-
COST RECOVERY IN PRODUCTION SHARING CONTRACTS:
OPPORTUNITY FOR STRIKING IT RICH OR JUST ANOTHER RISK NOT
WORTH BEARING?
Marcia Ashong
ABSTRACT: A vital feature of the modern Production Sharing
Contract has been the provision for
the recovery of costs. PSCs offer the IOCs the opportunity to
recover costs where there has been
successful exploration and future production costs. Since their
introduction Cost Recovery (Cost Oil)
has largely been accepted as the most attractive way for IOCs to
mitigate their investment risks, but is
this accurate? The Paper will examine the extent to which cost
recovery mechanisms are a sufficient
guarantee for the risks taken by the IOCs.
The Author holds a Bachelors degree in International Relations
and Political Science from University of Minnesota (US), a Law
degree from the University of Exeter (UK) and is currently pursuing
a
Masters Degree in Energy Law and Policy from the Centre for
Energy, Petroleum, Mineral Law and
Policy (CEPMLP) at University of Dundee, (Scotland). She is
currently acting as research assistant on the World Bank's
Extractive Industries Transparency Initiative (EITAF) Sourcebook
implementation, a
collaborative project involving CEPMLP and the World Bank's
EITAF. E-mail:
[email protected]
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TABLE OF CONTENTS
ABRREVIATIONS.....iii
1.
INTRODUCTION..................................................................................................1
2. GENERAL FISCAL STRUCTURE OFTHE
PSC.............................................3
2.1. Cost
Recovery........................................................................................4
2.2. Profit
Oil.................................................................................................6
3. THE ISSUES: COST RECOVERY A FURTHER
ANALYSIS........................7
3.1. Is Cost Recovery a Loss to the IOC?
.....................................................8
3.2. Consequences of Bad
Oil.......................................................................9
3.3. Gaming Cost
Oil...................................................................................10
4. COST RECOVERY: HOST COUNTRY
PERSPECTIVE.............................10
4.1. Positive Aspects of Cost
Recovery.......................................................11
4.2. Negative Impact of Cost
Recovery.......................................................11
5.
INCENTIVES.......................................................................................................13
5.1. Some Key
Incentives............................................................................13
5.1.1. Investment
Incentives...............................................................13
5.1.2. Tax Burden
Shift.......................................................................14
5.1.3.
Ringfencing...............................................................................14
5.1.4. Contract
Stability......................................................................15
6.
CONCLUSION.....................................................................................................15
BIBLIOGRAPHY
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iii
ABRREVIATIONS
HC Host Country
HG Host Government
IC Investment Credit
IOC International Oil Company
JVA Joint Venture Agreement
NOC National Oil Company
OC Oil Company
OECD Organisation for Economic Co-operation and Development
OPEC Organization of Petroleum Exporting Countries
PSC Production Sharing Contract
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1
1. INTRODUCTION
Since the introduction of the Indonesian Production Sharing
Contract (PSC) in the
1960s, the modern form PSC has gained tremendous momentum1
especially in
developing countries2 with abundant resources who often times do
not have the
required skills or technical know-how to manage exploration and
exploitation.
Coupled with the bad press associated with the traditional
concession contracts, host
governments (HGs) of these nations tend to lean in the direction
of PSCs more often
as an apparatus to shield against political attack, even where a
PSC might not be
completely suitable for their particular circumstances.
Nevertheless, in recent years
HGs have permitted extensive debate before entering into any
such petroleum
contracts, be it after first petroleum reserve discovery3 or for
the exploitation of
marginal fields. The ultimate aim of any HG is to ascertain the
best method through
which they can recover the most rent out of their natural
resources.
Obviously, if increasing government take is the ultimate goal
then PSCs are only
another method through which this can be achieved. The rival to
the PSC is the
modern concession or licensing agreement, most often utilised by
the Organisation for
Economic Co-operation and Development (OECD) with the
governments take being
the varying degrees of tax mechanisms imposed on the Oil
Companies (OC). Other
forms include Joint Venture Agreements (JVA) and more recently,
service (or risk
service) contracts (e.g. Iranian Buy Back).4
A main appeal of the PSC for HGs is that unlike its predecessor
(the traditional
Concession) they have turned the balance of ownership of
reservoirs from the
International Oil Companies (IOC) to the host countries (HC),
allowing the HGs
1 Marcel, V., Oil Titans: National Oil Companies in the Middle
East, 22, (2006). This was propelled by
the establishment of the organization of Oil Producers Exporting
Countries (OPEC) in 1960 which
coordinated the objectives and interests of producing countries.
This was a direct and concerted
response to the foreign companies control of the oil market. 2
They are also gaining traction in transitioning economies 3 Even
before full production begins in late 2010, Ghana a newcomer in the
petroleum industry has
experienced intense debate with regards to the best contract
model in an effort to steer the country away from the fate of its
other African counterparts, namely, Nigeria, Angola and Sudan whos
petroleum industries have been seen as more of a curse than a cure
for national development. 4 A form of risk service contract was
developed by the Iranian government, known as the Iranian Buyback
Agreement, under this type of agreement the IOC invests, when
production begins, the field is handed over to the government or
its NOC. The IOCs share is based on costs incurred and an agreed
upon share of the profit oil.
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2
more control of their natural resources and benefits from
production without the
transfer of investment risks. This is especially important for
developing countries who
seek to exploit their resources for economic rents but lack the
experience or technical
expertise to bear the financial burden. Under the current PSC
structure the IOC is
appointed as contractor to undertake petroleum operations in a
certain area5, it
operates at its sole risk, at its own expense and more
importantly under the control of
the HG. In recognition of the cost borne by the IOC the PSC
allocates a portion of
production to the IOC in order to recover costs they incur in
the process, this is known
as Cost Recovery (or Cost Oil)6.
This new arrangement experienced a slow start, as the major IOCs
preferred the more
traditional concession agreements. But new entrants in the form
of smaller
independently owned OCs who negotiated new petroleum contracts
in the form of
PSCs post OPEC started a trend which major oil companies in the
wake of
concessionary grievances had to follow.7 Later the PSC became
popular with the main
appeal for IOCs being its relatively simpler fiscal regime.8 The
Concession became
cumbersome, the lack of direct legal control over resources
produced led to an array
of complex tax systems designed to increase government take, to
which extent the
PSC seemingly corrects this by placing legal ownership of
production under the
control of the HG or its NOC, any subsequent taxes imposed 9
would merely be on
income made from profit oil, after the IOC receives its costs
from the inbuilt cost
recovery mechanism.
In this regard the design of the Cost Recovery clause in the PSC
is seen as especially
important to the IOC. Cost Recovery is unique mainly because it
comprises one of
two ways through which the contractors share usually gets
determined, that is, the
cost oil and the profit oil split. But at a time of risky
exploration (marginal fields and
deep sea exploration) investors (Contractors) are looking for
additional guarantees
5 Acreage usually smaller than concessions 6 The author will use
these words interchangeably 7 Kamaruddin, M.A., Production Sharing
Contracts in the Oil Industry, 7 (1980) 8 Blinn, K. W., Duval, C.,
Le Leuch, H., Pertuzio, A., Weaver, J., International Petroleum
Exploration
and Exploitation Agreements: Legal, Economic & Policy
Aspects, 69 (2nd ed. 2009) 9 Ibid, pg. 72. Though royalties are
somewhat incompatible with the legal nature of the PSC, because it
is hard to reconcile conceptually how a contractor that does not
own any production from a contract
area can be obligated to pay a royalty on that production to an
HC that is the sole owner of production
under the PSA.
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and recovery of costs alone might not be sufficient for such
prospects. Do HGs need
to design incentives with the intent on induce the IOCs to
undertake actions that will
maximise their welfare?10
Or are the current arrangements sufficient enough to cover
the risks they take, and at the same time make reasonable
profits to justify sound
investment? In this regard, cost recovery has been deemed as
attractive mainly due the
IOCs take in profit oil, leading to recent efforts by some HGs
to curtail cost oil.
Looking at PSCs generally, with key comparative examples the
paper will aim at
ascertaining the true worth of Cost Oil to the IOC and HC
especially in the case of
new oil producing countries.
2. GENERAL FISCAL STRUCTURE OF THE PSC
The goal of a fiscal system from a governments point of view is
to attract
investment and capture the maximum economic rent given the
geologic endowment
of their petroleum acreage.11 Economic rent can be defined as
income earned without
any enterprise, without any cost of production, to get the
excess of rental value over
and above the actual cost of production. The basic structure of
the traditional PSC is
designed to capture as much economic rent as possible for the
HC12
(see figure 1). In
this analysis we shall regard the fiscal system of the PSC as
consisting of two
categories13
, namely, Cost Recovery (Cost Oil) and Profit oil split (under
which
various tax regimes can be implemented).
10
Le Leuch, H., Contractual Flexibility in New Petroleum
Investment Contracts, in Petroleum
Investment Policies in Developing Countries, 82 (Walde T.,
Beredjick N., ed., Kluwer, 1988). In the
wake of volatile markets, the impact of oil prices on current
contractual arrangements needs to be
carefully analysed. The shape of petroleum contracts is largely
dependent on the state of the oil
markets, see examples from 1970s, as a consequence of the
increase in crude oil prices and the strong competition among oil
companies to conclude new arrangements, there had been a general
tightening
of contractual terms which showed in higher government take.
Conversely, since 1982, a tendency to
grant incentives to oil companies to attract exploration capital
has made itself felt because of falling oil prices. 11 Blake, J.
A., Roberts, M.C., Comparing petroleum fiscal regimes under oil
price uncertainty,
Resources Policy 31 (2006) 95105, at
http://www.sciencedirect.com/ (last visited on 12 January, 2010) 12
Johnston, D., International Petroleum Fiscal Systems and Production
Sharing Contract, 6 (Tulsa,
Oklahoma,
USA: PennWell Publishing Company, 1994) 13 Ibid, pg 40. Some
PSCs include the royalty system from the concessionary system, in
such a case the royalty come right off the top just as it would in
a concessionary system.
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Figure 114
2.1. Cost Recovery
Under most PSCs the cost oil regime is usually designed to allow
the IOCs to
recover exploration, development, production costs and expenses
from the share of
production or gross revenues. This share will usually vary
depending on the country
and or the characteristics of the field in question. Cost oil
can be split into two further
categories, the Indonesian model which allocates a certain
percentage of production
for cost recovery, sometimes known as the cost recovery limit
or, for the purpose of
this analysis cost ceiling. Originally, the Indonesian cost
ceiling was 40% of
production, but this was later increased to 80%15
. In some cases the limit could go as
high as 100% (referred to as the second generation Indonesian
PSC), under the 1977
model, the PSC could henceforth in the initial years of
production conceivably claim
100% of production as cost recovery. PERTAMINA (the Indonesian
NOC) only
started to receive a share of production whenever the PSC
reached a point where less
than 100% of production was needed for cost recovery.16 Cost
ceilings, however, if
they exist, typically range from 30%-60%.17
Furthermore, the valuation of cost
14 Ibid, pg 7 15 Blinn, K. W., et al, supra note 8, pg. 76 16
Machmud, T.N., The Indonesian Production Sharing Contract: An
Investors Perspective, 78 (Klulwer The Hague 2000) 17 Johnston, D.,
supra note 12, pg. 56
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ceiling may differ according to the category of recoverable
expenses. For instance in
an Egyptian agreement, exploration expenses could only be
recovered at the rate of
20% per annum, whereas operating expenses can be recovered in
their entirety in the
year in which they are incurred.18
With the original Peruvian model PSC19
on the other hand, the IOC will usually be
allocated a share of the total production as the sole payment to
cover costs incurred.
The share ranges from 44% -50%, this would usually depend on the
size of the
production and the contract area.20
This model however, became unpopular, for the
HCs the grievance was that a fixed share of production,
unrelated to price of
petroleum nor to production costs or expenses would (especially
at times of high oil
prices) give an unfair bonus to the IOC in the form of windfall.
For the IOC, a large
government percentage take had the same consequence as payment
of high royalties
similar to that under the concession agreements, if fixed the
result would be the same
irrespective of economic results of exploitation21
. For this reason the preferred
allocation is still the Indonesian model, of cost oil and profit
oil split22
(See figure 2).
18 Daniels, A.W.K., A Comparative Analysis of Selected
Provisions of An Egyptian and a Tanzanian
Petroleum Production-Sharing Agreement, 14 (A dissertation
submitted to the Centre for Petroleum
and Mineral Law Studies, University of Dundee, in partial
fulfilment of the award of a Diploma in
Petroleum Law, 1986) 19 This model was also used in Bolivia and
in Trinidad and Tobago. See: 1975 Trinidadian Offshore
contract with Mobil. 20 Johnston D., supra note 12, pg. 58 21
The consequence of which is that marginal fields would be left
unexploited, a situation which should
be avoided by any HG. 22 Blinn, K. W., et al, supra note 8, pg.
76
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Figure 223
2.2. Profit Oil
The profit oil is the predetermined allocation of production
after cost oil, split
between the contractor and the government. The contractors share
of profit oil is
usually subject to taxation. The Indonesian model uses the
simple percentage split, for
example, the contract will stipulate an 85%-15% split in favour
of the HC.24
Profit
split will also be adjusted to benefit the IOC in lieu of risky
offshore operations.25
The split can be sole profit oil split or a progressive
split.26
Any subsequent income tax can be deducted pre-production split
or like the original
Indonesian model which was taken post production split. Taxation
is taken out of
income generated from the IOCs share of production. In some
circumstances the
23 Johnston D., supra note 12, pg. 62 24 This split will
normally vary for gas and oil respectively 25 Arif, M., Pakistan
Production Sharing Agreement: Offshore Fiscal System, 4 OGEL .
As
exemplified in the Pakistan model, under the Petroleum Policy
2001 and the model PSA, offshore areas are divided into three
zones; (i) shallow, (ii) deep and, (iii) ultra-deep. Per Clause 6.6
of the model PSA, Contractor and State take is specified for each
zone separately. 26 Nakhle, C., Petroleum Taxation: Sharing the Oil
Wealth: A Study of Petroleum Taxation Yesterday,
Today and Tomorrow, 36 (Routlege, 2008). A progressive split
will usually be determined according to
an incremental scale of daily production, the cumulative
production from the commencement of
production or the effective profitability of the petroleum
project. Countries such as Angola, Equatorial
Guinea and Nigeria, use a progressive scale based on the fields
cumulative production.
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taxes may be fully assumed by the State Company27
and the percentages negotiated
will, naturally, reflect the assignment of income tax obligation
by either the contractor
or the State Company.28
3. THE ISSUES: COST RECOVERY FURTHER ANALYSIS
The world petroleum market within the past decade has been
gripped with heavy
volatility, recently the sharp drop in oil prices have been
largely linked to the world
financial crisis which originated in the United States, the OPEC
Reference Basket
rose to a record $141/b in early July [2008] before falling to
$33/b by the end of the
year, the lowest level since summer 2004.29 More generally,
however, the
uncertainty in the oil markets30
have been influenced by the fears associated with the
potential end of oil, underlined by increasing demand for new
energy sources, many
nations are on a rat race to find alternatives or unconventional
sources of fuel.
In the petroleum sector this trend has led to high risk
exploration projects such as
deep sea exploration and enhanced oil recovery techniques. Oil
companies are drilling
further out into the sea and deeper in the ocean floor, at
depths greater than before to
tap into the last pockets of oil reservoirs in the world.31
The success rate of these
projects32
have once again brought hope in petroleum as a fuel source which
will be
around for years to come, in the wake of depleting fields in
some of the largest oil
fields in the world this news for the oil companies comes at a
vital time33
. For reasons
27 In which case the government share is increased to take into
account the assumption of taxation,
Libya is a clear example, the PSA does not impose a separate
income tax on the IOC, however, the NOCs share can be as high as
81%. 28
Walde, T.W., The Current Status of International Petroleum
Investment: Regulating, Licensing and
Contracting, 18 (Centre for Petroleum and Mineral Law and
Policy, 1994) 29 Organization of Petroleum Exporting Countries,
World Oil Outlook 2009, 36, at
http://www.opec.org/library/World%20Oil%20Outlook/WorldOilOutlook09.htm
(Last visited, 28
January, 2010) 30 The solution though may be to hedge petroleum
prices with put options, however, put option
premiums can be considerably high especially when general market
conditions predict a fall in future
prices. 31 U.S. Department of the Interior, Minerals Management
Service, Gulf of Mexico Oil and Gas
Production Forecast 2004-2013, at,
http://www.mms.gov/assets/PressConference11152004/2004-
065.pdf (Last visited 28 January, 2010) 32 The past few years
have seen huge field discoveries based on offshore exploration in
countries such
as Brazil, Ghana and Sierra Leon 33 Though deepwater exploration
is considerably more expensive than conventional exploration,
the
high oil prices of 2007 made them financially feasible. High
demand for energy continues to be the
pushing factor for further deep sea projects amidst the drastic
fall in oil prices since 2008.
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of extreme high costs associated with petroleum projects in
recent years alone, cost
recovery in the past few years has become even more important,
where the preferred
tool for contracting is the PSC. The question which arises,
however, is whether the
PSCs system if cost recovery is still the best tool for
capturing the most rent from the
perspective of the IOC and the HC.
3.1. Is Cost Recovery A Loss to the IOC?
IOCs are concerned with several objectives, most important
include:
Achieving a reasonable return on their investment, taking into
account the
exploration risks and the long lead time between exploration and
exploitation;
Enjoying an acceptable pay-out time to recover their original
investment; and
Gaining long-term access to new supplies of petroleum through
the unfettered
right to export production obtained from the HCs fields34
Considering that a major objective is acceptable pay-out time to
recover their
original investment, a growing point of view sees cost oil as
adding no benefit to
the IOC in this regard. In fact from this perspective cost oil
is synonymous to bad
oil, that is, it has no potential of being of any benefit to the
IOC. It is bad because
taken into account the time value of money, costs being paid at
a later stage (in most
cases a year or two after costs are incurred) which do not do
not take into account the
depreciation of money over time will never accurately reflect
true costs. Very few
PSCs offer the opportunity for the recovery of financing costs
or interest expense35 in
fact, interest expense is usually not recoverable. Some PSCs do
allow unrecoverable
costs to be uplifted by an interest factor to compensate for
delay in cost recovery, but
if interest expense is allowed to be recovered, then there
should be no uplift for
unrecovered costs36. In a clear example of how the cost oil
system works from the
contractors perspective, if for instance, the contractor spends
$1.00 on recoverable
costs, the contractor will have to get a negative impact of
$0.15 after cost recovery.
Essentially, there is no value as not all costs can be recovered
and even those
recovered are subject to time-value depreciation. For a PSC with
a cost ceiling and
34 Blinn, K. W., et al, supra note 8, pg. 224 35 Nakhle, C.,
supra note 26, pg. 36 36 Sunley, E.M., Baunsgaard, T., Simard, D.,
Revenue from the Oil and Gas Sector: Issues and Country
Experience, in Davis, J.M., Ossowski, R., Fedelino, A., Fiscal
Policy Formulation and Implementation
in Oil-Producing Countries (International Monetary Fund,
2003)
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carry forward rights, this is even more of a detriment to the
IOC who will see his costs
spread out over several years, further adding to the negative
impact of the recoverable
amount.
3.2 Consequences of Bad Oil
The consequence of such a structure for an IOC who is expected
to bear the risk in
such capital intensive projects is surmountable. Cost oil alone
could be a disincentive
for investment into new fields. For new entrants in the game,
often times developing
countries with high social and political risk this is yet
another risk factor from which
IOCs would analyse their chances.37 Most of these resource rich
countries are
developing nations who suffer from poor annual growth,
underfunded energy
ministries or poorly run NOCs.38 With the rapid pace of economic
expansion over
the past decades, many developing countries experienced a sharp
annual growth in
petroleum demand. Nevertheless, of those with large or
potentially large petroleum
deposits, very few had sufficient financial resources for supply
side investments,
especially for the development of oil and gas exploration and
production.39 Keeping
this in mind the best way forward it would seem for any such HG
is to design an
environment conducive enough for the IOC to conduct business
keeping in mind the
risks he has to bear. According to Pongsiri the state has to
offer contract terms that
are attractive enough for the IOC to enter into an agreement. At
the same time, the
terms must allow the state to receive maximum economic returns
from the venture.40
A cost recovery system which undermines the chances of the IOC
in recovery his
entire costs it would seem should be avoided (keeping in mind
that the IOCs
investments includes debts from his end to the financer (most
likely a bank)).41
37 For any new prospecting country the aim is to reduce the
level of risk 38 Pongsiri, N., Partnerships in Oil and Gas
Production Sharing Contracts, 431 (Centre on Regulation
and Competition (CRC) University of Manchester, 2005) 39 Ibid 40
Ibid 41 But should this risk deter IOCs from undertaking these
projects? Perhaps the uniqueness of the
industry also eliminates other risks borne by firms operating in
other industries. For instance, since
petroleum products are normally sold on the futures market,
future sales can be forecasted with a high
degree of certainty. Hence given a certain level of operating
expenses , Return on Asset(ROA), and
Return on Equity (ROE) can easily be estimated
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3.3. Gaming Cost Oil
Another consequence of limits of cost oil to the IOC is the
potential for the IOC to
try to increase his gain by finding ways to game the cost oil
system. One method is
through cross-subsidization. Most PSCs create provisions for
ring fencing to avoid
this, ordinarily all costs associated with a given block or
license must be recovered
from revenues generated within that block. The block is
ringfenced.42 This has a
huge impact on the recovery of costs. Furthermore, the
opportunity for exploration
costs to cross the fence can be a strong financial incentive for
the IOC.43
Different
PSCs approach this in several ways, for instance, India allows
exploration costs
from one area to be recovered out of revenues from another,44
however, development
costs must be from the licence it is associated with. Whether or
not such an incentive
would be beneficial to the IOC or the effect of its existence
will be analysed further in
part 5 of this paper.
Where ring-fencing exists, another way that the IOC can game is
by proposing a
budget in which costs are higher than what they are expected to
be, doing so through
higher entitlement nominations45
, thereafter, more contractor share in the production.
If this is achieved, the contractor gets the reimbursed (albeit
overinflated) costs and
even if readjusted at a later date to reflect the overinflated
amount the benefit to the
IOC is that the recovered amount is received earlier which takes
away from the
potential of depreciating over time. The prospect of this
happening is slim with a
strong HG or NOC oversight.
4. COST RECOVERY: HOST COUNTRY PERSPECTIVE
For a HC cost recovery is essential in that it is the major
incentive that the HG can
give the IOC. Without cost recovery the IOC would have no
impetus for investing in
42 Johnston, D., supra note 12, pg. 68 43 Fiscal Terms for
Upstream Projects (Bureau of Economic Geology, Jackson School of
Geosciences,
The University of Texas), at
http://www.beg.utexas.edu/energyecon/new-era/case_studies/Fiscal_Terms_for_Upstream_Projects.pdf
(last visited, 28 January, 2010) 44 Johnston, D., supra note 12,
pg. 68 45 Ibid, pg 307, Under a lifting agreement the amount of
crude oil a working-interest owner is expected to lift, each
working interest partner has a specific entitlement depending upon
the level of
production...each working-interest partner must notify the
operator (nominate) the amount of its
entitlement that it will lift.
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the HC. Though interpretation of objectives may differ from
country to country, the
essential goal for any HC is to maximize their revenues while
minimizing their
financial risk.46
For the goal of risk minimization cost recovery acts as the
catalyst.
To say that oil companies provide capital and technology is an
over-simplification.
Actually, to a large extent companies provide a service of
procurement for and on
behalf of governments and themselves for both capital and much
of the technology.47
HGs with cost recovery are shielded from having to put their
limited resources at
risk,48
while at the same time benefiting from any potential revenues to
be generated
where there is successful exploration.
4.1. Positive Aspects of Cost Recovery
For the HC the merits of cost recovery include:
The sole risk of exploration is borne by the IOC, the HC
therefore benefits
when there is successful exploration
The IOC (in most cases) is only entitled to recover costs under
the PSC from a
portion of production from the area subject to the contract
(ringfenced), this is
of benefit to the HC in that costs are not
The cost ceiling is designed to ensure that the HC can have its
share of profit
oil as soon as production commences. The benefit if this is
essential as a late
return on revenues from production would be politically
difficult to justify.
A limit to the recoverable costs shields the HG from having to
pay for
frivolous expenses by the IOC.
Finally, the PSC has a relatively simpler fiscal regime compared
to the
royalty/concession system, thus, the HG usually does not have to
spend time
and resources designing complex taxation rules
4.2. Negative Impact of Cost Recovery
The cost recovery is therefore designed to benefit the HC.
However, even with cost
recovery, the potential for the IOC to be over compensated is
real. Often times a badly
46 Blinn, K. W., et al, supra note 8, pg. 224 47 Johnston, D.,
Changing Fiscal Landscape,31, Journal Of World Energy Law &
Business, 1 (2008) 48 For many resource rich developing countries,
these are just resources they do not have
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structured fiscal regime can lead to abuse by the contractor.
This has been the case for
many developing nations whose petroleum industries have been of
little benefit in
terms of spurring economic growth. To couple this with an
inefficiently run IOC, bad
resource management and lack of social and environmental
awareness49
, could spell
more disaster for the HC. A recent report funded by the European
Union describes the
extent to which a badly structured PSC in Kazakhstans Kashagan
field proved more
of a detriment to the government and the local communities. Greg
Muttitt, who
authored the report, commented that, the research reveals the
extent to which oil
companies took advantage of Kazakhstans weakness in the 1990s (a
time of very low
oil prices).50
The dispute arose after ENI the French IOC involved in the
dispute,
released a statement projecting costs to be higher than they had
envisaged, the
ultimate costs (amounting to a projected loss of over $20
billion dollars) would
thereby be borne by the HC through cost recovery.51
Furthermore, the design of the cost recovery structure can lead
to huge contractor take
in times of high oil prices which could then lead to contract
instability disputes with
the HG who is intent on finding ways to curtail the take by the
IOC. For example in
2008, in an effort to increase government revenues at a time of
high public scrutiny,
the Indonesian Energy and Mineral Resources Ministry proposed a
regulation to
eliminate 17 expenses contractors could claim under the cost
recovery mechanism,52
the Energy Ministry later issued a press release amid dropping
oil prices stating its
intent on abandoning the proposed caps on cost recovery.53
This decision was no less
influenced by Indonesias inability to attract new investment to
develop its oil fields.
49 Coupled with a corrupt and non-transparent public sector the
situation post-oil production for many
nations has been more of a struggle than pre-production, see the
Nigerian example. 50 Unravelling the Carbon web report, at
http://www.platformlondon.org/carbonweb/showitem.asp?article=308&parent=9
(Last visited, 28
January, 2010) 51 Kashagan Oil Field Development, a
collaborative report, at
http://www.foeeurope.org/publications/2007/KashaganReport.pdf
(Last visited, 28 January 2010). The
difficulty in rectifying the issue was further exacerbated by
the stability clauses which made any changes to the provisions a
legal quagmire. 52 The Jakarta Post Newspaper, September 25th,
2008, at
http://www.thejakartapost.com/news/2008/09/25/new-cost-recovery-scheme-will-save-little.html
(Last
visited, 28 January 2010) 53 Reuters News, January 5th, 2010, at
http://www.reuters.com/article/idUSSGE6040CF20100105 (Last
visited, 28 January, 2010)
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13
5. INCENTIVES
IOCs are constantly seeking new investment opportunities, they
have shareholders
and being able to secure a PSC with a HG ensures that they can
book reserves which
also means that their shareholders are kept happy. In this
regard their main goal is
profit maximization in whichever form possible, and with any
investment comes
risks, costs incurred should be one of the risks, after all
costs are costs, they will
always be a detriment to any business activity. On the other
hand, the IOCs do look
strictly at their ability to recover costs because unlike any
other business activity, they
do not get all the benefits of production as a consequence of
exploiting resources that
they do not own. The government takes an incredible amount from
the exploited
resources and as a result needs to build incentives to induce
the companies to want to
give up their resources. The mutual support and joint effort of
each party will lay
solid foundation for the win-win situation. As long as some
inclination appear in the
contract, if unfavourable to the host country, the execution of
contract will be
difficult, if unfavourable to the IOC, the reinvestment will be
hindered.54
5.1. Some key Incentives
It is therefore vital that the HC in an effort to increase its
investment chances
considers an array of incentives as a supplement to cost
recovery. They can come in
the form of:
Investment credits (IC)
Payment of taxes by the NOC as a stability mechanism
No ringfencing
Assurance of fiscal stability
5.1.1. Investment Credits
ICs are a fiscal incentive that allows the IOC to recover an
added percentage of real
capital expenditure through cost recovery. In general
application ICs are cost
54 Erdong, Z., Liwei, l., Research into Contract Mode in
International Oil Corporations Oil Cooperative Development
Projects, IEE Xplore 2008
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14
recoverable but not tax deductable.55
For example where an IC applies the contractor
may recover 125 percent of the recoverable expenses as opposed
to 100 percent,56
where this amount is not taxable is serves as mitigating factor
for the losses than can
be made through cost recovery.
5.1.2. Tax Burden Shift
The NOC bearing the burden of taxes can either be beneficial or
detrimental to the
IOC. In most cases, however, it serves to be a detriment since
allowing the NOC to
assume the tax burden usually translates into a higher
government percentage take in
the profit oil split. In most cases the IOC prefer to bare the
tax burden and take a
higher percentage split in order to sell more barrels of oil
(increasing chances of
windfall in high oil price seasons).57
5.1.3. Ringfencing
Allowing costs to cross a ringfence from the HCs perspective can
result to
subsidization of unsuccessful operations.58
But it could also be a strong incentive for
the oil industry and would give some level of assurance that
development of marginal
fields would be economically viable.59
In the UK such an incentive proved to work, in
the 1980s and early 1990s exploration activities in the North
Sea fields reached
record levels, upon abandoning cross-rinfencing, in 1994 the
government saw a
drastic decrease in exploration activities,60
it became of no economic benefit to the
OCs especially at a time of record low oil prices.
55 Nakhle, C., supra note 26, pg. 84 56 Blinn, K. W., et al,
supra note 8, pg. 429 57 Ibid pg. 80 58 Johnston, D., supra note
12, pg. 69 59 Development of marginal field or future exploration
for the HG is essential, in the world of depleting
energy resources they serve as a security blanket 60 Johnston,
D., supra note 12, pg. 69
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15
5.1.4. Contract Stability
As many low/middle income countries continuously increase their
efforts to attract
foreign investment61
legal provisions to promote contractual stability is what
investors
would be vying for. Stability in contractual provisions will
arrive in many forms, but
most importantly contractors will be looking for fiscal
stability. Under some
stabilization clauses, the HG entrusts itself not to change the
legal structure in a way
that adversely alters the economic equilibrium of the project,
and where it has failed
to do so provisions are included to compensate the contractor.
For instance in
Moroccos 2006 Model Petroleum Agreement, it stipulates that:
The economic terms and conditions which apply to
[Contractor]....In the event that a
change in Regulations has a significant adverse effect on the
economic benefits that
[Contractor] would have received if such change had not been
made, the terms of this
Agreement will be as soon as possible adjusted in order to
compensate [Contractor]
for such adverse effect.62
In some circumstances stability clauses also protect the IOC
against political risks. On
the other hand, any structure of stability in the contractual
terms should not undermine
the HCs pursuit of sustainable development,63 in which case such
provisions that
affect the environment and or social responsibility are usually
never (and should
never) be stabilized.
6. CONCLUSION
The truth is that a PSC might not always be the best instrument
for concluding
contracts even for low/middle income countries that are new on
the oil stage,64
the
decision therefore of which type of contractual instrument to
use is one that should
not be taken very lightly by any HG. Where a PSC is used on the
other hand, as has
hopefully been demonstrated, the benefits of the cost recovery
mechanism to the IOC 61 Cotula, L., Regulatory Takings,
Stabilization Clauses and Sustainable Development, (Global
Forum
on International Investment, 2008) 62 Blinn, K. W., et al, supra
note 8, pg. 344 63 Ibid 64
Ghana a newcomer in the petroleum world with its NOC, Ghana
National Petroleum Corporation (GNPC) chose the Royalty Tax System,
as decision that was made in consideration of the various tax
incentives the government could impose for the purposes of a higher
government take
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16
and the HC are not always clear cut. The cost oil system for the
IOC may be a chance
to hit a gold mine and for the HG an opportunity for its
resources to be abused the
situation can be reversed, ultimately, the devil is in the
detail.
For the IOC though cost recovery may not amount to full recovery
of costs (and may
even result to a loss to the IOC). The balance should be based
on the apparent benefits
included in the other parts of the contract. If coupled with
incentives to compensate
for this loss then cost recovery should be favourable to the
IOC. IOCs need to bear in
mind that as the global energy demand increases, new entrants in
the form of smaller
OCs (also the Chinese65 and NOCs66 who have had adequate
experience) would be
concluding contracts with HGs and at a time of rising oil prices
these contracts would
tend to be more favourable to the HGs. Without realising this
competition IOCs
would be left behind as they continuously seek for more
favourable terms.
On the other hand, while NOCs own the resources, they do not own
the market,67
HCs especially those new to the industry, must be aware that to
attract sound
investment the design of the fiscal regime, more specifically
cost oil, would be the
essential pulling force for any IOC. There must be minimum
assurances with clear
incentives in recognition of the technical ability of the
contractor. The Indonesian
governments attempt to drastically reduce the cost ceiling limit
should be avoided,
clearly in the Indonesian example the consequence was that
investments in
Indonesias petroleum sector have stalled.
Cost recovery should therefore be viewed as a catalyst for
investment and not as a
profit making mechanism. In view of its complex working a cost
recovery system
should have just a few aims including:
65 Cameron, P.D., International and Comparative Petroleum Law
and Policy Lecture, November 13 th,
2009, The Chinese as new market entrants are not as concerned
with rate of return as might the bigger companies like Exxon Mobil
and Shell, their motivations are considerably different and because
of
their ability to bring in State contractors at a relatively
cheaper rate than the IOCs their return rate becomes less important
than securing the contract to begin with. 66 Society of Petroleum
Engineers, The Way Ahead: The Magazine by and for Young
Professionals in Oil and Gas, IOCs and NOCs: A New Energy Landscape
(Vol.5, 3, 2009). The rise of the influence of NOCs has been
tremendous an updated list of the most powerful player in Oil and
Gas now includes mainly State-Owned OCs (e.g. Saudi Aramco,
Gazprom, China National Petroleum Corporation (CNPC), National
Iranian Company (NIOC), Petrobras (Brazil) and many more). IOCs are
facing increasing challenges from NOCs. 67 Ibid
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17
1. a detailed measure to ensure that exploration and production
costs of the IOC
are reimbursed
2. any uplift in recognition of depreciation is calculated
effectively so as to not
be a double payment
3. a careful cost ceiling implemented to avoid lack of profit
for the HG in early
years but also a reasonable recovery of cost incurred by the
IOC
4. and finally, any incentives designed to lure contractors
should not be a
detriment to the development of the HC, this includes any
stability clauses
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18
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