SPECIAL REPORT

ON THE INVESTIGATION OF THE AUDITOR-GENERAL REGARDING ARRANGEMENTS FOR THE UPLIFTMENT OF MOSSGAS'S PRODUCTS BY THE OIL INDUSTRY AND THE RESULTANT PAYMENTS OF SYNTHETIC FUEL ELEMENT SUBSIDIES FROM THE EQUALISATION FUND

1 Introduction

An investigation was conducted into the payments of subsidies in respect of synthetic fuel elements to Mossgas by the Equalisation Fund because the Office of the Auditor-General wished to establish whether these payments, which amount to very large sums of money, were reasonable, in particular from the perspective of the taxpayer and the motorist. The uncertainty regarding this matter resulted in a qualified audit opinion on the financial statements of the Equalisation Fund for the year ended 31 March 1996.

The qualification, set out in Paragraph 2.2.1(2)(c) on page 4 of the Auditor-General's Report, RP 123/1996 for 1995-96, reads as follows:

"The synthetic fuel subsidies in respect of Mossgas (Pty) Ltd are currently being paid directly to Mossgas (Pty) Ltd. and the calculations of the total sales by Mossgas to the various oil companies are based on certain assumptions. This procedure results in one of the critical conditions for the payment of the subsidy, namely that the relevant oil company must be able to prove loss in refinery throughput, not being followed up, which could lead to certain overpayments in this regard. This is a matter for concern especially when seen against the background of certain imports of refined products by the oil industry. This matter has al,eady been raised with the Department of Mineral and Energy Affairs, an investigation by this Office is envisaged, and this matter will be reported on in due course as the investigation progresses."

2 Mandate and method of reporting

The contents ol this report are based on the requirements of section 188 of the Constitution of the Republic of South Africa, 1996 (Act No. 108 of 1996), and sections 3 and 5 of the Auditor-General Act, 1995 (Act No.12 of 1995).

3 Nature and extent of the investigation

The investigation encompassed the compensation to the Oil Industry (Industry) for the effects on it brought about by Mosspas. For various reasons, and through particular administrative arrangements, this compensation to Industry is represented in payments of synthetic fuel element subsidies to Mossgas from the funds of the Equalisation Fund, and provisionally amounted to R523 154 000 up to 31 March 1997. In the absence of a formal agreement between Industry and Mossgas after 25 October 1994 (when the Interim Agreement terminated), and also in the light of apparent different interpretations of the Interim Agreement by Mossgas and Industry, this Office was concerned to assess the reasonableness or otherwise of payments which were made to Mossgas from the Equalisation Fund with respect to the upliftment of Mossgas's products by Industry. Reasonableness was to be assessed by giving due consideration to (inter alla):

1. Any informal agreements,
2. Declared/stated understandings, interpretations and assertions, and
3. An objective assessment of what is considered reasonable in the circumstances.

The details furnished in this report, and Annexure A thereto, are based on information gleaned from documentation in the possession of this Office, and from various discussions held by the Office. This Report and the Annexure are presented with a view to advance a fundamental understanding of the key issues. It is not practicable to reflect in this Report the detailed history and circumstances of these issues, which are well understood by this Office.

This Office holds no brief for Industry, Mosspas, the CEF group of companies, or the Department of Minerals and Energy, and tables these findings so that the matter may be resolved in the interest of the taxpayer and the motorist. It is, however, also recognised that the regulatory framework regarding the Oil Industry in South Africa is complex and that there may be other aspects of the framework which may also need attention. These are not addressed here as this is regarded as a separate issue revolving around a specific aspect which needs to be resolved.

4. Investigation findings

(1 ) General

(a) Formal agreements between Mossgas and Industry

Industry has been uplifting Mossgas's petroleum products since the time Mossgas commenced production in 1992. An Interim Agreement concluded between Mossgas and Industry covered the period from 26 October 1993 to 25 October 1994, at which date the Interim Agreement terminated, was not renewed, and was not succeeded by any formal agreement between the parties because the parties could apparently not agree on various issues.

(b) Disagreements between Mossgas and Industry

Certain disagreements exist between Mossgas and Industry, and relate to the consequences to Industry brought about by the existence of Mossgas, and they translate into the issue of compensation to Industry for the effects brought about by Mosspas.

It appears that disagreements between Mossgas and Industry involve, in part:

1. disagreement a, to the intentions of parties at the outset, or as they may have changed from time to time,
2. disagreement as to what is reasonable in the circumstances, also taking account of particular relevant assertions by various parties, and
3. disagreement as to the actual facts underlying particular relevant assertions.

(c) Ministerial Directives

• In terms of long-standing practice agreed on between Government and Industry, Industry receives In-Bond-Landed-Cost (IBLC) prices for the sale of its petroleum products. (These prices are not adjusted for Industry uplifting Mossgas product at less than IBLC prices.)
• When Government resolved in 1993 that Mossgas should receive IBLC prices for its products, it was decided also to compensate Industry (for losses) which it incurred as a result of excess supply on account of Mossc`;as) by agreeing that:
• Mossgas's products be sold to Industry at the (lower) prices which industry could fetch by exporting excess local production into Africa [Africa Netback (AND) prices], and
• the Equalisation Fund pay to Mossgas the difference between the amounts paid to it by Industry on the one hand, and IBLC prices on the other. [Ministerial Directives were issued in terms of section 1A(4) of the, Central Energy Fund Act, 1977 (Act No. 38 of 1997), on this matter.]

(2) Intentions

(a) Commercial neutrality (the so-called no pain; no gain principle)

1. In a letter to CEF, dated 1 April 1996, Industry stated that "With regard to the period from 26 October 1994 through to the date on which a new agreement with Mosspas takes effect, we would like to record Industry's position that, as there has been no agreement in place for the off-take of Mosspas's products over this period, apart from a shorter term, month-bymonth, ad hoc arrangement to uplift at export-related prices, there can be no owing by Industry above the price that has already been paid to Mosspas in respect of product lifted during this period Industry has been absorbing Mossgas production on the understanding that all Mossgas liftings, were on a Willing Supplier/Willing Purchaser basis at that price. We continue to lift product on this basis, pending finalisation of a longer term supply agreement".
2. Mosssgas appears to contend that a Willing Supplier/Willing Purchaser basis is tempered (inter alla) by a principle of commercial neutrality (the so-called no pain; no gain principle)
3. It is stated in sub-clause 3.3.1 of the draft Heads of Agreement, which was never signed, that "in terms of these Heads of Agreement and the Agreement, the oil companies are to be neither advantaged nor disadvantaged by the off-take of products from Mosspas". (See paragraph 2, Annexure A.)
4. In a letter to l\/lossgass Chief Executive, dated 6 April 1995, Industry stated that "While being appreciative of Mossgas's financial situation, regretfully Industry sees no way clear to deviate from the Principle agreed upon with Government in 1988 that Oil Industry would be kept whole, neither benefiting nor being penalised by the absorption of the Mossref production".
5. As recently as January 1997, an oil company indicated to this Office that "It must be recorded that it was the intention of both Government and Industry from the outset that any pricing basis should ensure that Industry is neither advantaged nor disadvantaged as a result of the Mossgas investment".
6. However, in its letter to this Office dated 11 October 1996, the South African Petroleum Industry Association (SAPIA) has stated that the no pain; no gain principle did not apply after October 1994.

(b) Industry's refining capacity

1. In a Departmental submission setting out the rationale reyard,u.~ the upliftment of Mossgas's products in the longer term, the term iinstalled capacity" is used
2. Mossgas appears to contend that
• "installed capacity" equivalent to "nameplate capacity" is an unreasonable benchmark which could not have been envisaged in reality, and that
• "streamday capacity" would be the appropriate benchmark, which allows for bottlenecking constraints ("integrated" refining capacity), breakdowns and plant turnarounds.
3. Mossgas's standpoint is that its own capacity has been absorbed by the increase in local demand:
• for Mogas, by some 5 times since 1986 - the date of Mossgas's announcement - (and by some 2,5 times since 1992), and
• for distillate, by some 1,5 times since 1986 (and by about once since 1 992).
4. Industry's standpoint appears to be that the issue concerns its overall surplus/unabsorbed capacity when the Mossgas project was announced.

(3) Reasonable

(a) Net export/import positions

(i) Clause 1.1 of the Interim Agreement stipulated how products are to be grouped pooled in orde! to determine the net import/export positions:

"Since industry has flexibility to switch between gasoline grades and to switch between gas oil and kerosene, the analysis of whether Industry is a net product exporter or importer will deem:

(i) Mogas 93, mogas 97 and mogas 95 (which is sometimes imported) to be one product family;
(ii) Gas oil, jet kero and illuminating kerosene to be a second product family"

(ii) Mossgas appears to dispute Industry's averred ability to switch production easily and significantly between Mogas grades (without incurring substantial additional capital and operating expenditure), and points to the fact that most of Mossgas's gasoline production is Mogas 97 (unleaded high octane) which Industry also imports (together with some Mogas'35) to meet the country's overall octane pool requirement; and that Industry in fact exports Mogas 93 (leaded low octane).

(iii) Accordingly, Mossgas apparently considers itself disadvantaged by a practice whereby all Mogas grades are pooled to determine Industry's net export/import position:

• This matter is of particular relevance to the period covered by the Interim Agreement. Mossgas contends that its production should be viewed as "import substitution" and therefore treated as part of "imports" for the purposes of the calculations envisaged in the Interim Agreement.
• According to Deloitte & Touche (who were appointed by Industry to express an opinion on the retroactive price adjustment relating to the Interim Agreement), applying Mossgas's interpretation can increase the amount of the retroactive price adjustment owing by Industry to CE F (for the period covered by the Interim Agreement, being from 26 October 1993 to 25 October 1994) from some R4,9m to:

- some R47,6m, allowing for Mogas 97 volumes only, or

- some R60m, allowing for both Mogas 97 and Mogas 93 volumes.

In this regard it should be noted that Deloitte & Touche confined its work to certification of volumes and IBLC/ANB price differentiates. Specifically Deloitte & Touche have stated:

"We are not in a position to interpret the terms of the Interim Agreement and therefore have not attempted to do so. We accordingly do not express an opinion as to whether the interpretation of the Interim Agreement made by the oil industry correctly reflects the intentions of the contracting parties."

(b) Other advantages to Industry resulting from the existence of Mossgas

Some of the advantages to Industry brought about by the existence of Mossgas, and for which MossOas receives no commercial quid pro quo, are averred by Mossgas to include:

1. Locational advantage,
2. Shipping optimisation,
3. Reduced fuel oil production, and
4. Quality of Mosspas's products, e.g.: high Motor Octane Number (MON factor); low sulphur content.

(4) Actual facts

(a) Export/import positions

1. As recorded in paragraph 4(3)(a)(ii) above, Mossgas appears to dispute Industry's ability to switch production easily and significantly between gasoline grades (without incurring substantial additional capital and operating expenditures).
2. With regard to the period covered by the Interim Agreement, Mossgas wrote to Deloitte & Touche on 18 November 1996 stating (inter alla):

"Our own estimates are that the oil companies were net importers of RON 97, but net exporters of RON 93. The RON 97 imports were, however, of such magnitude that it left the oil companies in an overall net import situation."

3. Deloitte &Touche's opinion indicates that, whilst the oil companies were net importers of RON 97 and net exporters of RON 93 during the period covered by the Interim Agreement, those companies nevertheless were in an overall net export (not import) situation, unless Mossgas's production is viewed as "import substitution" and is therefore treated as part of "imports".
4. In his letter dated 7 March 1997 to the Director-General of the Department of Minerals and Energy, Mossgasis Chief Executive refers to "The fact that the Industry is a net importer of finished products ....".
5. For particular reasons Industry refused to furnish this Office with the information requested, including information regarding its imports and exports. Accordingly, this Office had to make use of information obtained from different sources. Based on this information (and excluding the "import substitution" effects), it appears that Industry started moving into a net import position for Mogas in about June 1996 only and has remained a net exporter of kerosene and diesel.

5. Overall conclusions

(1) From a restricted perspective of probity, the payments to Mossgas are in line with Ministerial Directives.

(2) However, in the absence of any formal agreements for the upliftment of Mossgas's products by Industn/ since 25 October 1994 (when the Interim Agreement terminated and which Mossgas appears to interpret differently from Industry) and in the light of the information to hand (the important features of which are presented in this P<eport), this Office is unable to confirm that the payments in question are reasonable trom all perspectives and, in particular, from the perspective of the taxpayer and the motorist.

(3) The Department's stance on the matter hitherto puts distance between the Department and theta parties. The Department appears to regard the issue as a commercial matter which the parties must resolve amongst themselves, and has relied on compliance with Ministerial Directives to justify current arrangements whereby the Equalisation Fund, albeit in accordance with those Directives, continues to pay to Mossgas the difference between IBLC and ANB prices simply on the basis of the volumes of product sold by Mossgas to Industry at ANB prices This stand by the Department has not helped to expedite resolution of the apparent impasse between l\lossgas and Industry, and the issue of payments from the Equalisation Fund in respect of Industry's position vis-a-vis Mossgas, viewed from all perspectives

6 Recommendation

It is of concern to this Office that, after expiry of the Interim Agreement on 25 October 1994 (which Mosspas appears to interpret differently from Industry), there has been no formal agreement between Industry and Mossgas for the upliftment of Mosspas's products; and that the Equalisation Fund, albeit in accordance with Ministerial Directives, continues to pay to Mossgas the difference between IBLC and ANB prices simply on the basis of the volumes of products sold by Mossgas to Industry at ANB prices.

It is recommended that the Department, as a matter of urgency, considers new ways and means of securing a resolution of the apparent impasse between Mossgas and Industry and, in the process, adjudicates on and resolves the issue of payments from the Equalisation Fund in respect of Industry's position vis-a-vis Mossgas, considering the issue from all perspectives and, in particular, from the perspective of the taxpayer and the motorist.

7. Appreciation

I would like to express nay appreciation of the courtesy extended and assistance rendered by the staff of the various entities liaised with during the investigation.

HE KLUEVER,
Auditor-General.

Pretoria, 16/07/97.

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Annexure A

GENERAL INFORMATION

1. The basic issue

In terms of long-standing practice between government and the Oil Industry (Industry), Industry receives In-Bond-Landed-Cost (IBLC) prices for the sale of its petroleum products [gasoline (Mogas) and middle distillates (kerosene and diesel)].

(1) IBLC prices, and retail prices

(a) IBLC prices are derived as follows:

1. FOB component: based on a combination of posted prices from certain offshore refineries, and spot prices,
2. Ocean freight,
3. Insurance,
4. Ocean leakage,
5. Landing, and
6. Wharfage.

(b) Retail prices are derived by adding, as appropriate, the following elements to IBLC prices:

1. Retail margin,
2. Zone differential,
3. Service differential,
4. Equalisation Fund levy, (v) Fuel tax,
5. Customs and Excise duty, (vii) MVA levy,
6. CRSF levy, and
7. Wholesale margin.

(2) Since Mossgas started production in 1992, Industry has (with the exception of any retroactive adjustments for the period covered by the Interim Agreement) uplifted Mossgas's petroleum products at exportrelated Africa Netback (AND) prices, which are lower than import-related IBLC prices.

In terms of Ministerial Directives, the Equalisation Fund has compensated Mosses in respect of the difference between IBLC and ANB prices.

2. Draft Heads of Agreement

Although draft Heads of Agreement were prepared for the upliftment of Mossgas's products, Industry and Mossgas have up to now not been able to agree on a number of issues and, as a result, the Heads of Agreement were never concluded between the parties.

The following clauses in the draft Heads of Agreement are worthy of special note:

"3.1 The oil companies have agreed with Government (as discussed with the Minister of Energy Affairs on 17 December 1991) to purchase Mossgas production, as detailed herein, subject to the following conditions

3.1.1 the oil companies will be fully compensated by Government for demonstrable loss of manufacturing profit resulting from the upliftment of Mossgas production;

3.1.2 the current regulated marketing environment and PAR mechanism will be retained;

3.1.3 Mossgas will not market, in competition with the oil companies, subject to the conditions and/or exceptions contained and detailed in these Heads of Agreement.

3.3 It is the intention that -

3.3.1 in terms of these Heads of Agreement and the Agreement, the oil companies are to be neither advantaged nor disadvantaged by the off-take of products from Mossgas."

3. Interim Agreement

(1 ) In the absence of concluded Heads of Agreement, Industry and Mossgas concluded an Interim Agreement. This interim Agreement covered the period from 26 October 1993 through to 25 April 1994, but was later extended to 25 October 1994, after which it was not renewed.

Clause 2.2 of the Interim Agreement states that:

"The agreement shall end with immediate effect when the Heads of Agreement have been signed or, in the view of the buyers, there is no likelihood that the conditions in clause 3.1 of the Heads of Agreement will be met."

(2) The basis of the Interim Agreement is Industry's net imporVexport position, as distinct from the issue of refining capacity (which emerged in later Departmental submissions).

(a) Clause 1 of the Interim Agreement states that:

"For the period of the Interim Agreement, Industry will pay Mossgas a product"export" related price. This price is based on the"Mediterranean FOB mean price plus a $2.2/ton premium". There will however be an adjustment in the event that Industry has to import product. The total price paid will in this instance equate to the IBLC price for the product(s) in question."

(b) Clause 1.3 of the Interim Agreement states that:

"The pricing basis for the above period and product family will be based on forecast aggregated Industry product flows. There will be a retroactive price adjustment in the event that Industry is actually a net exporter when a net import situation was forecast and vice versa.

Where Industry is a net product exporter in this time period, but the surplus volume is below Mossgas liftings for the product family in question, an IBLC price will be paid on the difference between the two volumes. The residual Mossgas product will be priced at the "export" price level."

4. Cabinet resolutions

On 25 August 1993 the Cabinet resolved (inter a/ia) that:

1. "Mossgas should receive import parity (IBLC) revenue for its products"
2. The principle of compensation, should Mossgas receive less than IBLC prices for those products the Oil Industry may have to export as a result of excess supply, is accepted.

5. Ministerial Directives served on CEF

(1) In the Ministerial Directive served on CEF in terms of section 1A(4) of the Central Energy Fund Act, 1977 (Act No. 38 of 1977), and dated 26 January 1994, it is recorded (inter a/ia) that:

1. "Cabinet on 25 August 1993 decided that Mosspas should receive import parity (IBLC) prices for its products and the oil industry should be compensated for losses incurred while Mossgas fuel was being sold locally and its own fuel was being exported."
2. However, in the absence of final agreement between Mossgas and the Industry and in terms of the interim agreement governing the upliftment of Mossgas product, Mossgas is receiving export parity prices (Africa Netback) for its product and should therefore be compensated directly, at least during the currency of this interim agreement."

(2) A Ministerial Directive served on CEF and dated 25 February 1995 states (inter alla) that:

"- the Ministerial Notice of 26 January 1994 in respect of Mossgas tariff and compensation be withdrawn;

- the funds of the Equalisation Fund be utilised to compensate Mossgas (Pty) Ltd for the loss of income on volumes delivered to the oil companies at export parity prices commonly known as Africa Netback prices, effective from date of commencement of commercial sales by Mossgas (Pty) Ltd to the oil industry."