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Democratic Republic of São Tomé and Príncipe: Selected Issues and Statistical Appendix

Author(s):
International Monetary Fund
Published Date:
October 2006
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II. Assessing the fiscal impact of Oil Sector Development4

A. Overview and Conclusions

1. This chapter contains a preliminary quantitative analysis of the impact of oil sector development in São Tomé and Príncipe on government receipts, spending and savings. Section B presents a brief overview of fiscal rules that have been adopted by a number of oil-producing countries. Section C applies the Permanent Income Hypothesis framework to assess sustainable government consumption levels, under a conservative baseline scenario, consistent with a gradual build-up of an oil fund for future generations. Section D conducts a sensitivity analysis to explore the robustness of the quantitative findings under the baseline.

2. The analysis in this paper shows that, even under very conservative assumptions, the expected oil wealth of São Tomé and Príncipe could be significant, enabling for a stable annual funding amount into the budget and a gradual build up of a Permanent Fund for Future Generations. The annual funding amount into the budget would start in 2013, increase rapidly to about US$70 million (at constant 2006 U.S. dollars) by 2015, and converge to USS91.9 million by 2033, in perpetuity. At the same time, the Permanent Fund for Future Generations would gradually build up, reaching US$1 billion by 2018, and its steady state value of US$3 billion by 2033. The use of this fiscal rule would simultaneously ensure fiscal sustainability and intergenerational equity, while providing the country with a predictable stream of revenues out of oil to meet its pressing development needs.

Sources of Annual Funding Amount into the Budget, 2012-2050

(In millions of 2006 U.S. dollars)

Source: Fund staff estimates.

Build-Up of Permanent Fund for Future Generations, 2012-2050

(In millions of 2006 U.S. dollars)

Source: Fund staff estimates.

B. Fiscal Rules for Oil-Producing Countries

3. The abundance of oil resources imposes serious challenges for the design and implementation of macroeconomic policies in oil-producing countries. On the one hand, large oil tax receipts to the budget may allow oil-producing countries to significantly augment overall government spending towards reaching the Millennium Development Goals and thus addressing poverty and improving the provision of basic public services for education, health, and infrastructure development. On the other hand, macroeconomic management in these countries faces significant challenges arising from the exhaustible nature of oil resources, therefore raising important intergenerational considerations and the need to strike a balance between government consumption and savings over the long run. In practice, finding the right mix between consumption today or tomorrow, as well as prioritizing poverty-alleviating spending programs, may be a major challenge for policymakers. Also, the uncertainty surrounding the estimation of oil receipts, stemming both from volatile international prices and imprecise assessments of energy reserves, further complicates the design of fiscal policy rules governing the use of oil receipts.

4. A number of fiscal rules have been developed and implemented in oil-producing countries over the years. One extreme fiscal rule, the so called “balanced budget rule,” implies spending all annual oil receipts, while keeping the government’s overall financial position in balance. Although this fiscal policy would be sustainable in the short run, it would not benefit future generations. This policy rule would also subject the level of government spending to “boom-bust” cycles depending on developments in international oil markets.5 Another extreme fiscal rule is the so-called “Bird-in-Hand” policy, in which only the interest income accruing from accumulated oil revenues is spent on a consistent basis over time. While this policy mostly avoids the “boom-bust” spending cycle of the previous rule, it may create social tensions, as it would yield low levels of public spending while the oil revenues are being accumulated during the period of oil exploitation. Also, there could be a high opportunity cost in terms of foregone social and infrastructure spending in the early years at the expense of future spending. In between these two extreme scenarios, several other fiscal rules have been used.6 These include constant expenditure rules, rules that target a price of oil with any revenues generated due to prices in excess of the threshold being saved, rules that save a fixed percentage of oil revenues, among others. The oil windfall not being spent in these cases can be allocated to savings funds and/or to stabilization funds that seek to smooth out fluctuations in annual government spending. In addition, in designing fiscal rules, countries need to take into consideration their absorptive capacity constraints–at the technical, institutional and infrastructure levels–and the need to ensure an effective public expenditure tracking system aimed at minimizing wasteful spending.

5. A useful theoretical framework, with desirable intergenerational considerations, is based on Friedman’s (1957) permanent income hypothesis (PIH). According to the PIH, individuals, as well as benevolent governments, should be considered forward-looking, trying to smooth their consumption over time in line with permanent income. In the case of zero population and productivity growth, the PIH implies constant government consumption out of oil over time, equal to the annuity present value of expected oil wealth7. By definition, expenditures out of oil proceeds would be stable, thus avoiding ¨boom-bust cycles¨ mentioned earlier. The added predictability implied by this rule, should, in principle, help policymakers in avoiding bottlenecks in terms of absorptive capacity.

6. Formally, under the PIH, sustainable government consumption out of oil wealth (GC) at any point in time t+1 would be determined as follows:

where Ft is the value of the accumulated oil revenue in the oil fund at the end of the previous year, in constant prices, Ti is the expected oil revenue to the government (net of production costs) in period i, in constant prices; r is the expected average real rate of return on oil wealth; and I is the number of years until oil production ends.

7. The PIH could also be calculated in per capita terms. Under this modified rule, policymakers target constant per capita government consumption out of oil wealth over time. The modified rule would be determined as follows:

where GCt+1 is government consumption in period t+1, n is the annual rate of population growth and the other variables are as defined in equation 1.

C. Application of the PIH to São Tomé and Príncipe: Some Preliminary Baseline Projections

8. São Tomé and Príncipe’s Oil Revenue Management Law (ORML) of December 2004, uses the PIH framework to develop the country’s Permanent Oil Fund for Future Generations.8 São Tomé and Príncipe became the first country in Africa to apply such rule, demonstrating its concern for an efficient use of oil resources and for intergenerational equity considerations.9

9. The PIH framework in place in São Tomé and Príncipe includes a number of features reflecting policymakersconcerns about the intertemporal utilization of the country’s oil wealth. Formally, the calculation of government consumption—or annual funding amount—is determined each year as follows:

where d is the discount rate and the other variables are as defined in equation 1.

  • a. Equation 3 is not expressed in per capita terms as the Sãotomean authorities considered that such a formulation would unduly back-load needed spending on health, education, and infrastructure which, in the authorities’ view, would have a very high rate of return for the Sãotomean economy. The authorities also noted that a per capita PIH rule10 would (i) yield a level of government spending that would be lower than the one consistent with the current levels of donor support to the country; and (ii) the annual funding amount could possibly be very low in a situation of low real rates of return and a marginal hike in the rate of population growth.
  • b. The discount rate (d) and the long-run real rate of return (r) differ from each other.11 Specifically, for the purpose of setting the annual funding amount, the ORML caps the long-run rate of return at 5 percent, and states that the discount rate cannot be set below 7 percent. This latter feature in the Sãotomean formulation was introduced out of prudence to acknowledge the uncertainties involved in future oil production. Also, the established discrepancy between r and d, results in an initially lower but gradually increasing annual funding amount into the budget as the Permanent Oil Fund is being built up.12

10. The remainder of this section presents some preliminary staff calculations of the country’s oil wealth and sustainable government consumption under the PIH. Staff calculations are based on available seismic surveys for the Joint Development Zone (JDZ) and use information on the size of commercial energy reserves and production profiles in adjacent deep-water oil fields in the Gulf of Guinea as benchmarks for scaling purposes in the baseline scenario. Computation of the country’s oil wealth and the path of sustainable annual government consumption out of oil proceeds have been performed using the production sharing agreement (PSA) template developed by the World Bank’s expert group on oil. The baseline model’s parameters were calibrated to match the sample PSA posted in the JDA’s official website, which reportedly forms the basis for ongoing negotiations with prospective oil operators in the Joint Development Zone (JDZ).13

Source: National Petroleum Agency of São Tomé and Príncipe.

Sample of Deep-Water Discoveries in Gulf of Guinea
FieldDiscoveryProductionWater DepthRecoverable
NameDateStart DateDepthReserves 1/
(mts.)(million barrels)
Bonga SW200120071245600
Bosi199620061424683
Nnwa-Doro199920051283500
Akpo2000200613661000
Agbami-Ekoli1998200614351000
Bonga199620041125735
Erha1999200511911000
Zafiro Complex199519968501200
Sources: Johnston (2003), JDA webpage (2006).

At time of discovery.

Sources: Johnston (2003), JDA webpage (2006).

At time of discovery.

11. At the time of the drafting of this report, exploration drilling of Block 1 located in the country’s Joint Development Zone (JDZ) operated with Nigeria had just began, therefore, it is not yet possible to confirm any commercial discoveries. Against this background, estimates on oil reserves, annual oil production and export receipts discussed in the paper, should be considered speculative and subject to significant uncertainty and margin of error.

12. Baseline estimates of the impact of prospective oil wealth for São Tomé and Príncipe have been made under rather conservative assumptions. Indeed, the baseline assumes the discovery of only one commercially-exploitable block in the JDZ, with 500 million equivalent barrels of oil in reserves (equivalent to a total production of 70,000 barrels per day for twenty years, with 28,000 barrels/day being the Sãotomean share). This level of production per day is roughly equivalent to that of an average-sized block being exploited in the Gulf of Guinea. Oil production is assumed to begin in 2012 and the production profile is consistent with that of deep-seawater wells: peaking to approximately 150,000 barrels per day in the third year of production, and gradually declining thereafter, until reaching depletion after 20 years. The oil price is assumed at US$30 per barrel, in constant 2006 U.S. dollars. The baseline discount rate and long-run real rate of return were set at 7 percent and 3 percent, respectively.

Production Profile

(In barrels per day, JDA)

Source: Fund staff estimates.

13. Under the baseline scenario, oil wealth accruing to São Tomé and Príncipe would be significant. The annual funding amounts into the budget would converge to US$91.9 million14 (equivalent to 130 percent of projected 2006 GDP), while the Permanent Fund for Future Generations would stabilize slightly above US$3 billion by 2032 (equivalent to 43 times 2006 GDP; see Text Table II.1, below). As a ratio to projected GDP, the annual funding amount would peak at over 50 percent in 2015–16. Compared to current levels of donor support, the annual funding amounts would be substantially higher, for almost two decades, and should, in principle, allow the country to substitute for any decline in foreign aid as oil production takes off.

Annual Funding Amount vs. Historical Net Donor Assistance

(In percent of non-oil GDP)

Source: Fund staff estimates.

Text Table II.1.São Tomé and Príncipe: Oil Flows under Baseline Scenario 1/ 2/ 3/

(In milllions of 2006 U.S. dollars)

Annual Funding Amount for Public BudgetPermanent Fund
Oil ReceiptsTotalFrom annualFrom PermanentIn percent ofBalanceIn percent of
production 4/Fund 5/non-oil GDPnon-oil GDP
201225.90.00.00.00.00.00.0
201390.713.013.00.011.30.00.0
2014306.659.059.00.047.30.00.0
2015396.173.373.30.054.4128.295.1
2016364.675.972.03.852.1414.6284.7
2017333.678.265.812.449.8739.9470.5
2018300.580.458.222.247.31,042.0613.5
2019268.182.351.131.344.91,318.2718.7
2020237.684.044.539.542.41,567.3791.2
2021209.385.538.547.040.01,790.0836.6
2022183.586.733.053.737.51,987.7860.2
2023164.887.828.259.635.22,162.5866.5
2024140.188.723.864.932.92,318.5860.3
2025122.189.519.969.630.72,456.1843.8
2026106.290.116.473.728.72,575.2819.2
202792.190.613.477.326.72,679.8789.3
202879.891.010.680.424.82,771.6755.9
202969.191.38.283.123.12,852.3720.3
203059.691.66.085.621.42,923.2683.5
203147.091.74.087.719.92,985.6646.4
20320.091.82.389.618.43,038.5609.1
20330.091.90.791.217.13,062.7568.5
20340.091.90.091.915.83,063.2526.5
20350.091.90.091.914.63,063.2487.5
20360.091.90.091.913.53,063.2451.3
20370.091.90.091.912.53,063.2417.9
20380.091.90.091.911.63,063.2387.0
20390.091.90.091.910.73,063.2358.3
20400.091.90.091.910.03,063.2331.8
20410.091.90.091.99.23,063.2307.2
20420.091.90.091.98.53,063.2284.4
20430.091.90.091.97.93,063.2263.4
20440.091.90.091.97.33,063.2243.8
20450.091.90.091.96.83,063.2225.8
20460.091.90.091.96.33,063.2209.1
20470.091.90.091.95.83,063.2193.6
20480.091.90.091.95.43,063.2179.2
20490.091.90.091.95.03,063.2166.0
20500.091.90.091.94.63,063.2153.7
Source: Fund Staff estimates.

Unless otherwise indicated, amounts expressed in millions of 2006 U.S. dollars assuming 2.5 percent annual foreign inflation.

Assumes exploitable oil reserves of 500 million barrels in the JDZ, 40 percent being São Tomé and Príncipe’s share.

Present value of flows calculated using 7% discount rate.

Includes interest accrued at the Unrestricted Portion of the National Oil Account pending the annual drawing or transfer to Permanent Fund.

Assumes real return of 3% on Permanent Fund.

6/ Assumes non-oil GDP growth rate of 6.25% on average for 2006-10 and 8% thereafter.
Source: Fund Staff estimates.

Unless otherwise indicated, amounts expressed in millions of 2006 U.S. dollars assuming 2.5 percent annual foreign inflation.

Assumes exploitable oil reserves of 500 million barrels in the JDZ, 40 percent being São Tomé and Príncipe’s share.

Present value of flows calculated using 7% discount rate.

Includes interest accrued at the Unrestricted Portion of the National Oil Account pending the annual drawing or transfer to Permanent Fund.

Assumes real return of 3% on Permanent Fund.

6/ Assumes non-oil GDP growth rate of 6.25% on average for 2006-10 and 8% thereafter.

D. Sensitivity Analysis15

14. According to preliminary staff estimates, the scale of oil wealth could vary significantly, depending on the number, size and quality of commercial oil discoveries made. The baseline scenario assumes that only one medium-sized block in the JDZ is found to be commercially exploitable, with an average production of 70,000 barrels per day for twenty years (i.e., 28,000 barrels/day being the Sãotomean share in total daily production). If oil reserves were found to be twice as high as in the baseline, annual transfers into the budget would broadly double to US$183.9 million, and the Permanent Fund for Future Generations would converge to a steady-state of roughly US$6.1 billion. The annual funding amount and the level of the Permanent Fund would keep increasing as new blocks come into production—an issue that could eventually raise questions about the country’s absorptive capacity.16

Sensitivity to Alternative Levels of Commercial Reserves in JDZ

(in millions of barrels)

15. The annual funding amount and the steady-state level of the Permanent Oil Fund are also very sensitive to changes in oil prices. Since oil prices are highly volatile and unpredictable,17 the sensibility analysis covers a wide range of prices. However, there is now a consensus that at least part of the significant oil price increase observed over the past two years is due to structural reasons, with most forecasts predicting oil prices to stay at or above US$40 a barrel (in real terms) over the long run.18 In this context, an increase in oil prices from the baseline assumption of U$30 per barrel to U$40 per barrel over the long run, would imply a significant increase in the annual funding amount (from US$91.9 million to US$137.0 million) and in the Permanent Fund for Future Generations (from US$3.0 billion to US$4.5 billion). The point elasticity of changes in the annual funding amount to changes in oil prices, evaluated at the baseline, is estimated at 1.49.

16. Changes in the real rate of return on oil wealth have important effects on the annual funding amounts. Annual funding amounts are very sensitive to changes in the real rate of return, since, by definition (see equation 3, above), these amounts are equal to the real rate of return multiplied by the present value of oil wealth. The point elasticity of changes in the annual funding amount to changes in oil prices, evaluated at the baseline, is currently estimated at 0.74. For example, an increase in the baseline long-run rate of return to 4 percent would increase the annual funding amounts from US$91.9 million to roughly US$115 million on perpetuity.

Annual Funding Amount

Sensitivity to Real Rate of Return and Oil Prices

Source: Fund staff estimates.

17. Changes in production costs alter the calculation of the annual funding amounts into the budget and gradual build-up of the Permanent Fund for Future Generations. Specifically, a change in investment and/or operating costs would change the government’s take from tax oil (levied on profits at a negotiated rate with oil operators) and profit oil.19 In the latter case, cost increases reduce the base and rate (so called, R-factor) used in assessing the government’s return. Specifically, the base would decline as profits (net of taxes) would shrink with an increase in costs. Also, the R-Factor, as defined in the JDZ Model PSA, declines with an increase in the contractor’s accumulated costs (see Annex I). Staff calculations indicate that an increase in total production costs per barrel from US$7.8 per barrel (assumed under the baseline and considered average for deep-water wells) to US$11.0 per barrel would reduce the annual funding amount to US$77.2 million and the steady-state level of the Permanent Fund for Future Generations to US$2.6 billion. In the baseline, the elasticity of the annual funding amount into the budget to changes in total production costs, assessed at −0.41, is less than one third in magnitude of that assessed for changes in oil prices. Also, standard practices in the industry suggest that production costs are less volatile, and more predictable, than oil prices. Sensitivity analysis for changes in other variables, such as the oil tax rate, are presented in Text Table 2.

Annual Funding Amount

Sensitivity to Operating Costs (In dollars per barrel)

Source: Fund staff estimates.

Text Table II.2.Sensitivity Analysis at a Glance: Baseline vs. Alternative Scenarios 1/(In millions of 2006 U.S. dollars)
AnnualPermanent
FundingFund
AmountSteady-state level
Oil Prices (per barrel)
US$2049.91,663.7
US$30 (Baseline)91.93,063.2
US$40137.04,566.4
Real Rate of Return (r)
1%34.13,406.9
3% (Baseline)91.93,063.2
5%137.72,754.7
Discount Rate (d)
3%89.22,974.5
5% (Baseline)91.93,063.2
12%94.43,147.2
Production Costs
US$7.8 (Baseline)91.93,063.2
US$1177.22,574.9
Tax Oil
40%88.02,933.0
50% (Baseline)91.93,063.2
60%96.63,219.1
Oil Reserves in JDZ (million barrels)
25045.81,527.9
500 (Baseline)91.93,063.2
1000183.96,129.8
1500276.09,198.4
3x500 2/295.89,860.3
Per-capita rule 3/IncreasingIncreasing
Source: Fund Staff estimates.

Baseline assumes: Oil price US$30, r=3%, d=7%, production costs=US$ 7.8 p/b, tax oil=50%, oil reserves=500 million barrels.

Assumes three blocks with 500 million barrels of oil each, going into production at six year intervals.

See Annex II for figures showing the path of the annual funding and the Permanent Fund under this rule.

Source: Fund Staff estimates.

Baseline assumes: Oil price US$30, r=3%, d=7%, production costs=US$ 7.8 p/b, tax oil=50%, oil reserves=500 million barrels.

Assumes three blocks with 500 million barrels of oil each, going into production at six year intervals.

See Annex II for figures showing the path of the annual funding and the Permanent Fund under this rule.

E. References

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Chapter II Annex I
Joint Development Zone (JDZ) – Model Production Sharing Agreement (PSA)
BonusesSignatureBid $30 million minimum
Rentals$200/km2 for Oil Prospecting License (OPL)
$500/km2 for Oil Mining License (OML) first 10 years
$200/km2 for OML after 10 years
Royalty Rate
Production (P) in thousand barrels of oil per day (MBOPD)
MBOPDRoyalty
0 - 200%
20 - 705%{1-[(70-P)/(70-20)]}
> 705%
Cost recovery limit80% of production after royalty
Taxation50% “Tax Oil” levied on gross revenues net of royalties and
production costs
Investment allowance50% of Tangible capital costs
Profit oil split
Contractor’s Share
R-FactorShare
0 - 1.280%
1.2 - 2.525%+{[(2.5-R)/(2.5-1.2) x (80%-25%)]}
> 2.525%
JDA’s Share 1 – Contractor’s share
R-Factor = Contractor accumulated receipts/Contractor accumulated costs
RingfencingYes
Government participationNo provision for States to take up a working interest
Sources: Gomes (2003) and Johnston (2003).
Sources: Gomes (2003) and Johnston (2003).
Comparison between Constant PIH Rule (Baseline) and Per capita PIH Rule

This annex shows the path described by the annual funding amount to the budget and the Permanent Fund for Future Generations under two alternative rules. Under the constant PIH rule adopted by São Tomé and Príncipe (Baseline), both the annual funding amount and the Permanent Fund converge to a steady state level in constant dollar amounts. On the other hand, under the per capita PIH rule, both variables would permanently increase over time, in order to allow for a convergence to a steady state, but on per capita terms.

The annual funding amount predicted by the per capita rule would surpass that under the Baseline scenario as late as 2070, and would imply significantly lower annual funding amounts during this transition, specially in the early-decades. Nevertheless, in terms of nonoil GDP, both rules would predict decreasing annual resources into the budget.

Baseline vs. Per-capita rule

4Prepared by Alonso Segura.
5A softer version of this policy would be to target a balanced budget over a longer period of time, for example three to five years, using a projection of oil prices and revenues.
6See for example, Wakeman-Linn et al (2004).
7If population growth is different from zero, a per capita PIH rule would apply.
8See chapter I in this Selected Issues Paper.
9Even among developing countries, São Tomé and Príncipe was the first country to approve this type of rule. The Democratic Republic of Timor-Leste also approved a similar rule recently. However, in the latter case, the Parliament can deviate from the spending amount indicated by the PIH (see Kim (2005)).
10See Annex II for figures depicting the dynamics under the PIH per capita rule. In this case, both the annual funding amounts into the budget and the level of the Permanent Fund, increase ad-infinitum.
11This is not uncommon as the discount rate is often set up to include also country or industry specific risk.
12Industry standards indicate that while this is a reasonable floor for the discount rate, perhaps a higher rate would be recommended on grounds of valuation practices in the oil industry (see Johnson-Callari and Berkelaar (2005). In practice, however, the impact of using a higher discount rate, on the annual funding amount and the steady state value of the Permanent Fund, is relatively small.
13For detailed information on the characteristics of the PSA modeled under the Baseline Scenario, see Annex I.
14In the remainder of the document, all references to dollar amounts are in constant 2006 U.S. dollars, assuming international inflation at 2.5 percent annually.
15See Text Table 2, at the end of this section, for a summary of results.
16Alternatives available to the country, if this were the case, could possibly include switching to a per capita PIH rule at that point.
17Numerous studies have found the path of oil prices to be characterized as a random walk process, implying that the best predictor of tomorrow’s price is today’s price, subject to wide margins of error. For example, see Engel and Valdes (2000).
18WEO projections currently forecast oil prices at US$56.50 on average for the period 2008–11. Even assuming a gradual nominal reduction of prices in dollars in the following years, that projection would imply a higher-price scenario than the US$40 (2006 prices growing at 2.5 percent annually) we assume as our high-price scenario. Under these assumptions, the revenue windfall from oil to STP would be even larger.
19A third source of government revenue is the royalty which, in the case of the JDZ Model PSA, is levied on gross revenue. With this mechanism, which is not standard in all PSAs, the government ensures itself of a minimum take, even if production costs balloon.

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