Are Production Sharing Contracts Modern Concession Agreements by Another Name?

Valentine Ataka*

*Valentine Ataka is an Advocate of the High Court of Kenya, a commentator on Law and Policy on Energy. He is an LLM Candidate in Oil and Gas Law (RGU-2013)

Are Production Sharing Contracts Modern Concession Agreements by Another Name? Introduction Production Sharing Contracts (PSCs) have become more of a fad in Oil and Gas contracting since their emergence in the late 1960s1. They have gradually replaced the classical Concessions which were seen to be unduly skewed in favour of IOCs. On the other hand there are a number of countries that have continued to use Concession Agreements albeit in a modified form- what I describe here as Modern Concessions. As it turns out, on a measure of government control, benefit drawn by the IOC and division of obligations, modern Concessions are very similar to PSCs. There are however some menial differences which are discussed below. The discussion relies on available models from Brazil2, Angola3, Kenya4, Kurdistan5 and Egypt6.

First recorded use was in Indonesia in 1966

Brazilian Ministry of Mines and Energy Model Concession Agreement for Exploration, Development and Production of Oil and Natural (Clause 2.4) http://www.eisourcebook.org/cms/Brazil,%20Model%20Concession%20Agreement,%20ANP %2010th%20Rnd,%202008.pdf accessed 12th April 2013
3

EI Source Book Model Angolan Production Sharing Contract http://www.eisourcebook.org/cms//files/attachments/policy-legal-contractualregulatory/Angola%20-%20Model%20of%20PSA%202008.pdf accessed 12th April 2013
4

EI Source Book Republic of Kenya Model production Sharing Contract http://www.eisourcebook.org/cms/Kenya%20Model%20Production%20Sharing%20Contract .pdf accessed 12th April 2013
5

EI source Book Model Production Sharing Contract for Exploration and Production in Kurdistan http://www.eisourcebook.org/cms/Iraqi%20Kurdistan%20draft%20Model%20Production% 20Sharing%20Contract.pdf accessed 12th April 2013
6

Egyptian Gas Holding Company Concession Agreement FOR Gas and Crude Oil Exploration and Exploitation (2005 Model) http://www.egas.com.eg/BidRound2012/MODEL_AGREEMENT_2012_new.pdf accessed 23rd March 2013

Similarities in the Development aspects of the Concession and the PSA Parties In a concession as well as a PSC, the IOC enters into the contract with an NOC acting on behalf of the government. For example in Brazillian Concessions, the ANP is the opposite party while in the Angola PSCs the government is represented in the contract by SONANGOL. An interesting variation is the Kenyan PSC where the Ministry in charge of energy signs the Contract and the National Oil Corporation has no role defined under the contract. Security for performance In both forms of contracting the concessionaire or the contractor is required to provide some form of security to guarantee the performance of the development work under the contract. The Angolan model PSA requires the IOC to provide a financial guarantee not later than 30 days before execution of the agreement. Clause 15 of the Brazilian Concession requires the lodging of security in the form of irrevocable letters of credit, guarantee insurance or Oil pledge Agreement.

Reversal of ownership of installations Under both regimes, once the contract expires, the ownership of the installation (i.e. infrastructures, equipment and all wells) reverts freely to the HG. However the Concessionaire/contractor may also be required to decommission the installations at its own costs. Under the Norwegian Concession regime, installations are to revert only if they are in good and safe working condition, failing which the IOC would be liable to pay compensation to the state. Similarly under the Angolan PSC, within 60 days of expiry of the contract the contractor is to hand over to the NOC all the installations

Relinquishment In both systems the IOC is obliged to progressively either relinquish or reduce the contract area held by it for purposes of exploration. This is a government mechanism used to ensure progressive and optimal development of the granted fields. Article 3 of the Kenyan Model PSC provides for progressive surrender of the contract area. A similarly progressive relinquishment model is in the Egyptian Concession (Article V). Oversight over Development Process Under both regimes, the government is usually not directly involved in the development processes. The NOC and the IOC usually constitute an E&P oversight body to report to the respective parties. For instance under Article IV of the Egyptian Concession, a Joint Exploration Advisory Committee is to be established to review and give such advice as it deems appropriate with respect to the proposed Exploration work program and budget while under Article 31 of the Angolan PSC, a Joint Operating Committee is established. Differences in Development aspects Ownership of Oil resources Under Concession agreements the resources belong to the government only to the extent that it is still in the reservoir. Once oil is extracted, for example under the Brazilian concession, the title transfers wholly to the concessionaire7. On the other hand under a PSC the ownership of the resources at all times remains with the government. Article 2.1 of the Kurdistan Model PSC is categorical that the government is the sole owner of the petroleum.

See Clause 2.4 of the Brazilian Concession model

Similarities in the fiscal aspects Bonuses In both cases, the contractor/concessionaire is expected to pay a signature bonus and/or a production bonus. The signature bonus is paid o the government before the contract is signed. The production bonus kicks in when a predetermined threshold in production is met. The nature of the bonus and its status for the purposes of tax or costs deductions may vary. For example Article XI of the Egyptian Model Concession provides for development lease, development lease extension, training and assignment bonuses in addition to signature and production bonuses. The Kurdistan Region Model PSA provides for both signature and production bonuses at Article 6 and 32 respectively. Under the Egyptian concession model the bonuses are not deductible for tax purposes. Similarly under the Angolan PSC the contractor cannot recover bonuses paid as costs. Royalties The concept of royalty payment was originally intended under concessions to deliver compensation in kind to the ultimate owner of the resources i.e. the state8. This is why it is predominantly used in Concessions. However some PSCs, for example Article 24 of the Kurdistan Model, require the payment of Royalties. The Royalty is usually worked out on the basis of a percentage of the oil and gas produced. For example, under Annex V of the Brazilian Model Concession the IOC is to pay in the amount of 10% of Oil and Natural Gas produced in each Field within the Concession Area from the respective Production Start-up dates.

M.R Oliveira, The Overhaul of the Brazilian Oil and Gas Regime: Does the Adoption of a Production Sharing Agreement Bring Any Advantage Over the Current Modern Concession System (OGEL, Vol 8 issue 3, 2010)

Since royalties are by nature payments irrespective of tax, they are generally not deductible for the purposes of tax or calculation of recoverable costs in either form of contracting. Minimum Work Obligation Both under a Concession and a PSC, the IOC is expected to submit and comply with a program indicating work to be accomplished under each phase. The Kurdistan PSC for instance provides for the obligation under Clause 9.2 of while the Brazillian Concession Agreement provides for the same at Clause 15. Differences in Fiscal aspects Cost Recovery This is only known to the PSC regime whereby the contractor has the right to recover its costs by taking a proportion (known as cost oil), not exceeding a certain percentage (cost recovery limit), of the annual production within the contract area. The limit is fixed at a minimum of 55% and a maximum of 70% in the Kurdistan Model PSC depending on the quality (gravity) of oil produced. Concessions regimes have their own systems of cost relief. For instance the cost recovery mechanism under the Brazilian concession regime is represented by depreciation, amortisation and deduction of capital and operating cost against taxable income and special participation fee.9

Sharing of Profit Oil This is only found in PSCs. It is the portion of the production that is left once the cost oil has been deducted and is shared between the government and the IOC on the basis of a predetermined formula. A number of countries now have production sharing mechanisms, based on the rate of return (or other assessment of

Oliveira Ibid

profitability) to the contractor on a given date. Examples of such countries are Liberia, Libya, Equatorial Guinea Tunisia, India, and Azerbaijan. Income Generally Under the PSC the government draws financial benefit mainly through a share in the production and not profits as the case is with the Concession. Under a Concession regime the host government seeks its share of the rent through taxation, bonuses and royalties only. Income tax is chargeable in both regimes. However as pointed out by Oliveira, its weight in a Concession regime is much greater than in the PSA regime as it is the main source of revenues to the government. On the other hand, in a PSA the role of income tax is outweighed by the government profit oil.
Venn diagram comparison of Concessions and PSCs (by Author)

CONCESSION

PSC

-HG share in profit -IOC owns oil

- Similar parties - Bonus& Royalty payment - Relinquishment of fields -Minimum work Obligation -Income tax - Performance guarantee -Assets revert to HG

HG share in production-HG owns oil -cost oil -profit oil

Exploitation of Early Concessions by Oil Companies Concessions in their classical form have in the past dues to their lopsided nature used by IOCs to great advantage especially in the Middle East.

An example is the 1901 D'Arcy Concession obtained by William DArcy from the Shah of Persia to explore 500,000 sqm of land for duration of 60 years10. In return the company had to pay a US$ 100,000 bonus, a 16 percent royalty, and give the government a share worth US$ l00, 000 in the company. Similarly, the 1933 contract between the King of Saudi Arabia and Standard Oil of California specified that the foreign contractor had to pay 50,000 pounds of gold to the King in return for a concession covering 500,000 sqm for a 66 year period. The Abu Dhabi concession of 1939 granted a consortium of five major oil companies the right to explore the entire country for 75 years.

However beginning 1950s onwards the classical Concessions have either been renegotiated or abandoned altogether with governments realizing their lopsided nature. For example under an original concession between Saudi Arabia and ARAMCO the HG was to receive 21% per barrel at a time when the barrel sold for over US$2. The Saudi government forced a renegotiation requiring profits to be shared fifty-fifty, and requiring payment of royalty. The Iran and Iraq concessions underwent similar changes. Also introduced were changes in taxation. In addition OPEC, after its foundation in 1960, sought to readdress control over production and prices by changing the balance of bargaining power in favour of the producing countries and away from the majors11.

Which of the two offers Economic leverage to an IOC? The modern Concession has evolved to such nature that beyond the ownership and level of control, it is no better or worse than a PSC. Both regimes contemplate royalties, taxes, bonuses, etc. and some form of cost recovery. Even though in a
10

Paul Lunde, A king and a Concession, Saudi ARAMCO World, Vol 35 No 3 1984 http://www.saudiaramcoworld.com/issue/198403/a.king.and.a.concession.htm accessed 15th April 2013
11

Daniel Yergin, The Prize: The Quest for Oil, Money & Power (Simon& Schurster, 2008) p126

concession the IOC has exclusive rights to develop and owns the extracted oil, the payment of royalty, bonuses and taxes the rates of which the government may adjust at will negates the chance of any economic advantage to the IOC. Therefore from an IOCs point of view, whichever system is used, it should decide to make investment only if at the negotiation it foresees a profitable outcome taking into account its own particular economic standards and methods of calculation of payments which are specific to contracts and cannot be generalised as a matter of form12.

12

Johnston, Daniel, International Petroleum Fiscal Systems And Production Sharing Contracts (Tulsa, Okla. : PennWell Books, 1994), pp. 39.