From their very inception, oil agreements/contracts have embodied dynamic processes between states, as sovereign owners or guarantors/regulators of rights to a country’s petroleum wealth, and individuals/oil-companies that contract to develop this wealth. They are living documents, which respond to their special location (local/regional/international) as well as the varied dimensions of society (social, economic, political, and environmental), in which they are situated. Contracts are also interactive; they drive societal responses as well.
Today’s column briefly portrays how Guyana-type production sharing agreements (PSAs) have responded to these societal forces.
Responding to concerns about how cost recovery is treated in PSAs, variants to the mechanism have been introduced. Generally, these have directly addressed the functioning of principal-agent relations. Thus, four principal cost recovery variants have been introduced. Serially these are termed as: 1) Full cost recovery and deferred profit shares. In this instance gross oil and gas revenues are applied to cover contractors’ accrued costs, without any limit. And, consequently, profit is determined and subsequently shared at the pre-agreed ratios, only after the contractor has recovered all accrued costs. In this case, theoretically, the state’s share of profit could be zero.
2) Full cost recovery, deferred profit shares with an agreed first tranche of oil and gas revenues. Here the first tranche of revenues is divided between principal (state) and contractor (agent) before remaining revenues are applied towards reimbursement of the contractor’s accrued costs. After that, there are no other limits on full cost recovery. The profit allowed to be shared at the pre-agreed ratio, is only shared between the state and contractor after the latter recovers all costs (subject to the first revenue tranche).
3) Capped cost recovery and simultaneous profit shares: From what is known at the time of writing this column, this variant typifies Guyana’s PSA. Gross revenues from petroleum sales are first used to cover the contractor’s accrued costs (that is Exxon and partners) up to a pre-agreed limit (percentage). After this limit is reached, the remaining gross revenues are then distributed to the state and contractor according to the pre-agreed profit sharing arrangement for the remainder of the period, which is usually annual.
4) Finally, there is a hybrid of the above three types known as first tranche capped cost recovery, simultaneous profit shares. As the title suggests, this combines (i) a pre-agreed tranche of gross revenues to be split between state and contractor; (ii) the remaining revenues are then used to meet the contractor’s accrued costs up to a pre-agreed limit; and (iii) beyond that limit, the remainder of gross revenues, if any, are shared by the state and contractor at the pre-agreed ratios.
The variation in types of cost recovery mechanisms as an adaptation to concerns over standard PSAs is matched by similar variation in the profit share ratio. Thus, these can 1) be set at fixed ratios for the entire contract’s duration; or 2) change over time, particularly in order to increase the state’s share progressively, if production and productivity improve.
Such a sliding scale for profit sharing is increasingly used in oil contracts and is known as the R (ratio) factor. This factor is established by dividing the revenues the contractor obtained from the operations by the costs the contractor incurs; that is: R= (contractor revenues)/(contractor costs). After this is completed, the contractor then assigns the payable profit shares (between principal and contractor) for the various bands of the calculated R factor. Generally, at the beginning of the operations, costs are likely to be greater than revenues, so that the R factor would be quite low. However, since gross revenues rise as the operations grow, then the profit share for the
state should also rise. In this way the desired balance, as originally negotiated in the contract, is basically maintained. As net profitability of the contactor rises, the contractor’s profit share reduces.
Just as PSAs as a class of contracts/agreements have responded to the commanding critique that concession-type oil contracts deny states their sovereign rights to sub-surface mineral resources, in similar vein there is the response to the commanding critiques that PSAs facilitate full cost recovery by contractors thereby incentivizing gold plating of their costs. This has given rise to efforts at incorporating contractual revenue sharing (splits) between the state (principal) and contractor (agent) as an element of PSAs.
Before proceeding further, I admit upfront here that, theoretically, gold plating of costs can be avoided by effective auditing and cost monitoring capacity. However, in practice most developing oil producing states, relying on foreign oil companies (FOCs) as contractors, do not (and indeed cannot) mobilize such capacity. This makes the alternative profit sharing contract mechanism appear more attractive. The question is, however, are they really better? Is there a silver bullet to resolve principal-agent relations, even in theory?
The premise of revenue sharing variants of PSAs is to disallow full cost recovery, taxation, royalty, etc, as presently obtains in PSAs. And, instead, gross revenues from petroleum sales are split between the state (principal) and FOC (agent) at a pre-agreed percentage. And since this contract variant splits the gross revenues, it should incentivize the FOC (agent) to keep operational costs low. Further, we can expect that this form of contract will not incentivize the state to seek further means for capturing revenues from the contractor.
As we should expect such a form of contract raises concerns from the standpoint of principal-agent analysis. As an example, consider that the FOC (agent) is exposed to petroleum prices, and as we know changes in such prices will impact gross revenues. Therefore, if prices are changing this would incentivize contractors to wait for higher prices in times of low prices, before going forward. Such a result could lead to deferment of higher cost/marginal fields. The principal, however, would be keen on having these exploited, in contrast to the FOC’s (agent’s) wish to defer.
The variant of this revenue sharing PSA contract that is referred to most frequently in the local media is Indonesia’s gross-split PSA, and to a far lesser extent that of India, Russia, Peru and Libya.
I have already briefly referred to Indonesia’s mixed and controversial experience with the gross-split revenue sharing variant. However, I shall treat with this topic a bit more in-depth at the beginning of next week’s column, which as I have already indicated opens up my treatment of the signature bonus, along with recent local debates on Guyana’s petroleum contract and related matters.