natural gas prices up to 85 lei/MWh and an 80% rate for everything that exceeds that price level. Without an offshore gas production, the windfall profit tax was paid since 2013 by the onshore producers (mainly Petrom and Romgaz).

Now an interesting fact: the initial form of the Offshore Law (the Senate version) exempted the offshore production from paying the windfall profit tax (the one due under Law 73/2018) altogether. So, on the cusp of Romania’s biggest ever gas production in the Black Sea, the Romanian Senate wants to exempt the producers from paying any WPT and, opts for more of the same (i.e.: what we had before 2013)?  Naturally, there was a huge public backlash.

 The Offshore Law debacle: the root cause of the problem is administrative chaos

What all this shows is Romania’s petroleum fiscal policy planers (if they exist, big “if”) are in deep counter step and fundamentally misunderstand the markets. When the prices are high, Romania did not tax appropriately and lost money. When the prices are low, it wants to tax too much. This underscores a deep and profound lack of specialized expertise on such matters within the government and state apparatus.

Romanians pride themselves in having 150 year of tradition in oil production and 100 years of tradition in gas production. However, if you look at how such an important issue of hydrocarbon taxation was handled in the past years, you arrive at a different conclusion. To no avail have Western countries tried to illuminate Romania on the aspects of modern petroleum fiscal systems. Back in 2013, for instance, the Canadian Embassy in Bucharest has organized a workshop for NAMR to share best practices and brought Canadian experts to talk about how this question is approached in their country. Little did they know they were barking the wrong tree: despite being designated by law as the agency in charge of Romania’s mineral resources, NAMR has repeatedly declined responsibility on the issue of taxing mineral resources, as did the Energy Ministry[3] for that matter!

This has shown that Romania’s much praised expertise is confined to petroleum engineering and geology, and does not extend to the business side of energy. Romanian institutions today have no business acumen or policy knowledge of such issue (the vast majority of the people populating the Romanian institutions today are still the products of the communist education system, which produced excellent engineers but no business-savvy managers, petroleum economists or market-oriented energy policy planers), but nor do they want to engage the younger generation who was exposed to such concepts and schooled on such matters abroad (Petrescu was the exception, not the rule). No interest whatsoever to cooperate with think tanks, institutes or specialized centers that possess the necessary expertise, established in the meantime by Romanian alumni of Western universities who have returned home to do their part for modernizing their country.

No wonder, companies and investors (Romanian as well as foreign ones) are frustrated. Professional negotiation on this matter should have happened a long time ago. You need to know exactly what the taxes will be in order to take a Final Investment Decision (FID) or to sanction a project, especially one that runs in the order of billions. Instead, investors were left hanging. They were lead on by different governments with promises of a stable and predictable legal and fiscal framework, and have seen none of that.

It would have been much more honest to tell the companies what the position of the Romanian government is, but for that you need professionals who can articulate such a position and provide solid arguments, you need a solid study with scenarios and options, and no such study was commissioned by the Romanian government (apart from the World Bank one, which is not public). Only the petroleum industry associations (ROPEPCA and FPGG) commissioned such studies and made their conclusions public. Needless to say what they say: that Romania has a high taxation level of the petroleum production. Of course, it reflects the interest of the companies who would like to pay less taxes and skew the message to fit their interest.

Where we are today: Dragnea’s Deus ex machina

Relying on the wits of a convicted baron from Teleorman is by no means the ideal solution. But this is what it has come to. With no formal background in energy, the leader of the Social Democratic Party just has a practical business sense. He intuitively insists on a fair deal for Romania. No sophistication, just a knack for business, and maybe a lesson learned from Ioana Petrescu’s 2014 work on what a fair petroleum taxation would have to look like. The fact that among the supporters of the windfall profit tax for offshore gas production are controversial figures such as Darius Valcov – a person sentenced to 8 years in prison for money laundering and influence peddling, who (in spite of this) serves as economic adviser to Romania’s current PM – does not help either. But, what we have to bear in mind is that Valcov was the one that succeeded Ioana Petrescu as Finance Minister in December 2014. Even if his tenure as Finance Minister was a short one (3 months), he had access to and understood her work on the issue of petroleum taxation because he is an economist by training. Moreover, Valcov is credited with being the Social Democrat’s eminence grise (the one who actually wrote PSD’s economic program), a trusted associate of PSD leader Liviu Dragnea, and (many believe) the true PM of Romania.

In conclusion, and to state my own opinion: the windfall profit tax on the offshore O&G production is a good and necessary provision. Not having it at all would be indeed outrageous. The Black Sea production should have never been exempted from it in the first place, instead the WPT should have been negotiated from the start with the Black Sea operators (its form, conditions and duration of application). Yes, it could have been better thought through and it could have had a more sophisticated design. Granted, it was wrong and cowardly to introduce it out of the blue and overnight (as it was done in July), but there is no doubt about it: a windfall profit tax should exist in any country that thinks of itself as a serious oil and gas producer. The price level that triggers the WPT is exactly what should have been honestly and thoroughly negotiated with the investors. What you don’t do is re-assure companies of official support for Black Sea O&G projects, fail to do your own homework on petroleum tax reform for years and then cover your institutional impotence by slapping a tax (even if a just one) at the last minute. In a word, right solution, bad delivery.

FOOTNOTES:

[1] Agerpress, Interview with Finance Minister: the current royalties will be extended by one year, new taxation as of 2016, November 27, 2014: https://www.agerpres.ro/economie/2014/11/27/interviu-ministrul-finantelor-sistemul-actual-de-redevente-va-fi-prelungit-un-an-din-2016-va-fi-un-nou-mod-de-taxare-11-07-00

[2] https://www.growthopportunity.org/eytan-sheshinski/

[3] Chaos in regulations. Taxation of petroleum companies, the “hot potato” passed between institutions, 05.04.2018, http://www.ropepca.ro/en/articole/chaos-in-regulations-taxation-of-petroleum-companies-the-hot-potato-passed-between-institutions/564/