In the past five years, East Africa has been an attractive location for investors prospecting for petroleum resources.

A combination of factors, both domestic and global, drew these investors. They included high crude oil prices, hitherto insatiable demand for oil and gas from China and India, attractive geology and an investment climate that made it easier for firms to raise the required risk capital.

These factors explain the oil exploration forays in Uganda, Kenya, Ethiopia, Tanzania and Mozambique, some of which have resulted in commercial discoveries.

With the recent fall in petroleum prices, investors have started to ration their capital, as they now face the risk that they may not recoup their investment as more oil and gas is discovered around the world.

Besides the fall in global prices, fiscal and taxation policy issues will be a major determinant as investors decide on the level of investment to commit to East Africa’s nascent upstream petroleum industry.

Certain aspects of the emerging tax policy in relation to upstream development have the potential to escalate project implementation costs in the event of monetising the resources already discovered. This may render the envisioned projects uneconomical.

The imposition of the capital gains tax (CGT), without exception, on farm-out transactions, through which firms sell a stake of their interest in an exploration block with a view to splitting the exploration and development costs, may deter the entry of new firms. Capital gains tax on farm-outs is the subject of litigation and adjudication in Uganda.

The above issues raise the broader question: How then can East Africa ace the competition and ensure international oil companies keep supporting the region’s drive towards becoming a successful commercial oil producer?

For example, the imposition of CGT raises the question whether Kenya’s tax policy in relation to upstream petroleum activities is focused on taxing profits generated by the sector or investments made by companies.

Like other investors, petroleum companies seek investment opportunities in countries that have built a conducive environment for doing business. The prevailing tax regime therefore remains a critical consideration for any prospective investor.

It also presents an opportunity for East African countries to set themselves apart as favourable domestic and foreign investment destinations.

Adopting an exceedingly short term view of maximising revenue collection from natural resource projects, characterised by high and unsuitable taxes, may affect investment flows to the nascent sector.

One key area that calls for attention is the question of farm-out or farm-down transactions. Farm-out techniques are extensively used in the upstream petroleum industry especially at the exploration and development stages. Given the high risk of failure, upstream petroleum companies diversify their interests as much as possible by way of farm-outs.

The upstream industry is characterised by both systematic and diversifiable risks. Diversifiable risks can be eliminated by diversification and include exploration, development and political risks.

Systemic risks are those that cannot be avoided regardless of how much you diversify, and examples include inflation and commodity price fluctuations.

Onerous requirements may discourage companies from pursuing transactions that would provide the opportunity to mitigate political, exploration and development risks. As such, the cost of capital to do business in such a country would be higher resulting in a greater net take demand upon the resource wealth by the upstream oil and gas companies.

Currently, there is an unclear tax policy position on such transactions. Is the tax policy aimed at taxing profits generated by such activities or the investment commitments made by the investors resulting from the farm-outs?

Not all farm-down transactions are motivated by the desire to make windfall profits. In fact, such transactions are good for the industry and the country at large.

They present an opportunity for big oil companies to acquire working interest in the country’s petroleum sector, originally dominated by smaller oil companies during the exploration stage.

Mitigation of risks in the sector affords the government the opportunity to press for a higher recovery of the natural resource wealth on the premise that risks have been mitigated, hence lowering the cost of capital.

Perspective

EAC member countries should consider looking at the issues in the energy sector from a regional perspective to outcompete other economic blocs.

With shaky global energy markets, an investor would find it favourable to allocate money to exploration in the region if Kenya, Uganda, Tanzania, Mozambique, South Sudan and Ethiopia forged a common front in harmonising their policies on taxes, investor protection, labour laws, environmental standards, local content rules, and the development of large infrastructure projects such as pipelines.

Thus, in order to encourage the upstream petroleum sector to thrive by continuously attracting long-term investments, it is important that governments take a long-term view.

Denis Kakembo is an oil and gas expert with Deloitte East Africa. The views expressed here are his own.