Ring fencing is simply the level at which each fiscal or administrative component is to be calculated or administered. The level can be as low as the field/deployment area or up to the entire contract area; in some cases the entire region or country. While PSC fiscal components of cost oil, profit oil, royalties, taxes and bonuses can be ring fenced, the concept applies to other fiscal arrangements. It is common that more than one commercial field is discovered within one PSC area. Ring fencing allows the costs and production to be pooled along with certain exploration expenses. This removes some of the risk for the contractor group and encourages them to make additional expenditures. It can also act as a fiscal incentive to further activity (for example, if the host nation is taking 80% of profit oil, drilling a new exploration well means that the state is also paying 80% of the exploration costs). For this reason some countries are reluctant to allow such ring fencing as it may significantly reduce their revenue in the short term.
The key points related to booking of reserves for PSCs is that the terms of the PSCs both in letter and in spirit must be read carefully to accurately reflect what reserves can be booked by the contractor group. Typically reserves are booked by what is known as the Entitlement Method. This looks to the volume of barrels that an IOC can lift as a result of its financial entitlements under the PSC (cost oil plus profit oil). The dollar amount, calculated on a pre-tax basis, is equivalent to a certain barrel volume at prevailing world prices. This is the “entitlement” that is booked.
An unusual behavior of PSCs is the impact of product prices on the reported reserves by the contractor group. In tax/royalty schemes a decrease in product prices lowers the economic limit and decreases the reserves. This only has an impact in later life situations and is more significant for wells and fields with shallow decline rates. However, marginal, undeveloped reserves may not be economic, such as an expansion of a steamflood or additional undrilled well locations.
In PSCs, the lower hydrocarbon prices may actually increase reserves. While the value of profit oil reduces with reducing prices, cost oil remains constant (reflecting unrecovered costs, unrelated to price) and therefore more barrels are required to pay for the same cash entitlement. Assuming the development of the PUDs becomes marginal, the contractor group may be able to nonetheless drill them (with host government approval and modifications of contract terms) while getting (more barrels of) cost oil and corresponding profit oil to pay for the activity that would not have been undertaken in a tax/royalty scheme under comparable circumstances. Essentially, the host government subsidizes such development and may wish to do so to reach production rate, recovery and even employment objectives.
Service contracts primarily differ from PSCs based on the fact that reimbursement from service is typically in cash and the contractor group has no rights to the produced hydrocarbons. Service contracts can be pure service contracts in which there is (for example) a flat fee per barrel or a risk service contract in which the fee is tied to production or other measures of performance. Pure service contracts may or may not be operated in conjunction with purchase agreements for the produced crude oil, where such “back to back” lifting agreements exist and where the service contract has at-risk components the service contract may in fact be very similar to a PSC. In any event many of the concepts and clauses of a PSC may also be found in a risk service contract.
Hybrid agreements are possible incorporating any aspects of the various agreements; the major limitations to such agreements are governmental regulations and laws specifying how terms and provisions are to be applied. Reserve booking by the contractor group for service contracts may be more difficult than in other international fiscal regimes, but not always impossible and will typically follow the Entitlement Method described above.
PSC and service contract terms often leave production levels in the hands of the contractor group. When there is no ring fencing, the contractor group may be in a position in which it must limit investments in one discovery that would only recover its costs very slowly due to high operating expenses or declining production rates. Decisions towards the end of the agreement can be held hostage to extension discussions.
When successful fields are discovered and a contract has generous terms for cost recovery, the operator has relatively little incentive to minimize costs and may test complex and expensive technologies in fields where they may or may not be applicable. On the other hand, generous cost recovery terms encourage experimentation and taking of capital risks that may well benefit the host government.
When the host government participates as a working interest partner in development, the host government (or its NOC) will have to actually write checks for large amounts. In some cases the host government is very slow in making such payments and may owe large amounts of cash to the contractor group. This changes and complicates the dynamic between the host government, the NOC and the contractor group with respect to capital decisions, operating practices and contract extensions.