41957 No. 7 Petroleum Sector Briefing Note October 2007 Contracts for Petroleum Development - Part 1 In virtually every country around the world, petroleum resources in the ground are considered the property of the state. Whether and how the country's petroleum resources are developed, and how much revenue will flow to the government, depend on the nature of contracts signed between the government and the investor. This briefing note, the first in the series of three, describes basic features of petroleum contracts for exploration and production. The series focuses primarily on production sharing agreements, the type of contracts used in Cambodia, with a focus on fiscal terms. I n all countries except the United States, the gov way of regulations and individual contracts. A ernment owns petroleum resources under the sur petroleum law would typically state that petro- face (ground or sea). These resources can be ex- leum resources are the property of the state; tracted and converted into financial assets only once and establish the regime(s) under which petroleum areeventuallydepleted.Animportantobjectiveistomaxi- companies may be granted the right to conduct mize the revenue to the government that can be effec- petroleum operations; designate the state authori- tively utilized in the long run. Achieving this objective ties and agencies to administer the law, autho- depends on many factors, including the government's rize them to issue regulations, and negotiate and abilitytoattractqualifiedinvestors,thetimingofproduc- enter into contracts; and set out the basic rights tion, petroleum price movements, and the government's and obligations of petroleum companies, permit capacity to spend revenue productively. investment protection guarantees, and identify the main principles of the fiscal regime to which pe- Governments have considerable influence over when troleum companies are subject. More recently, and how fast to extract petroleum resources. The several petroleum laws have required that con- timing and pace of resource development in turn de- tracts, petroleum revenues, or both be made pub- pends, amongst others, on the legal, fiscal, and con- lic [1] to promote transparency and greater ac- tractual framework for the petroleum sector. Petro- countability. leum exploration and production carries high risks and is capital-intensive. That said, it can be extremely There are other laws governing various aspects of profitable if a sizable commercial discovery is made. the petroleum sector. They include general income The fiscal and contractual framework determines tax and custom laws; foreign investment laws; en- how risks and profits are shared between the gov- vironment protection laws; and laws governing the ernment and the investor. collection, management, use and reporting of state revenues. Providing taxation rules of the petroleum Overall Legal Framework sector in the general income tax law is considered good practice. In this way, tax rules are not prolif- Thepetroleumsectoristypicallygovernedbylaws,regu- erated in a number of sector-specific laws, which lations, and contracts. could potentially lead to inconsistencies. This ap- proach--consolidating all matters related to taxa- Petroleum laws, enacted by the legislature, set tion in the tax law, all matters related to environ- out basic principles and enable the executive ment in an environmental law, and so on--has many branch of the government to implement them by advantages. 2 Petroleum Sector Briefing Note October 2007 Petroleum regulations are issued by the govern- sible for all financing and technology required for pe- ment or the ministry in charge of the petroleum troleum operations and bears the risks. sector. They provide implementation details for the petroleum law, such as the organization and Differences between the Two Systems roles of the public authorities in the administration of the law and in the conduct of petroleum opera- A general consensus among industry analysts is that tions; rules for granting petroleum rights; rules on the choice between concessionary and production-shar- operational and technical matters; requirements ing systems is primarily politically motivated. PSAs can for submission of reports and accounts on petro- be viewed as giving governments greater control over leum operations; environment, health, and safety petroleum resources because title to petroleum is not standards; and such financial obligations as sur- transferred to the investor at the wellhead. However, face rental fees (which are fees paid annually in both cases, the investor conducts petroleum opera- based on the size of the area covered by the con- tions at its sole risk and expense, and if no commercial tract), other fees, and fines. discovery is made, the investor is not reimbursed by the government for any of the work undertaken. Im- Petroleum contracts between the state and the in- portantly, the same financial end-result can essentially vestor--which are the subject of this three-part se- be achieved for the government in either system in terms ries--are normally negotiated by the minister in of risk and revenue sharing. charge of the sector, under the supervision of an inter-ministerial committee, and executed by the The rest of this note focuses on PSAs for exploration minister on behalf of the state. and production, which are the type of contracts being signed by the Government of Cambodia. Two Types of Contractual Regimes Typical Content of Production Contracts can be classified into two regimes, conces- sionary and production sharing. SharingAgreements Concessionary systems Petroleum companies signing PSAs are referred to as contractors, and the area covered by the agreement Under a concessionary (or tax and royalty) system, the contract area. The contract area is not static but as in Thailand, the petroleum company obtains title to diminishes over time as technically-challenging or non- all of the oil and gas at the wellhead and pays royalties, producing portions are relinquished. Production shar- bonuses, and income and other taxes. ing agreements typically contain the following provi- sions. Production sharing The agreement states the duration of the explora- The first production sharing agreement was signed in tion and production periods. The exploration period 1966 in Indonesia. The agreement may be with one is divided in short phases, each having a minimum or more firms; if it is with several firms, one is desig- work program, in part to ensure that the contractor nated as the operator to conduct the operations. The does not tie up a prospective area without doing firms and the operator may change over the life of work for a prolonged period of time. The explora- the project as a result of transfers of interests. Pro- tion period is usually 5 to 10 years, and the produc- duction sharing agreements (PSAs) normally provide tion period 15 to 20 years for oil and 20 to 30 years for the sharing of production rather than profits. The for gas, with further extensions permitted under state, which owns all petroleum, transfers title to a certain circumstances. portion of the extracted oil and gas to the contractor at an agreed delivery point. Normally, the equipment Successive relinquishments of portions of the con- used in the petroleum operations by the contractor tract area are commonly required at the end of each becomes the property of the state once its cost has phase of the exploration period. For example, the been recovered, except leased equipment or that pro- exploration period may consist of three phases of 2 vided by service companies. The contractor is respon- to 4 years each, and the contractor may be required October 2007 Petroleum Sector Briefing Note 3 to relinquish a percentage, often around 25 per- the contractors are required, on a pro rata basis, to cent, of the contract area at the end of each phase. supply oil or gas to the state at a mutually accepted Payment of surface rental fees, based on the num- price (often the fair market value), if the state's ber of square meters of the contract area, gives an share of production is not sufficient to meet do- incentive for relinquishment. mestic demand. The rights and obligations of the contractor are Model Contracts stated. The obligations include minimum explora- tion commitments (such as the minimal number of Model contracts give prospective investors a good idea exploration wells to be drilled), conducting the op- of what to expect. They foster transparency and help erations in accordance with best international prac- ensure equal treatment of potential investors. They can tices with due regard to safety and the protection be attached as exhibits to petroleum regulations, or is- of the environment, annual submission of work pro- sued in connection with licensing rounds. Timor Leste grams and budgets to the government for approval, attaches a model production sharing contract to the keeping the authorities regularly informed of the Petroleum Act (a draft of which was circulated earlier results of the operations, recruiting and training lo- for public consultation [2]), and Trinidad and Tobago cal personnel, and giving preference to local goods posts a model production sharing contract on the offi- and services. In return, the contractors are typi- cial website of the Ministry of Energy and Energy In- cally given the right to conduct petroleum opera- dustries [3]. tions in the contract area on an exclusive basis (meaning that other parties cannot be conducting Model contracts are, as the name implies, models only operations); in case of commercial discovery, pro- and should provide scope for variation. It is good prac- duce petroleum and export their share of produc- tice to limit the number of negotiable clauses in model tion over the exploitation period; import goods contract for transparency and administrative efficiency. needed for petroleum operations (often within the In licensing rounds prospective investors are typically limits of local content obligations); retain abroad, asked to bid on the basis of the model contract, subject and pay foreign subcontractors with, foreign cur- to one or more open parameters. The greater the num- rency, and purchase and sell local currency; and, ber of bidding parameters, the more difficult it is for the under specified circumstances, assign or transfer host government to compare bids. Algeria issues ten- the rights under the agreement to third parties. ders based on a single bid parameter: (1) the signature bonus, (2) the royalty rate above the minimum speci- The agreement stipulates how petroleum is to be fied in the petroleum law, or (3) work commitments. If valued, how the contractor may recover costs the bid parameter is the work program, there is a scor- out of their share of the production, how the ing system assigning a number to each work commit- remainder of production is to be shared, tax ment, enabling conversion of each bid into a single num- obligations of the contractor, and when and for ber. Bidding policies do and should differ to reflect dif- which payment streams fiscal stability might be ferent technical, economic, and market circumstances. granted. Fiscal stability guarantees the investor Whatever the policy, transparency and objectivity of that, even if the country's tax and other fiscal sys- the evaluation criteria is important for attracting quali- tems are changed in the course of the project, the fied investors. original terms in the PSA will continue to apply. This is an important consideration in the upstream Assessing Revenue Flows petroleum sector where upfront capital invest- ments can be very large and the duration of There are two revenue considerations for the projects long. government¾the size of the overall revenue and the timing of the revenue collection over the life of any Other provisions include specific clauses for natu- given petroleum contract. The size of the overall rev- ral gas, dispute resolution, and confidentiality/trans- enue depends on the price of petroleum, the amount parency provisions. The PSA may also provide for produced, and the fiscal parameters. In addition to the state participation in the project. Finally, the PSA total government revenue, the timing of revenue col- may contain a domestic supply obligation whereby lection matters. 4 Petroleum Sector Briefing Note October 2007 Consider an oil field with total economically recover- Another reason the timing matters is that, to the ex- able reserves of 100 million barrels. The oil field may tent possible, it would be in the interest of the govern- contain a total of 350 million barrels, but some of the ment to smooth petroleum revenues over time because remaining 250 million barrels may not be either techni- smooth revenue flows make government budget plan- cally or economically recoverable at the current stan- ning and expenditure easier. In practice, annual pe- dards of the oil industry.1 Suppose the price of extract- troleum revenues fluctuate because of oil price vola- able oil averages US$45 a barrel over the life of the tility, changes in annual oil production which rises rap- field. One hundred million barrels will fetch US$4.5 bil- idly as production begins and then levels off as the lion. Some of this money will be used to recover the field goes into decline, and, to a limited degree the costs of exploration and production, some will be re- way the fiscal system is set up. A government does tained by the investor as profits, and the rest will flow not have much control over world oil prices (with the to the state. exception of very large oil producers and cartels) or the field's production profile, but it has some control The fiscal system determines both how much of the over the fiscal system. US$4.5 billion the government will capture and the tim- ing of the revenue flow. Focusing on the latter, some All other things being equal, regressive fiscal systems fiscal terms are designed to provide early revenue to tend to smooth revenues more than progressive ones. the government, in some cases as early as at the time That said, regressive fiscal terms deter investment, dis- of contract effectiveness. At the opposite end of the courage development of marginal fields, and could lead spectrum are those fiscal terms designed to give incen- to early abandonment of producing fields. Setting high tives to investors to explore and produce oil in times of tax and other rates have a similar effect. Governments both high and low world oil prices, and in both low-cost, need to weigh these trade-offs in setting fiscal and highly prospective fields and high-cost, marginal fields. contractual terms. These terms may not provide as much early revenue. Fiscal terms that provide increasing rates of revenue to Briefing note no. 8 will review the terms used in produc- the government with increasing net-of-cost income are tion sharing agreements that define what contractors called progressive; those in which the rates become must pay. Briefing note no. 9 will provide the results of lower are called regressive. simulations of different fiscal regimes to assess how dif- ferent terms affect government revenue flow. The timing of revenue collection matters for several reasons. One is the time value of money. Simply put, References a dollar in hands today is worth more than a dollar five years from now. This is because the dollar in hands [1]WorldBank.2007."CountryExperiencewithEITI­ can be deposited in an interest-bearing bank account Part 1." Petroleum Sector Briefing Note No. 5, July. or invested elsewhere to earn a return. In addition, [2] Timor Leste Ministry of Natural Resources, Min- inflation erodes the value of that dollar over time. For erals & Energy Policy. "Model production sharing this reason, discounted cash flow analysis is commonly contract under the Petroleum Act." www.timor- conducted, whereby all future cash flows are estimated l e s t e . g o v. t l / e m r d / P S C % 2 0 m o d e l % 2 0 and discounted. The discount rate is generally the 270805.pdf. appropriate cost of capital plus a risk factor, and calls [3] Trinidad and Tobago Ministry of Energy & En- for judgments of the uncertainty (degree of risk) of ergy Industries. 2000. "Model production sharing the future cash flows. Location-specific uncertainties contract, 2nd version." www.energy.gov.tt/ include those regarding the size of economically re- applicationloader.asp?app=doc_lib_details&id=135. coverable reserves; stability, clarity, and transparency of regulatory and fiscal frameworks; administrative For more information contact: efficiency of regulatory implementation and enforce- Mr. Bun Veasna ment; and the government's commitment to the sanc- Infrastructure Officer Email: vbun@worldbank.org or tity of contracts. The higher the perceived level of Masami Kojima risk, the higher the discount rate applied and the lower Lead Energy Specialist the amounts contractors would be willing to pay to the Email: mkojima@worldbank.org government. 1Oil is not technically recoverable if, given today's technology, it is very difficult or virtually impossible to get the oil out of the ground; oil is not economically recoverable if it is too expensive to extract, although the technology to do so may exist.