How Did We Get Here?

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Natural endowments (resources), if adequately developed and harnessed, can propel any nation, whether developing or developed, to a steady and sustained economic growth with positive effects on those below the poverty line. In some countries, natural resources are the only means of hoisting citizens above the poverty margin. Anticipated revenues along with all the associated benefits of natural resources (oil and gas) are rarely seen or felt amongst the suffering masses if the necessary precautions are not established from the beginning.

Typically, the first step toward addressing this quagmire is for the host government to decide on how the resources will be managed and then work along the line of developing different agreements which will support the overarching national objectives. Radon (2011) suggested three ways in which governments around the world can develop their oil and gas resources. One way is to create state-owned national oil companies (NOCs) to exclusively conduct exploration and production as in the case with Saudi Arabia, Mexico, Venezuela, Iran, and Oman. Additionally, governments can offer the entire exploration and production of the country oil and gas resources to private investors or international oil companies (IOCs) without participating in the major commercial decision as being practiced in the United States, United Kingdom, Russia, and Canada. Alternatively, the government can combine the two approaches by establishing NOCs and inviting IOCs as in Indonesia, Nigeria, Ghana, Azerbaijan, Kazakhstan and even Liberia.

Understandably, the Government of Liberia decided to choose Option-3 by establishing NOCAL through an act of the National Legislature in 2000 and offering its offshore blocks for bid, an approach which has attracted many IOCs including two of the world’s super-majors- Exxon and Chevron. (To note quickly, Exxon is the world’s biggest non-state owned oil and gas (energy) company). Following its decision on the sector governance structure, the next step was to create a regime for managing oil and gas endowments. Consequentially, a contractual agreement is reflective within all the options aforementioned. The need for license/contract is critical to the country's objective because 1) it protects the country's interest and ensures that both parties understand their responsibilities; 2) it maximizes and secures benefits accruing to the state; 3) it allows the government to control and exercise oversight of IOCs activities and; 4) it protects the interest of both parties. Overall, oil and gas license/contract has a common goal: to share profit (rent) and adequately treat cost.

Petroleum Regimes (Contracts/Agreements)

Despite the enormous revenue generating potential for private investors and the state, exploring and producing oil and gas is physically onerous, economically expensive and technologically complex with grave uncertainty and higher risks. During negotiations of any oil and gas contract, uncertainty factors can significantly drive most of the key decisions that are agreed upon. These factors, including uncontrolled oil price gyration, probability of hydrocarbon presence, quantity and quality of potential hydrocarbon, etc can trigger the result of an oil contract irrespective of the regime that is adopted.

Globally, petroleum operations are managed under four major types of contractual agreements (regimes). While other countries may change the name of their regime, conceptually, it is still an embodiment of one of the four systems discussed in this paper.

  1. Concession Agreement/ Royalty Tax System

Concession agreements/royalty tax system in the oil and gas industry can better be understood when relating to a Mineral Development Agreement (MDA) within the mining sector as well as other natural resource extraction sector. Typically, government grants the IOC the exclusive right to explore for, develop, produce, transport and market the petroleum resource at its (IOC) own risk and expense within a fixed area for a specific amount of time. When commercially viable oil/gas is discovered, the regulator takes the stipulated fixed amount (royalty) from the gross that is produced. The rest belongs to the operator (IOC). The system was introduced in the early 1900s as one-sided contracts when many of the resource-rich nations of today were dependencies, colonies, or protectorates of other states or empires.

Under the modern Royalty Tax System, title to oil only transfers to the IOC at the wellhead. At this point, the IOC takes title to gross production minus royalty. The state also has a more direct involvement and control over operations through state participation, bonus payments, local taxes, import, etc. Royalty can be paid in kind (royalty oil), unless of course the state has agreed to be paid royalty in cash. Companies compete by offering bids, often coupled with signing bonuses, for the license to such rights. This system is used in Kuwait, Sudan, Angola, and Ecuador.

  1. Production Sharing Contracts (PSC)

Conceptually, PSC is a system where host government ownership of the natural resources rests in the state but at the same time permits IOC to manage and operate the development of the oil field at their (IOCs) own financial risk. It is similar, in concept, to Petroleum Sharing Agreement (PSA). However, PSC is mostly one-sidedly outlined and stipulated based on a contract template with terms generally applicable uniformly for all blocks. PSA, meanwhile, is typically based on negotiable terms and conditions (profit split, incentives, accounting rules, etc) agreed by the investor and the host government, to the extent that each PSA could be unique even within the same country. In most cases, the host government has the cost of its initial contribution “carried” by the other companies. This carried cost will be repaid to the companies from the host government’s future profits under the PSC.

The financial costs, up till production, of the investor (IOCs), are recovered (cost recoverable) based on agreed percentage and spread-out over the lifetime of the producing field. This cost (known as cost oil) is deducted from the gross production. The remaining portion (known as profit oil) is split between the government and IOC based on daily production profiles of the field. The higher the daily production, the higher government share of the profit oil; correspondingly, the lower the production of the field, the higher the IOC share of profit oil. PSC was first used in 1966 in Indonesia and is now applied in Azerbaijan and Central Asia.

  1.  Service Agreements

Under Service Agreement, government hires an IOC (contractor) to carry on drilling operations for the country to ensure strong control over resources. The IOC's risk is rewarded, if successful production is obtained, by reimbursement of its costs by means of a discounted price for petroleum that it was entitled to purchase from the oil/gas, up to a given percentage of the total production. While this is mainly workable in already oil and gas producing countries, a host government must have the requisite technological know-how and access to capital in order to yield the required economic dividends.  Three main types of service contracts exist: the risk service contract, the pure service contract and the technical assistance contract. Nigeria's National Petroleum Corporation (NNPC) has applied this system in Nigeria and it is also used in Iraq.

  1. Joint Venture (JV)

There is no commonly accepted definition or meaning for a JV. It simply implies that two or more parties wish to pursue a joint undertaking in some still to be clarified form. JVs require painstaking negotiations over an extended period of time to ensure that all matters are thoughtfully addressed and that the parties agree on how to work with each other. Based on risk sharing decisions, JVs could be classified as pure JVs, typical JVs, full carried JV, or former Soviet Union type JV. Frontier countries or developing states are strongly advised against JVs. For example NNPC favored this format until it could no longer meet its share of the JV’s financial commitments. The system is practiced in North West Shelf (Australia) and Russia

Liberia PSC system

Liberia's system is generally considered as a PSC but conceptually, as described previously, it is difficult to say so. As a uniquely designed “hybrid” system, it clearly attempts to combine the royalty tax system (concession) and the PSC. Under the terms of agreement within the current Liberia’s “model PSC”, government benefits from both royalty and profit oil. Simply put, royalty is taken off the top of gross production. The remaining portion is treated as 100% allowing for cost oil to be extracted on the agreed percentage in the PSC. The Balance, after cost oil, is shared between the government and the operator as profit oil.  In addition to its share of the profit oil and royalty, the government receives, as part of the agreed terms, taxes, social contributions, other earmarked funds (like the renewable energy fund) and upfront payments such as signature bonuses. Most of the fundamental issues within the hybrid system were designed in compliance with the New Petroleum Law of Liberia (2002).

Under the hybrid PSC system, inherently, there are sticky issues which form the basis for a negotiation. These may include cost recovery rate, production sharing ratio, stability clauses, government equity, Liberia (citizens) participating interest, and work commitment (particularly well commitments).  Government's (negotiators) understanding of these critical issues can significantly lead to a better deal which can maximize government take and the overall revenue accruing to the state.

Urias Goll is an environmental economist with appreciable knowledge in petroleum operations. He can be reached through [email protected]

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