Production-Sharing Contracts

I am pleased that we are able to focus with this first OGEL issue in 2005 on production-sharing contracts. Production-sharing contracts now dominate the world of upstream exploration and development for oil and gas, with some exceptions in Europe (where concession-licenses prevail), in the US and in some Latin American countries which have during their privatisation period in the 1990s re-introduced mineral concessions on the Chilean model (Chile, Argentina, Brazil, Peru in particular). Production-sharing contracts are also used, though sparingly and with limitations, in Russia. We are grateful in particular to Philip Weems, of King & Spalding in Houston, and his competent team for helping to assemble an impressive number of relevant studies and comments on the modern use of production-sharing contracts.

The production-sharing contract originated in the 1960s in Indonesia, conceptually and culturally derived from the share-cropping model then familiar to Indonesians (and indeed much of the agricultural world where agricultural leases have traditionally often been based on simple production-sharing). It offered a new model to reject the "mineral concession" then seen as colonialist (though in itself it is nothing but a particular form of a legal title to exploration and subsequent development in case of a commercial discovery); it was made attractive to the then (and now) nationalistic sentiments in producing countries as it did (or seemed to give) the symbolic functions of ownership and control of the resource, both underground and after extraction, to the state enterprise (in Russia the state) as the agent of the nation. It also provided the state with oil in kind to supply domestic needs. To the international oil companies, it was first seen as revolutionary and widely resented.

When I started my career in oil and gas law, older executives still considered there was something "Communist" about this new form of state-oil company cooperation. But industry appreciation changed as companies were able to appreciate that production-sharing contracts - itself not much more than a formal structure that can be deployed for many purposes and requirements - also had significant advantages: The state shared to a considerable extent in the risk of development and production cost (which tend to be recoverable - full or in part - before the state's share is triggered); it also shared in the commercial risk of oil price volatility. Furthermore, the cost recovery system of production-sharing contracts allows - in its pure form of 100% recovery - to recover against the state and before the state's share is triggered all sorts of costs, including new, or unknown and un-identified, direct and indirect taxes and levies from the state - including the often unpredictable sub-national authorities. Given that the marginal total government take is often 85-90%, it means that such PSC in effect allocates the risk of not well identified costs and taxes to the state-owned enterprise.

The relative simple and clear model of PSCs of the mid-1960s in Indonesia (see here the seminal study by Robert Fabrikant which we have managed to re-publish in this issue) was modified in several aspects: Sometimes hybrid models (China) evolved; US tax credit rules required that the operation was taxed - to generate US tax credits, but usually the state enterprise assumed such taxes, or, in subsequent models, taxation was built into a combined tax-plus-production-sharing mechanism, itself a source of great complexity and disputes.

Currently, production-sharing contracts are still very popular - as they give to the state and state enterprise the symbolics of ownership, and a reality (or at least appearance) of overall or shared control over operations and as they can be structured in a way that satisfies the investor's need for day-to-day management powers, a reasonable rate of return with accelerated amortisation of the original investment plus a standard rate of return. Nevertheless, there are now a number of problem areas which have given rise to disputes (which I suggest are likely to increase):

Such disputes tend to centre, as is normal, about ambiguities either within the contract or, more frequently and likely, on contradictory regulation between the production-sharing contract on one hand and domestic laws, regulations or administrative rules, practices and interpretation on the other side. This is so since the "pure" model of a legal-enclave created by a PSC is rare in practice, in particularly in larger countries. Recent disputes, for example, have focused on interpretation of the accounting rules relied upon for cost recovery, on additional-profits-based quasi-tax systems instituted in a PSC (or in general laws, as the 1987 Australian resource rent tax) and on the difficulties of factoring in the end-game obligations to execute and pay for decommissioning of offshore production facilities (see on this Dayo Ayoade, in OGEL, volume 1, issue #02, and his 2003 book published by Kluwer).

The relationship between a production-sharing contract (intended by the investors to be an as exclusive and comprehensive instrument of legal and fiscal regulation) and applicable law and tax rules is likely to come under increasing stress as governments change, resentment of foreign and private oil operations grows again and as the "hostage" effect of foreign investment allows new governments to try to squeeze out more income - both on the national as on sub-national levels of government. In larger countries, the PSC is unlikely to have achieved the intention of constituting an exclusive and comprehensive - legal enclave - regulatory instrument so that tensions between the contract and the law will show up in intentional ambiguities and efforts to obtain greater legal certainty through the use of comfort letters and similar strategies.

The production-sharing contract allows governments to be, or to appear to be, in charge, while still offering attractive terms to investors and to free governments from the budgetary burden of having to finance - as in 100% state-owned operations or in true joint ventures and association contracts - exploration and in particular the huge costs of development. Should OPEC countries - hitherto, since 1972 - closed to the international oil companies, truly decide to open up gas, and perhaps later oil, acreage to the private industry, production-sharing contracts will certainly be the prime instrument to be examined for that purpose.