RD KMG in the First Half of 2015: Low Netback, Rising Salaries and Taxation of Oil Producers

KazMunayGas Exploration Production (RD KMG) recently published its report for the first half of 2015.

The company has its own management, board of directors and shareholders, and naturally they assess its performance.

Without studying the financial statements in detail, I decided to offer a short commentary on RD's results.

So, the company roughly broke even in the first half of the year, and, given current oil prices, I doubt its shareholders will see a profit by year-end.

There are two reasons for the company's losses, and they deserve detailed study:

1. A significant fall in oil prices.

2. Growth in production and administrative expenses.

There is also a third reason, indirectly related to the first: the tax system for oil producers, which exposes the flaws of taxation in this sector.

Let's take them in order.

The average oil price, comparing the first half of 2014 with the first half of 2015, fell from $108 per barrel to $57 per barrel.

RD's net realized price on the domestic market was $13.5 per barrel, or $95 per ton, compared with $33.2 per barrel, or $232 per ton, in 2014. Most of RD's oil sales go to the domestic market. The revenue loss from the lower domestic price came to $137 per ton, or $124 million. The gain from higher domestic sales volumes was $4.8 million. The net loss from the domestic market from these two factors is therefore $119.2 million.

Here, what interests me most is the domestic realization price. A netback of $95 per ton is quite low, given the price caps on fuel sales in Kazakhstan.

This deserves attention. If we work backward from domestic fuel prices, oil should have been sold on the domestic market at around $200–250 per ton, that is, with no change from last year's price. Shareholders would then have earned a profit of around $100 million.

Naturally, this calls for detailed analysis and extensive calculations, but it is a reserve that the company's management should work on.

Another very interesting point: in 2015 the netback realization price on the export market was almost twice as high as on the domestic market ($22 per barrel versus $13 per barrel). This is highly paradoxical. Given domestic fuel prices, it cannot and should not happen.

The decline in export revenue due to price is an objective factor, and there is no point in examining it.

Now to production and administrative expenses.

The main source of RD's higher costs is (ATTENTION) growth in salary costs: 34% for production personnel and 16% for management.

In monetary terms, that is about $110 million.

Here, too, I have a question. Oil prices fell sharply throughout the second half of 2014, and oil producers, metallurgists and other commodity companies have been unanimously asking for a devaluation of the tenge in order to cut labor costs in dollar terms.

Yet at the same time, salaries are being raised by 30%.

Perhaps the raise came after the 2014 devaluation, as a way to make up the difference. But then why have a devaluation at all, if salaries were raised by more than the devaluation itself in 2014? Besides, I doubt that companies raise salaries immediately after a devaluation. There should be some reasonable schedule that takes inflation into account.

In short, this expense item also requires additional analysis.

In sum, on these two items alone, with normal domestic oil sales and a sensible approach to pay (at a time when everyone wants to cut labor costs), shareholders would have received a profit of about $200 million, or around KZT 37 billion, instead of zero for the first half of the year.

All of this points to the shortcomings of state management of private-sector companies. However much we might wish otherwise, even when a company is publicly listed, if it is state-owned we cannot expect high efficiency from it.

Now, the tax system.

Oil producers pay three basic taxes that significantly affect the cost of sales:

1. Export rent tax.

Revenues from this tax go entirely to the National Fund. The rate is progressive: the lower the price, the smaller the share of taxes in the cost structure. In principle, this is logical: through the progressive scale, the state captures part of the excess return as the owner of subsoil resources. However, I wrote an article some time ago arguing that the system itself is not quite right, since it sometimes turns out that a lower price is more advantageous for oil producers than a higher one, especially around the price thresholds at which rates change. Rates range from 0 to 32%.

2. Mineral extraction tax (MET), which is also credited to the National Fund. Whereas the first tax depends on the volume of oil sold for export, MET depends on the volume of crude produced per year. Rates range from 3% to 18%.

A company producing up to 250,000 tons pays 3%; one producing more than 10 million tons pays 18%.

It is not entirely clear what our legislators based this on. Presumably it was the cost of production at the fields. But that is not quite right. I am not sure that production costs at large fields are significantly lower than at small ones. Moreover, oil quality varies from field to field, and there are many nuances that determine the cost of oil. Nor does such a system do anything to encourage higher oil production at the fields.

In short, I completely disagree with the MET methodology for taxing subsoil users.

A different approach is needed here, and at some point I will write up my own version of how subsoil users should be taxed.

3. Export customs duty (ECD), set at $60 per ton. This is the least well-conceived form of taxation. It could also be called a lump-sum tax: a fixed amount is simply paid. For goods subject to price swings, setting a fixed rate is highly unprofessional, because the share of this tax in the price structure will keep changing. For example, the price is currently $49 per barrel. The ECD of $60 comes to $8.6 per barrel. That means the ECD alone takes 17.4% of the price! Let us subtract from this the 7% rent tax, or $3.4, and MET (9% on average), or $4.4.

Transportation to the end markets costs $7 per barrel, and the trader's discount is around $3 per barrel.

The net price for oil producers therefore comes to $25.6 per barrel. This is at the limit of operating costs, and for some companies, especially those just starting production, it is far below cost.

The ECD was introduced to replenish the budget at a time of high oil prices. Now it is being cut reluctantly, and for the same reason: the budget would lose additional tax revenue. But we should not forget corporate income tax (CIT): the budget actually receives not $60 but $60 × 0.8, because 20% of the duty replaces CIT.

In essence, the ECD is the same thing as the export rent tax, the only differences being the fixed rate and the allocation, a mythical split between the budget and the National Fund.

It would, of course, be more logical to set the ECD rate according to the world oil price, for example by taking the average monthly Platts price for the month preceding shipment.

Naturally, nobody is going to reduce the tax burden on oil producers now, given the significant budget deficit. But a devaluation will still raise a host of questions for me when labor costs are rising during a currency revaluation.