Advantages and Disadvantages of Service Contracts and Production Sharing Contracts - Essay Example

? Advantages and Disadvantages of Service Contracts and Production Sharing Contracts and the Kind of Situations in Which They Are Best Able to Operate Successfully Name Course No: Course Name: Instructor’s Name: Date: University: Advantages and Disadvantages of Service Contracts and Production Sharing Contracts and the Kind of Situations in Which They Are Best Able to Operate Successfully Introduction The ever increasing trend in the oil prices over the past several years enables the companies / individual investors to make hay while the sun shines. This has attracted many investors to shift their business into the profitable venture of oil and gas. The booming profits compel host countries to revisit their agreements with the investors. In many countries where oil and gas are being produced, made abrupt and unilateral changes in the already executed agreements. This unilateral change at the end of oil and gas producing countries hit hard the investors. This would definitely shake the confidence of the investors who invested a lot of money in oil and gas projects. The governments of Venezuela and Bolivia have gone to the extent of breaking the contracts or termination of licenses at their own sweet will. This move can be branded as “resource nationalization”. To lessen the negative impact on the profitability of the investing companies, the sovereign governments of Canada, UK and the USA have proposed compensation in terms of further extension of their contracts on soft terms to address this issue1. To safeguard the interest of the investor companies came from abroad, the effective legislation is necessary to mitigate the risks associated with it. However, the legislation in this respect varies from country to country. This does not only effectively take care of the interest of the host countries but the interest of the investors those who are in the run. However, the main objectives of each state are the same, to take control of its strategic assets and to get maximum revenue for the economic development of their country and to improve quality of life of their citizens. The apex regulatory body of oil and gas producing countries is the OPEC. The OPEC, by virtue of its appropriate forum is responsible to monitor the affairs of the oil and gas companies and the host governments whose territories are being used to produce oil and gas2. On the other hand, the state in return will receive royalty payments, income tax and other liveable taxes on the oil and gas producing companies. Contrary to that as per PSC the government will be the owner of all oils and gas productions, and the IOC will act as technical and financial services provider to take care of oil exploration and the development of oil wells / gas fields. Alternatively production will be shared between IOCs and the State in line with the provisions of PSC3. In the developing dominions, PSC system is an effective tool to access oil and gas exploration as well as development of oil wells. As per Johnston view, this access dependable on the political system of that country. As far as functional and financial considerations, the PSC system is more or less at par with concessionary system. The only difference between the two is the management control and its effective implementation4. Upstream Oil & Gas Agreements Overview Upstream agreements in fact create and establish legal business entity and working relationship between the sovereign government and the individual who owns land of exploration for oil and gas. The agreement is a legal document where rights and obligations of the stakeholders are clearly defined, leaving no ambiguity5. In the developed countries like USA, Canada and the UK where two forms of agreements are in existence. One is for the execution of individual land owner for exploration of oil and gas, the other one between the host government and the investor. The agreement executed between the host country and the investment company is called “Concession Agreement and the Production Sharing Contract” 6. In other words the Oil and Gas Exploration Agreement between the oil producing countries and the investors established legal relationship which empowers them to explore oil and gas to generate revenue for them and to the country in shape of royalty payments and taxes in return of lease contract to explore natural resources. But in most of the developed countries that includes USA, UK, Canada and Germany where host country has nothing to do with the lease agreement of private property in connection with oil and gas exploration. The oil and gas companies themselves make agreement with the individual owner of the oil well and gas fields7. Therefore, the oil and gas exploration companies may establish their relationship with them without the intervention of the government. The lease may be for a specific period or for an indefinite period as the case may be and its renewal on expiration of lease depending on the attitude and performance of the oil and gas exploration companies. These agreements are called “Oil and Gas Leases”. The exploration agreement restricts investing companies to confine their activities from exploration to abandon oil and gas in the explored zone8. More than 200 oil and gas companies hailing from different parts of the globe are invited by the oil and gas producing countries to negotiate and execute agreements with the states keeping in mind their competencies, capacities and the ability of capital investment in the projects to negotiate and find out oil in the arena of onshore, offshore, shallow offshore and deep offshore. Under mentioned scenario the states leased out specified areas to dig out and explore oil by the investors that vary from area to area in terms of risks and its mitigation. These areas are temporarily assigned to the cited companies for the identified purpose9. The mentioned companies have to abide by the rules and regulations of the States meant for the digging and developing oil wells. Violation or breach of any term of contract may attract penal action against the company by the host country which may culminate to the termination of lease agreement for which consequences to be borne by the breached. The financial terms and conditions between the investor and the host country or individual land owner should be clear in terms of investment, share of profitability, time line to accomplish the task so as to avoid any distasteful event during the tenure of agreement. Most of the countries drafted and designed agreements in a manner which encourage direct foreign investments in their countries to find out new avenues of income generation10. The generation of income aims at to be used for the development of country’s logistic system and for the betterment of their citizens in the areas of employment, health, education and technology etc. We should take the example of Lebanon who offers lucrative offers to the investors associated with mentioned fields to explore oil and gas in the specified areas of the country. Their efforts to woo the investors bore fruits to find out the new avenues of income generation for the country. The similar experience was carried out in the countries like Venezuela, Nigeria and Indonesia11. Historical Perspective The upward and downward trend in the oil and gas prices over the periods of time have compelled the host countries and the investors to revisit their agreements intermittently in the perspective of windfall profits which force the government of weaker economies to ensure price stability in their countries. The developing countries who import oil from oil producing countries to meet their day to day requirement have to bear the burden of import bill in major currencies which surely have the devastating impact on their economies12. Although the Investors have not shown their willingness to face the consequences of price fluctuation in the oil and gas industry. To meet the eventualities of the price hike, they stressed upon the host countries to insert stability clauses. In the Scandinavian countries stability clauses are backed by the stability guarantees enshrined in the domestic legislation and the operative parts of Bilateral Investment Treaty to meet associated risks with the vulnerable business13. The volatility in the price of petroleum and its products and the unilateral breach of agreements by the host states attracts arbitrations. The investors find themselves in a fix where the governments offer guarantees against stability clauses. Hence, they are compelled to re-negotiate the price with the host state’s concerned ministry. The rapid change in terms of price put the interest of the investor at stake. This state of affairs raises many questions in the minds of the investors: a) What should be the safe passage in view the ever changing contractual / fiscal terms which make the agreement ineffective for a longer period of time b) How can the investors follow the suit of UK and USA in the similar situation14. In extreme cases, host state can cancel the licenses, contracts or terminates the lease agreements of the IOC and may take over control of the operations of oil and gas companies thereby forcing the oil and gas exploring investing entities to leave the country forthwith by seeking compensation against their colossal losses. This sort of situation was witnessed in the 70s. In the event of nationalization of assets of the mentioned companies due to economic policies / political reasons, the state oil companies come forward to take effective control of the assets of the companies. By so doing governments have their own objectives. In case of rejection of offers by the offshore companies, the state owned companies, take over the control of the entire assets of the companies. Under the mentioned scenario, the remaining offshore companies have to face the consequences of new regulations which may be harsher than the existing rules15. The ever changing regulatory discretion of government speaks itself for the economic interest of the government in the ongoing projects: a) to replace existing contract / lease agreement b) persuade oil companies to opt for new contract with minimum favourable terms c) ensure that offshore companies invoke national laws / local courts for remedy rather than the assistance of International law for arbitration in case of acute disputes. Cited arrangements will frustrate the remaining companies to come to the terms of the host state16. These moves are nothing but to mount pressure on the companies to offer better terms to the government. So far few arbitration cases have been filed in the International Court of Law by the affected companies. The forced new rules, regulations and conditions make the stay of the companies miserable. Under the given condition, either they have to leave the country or to abide by the newly introduced terms. The new agreement must reflect increase in royalty payments / payable taxes as proposed changes17. The driving force behind the change of conditionality is a big chunk of profits for the host country. The levies of so many taxes are a deliberate move by the governments to raise their stake in the oil and gas business and to shrink the profitability of the offshore companies at its maximum. However, the host governments are well aware that the cost of projects with the passage of time has been swollen; therefore, chances of maximum profits as a result of new contracts have become imminent / visible18. The investors will hardly agree extension of contract in return of more accommodation of government desire to have maximum share of profit as in the case of investors in Libya, Indonesia and UAE. This type of negotiation may ignite either of the stake holders. To sort out the differences with the host countries, investing companies may have the opportunity to lodge a claim with the arbitrator but later on initiate a dialogue for rehabilitation before the decision of the arbitrator is implemented19. We may quote here the example of Repsol who in the similar situation have filed a claim against the State Ecuador for settlement of disputes over the revenues generated from the sale of oil. Subsequently the officials stroke a deal with government and got extension for another term with fringe benefits. In another example we may refer the case of a US based company called City Oriente who settled the disputes outside the purview of the arbitrator20. Besides above mentioned countries, in the states of USSR where host governments realize that they are getting fewer revenues than expected from ongoing projects. The cost overrun which attributes delay in projects has compelled the interested party to re-negotiate the terms to continue their contract for another period of time21. Methods for Obtaining Host Government Agreement Countries having small reserves or highly exploration risk usually agrees on lower share of revenues. In this respect we have the examples of Nigeria who contributes 3% of world oil reserve gets 81% profits thereon and Argentina gets 44% profits merely on 0.3% of their oil reserve of world oil. No doubt, the skill of negotiators in determining the right profits always plays a vital role. The threatening attitudes of the companies to wind up and shift their business somewhere else create deterrence for the host countries to bargain. The concerned ministry in the United Kingdom always stress upon favourable tax collection to meet budgetary allocations22. The United Kingdom has always been a favourable country as far as investment in oil and gas sector is concerned for two consecutive years (1997 and 1998). That credit goes to liberal government policies. Renowned world class economists Mr. Ian Rutledge and Mr. Philip Wright of Sheffield University are of the view that due to supportive and consistent policy of the government, the profitability has registered twice as high as in other profitability sectors23. The current turmoil of Iraq due to its political instability and security concerns negatively impacted on a deal with offshore oil companies. Had the country political stability and controlled law and order situation, the situation would have been different if that is today. This has deprived Iraq from earning hefty profits against the backdrop of its vast oil reserve and low cost of production24. Moreover, once a deal is inked, its terms and conditions are fixed till expiration of the contract or lease agreement. The political and law and order situation in the country makes the deal ideal for the country. But in Iraq’s case it is the other way round. The investors have exploited the situation and stroke the deal for a longer period of time for potential gains. From the above facts, it is very much clear that oil companies shown their eagerness to get complete control over the oil and gas assets of Iraq. As per a survey report, Iraq rated third in the world ranking of 147 countries as favourable country for investment in the cited sectors25. Types of Exploration Agreements Concession The insertion of “stabilization clauses” in the exploration contract or in the lease agreement address changes in the law of the land during the course of contractual period. Stabilization clauses are those clauses which protects the interest of the investors. In other words and in view the prospective investors, the same is an effective toll of risk mitigation as well as to safeguard the interest of the investors. The mentioned clauses are also taken care of environmental and social issues to promote healthy trade and business26. In emerging economies stabilization clauses ensure smooth sails. It creates favourable investment climate. This of course brings more investment in the country for the betterment and well being of its people. This will provide ample opportunities for the solid investors to come forward and play its due role to strengthen the working relationship between the stakeholders of either side27. Risk Service Contract A thorough study of the case indicates three broad clauses that are to be inserted to protect the investment: a) “Freezing clauses” with respect to the investment project that span till completion of the project b) “Economic equilibrium clauses” binds the investor to comply with the newly introduced laws c) investor be compensated in the form of adjusted tariffs, concessions, tax reductions, monetary compensation etc. However, exemptions were not specifically identified in the contract. d) “Hybrid clauses” ensure that the state will restore the previous status of the investor where he / she / entity prior to promulgated changes in the laws and regulations / exemption from new laws as mentioned in the contract28. Production Sharing Contract The recent seminars and conference organized by the officials of the European States witnessed harsh comments from the participants of the affected oil and gas companies complaining unjustifiable attitude and unfair treatment they received from the concerned incumbents of the host state. There shouldn’t be an issue if oil and gas companies should allow fair share of production income to the host countries keeping in mind the windfall profit that they earn from increased oil price29. Initially upstream contracts / lease agreement issued for a longer period of time that usually span for a period of 50 years whereas the production sharing agreement lasts from 25 years to 40 years. Such type of agreement has witnessed basic changes once during the tenure of contract / lease30. Issues Surrounding Petroleum Agreements At present, Oil and Gas Industry on the global level encounter a number of issues in terms of rights and obligations. The importance may have the different direction in line with the interests of the different stakeholders. For example a private oil company may have another priority and the national oil company may have different priorities as far as producing, consuming, and exporting of oil and its associated products are concerned. The issues engulfed with the partners of this business off and on and discussed in the appropriate forums are: a) relationship between host countries and the offshore oil companies (b) dominating forces of oil price regime31. The status quo of already established contracts face new dimension when the host country enter into the phase of changing political reality and the economic needs. At this time the new incumbents invite the top brass of the company to re-negotiate the contract since in their view the previous one is not beneficial for the country. Most of the companies start re-negotiation to carry out their business. Few of them reluctant to accept the change, making hue and cry and later on finds no other option but to come to the terms of the host state or to leave the country for another green pasture32. According to prominent American Lawyer Mr. George Kahale, referring matter under the “Pacta Principle” does not bear fruit under the circumstances where oil prices are increasing high day by day or on fortnight basis. The oil companies are compelled to come to the negotiating table under the changed scenario despite the facts that the contract was inked for a longer period of time say 20, 25, 30 or 40 years. The host country does not afford to bear the opportunity loss against the back drop of sharp increase in oil prices which have direct bearings on the economy of their country. Under the mentioned circumstances it is unacceptable for the host country to carry on their business on the same terms and conditions agreed upon years back with the oil exploration companies33. The former interior US secretary very rightly pointed out that “Just as your shareholders expect you to get a fair return on your investments, the American people are asking the same of us as we manage their resources.” The fair exchange of returns merits consideration to re-negotiate the terms that exists to run the business by oil and gas companies in the host countries. We are of the view that the oil and gas companies around the globe should respect the thoughts of the said American secretary to take care of the interest of their share holders but for the citizens of the host countries as well34. We cannot ignore the volatility of oil price. During 70s when Arabs put an embargo on the exploration and exporting oil, the oil priced jumps out to the new height. The 80s witnessed increase in oil production by the Saudi Arabia thus reducing the oil price to 18 USD a barrel which lasted up to subsequent decade. In the year 2004 the oil price suddenly registered to the extent of 40 USD a barrel. This trend continued for the next four years and subsequently fixed 100 USD per barrel35. In the year 2008 it reached up to 150 USD a barrel. The above changes in oil prices forced the oil companies to re-negotiate the terms and conditions accordingly36. Thirdly we cannot undermine the importance of oil producing countries. A slight mistake of the host countries in devising / drafting oil policies and negotiating the terms with the oil exploration companies shall have the irreversible impact on their economy. Therefore, they should be mindful of their responsibilities. Fourthly, the off and on restructuring for adjustment attributes to volatile oil price in the world market. We have witnessed that soon after the dismemberment of USSR, the private ownership found their way to explore natural resources. At that time, many agreements executed, were not favourable to the point of view of host countries. The host states found no other option but to accept it as reality keeping in mind the political and economical situation of the country37. Last but not lease many of the contracts executed between the foreign oil companies and the beneficial countries faced the hurdles in exercising their rights due to changed political / economical situation that has raised serious legal issues. In some countries, political parties have felt it compromising to the sovereignty of the country as far as the operational control of the national assets by the offshore oil companies and their influence in the country’s affairs. This has discouraged public private partnership in a country where similar doubts come to surface. This sort of attitude though valid, deprives the country from foreign investments38. Case Studies To handle the unforeseen and unpredictable situation many oil producing countries which includes Algeria, Bolivia, Canada, China, Ecuador, Kazakhstan and Venezuela have taken remedial measures in this regard. The mentioned countries imposed new taxes / royalties on production, exports and windfall profits. Bolivia and Venezuela sought mandate for structural changes in the existing contracts when need be. Canada the other day raised 20 percent in oil and gas royalties on its production39. In the year 2007 the US government submitted a detailed report to the Congress to seek permission for a raise in the share of government out of the thriving income of the oil companies during yester years. The incumbents could not defend the government stance in front of Congress for petty returns to the government exchequer against the hefty income they generated from oil40. Conclusion There are so many oil and gas producing countries where after taking necessary risk mitigating measures, made oil and exploration business profitable in terms of fair share of returns. The risk protecting measures were: a) “Freezing clauses” with respect to the investment project that span till completion of the project b) “Economic equilibrium clauses” binds the investor to comply with the newly introduced laws c) investor be compensated by the state in the form of adjusted tariffs, concessions, tax reductions, monetary compensation etc. However, exemptions were not specifically identified in the executed contract. d) “Hybrid clauses” ensure that the state will restore the previous status of the investor where entity was prior to promulgated changes in the laws and regulations / exemption from new laws. From a thorough review of the cited contents of the topic, it reveals that the success attributes to the factors: a) environment that makes working relationship of both the stake holders stronger and stronger with the passage of time b) Legal and structural changes should not hamper the interest of the host state and the investors since unrealistic off and on changes in the contract / lease agreements may divert the investment to other business friendly state. There are many advantages and disadvantages of oil and gas contracts and agreements between different parties as countries show interest towards dealing in oil and gas because of their profitability. Host countries, which are rich in the wealth of oil and gas and the investors, both are involved in forming a contract or agreement. These contracts are beneficial when they fall in interest of both the parties. An analysis of the contracts and agreements done in this paper in terms of finding advantages and disadvantages of service contracts and production sharing contracts indicate that risk analysis and management of resources are crucial for the success of any contract or agreement. Bibliography Awambu, Anozie I 2008, Unitization Of Contract Areas: Is it an Obligation Defeating the Stability of International Petroleum Agreements?, University of Dundee, pp. 1-18, viewed 27 Dec 2011, Bunter, Michael A. G 2002, The Promotion and Licensing of Petroleum Prospective Acreage, Kulwer Law International, London, pp. 255-284. Cameron, P 2010, International Energy Investment Law: The Pursuit of Stability, Oxford University Press, London. pp. 72-89. Cotula, L 2008, ‘Regulatory Takings, Stabilization clauses and sustainable development’, Global forum VII on international investment, pp. 1-18, viewed 28 Dec 2011, David, Martyn 1996, Upstream Oil and Gas Agreements, Sweet & Maxwell Publishers, London. Eljuri, E 2008, ‘Venezuela's Exercise of Sovereignty over the Hydrocarbon Industry and Preventive Protections to be considered by Investors’, Transnational Dispute Management Journal, Volume 5, issue 2, viewed 28 Dec 2011, Farhan, M 2008, ‘Production Sharing Contract: A Comparison with Concessionary System from the Political, Financial and Functional Point of View’, Energy Law Journal, viewed 27 Dec 2011, Kahale, G 2010, ‘The Uproar Surrounding Petroleum Contract Renegotiations’, Oxford Institute of Energy Studies: Oxford Energy Forum, viewed 28 Dec 2011, Mackenzie, Wood and CEPMLP 2008, Contract and Fiscal stability: Rhetoric and Reality, University of Dundee: Center for Energy, Petroleum and Mineral Law and Policy, pp. 1-12, viewed 28 Dec 2011, Muttitt, Greg 2005, Production Sharing Agreements: Oil Privatisation by another name?, General Union of Oil Employees’ Conference on Privatisation Basrah, pp. 1-16, viewed 27 Dec 2011, Otillar, Steven P & Sonnier, James C 2010, ‘OGEL Special Issue: "Host Government Contracts in the Upstream Oil and Gas Sector"’, Oil, Gas & Energy Law Intelligence Journal, Volume 4, viewed 28 Dec 2011, < http://www.ogel.org/article.asp?key=3047> Petroleum Online 2011, Overview, IHRDC: e-learning solutions, viewed 27 Dec 2011, Shemberg, Andrea 2008, Stabilization Clauses and Human Rights: A research project conducted for IFC and the United Nations Special Representative to the Secretary General on Business and Human Rights, International Finance Group, pp. i-xv, 1-43, viewed 28 Dec 2011, Tienhaara, Kyla 2011, ‘Foreign investment contracts in the oil & gas sector: A survey of environmentally relevant clauses’, Investment Treaty News, viewed 27 Dec 2011, Read More