Incremental economics and ringfencing

A "ringfence" is commonly used to describe a calculation that occurs at a specific granular level. For example, a country may have a corporate tax calculation at the business/country level but a royalty at the field level. Many users would identify the ringfence to be on royalty at the field level; this is particularly true for users with a financial orientation.

In FINANCIALS, ringfences are defined from the opposite direction (bottom-up). This is because, by default, each project is calculated independently and FINANCIALS needs a defined ringfence node to force a calculation to occur at some higher level, i.e. FINANCIALS forces an aggregation to occur for that specific calculation. It is this approach to calculations in FINANCIALS that leads to the 'bottom-up' as opposed to 'top-down' definition of ringfences.

Generally, the level at which a fiscal calculation must occur is determined by the fiscal rules of each country and sometimes by the terms of individual contracts such as PSCs (see examples below in this section).

FINANCIALS supports ringfencing of Regime modules and capital categories; for information about considerations involved in ringfencing categories, see Capital depreciation pools. For information about different types of ringfencing supported by FINANCIALS, see Ringfence types. For instructions on how to set up a ringfence in a hierarchy, see Setting up a ringfence.

There are several techniques used to aggregate projects into a single economic entity and also to examine the differences between versions and/or groups of projects. These are some of the common situations that an analyst may wish to evaluate:

Aggregation of several projects for a corporate tax calculation
Aggregation of several projects into a single unit for royalty
Aggregation of several projects into a single PSC
Multiple incremental development options
Sequential incremental development options

Many royalty calculations are tiered with royalty rates rising at specified production thresholds. The royalty tends to be defined at a field level but the projects may represent a sub-set of the fields such as wells. If each well were calculated separately, then each would be perceived to be in a low royalty tier, thereby generating an artificially low royalty result overall.

To solve this, royalty is normally ringfenced to ensure that it is calculated at the group level. The resulting royalty is then back-allocated to the individual projects.

If the mathematics behind a royalty calculation are linear, then it may not be necessary to apply a ringfence. For example, if a royalty is a flat 10%, then it makes no difference if we calculate it at the project level or some aggregated level.

A Production Sharing Contract (PSC) generally applies to a block. If that block contains multiple fields, then it is likely that the terms such as Royalty, Cost Recovery and Profit Oil should be calculated at the group level.

Example: A production sharing contract covers a block in Algeria. This block contains three fields which are separate projects with independent facilities and different start dates. However, from the economic point of view, they are treated as a single entity with cost recovery and profit being calculated at the group level.

Example: A company has 10 assets in the UK. They are generally calculated separately. For better accuracy, the corporate tax is calculated for the entire group and the results are allocated back to the individual projects.

Clearly, the viability of this kind of calculation depends on the number of projects. If there are several hundred projects in a single country, then it is not practical to calculate the entire set ringfenced. In this situation many companies assume that overall they are in a profit-making position and, when calculating a project, they allow a loss to generate a negative tax result. When aggregated with all the other projects, the aggregated tax will be positive. This tends to represent a more accurate view of the actual situation since it prevents carry-forward from being calculated at a project level.

The term ringfence in the oil and gas industry is often used in a more specific way for calculations that occur at a field level. Many analysts who are more used to the considerations of corporate tax (which tends to apply at a country level) view a ringfence as a calculation that occurs at a more granular level.