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Is there any economic rationale for the Early Oil Pilot Scheme?

Since Kenya has opted for a classic production sharing fiscal system, Production and the resultant revenue would first be allocated to the company recovery of costs

President Uhuru Kenyatta flanked by Deputy President William Ruto flags off the crude oil trucks during the Inauguration of the Ngamia 8 Early Oil Pilot Scheme , Turkana County./PSCU
President Uhuru Kenyatta flanked by Deputy President William Ruto flags off the crude oil trucks during the Inauguration of the Ngamia 8 Early Oil Pilot Scheme , Turkana County./PSCU

It was recently announced by the government that Kenya has joined the league of Africa oil exporters after its first consignment of 200,000 barrels fetched $12 million for the country.

Further to this, a recent article published in one of the local dailies, states in part that, "Under the Early Oil Pilot Scheme (EOPS), Kenya earned its first billion shillings wealth from its oil findings in August, a major milestone given that Uganda which discovered oil deposits in 2004 before Kenya, is yet to ship out even a drop of its black gold."

The Early Oil Pilot Scheme (EOPS) which commenced in June of 2018 is a crude oil export scheme aimed at assisting Tullow oil company, its Kenya Joint venture partners, Africa Oil, Total S.A and the Government of Kenya to, amongst various reasons, test the market for Kenya’s crude oil and review the logistics of handling the crude export in readiness for the Full Field Development (FFD) of the South-Lokichar oil basin after the Final Investment Decision (FID) expected in the first quarter of 2020 is arrived at.

The Early Oil Pilot Scheme (EOPS) is therefore an interim measure/experimental Scheme that would enable the country to achieve first oil exports and generate pertinent technical information before the development of the mid-stream capabilities that would involve the construction of an 821 km heated-pipeline from the South-south-east oil fields to Lamu.

The recent announcement that the government has earned $12 million dollars from its first oil export, has raised very high expectations at both the national and local level as this is seen as a potential ‘game changer’ that would bring a new stream of revenue flow, provide employment and business opportunities.

However, before we begin to celebrate, it is important to revisit the revenue figures that have been reported in the various media outlets. The often-quoted figure of $12 million dollars as "earned by the government of Kenya " from the first oil export is erroneous, misleading and factually incorrect as it doesn't explain how this revenue has been arrived at.

It is important to note that revenues derived from oil/petroleum exports are split between the host country, in this case, Kenya and the International Oil Companies (in this particular case, the Kenya Joint Venture made up of Tullow Oil Company as the lead partner, together with Total S.A Oil Company and the Canadian Company, Africa Oil ).

The treatment of revenues derived from the Early Oil Pilot Scheme, must be linked to the Petroleum Sharing Contract/Agreement signed between the Kenyan government and KJV.

The most important factor of note is whether the oil exports currently taking place under the Early Oil Pilot Scheme should be seen as consisting of a separate Petroleum Sharing Contract or as part of the entire Petroleum exploration and production agreement that contains the model Production Sharing Contract ( PSC) which forms the basis of negotiations between the International oil companies and the Government. A clear distinction of the same would shed more light on how to treat the revenues.

The PSC contains the terms, rights and obligations of parties, the fees payable and sharing of revenue under the contract. The fiscal terms for Turkana crude are set out in production sharing contracts (PSCs) signed for Blocks 10BB and 13T in 2007/2008. The profit share of the government is thus based on the profit oil alone and the share increases as production increases.

To determine the exact amount that goes to the government even in the absence of the  Petroleum Sharing Contract governing the exploration and development of the South-Lokichar oil field (this remains closely guarded and shrouded in secrecy), a profit sharing formula could still be derived based on cost oil and profit oil contained in previous/ similar PSCs signed in the past.

That means the sweet light crude sold at $60 per barrel, an uptick of nearly 40 per cent above the $43 per barrel that the government had set as the break-even point for the Early Oil Pilot Scheme( this is within the range of the break-even point in my project analysis), has generated a gross revenue of $12 million dollars for the 200,000 barrels recently exported.

Since Kenya has opted for a classic production sharing fiscal system, Production and the resultant revenue would first be allocated to the company recovery of costs. A limit on the volume of production allocated to “cost oil” is set at 60 per cent.

This therefore means that 40 per cent of earned revenue would be considered as “profit oil” even if the project is losing money, and it is out of this "profit oil" that the government's share of profit will be determined. The " profit oil" is thus shared between the KJV and the government based on the volume of production.

As the EOPS will never exceed the first production threshold estimated at 60,000 barrels of oil per day, it is assumed that 50 per cent of profit oil will be allocated to the government. It has been widely reported that Tullow Oil has so far spent close to $2 billion to date and the joint venture partners would seek to recover some of the costs.

Therefore, given the aforementioned, a simple analysis indicates that the fiscal terms would almost certainly over-estimate the revenues that will flow to the government. The cost recovery limit of 60 per cent, would wipe-off $7.2 million dollars from the revenue (assuming that the transportation costs of $21 dollars per barrel has been factored into the cost oil limit. It should also be noted that substantial costs like CAPEX and enhanced logistical costs associated with new road modifications to enable the transportation of the crude have been omitted in this analysis).

An even split of profit oil would then mean that the Kenyan government will derive a very modest economic benefit of $2.4 million. Further to this, the government has a Revenue and Benefit sharing obligation, a Constitutional requirement.

An additional obligation in Article 202 of the constitution requires the equitable sharing of national revenue “among the national and county governments”.

These obligations are embodied in the Petroleum Bill, which specifies the exact percentage of petroleum revenue that shall be shared between the national government, the county government and the local community in the following proportions: 75 per cent of the revenue to the national government, 20 per cent of the revenue to the county government.

This amount should not be more than double the amount allocated to that County by the Commission on Revenue Allocation and five per cent to the local community, provided that this amount does not exceed a quarter of the amount allocated to that County by the Commission on Revenue Allocation.

Therefore, from this simple analysis, if the government is to strictly abide by the constitutional requirement on revenue and benefit sharing obligation, then, only a paltry 75 per cent of the remaining $2.4 million dollars ($1.8 million dollars) will be transferred to the government coffers.

Why then is the government proceeding with EOPS given that a Cost-Benefit analysis of the project indicates that the costs would exceed the benefits by far? Is there any Economic rationale for EOPS and are the costs associated with the EOPS worth the benefits?

The conclusions of this analysis suggest that the government is driving EOPS for non-economic gains, namely, for National pride.

Other than this, by enabling the export of the Turkana crude, the government is trying to demonstrate progress in the development of the oil industry whilst at the same time, hoping to appease the restless locals who for the time being, do not see any economic benefits associated with the oil extraction on the ground. It is a non-economic measure (more political) to keep the public in anticipation rather than be seen to be doing nothing.

Tullow Oil Company and partners are set to benefit more from EOPS than the government. EOPS will enable them to fine-tune their plans and investments by collecting the relevant data from the reservoirs to the Off-take points in readiness for the Full Field Development (FFD).

BY Duncan Otieno Ogwang, Petroleum and Energy Economist.