Production Sharing Agreements

Production Sharing Agreements

While the existence of oil is common in developing countries, these countries often lack the technical capacity, expertise, equipments and financial might to explore and produce the crude oil. As a result, a country may seek an international oil company (IOC) to do this on its behalf or to assist the host government (often through the national oil company (NOC) in achieving oil production. Accordingly, the industry has established a myriad of contractual arrangements to allow cost effective and efficient ways of risk and liabilities allocation amongst the contractual parties (Feng, Zhang & Gao, 2014). One of the many contractual arrangements for exploration and production of oil and gas is the product sharing agreement (PSA). Owing to the operational intricacy and the high risks associated with the oil and gas industry, the contractual parties must identify possible risks and obligate to aptly managing them throughout the contract’s lifespan.

Actually, in any contracts risks may be skewed to one party of the contract if not well managed and this may impact on the effectiveness of the contract (Marcel, 2006).  To address the risks it is therefore vital to explore the means that can be used by all the parties in a production sharing agreement to mitigate the risks. This paper thus explores the available ways that can be used to manage risks in the oil and gas industry with a particular focus on the PSA. The paper begins by giving a succinct definition of the PSA, putting it into content for this paper by briefly illustrating the risks that are likely in such kind of contracts. The paper proceeds discussing the different methods of managing the risks both for the host country (NOC) and the IOC. It then culminates in a conclusion that summarizes the overarching contents and gives any recommendations as to whether the currently used measures suffice or whether there is need for other risk management systems.

Production Sharing Agreement: Definition

Since its 1966 introduction in Indonesia, PSA has grown to be one of the most popular contracts between governments and foreign organizations in the oil and gas industry. Under the PSA arrangement, the country that owns the mineral resources, often represented by the NOC indulges an IOC as a contractor that provides financial and technical services for oil and gas exploration, development and production (IIED, 2012). The IOC gets a specifically stipulated share of the oil produced (cost oil) to cover the services rendered and the risks incurred. Nevertheless, the owning state remain the outright owner with the production after the cost oil is covered (profit oil) shared amongst the parties in the contract. The amount shared is often a result of in-depth negotiations and sometimes renegotiations between the NOC and the IOC although the most common ration is 80: 20, NOC: IOC respectively (Feng, Zhang & Gao, 2014).

In essence, thus, PSA recognizes that the oil resources belong to the government and thus must be controlled by the same entity. However, they also note that for growth and optimal production from the sites, there is need for expertise, experience and financial might which might lack within the government and for this welcomes foreign countries to help in the deficiencies. As a means of conflict mitigation and interest representation, the PSA may have a joint committee that oversees the exploration and production processes to ensure mutual transparency and accountability. In these types of contracts, risks take a centre stage with each party careful not to carry a great deal of loss. According to Wälde (2008) however, the weight of the risk often lies with the IOC whose success depends mainly on the success of exploration and production. IIED (2012), however, notes that while the risks may literally be on the IOC, the NOC is also a bear of a wide range of risks. These risks may include, among others, the quantity of resource on site, finding other viable fields, commercial feasibility, political instability, local law changes, required technology, the disenfranchising of the operating community and the condition of the resource as gas or oil. The following section discusses way of managing these risks between the two parties.

Risk Management

Risk management in the PSA is one central point of concern if the whole process has to be a success. according to Blinn et al (2009), risks are inevitable facets of any exploration and production process of oil and gas. To him, the risks even get escalated when the process has to be done in a contractual arrangement, introducing the complexity of multiple parties all interested in optimal profit gain. Have these in mind several ways of managing risks have been posited for both the NOC and the IOC. The first element of managing risks is risk allocation, followed by other legal and non legal risk management approaches.

Risk Allocation

Risk allocation is one of the most vital elements of risk management in an oil and gas exploration contract. Risk allocation is in most cases a legal approach accomplish by embedding clauses in the contract document that declare ones liability (or exemption) to a risk with specification of the extent. According to Ghandi and Lin (2014) risk allocation can take three approaches namely limitation of liability, exemption and indemnity.

Indemnity entails and arrangement where the indemnifying entity commits to paying the individual with the indemnity benefit in the unfortunate situation that the indemnified contractual party bears losses due to particular occurrences specified within the contract document. According to Pongsiri (2004) a contractual indemnity is   “an obligation to protect against or keep free from loss, to repay for what has been lost or damaged, to compensate for a loss” (434). 

The inclusion of an indemnity clause thus protects parties within the contract from losses associated with the operations of the contracts. Actually, Ghandi and Lin (2014) note that indemnity should be distinguished from exclusions. Actually, this distinction is best attained by the operation of contractual clause that refers to “hold harmless” and “indemnify” in their statements. In essence, if the clause works to build an exposure responsibility to a “third party” like insurance company, bank etc then it is an indemnity clause while if it creates an exposure responsibility to a party to the contract then it is an “exclusion clause.” These two insinuates two risk destination for risk allocation namely parties to the contract and a third party. Indemnity can either be unilateral (only one party can enjoy the indemnification) or mutual where both contractual parties are simultaneous beneficiaries of a possible indemnity and possible indemnifiers. According to Johnston (1994), the term “defend” is sometimes added to an indemnity clause to connote a possibility of litigation in a court of law on behalf of the beneficiary.

A liability exclusion clause is another way of risk allocation. This is used in absolving a party’s responsibility to losses resulting from identified risks. A category of losses/injuries is created by this contract clause that is not eligible for remediation by the party obligated to remedy the covered risk. Most common risks that are often excluded in a PSA include losses borne of gross negligence and willful conduct as well as consequential losses.  While an exclusion clause offers holistic absolution of the liability, a liability limitation clause just restrains then liability scope of the obliged. Most popular limitations include the proportionate limitation and the fixed amount limitation.

Legal/ Contractual risk Management means

While risk allocation often addresses a myriad of possible disputes as regards the management of risks still scholars have suggested the inclusion of some clauses within the legal documents to save both the parties from taking advantage of each other. According to Nakhle (2008), since the greater portion of the risk in PSAs is on the IOC, more clauses should be tuned towards protecting it. Nevertheless, the NOC must also be covered to ensure a balanced risk management.  Below are some ways of managing the risks in PSA arrangement.

Governing Law Clause

It is common knowledge that a host country can amend its law at pleasure and thus incorporating the law of the host as the contract governing law is very risky to the IOC. Moreover, using the law of the IOC’s origin may also limit the authority of the host government. It is thus critical that the contract have as a feature, international law and/or other non-national rules, legal systems, and principals as the governing law as a means of risk aversion. This option deprives either the host or the foreign governments from influencing the legal control of the contract. Even so, Pongsiri (2004) warns that international law cannot prescribe a sufficing recipe for a successful contract as it does not cover all facets of legal requirement. Johnston (1994) further notes that state contracts provide myriad theoretical and practical challenges in the application of international law that cannot be ignored. As a result a many legal scholars have popularized the mixing of state law and international law with latter controlling the former on the basis of the ICSID Convention, Article 42(1). This reduces the risk of legal manipulations to favor either the IOC or NOC.

Dispute Settlement Clause: Mediation/Arbitration

Another generally applauded means of managing PSA risks is the presentation of internationally recognized dispute settling mechanisms like mediation or arbitration between the NOC and IOC. According to Ghandi and Lin (2014) this provision not only manages risks but also reinforces the stability of the contractual regime. The IOC’s apprehension is explicable owing to the fact that the mandate of courts are not as developed n the developing world as in the developed world and therefore a high risk of manipulating court decisions to favor the host country are likely. Actually, the use of mediation/arbitration may not only address this apprehension but also be a foundation to building a stronger relationship between the contractual parties.  According to Bernardini (2008) the choice of an international settlement mechanism for disputes may even override the importance of choosing international laws since an international arbitral tribunal can actually interpret the laws of the host country in light of the international law.

Stabilization Clause

As aforementioned, developing countries have weak legal systems and thus may be prone to manipulation if the manipulation favors the state. Johnston (2008) actually notes that if nothing within the contract bars the host state from using legal systems to undermine the contract from within the contract, there are high chances of the host state will embrace the opportunity. This provides the risk of marred host-IOC relations, as well as destabilizing the contractual regime. IOCs often include a stabilization clause in their contracts with NOCs as a measure to safeguard themselves against the host country’s regulatory and legislative pressures. This is particularly important for contracts done with developing countries especially owing to the huge political risks associated with such states (Nakhle, 2008). On the contrary, stabilizations clauses are often not included in the contracts with developed nations as the political risk is negligible, owing to the stable legal regimes within such jurisdictions. Stakeholders in the oil and gas exploration and production fraternity also take special interest on the stabilization clauses as they also determine their support of the regime. According to Bernardini (2008) stabilization clauses can be categorized into modern and classic. The classic clauses on stabilization prohibit the sovereign authority of the host country from interfering with the interest of the IOC through legal means. The modern clauses of stabilization on the other hand, strike a balance between the authority of the state to administer its sovereign power and the interests of IOC.

Profit Sharing/Progressive Taxation Method

Oil is one of the commodities with the highest price fluctuation rates. It has, however, been observed that during periods of increased prices, unscrupulous governments impose unilaterally decided additional monetary obligation to the IOC in order to optimize their revenues.  According to Bernardini (2008) this actions can even be perpetrated by the government in the presence of pertinent stabilization clauses. In this regard, a risk of destabilizing the contract and rendering it unviable is most likely. Actually, in the long term life of the PSA, many changes in the fiscal regime may occur, including increased prices and discovery of more resources in the oil fields. In such instances, the host government may succumb to political pressures and the nationalistic sentiments to inflate its stake within the dealings of the contract.

To overwhelm this possibility of unilateral action, firms can develop a progressive system of taxation that works as an in-built fiscal mechanism that sustainably operate without the necessity of renegotiating the terms of the contract between the parties. Saving the deal renegotiation hurdle, the system bases its operation on a predetermined profit sharing equation and thus botches the possibility of a unilateral decision by either party to the contract (Nakhle, 2008). The latest evolution of this system is the concept of “economic resource rent” (ERR), which adds profits to the government depending on the increase of earnings by the company using a predetermined mathematical formulae. The ERR has different names depending with location. For instance, it is Resource Rent Tax (RRT) in Australia and Petroleum Revenue Tax (PRT) in UK and Windfall Profit tax in other countries (Wälde, 2008). The progressive taxation system is particularly vital in the long term stability of the contractual relation.

 Insurance

This is important for both the host country and the IOC. Many firms in PSA contracts take insurance against political and other risks. The firms’ risks are transferred to the insurer who offers remediation and even litigation in the event that the firm losses. Insurance firms have grown to even offer covers against political risks such as currency inconvertibility, contract breach, property expropriation and political violence. This is another sure way of managing risks.

Conclusion and Recommendation

From the discussion herein, it suffices to conclude that a myriad means are available to legally manage risks in a PSA arrangement. These risks ranging from financial to political risks pose a big threat to the contractual lifespan and thus must be addressed to ensure sustainability. Resource allocation is identified as the basic yet very fundamental element of risk management. Risks can be allocated to either of the contractual parties either unilaterally or mutually or to a third party. Other means identified herein include governing law clause, Dispute Settlement Clause: Mediation/arbitration, stabilization clause, progressive taxation and insurances. One thing that comes out clearly is the fact the most of the risk management means available across literature give the IOC much attention at the expense of the host country. As long us, it is agreeable that most risks in a PSA lie on the IOC, there is need to find other risk mitigation and management means that focus on the host country. It is thus recommended that research should be done to establish the different methods available for the exploration of the host country in a bid to avert contractual risk in a PSA case. It is also recommended that while focusing so much on legal means of risk management, other non-legal means should explored to ensure risk mitigation in a PSA context is broad in scope.