PRODUCTION SHARING CONTRACT

By
SIDDHARTHA SINGH ROY

Petroleum as a source of energy plays a vital role in the progress of economy of any country.
This has led to evolution and development of different contracting practices in the world over
the years.

Production Sharing Contracts (PSC)

In this arrangement a contract is entered into among State and/or National Oil Company (NOC)
and the Contractor for exploration and production of Oil and Gas from an area. The Contractor
bears all the exploration and development costs, in case of discovery, the State shares
production at predetermined rates as incorporated in the contract.

The first Production Sharing Contract (PSC) was signed in 1966 in Indonesia. At least 50% of host
governments now use production sharing contracts regime. PSCs are in use in North Korea,
China Indonesia, Philippines, Sudan, Libya, Oman, Qatar, India, Bahrain, etc.

The acreage may be given at different stages to the contractor. It may be awarded at a stage
when no exploration work has been done or after some exploration work. Such acreage or
blocks are termed as Exploration Acreage or Blocks. There may be acreage in which discovery of
oil or gas has been made. Such acreage is known as Discovered Fields or simply Fields. In India
PSC are in operation for Exploration Blocks, Small and Marginal Fields and Medium Size Fields.

The PSC contains provision for deciding as to appraisal program, development program and
overall sharing of oil or gas on the basis of a formula given in the PSC.
Introduction

There are various mechanisms and systems in the field of upstream oil business of the world on
which host Government award right to explore and exploit petroleum resources. For
exploration and exploitation of natural resources, India has adopted a mixture of concessionary
and production sharing regimes which has been adopted under a Model Production Sharing
Contract.

Development of Production Sharing Concept

In 1960, Law No. 44 was passed in Indonesia providing that oil companies will be known as
“contractors” rather then “concessionaires”. The Western Oil Companies were very upset and
much worried because of its possible impact on Middle East concessions. The companies
working in Indonesia refused to accept this law. Negotiations failed and Government of
Indonesia declared that incase agreements are not reached the companies will be nationalised.
In this backdrop and after the intervention of USA, an agreement was reached through which
these companies were allowed to carry on the operations under a “Contract Of Work”
arrangement. The sharing of production and control under a production sharing arrangement
was not agreed to by major oil companies operating in Indonesia but when some Japanese and
American independents entered into such contracts, others followed suit. So after 1970, the
things were concretized and a new era of Joint Ventures of oil companies with the host
government started. With the passage of time these Contract of Work graduated into
Production Sharing Contracts.

In India, PSC incorporates the charging of Petroleum Exploration License fees and royalty as well
as sharing of profit oil left after cost recovery. Thus it is the hybrid of both the concessionary
and production sharing regime. The Indian PSC makes following declarations as to its legal
position in the Recital Clause, which put PSC in proper legal perspective:
For offshore areas Recital in the contract provides as follows:-

By virtue of Article 297 of the Constitution of India, Petroleum in its natural state in the
Territorial Waters and the Continental Shelf of India is vested in the Union of India. The Oil
Fields (Regulation and Development) Act, 1948 (53 of 1948) and the Petroleum and Natural Gas
Rules, 1959, made there under (hereinafter referred to as “the Rules”) make provisions, inter
alia, for the Regulation of Petroleum Operations and grant of licenses and leases for
exploration, development and production of Petroleum in India.

The Territorial Waters, Continental Shelf, Exclusive Economic Zone and other Maritime Zones
Act, 1976 (80 of 1976) provides for the grant of a license by the Government to explore and
exploit the resources of the continental shelf and exclusive economic zone and any Petroleum
Operation under this Contract shall be carried out under a license granted by the Central
Government;

The above Acts and Rules provide for the grant of License and Lease in respect of any land or
mineral underlying the ocean, within the territorial waters, the continental shelf and exclusive
economic zone of India by the Central Government; Rule 5 of the Rules provides for an
agreement between the Government and the Licensee or Lessee containing additional terms
and conditions with respect to the License or Lease;

The Government desires that the Petroleum resources which may exist in the territorial waters,
the continental shelf, and the exclusive economic zone of India be discovered and exploited
with the utmost expedition in the overall interest of India and in accordance with modern
oilfield and petroleum industry practices;

For onshore areas Recital in the PSC provides as follows:-

The Oilfields (Regulation and Development) Act, 1948 (53 of 1948) (hereinafter referred to as
“the Act”) and the Petroleum and Natural Gas Rules, 1959, made thereunder (hereinafter
referred to as “the Rules”) make provision, inter alia, for the regulation of Petroleum
Operations and grant of Licenses and Leases for exploration, development and production of
Petroleum in India;

The Rules provide for the grant of Licenses and Leases in respect of land vested in a State
Government by that State Government with the prior approval of the Central Government; Rule
5 of the Rules provides for an agreement between the Central Government and the Licensee or
Lessee containing additional terms and conditions with respect to the License or Lease;

The Government desires that the Petroleum resources which may exist in India be discovered
and exploited with the utmost expedition in the overall interest of India in accordance with
modern oilfield and petroleum industry practices;

The clauses of PSC deal with technical, administrative, financial, and legal aspects. There are
also clauses which manage uncertainties.

Contractual Framework
The Production Sharing Contract (“PSC”) Concept

A. General Principles of PSCs

PSC – this is a special form of subsoil use relations based on civil-legal contractual
principles for relations between a state and an investor with respect to prospecting,
exploration and extraction of mineral resources.

PSC is a contract pursuant to which the state (owner of the subsoil) entrusts the
investor to conduct prospecting, exploration and extraction of mineral resources within the
confines of a defined subsoil area on a compensated basis and for an established time
period during which the investor is obligated to conduct the indicated work at its own
expense and own risk.

B. Basic Distinguishing Characteristics of PSCs

The principal distinguishing characteristics of a PSC from other types of a civil

legal agreement are set forth below.

1. The Subject of a PSC

The subject of the given contract is the agreed program of the parties for the
extraction of mineral resources which must be fulfilled by the investor in favour of the
state. Such program includes the type, costs and period of performance. In other words,
the state has hired the investor as a contractor to perform the work envisioned by the
program.
 As a result, contractual relations arise between two legally equal parties, each having
rights and obligations, the violation of which shall entail their legal liability.

The State hires the investor as a contractor for the conduct of work connected with
the extraction of useful minerals. At the same time, it takes onto itself the obligation to
transfer to the investor for use the subsoil area specified in the contract. In the majority of
countries in the world, the subsoil belongs to the state. The state has a monopoly over the
use of the subsoil and the removal from it of natural resources. The granting to an investor
of exclusive rights denotes that the state during the period of PSC’s validity, is obligated to
abstain on the given subsoil area from activity included in the volume of the transferred
rights and not permit such activity on the part of third persons. Only the investor may
conduct activity envisioned by the contract. But this does not mean that the investor shall
obtain unlimited rights. The exclusive rights being transferred to the investor are limited by:
(i) the types of activity envisioned by the contract, (ii) the types of minerals indicated in the
contract, and (iii) the terms indicated in the contract.

2. The State as a Party to a PSC

A PSC as a civil-law contract is concluded between legally equal parties: the state and
an investor. All conditions for use of the subsoil and the performance of work is established
by the parties by mutual agreement.

Nonetheless, one has to take into account that the state participating in the contract
preserves its state prerogatives. Therefore in relations for subsoil use arising on the basis
of a PSC, the state acts in two roles: on the one hand it fulfills its obligations under the
contract, and on the other hand it preserves its state public-legal functions. These roles may
converge or come into conflict with each other. In their delineation, one should be guided
by the following principle: within the scope of conditions provided by the contract , the
state and the investor are equal partners, outside such scope - the state makes decisions
related to subsoil use on an authoritative, administrative-law basis.

3. The Activity of an Investor at its Own Expense and Risk

The investor carries out the activities envisioned in the contract (prospecting,
search, exploration, extraction and other works) at its own expense and risk. The state, as
the other party to the contract does not bear any expenses or risks. If the investor invests
funds in the prospecting and exploration but did not discover any minerals, or discovered
that their extraction would be economically unprofitable, the expended funds shall not be
refunded to the investor. This is a basic principle of a PSC. The parties, however, may agree
otherwise.

4. Ownership of Product Produced under a PSC and the Contractor Nature of

an Investor under a PSC
 Under a PSC, the state transfers to the investor only exclusive rights to conduct
activity involving a subsoil area, but does not transfer rights to such subsoil area into either
ownership or lease. Therefore, all extracted minerals or extracted and processed minerals
(i.e., the produced product) are the property of the state. The state hires the investor as a
contractor to perform work for it, but at the expense and risk of the investor. The work is
carried out on a compensated basis, with the state paying the investor not in money, but
with a portion of the produced product. This is the so-called production sharing, i.e., the
sharing of the results of the work carried out by the investor.

5. The Sharing of Product: Substance and Procedure

Production sharing is the central part and the main distinguishing characteristic of a
PSC. This principle actually gave the contract its name.

In order to determine the volume of the extracted raw materials and to carry out
production sharing, the concept of the “point of measurement” is used - an arbitrary point
related to the movement of extracted raw materials specified by the parties in the contract
(the mouth of the shaft, the delivery point, etc.). At the point of measurement all the raw
materials being extracted is the property of the state. The production sharing is also carried
out at the same point and usually follows the following procedure:

 from the product produced by the investor is separated that part that goes
toward the compensation of the investor’s expenditures (cost-recovery
product);

 that part of the produced product that remains (profit product) is divided
between the investor and the state in a proportion provided in the PSC.

From the time of production sharing at the measurement point the investor has the right of
ownership to the cost-recovery product and its part of the profit production.

The conditions for production sharing between the state and the investor are
determined in each specific contract.

As a result of the production sharing, the state, without investing its own funds into
the prospecting, exploration and extraction of mineral resources and without bearing any
commercial risks, receives a substantial part of the product produced by the investor.
Instead of the product, the investor may transfer to the state its value.
 6. PSC and Taxation

During activities on the basis of a PSC, a special tax regime is used for the investor.
Within the time period of validity of the PSC, the existing state taxes and other mandatory
payments are replaced by a part of the profit product. They are taken into consideration
while drafting an agreement to determine the part of the product produced by the investor
which remains in the ownership of the state. Apparently, no tax privileges are granted to
investors. The existing tax system is simply replaced by production sharing in the case of the
use of a PSC.

Production sharing between the state and the investor is carried out on the basis of
principles determined in each specific contract.

There are two known systems for replacement of taxation by production sharing:

 complete replacement of taxes by a part of profit product (for example, in Libya, the
state divided the produced products between itself and the investor in the proportion
81:19 without levying any taxes or fees);

 partial replacement, when simultaneously with production sharing is envisioned the

levying of certain taxes (for example, in Russia profit tax and fees for subsoil use are
levied, and in Indonesia - income tax and a dividend tax are imposed).

Therefore, the PSC concept, on the one hand, protects the interests of the state, and
on the other - makes the investor immune from the changing tax policy of the state.
Production sharing creates a new procedure for subsoil use, as an alternative to the
conventional tax system, in accordance with which individual characteristics of subsoil use
are taken into account on a contractual basis in each PSC.
Characteristics Distinguishing a PSC from Other Forms of Subsoil Use

In the world practice, the concession and licensing forms of subsoil use are widely
used.

A concession is a civil agreement under which the state provides on a compensated

basis and the investor purchases the exclusive right to the use of a subsoil area for agreed-
upon purposes, in particular, for prospecting, exploration and extraction of useful minerals,
bears all expenses and risks, as well as makes payments to the state for the use of the
subsoil and for all other taxes and mandatory payments envisioned by law. A concession by
its legal nature is a type of a lease agreement.

The licensing system of subsoil use is by its nature administrative-authoritative.

Under the licensing system, the investor also purchases from the state the exclusive right to
use a subsoil area for the extraction of useful minerals. The investor is also the owner of the
extracted raw materials, bears all expenses and risks, makes payments to the state for the
use of the subsoil and all other taxes and fees envisioned by law, but the state structures its
relations with the investor on an authoritative, administrative- managerial basis. By
granting a license, the state by its authoritative act permits the investor to use the subsoil
on conditions established by the state unilaterally. In the same manner, the state may
withdraw its decisions, limit the rights of the investor or completely withdraw the investor’s
rights and revoke the license.

Under a PSC the relations between the state and the investor are contractual, that is
formally equal. In the contract itself, the parties define conditions governing the transfer of
subsoil for use. The produced product is the property of the state, and after production
sharing at the measurement point, a certain part of it is transferred to the ownership of the
investor. A PSC is a type of contract where the right of ownership belongs to the customer
[i.e. the state], and the contractor receives compensation for the performed work.

In this case the tax system envisioned by law is replaced by a special new system of
settlements between the parties - production sharing.

When subsoil is used under a PSC, a license issued by the relevant body of the state is
also needed. But its role is different. The rights and responsibilities of the parties are
determined in the contract itself, while the license only exists for purposes of formalizing
and registration when a right to use the subsoil arises.

Conclusion

It follows that in the environment of a transitional economy and changing legislation,

subsoil use under PSCs is desirable both for the state and the investor. It is desirable for the
state because:
  attracting substantial volumes of investment, including foreign, to the exploration and
extraction of useful minerals is important not only for the stable functioning of the
economy but also for ensuring the national security of the country by means of
reducing dependency on energy imports;

 exploration and extraction of useful minerals demands less material-financial

resources which the state does not have. The necessary resources are contributed by
the investor;

 the state has the opportunity to conclude long-term agreements with investors on
the basis of which it can calculate future growth in the extraction of oil, gas and
other useful minerals, as well as budget income;

 instead of tax payments, which as practice shows are often difficult to collect, the
state receives a certain fixed part of the extracted product.

It is also desirable for the investor to invest under a PSC, because it gives such
investor a greater degree of independence from the constantly changing tax system. The
relations of the investor with the state under a PSC are in large part structured on a civil-
legal basis. Of particular importance to the investor is the stability of legal relations between
the state and itself in the time-period of validity of the contract.