Time passes quickly. Eight years have passed since the Sheshinski Committee decided to tax the profits on natural resources, with a focus on taxing the natural gas partnerships. Prof. Eitan Sheshinski, a respected and well-known figure in economics, was selected to head the committee, thereby becoming an overnight media star, with millions of people expecting him to achieve historic justice, and he did not disappoint them. He issued recommendations, which became law, that the gas partnerships should pay the state 50-60% in taxes.
He showed the greedy oil and gas exploration tycoons who got rich at our expense a thing or two. Some people at the time already disagreed, but I must admit that it was unpleasant. I said that the state could not change the rules in the middle of the game, and people responded angrily. I said that billions had been invested to date in oil and gas exploration by "nuts" who insisted that there was something here, with nothing to show for it, and had now found something, only to be mobbed. They told me that I didn't understand; it was known that there was gas here.
I explained that we could all have shared in the profits, because all of the partnerships that found gas were listed on the Tel Aviv Stock Exchange (TASE) and their shares could have been bought for a mess of pottage, had we only believed, like the nuts, that there was gas here. They told me that the partnerships got the exploration franchises for nothing. I was wrong; we could have been partners, but not full partners.
The (still unsolved) problem with the exploration model, the source of the big distortion in this very important matter, is that the gas partnerships are managed by a general partner controlled by the gas barons (mainly Yitzhak Tshuva and Koby Maimon), whose very high super royalty rates are disproportionate to the investment and the risk. Profits are transferred to the general partner at the expense of the minority partners. This has nothing to do with the tax, but had they limited the super royalties, the public would have benefited immediately - probably far more than the tax set by the Sheshinski Committee. That would have taken money away from the tycoons (justifiably, in this case), and given it to the other participation unit holders - mainly investment institutions.
The state set the tax rate at up to 60%. It did not eliminate the super royalties. Based on the Sheshinski Committee's recommendations, the state enacted a law with a great many clauses, calculations, and definition. I do not believe that anyone really understands how much the extra tax on the gas partnerships should be.
Some very smart people sometimes prefer to keep things complicated. Had they set a higher tax rate on the gas partnerships from the beginning or higher royalties for the state, it would have been simpler, easier to understand, and more profitable for the state. I'm not accusing the Sheshinski Committee of being an agent of the gas partnerships, of course, but it might as well have been one - the effect was the same.
The law is bad for the state treasury. It is good for an unproductive group of people (I'm one of them) - accountants, lawyers, tax advisors, lobbyists, and others - who will write thousands of pages, opinions, memoranda, discussion summations, objections, and appeals, so that their clients pay as little tax as possible. They will succeed, because the law is opaque and unclear, with loopholes that facilitate large-scale tax planning.
Eight years without a shekel for the state treasury
Eight years have passed since the law was enacted, and the state treasury has not received a single shekel from the Tamar natural gas reservoir, which was the reason for the Sheshinski Committee's appointment. Tamar has earned nearly $5 billion since it began operating in 2013. Isramco Ltd. (Nasdaq: ISRL; TASE: ISRA.L), which owns 28.75% of Tamar, has earned $1.5 billion from it, but the Sheshinski tax was not applied. When will it be applied? They are now talking about the second half of 2020 - they will start paying the tax 10-11 years after the law was passed, and even that is doubtful.
The Sheshinski tax is designed to ensure the partnerships a reasonable return on their investment. The rate is therefore 20% above a certain amount, and reaches up to 50%.
Isramco's financial statements list the investment in its oil and gas assets at $1.1 billion (over $1.2 billion before depreciation). The partnership made back its investment, but not only on paper - it also distributed large dividends reflecting return on investment. Furthermore, it will make back its investment 1.5 times next quarter, and it is still two years away from paying the Sheshinski tax. There are a number of reasons for this. The first is that an exception was made for Tamar - its factor is 2, a return that the Tamar partnership expects to reach in the second half of 2020.
The second reason is that the Sheshinski Committee's calculation is not very clear. It is quite likely that the tax will be repeatedly postponed.
A formula with an unknown variable: the gas partnerships factor
The Sheshinski Committee defined R - a factor above which tax will be imposed. This factor is actually the square of a factor with a numerator that expresses revenue from the gas venture (accumulated proceeds minus accumulated payments). The mistake is in the source. The committee's documents say revenue/profits, while the calculation is for all cash flows - proceeds minus payments. The committee probably did not include any accountants. In any case, the numerator of the factor is the aggregate total cash flow from the venture, but it is linked and also includes payments for exploration of an oil field in the same prospect. This was added to the law in 2015, but it is very significant.
The Tamar prospect is producing gas. Its area, however, is of course larger than the drilling area, and is likely to include other locations of interest in exploration. The payments for this exploration and deeper explorations close to Tamar will be added to the formula, thereby reducing the cumulative cash flow from the gas venture. This can be significant.
The big problem, however, is in the denominator. The denominator expresses the investment in the gas venture - not the investment in cost, but the investment with a bonus factor. The investment at the exploration stage will be used with a coefficient. It will be calculated in practice at double the amount for the purpose of investment. The investment at the set-up stage will be calculated using LIBOR + 3%. Why is this significant? The set-up stage is the stage with the largest investment. They told the developers, "We want you to pay taxes on profits in excess of normal profits." Normal profits in oil and gas ventures are 50% (except for Tamar, in which untaxed normal profits are 100%). In other words, once the profits divided by the investment are greater than 1.5, the profits are higher than 50%, and tax is paid.
The inflated investment in the denominator of this formula, however, is not the actual investment. It includes a factor and linkage of LIBOR + 3%, in other words a 5.5% interest rate. To put it simply, tax is paid not after 50% aggregate profit, but after aggregate profit of 50%, 5.5% annual linkage, and a double factor for exploration expenses. Furthermore, two years of running-in expenses are considered investment. The partnerships receive two extra years in calculating the determining date for the end of investment. These two years are defined as a running-in period, and are added to the denominator.
The result is that the investment in the denominator is far greater than the real investment, and is multiplied by 1.5. Even then, tax is paid only after a 100% profit.
That is not all. As soon as the partnership distributes dividends to holders of its participation units, it reduces their investment. Why shouldn't the distribution of dividends decrease the denominator in the R factor formula? I hope that I am wrong, and that the legislator intended to include dividends in the formula, but the law and the agreed explanations do not mention the return on the investment. This is ridiculous. Assume that a partnership invested $1 billion in a gas venture that generates a $200 million net annual cash flow and all of the cash flow is distributed as a dividend. The investors will make back their investment in five years, but the investment for calculating the tax will be over $1 billion, because it includes linkage, a set-up coefficient, an exploration coefficient, running-in expenses, and more, which can increase the investment to $1.5 billion.
The investors make back their investment in five years, but will begin paying tax only after 11-12 years (without taking into account at all financing of LIBOR plus 3% and linkage, which increases the investment every year and makes tax liability less likely.
It is complicated, but the example shows that tax will be paid only after the investors receive 2-3 times their investment. More importantly, the investment changes. It is $1 billion at the peak, then declines to zero. The (approximate) average investment in the early years is $500 million (and the average investment decreases with time).
If the average investment instead of the maximum investment (increased by linkage and interest) is used, a factor of 1.5 is obtained, which is actually a factor of 3, because the partnerships naturally return the profits to holders of participatory units. In other words, what we have here, with all of these benefits, is a colossal failure. They wanted to tax excess profits. The law has many gray areas, and there is a high return for investors in oil and gas. The Sheshinski Committee recommended a tax, but shot itself in the foot. It recommended a tax, but what we got was not a simple tax. It was a tax with linkage, formulas, conditions, and disputes.
Furthermore, the law creates motivation that distorts investment. Exploration will not be conducted where oil and gas are most likely to be found, and production will according to the formula. The partnerships will seek exports, because there is no tax on exports, and will explore in places where they get benefits. They will produce little at one stage in order to avoid increasing the factor. In short, the tax, not the real needs, will determine the course of oil and gas exploration.
I originally thought that the rules of the game should not be changed after the game. If the rules are to be changed, however, they should be simple and clear, with no tricks or games; otherwise, the tycoons will just get richer.
The Ministry of National Infrastructure, Energy, and Water Resources and the Ministry of Finance, declined to respond.
The author is a lecturer in accounting, financial statement analysis, and valuations, and a consultant in these areas. In any case, these reports should not be regarded as advice and/or a recommendation to buy or sell any security. Anyone whose actions are based on the article and/or on its content bears the exclusive responsibility for any damage and/or loss caused to him or her.
Published by Globes, Israel business news - en.globes.co.il - on January 9, 2019
© Copyright of Globes Publisher Itonut (1983) Ltd. 2019