THE JOURNAL OF ENERGY AND DEVELOPMENT

Mary Sabina Peters and Manu Kumar,

An Insight into Production-Sharing Agreements: How They Prevent States from Achieving Maximum Control over Their Hydrocarbon Reserves,
Volume 37, Number 2

Copyright 2012

AN INSIGHT INTO PRODUCTION-SHARING AGREEMENTS: HOW THEY PREVENT STATES FROM ACHIEVING MAXIMUM CONTROL OVER THEIR HYDROCARBON RESOURCES
Mary Sabina Peters and Manu Kumar*

Introduction ecently, the unprecedented increase in oil prices has prompted most countries to revisit their oil contracts with international oil companies with a view to renegotiating these contracts to reflect current market trends. As of 2012, Nigeria is considering renegotiating its 1993 deep offshore production-sharing contracts.1 The governments argument is that the early deep offshore petroleum-sharing contracts are based on a production-related sliding scale, which analysts have

*Mary Sabina Peters, Lecturer and Legal Research Analyst, is on the Faculty of Law at the University of Petroleum and Energy Studies in Dehradhun, India. The author earned an LL.M. in oil and gas law from the University of Aberdeen, Scotland, and has worked for more than a decade teaching postgraduate and undergraduate students. In addition to oil and gas law, her research has focused on the promotion of strategic and environmental assessment methodologies with publications in such journals as European Energy and Environmental Law Review, Acta Juridica Hungarica, and European Journal of Commercial Contract Law. Manu Kumar, Vice President of Corporate Affairs at the Asia Pacific Institute of Management, holds a B.Tech degree in electrical and electronics engineering and a post-graduate degree in management; he has been a part of the Indian education system for the past 11 years where he has overseen projects including the commonwealth volunteer program. The author also is a faculty member at Amity University, Indias top-ranked private university, in the research methodology division for Ph.D. and M.Tech students. Mr. Kumars expertise is focused on the oil and gas sector in part because of his position with the Reliance ADA Group where he contributed toward research in the field of law through his publications in such journals as European Energy and Environmental Law Review, Acta Juridica Hungarica, and European Journal of Commercial Contract Law. The Journal of Energy and Development, Vol. 37, Nos. 1 and 2 Copyright 2012 by the International Research Center for Energy and Economic Development (ICEED). All rights reserved.

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argued is not an effective proxy for project profitability; hence, the resultant profitoil split under that scale inevitably results in the minimal impact of increasing crude oil prices on government take.2 Similarly, production-sharing agreements (PSAs) entered into by Russia in the 1990s have been the subject of extreme controversy for some time. The real problem here is Russian reluctance to let go of regulatory control, so areas of the PSAs that should have been made simple contractual matters, such as taxation, export rights, and costs recovery, remained subject to regulation by a variety of government bodies.3 However, what underlies Russias reluctance is the fear of the loss of state control perceived to be inherent in PSAs. It is, indeed, similar fears that have been resounding in the case of the proposed Iraqi Oil Law, especially as it concerns PSAs.4 PSAs are widely used in developing and transitional economies because they are in line with government aspirations to be more proactive and involved in managing the oil and gas resources.5 As such, it is rather ironic states would be wary of accepting them because of apprehensions that they may not be able to exercise maximum control over their hydrocarbon resources as a result. This article attempts a modest discussion of some major provisions of PSAs, highlighting their advantages to contractors and how, in the final analysis, they serve as a hindrance to states achieving maximum control over their hydrocarbon resources.

Production-Sharing Agreements and Their Attraction to Host States Generally in a PSA,6 the state, in theory, has the ultimate control over the hydrocarbon resources, while a foreign oil company or consortium of companies extract it under contract. The foreign firm provides the capital investment, first in exploration, then drilling and the construction of infrastructure, thereby assuming the entire cost risk. The first proportion of oil extracted is then allocated to the company, which uses oil sales to recover its costs and capital investment. The oil used for this purpose is termed cost oil. There is usually a limit on what proportion of oil production in any year can count as cost oil. Once costs have been recovered, the remaining profit oil is divided between the state and the foreign company in agreed proportions. The foreign firm is usually taxed on its profit oil. There also may be a royalty payable on all oil produced. On some occasions, the state also participates as a commercial partner in the contract, operating in a joint venture with foreign oil companies as part of the consortium. In this case, the state generally provides its percentage share of development investment and directly receives the same percentage share of profits. PSAs are most favored by developing and transitional economies as well as countries with small oil reserves and/or high extraction costs. Oil and gas development projects are characterized by large capital investments, and very few

PRODUCTION-SHARING AGREEMENTS AND STATE CONTROL 291 developing nations have sufficient financial resources and expertise for such investments.7 Thus, the attraction for developing countries rests on the fact that the state, without investing its own funds into prospecting, exploration, and extraction of mineral resources and without bearing any commercial risks, builds up a domestic petroleum industry and receives a substantial part of any oil or gas produced by the company.8 Moreover, PSAs often contain clauses offering special advantages that a contractor may offer to the government such as scholarships, training, grants to government authorities or educational institutions, production bonuses, domestic market obligations, and public participation options. Furthermore, coupled with the foregoing advantages, developing and transitional economies widely adopt PSAs in the belief that they would gain all those advantages while, at the same time, they remain proactive and more involved in the control of their oil and gas resources. In other words, states do not have to make concessions in the matter of sovereignty over their domestic petroleum resources and thus running the risk of foreign domination over the oil and gas sector.9 This control in PSAs presumably is achieved through the establishment of a national oil company that monitors operations and participates in decisions regarding production levels and accounting practices.10 Be that as it may, in practice the actions of the state are severely constrained by stipulations in the contract. Hence, it would appear that while PSAs give a semblance of state control,11 in reality it is the foreign companies that exercise greater control over hydrocarbon resources under PSAs. This greater control is achieved through the inclusion of certain provisions in the PSAs that will be examined subsequently.

Objectives of Foreign Oil Companies under PSAs Foreign oil companies invariably seek to gain rights to oil reserves for many years to ensure their future growth and profitability and, in many ways, PSAs tend to meet this aspiration. The flexibility offered by PSAs grants foreign oil companies the opportunity to make large profits. Although such contracts are largely speculative, they still give them a chance of making a sizeable profit once they are successful. Moreover, accounting procedures in PSAs allow companies to book the reserves in their balance sheets, notwithstanding the fact that they do not own them.12 Furthermore, companies often seek to ensure predictability in regard to taxation and regulation. As such, while foreign companies have to accept the risk that they may not find oil or that the price of oil may fallboth being beyond their controlmore often than not they strive to manage the risks of changing taxation or regulatory demands by tying-in governments. Hence, they seek to bind governments into long-term contracts that fix the terms of their investments. Generally, PSAs last for 25 to 40 years with terms protected from potential change by incoming governments.13

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Certain Provisions in PSAs: A Barrier to States Exercising Maximum Control of Hydrocarbon Resources While the objectives of foreign oil companies is to build equity and maximize wealth by finding and producing oil reserves at the lowest possible cost and highest possible profit margin, the states objective, on the other hand, generally relates to the pursuit of the public interest goals, particularly sovereignty, economic growth, and quality of life. Thus, very often states operating under PSAs aim to develop their hydrocarbon resources optimally, which includes satisfying domestic demand, minimizing adverse effects of mineral exploitation on the environment, fostering employment, and accumulating expertise.14 As stated earlier, PSAs are fashioned to strike a balance between these divergent interests. Nonetheless, this balance is hardly struck as most PSAs appear to favor foreign companies interests over that of the state. Economic stabilization clauses15 are invariably used by foreign oil firms to safeguard one of the underlying principles of PSAsthat the contractor should not be subject to the whims of the taxation authorities but should be able to rely on the contract, which cannot be unilaterally amended. Usually, the clause provides that if the state amends any existing tax rates or enacts any new tax that would affect adversely the economic benefit a contractor will derive from the contract, then the parties will amend the contract so as to effectively eliminate such adverse economic effects. The inference is that when changes occur in laws and regulations governing employment and environment protection, which are applied to and are applicable to business, business transactions, and work environment, they do not affect the contract nor do they attribute to amending the PSA.16 Moreover, if a contractor has been exempted from paying income tax or if the income tax actually is paid on its behalf by the state party concerned, the rate of the tax or any change thereof in the future has no consequences for the contractor or the economics of the venture.17 This, in no small measure, deprives governments of control over the development of their oil industry. Because PSAs generally override any future legislation that compromises company profitability, it effectively limits the governments ability to regulate in critical areas such as tax laws or regulations relating to labor standards, work place safety, community relations, and the environment. This apparent lack of control by the state becomes more glaring when it is considered in light of the duration of PSAs, usually lasting 25 to 40 years. As such, if there is a change of government or if the political climate changes, the terms of PSAs cannot change to reflect the countrys new priorities.18 Although stabilization clauses in a PSA may sometimes be subject to constraints imposed by the host states legal and constitutional framework, it is not common as foreign oil companies are wary of such terms since this would leave them without the desired protection against any unilateral action by the state.19 Moreover, most developing countries find themselves in a weaker bargaining position

PRODUCTION-SHARING AGREEMENTS AND STATE CONTROL 293 considering security concerns and political risks often prevalent in the developing nations. Furthermore, PSAs often rule out governments influence over production rates, thereby depriving the state of control over its oil industry.20 Although there is usually a requirement that work programs, budgets, declarations of commercial discovery and corresponding development plans, and the award of major contracts should obtain the approval of the supervisory body, i.e., usually the national oil company, the contractor, however, cannot be forced to develop a discovery that in its opinion is not commercial. Similarly, a state party may be interested in further and additional exploratory work in order to know the full potential of its hydrocarbon resources, while the contractor is satisfied that the area of the contract has been fully investigated.21 The difficulty for the state in this scenario is the fact that it usually depends on the foreign oil company to provide information on hydrocarbon reserves during both exploration and production phases. Consequently, where there is the problem of adverse selection at the development phase of the contract, it becomes hard for the state to gauge the quality of the project.22 Even though states can try to reduce this problem by incorporating a tighter control mechanism in order to increase their involvement in the venture, it is not always the case. Most developing countries find it difficult to control the depletion rate of their oil resources; hence, they face problems in complying with quotas under certain agreements. Again, most PSAs specify that disputes should be resolved in International Arbitration Tribunals and not the domestic courts of the country concerned. In as much as it would be completely untrue to say these tribunals do not consider the broader issues of national interest and sovereignty, it is still correct to say their overriding concern usually is investment interest. Very often states are treated in arbitration tribunals as just a commercial partner; thus, non-commercial issues are not aired, and representation and redress for populations affected by the wide ranging powers granted to foreign oil companies is excluded.23

Conclusion From the foregoing discussion, it is clear that, while in theory PSAs appear to give states maximum control over hydrocarbon resources, in practice this control is constrained by certain restrictions in the contract. Therefore, it is not so much the form as the content of the contractual arrangements that determine the level of state control in PSAs. Interestingly, PSAs cannot be easily disposed of in the oil industry. Developing countries that lack the technical competence and financial wherewithal still find PSAs very attractive. Furthermore, because of security concerns and political instability, foreign oil companies always will need a longterm assurance of future income and a supportive contractual framework that is

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necessary to secure the capital investment needed for energy projects. Thus, with transparency and commitment, states and foreign oil companies can take advantage of the flexibility PSAs offer in achieving an appropriate balance of incentives.
NOTES M. Green, Nigeria Threatens to Renegotiate Generous Contracts of Oil Groups, Financial Times, October 24, 2007. C. P. McPherson and K. Palmer, New Approaches to Profit Sharing in Developing Countries, Oil and Gas Journal, June 25, 1984, p. 119; A. Kemp, Petroleum Policy Issues in Developing Countries, Energy Policy, vol. 20, no. 2 (1992), p. 104; and D. Johnson, International Exploration Economics, Risk and Contract Analysis (Tulsa, Oklahoma: Penwell, 2003). M. R. David and S. Hodgson, Production Sharing Agreements: The Commercial Implications of Their Development, [1999] 11 O.G.L.T.R 303. G. Muttitt, Crude Designs: The Rip-Off of Iraqs Oil Wealth (London: Platform, 2005), available at http://www.globalpolicy.org/security/oil/2005/crudedesigns.htm.
5 N. Pongsiri, Partnerships in Oil and Gas Production Sharing Contracts, International Journal of Public Sector Management, vol. 17, no. 5 (2004), p. 432. 4 3 2 1

For an elaborate description of PSAs, see generally, B. Taverne, Petroleum, Industry and Governments: An Introduction to Petroleum Regulation, Economics and Government Policies (The Hague: Kluwer Law International, 1999).
7

See N. Pongsiri, op. cit., pp. 43132.

8 Nigeria generally adopts PSAs as the sole contractual mode for the exploration and production of petroleum due to the inability of the government to pay its cash-call obligations promptly under the contractual joint ventures. See C. E. Emole, Recent Legislative Developments in Production Sharing Contracts in Nigeria [2000] I.E.L.T.R. 72. 9

See B. Taverne, op. cit., p. 57. See N. Pongsiri, op. cit.

10 11

See D. Johnston, International Petroleum Fiscal Systems and Production Sharing Contracts (Tulsa, Oklahoma: Penwell, 1994), p. 39.
12

See N. Pongsiri, op. cit., p. 435.

13 W. Van der Vijer, A New Era for International Oil Companies in the Gulf: Opportunities and Challenges, speech at the Emirates Center for Strategic Studies and Research Conference, Abu Dhabi, October 19, 2003. 14 15

See N. Pongsiri, op. cit., p. 437.

See M. R. David and S. Hodgson, op. cit., p. 304, for a distinction of the different kinds of application of the stabilization clause.

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16

See B. Taverne, op. cit., p.85.

17 For example, Azerbaijans ACG PSA [XXIII, Clause 23.2] allocates risks for tax or legislative change to the state. Ibid, p. 64. 18 19

The Russian example is instructive in this regard.

A. F. M. Maniruzzaman, Drafting Stabilisation Clauses in International Energy Contracts: Some Pitfalls for the Unwary [2007] I.E.L.T.R. 23. The extent to which this is a problem will depend on the outcome of negotiations. However, experience suggests it will be difficult. For example, Nigeria and Algeria consistently have struggled and largely failed to rein in foreign companies production rates.
21 22 20

B. Taverne, op. cit., p. 52. See N. Pongsiri, op. cit., p. 439.

23 S. Leubuscher, The Privatisation of Justice: International Commercial Arbitration and the Redefinition of the State, (2003) quoted in G. Muttitt, Production-Sharing Agreements: Oil Privatisation by Another Name? Paper presented to the General Union of Oil Employees Conference on Privatisation, Basrah, Iraq, May 26, 2005, available at http://www.platformlondon.org/ carbon/documents/PSAs_privatisation.pdf.