This article first appeared in The Edge Malaysia Weekly on July 30, 2018 - August 5, 2018

UNDER the Petroleum Development Act 1974, a state is entitled to 5% of the total production volume of each oilfield in the state. So does the federal government.

In a simplistic calculation, assuming 100 million barrels of oil are produced that year at a particular oilfield in offshore Sarawak, the state would be granted five million barrels as oil royalty. In the heyday when crude oil prices were at US$100 per barrel, the oil royalty would have been US$500 million.

Petroliam Nasional Bhd’s (Petronas) total production was 2.32 million barrels a day last year and 2.36 million barrels a day in 2016.

Below are several scenarios on how the federal government could fulfil its pledge to pay higher royalty to the oil-producing states:

Scenario 1: The federal government gives up its 5% share to the states

This is seen as the simple and easier way of raising the oil royalty for the states. This will not affect the existing production-sharing contracts and future negotiations for such contracts. Things will remain status quo as far as Petronas and the international oil majors, which are involved in the development of the domestic oil and gas fields, are concerned. The issue of raising oil royalty will not send shock waves through the oil and gas industry.

But this would mean the federal government’s revenue will be reduced by a few billion each year. It will have to find ways to make up for the shortfall.

Petronas paid oil royalty of RM8.7 billion last year and RM7.1 billion in 2016. Half of these amounts went to the nation’s coffers as the state and federal governments have the same entitlement — 5% of the total production.

Scenario 2: 20% oil royalty based on production/revenue

The Sarawak government is demanding that the oil royalty be increased to 20% from 5% based on revenue.

This is a substantial jump, raising many an eyebrow, including that of international oil majors. The federal government’s entitlement alone is not enough to pay the increment that Sarawak wants. Someone else will have to chip in should the oil royalty be raised to 20% based on production.

Petronas is probably the apparent one that will have to foot the bill, even with the assumption that the federal government is giving up its 5% entitlement.

This is one scenario that is likely to send shock waves through Petronas — its employees may have to forgo their perks, especially if crude oil prices stay below US$70 per barrel.

By giving up that 15% entitlement, the national oil company’s revenue will shrink by 15% instantly without any change to lighten its cost burden. This will hurt Petronas’ earnings significantly. Consequently, it may not be able to flex much financial muscles in terms of reinvestments, including replenishing oil reserves that are depleting fast locally, to sustain future growth. There could also be a downgrading of the rating of Petronas’ bonds as a result higher borrowing costs in future.

Petronas may not be able to pay as much dividend to the federal government as a result of lower profitability. In that case, the federal government will have to tighten its belt further.

Scenario 3: Raise oil royalty to 20% but based it on profit

Prime Minister Tun Dr Mahathir Mohamad has announced that the federal government intends to raise the oil royalty to 20% of Petronas’ net profit.

The mechanism is not known yet. The proposal could give the federal government room to manoeuvre, assuming it would take up the states’ current 5% entitlement (based on production).

Furthermore, oil royalty that is based on net profit will be a mechanism to have the oil-producing states also shoulder the production costs. Currently, the states are not obliged to bear the production costs.

However, it is unlikely that the states will agree to such a proposal, which seems to help the federal government obtain more oil revenue than the states.

Scenario 4: Share the dividend rather than raise oil royalty

Some pundits suggest that it may be a wise move to make the oil-producing states shareholders of Petronas so that they can enjoy the company’s dividend directly.

To ensure Petronas’ independence and minimise shareholders’ interference, the federal government will hold the shares in trust for the states.

In this scenario, the oil-producing states will continue to enjoy the existing 5% share of the production plus a share of Petronas’ dividend. It may not be the ideal solution, but it could be a win-win deal for both the federal and state governments.

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