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December 30, 2013

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"The purpose is to maximize revenue for the Mexican federal government. That may involve maximizing production or it may involve tightly rationing license rounds and writing in high royalty rates after cost recovery. (It depends on exploration risk.) I suspect the latter". I completely agree with the first sentence. But can you explain your suspicion more? I would suspect that conditional on the govt expecting to stick around for many years (decades?) the former option would maximize revenue (consider tax revenue elasticity to GDP growth besides direct royalties).

Good question!

There are two moving parts: the auction and the tax-and-royalty system.

Taxes in hydrocarbons have a Laffer-curve-like quality for new developments. The higher the tax rate, the more marginal sites become uneconomical to explore or develop. A tax-and-royalty system designed to maximize government revenue will, almost by definition, keep some production off the market.

One way to square the circle are the way PSAs allow for cost-recovery (including a guaranteed return) before the production-sharing kicks in. But even there, you are taking away some of the upside from the private investor and pricing out some otherwise promising blocks at the margin.

The auctions, though, are a different story. (I hadn't really thought about this until your question, Federico. Thank you!) High prices will of course leave some license blocks undeveloped ... but they will also risk the winner's curse, lowering future revenue.

E.g., the highest bidders are likely to be the most overoptimistic rather than the best at E&P. Future production will be both lower and arrive later.

Does that make sense?

Thanks for the clarification. For the auctions part -- can't the govt implement something like using pricing from the second best bidder (I can't remember what the formal name for this is) to avoid the winner's curse? I don't know of any govt that does this, but it would still be interesting to think about. Nonetheless there is still one extra point I wanted to raise -- the added tax revenue that the govt can get from higher GDP growth. If you believe that higher oil production would have some spillovers, then maximizing tax revenue involves maximizing the tax revenue from both the oil part and the spillovers. My guess is that this maximization problem would result in higher oil production compared to the oil production if you just tried to maximize revenue from the oil part.

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