Production-Sharing Agreements: An Economic Analysis

1 OXFORD INSTITUTE ENERGY STUDIES - FOR - Production-Sharing Agreements: An Economic Analysis Kirsten Bindemann Oxford Institute for Energy Studies WPM 25 October 1999 Production-Sharing Agreements: An Economic Analysis Kirsten Bindemann Oxford Institute for Energy Studies WPM 25 October 1999 The contents of this paper are the author s sole responsibility. They do not necessarily represent the views of the Oxford Institute for Energy Studies or any of its Members. Copyright 0 1999 Oxford Institute for Energy Studies (Registered Charity, No. 286084) All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior permission of the Oxford Institute for Energy Studies.

2 This publication is sold subject to the condition that it shall not, by way of trade or otherwise, be lent, resold, hired out, or otherwise circulated without the publisher s prior consent in any form or binding or cover other than that in which it is published and without a similar condition including this condition being imposed on the subsequent purchaser. ISBN 1901795 15 2 CONTENTS List of Tables List of Figures List of Abbreviations Acknowledgements 1 INTRODUCTION Part I: The Background 2 THE RATIONALE BEHIND Production-Sharing AGREEMENTS Mineral Development in General Ownership and Mineral Development Rights A Brief History of Petroleum Contracts 3 Production-Sharing AGREEMENTS IN GENERAL The Contract Elements Some Simulations A Discussion of the Simulation Results Part 11.

3 Some Theory 4 INCENTIVES, RISKS AND REWARDS Sharecropping Principal-Agent Relationships Risk Allocation and Contracting Risk An Application of the Principal-Agent Model Appendix The Principal-Agent Model Part 111: An Empirical Analysis 5 Production-Sharing AGREEMENTS 1966B98 The Dataset Contract Development Over Time Some Further Evidence Appendix Dataset Information i ii iii iv 1 5 5 7 9 13 13 18 20 29 29 31 35 36 41 47 47 48 59 63 6 CASE STUDIES 67 The Development of PSAs in Indonesia Angola: Tough PSA Terms are no Deterrent Azerbaijan: The Next Big Oil Play? India 's PSA Incentives in a Global Context Iran's Buy-Back Tender: Production-Sharing or Service Agreements?

4 Peru: PSAs with a Difference Part IV: Conclusions 7 THE MAIN FINDINGS AND CONCLUSIONS LITERATURE 67 70 71 73 75 81 85 91 LIST OF TABLES Risk and Reward of Main Contract Types Profit Oil in Indonesia Profit Oil in Azerbaijan A Comparison of Royalty and Tax Sample PSA Cash Flow with Fixed scale Sample PSA Cash Flow with Volume-Based sliding scale Sample PSA Cash Flow with R-Factor sliding scale Scenario 1 - Fixed scale with Low Oil Price Scenario 2 - Fixed scale with Medium Oil Price Scenario 3 - Fixed scale with High Oil Price A Comparison of Fixed and sliding Scales Risk-Bearing under Different Contract Types The Regions The

5 Parameters Profit Oil for FOCs Regional Correlations Production-Sharing Agreements 1966-98 Current Trends Main Features of Asian PSAs Onshore Oil and Gas Development Offshore Oil and Gas Development 11 18 18 21 22 23 24 25 25 25 25 31 47 48 51 62 63 65 74 76 77 i LIST OF FIGURES The Basic Features of a PSA PSA Flow Chart The Impact of Royalties A Landlord-Tenant Relationship Some Principal-Agent Relationships The Optimal Incentive Structure Maximum PSA Royalty Distribution of Maximum Royalty Maximum Cost Oil Distribution of Maximum Cost Oil Minimum Profit Oil for FOC Distribution of Minimum Profit Oil for FOC Maximum Profit Oil for FOC Distribution of Maximum Profit Oil for FOC Difference Maximum-Minimum Profit Oil for FOC Distribution of Difference Maximum-Minimum Profit Oil for FOC Characteristics of PSA Elements PSA Partners in Azerbaijan Legal Structure for Buy-Backs Buy-Back Procedure PSA Risks and Rewards 13 15 21 32 39 44 53 53 54 54 55 55 56 56 57 57 60 73 79 80 89.

6 11 LIST OF ABBREVIATIONS bbl b/d bn cfd DD&A DMO EIA FOC FSU FT FTP Gov IIAPCO IRR mb mb/d MEES mn n/a NCF NIOC NOC NPV OGJ OPEC PIW PON PR PSA ROR sqm TCF Barrel(s) of oil Barrel(s) per day Billion Cubic feet of gas per day Depreciation, Depletion and Amortisation Domestic market obligation Energy Information Administration Foreign oil company Former Soviet Union Financial Times First Tranche Petroleum Government Independent Indonesian American Petroleum Company Internal rate of return Million barrels Million barrels per day Middle East Economic Survey Million not applicable Net cash flow National Iranian Oil Company National oil company Net present value Oil and Gas Journal Organization of Petroleum Exporting Countries Petroleum Intelligence Weekly Platt's Oilgram News Petroleum Review Production-Sharing agreement Rate of return Square miles Trillion cubic feet.

7 111 ACKNOWLEDGEMENTS I should like to thank seminar participants at OIES, at the 22nd IAEE Annual International Conference in Rome in June 1999, and at the BIEE Conference in Oxford in September 1999 for their comments on parts or all of this study. I especially acknowledge many helpful and stimulating discussions with Peter Greenhalgh, Robert Mabro, John Mitchell, Bernard Mommer, and Ian Skeet. Lacking a co-author, all remaining errors are unfortunately mine. iv 1 INTRODUCTION Production-Sharing Agreements (PSAs) are among the most common types of contractual arrangements for petroleum exploration and development. Under a PSA the state as the owner of mineral resources engages a foreign oil company (FOC) as a contractor to provide technical and financial services for exploration and development operations.

8 The state is traditionally represented by the government or one of its agencies such as the national oil company (NOC). The FOC acquires an entitlement to a stipulated share of the oil produced as a reward for the risk taken and services rendered. The state, however, remains the owner of the petroleum produced subject only to the contractor's entitlement to its share of production . The government or its NOC usually has the option to participate in different aspects of the exploration and development process. In addition, PSAs frequently provide for the establishment of a joint committee where both parties are represented and which monitors the operations.

9 PSAs were first introduced in Indonesia in 1966. After independence nationalistic feelings were running high and foreign companies and their concessions became the target of increasing criticism and hostility. In response to this the government refused to grant new concessions. In order to overcome the subsequent stagnation in oil development, which was a disadvantage to both the country and the foreign firms, new petroleum legislation was brought in. PSAs were regarded as acceptable because the government upholds national ownership of resources. The major oil companies were initially opposed to this new contract form as they were reluctant to invest capital into an enterprise which they were not allowed to own or manage.

10 More importantly, however, the FOCs did not want to establish a precedent which might then affect their concessions elsewhere. The first PSAs were therefore signed by independent FOCs who showed a greater willingness to compromise and accept terms that had been turned down by the majors. Furthermore, it has been argued that the independents saw this as an opportunity to break the dominance of the big oil companies and gain access to high quality crude oil (Barnes 1995). Thus challenged, the major FOCs bit the bullet and entered into PSAs (and found that in reality the foreign firm usually manages and operates the oilfield directly).