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Even Amid Low Prices, Tax Breaks for Latin American Oil Projects Are Rarely Necessary

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The coronavirus pandemic and the collapse in international oil prices have hit the Latin American oil industry hard. Companies and governments are discussing alternatives to make operations economically viable, such as reducing oil royalties for some projects in Brazil or reducing transport tariffs in Colombia. However, given the industry’s long-term trends, cyclical oil prices and the varying operating costs of projects, tax incentives are not a correct response to low oil prices.

In a recent publication, NRGI analysts provide a global analysis of the fall in the price of oil, the pressure on governments to reduce taxes and the risks of modifying tax burdens in an industry where prices cycle between collapse and recovery. In the briefing they argue that countries that reduce taxes due to low oil prices risk missing revenues if prices recover, and thus should only give tax incentives in exceptional cases and on a clear and temporary basis.

For projects currently operating, it is important for governments to consider the relationship between changing oil prices and operational costs. After its historic fall in April, the price of oil rebounded to around USD 40 per barrel. The United States Energy Information Agency (EIA) forecasts that monthly Brent spot prices will average $42 per barrel during the fourth quarter of 2020 and will rise to an average of $47 per barrel in 2021. However, a survey of international oil companies indicates that, on average, they expect the oil price to rise to $65 by 2025. Future oil prices are uncertain, as always.

NRGI’s recent research finds that, according to Rystad estimates, the average per-barrel operating costs of a set of 19 oil-rich countries are still far below the oil price. In most cases, therefore, it is not advisable for governments to reduce taxes, as changes in the tax regime could lead to a loss of tax revenue in the long term, if prices recover. Furthermore, a tax break could erode confidence in the stability of the fiscal regime, as governments could be tempted to raise taxes again when prices rise. In the oil industry, it is more important to have a long-term perspective than to respond hastily to price volatility.

NRGI data for some Latin American countries indicate that operating costs plus taxes are on average $20 per barrel, of which approximately half are operating costs ($9.40) and the rest taxes ($10.60), for which there is still a considerable margin with respect to the international price. These are however average prices per country; each operating project has a particular cost profile that depends, among others factors, on the distance to the markets, the quality of the oil and the cost of capital for the investments in exploration and extraction.

Average operating costs and government taxes on upstream per barrel (2020 estimates)

The oil bidding rounds in Brazil and Colombia demonstrate how the stability of fiscal terms has been key to attracting investment, developing the oil industry and increasing fiscal revenue. In both cases, competitive and transparent processes, based on stable regulatory and fiscal frameworks, have allowed the countries to substantially increase oil production. Brazil went from being an oil importer to becoming the main oil producer in the region, with three million barrels per day. Colombia managed to produce one million barrels per day, despite its limited potential.

Governments must therefore interrogate whether operating projects really need tax breaks to be profitable. However, if an adjustment of the fiscal regime is unavoidable, progressive tax instruments (with which the tax burden changes automatically depending on company profit levels) are preferable to tax breaks. If officials choose breaks, they should include a sunset clause, so they are only applied during the extraordinary circumstances of the coronavirus pandemic. In the case of new projects, it may be appropriate to delay bidding rounds until after the crisis.

Finally, governments must publicly disclose information about any change to their fiscal regime as well as to oil project contracts. This ensures that citizens are informed and can hold their governments accountable over engaging in a “race to the bottom” – and subsequently losing the “race back to the top” when prices recover and the tax regime is not able to collect appropriate levels of revenues.

Fernando Patzy is a Latin America senior officer with the Natural Resource Governance Institute (NRGI).