POG220 Legal Aspects Of The Oil And Gas Industry

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POG220 Legal Aspects Of The Oil And Gas Industry

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POG220 Legal Aspects Of The Oil And Gas Industry

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Course Code: POG220
University: Greenwich School Of Management

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Country: United Kingdom

Question:

Discoveries of oil and gas generate much excitement and great effort is put into understanding technical, commercial and legal aspects of field development. In fact however the first challenges to governments are negotiation challenges.
Examine and evaluate the key areas and features that governments should focus on during their negotiation process and in the drafting of contracts with the International Oil Companies.

Demonstrate a good understanding of the substantive rules of international law applicable to the oil and gas industry
Evaluate the key principles of contract formation in international commercial transactions and key international law principles and trends in the oil and gas sector
Assess the effectiveness of international law in addressing the environmental impact of oil exploration and exploitation
Demonstrate a critical understanding of the importance of oil and gas law as a distinct subject, studied in a practical and commercial context.

Answer:

Introduction
The prospects of a hydrocarbon discovery tend to ignite the imagination of various national governments of the potential riches and development that could be attained similar to that witnessed in the Gulf countries.  Often it is assumed that there are geotechnical issues with regards to carry out exploration and development. However, for the developing countries typically the greatest challenge is to negotiate a successful contract with an International Oil Company (IOC). However, most of these oil companies have huge experience in negotiating contracts unlike the home governments (Salih and Salih, 2015). As a result, there are often a host of arguments regarding various aspects of negotiation of the contract. One of the key aspects in this regard is the contract from which primarily assumes four different forms namely PSC (Production Sharing Contract), Concessions, Joint Venture and Service contracts  (Radon,nd). The key objective of this essay is to critically analyse the different forms of contract between the home government and the IOC. Additionally, other significant clauses of these contracts such as stabilisation and unitisation would also be discussed in order to highlight the various facets of the same and there underlying utility in an oil contract.  
Production Sharing Contract (PSC)
In a PSC, the natural resource ownership continues with the state and the IOC tends to act as the operator of the given oil field. Most of the financial risks associated with exploration and development works are assumed by the IOC. Typically, the domestic government also needs to make some equity contribution to the project which is typically done by making the national oil company as a stakeholder in the project.  The national oil company tends to contribute equity by putting in the profit share derived from the venture.  In cases where the domestic government does not agree to put in any equity, in such cases, the profit sharing may be skewed in favour of the IOC (Machmud, 2000). In this contract, the IOC would first recoup all the costs which would include not only operating costs but also the capital expenditure carried out in developing the oil well and the requisite infrastructure.  The profit sharing tends to commence only when the operator has recouped all the costs spent during exploration and operations. The  fixing  of the profit sharing  between the  government and  IOC would  typically  depend on the respective bargaining  position  and  skills of the two parties (Radon, nd).
The main advantage of PSC for the host government is that a host of operational and financial risks are transferred to the private operator and thereby losses of the government are minimised to negotiation costs only.  Another advantage is that the government is able to derive a share in the profits and thus could reap the gains of oil price increase. Also, if the work is not carried out in accordance with the PSA, the host government can nullify the contract and cease the operations (Wäelde and Beredjick, 1988). For the operator, the main advantage would be profit sharing commences only after all the costs including the capital expenditure have been recovered. Besides, during the negotiation process, the IOC has the upper hand on account of immense experience in the past. Besides, with the government’s profit claims in the profit, the various clearance and regulatory nods are expedited which helps in avoiding delays (Blinn et. al., 2009).
With regards to disadvantage for the host government, there are significant costs attached with the negotiation of the PSA which tends to be quite complex in actuality.  It places the government in a conflict of interest as on one hand it should aim to maximise oil production for deriving profits but on the other it needs to consider the environmental implications of the extraction process.  Also, there is the potential of the operator overstating the costs so as to delay the profit sharing as firstly the cost would be recovered  (Radon, nd). Thus, incremental monitoring and audit related cost have to be incurred by the domestic government.  The major disadvantage with regards to the IOC operator is that the initial costs and risk is borne primarily by the operator only. The risk associated with exploration typically increases as the limited data available regarding the well might have limited accuracy (Cotula, 2010).
Concessions or Licenses
In this, a license or concession Is required by the operator to be obtained from the home government. These are typically long term and provide the IOC with the exclusive right to explore, develop, operate and market the oil extracted from a given block. A pre-fixed license fee is paid to the government on every unit of oil extracted irrespective of the profits or the losses that the operator might make in the process.  Additionally an initial licence fee coupled with signing bonus is extended to the government. Competitive bidding   is deployed to shortlist the interested bidders who afterwards are invited for negotiations before the license is offered (Wäelde and Beredjick, 1988).
One of the advantages for the host government is that these contracts are simple in comparison to PSC and joint venture agreements.  Also, the amount of professional support required is less and hence this was followed before more sophisticated models such as PSC emerged. Also, the host government does not assume any risk while being assured of initial payments coupled with a fixed royalty payment irrespective of the prevailing prices. For the IOC, the main advantage is that the upside is potentially unlimited as only royalties need to be paid to the government. Secondly, the contracts are typically long term and thus ensure that their initial investments are recouped (Blinn et.al., 2009).
One of the key disadvantages of this method both from the perspective of the government and IOC is lack of authentic knowledge with regards to the potential of a given block and hence it may be possible that even after granting a license, no production is achieved. In this situation, financial losses are suffered by the IOC besides loss of royalty for the government. Another disadvantage for the government is that even though the licensee may earn huge profits on account of increase in price but the same would not be shared by the government. The downside for IOC is assumption of financial, operational and political risk related with exploration of the given block (Radon, nd).
Joint Ventures or Partnerships
There is a lack of a specific definition of Joint Ventures (JVs) as a result which the usage of this contract mechanism is rather limited perhaps with the exception of potentially Nigeria.  As the name suggests, in this contractual relationship both the state (usually represented by the national oil company) and the IOC tend to forge a JV and jointly are responsible for the exploration and development of the oil block  (Cotula, 2010). Due to joint execution, a host of issues tend to crop up during execution which requires painstaking negotiation to reach a common ground. Further, unlike other contracts discussed thus far, this requires the state to make significant equity into the project and thereby assume a proportional project risk also. The extent of risk sharing typically depends on the type of JV as indicated below (Radon, nd).

One of the plausible advantages for the host government is that it has an expert partner in the form of IOC in order to make relevant decision making. Also, this allows for better profit sharing for the government but then losses would also have to be borne by the government. For the IOC, there is decreased financial and operational risk as there is another stakeholder in the form of state which would take measures for smooth project completion (Blinn et.al., 2009).
The main disadvantage from the perspective of host government is in the form of long and torturous negotiations involved at execution of project. This would also be a disadvantage for the IOC as JV tends to impede the independence they have with regards to taking key decisions in a prompt manner  (Wäelde and Beredjick, 1988). Also, in this contractual form, significant investment would be required to be done on behalf of the government and also there is possibility of the government suffering losses on account of the project. Hence, it is a riskier proposition for the host government in comparison to other contractual forms but results in higher gains. The situation is the opposite for the IOC as risks assumed are lower but so are the returns (Salih and Salih, 2005).
Service Contracts
In a bid to ensure that sovereignty over national asset remains safeguarded, some countries are now moving from PSC to service contracts whereby the IOC are essentially appointed as contractors that are required to bring their technological expertise along with the initial investment required to develop the block. However, unlike PSA where there is a profit sharing, in case of service contracts a fixed pre-determined return is offered on the investments made by the IOC. Also, in these contracts, the ownership of the field along with any oil drilled is with the host government and not with the IOC (Cotula, 2010). A comparison with the PSC in terms of risk assumption by concerned parties is indicated below (Blinn et.al., 2009).

The advantage for the host government is that initial investments are limited and also the asset sovereignty is maintained coupled with that of oil extracted from the block. Besides, only a predetermined return is given while remaining proceeds are profits for the government. For the IOC, it offers protection from the fluctuation in oil prices. Also, their risk is reduced as they are required to function as the contractor responsible for operations and thus risk is minimised (Cotula, 2010).  The key disadvantage for the host government is the higher risk in the execution phase and also a lower economic efficiency as the IOC may not have incentives to enhance production from the block. For the IOC, the key disadvantage is that upside is capped and limited since role reduced to contractor and also required large initial investment (Machmud, 2000).
Additional Clauses
There are certain clauses that are critical to the success of the above contractual relationships and are outlined below.
Stabilisation Clause
Stabilisation clauses refer to the certain clauses in the private contract which are meant to safeguard the interest of the investor from the changes in laws of the host government during the contractual period. This is because some of these legal and financial changes may jeopardise or adversely impact the viability of the project. These tend to ensure the investors are protected from various sovereign risks which include actions such as obsolescence bargain, expropriation or nationalisation. Besides, these clauses also offer protection to IOC against stringent environmental and social laws that may be enacted during the contractual period. The host governments also favour putting these clauses as these indicate to the IOC that a favourable investment climate is being offered which minimises the legal and political risk going forward. Also, the inclusion of these clauses is critical from the perspective of lenders who view theses as a measure of the project being bankable or not. Thus, in absence of these clauses, the underlying risk would be very high and the banks may be unwilling to lend to the IOC for execution of the project (IFC, 2009).
Unitisation Clause
The unitisation clause tends to allow the lessee (the IOC) to take either a portion of the land or complete land provided by the lessor (host government) and combining or pooling the same with other lands in the neighbourhood for the formation of an appropriate drilling unit. This is required as typically the land requirement for conducting drilling operations is essentially huge and therefore the peripheral land would be required to carry out successful operations. Depending on the depth of the well dug, the land requirements would typically increase. While this clause is useful for the lessee or the IOC but it can be potentially abused specially when such clauses are utilised at a later stage when the lease is about the expire. Thus, suitable checks and balances are required so as to ensure that abuse of the same is minimised (Vessels, 2014).
Conclusion
Based on the above discussions of various contracts and existing oil prices, the service contracts seem to be a suitable mode for the execution of oil and gas projects. This is because with the oil prices expected to remain at their current prices with limited upside, the IOC would desire that host governments provide assured returns for investing into oil and gas projects. The other contracts would put a host of risk on the iOC, which it would not be willing to undertake especially when there is a oversupply in context of oil. Also, service contracts ensure that asset sovereignty tends to remain with the concerned government only and hence is beneficial for all the project stakeholders (Cotula, 2010).
References
Blinn, K. W., Duval, C., Le Leuch, H., Pertuzio, A., Weaver, J. L., Anderson, O. L., et al. 2009 International Petroleum Exploration and Exploitation Agreements: Legal, Economic and Policy Aspects, 2nd edn., New York: Barrows Company Inc.
Cotula, L. 2010 Investment Contracts and Sustainable Development; How to make contracts for fairer and more sustainable natural resource investment, 1st edn., London: International Institute for Environment and Development IIED.
IFC 2009 Stabilization Clauses and Human Rights, International Finance Corporation, [Online] Available  at  https://www.ifc.org/wps/wcm/connect/9feb5b00488555eab8c4fa6a6515bb18/Stabilization%2BPaper.pdf?MOD=AJPERES [Accessed  April  09,  2017]
Machmud, T. N. 2000 The Indonesian Production Sharing Contract: An Investor’s Perspective. 3rd edn, New York: Kluwer Law International.
Radon, J.  nd   The ABCs of Petroleum Contracts: License-Concession Agreements, Joint Ventures, and Production-sharing Agreements in S Tsalik & A Schiffrin (eds), Covering Oil: A Reporter’s Guide To Energy and Development, [Online] Available  at   https://pdfs.semanticscholar.org/6b7c/25c01416fae48c60005a4d19cec10f0a1080.pdf [Accessed  April  09,  2017]
Salih, M.S. and Salih, R.S. 2015, ‘Strategy of Oil Contract Negotiation’, International Journal of Business and Social Science,Vol.6 No.9, pp. 168-175
Vessels, E. 2014 Were the oil, gas lease unitization clauses fair?, Oil and Gas Magazine, [Online] Available  at   https://www.gasandoilmag.com/opinion/2014/02/05/were-the-oil-gas-lease-unitization-clauses-fair [Accessed  April  09,  2017]
Wäelde, T. W., and Beredjick, N. 1988 Petroleum Investment Policies In Development Countries. 2nd edn, London: Graham and Tortman Ltd, Sterling House.

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