Production Sharing Contracts
The first production sharing contracts (PSC) were signed in 1967 with Indonesia. The two parties to the PSC are the NOC and the IOCs, referred to as the “Contractor”. Unlike tax/royalty systems, PSCs (in some countries also known as Production Sharing Agreements (PSA) generally transfer title to the produced hydrocarbons at the export point (compared to at the wellhead in tax/royalty systems where the resource in the ground is owned by the state). PSCs typically differ from service contracts in that reimbursement to the IOC is in kind and the parties to the PSC own the rights to their share of the oil.
In general, PSCs divide gross production into what is frequently referred to as cost oil (oil or gas applied to reimburse costs; for simplicity here both are referred to as “oil”) and profit oil (that in excess of cost oil) with the contractor receiving its compensation from cost oil and a share of the remaining profit oil.
As is indicated by their name, PSCs are a contract, which includes provisions covering the way that matters will function operationally and financially including:
- Descriptions of the acreage conveyed in the PSC and the term (duration) of the agreement
- A lengthy set of definitions to such terms as “arm’s length sales” and “community and social programs”
- A schedule for relinquishment of the acreage. Over time, certain percentages of the acreage must be returned to the host government. These often correspond with terms of work commitments.
- Work obligations or minimum expenditures as a function of time (typically referred to as the work commitment). Participation with the host government. While all PSCs have the host government, typically through the NOC as a partner, some also allow the host government to participate as a working interest partner. In all cases the contractor group carries all of the exploration and appraisal costs to a certain point, typically the approval of the field development plan, where the state is also a working interest partner. It may pick up its pro-rata share of costs thereafter.
- Definition of discovery and of commerciality. Many PSCs require the contractor group to declare a commercial discovery and submit a field development plan upon commerciality for government approval. A number of things are typically triggered at each of these events. The obligations for a non-commercial discovery are also described (typically surrendering the acreage associated with the non-commercial discovery no later than the end of the exploration period).
- Cost oil and profit oil splits. This fairly unique aspect of PSCs describes how the contractor group is compensated for its expenditures.
- A certain percentage of oil production is considered “cost oil” from which recoverable costs can be recouped by the contractor group. Most PSCs allow a wide range of costs to be recovered including personnel costs for studies. Modern PSCs may limit recoverable costs in a variety of ways. Generally “operating” costs are 100% recoverable immediately from available cost oil, although the amount of production dedicated to cost recovery may be limited to ensure that the host government always receives a share of what is being produced. By the time production commences, the contractor group will typically have spent a significant amount of capital in exploration, drilling, completion and equipment costs. These costs may have to be depreciated over time for cost recovery; in some cases an uplift is allowed in recognition of the delay (time value of money) incurred in cost recovery. In general though this acts very much like depreciation for corporate tax purposes.
- Cost oil in excess of that which is needed for cost recovery is referred to as ullage. It may be handled many different ways including having a specified split between the government and the contractor group (e.g. 90/10), going entirely to the host government or (more typically) being added to and split as part of the profit oil. When a PSC has a high portion of the oil allocated to cost recovery, the ullage may be a very significant portion of total revenue.
- Profit oil is the portion of hydrocarbons reserved to compensate the contractor group for taking risks and succeeding. In many cases the percentage of the profit oil going to the contractor group is based on production rates (by quarter or by month). Alternatively, it may be a fixed split between the host government and the contractor group.
- As an alternative to modifying the profit oil split by production, it may be split according to a profitability concept. In some cases this may be Rate of Return, in others (and probably more common) it may be what is known as an R Factor. The specific definition of R Factor may vary between contracts but in general it is the ratio of cumulative revenue to cumulative costs. An R Factor of 1.0 is achieved when the operation pays out (on a cash basis, ignoring the time value of money).
- Taxes. Most PSCs specify that the contractor group is subject to all local taxes. In some cases, the PSC states that all taxes (and specifically corporate income taxes and any other production related taxes) are to be paid for by the host government entity and not the contractor group. If any petroleum income taxes or other taxes are deemed payable by the contractor group they are typically spelled out in the PSC.
- Rights and obligations. Most (if not all) PSC’s grant the right to freely export contractor’s share of petroleum and retain abroad proceeds from the sale of hydrocarbons. However, some PSCs restrict the amounts of local and foreign currencies to be used or expatriated. Many waive or limit import duties.
- Some PSCs may also have an obligation to sell a portion of hydrocarbons to the local market, which typically means at a price lower than that attainable in export markets. The impact of this may be factored into the profit oil equation.
- Bonuses, royalties and other payments. Most PSCs require specific bonus payments initially and at certain time or production hurdles. While some PSCs have no royalty provisions, many have a basic royalty in order to ensure a certain level of cash flow to the host government. Most require some form of investment in scholarship or educational programs annually, typically increasing once production is achieved. While host governments prefer to have the contractor group simply write a check and allow ministerial control over such funds, oil companies need to exercise caution in this area. It is generally preferable to take an active role in education and scholarships to avoid any potential for corruption, although some government view this as interfering in local affairs. Payments for social programs in the country similar to scholarship and educational programs are also typical. Acreage rentals for exploratory areas are also typical as are development and production rentals. In general, bonus payments and royalties are not recoverable from cost oil.
- Most PSCs have extensive local content provisions requiring hiring and training of nationals as well as commitments to utilize certain national companies and partnerships for a significant portion of the total expenditures.
- PSCs will also contain extensive legal discussions around dispute resolution, termination of the agreement, governing law, marketing, force majeure, etc.
- A key area is also contract stability and dispute resolution. Contract stability is something that seeks to protect the IOC from another government changing terms at a later date. While emerging markets are very important to IOCs, these are controversial and can be very difficult to write. Nations such as those in North America and the North Sea would not accept the limitation on sovereign rights, for example. Dispute resolution increasing includes arbitration clauses. Even if the contract is written under the law of the host country, they may agree to disputes being heard by one of the international arbitration bureau in a neutral location.