Kenya is reviewing how revenues from oil and natural gas sales will be shared in a bid to maximise the benefits to the government, communities and counties while safeguarding the interests of investors.

A production contract now under discussion by government officials proposes a model of sharing that is not based on volumes of oil brought to the surface but is calculated on profitability, known as “R-factor” in industry-speak.

“With a progressive R-factor, if a discovery is not made, the investor’s loss is limited to costs incurred during exploration phase,” said Hunton & William’s lead consultant John Beardworth.

Hunton & Williams of the US and Challenge Energy Ltd of Britain were contracted by the Kenyan government and the World Bank to advise on how the revenues should be shared.

The R-factor is the ratio of revenue earned from oil divided by the costs of bringing the oil to the market. The smaller the ratio, the less the profit realised, with a ratio of less than one indicating a loss-making operation.

In the proposed formula, the government would earn more from production as the profitability rises, starting with sharing of the losses equally with the operator when the R is less than one.

The government’s share will increase to 65 per cent of the profit where R is between one and 2.5 and 75 per cent when it is 2.5 per cent or above. The three bands were proposed by the International Monetary Fund (IMF) in the draft Extractive Industries Fiscal Regimes report.

However, a consultant report seen by The EastAfrican recommends that the middle band be split into three so that, for R of between one and 1.5, the government’s share would be 55 per cent, 60 per cent for between 1.5 and 2.0 and 65 per cent for2.0-2.5.

“This would maintain the higher flexibility afforded by a five-band R-factor framework while providing returns for contractors that are still competitive with Mozambique,” the report said.

As an alternative, the consultant recommended a sliding rate such as that used in Cyprus and Kurdistan, where the tax rate is calculated for a given R factor.

“This provides much more granularity when fewer bands are used,” the report said.

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Energy Principal Secretary Joseph Njoroge said the model production sharing agreement (PSA) would be used to negotiate agreements with contractors — including those involved in natural gas exploration, who were not covered in previous documents.

Currently, the profit will be shared based on daily output in four bands — the first 20,000 barrels, the next 30,000 barrels; the next 50,000 barrels and above 100,000 barrels. The accruing percentages were kept strictly under wraps in line with confidentiality clauses that make the extraction industry one of the most opaque in the world.

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Legislators in Uganda have tried to push the government to make full disclosure of provisions of PSA signed with exploration companies operating in the country but the efforts have borne little fruit.

Hunton & Williams and Challenge Energy said existing contracts can be published to a level agreed on by the government and each individual firm without giving access to confidential documentation.

“Future PSAs are subject to parliamentary approval, and thus will likely need to be made public,” said the firms.

Kenya’s new Constitution requires all new oil and gas rights negotiated by the government to be ratified by parliament. The tax consultancy firm KPMG said the government would ensure a firm owning various PSAs does not combine costs of one block area with revenues of other acreages to depress the share of revenue due to the state.

“This will be ring-fenced by only using costs with revenues from same block to compute the state’s earning so the government’s share rises as the profitability of a project increases,” said KPMG tax services manager Robert Waruiru.

The model PSA, when complete, is expected to enable investors to quickly make decisions about exploring blocks with potential for natural gas.

Sources in the Ministry of Energy cited BG Group as among firms that could not proceed with drilling of wells in gas-prone offshore exploration blocks due to absence of fiscal and contractual terms for natural gas.

Substantive investments

“Changes contained in the new draft model PSA will to lead to substantive investments being made in gas-prone blocks in Kenya’s Lamu basin as a result of greater certainty of gas terms and markets,” said the officials.

Lamu basin, which spans Kenya’s coastline both onshore and offshore, shares geological features with the coastal areas of Tanzania and Mozambique, where vast quantities of natural gas have been discovered.

The R-factor will ensure the government’s revenue reflects the licensed firm’s production costs and total revenues. It also balances taxation with project profitability, protecting investors from margin dips caused by additional taxation. The R-factor also ensures that Kenya remains competitive and attracts investment.

Qatar, Malaysia, India, Kurdistan, Algeria, Tunisia, Mozambique, Nigeria, Libya, Madagascar, Cameroon, Colombia, Suriname, Afghanistan, Azerbaijan and Turkmenistan are among countries that use the R-factor to compute what accrues to the state. Hunton & Williams said any changes to existing PSA can only be made by consensus between the government and the contractor.

Last year, Tanzania issued a new model PSA entailing payment of higher fees by companies following the discovery of massive quantities of natural gas in offshore blocks. The Tanzania model outlines capital gains tax obligations and requires firms to make a one-off payment (signature bonus) of $2.5 million on signing of the agreement and at least $5 million when production starts.

In addition, firms are to pay the government a royalty of 12.5 per cent of total oil and gas production for onshore or shallow water operations and 7.5 per cent for deep water offshore. The previous deep water gas rate was five per cent.

The Kenyan draft PSA sets the terms for negotiation with the government on the exploration period, field evaluation once a discovery is made and duration of development and production.

Revise spending upwards

In February last year, the Ministry of Energy completed a term sheet proposing that Kenya revises upwards the minimum amount of money firms have to spend on exploration for onshore and offshore blocks. The signature bonus was to rise to $1 million from $300,000 to keep off speculators.

Were the term sheet to be incorporated in the PSAs, firms applying for new blocks will be required to spend $28.2 million in the initial two-year period for onshore blocks and $31.2 million in three years on offshore blocks.

Firms can get a renewal of two years only two times after the initial phase, bringing to six years and seven years the period a contractor can hold on to an onshore or offshore block, respectively.