2.2 Methodology for Evaluating Profitability of the Projects

In this paper, I am going to apply the method developed by A.J. Alawode and Olusegun A. Omisakin. Adeolu Julius Alawode has a Master Science degree in Petroleum Engineering from University of Ibadan, Nigeria and his area of interest is Reservoir Engineering and Enhanced Oil Recovery. Olusegun Akin Omisakin has a Ph.D. in Economics from the University Ibadan, Nigeria and his area of research interest is Econometrics, Petroleum, and Energy Economics. In their paper Economic Profitability Studies of Liquefied Natural Gas Project under Joint Ventures and Production Sharing Contracts, they conducted NPV analysis improving this method with specifications of the LNG project and using cash flows modeling in different fiscal regimes. Their method allows using limited amount of variables and helps to evaluate the economic profitability with broadly applicable indicators.

First, the production parameters used for my research are stated as follows: prospective years of project life, discount rate on project, and the planned days of operation per year for a project, conditions and terms of tax burdens determined by Product Sharing Agreements or Joint Venture Agreements. Other important assumptions are operating expenses, feedstock costs and annual revenue distributed equally over the entire life of the project; cash flows occur at the end of the year; bonuses paid by companies upon successful bids are not considered in computing net cash flow to the government; equal distribution of capital expenditures (planned investments) over the construction period.

Using Figure 1 and Figure 2 schemes the economic modeling of fiscal regimes were conducted. In order to evaluate the economic indicators for the projects annual gross revenue is generated as a function depended on a sale price of a product. Cost functions, royalties and amount of income tax were designed and then used in undiscounted cash flows for three main stakeholders of any project - companies, government and contractors. After that, a Net Present Value (NPV) analysis will be carried out in order to determine this cost-effective product price and then corresponding economic indicators will be calculated.

Main assumption in Joint Ventures economic model is rather logical - the investor maximizes the net present value of cash flows from the project during its operational cycle. The net cash flow in that case is defined as a function, depended from several internal functions:

They are Revenue which is the gross revenue for a given project during one year, Royalty that refers to the money paid to the government by a company, OPEX is the operating expenditures for a given project per year, FDstockcost is the cost of the natural gas feedstock needed by the plant during a year and finally Incometax is a tax on gross income from a given plant. Y refers to the one year while P determines the size of the plant under consideration.

The contractors (in our case it is a group of international investors) and the government shares of plant net cash flow is defined as follows:

In these formulas, contractinv and govtinv are the contractors and state equity in the plant and CAPEX refers to the capital expenditure (in our case - initial investments).

The net cash flow to the government during the project life includes passive revenue from royalty and taxes and revenue from the state equity in the plant:

The net present value of Cash Flow for the plant is defined as:

Here the discount factor is determined based on future cash flows. The NPV of CF for contractors and government is defined as:

In order to find the minimum cost-effective LNG price for the plant we should find the price at which NPV will be close to zero. After finding the price, we could come to the other economic indices, such as profitability index, which is counted as follows:

Here the PVfutureCF and PVinitialinv refer to the present value of future cash flow and present value of initial investments. In addition, we can find the rerun on investments for a given plant size:

In this formula, invprof refers to the profit on investment during one year on the plant. Annualized means that we count returns on an average basis - usually, it is distributed through the life cycle if the plant.

In case of plants and projects developed under the Production Sharing Agreements, assumption is the same as in case of Joint Ventures. The investors maximize net present value of cash flows during the life of the project.

However, the net cash flow is defined differently:

Here the new variable has appeared - costoil that means the allocation of gas to compensate capital investments, operating expenditure and feedstock costs. Taking into consideration the taxing system under PSAs, we change the formula for net cash flow for contractors:

The total cash flow to the contractors is counted as a sum of costoil and contractor's after-tax share of the plant cash flow:

But the actual cash flow for contractors during the life of the plant also includes capital expenditures returned per year (CAPEXperannum) and contractor's after-tax share of the plant cash flow:

After the counting of contractors' share let us move to the state:

Here the calculation is rather simple and after all we can get a net cash flow to the government during the life of the project, which includes passive revenue from royalty and taxes and a government share:

The net present value of cash flow for the plant is defined as follows:

Moreover, respectively the NPV for the state and contractors is the next:

Excluding all formulas, described earlier the calculation for the profitability and return on investment are the same as in case of Joint Ventures.

In order to calculate NPV profits I will use the Excel spreadsheet. The application of some statistical programs, as Stata, is also possible in order to determine the variation of NPV for different stakeholders with various LNG prices and discount rates. Some difficulties may appear at the stage of examining the parameters of the projects because not all of them have a determined investment portfolio structure or a plan of investment process. For my analysis, I will choose one the most suitable Russian-Japanese LNG projects and calculate its return on investments and profitability indices using PSA and JV economic modeling. It will help me to understand whether the state has made the right decision choosing the certain type of agreement and compare in what case the profitability of the project will be higher.

2.3 Risk-Adjusted Returns for LNG Investments

The model described in the previous paragraph is not ideal and does not accurately reflect the reality. There also exists a risk that the capital the stakeholder spends will return partly or will not return at all. There exist many models calculating possible risks and advising managers to do the right decision. But in case of LNG, the profitability of the projects is rather obvious. The main thoughts of investors often turn not to how many returns do they get but rather to the safety of their investments in particular country or region.

After looking through the material on LNG projects some assumptions can be easily drawn. In LNG market, the least risky investments go to the construction of pipelines, which is followed by re-gasification and liquefaction terminals and exploration and development of the projects. The risk of investments in pipelines is rather low due to the regulation that keeps the costs for gas transportation rather stable. In case of re-gasification and liquefaction terminals, the risks depend on the costs spender on technology and may vary broadly. And the most risky is mining cause it is depended from geological uncertainty and economic uncertainty caused by fluctuation of commodity prices.

Despite of all these risks to less or more extend common for all countries there exist political factors that also influence the investors mood. Peter Hartley and Kenneth B. Medlock III improved the Baker Institute World Gas Trade Model (BIWGTM) and added a Reference Case, which takes into account this assumption. They calculated risk-adjusted returns for gas investments. They used two sources of information taking into account both economic and political factors. In their case, they look at a private investor in a host country. The first source is a data from International Country Risk Guide (ICRG), published by the PRS Group, Inc. And the next source is a risk premium on lending provided By World Bank. They derived a set of country-specific risk premiums for investments in gas industry relative to the USA.

They constructed a «gas investment risk index» using a variables connected with political risks. These variables are represented in ICRG calculations. The first variable is government stability. It depends on the type of the governance, the closeness of next elections, the governing party or parties, popular approval of government policies. The next is an investment profile refers to a measure of the government's attitude to inward investments as determined by the assessment of several points: level of taxation, the risk to operation, labor costs. The next variable is connected with internal conflict. This variable is connected with assessment of political violence in the country. The highest rating is given to those countries where neither is nor armed opposition to the state and the state does not involved in arbitrary violent actions. Other variables are corruption level, law and order (the strength of legal system), ethnic tensions and bureaucratic quality (the strength of institutions). The value of all variables were summed and then divided by ten to get a total score from 0 to 10 with lower numbers corresponding to higher risks. The resulting index Peter Hartley and Kenneth B. Medlock III called GIRI - gas investment risk index.

After calculating it with the help of International Country Risk Guide, they used the World Bank data on risk premium on lending and mapped the GIRI scores to interest rates with the help of regression. They pointed out that there exists a statistical correlation between lending risk premium and calculated GIRI. They applied results to the Base Case of the Baker Institute World Gas Trade Model and get a new projections on how the natural gas market will be transformed in the next forty years (the forecasts horizon of the model is 2040). Therefore, the risk adjustment changed their forecasts that points out the significance of such risks that varies considerably from country to country.

The Baker Institute World Gas Trade Model example gives a matter to the adjustment coefficients. In my case I tried to find this coefficient to draw out the possible deviations of the future returns. As I am using the Net Present Value Analysis, I took as my main coefficient the discount rate, which takes into account not just the time value of money, but also the risk or uncertainty of future cash flows. The more difficult due to the different political, economic and social reasons to forecast the loan rates banks provides, the exchange rates of currencies, the prices for oil and gas products the greater the uncertainty of future cash flows are and thus the higher the discount rate is. So, to the purpose of my analysis I will apply the average discount factor that is usually used when forecasting the project future cash flows in the oil and gas industry for the LNG projects.

3. THE PROFITABILITY ANALYSIS OF THE SAKHALIN 2 PROJECT

3.1 Net Present Value Analysis of the Project Sakhalin 2

The project Sakhalin 2 is widely discussed and researched in the open sources. At the same time, researchers and journalists verify not all figures. Therefore, for the relatively adequate analysis and results I have used different sources to prove the figures I have found out. Among primary sources used in my paper are articles of financial media sources that are highly sited in the last quarter ended in April 1 2015. The ratings are provided by Russian analytical agency Medialogia and I took the sources only from Top -10 in order to avoid not verified information on my topic. Usually the press has an access to the some confidential information as companies used the media as a tool to build their reputation and raise knowledge about the companies' success in the field. Such kind of advertisement is the proof of the company's transparency towards its activity. The next primary sources I have used are company's press releases on the official sites, both Japanese and Russian. The additional primary source I have used is the International Financial Reporting Standards. Each year the company Sakhalin Energy Investment Ltd. published its financial results on either the site or newspaper or other media resources.

So, after revising the figures that described the project Sakhalin 2 the next parameters were isolated:

1. 49 years of plant life,

2. a first stage capital expenditures (i.e. capital investments) was 1,5 bln dollars, while second stage capital expenditures was 20 bln dollars,

3. total expenditures from 1994 to 2014 was 61 bln dollars,

4. profit in 2013 was around 2,61 bln dollars,

5. forecasted prices for LNG, natural gas and oil are $10,1/MMBtu for LNG, US$17,9/MMBtu for oil and US$9,6/MMBtu for natural gas.

After determining main parameters of the project, I went further, and draw out assumptions for this certain project to make the case close to reality. I relied on the model described in the previous chapter, developed by A.J. Alawode and Olusegun A. Omisakin.

6. fifteen percent (15%) of discount rate on project (adjustment coefficient in my case),

7. operating expenditures and annual revenue are assumed to distribute equally over the entire life of the plant,

8. all cash flows occur at the end of the year,

9. bonuses paid by companies upon successful bids are not considering in computing net cash flow to the government,

10. capital expenditures are distributed equally over the each stage construction period.

Finally, I get through the Russian legislation, regulating Production Sharing Agreement and joint ventures with international investors, Tax Code to understand what tax assessment method should be applied in case of Sakhalin 2 and isolate next figures:

11. under Joint Ventures, 10% severance tax on gross revenue and 24% tax on gross income are considered,

12. under Product Sharing Agreement, 10% severance tax on gross revenue and 32% tax on gross income are considered.

To evaluate economic indices for the projects, in the paper were used functions constructed with the help of revenue flows for the project under two types of fiscal regimes in Russian Federation - national regime, when the project is manipulated as joint venture with international investor, and product sharing agreement regime, both of them are described in the previous chapter.

To calculate cash flow of the project for each year of its entire life (49 years from 1994) the Excel spreadsheets were used. For each year the revenue flow for government and contractors were calculated and after adjusting taxation and discounting the net cash flow for each stakeholder were found. After that the net cash flows were summed up and Net Present Value for the completely 49 period was generated.

3.2 Project Profitability Analysis and Explanation of Results

Joint Venture with International Investor Model

Excel spreadsheet is used to calculate Net Present Value profits for the Sakhalin 2 project at 15% discount rate on loan for investment and at different prices of LNG within the range of US$0.5/MMBtu to US$10/MMBtu to determine the minimum cost-effective LNG price (at NPV=0). Here the minimum iterated value of cost-effective price at 15% discount for the company and the contractors is US$ 6,81/MMBtu.

Table 3: Variation of NPV with LNG Price for Sakhalin 2 Project under JVs at Natural Gas Price of US$9,6/MBtu and 15% Discount Rate.

Source: author analysis.

Figure 5: Sakhalin 2 NPV versus LNG Price under JVs.

Source: author analysis.

To determine Internal Rate of Return (the minimum possible rate of investment returns from this project) for the company, contractors and government at LNG of US$10,1/MMBtu, oil of US$17,9/MMBtu and natural gas of US$9,6/MMBtu, NPV profit analysis at different discount rates within the range of 15% to 50% is carried out. The iterated value for the company, contractors and government are 21,9%, 21,9% and 42,4%, respectively.

Table 4: Variation of NPV with Discount Rate for Sakhalin 2 Project under JVs at LNG Price US$10,1/MBtu.

Source: author analysis.

Figure 6: NPV versus Discount Rate for Sakhalin 2 Project under JVs at LNG Price US$10,1/MBtu.

Source: author analysis.

The net present value of future cash flow at LNG price of US$10,1/MMBtu is estimated, at the discount rate of 15%, as US$ 31 414 513,71 dollars. Profitability index for is 1,461, R-factor is 5,739.

Product Sharing Agreement Model

Also, NPV profit analysis is done for the project under PSA regime and at 15% discount rate at different prices of LNG within the range of US$0.5/MMBtu to US$25/MMBtu to determine the minimum cost-effective LNG price (at NPV=0). Here, the price is US$ 3,49/MMBtu.

Table 5: Variation of NPV with LNG Price for Sakhalin 2 Project under PSAs at Natural Gas Price of US$9,6/MBtu and 15% Discount Rate.

Source: author analysis.

Figure 7: Sakhalin 2 NPV versus LNG Price under PSAs.

Source: author analysis.

To determine a corresponding Internal Return Rates of the project under PSA at LNG price US$10,1/MMBtu, another NPV profit analysis is carried out at different discount rates within the range of 15% to 50% is carried out. The iterated value for the company is 33,4%, for contractors - 19,2% and for the government - 43,3%. The net present value of the future cash flow at LNG price of US$10,1/MMBtu is estimated at the discount rate 15%, as 43 409 289,55 dollars. Profitability index for company is 2,019, R-factor is 5,994.

Table 6: Variation of NPV with Discount Rate for Sakhalin 2 Project under PSAs at LNG Price US$10,1/MBtu.

Source: author analysis.

Figure 7: NPV versus Discount Rate for Sakhalin 2 Project under PSAs at LNG Price US$10,1/MBtu.

Source: author analysis.

Results Explanation and Comparison

As shown in Table, the minimum cost-effective LNG prices for Sakhalin II project under JVs and PSAs are US$ 6,81/MMBtu and US$ 3,49/MMBtu respectively. That shows that PSAs accommodate relatively lower product sales price compare to JVs. That means that extracting and processing hydrocarbons under PSAs is more effective and less costly in case of Sakhalin 2. So, in under PSA the low cost-effective price allows at the same rate of LNG price get higher margin and more profit. Alternatively, it could allow changing the strategy for Russian LNG plants, decreasing the selling price and competing with cheap LNG from Qatar and Nigeria, increasing Russian share on the world LNG market.

Also, for the company under JVs at LNG price of 10,1 US$/MMBtu, the Internal Rate of Return for the company , contractors and government are 21,9%, 21,9% and 42,4%, respectively. However, at the same price, the Internal Return Rate for the company under PSAs are 33,4%, 19,2%, 43,3% respectively. For Japanese contractors Sakhalin 2 under JVs is a more favorable fiscal regime compare to PSA (IRR^JV=21,87%, IRR^PSA=19,2%).

Table 7: Results of Analysis

Source: author analysis

At LNG price 10,1 US$/MMBtu the profitability index and R-factor under PSA are 2,019, R-factor is 5,994, these are observed higher than the corresponding values of 1,461 and 5,739 under JVs. It means that the PSA regime allows accumulating higher returns that in case of JVs for the company (That is also proved by NPV calculations). The close meanings of R-factor mean that the usage of resources and money in both regimes are effective for the company as a whole (so, the scheme of cash flows is well designed and allowed to get profit in both case).

To sum up my findings, for Japanese contractors Sakhalin 2 operated as a joint venture with international investor is a more favorable fiscal regime compare to project sharing agreement. PSAs accommodate relatively lower product sales price compare to JVs. The anticipated 49-year ROI of the project (under PSA) of Japanese contractors and Russian government are 1,373 and 2,955 or 37,3% and 95,5% respectively. The Internal Rate of Return of the project currently for both sides is about 19,20% for Japanese side and 43,00% for Russian government.

3.3 Risks at the Current Stage of the Project Sakhalin 2

The profitability of the project is undeniable and was proved by my results. However, at the current stage some risks could lead the project to the very pessimistic scenarios and decrease the possible returns from it.

After revising the primary sources on the project, I have identified seven groups of potential risks. These risks are equally important for Japanese and Russian side because they influence the success of project and its efficient returns from the money invested. They are operational risks, regulative risks, political, environmental, structural, loan market risks, risks connected with new projects. Then I gave them some values in order to compare. The methodology for evaluating the risks implies the next criteria: the amount of experts' comments on the topic (the significance of the problem which raises the certain risk), the existence of certain problem direct bad influence in the world practice in the oil and gas industry, the existing losses experienced after facing the problem, the range of possible resolutions to the one problem (the higher the range - the higher the uncertainty is, the higher the uncertainty - the more difficult to mitigate the risk).

Figure 7: The Risks' Values of the Sakhalin 2 Project.

Source: the author estimations.

Medium operational risks are connected with losses of the production due to the ineffective equipment. At the Hariaginskoe PSA, there were some difficulties with installation of system of gas utilization that allows not losing the associated gas during the production. In case of Sakhalin 2 this risk still exists.

High regulative risk is a result of not fixing of expenses on creating an intellectual property by company-operator, which could lead to difficulties in using technologies by the parties of the project when the project ends.

High structural risk is connected with the fact that in 2015 the Russian government is going to get into a property all infrastructure of the PSA projects: the expenses for contractors could rise (cause they will pay for rent and maybe some others taxes plus the existing ones) and they will not invest in building new plants and capacities for the project.

Political risks are rather low, because the current situation in Russia shows that implemented by Europe and USA sanctions does not mirrored in the gas and oil field. As I have stated in the beginning of my thesis the both countries are coping with their dependencies from capital (Russia) and from Middle East oil and gas products (Japan), so, their interests are laying on the same plane.

Environmental risks are relatively high. The gas and oil extraction in Russia not always met all needed standards even if everything is good in the paper and documents. Sometimes environmental organizations pay attention to this and sometimes their noticing could be sponsored by ruling elite of other states in order to spoil the existing relations between partners due to the political or other irrational reasons.

Risks connected with loan market are rather high due to the volatility of the exchange course of the ruble to the dollar. The current situation with prices, inflation and the key rate of the Central Bank makes difficult for Russian companies to use loan financing and many of their operations are performed without a cash advance. In such situation, they could easily go bankrupt. Taking into consideration that according to PSA 70 percent of operations on the project Sakhalin 2 should be performed by Russian subcontractors it is rather risky if the situation do not stabilize.

Risks connected with launching new projects in the Russian Far East are not very high. The project itself is rather attractive for further investing and increasing existing capacities. The reserves of two project oil deposits are enough to fill the existing capacities of LNG plant and the infrastructure and logistics is already build and used successfully.

To sum up, among seven risks the most important ones are structural risk, regulative risk and loan market risk.

Conclusion

In this paper, six Russian-Japanese LNG projects developed since 1990s have been studied. They are Sakhalin-1, Sakhalin-2, Pechora LNG, Baltic LNG, Yamal LNG, and Vladivostok LNG. Sakhalin-1 and Sakhalin-2 are projects developed under Production Sharing Agreements. Other projects were developed as Joint Ventures. All projects excluding one (Pechora LNG) have a Japanese companies or consortiums as investors. Therefore, the possibility of being partner with Japan side in the Pechora LNG project is rather high. All of the projects except Vladivostok LNG emerged as ideas in early 1990s and at the first stage of development experienced some failures. But the situation on the world LNG market and the economic development of Russia pushed the active participation of the government to attract investments in developing gas deposits and start construction of LNG pants. On Russian LNG market are three main players. They are Gazprom, Novatek and Rosneft. Investors and partners of the projects from the Japanese side are following companies: Mitsubishi, Mitsui, Sodeco, Japex, and Itochu.

The Joint Operating Agreement is one of the main vehicles widely used by joint ventures in exploring and producing oil and gas resources. All rights and liabilities arising in connection with the production license will be shared between the licensees in proportion to their percentage interest. The JOA creates contractual duties of performance between the co-ventures and it provides a set of rules for the conduct of operations under the production license. A Production Sharing Agreement is an internationally binding contract in commercial purposes between an investor and a government. A standard PSA defines the conditions for the development and exploration of natural resources from a certain field over a determined period. According to the terms of any oil and gas PSA, ownership is retained by the state and the investor held responsibility for extracting the resource.

In order to prove whether the Russian-Japanese LNG projects developed under Production Sharing Agreement are more profitable than ones developed as a joint ventures there was chosen a method developed by A.J. Alawode and Olusegun A. Omisakin. The method uses an economic modeling of cash flows in different fiscal systems (under PSA and JOA) and will help to count profitability of the projects and return on investments.

To sum up, PSA seems to be more preferable as it take into account the interests of both sides - the investor and the government. The PSA regime allows accumulating higher returns that in case of JVs for the company (That is also proved by NPV calculations).

For a Japanese contractors Sakhalin II under JVs s a more favorable fiscal regime compare to PSA (IRR^JV=21,87%, IRR^PSA=19,2%).

At the same time, PSAs accommodate relatively lower product sales price compare to JVs. That means that extracting and processing hydrocarbons under PSAs is more effective and less costly in case of Sakhalin 2. So, under PSA the low cost-effective price allows at the same rate of LNG price get higher margin and more profit. On the other hand, it could allow changing strategy for Russian LNG plants and decreasing the selling price and compete with cheap LNG from Qatar and Nigeria, increasing Russian share on the world LNG market.

The anticipated 49-year Return on Investment of the project (under PSA) of Japanese contractors and Russian government are 1,373 and 2,955 or 37,3% and 95,5% respectively. The Internal Rate of Return of the project for both sides is about 19,20% for Japanese side and 43,00% for Russian government.

Hypothesis that currently profitability of Russian-Japanese LNG project Sakhalin II developed under Production Sharing Agreements (PSAs) is higher than in case it would have been developed under Joint Ventures (JVs) was partly proved.

There were identified seven groups of potential risks. The highest risks are connected with regulative and structural parts of the project. High regulative risk is a result of not fixing of expenses on creating an intellectual property by company-operator, which could lead to difficulties in using technologies by the parties of the project. High structural risk is connected with the fact that in 2015 the Russian government is going to get into a property all infrastructures of the PSA projects: the expenses for contractors could rise and they will not invest in building new plants.

In future for Japanese side, it could be rational to get a share in the projects in the oil and gas field on the Russian territory developed as joint ventures. For Russian side in both types of projects the relative returns are rather high but in case of PSAs, it would be difficult to make the transition of infrastructure property to the government. On the other side, it is difficult to accumulate such capital to start a new project without help of international investors, for whom usually PSA is more attractive because of the rights it gives them and the relative independency during launching stages of the projects.

References

Chart 3: Global Gas Price Stages and Forecast.

Source: Timera Energy

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