Production sharing agreements or contracts (PSAs), have been, from the time of their earliest introduction to the oil and gas sector, subjected to in-depth critical analyses and/or evaluations from economic, legal, and institutional perspectives. Among the most rigorous and perceptive of these evaluations, in my view, are: 1) K. Bindemann, Production-Sharing Agreements: An Economic Analysis, (Oxford Institute for Energy Studies, October 1999) 2) T.A. Ogunleye, ‘A Legal Analysis of Production Sharing Contract Arrangements in the Nigerian Petroleum Industry’, (Journal of Energy Studies and Policy, 2015) and 3) Y. Omorogbe, Contractual Forms in the Oil Industry: The Nigerian Experience with Production Sharing Contracts, 1986. The first of these listed studies is an empirical evaluation of a dataset of as many as 268 PSAs, worldwide! And, the second and third studies have focused, selectively, on Nigerian PSAs. After careful review, I find that these documents offer several cogent criticisms of PSAs, with quite a few having been repeated by others, as I do in this column. In my opinion, their most useful criticisms for present purposes centre on four salient issues.
In random order, the first of these follows from the consideration that, the Principal (state) and Contractor (foreign oil company, FOC) regularly hold differing objectives, aims, and goals. Empirically, PSAs have been revealed as incentivizing contractors to explore the immediately lucrative petroleum fields, in the pursuit of quick and immediate profit. And, as a consequence, Contractors seek to defer the riskier fields. By ordinary inference, such incentivization is not surprising, even in cases where the riskier fields, might, over the long run, generate even greater profit. As we noted last week, risk-reward theorems, conclude that the greater the risk, the more must be the expected immediate profit (rewards) required to incentivize petroleum investors.
The second critique follows from the further consideration that, Contractors (agents) are contractually able to claim specified accrued costs incurred in exploration and production. This provision dis-incentivizes them from intensely (and costly) pursuing cost reduction. The reason for this is obvious. Such cost efficiencies/gains would mean giving up part of such gains to the Principal, in keeping with the pre-agreed profit-oil split. It is logical therefore, to presume that, if contractors are not able to benefit entirely from their efforts to secure cost efficiencies, they would not be as motivated to work at this as if they received the entire benefit.
The third critique is that PSAs often create the potential for Contractors (agents) to obtain windfall profits, as defined in economics/finance. Such profits could occur, if, after the contract is signed, crude oil prices rise greatly. “Windfall profits” have been succinctly defined as “huge profits that occur unexpectedly due to fortuitous circumstances. Such profits are generally well above historical norms” (Investopedia).
The fourth critique derives from the economic notion of moral hazard. This notion was introduced last week and is defined in the literature as: “the risk that a party to a transaction (PSA) has not entered into the contract in good faith” (Investopedia). In the literature, evidence is regularly adduced showing that FOCs routinely inflate (gold plate) their accrued costs. This occurs basically, because such costs can be claimed against the gross revenues that are obtained from the production and sale of crude. These accusations border on claims that FOCs systematically practise fraud! Indeed, some FOCs have been directly accused of procurement fraud and related abuses due to the non-arms length relations, which they hold with affiliated companies.
Sometimes this concern is portrayed in the economic literature as an example of adverse selection. This basically means that Contractors have information, which the Principal (state) in the contract/ agreement does not possess. Both adverse selection and moral hazard indicate that, underlying the contract/agreement there is an asymmetric information flow, or information failure. In such an instance, one party to the PSA (Agent/ Contractor) has more material knowledge of the economics of oil and gas exploration and production than the other party, which is the Principal (state).
This latter economic theorem was developed over the past six decades for the specific purpose of explaining how such imbalances in material knowledge can lead to inefficient economic outcomes, even in environments of supposedly competitive markets!
PSAs as disruptive
Further, readers should keep in mind that, originally, the introduction of PSAs was seen as a solution to foreign ownership, control, and domination of developing countries’ oil and gas resources. PSAs were very disruptive in the 1970s and after. For sure, the established traditional transnational oil majors were dead set against the surrender of their legal ownership to the sub-surface rights of a country’s oil and gas reserves. The wave of nationalizations of oil wealth, as well as growing anti-colonial and anti-imperialist sentiment was making concessionary contracts obsolete. The Organization of Petroleum Exporting Countries (OPEC) had been created by 1960.
The balance had indeed been tilted in favour of PSAs by the 1960s. PSAs were seen as new, radical and innovative contracts for deployment wherever oil and gas exploration and production was taking place in poor countries. This was supported the rise of the oil independents. These independents were large oil and gas companies, which were willing to challenge the dominance of the established transnational oil and gas majors. Independents accepted the PSAs, because they were convinced they still offered enough scope for profit-making, despite their radical shift towards full acceptance of the state’s sovereign rights over their petroleum reserves. As we would have observed from the descriptions of PSAs above, there is indeed such great scope.
In the final analysis each and every PSA in existence today, represents a unique contract, with its own fingerprints. This is the case, even though PSAs have been introduced in these columns as one set belonging to four typologies of contracts. Readers can understand this apparent contradiction through a simple analogy. Consider, cinematic films can be represented in classes: dramas, westerns, romance, crime, comedy and so on. Yet there is a clear simultaneous realization that each and every film is a unique construction. In similar fashion, no two contracts are the same, even when negotiated from the basis of a model contract. Being both unique and simultaneously of a recognized typology suggests that, important as today’s column is for giving insight into Guyana’s PSA, ultimately, Guyana’s PSA would need to be examined if this analysis is to be further enriched.
I await the release of the contract/agreement.