13.
Contractual regulation
with respect to exploration for
and production of hydrocarbons
13.1.1 The oil contract
The oil contract is one of the most significant examples
of a particular type of contract characteristic of
international trade, the so-called state contract (in
French contrat d’État). It is in fact a contract, concluded
between a state (or a public entity) and a private person
(sometimes a physical person but more frequently a
legal person), the content of which is the carrying out
by the private party of a particular activity in the oil
sector, that is the exploration for and production of
liquid and gaseous hydrocarbons as well as the
downstream activities of transport and refining. Such
activities are carried out on the basis of an agreement
with the entity (the state or a public entity) that retains
ownership of, and the right to exploit, natural oil
resources. In return for the assignment of such rights, in
the ways and to the extent envisaged in individual
contracts, the private party assumes the obligation to
carry out the oil-related activity in conformity with the
terms and conditions agreed with the other party, and
agrees to invest the economic, technical and managerial
resources necessary for the best development of the oil
resources referred to in the contract.
As practical experience shows, also historically, this
type of contract is concluded for various reasons. Among
these, at least in an initial phase, is the absence of a set of
relevant rules in the contracting state or the circumstance
whereby the domestic legal system itself requires that the
oil-related activity be carried out on the national territory.
This can be achieved on the basis of a contractual
relationship with the state or with the public entity that
has been put in charge of the activities in this sector by
the state. On the other hand, in the more evolved legal
systems, both civil and common law, exploration for and
production of hydrocarbons are carried out by private
persons on the basis of a title (licence or mining title, an
administrative act) granted by the local authority to the
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private person on the basis of the laws governing
hydrocarbons or mines in general. The present
contribution aims at considering only the first situation
described, namely one featuring the presence of a
contractual relationship between a state (or a public entity
of a determined state) and a private person.
From the oil contract’s characteristics mentioned
above derives the connection between the type of
contract under consideration and the subject of private
investment in developing countries as well as the
protection of such investment. In fact, a characteristic
of the oil contract is the great size of investments
needed on account of the high level of risk involved in
the exploration for hydrocarbons; hence the need for
effective protection of the private party’s investment.
The oil contract, as such, fully falls within the
broader category of investment contracts, a matter
analysed in the international literature with particular
regard to the problems of protecting private investment
as well as of the bilateral and multilateral international
instruments implemented by different states to ensure
such protection.
As, in actual fact, with a view to the economic
development of the country on whose territory the
activity is carried out, the oil contract has been
included in the category of economic development
agreements. Legal writings of the 1960s dedicated
particular attention to this type of contract above all
with regard to the problem of the applicable law on
account of the particular characteristics of the contract
in question (Hyde, 1963).
13.1.2 Legal regulation
Nature
The nature of the legal rules governing oil
contracts is of particular importance. It varies
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CONTRACTUAL REGULATION AND SETTLEMENT OF DISPUTES
according to the legal system of the state on whose
territory the related activity is carried out, as well as to
the characteristics of the individual contract. In
relation to these factors the applicable rules have been
considered, on a case by case basis, either as part of
the state’s public law or as private law, depending on
whether the state is party to the contract iure imperii
(i.e. in the exercise of its sovereign prerogatives in
the pursuance of the public interest) or iure gestionis
(i.e. as if it were acting as a private party).
In consideration of the fact that under an oil
contract a natural resource which is the heritage of the
state is being put at the disposal of a private party and
rights are granted to exploit that resource, it seems that
this type of contract, as concerns various aspects,
cannot escape the application of the public law
whereby the state regulates fundamental sectors of its
economy. The inequality of the parties to this type of
contract derives precisely from the fact that the state
(or the public entity delegated by the state) intervenes
as a party to the contract in the capacity of defender of
the public interest.
Hence, the need to distinguish between the
contractual regulation governing the parties’ rights and
obligations and the state’s power to safeguard the
public interest underlying the oil contract when
considering that through such contract a natural
resource, which is property of the state, is exploited.
Such a distinction, although not easy to draw in view
of the diversity of national legal systems, is of utmost
importance in establishing the extent to which the oil
contract (as any other contract concluded with a state),
being an administrative contract, is subject to the
principles of public law.
The administrative contract
The category of administrative contracts, as public
law contracts, has mainly developed in the French
legal system. The French model, which was adopted in
Egypt following the work of the great jurist al-Sanhuri
(1948), was subsequently introduced via this country
in many Arab states (Iraq, Syria, Libya, Qatar, Kuwait,
United Arab Emirates, Algeria, Sudan, Lebanon,
Yemen, Tunisia, Morocco and still others). The
Egyptian Civil Code governs a special category of
contracts, the concession of services of public utility,
subject (as are other contracts having the same
characteristics) to special rules and to the jurisdiction
of a special court (the Conseil d’État in France, Egypt
and other states whose legal culture is French; the
Administrative Law Chamber in other Arab states).
The conditions according to which each legal
system recognizes that specific contractual
relationships are in the nature of a public law
contract depend largely on each system’s concept of
848
public interest and the guarantees it provides to
safeguard it. From a general point of view, the
notion of public contract in the various legal systems
indicates the state’s power to adopt unilateral
measures whenever the protection of public interest,
as interpreted by the state, so requires. Among such
measures is the power to modify contractual terms
on account of supervening changed circumstances,
according to the principle of changing circumstances
recalled in the Resolution No. 16 of 25 June 1968,
para. 90 of the Organization of the Petroleum
Exporting Countries (OPEC; see below) and even
the extreme measure of revocation of the contract in
the presence of specific conditions.
In consideration of the possible subjection of the
oil contract to the principles of the contracting state’s
public law, the private party has attempted to provide a
series of contractual conditions and guarantees aimed
at reducing the risk of intervention by the state in the
exercise of its regulatory powers to protect public
interest (see below).
13.1.3 Contractual regulation
Characteristics
The most significant characteristics of the
contractual regulation regarding oil contracts can be
summarized as follows:
• One of the contracting parties is a state, a Ministry
or a state-controlled entity that, while formally
autonomous, is acting on behalf of its country’s
government. This is the case of the numerous state-
owned companies that have been created, since the
1950s in oil-producing countries, such as the
Egyptian General Petroleum Corporation (EGPC),
the National Iranian Oil Company (NIOC), the
Iraqi National Oil Company (INOC), Sonatrach in
Algeria, the Nigerian National Petroleum
Corporation (NNPC), the Libyan National Oil
Company (LNOC), Pertamina in Indonesia,
Yacimientos Petrolíferos Fiscales (YPF) in
Argentina, the Pedevesa (PDVSA, Petróleos De
Venezuela Sociedad Anónima), the CNOOC in
China and others.
• The object of the contract consists in an activity to
be conducted in a specified area of the state’s
territory for the exploration for and development of
hydrocarbons together with the activities of
transportation, stockpiling, refining, exporting and
marketing connected to the primary activities.
• Essential to carrying out the activity envisaged in
the contract is the investment in the territory of the
state, both in terms of capital as well as technology,
goods, services and managerial capacity.
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• A long-term relationship is established between the
parties lasting, in an initial phase, about fifty to
sixty years and more recently lasting not less than
thirty years.
• The regulation envisaged by the contract tends to
be complete: the private party, in fact, attempts to
regulate its relations with the state in the contract
as much as possible, in order to limit possible
interference by domestic laws.
• Particular clauses relative to the law applicable to
the contract and the rules for settling disputes by
arbitration are regularly found in order to provide
the private party the best protection against
interference by domestic laws and courts.
Given their importance, both in the framework of
contractual instruments for the protection of
investments and for the evolution of the contractual
relations between the parties, the matters of applicable
law and arbitration deserve particular consideration.
The applicable law clauses and the arbitration
clauses
Among the instruments developed by the oil
contracting practice designed to guarantee adequate
protection for foreign investment in the sector of
exploration for and production of hydrocarbons, the
applicable law clause and the arbitration clause have
always constituted conditions for a positive outcome of
negotiations between the private party and the state
recipient of the investment. They are two contractual
provisions related to one another because, as
demonstrated by relevant arbitral awards (see Chapter
13.3), an international arbitrator has systematically
applied the parties’ choices of law even where, in
contrast with the principles regulating conflicts of
laws, a-national rules have been chosen instead of
domestic legal systems (to which the state conflicts
systems usually refer). In addition to these two
protective measures widely adopted in oil contracting
practice there is a series of further contractual
provisions (see below).
The traditional principle with respect to the
applicable law, affirmed by the Permanent Court of
Justice (today the International Court of Justice) in the
case concerning Serbian and Brazilian loans in 1929
is, as is known, that contracts between states and
private parties are subject to the laws of the state party
to the contract. This also in relation to the fact that
such contracts, among which oil contracts are
included, are normally performed on the territory of
the state. Therefore, the conflict rule lex loci
executionis applies.
The intervention of the law of the state recipient of
the investment could not, however, satisfy the private
party’s need to guarantee its contractual relationship
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with the state, an adequate degree of stability of the
conditions stipulated and predictability as to their
application over time. It was therefore necessary for
the private party to remove what French doctrine so
effectively refers to as l’aléa de la souveraineté, i.e.,
the risk that the state party to the contract may resume
the role of sovereign state during the course of the
relationship in order to modify its legal regime,
altering to its own advantage (although by taking
measures of a general nature) the contractual terms
freely agreed with the private party.
Hence the search for techniques for formulating
applicable law clauses aimed, in some cases, at
internationalizing the contractual relationship by
subjecting it to international law and, in others, at
denationalizing it by means of a reference to “the
general principles of law recognized by civilized
nations” (Statute of the International Court of Justice,
art. 38, para. 1, c), or to the principles of law common
to both the state party to the contract and to the state
of which the private party to the contract is a national
(the tronc commun, in the words of the contract
between Agip Mineraria and the National Iranian Oil
Company, of 1958) or, lastly, by freezing the law of the
state on the signature date of the contract (a technique
which was adopted in the contract between Agip and
Tunisia in the 1970s).
In this context of denationalization of the oil
contract, the choice of law is to be considered as
contained in the oil concession agreements with Libya
(before the revolution of 1969), according to which
“The Concession shall be governed by and interpreted
in accordance with the principles of law of Libya
common to the principles of international law and in
the absence of such common principles then by and in
accordance with the general principles of law,
including such of those principles as may have been
applied by international tribunals” (ICCA, 1979). In
view of the complexity of its formulation, it is not
surprising that such reference has been the subject of
diverging interpretations in the three arbitral awards
rendered after the Libyan nationalizations of 1970 (see
Chapter 13.3).
The choice of international arbitration as the sole
method for settling disputes arising from oil contracts
has historically been of substantial relevance. As in the
case of the choice of a legal system different from that
of the state party to the contract, the exclusion of the
jurisdiction of domestic courts has raised sensitive
issues in view of the state’s consequent abstention
from exercising sovereign prerogatives.
In addition to the tenacious resistance put up in this
regard by the states of Latin America in the name of
the doctrine elaborated in the second half of the
Nineteenth century by the Argentine jurist Carlos
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CONTRACTUAL REGULATION AND SETTLEMENT OF DISPUTES
Calvo, known as the Calvo doctrine (according to
which disputes must be submitted to the exclusive
jurisdiction of domestic courts), states have invoked
international law principles concerning their immunity
from jurisdiction. Alongside the progressive
re-dimensioning of such principles with the
acceptance of so-called restricted immunity (restricted,
that is, to the exercise of sovereign prerogatives,
excluding acts performed iure gestionis by the state),
over time it has been held that immunity from
jurisdiction can be waived, even implicitly, and that a
state’s acceptance of arbitration implies such a waiver.
On the other hand, for the private investor
international arbitration represents a condition that
cannot be renounced not only to avoid disputes arising
from oil contracts being decided by domestic courts,
which are perceived as being subject to political
influence by the contracting state, but also to
guarantee the actual enforcement of applicable law
clauses referring to a-national rules, which are usually
accepted by the international arbitrator, where the
same reference would have not foreseeably had the
favour of the state’s judge.
Other contractual provisions
Among the further contractual provisions aimed at
strengthening the protection of the private party with
respect to the regulatory power of the state party to the
oil contract, are:
• The clause according to which the contract has the
force of law of the state (Petroleum Concession
Agreement, art. 34.4, concluded in 1975 by the
Ruler of Sharjah, one of the United Arab
Emirates).
• The intangibility clause, whereby the state
undertakes not to modify contractual terms unless
by mutual agreement (contract between Agip
Mineraria and the Iranian NIOC, of 1958, art. 39;
Mozambique model production sharing agreement
of 2000, art. 30.7, d and e).
• The stabilization clause, whereby the state assumes
the obligation not to enact laws or regulations
contrary to the content of the oil contract or, at any
rate, not to apply them to the detriment of the
private party to the contract and not to derogate
from specific contractual guarantees such as those
concerning taxation, customs, currency and the
like. In some cases the law itself makes provision
for the stabilization of contractual conditions, as
evident in the Oil Law of Kazakhstan (Law
No. 2350/1995, art. 57), the Nepalese model
production sharing agreement 1994 (art. 70.1), the
Petroleum Code of the Côte d’Ivoire (Law
No. 669/1996, art. 18, lit. m). Stabilization clauses
in oil contracts present a wide variety of
850
formulations concerning the time limitations for
such guarantees and the matters covered by those
guarantees as well as the reciprocity in favour of
the state (Montembault, 2003).
• The obligation to renegotiate the contractual
conditions in case of a change in circumstances,
with the possibility of submitting any
disagreements that might arise to international
arbitration for settlement, according to what has
been provided by some national laws (the Russian
Oil Law on production sharing contracts of 1999,
art. 18.2) or by the various national model
production sharing agreements (the Ivorian model
of 1997, art. 36.2; the Chinese model of 1992,
art. 28.2; the Angolan model of 1997, art. 37.4)
or by concession (the Egyptian model of 1998,
art. 19; Bernardini, 1998).
Bilateral treaties for the protection of investments
The oil contract is therefore of fundamental
importance in creating the conditions necessary to
avoid its subjection to the legislating power of the state
in which the activity is being carried out. Forms of
protection are provided in the bilateral treaties for
the protection of investments concluded by the great
majority of states having most diverse political, social
and legal systems. Their number had, by the end of
2005, exceeded 2,400. These Bilateral Investment
Treaties (BITs) make provision for direct access by
private investors (in this case the oil companies) to
mechanisms for settlement by arbitration of disputes
with the state in case of violation of the guarantees
agreed in the BIT with the investor’s state.
Such guarantees reflect commonly recognized
standards of treatment: fair and equitable treatment;
non-discrimination; most favoured nation treatment; as
well as a series of further guarantees such as those
relating to the use of freely convertible currencies, the
freedom to transfer them abroad and the compensation
due in case of nationalization or expropriation of the
private investment.
13.1.4 The evolution
of the oil contract
The development over time of the contractual relations
between states and private persons with respect to oil
has been influenced particularly by the evolution of
the contracting parties’ relationships with respect to
the strength of their positions. There are three phases
in which in a completely conventional manner this
evolution may be distinguished: the phase of the oil
concession; the phase of participation by the state; the
phase of the new generation of oil contracts.
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The oil concession
In an initial phase, which may be identified in the
period culminating at the end of the 1950s, the
disparity of positions between the two parties from a
legal point of view (on the one hand a sovereign state,
even though it may often lack a developed legal
system and, on the other, an oil company of the
industrialized world) was counterbalanced by the
economic power of the oil companies, the famous
‘seven sisters’: British Petroleum (BP), Exxon
(formerly Standard Oil of New Jersey), Gulf, Mobil,
Royal-Dutch Shell, Standard Oil of California
(SOCal) and Texaco, which were often sustained by
the state to which they belonged (as made evident by
the case of the Anglo-Iranian Oil Company, for whose
protection against Iran Great Britain brought an action
before the International Court of Justice in the early
1950s).
The ‘legal container’ in which the different
positions of the two parties to the contract (on the one
side, a state with limited sovereignty; on the other, a
private entity with full powers) are fully expressed is
the petroleum concession. As evidenced by its name,
by means of the corresponding contract (the petroleum
concession agreement), the state, as owner of the
subsoil resources, grants the private entity the
exclusive right to explore, appraise, develop and
produce hydrocarbons, for a period of more than fifty
years, on a vast area of the national territory, as well as
the right to store, transport, treat and sell the
hydrocarbons produced, in consideration of the
compensation set out in the contract. The most
important legal effect consists in the transfer of the
state’s ownership of hydrocarbons to the private
concessionaire at the well head, i.e. at the place where
the product which has been found is physically taken
over. As will be seen, from the point of view of the
state’s sovereignty, this moment in which ownership is
transferred is less acceptable than the point of export
indicated in the Production Sharing Contract (PSC;
see below).
Investment obligations
Limited obligations concerning investment
(expressed as sums to be invested in the various
periods of the exploration phase), work (expressed as
the number of wells to be drilled in the period) and the
release of the area covered by the concession
characterize the relationship in this phase. It is up to
the concessionaire, in compliance with the obligations
concerning investment and work, also to draw up
annual programmes and budgets, without any
interference by the authority granting the concession.
Even the obligation to use local human resources
(essential for the acquisition of the necessary
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professionalism) is normally subordinate to the
priority need to conduct oil operations efficiently. The
obligation to train staff (training) is deferred to the
commercial production phase and made subject
nevertheless to various limitations. Complete freedom
is guaranteed with respect to currency as the
concession agreement grants the concessionaire the
right to open and maintain in the country accounts in
any currency and to export freely the profits made as a
result of its activity. Equal freedom is granted to the
concessionaire and its contractors with respect to
imports, free from customs and similar duties, of all
material required to carry out oil operations and their
re-export. The same applies also to the exportation of
the oil produced.
In return for the set of rights and privileges granted
under the petroleum concession, at least in an initial
phase, the concessionaire is required only to pay a
quota of production, in cash or in kind, as a royalty.
Only subsequently, on the initiative of Venezuela
(1943), the payment of income tax was added to the
payment of a royalty. This income tax was normally
limited to 50% of the income calculated on the basis
of a posted price in conformity with the principle of
equal profit sharing. This price is determined, in this
phase, by the concessionaire company and
corresponds to the price at which the concessionaire
company is prepared to sell the crude oil produced.
The amount of the royalty constitutes a deductible cost
for the purposes of calculating the income tax, the
latter being set at an overall rate of 50% of the income
calculated as indicated above.
The absence of any control by the state over the
concessionaire’s activities and over the hydrocarbon
production, as well as the concessionaire’s exclusive
responsibility for the downstream activities of
marketing, transport and refining characterize this
phase of the relationship, defining the petroleum
concession contract as a real enclave in the legal
system of the state granting the concession, made
almost impenetrable by an impressive apparatus of
protective contract terms (see above).
For many decades the control of oil resources in
the Middle East has been exercised in a practically
exclusive way by the oil companies as a result of
contracts concluded since the early 1900s. These
companies, also known as majors, holders of the most
important petroleum concessions in the Middle East,
have provided the capital, technology and managerial
capacity necessary for the exploration for and
production of hydrocarbons, bringing into being
sophisticated relationships for the marketing and
supply of hydrocarbons on the markets of
industrialized countries. However, in the view of many
oil-producing countries, the activities carried out by
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the concessionaires have seriously limited the
sovereign prerogatives of the state, hindering the full
integration of the oil industry into the national
economy (From concession [...], 1973).
Participation of the state
The independence of the colonies
The point of departure of the second phase of the
evolution of relations between oil producing countries
and the oil companies is determined by the
achievement of independence of numerous states,
which had formerly been colonies of the western
powers, and by the coordinated action of various oil
producing states.
The first phenomenon embraces a time span of
more than five years from 1956 to 1962, with the
independence of Morocco (1956), Tunisia (1957),
Belgian Congo, French Congo, Côte d’Ivoire, Gabon,
Ghana, Madagascar, Nigeria, Upper Volta (today
Burkina Faso; 1960), and Algeria (1962). The
intervention of these new states significantly altered
the equilibrium of power within the international
organizations as they had been granted voting power
equal to that of industrialized countries. Through the
position taken in these organizations and the treaties
they stipulated, the new states brought about a
profound revision of the traditional principles of
international customary law (such as the pacta sunt
servanda principle), considered to be expressions of
the old international economic order and functional to
the interests of the old colonial powers.
The new principles were formulated in various
resolutions of the General Assembly of the United
Nations in the 1960s and early 1970s. Particularly
relevant among these are those that solemnly affirm
the “permanent sovereignty over natural resources”
(Resolutions of 14 December 1962, No. 1803-VI and
of 25 November 1966, No. 2158-XXI) or those
concerning the establishment of a new international
economic order (Resolutions of 1 May 1974, No. 3201,
S-VI and No. 3202, S-VI), or those defining the
economic rights and duties of the states in the
so-called Charter of Algiers (Resolution of
12 December 1974, No. 3281-XXIX), which was
adopted notwithstanding the opposition of the
industrialized countries, as well as the Resolution on
development and international economic cooperation
(19 September 1975, No. 3362, S-VII).
The above principles also decisively affirm, among
others, every state’s inalienable right to its own natural
resources and its right to adopt measures of
nationalization for the complete recovery of such
resources, as well as the jurisdiction of domestic
courts to judge on the basis of their own laws disputes
852
concerning nationalization measures. The affirmation
of such principles served the purpose to recover the
sovereignty, which had in part been restricted by
instruments, such as the petroleum concession, which
were considered an expression of the old economic
order. The newly independent states’ awareness that
they had at their disposal energy producing resources,
first of all oil resources, upon which the development
and well-being of the industrialized world depended,
favoured the affirmation of the above-mentioned
principles.
The action of oil producing countries
In addition to developing countries’ capacity to
exert pressure in this way, there was the action of oil-
producing states united in the OPEC, which was
created at the beginning of the 1960s. OPEC, in its
Declaratory Statement of Petroleum Policy in Member
Countries (Resolution of 25 June 1968, No. 16.90),
sets out the basic principles of a common petroleum
policy, prevalent among them being those relating to
the participation of states in the ownership of
concessionaire companies, to the renegotiation of the
financial conditions of the oil contracts and to the
settlement of disputes by regional courts (not,
therefore, by international arbitration).
The above-mentioned Resolution, after recalling
the inalienable right of each state to exercise
permanent sovereignty over its natural resources (a
universally recognized principle of public law, as
repeatedly stated by the resolutions of the General
Assembly of the United Nations) set, among others,
the goal of attaining reasonable participation in the
ownership of the concessionaire company on the basis
of the principle of changing circumstances.
By means of the General Agreement on
Participation, signed in New York on 20 December
1972, various states of the Middle East obtained a
25% participation in the concessions that had been
granted in the past to the oil companies operating on
their territories and, at the same time, the commitment
of those companies to transfer, within the following
ten years, up to 51% of their participation in those
concessions. This agreement marked, on a formal
level, the end of the exclusive control the companies of
the sector had over the oil resources and the entry
on the scene of the state as co-participant
associated in the planning and management
of oil-related activities. In fact, the attainment of
participation by the oil producing countries of the
Middle East ought to have given rise to a joint venture
with the oil companies for the joint management of
oil-related activities without, however, modifying the
formal instrument (the oil concession) through which
such activities are carried out.
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According to the intentions of the producing
countries, from this participation, with the association
form it would create, would derive the power of the
state-owned company of the producing state to share,
on account of the quota thus acquired, the rights,
obligations and profits involved in oil-related
activities, as well as the power to co-manage such
activities by means of the participation in mixed
committees (of management, technical and operative)
composed of representatives of both parties in the
relationship, with decision-making powers
proportionate to their quota of participation.
The state-owned company becomes in this way the
instrument that enables the state to acquire
progressively the professional, technical and
managerial competence and experience it needs to
exercise control over oil-related activities in order to
ensure that such activities are directed to pursue public
utility or, at least, do not exclusively serve the private
party’s interests. While this was one of the goals of
governmental participation set by OPEC Resolution of
25 June 1968, No. 16. 90, it is a goal that has been
achieved only in minimal part. Apart from a few
exceptions, in fact, the state-owned companies’ lack of
staff having technical experience and managerial
capacity has impeded them from fully taking
advantage of these new opportunities. Oil companies
that have deliberately kept their governmental partners
in the dark as to the geological, financial and
commercial information relevant to oil-related
activities have therefore continued for a long time to
exercise wide decisional powers and full control over
the activities.
This hardly satisfying result came about also by the
fact that private companies were permitted to continue
to establish operative programmes and budgets as
operators of the joint venture. The role of the entity in
which the state was represented ended up, therefore,
being limited merely to approving such programmes
and budgets with the result that if approval was not
given, the entity would be unable to approve alternative
programmes and budgets without the assistance of the
operator of the joint venture. Precisely in the light of
these aspects an arbitral award of 1975 rendered in
Anaconda Company v. Overseas Private Investment
Corporation (OPIC), in the Chilean copper sector,
affirms that, notwithstanding the restructuring of the
relationships by means of joint ventures actual
decision-making rested with the Western head
companies; consequently, operations continued to be
conducted by Anaconda as in the past “through
substantially the same practical chain of control as
before” («International Legal Materials», 1975).
The experience of joint ventures, has therefore
turned out to be disappointing and does not, at any
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rate, respond to the states’ need for a more complete
recovery and actual exercise of that permanent
sovereignty over its natural oil resources, that was so
strongly proclaimed in the resolutions of the General
Assembly of the United Nations.
The new generation of oil contracts
The search for other instruments capable of better
satisfying the above-mentioned needs and the goal of
obtaining greater profits from the oil-related activities
carried out on a state’s territory stimulate the search
for and preparation of new contractual formulae. To
this third phase of evolution of the relationships
between oil companies and producing countries, which
started in some states at the end of the 1960s and
developed later during the 1970s, contributes the
processes of nationalization or the revocation of oil
contracts taking place in various states (Libya, Algeria,
Kuwait, Iran, Iraq, Venezuela), dissatisfied with
OPEC’s action – considered too moderate and slow –
to recover complete control over oil resources.
This evolution is marked by the progressive
abandonment of the oil concession in favour of other
types of contractual relations in which the state, by
means of the public enterprise designated for that
purpose, becomes an active party to the activities of
exploration for and development of hydrocarbons.
Even though the concession contract continued to be
used in various countries (Sharjah, Abu Dhabi,
Brazil, Egypt were still concluding this type of
contract as late as the 1970s and 1980s), this process
of transition led to the progressive adoption of new
contractual schemes in which the mining title, held
fully and exclusively by the state-owned company,
has become the point of reference and the raison
d’être for the association of private companies with
oil-related activities. Indeed, the private company
still has access to the financial, technical and
managerial resources the state needs in order to
better exploit its oil resources. A change in the oil
company’s role followed: no longer a concessionaire
in relation to the host state but a contractor, i.e. a
contractor of works and services on behalf of the
state-owned company. The most significant new
contractual formulae are: the production sharing
contract; the service contract, with or without risk;
the technical assistance agreement.
It is worth examining the characteristics of these
different contractual formulae, referred to in legal
writings as the “new generation of petroleum
agreements” (Maniruzzaman, 1993), and how they
differ from traditional oil concession agreements, in
order to assess the extent to which they have enabled
states to actually recover sovereignty over their natural
oil resources.
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CONTRACTUAL REGULATION AND SETTLEMENT OF DISPUTES
The production sharing contract
Among the new contractual formulae, a
particularly important one, also because it is so widely
used, is the production sharing contract. By stipulating
a production sharing contract a foreign company
associates itself exclusively with the oil-related
activities to be conducted in the contract area but not
with the title to the mineral resources. That title rests,
together with the exclusive right to explore for and
produce hydrocarbons and to carry out activities
related to such rights, with the state-owned company
competent in the oil sector. The oil company,
contractor on behalf of the state-owned company, takes
on the risk that hydrocarbons might not be found. The
contractual relationship being set up in this way, it
follows that both the ownership of the hydrocarbons
found and responsibility for carrying out the related
activity rest with the state-owned company.
The newest element introduced by the PSC that
characterizes the scheme is the provision that
management of operations is in the hands of the
state-owned company (the so-called management
clause). The formula adopted in this connection in one
of the first Indonesian contracts concluded with
Pertamina in 1968, the state entity for hydrocarbons,
reads: “Pertamina shall have and be responsible for the
management of the operations and contractor shall
be responsible for the execution of the works
program”. The purpose of the clause is to allow the
public party to be trained, an objective to be achieved
by close interaction between Pertamina and the
contractor. Such a provision, however, involves the
need to harmonize the powers the state-owned
company has been granted in order to recover
sovereignty through public control over the oil-related
activities carried out on the national territory and the
contractor’s contractual responsibility to conduct
operations in the field. As has been stressed, “If not
handled wisely and carefully, such a structure may
lead to immense frustration on the part of the foreign
partner” (Machmud, 2000).
The duration of the PSC is normally much shorter
than that of the oil concession (about 30 years). It
usually starts with an exploratory phase (4 or 6 years,
renewable), followed by a phase of development and
production in case of a commercial discovery (20
years, extensible for another 10 years on the
contractor’s option). The contractor’s minimum
obligations with respect to expenditure and operations
to be carried out (seismic and minimum number of
wells) are established for the exploratory phase.
As concerns the availability of financial resources,
the PSC requires the contractor to provide all the funds
necessary to carry out operations and to assume the
risk of losing its investment should the activity not
854
lead to the discovery of a marketable quantity of
hydrocarbons. Where operations lead to a
commercially viable discovery, as defined in the
contract, as from when commercial production starts,
the contractor will have a right to two different quotas
of the available production, one of which will serve to
reimburse the costs of exploration and development
incurred for the conduct of the operations, often
including interest that has accrued on the investments
for development (so-called cost oil), and the other to
provide the contractor a return on his investment
(so-called profit oil).
The quota recognized as a profit is intended to
remunerate also the risk the investor has taken in the
exploration and development phase. Ownership of the
quota of hydrocarbons due to the contractor is
transferred at the point of export, thereby qualifying
the contractor’s rights not as mineral rights (as in the
case of the concession) but only as economic rights.
Each of the two parties has available, and markets
without restraint, its own quota of the total production.
Ownership of all goods imported for the purpose of
conducting operations passes to the state-owned
company, the relative cost being one of the items to be
reimbursed by the cost oil.
In the Indonesian scheme taxes and royalty are not
due from the contractor precisely on account of the
absence of profits in the country and of ownership of
hydrocarbons at the well head as, on the contrary, is
envisaged in the oil concession contract. As of 1976,
in order to satisfy the need of the companies of the
United States to provide their fiscal authorities with
documentation as to the income tax paid abroad, the
Indonesian PSC requires that Pertamina’s quota of
production shall include the sums the latter has paid
on behalf of the contractor as taxes and a receipt is
issued for this purpose. The PSC concluded on 18
November 1997 between the Republic of Kazakhstan
and a consortium of international companies (one of
which was Agip) makes provision for a 30%
withholding at the source as a profit tax.
Defined in its structure by the President of
Pertamina (formerly called Permina), Ibnu Sutowo,
and inaugurated in 1966 with a contract concluded
with the consortium IIAPCO (Independent
Indonesian American Petroleum COmpany), the
contractual formula in question has been used in
many other states since the 1970s. The PSC
concluded in Indonesia by Agip in 1968 provides
that the contractor will receive annually a quota of
production equal to 40% as cost oil and a quota
equal to 35% of the remaining 60% as profit oil. The
PSC concluded by Exxon in Angola in 1998
provides for a 50% quota as cost oil and the sharing
of profit oil: 80% for Sonangol and 20% for the
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 CONTRACTUAL REGULATION WITH RESPECT TO EXPLORATION FOR AND PRODUCTION OF HYDROCARBONS
contractor. Other PSCs provide for a different
percentage sharing of production in relation to the
mining prospects in the contract area and to the
ability and negotiating power of the private investor.
Thus, in some of these contracts the production
quota due to the state increases in relation to the
increase of the contractor’s pre-tax rate of return, as
provided in the form of contract appended to Law
1982 of 26 March of the Republic of Liberia.
The Indonesian PSC has represented the model oil
contract adopted in Malaysia and in China. In all three
countries the respective governments actively
participate in carrying out oil-related operations in
order to control and optimize the benefits deriving
from the development of a resource considered to be
of strategic importance for these countries. All three
countries have very well-structured state-owned
companies for hydrocarbons thanks to which each
national oil industry is active in both upstream and
downstream activities. This has been the result of
using the PSC, both as an instrument for professional
training of staff so as to consent an effective control
over oil-related activities and as a source of significant
capital investments.
While the Indonesian and Malayan models are
similar, the Chinese PSC contains various elements of
differentiation. Thus, with regard to the management
clause, the Chinese model provides for a joint
management committee that closely follows the
carrying out of operations rather than just merely, as in
other models, setting generic guidelines. The Chinese
PSC represents a hybrid formula to the extent that the
royalty and taxes are an integral part of the contract in
contrast to the typical scheme. Moreover, in both
Malaysia and China, the state-owned company tends to
participate in the contract, transforming itself from a
partner without risk to co-adventurer under the PSC
(Machmud, 2000).
At present the PSC is the prevalent model of
contract in many Asian states (Bangladesh,
Burma – today Myanmar, China, the Philippines,
India, Indonesia, Laos, Malaysia, Mongolia, Nepal,
Pakistan, Sri Lanka, Vietnam), in countries formerly
members of the Soviet Union (Azerbaijan,
Kazakhstan, the Russian Federation, Turkmenistan,
Ukraine, Uzbekistan), in states of the Middle East
(Jordan, Iraq, Israel, Oman, Qatar, Syria, Yemen), in
Central and South American states (Netherlands
Antilles, Colombia, Cuba, Ecuador, Peru, Trinidad and
Tobago) and in some European states (Albania,
Croatia, Malta, Romania) and African states (Algeria,
Angola, the Republic of Congo, Côte d’Ivoire, Eritrea,
Ethiopia, Ghana, Guinea, Kenya, Liberia, Libya,
Mozambique, Nigeria, Sudan, Tanzania, Togo, Tunisia,
Uganda, Zambia).
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Some of these states provide, as alternative
formulae, the concession contract and the service
contract. Other states (Thailand, Nicaragua) still
continue to adopt the model of the concession
contract. With respect to the original PSC scheme,
many states have introduced variations in order to
satisfy some national aspirations and to harmonize this
new type of contract with their respective legal
systems. Finally, in other states, still unsatisfied with
certain contractual terms, the revision of such terms is
under discussion (as in the Russian Federation with
regard to the PSC in force for the Sakhalin area).
The flexibility of the contractual formula and the
fair balancing of the positions of the two parties in the
relationship are among the reasons for the PSC’s
success. This explains why the same formula could be
adopted for projects in the oil sector not limited to
exploration and production of liquid hydrocarbons, but
also for the construction and operation of plants. Such
is the case of the contractual relations whereby Royal
Dutch Shell and Exxon, two of the majors, have
agreed to collaborate with Qatar to develop and put
into production large reserves of natural gas.
According to information published in the
specialist press, Shell’s project envisages the
construction of the largest plant ever built for the
production of Gas To Liquids (GTL) at Ras Laffan
(Qatar) on the basis of an integrated development and
production sharing agreement. The project calls for an
investment by Shell of about 5 trillion dollars to
develop natural gas reserves and to build a GTL plant
capable of supplying 140,000 barrels of GTL products
per day. The agreement concerns both upstream as
well as downstream aspects of the project, with Shell’s
commitment to comply with strict directives for
safeguarding the environment, health and safety. The
sharing of production between Qatar, owner of the
natural resources, and Shell, the contractor, is
considered by both parties to be fair and to provide
satisfactory returns.
Also Exxon’s project in Qatar, which also concerns
GTL products, is being implemented on the basis of a
PSC concluded in 2004. Exxon’s investment is
estimated at 7 trillion dollars for the production of
154,000 barrels per day.
The service contract
By the service contract the state-owned company
retains exclusive ownership of the mineral rights for
the contract area and ownership of the hydrocarbons
found and produced in the area. The private company,
either directly or through a company it controls, acts as
a general contractor in the name, and on behalf, of the
state-owned company and, in that capacity, carries out
all operations necessary for the exploration for,
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CONTRACTUAL REGULATION AND SETTLEMENT OF DISPUTES
development and production of hydrocarbons, on
payment of a flat fee or a sum commensurate with the
quantity of production in the reference period. The fee
can be graded according to the size of the discovery,
the amount of risk capital invested and other factors.
The private party does not, therefore, have the
capacity, prerogatives and rights of a concessionaire or
of an associate, its role being limited to that of a
contractor. It follows that programmes and budgets for
the activity to be developed in each year of the life of
the relationship, even if drawn up by the contractor,
must be approved by the state-owned company.
Two types of service contract can be distinguished
in practice: those with risk and those without risk. In
the case of a service contract with risk the contractor is
required to finance entirely the exploration for
hydrocarbons and subsequently the development of
deposits found in the contract area. This financing
consists of assuming the risk of failure to find
hydrocarbons (usually crude oil) in commercially
viable quantities. Only in the latter case, indeed, the
sum of all the costs sustained up to that date is
considered a loan granted by the contractor to be
reimbursed by the state-owned company.
Reimbursement is normally made in money, and it is
the contract that establishes the amount and the date
(normally every three months) of each instalment.
Production costs are, instead, reimbursed directly by
the state-owned company in the local currency, on
issuance of an invoice. In addition to reimbursement
of costs, the contractor has the right to receive, for
services rendered, additional sums calculated
according to the terms of each service contract.
Various service contracts provide for the contractor’s
right to quantities of crude oil, assessed at market
price (set out in the contract), instead of payments in
money by the state-owned company.
The ‘with risk’ formula was adopted in the 1960s
and 1970s in service contracts concluded, among
others, in Iran, Iraq, Nigeria and Venezuela. In a
subsequent stage this contractual formula permitted
some states to obtain more favourable conditions: this
is the case of the service contracts concluded in Iran
and Burma, as well as in Brazil on the basis of the
1976 Petrobras model contract.
The distinction between the PSC and the service
contract with risk is not an easy one to make, also in
view of the variations each country introduced in the
different schemes. It lies essentially in the method of
payment of the amount due to the private party to the
contract. While the PSC makes provision for direct
access to a quota of production in kind, in the service
contract the contractor is paid in money, unless the
contractor has opted for taking a quantity of crude oil
of an equivalent value.
856
Other service contracts are ‘without risk’ because
the contractor is not obliged to finance at its own risk
hydrocarbon exploration and development, and is
remunerated by a pre-established sum. On the basis of
this contract the private company places at the disposal
of the state-owned company qualified staff, its own
experience and know-how in order to conduct
hydrocarbon exploration, development and production
on the basis of programmes and budgets set by the
state-owned company. Also in this type of contractual
relationship the contractor can have access to
determined quantities of production, usually on the
basis of a separate sales contract.
Various service contracts have been concluded in
recent years by companies of the Italian Eni group.
The most significant of these are the following.
Buy back service agreements. They are contracts
stipulated in Iran with the NIOC between the late
1990s and the beginning of 2000, for a 4-5 year
duration for the development phase and a 6-7 year
duration for the hydrocarbon extraction phase.
Programmes and budgets are approved by a Joint
Management Committee (on which both parties are
represented) that decides unanimously (except for
mechanisms aimed at overcoming a possible
deadlock). Reimbursement of investments (up to a
determined amount) and a fee are paid out of the
returns generated by the sale of a quota (up to 60%) of
hydrocarbons produced, while reimbursement of
operating costs and income tax is made directly. The
contractor is also granted the right to purchase from
the NIOC a quota of production.
Service contract. It was concluded in 2000 with the
Nigerian Petroleum Development Company, holder of
oil petroleum licence n. 91 and of subsequent oil
mining leases. It provides for the development of two
fields that had already been discovered. The relative
investments were financed by the available crude oil
or, if that was insufficient, by funds provided by the
contractor. The entire production is owned by the state,
but the contractor’s own costs (both capital and
operating costs) are reimbursed from a quota of the
cost oil and the contractor is remunerated for services
rendered out of the residual production profit oil on
the basis of percentages established in the contract.
Operations are conducted under the direction of a Joint
Management Committee that decides unanimously
(except in the case of disagreement when an
independent expert intervenes). As concerns taxation,
the state-owned company pays the petroleum profit
tax, as well as the royalty, while the contractor pays
income tax.
Operating agreement. This contract, concluded in
1997 with Corpoven in Venezuela, provides that the
Eni company, as operator, shall make available
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 CONTRACTUAL REGULATION WITH RESPECT TO EXPLORATION FOR AND PRODUCTION OF HYDROCARBONS
investments and provide the know-how needed to
carry out the project for the rehabilitation of certain
basins of hydrocarbons, as well as the development,
production, transport and refining of production on the
basis of a master development plan approved at the
time the contract was stipulated. Investments made,
including interest, are reimbursed in money, in
addition to the payment every three months of a
service fee. The entire production is owned by the
state-owned company.
The technical assistance contract
As its name suggests, this type of contract
stipulates the services to be rendered by the foreign
partner, often limited to specific phases of oil-related
activities, in return for the payment of predetermined
sums of money and without the contractor bearing the
risk of not finding hydrocarbons.
The position taken by the state-owned companies in
the management of natural oil resources constitutes one
of the most significant innovations introduced by the
new contractual formulae. Even though many of the
terms agreed in the new schemes reflect those typical of
the oil concession contract, the circumstance that the
state-owned company signs the contract and not the state
leads to important legal effects with respect to the
protection of private investment. The state cannot, in
fact, be called on to be directly responsible in the case of
breach of contract nor can it attribute to the intangibility
and stabilization clauses contained in the contract the
same legal value deriving from the assumption of the
related obligation by the state (see above).
In order to hold the state contractually liable for
possible breach of contract by the state-owned
company or for any interference by the state in the
performance of the contract, there are various forms of
guarantee that the state can have issued on conclusion
of the contract. Among these is the approval of the
PSC by law, according to the provisions of some legal
systems such as that of Azerbaijan (Bati, 2003). On
the other hand, useful effects, which in terms of
economic equilibrium might be derived from a
stabilization clause accepted by the state, are achieved
by the inclusion, in various contracts, of a clause
concerning the public party’s obligation to compensate
the contractor for the economic consequences of
measures adopted by the state in violation of
guarantees for the contractually agreed stabilization
(this is the case of contracts concluded with
state-owned companies by states formerly members of
the Soviet Union).
The aspect characterizing the most recent evolution
of contractual relations with respect to the activities of
exploration, production, refining and marketing is
provided by the position taken by many states when
VOLUME IV / HYDROCARBONS: ECONOMICS, POLICIES AND LEGISLATION
granting mining rights regarding hydrocarbons. A
widespread practice is that whereby the company
wishing to obtain a contract for exploration for and
production of hydrocarbons on the territory of specific
states must submit a secret offer to the competent
authority declaring acceptance of the model contract
established for this purpose by the host state.
The prospects of success in obtaining the contract
are based solely on the commitments concerning
investment and execution of works made on the
occasion of the tender, with the possible addition, if
requested, of the payment of sums of money (bonuses)
at established time-limits. The model forms for the
various types of contracts (PSC or service contracts)
are by now widespread in countries from the most
varied geopolitical areas and diverse legal cultures.
An example of the most recent evolution is the
tender whereby the Algerian Sonatrach, in 2004,
invited offers for the execution of an integrated project
(to be carried out in association with Sonatrach) to
explore, develop, liquefy and market natural gas from
fields located in the Gassi Touil region, on the basis of
a PSC, non-negotiable, for the duration of 30 years.
The contract envisages a phase for the development
and production of hydrocarbons financed for 65% by
the contractor and for 35% by Sonatrach, as well as
two phases of exploration for new fields financed for
100% by the contractor. Decisions are unanimously
taken by a management board on which the two parties
are equally represented, with a third person being
called on to settle any possible disagreements.
The activity of liquefying natural gas and
marketing the LNG (Liquefied Natural Gas) are
carried out by two different companies in which
Sonatrach and the contractor participate with different
quotas depending on the company. The contractor is
reimbursed the costs incurred and is remunerated for
its investments and for the activity carried out by a
quota of production of crude oil, LNG, natural gas or
other products of the refining process, the remaining
part of production being property of Sonatrach.
The contractor’s income tax on the remuneration
stipulated in the contract is paid by Sonatrach, who is
also charged with the royalty on the production of
hydrocarbons. The contract is governed by Algerian
law, and disputes are settled by international
arbitration on the basis of the Rules of Arbitration of
the United Nations Commission on International
TRAde Law (UNCITRAL).
13.1.5 Conclusions
Joint ventures, production sharing contracts and
service contracts represent respectively stages of a
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CONTRACTUAL REGULATION AND SETTLEMENT OF DISPUTES
process whereby developing states have sought to
attain broader control over their natural resources and
greater profits from oil-related activities, recovering at
the same time complete sovereignty over their oil
resources that the granting of concessions had
seriously limited. Moreover, unlike what normally
occurs with respect to oil concession (see above), the
new types of contracts are as a rule subject to the
domestic law of the state on whose territory the
oil-related activity is carried out, thereby satisfying
one of the objectives of the states’ action aimed at
recovering sovereignty.
Some new international instruments, first of all the
1965 Washington Convention on the settlement of
investment disputes between states and nationals of
other states, refer to the law of the host state as
regulating the private investment. Legal writings refer in
this connection to the re-localization of the applicable
law in the legal system of the host state. However,
international arbitration continues to constitute the
normal method of dispute resolution between the
parties also by means of the above-mentioned
Washington Convention on investments. Despite these
corrections, it cannot be affirmed that the goal of actual
control by the state over the development of its
resources is always and everywhere achieved. Such
control depends, indeed, largely on the state’s ability to
make available professionally suitable resources as a
result of the implementation of serious training
programmes for its staff.
However, from the point of view of the private
party the new contractual schemes may prove
acceptable (as, after all, their diffusion demonstrates),
to the extent that the investment is reasonably
protected and access is allowed to a quota of
858
production of hydrocarbons at an acceptable cost in
order to ensure continuity of supply on its own outlet
market.
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From concession to participation: restructuring the Middle
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Hyde J.N. (1963) Economic development agreements, in:
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ICCA (International Council for Commercial Arbitration)
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«International Legal Materials» (1975), 14, 1237.
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593-643.
Piero Bernardini
Counsel, Ughi e Nunziante Law Firm
Università LUISS - Guido Carli
Roma, Italy
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