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10 November 2014
Oil companies now have an additional cost to consider when it comes to well assessment in Brazil. The board of the Brazilian Agency for Oil, Natural Gas and Biofuels (ANP) recently declared, through Board Resolution 862/2014, that royalties are also due for oil and natural gas produced during well formation tests, a phase that was previously deemed to be royalty free. The decision is in response to a recent increase in production and a subsequent increase in revenues resulting from the sale of such production.
Brazil has a royalty-based oil and gas regime grounded in a constitutional provision which states that Brazilian mineral resources belong to the federal government, irrespective of where they are situated. Exploration and production of oil and gas constitute a government monopoly. The government can engage in energy and production activities directly or through contracts with public or private companies. Under the current model, the government contracts oil companies under three kinds of agreement:
Among other kinds of government stake provided for by law (eg, lump-sum signature bonuses or special participations for fields with substantial reserves), royalties are due to the federal, state and municipal governments for the economical exploration of such assets. For onerous assignment and concession agreements, the percentage of royalties ranges from 5% to 10%, depending on the geological risks and production potential of the block. Production sharing agreements have a 15% flat rate.
The complex formula for distributing royalties between the federal government, states and municipalities was the subject of recent exhaustive negotiations in the National Congress. Particularly after discovering the pre-salt area and its significant potential for oil and gas production, the majority of Congress decided that there should be a new divide between the three levels of government for royalties raised by the increasing amount of hydrocarbons. Since then, a new range of municipalities and states have been entitled to receive royalties – which in turn has dramatically increased the pressure from the entire country for stricter rules when it comes to the collection of government stakes from oil companies.
The ANP's new resolution is based on Article 47 of the Petroleum Law (9,478/1997) and Article 42-A of Law 12,3561/2010. Both laws state that royalties must be paid monthly, in domestic currency, from the day on which commercial production begins in each field. Thus, a core issue for the payment of royalties is attached to the definition of 'commercial production'. Neither the Petroleum Law nor Law 12,351/2010 is clear about this relevant expression, and the matter has since been subject to interpretation and intense debate between oil companies and the ANP. The bidding documents and contracts signed between the government and oil companies also provide no clarification on the matter.
Contracts, irrespective of their type, are divided into two phases: exploration and production. Under the Petroleum Law, 'exploration' is described as "the set of operations or activities performed for the assessment of areas as a means to discover and identify oil and natural gas reservoirs". According to the law, the exploration phase encompasses the activities for evaluating an eventual discovery of oil and natural gas; there is no commercialisation in this phase.
'Production' is the "set of coordinated operations for the extraction of oil and natural gas from a reservoir and for preparation of its transportation". Contracts list the beginning of the production phase as the delivery of the statement of commerciality, which is issued by oil companies when a commercial discovery is made.
The logical conclusion from such provisions is that commercial production is irrelevant during the exploration phase, while the commerciality of the field is still under assessment and a statement of commerciality has not been issued. In technical terms, commercial production begins in the production phase, starting with the statement of commerciality.
The general rule is that once oil and natural gas are produced during the production phase, royalties are due. The main argument between the ANP and oil companies at this point is whether legal and contractual deductions (eg, gas burning for safety reasons, gas reinjection and gas lift) should be included in the calculation of actual commercial production.
The ANP recently ruled on the controversy surrounding the performance of activities during the exploration phase that result in the extraction of oil and natural gas, such as long-term tests and well formation tests. Could they be considered to be commercial production for the purpose of imposing royalties?
The ANP has imposed royalties on oil and gas produced during long-term tests for some time, following the rationale that, irrespective of when the production phase starts, substantial amounts of hydrocarbons can be extracted during test phases and companies trade this oil for profit. Thus, the ANP put aside the legal and contractual concept of commercial production (ie, oil and gas extracted during the production phase) to hold that commercial production triggers royalties whenever economic gains are made by oil companies.
Doubt regarding well formation tests has always existed and the ANP finally ruled on the matter, following the same rationale applied for long-term tests. According to Resolution 862/2014, the rule for concession and production sharing agreements is that royalties must be paid for oil and gas produced in well formation tests performed during the exploration phase only if oil companies receive economic gains from the activity. In other words, royalties are due if the oil and gas is traded. As for well formation tests performed during the production phase, royalties will continue to be due. Regarding onerous assignment, Resolution 862/2014 sets forth that the payment of royalties for well formation tests has always been an obligation of Petrobras, irrespective of the phase.
The total amount of royalties paid in 2013 in Brazil was R16.3 billion (around $6.8 billion). This amount is expected to increase dramatically in the few next years, when oil companies (particularly Petrobras) will begin pumping large volumes of oil from the giant reservoirs in the pre-salt area (according to the ANP, production from pre-salt reservoirs has already exceeded the 400,000 BOE per day level, which is still a small amount compared to what is expected from the area). Given those figures, royalties are an important source of funds for the federal, state and municipal governments since the pre-salt discovery, and there is pressure on the ANP to improve efficiency in royalty collection.
The payment of royalties during well formation tests has been clarified: once companies have reached substantial production levels during this phase of exploration and might profit as a result, royalties must be paid. In addition, the rule discourages companies from extending well formation tests unreasonably as a strategy to avoid royalties.
The new ANP resolution has broadened the legal basis for the imposition of royalties by deliberately changing the technical definition of 'commercial production' – something that only the National Congress could do by amending the Petroleum Law. This could represent grounds for future challenges. Additionally, the rule might make well formation tests too burdensome and not worthwhile where budgets are tight, and oil companies might choose to invest their money elsewhere.
For further information on this topic please contact Godofredo Mendes Vianna or José Augusto Dias de Castro at Kincaid | Mendes Vianna Advogados by telephone (+55 21 2276 6200), fax (+55 21 2253 4259) or email (email@example.com or firstname.lastname@example.org). The Kincaid | Mendes Vianna Advogados website can be accessed at www.kincaid.com.br.
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Jose Augusto Castro