How to negotiate the ‘right’ oil contract BY JENIK RADON

How to negotiate the ‘right’ oil
contract
BY
JENIK RADON
COLUMBIA UNIVERSITY
PHNOM PENH, MARCH 26 – 28, 2008
Background
Done right, natural resource extraction can be a
boon for social and economic development
The so-called natural resource curse is not inevitable
(see success stories of Botswana and Norway)
Negotiating the right contract is vital to a
government’s effort to reap the benefits of its natural
resources.
How governments can develop
their resources
1. STATE COMPANIES, E.G. SAUDI ARABIA,
BRAZIL (SEMI)
2. PRIVATE INTERNATIONAL MAJORS, E.G. US, CANADA,
UK,
3. COMBINATION OF 1 & 2, E.G. NIGERIA, AZERBAIJAN,
KAZAKHSTAN
Why do contracts matter?
Contract terms determine
(1) how much a producing country
earns from it natural resources;
(2) the regulatory power of
government to enforce environmental,
health and other standards, if legal
and regulatory system not well
established
Key issues of all oil contracts
How profits are divided between government and
participating companies
How costs are treated, expensed or depreciated
What to treat as costs, e.g. Expat housing, best technology
Taxes, royalties, excess profit taxes
Stablization, what kind
Timing
Uncertainty about development and exploration costs
complicates negotiations
abandonment
Balance needed between country’s and investor’s interests.
Contractual Systems
To achieve such balance of country and investor
interests the choice of contractual system is crucial
4 basic contracts:
Concession
or license agreement
Joint venture (JV)
Production-sharing agreement (PSA)
Service Agreement
Transparency
All contractual systems and most terms should
be disclosed; no need for full confidentiality.
Contract transparency is key to curb corruption
“biggest obstacle to social and economic
development” (World Bank)
The four basic contractual
provisions
• CONCESSION OR LICENSE
AGREEMENT
• JOINT VENTURE (JV)
• PRODUCTION-SHARING
AGREEMENT (PSA)
• SERVICE AGEEMENT
Concession or license
agreements
GRANT OIL COMPANY EXCLUSIVE RIGHTS TO
EXPLORE, DEVELOP, SELL, AND EXPORT OIL FROM A
SPECIFIED AREA FOR A FIXED PERIOD OF TIME
USED IN KUWAIT, SUDAN, ANGOLA, AND ECUADOR
Concession or license agreements
Advantages
Disadvantages
More straightforward,
Lack of adequate
particularly if basic terms
set in public bidding
system
Less expertise needed to
negotiate them than JV or
PSA
BUT well-developed bidding
process and legal system to
interpret complex
agreements needed
information about the
potential of concession
turns bidding process
into auction
Continued
Advantages
Disadvantages
Financial and other terms
Companies will be
of license are set forth in an
agreement drafted by the
host government (should
be published and opened to
competitive bidding
process)
Successful bidder pays
bidder price (usually
license fee and/or signing
bonus)
cautious in the amount
it is prepared to bid
since there is no
guarantee that the
concession will cover
the company’s costs
and return a profit.
Continued
Advantages
Disadvantages
If production occurs,
Risk that government
government earns
royalties based on
gross revenue and/or
profit tax based on net
income; both are based
on the quantity
produced and the price
at which oil is sold
will not realize full
potential from auction
system
Continued
Advantages
All financial risks of
development and
exploration are borne
by the successful
bidder
Disadvantages
Joint Ventures
• NO SINGLE DEFINITION; HIGHLY FLEXIBLE TOOL
• 2 OR MORE PARTIES WISH TO PURSUE A JOINT
UNDERTAKING IN SOME STILL TO BE CLARIFIED FORM
• LOW SUCCESS RATE; LESS COMMONLY USED
• NIGERIA: STATE OIL COMPANY FAVORED JV UNTIL IT
COULD NO LONGER MEET ITS SHARE OF THE JV’S
FINANCIAL COMMITMENTS; NOW GOVERNMENT OF
NIGERIA PREFERS PSA
• AS NAME IMPLIES, IN JV THINGS ARE DONE JOINTLY;
THEREFORE, MATERIAL ISSUES NEED TO BE RESOLVED
PRIOR TO ENTERING INTO A JV; REQUIRE LONG
NEGOTIATIONS TO ENSURE THAT ALL MATTERS ARE
THOUGHTFULLY ADDRESSED.
Joint Ventures
Advantages
Disadvantages
Government is not alone
Risks and costs are also
in the decision-making
and responsibility for a
project
Government can count
on expertise of oil
company
Government shares
profit, on top of taxes or
royalties
shared
Responsibility also brings
with it potential liability,
incl for environmental
damage
JV is inherently ambiguous
and can complicate
negotiations which tend to
be lengthy; require more
legal advice than any other
agreement
Joint Venture Characteristics
Pure JV
All costs/risks
Shared
Typical JV
Government
carried through
Exploration
Full carry JV
Former Soviet Union type JV
Government carried
Government carried through
through exploration and
rehabilitation and development
development
until cash flow from operations
NOC←------------------------------------------------------------------------------------------------→IOC
Risk sharing
Production-sharing
agreements
FIRST USED BY INDONESIA IN 1966 AFTER INDEPENDENCE TO
REPLACE OLD COLONIAL LAW (“LICENSE CONCESSION”)
BASIC CONCEPT: STATE RETAINS OWNERSHIP OF NATURAL
RESOURCES AND NEGOTIATES PROFIT-SHARING SYSTEM
NOW COMMON FORM OF AGREEMENT, ESPECIALLY IN CENTRAL
ASIA AND THE CAUCASUS
PSA RECOGNIZES THAT THE OWNERSHIP OF THE NATURAL
RESOURCES REST WITH THE STATE BUT AT THE SAME TIME
PERMITS FOREIGN CORPORATIONS TO MANAGE AND OPERATE THE
DEVELOPMENT OF THE OIL FIELD.
OIL COMPANY CARRIES MOST FINANCIAL RISKS OF EXPLORATION
AND DEVELOPMENT
OFTEN GOVERNMENTS CONTRIBUTE TO THE SHARE CAPITAL OF
THE CONSORTIUM
Production-sharing agreements
(continued)
EXACT SPLIT OF SHARES IS THE RESULT OF HARD BARGAINING
FINANCIAL TERMS: HOST GOVERNMENT OFTEN EARNS SIGNING BONUS,
REGULARLY WAIVED FOR A GREATER SHARE OF FUTURE PROFITS; OIL
COMPANY IS FIRST ENTITLED TO COST RECOVERY ; DEFINITIONAL
PROBLEMS OF WHAT IS A CAPITAL COST.
WHAT REMAINS IS SHARED ACCORDING TO THE AGREED PERCENTAGE
DIVISION WITH THE HOST GOVERNMENT.
FOREIGN COMPANY IS REQUIRED TO PAY TAXES BUT OFTEN WAIVED AND
INCLUDED IN THE COMPANY’S PORTION OF THE AGREED PERCENTAGE
SPLIT.
THE COMPLEXITY OF A PSA DEPENDS ON THE SOUNDNESS OF THE LEGAL
INFRASTRUCTURE OF A STATE; IF BASIC RULES ARE ABSENT PSA WILL
HAVE TO ADDRESS THEM
Production-sharing agreements (continued)
Advantages
Disadvantages
Government shares
Government generally has
potential profits without
having to make a direct
investment
PSA can be enacted into
law to provide legal
security (Azerbaijan and
other former Soviet
republics)
less knowledge about
potential of oil field than oil
company
If government holds
significant share, it will
face conflict of interest: it
has to balance the desire
for higher profits with the
enforcement of
environmental and other
regulations
Production-sharing agreements (continued)
Advantages
Disadvantages
PSA grants oil companies a
say in environmental and
other standards when these
standards have been
incorporated as contractual
provisions; violating a
contractual provision is
less costly than violation of
a regulation because only
in case of a serious or
material breach of contract
is the termination of the
agreement a possibility
Production-sharing agreements (continued)
Advantages
Disadvantages
Violation of a legal statute
is an offense, subjective to
legislatively approved
sanctions and penalties
Making contracts into law
creates a legal
infrastructure of
exceptional situations;
little possibility of
developing a coherent and
comprehensive legal
system;
Production-sharing agreements (continued)
Advantages
Disadvantages
PSA positive legal
discrimination for oil
companies; investors
in other sectors will
invariably lobby the
host government for
similar special
treatment
Contractual Provisions
COMMON PROVISIONS FOR CONCESSION OR LICENSE
AGREEMENTS AND PRODUCTION-SHARING
AGREEMENTS
Parties
Host government should not assume contractual liability as a
direct party to an agreement to avoid direct responsibility and
unlimited liability
Instead, it should engage a state-owned enterprise as a
separate legal entity as contractual partner to limit its liability;
in case of liability only the enterprise’s assets can seized
In practice national oil companies often serve as
intermediaries for government
Oil companies usually create local subsidiaries with limited or
no assets of their own
Government should require guarantee from parent company
so it can tap into its resources to cover potential liabilities
Accounting Methods
To determine profits, there must be a decision on
accounting methodology
Still no international accounting principles; only
national standards
Accounting standards leave room for discretion and
can lead to serious disputes; e.g. they don’t have
provisions prohibiting any particular type of
expenses; clarification in contract needed
Accounting standards do not provide resolution for
intercompany pricing, which can inflate costs and
decrease government compensation
Recovery of Costs
How companies account for their costs determines
the taxes companies pay and the royalties they share
with governments
2 types of costs
Current operating costs: expensed in the year in which they are
incurred; immediate reduction in taxable profits
Capital investment costs: long term and can be depreciated
over a set period of time: quick depreciation means less profits
and decreases incentives to continue operations
Taxation or Compensation
Taxation of production matters because income from
oil production often accounts for biggest portion of
government budget
Profit tax
Can come in form of corporate income tax or as part of the
amount government agrees to take from any profits
Tax inspectors need to collect production and sales data and
audit company expenses
Problem of transfer pricing: oil sold to subsidiaries may be
priced above or below market price
Taxation or Compensation (continued)
Royalty or excise tax which is normally a percentage
of the value of the production
Often imposed on top of other taxes
Easy to administer
Can be inefficient, however, because they tax production
without regard to profit; when project is marginal, excise tax
may discourage further investment
Bonuses
Signature bonus: one-time payment before exploration starts
Production bonus: continued fixed payments
Bonuses are fixed payments and do not take profitability of
project into account
SERVICE AGREEMENT
SIMPLE: Payment for services, effectively set fee
CHALLENGE: Most energy companies reluctant to
sell services and/or technology know-how as earning
more limited
Country Case Study: Norway
NORWAY HAS ORDINARY CORPORATION TAX (28%) AND
PETROLEUM TAX(50%)
BOTH TAXES ARE BASED ON COMPANIES’ NET PROFITS
AN UPLIFT ALLOWANCE LETS COMPANIES DEDUCT 30%
MORE THAN THEY INVEST AGAINST PETROLEUM TAX
FAVORS MARGINALLY PROFITABLE PROJECTS
TAX RATE HAS CHANGED OVER TIME
Environment
When environmental standards are covered by
contractual agreements, oil companies can interpret,
negotiate, or even veto environmental standards
No reason why environmental standards should be lower
in developing countries considering that oil and gas are
in such high demand
Governments must take into account that companies
prefer to pay relatively low noncompliance penalties over
investments in pollution control
Fines should be high enough to act as deterrent
Restoration of polluted area by companies should be mandatory
Country Case Study: Azerbaijan
PSA ALLOWS COMPANIES TO DISCHARGE AIR
EMISSIONS “IN ACCORDANCE WITH GENERALLY
ACCEPTED INTERNATIONAL PETROLEUM INDUSTRY
STANDARDS AND PRACTICES”
PROBLEM: THERE ARE NONE!
Work Program
A work program details a company’s exploration or
development plan
Companies tend to slow down projects they deem too
expensive
Governments should insist on a work plan that
specifies clearly the circumstances under which a
project could be delayed or discontinued
Stabilization
Stabilization provisions protect oil companies from
the cost of governmental or legislative changes
affecting contract terms during life of agreement
Stabilization provisions are extremely
disadvantageous for governments because it freezes
the legal and regulatory situation of the country for
an extended period of time (“Contractual
Colonialism”);
Price
Method of determining market price is critical as it
directly impacts compensation of government
A contract should specify what prices serve as
benchmark (e.g. price established by spot market in
the particular region)
Governments should never accept as contract price
the price paid between related companies; this price
is likely to be well below market price
Termination
Contract needs to address under what circumstances
an agreement can be terminated
Examples:
Repeated and/or severe environmental violations
If companies no longer develop the field
Outside Experts
Governments have to ensure that foreign experts
who negotiate contracts are truly independent
Outside experts must be evaluated, selected, then
managed and directed
Transparency
Oil contracts are complex and can be subject to
abuse and corruption
To avoid corruption all terms should be disclosed to
the public
Transparency will prevent governments from
agreeing to terms the public cannot accept