Guyana-type petroleum contracts: Intellectual origins and dynamics

Introduction

At the time of writing this column media reports indicate that a signature bonus of US$18 million has been paid to the Government of Guyana (GoG) by Exxon and its partners. This report had been circulating in Guyana for most of this year, and the failure of the GoG to address it categorically months ago, had led the public, including myself, to believe this was a speculation. When the 2018 Budget did not directly address this matter, that belief became certainty.

The recent public disclosure indicating that a signature bonus had been paid by Exxon Mobil and its partners to the GoG since last year has been stunning, dismaying and deeply distressing to members of the public. I shall address the disclosure immediately on completion of my already announced intention to evaluate Guyana-type Production Sharing Agreements (PSAs) this week and the next. Treatment of the signature bonus will be incorporated into my earlier indicated columns, which would share my reflections on the recent debates on Guyana’s petroleum contracts. As of now, this exercise should commence on the first Sunday of the New Year.

Origins

Informed readers should be cognizant of the intellectual/theoretical origins of PSAs. Historically, these originate in three major theoretical fields of inquiry. One is longstanding (that is, legal), and the other two are relatively recent (namely, behavioural economics and institutional theory). As A Ogunleye has observed “PSA concepts date back to French Napoleonic traditions” of granting state-owned mineral rights to individuals for them to develop for the benefit of all citizens; a good example of this is the Netherlands Indies, Mining Law, (see Journal of Energy Studies and Policy, 2015). The initial use of this legal construct could be found in agriculture (especially in instances of landowner-farmer-tenant-sharecropping). This is indeed, probably, the oldest form of risk capital, with what is labelled a ‘dual nature’. Dual in the sense of (1) rights to explore for and produce (mineral resources), and (2) cooperation between parties to a contract (state or its designee), and oil company (typically foreign owned, FOC).

The second theoretical field is behavioural economics. Here PSAs originate in risk-reward theorems and the analysis of trade-offs between the two. Such analysis has contributed greatly to the worldwide proliferation of PSAs. This theory specifically analyses expected rewards from investments in relation to the amount of risk involved with different risk-reward ratios applying to different types of investments. Significantly, those in petroleum exploration are considered to be quite high, as this is considered as one of the riskiest businesses, worldwide. The general principle that applies is: potential returns must rise if risks increase.

The third theoretical field is institutional theory, which has explored principal-agent relations. Such relations are typified, in the state (owner of hydrocarbon resources) and oil company relations, which in Guyana-type circumstances typically has an FOC as the contractor (agent). Here the contractor explores for hydrocarbon resources and manages their production, if any are found. This theoretical field has generated several well-known theorems such as: 1) contract completeness/ incompleteness; 2) asymmetric information flows (information failure); 3) insider trading; 4) moral hazard; and 5) agency costs. Rather than abstract explanations of these theorems, they will be illustrated where appropriate, as I proceed with the analysis. Of note, this theoretical field’s central explorations relate to notions of ownership and control of organisations.

PSA dynamics

Following on the above, it is important that readers recall two features of PSAs: 1) they guarantee state’s sovereign rights over its resources and 2) pose no financial risks to the state, because the contractor is legally expected to provide capital for exploration and start-up, as well as technology and know-how to produce/distribute/market the petroleum. Obviously, a good outcome for this principal-agent relation is one where the state (principal) maximizes revenue collections over the short run and simultaneously stimulates profitable FOC (agent) investments over the long run.

To be sure, certain contract outcomes are necessary, if not sufficient. One such, is that the contract should be comprehensive. Because there is uncertainty about future events and occurrences, no contract can be totally complete in its coverage given that petroleum exploration and production are extremely risky. Second, the contract should encourage competitive outcomes, if it is to drive innovation and cost efficiency. Third, the contract should be considered by both principal and agent, as a dynamic document, which will be adapted if circumstances change significantly. Fourth, the contract should be situated in a fiscal environment such that, after trade-offs, both the state (Principal) and FOC (agent) find it acceptable for going forward, without significant disagreements.

Energy economists constantly remind us of an irreversible secular technical condition that governs the dynamics of the petroleum industry. That is, hydrocarbon resources are ultimately finite and the effect of this finiteness is captured in the theorem of the energy return on investment (EROI). EROI quantifies the amount of energy required (barrels of oil, worldwide) to produce more energy. The industry rule-of-thumb is, overall, it took one barrel of oil to produce 100 barrels in the middle of the 19th century. Nowadays though, overall, it takes as many as 5-15 barrels of oil to produce 100 barrels of oil. Obviously, among other things, this signifies a secular decline in crude oil quality. If true, this would have serious long-run consequences for the economics of petroleum and hence, contracts for their exploration and production.

Finally, readers are aware, thus far, we are unable to access the details on Guyana’s PSA. Readers should note, however, that, mechanisms are typically inserted into PSAs in order to anticipate and address problems which arise over time. Consider a few examples of these: one such is that the state may directly operate through the GoG or may create a National Oil Company (NOC) to serve as the principal in the contract. Sometimes such NOCs engage in petroleum and related industries. Another example is that the NOC may secure a financial stake in the exploration/production/management of petroleum activities jointly with the FOCs. Or, again, the NOC and the GoG may, under the contract, create a joint committee to monitor operations of the undertaking.

Conclusion

Next week I pursue a critique of PSAs.

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