“An Insight into Production-Sharing Agreements: How They Prevent States from Achieving Maximum Control over Their Hydrocarbon Resource" by Mary Sabina Peters and Manu Kumar

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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


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argued is not an effective proxy for project profitability; hence, the resultant profit-

oil 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 pro-portion 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 de-

velopment investment and directly receives the same percentage share of profits.

PSAs are most favored by developing and transitional economies as well ascountries with small oil reserves and/or high extraction costs. Oil and gas de-

velopment projects are characterized by large capital investments, and very few

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developing nations have sufficient financial resources and expertise for such in-

vestments.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 do-

mestic petroleum industry and receives a substantial part of any oil or gas pro-

duced 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 transi-

tional 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 re-

garding 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 ofcertain 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 com-

panies the opportunity to make large profits. Although such contracts are largelyspeculative, 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 taxa-

tion 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 gov-

ernments into long-term contracts that fix the terms of their investments. Gener-ally, PSAs last for 25 to 40 years with terms protected from potential change by

incoming governments.13

PRODUCTION-SHARING AGREEMENTS AND STATE CONTROL 291


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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 hydro-

carbon 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 hydro-

carbon 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 InternationalArbitration 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 securityconcerns and political instability, foreign oil companies always will need a long-

term 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 advan-

tage of the flexibility PSAs offer in achieving an appropriate balance of incentives.

NOTES

1M. Green, Nigeria Threatens to Renegotiate Generous Contracts of Oil Groups, Financial

Times, October 24, 2007.

2C. P. McPherson and K. Palmer, New Approaches to Profit Sharing in Developing Coun-

tries, Oil and Gas Journal, June 25, 1984, p. 119; A. Kemp, Petroleum Policy Issues in De-

veloping Countries, Energy Policy, vol. 20, no. 2 (1992), p. 104; and D. Johnson, International

Exploration Economics, Risk and Contract Analysis (Tulsa, Oklahoma: Penwell, 2003).

3

M. R. David and S. Hodgson, Production Sharing Agreements: The Commercial Implicationsof Their Development, [1999] 11 O.G.L.T.R 303.

4G. Muttitt, Crude Designs: The Rip-Off of Iraqs Oil Wealth (London: Platform, 2005),

available at http://www.globalpolicy.org/security/oil/2005/crudedesigns.htm .

5N. Pongsiri, Partnerships in Oil and Gas Production Sharing Contracts, International

Journal of Public Sector Management, vol. 17, no. 5 (2004), p. 432.

6For 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).

7See N. Pongsiri, op. cit., pp. 43132.

8Nigeria 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.

9See B. Taverne, op. cit., p. 57.

10

See N. Pongsiri, op. cit.11See D. Johnston, International Petroleum Fiscal Systems and Production Sharing Contracts

(Tulsa, Oklahoma: Penwell, 1994), p. 39.

12See N. Pongsiri, op. cit., p. 435.

13W. 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.

14See N. Pongsiri, op. cit., p. 437.

15See 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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16See B. Taverne, op. cit., p.85.

17For example, Azerbaijans ACG PSA [XXIII, Clause 23.2] allocates risks for tax or leg-

islative change to the state. Ibid, p. 64.

18The Russian example is instructive in this regard.

19A. F. M. Maniruzzaman, Drafting Stabilisation Clauses in International Energy Contracts:

Some Pitfalls for the Unwary [2007] I.E.L.T.R. 23.

20The 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.

21B. Taverne, op. cit., p. 52.

22

See N. Pongsiri, op. cit., p. 439.

23S. 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 Con-

ference on Privatisation, Basrah, Iraq, May 26, 2005, available at http://www.platformlondon.org/

carbon/documents/PSAs_privatisation.pdf.

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“An Insight into Production-Sharing Agreements: How They Prevent States from Achieving Maximum Control over Their Hydrocarbon Resource" by Mary Sabina Peters and Manu Kumar