Petroleum Policy. Overview. 1. Production phases: exploration to export/refinement

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1 Petroleum Policy Overview This topic provides policy makers and other stakeholders with guidelines on the fundamental issues in governing the petroleum sector. For new or emerging petroleum producers, it is essential to be aware of what constitutes success in the petroleum sector, particularly in the design of the foundational policy document. This topic contains the following chapters: 1. Production phases: exploration to export/refinement 2. Purpose of a planned strategy 3. Scope of policy framework 4. How petroleum is formed 5. National Oil Companies 6. National petroleum policy 7. International best practices 8. Industry view 9. Key policy considerations 1. Production phases: exploration to export/refinement The oil and natural gas (petroleum) industry is generally broken into three sectors based on corresponding stages of production: upstream, midstream, and downstream (see figure below). This Topic Overview focuses on upstream as this phase is crucial to position any country to maximise the potential of its petroleum resources.

2 2. Purpose of a planned strategy As petroleum projects are complex, layered and require high-risk investments a carefully planned strategy needs to be crafted when developing petroleum resources. This would ensure: 3. Scope of policy framework The policy framework would also usually have the objective of ensuring rapid exploration, efficient development of resources, maximum recovery, environmental protection and access to information. In addition, the policy

3 framework will identify which kind of legal approach will be adopted, what subjects are negotiable and determine the type of international petroleum agreements that suit the host state most (although that can change over time). It is also important for the framework to cover: The role of NOCs Rates of production Health and safety issues Efficient management of revenues Methods of capacity building and training in the host state However, there are examples of countries which have preferred not to establish a strategic policy framework, and instead have directly initiated contract negotiations, often due to time concerns. Assuming that significant geological data is available and investor interest is high, an open door or first come first served approach is not recommended since it fails to lever the benefits of competition between potential licensees seeking contract award, competition that should strengthen the bargaining power of the licensing authority and, all other things being equal, result in a more advantageous deal for the country government. There will also be differences between gas and oil policy, because the latter has a major external dimension in that it is traded globally while gas markets are predominantly regional, particularly for land-locked states. In Mozambique s case, the preparations for a legal framework and institutionbuilding were sound in the late 1990s but had to be overhauled when large deposits of gas were found instead of the expected oil, requiring a new petroleum law. 4. How petroleum is formed Petroleum is a combination of liquid crude oil and natural gas and is called a fossil fuel. Natural gas and oil are formed from the remains of plants and animals trapped in or between layers of fine-grained sediment called shale laid down in oceans and large lakes millions of years ago. It thus generates in subsoil but may evaporate or escape to the surface and when in contact with the atmosphere may turn into a solid, such as asphalt. Different geographical locations and conditions cause petroleum to be formed differently.

4 Classification of oil The oil industry classifies crude by the location of its origin and by its relative weight or viscosity ( light, intermediate or heavy ). The relative content of sulphur in natural oil deposits also results in referring to oil as sweet, which means it contains relatively little sulphur, or as sour, which means it contains substantial amounts of sulphur. Petroleum can be separated into fractions including natural gas, gasoline, naphtha, kerosene, fuel and lubricating oils, paraffin wax, and asphalt and is used as a raw material for a wide variety of derivative products. Natural gas can be exploited in association with oil or coal (non-associated natural gas). 5. National Oil Companies NOCs now play an important role in the international oil and gas industry. Similarly, there has been research into the role of junior oil companies and their effectiveness, particularly at the exploration stage, where they are assumed to have an advantage. However, the complex and dynamic ways in which extractive industries players respond to exploration, development and production activities are still too often shrouded in myth and simplistic generalities. This can have negative effects on the design of effective public policies in an area in which a long-term view is essential for governments to

5 take in their role as custodians of finite and, in most countries, publicly owned resources. The way in which companies obtain access to new reserves helps to illustrate this point. Exploration activity is not the only way companies gain access to reserves. Oil and gas companies routinely buy and sell their interests through mergers and acquisitions (M&A). The buyers are often NOCs from countries with insufficient domestic resources such as China and India. In 2010 alone upstream M&A activity jumped 33% in value from 2009, reaching US$183bn. Cash-rich NOCs from China and South Korea played an important part in that activity. In 2012 one of China's largest oil companies, China National Offshore Oil Corporation (CNOOC), purchased the Canadian company, Nexen, for US$15.1bn. It thereby acquired 900 million barrels of oil equivalent (boe) of proven reserves and 1,222bn boe of probable reserves, plus contingent reserves of 5.6bn boe, mainly in Canadian Oil Sands. At virtually the same time, another Chinese company, Sinopec, acquired a 49% equity interest in Talisman Energy's UK operations for US$1.5bn. NOCs versus IOCs For an international oil company (IOC), this kind of a sale to an NOC (or other) buyer can represent a way of raising funds for new projects, but it can also be a way of generating a return from selling an asset that has been created by identifying commercially viable reserves. Its market value is derived from its future production potential. As the project matures, the share value increases and a sale follows. This kind of IOC has a different business model from that of better-known integrated oil and gas companies (e.g. Exxon Mobil or Shell) and instead of producing oil from a successful exploration effort to realise a steady stream of available cash to return to its shareholders in the form of dividend payments, it sells the asset at an early stage. In this way, it avoids the complexity of bringing a large find into production, drawing upon large upfront investment and often requiring a joint venture structure to finance the development. Other IOCs may choose to produce any reserves that they have themselves found, just as they may acquire new projects to gain access to the reserves they contain and thereby increase the volume of reserves under their control without having discovered them in such cases. 6. National petroleum policy Uganda and Kenya experience particular problems with an evolving petroleum legal framework. Faced with interest among IOCs, the respective governments may act prior to drafting all-encompassing legislation and

6 regulations. Faced with uncertain prospects and limited resources, they usually take a gradualist approach to building capacity in relevant government institutions. Despite this, there is always a need to swiftly establish mutual trust between the IOCs and the government and to establish a predictable business and legal framework. Communities in newly emerging oil and gas producing countries are more informed than before. This means that social impacts of sector activities, if ignored in legislation, may result in delays in the project due to objections from civil society. National content rules, although new to emerging market countries, need to be crafted in advance and done transparently to manage expectations. Regional cooperation frameworks Another issue of note for policy-makers is the impact of regional cooperation frameworks. While this Topic Overview mainly focuses on international and national legislative instruments, the impact of soft collaborative efforts and regional policy initiatives in petroleum resource development is highly important. This can be the case of land-locked states, where the construction of export pipelines, in agreement with transit and coastal states, requires establishing a common ground on regional policies. One example is the East African Community (EAC), whose members include Burundi, Kenya, Uganda, Rwanda and Tanzania. EAC has extensive potential for regional energy trade and cooperation for energy infrastructure projects. For example, an oil pipeline from Uganda to Tanzania is being planned, and the recent oil discoveries in Kenya and Uganda, as well as gas discoveries in Tanzania are bound to open the door to future cooperation in the region. Where there is political will, this can benefit the countries concerned. Regional cooperation is also important from a security of supply perspective, e.g. if one country s strategic reserve of petroleum is exhausted then supplies for priority usages through emergency replenishment by a country s neighbour(s). Explore the International and Regional Organisations Topic Overview for a more detailed review. Environmental aspect of the petroleum policy Another challenge is to understand and act on the importance of environmental legislation, especially Environmental Impact Assessment

7 (EIAs) requirements. A draft EIA should be made available to the public before a project can go ahead. Regulations should make this obligatory. Harmonisation of regional standards, policies, legal framework and regulations, the promotion of cross-border public-private partnerships and collaborative sustainability efforts are thus important components of petroleum law and policy. As the discovery and commercial development of new sources becomes increasingly challenging, the right balance of priorities also needs to be made: for instance, exploration in lakes puts biodiversity at risk and requires vigorous social, economic and environmental planning. Finally, investors entering a new market have a strong interest in assisting governments in designing the best policy and regulatory framework for the country concerned. A long-term, sustainable legal framework will provide investor security but also increase the likelihood that benefits will accrue to the country s citizens. Explore Environmental Management Topic Overview for a more detailed review. 7. International best practices Industry initiatives The Association of International Petroleum Negotiators (AIPN) has also developed model agreements which range from commercial contracts to host government agreements, such as the 2012 Joint Operating Agreement (JOA), the 2004 Farm-out Agreement, and the 2006 Unitisation and Unit Operating Agreement. The different types of agreements are explained below. Good oilfield practice Good oilfield practice is an internationally recognised principle calling for sound and safe practices in daily upstream activities. This principle can be inserted into contracts or be contained in national laws, such as the 1982 Petroleum Submerged Lands Act of South Australia. There are many other examples of international organisations that are important policy makers for the sector, including the: International Energy Agency (IEA); European Union; and Organization of Petroleum Exporting Countries (OPEC). For instance, the IEA and the 2009 EU Oil Stocks Directive require their members to maintain minimum stocks of crude oil and

8 petroleum products for 90 days, in order to act as a buffer against any instances of tight supply. 8. Industry view In order to foster petroleum development within a resource rich developing country, the boundaries of sovereign resource ownership and nationalist sentiments need to be safeguarded. This needs to take into account how much the host state is willing to open the sector for private and foreign investor participation, otherwise too much host state protection may act as a deterrent for investors. Investors can also be wary of long-term investment security and a track record of nationalisation and unilateral changes to contracts by the host state or it s NOC. The various roles of the NOCs is a key consideration for the private sector. The clearer the national vision, NOC capacity and capabilities and priorities, the more likely that the petroleum sector would be willing to invest in the host country. There is also the risk that host government policy will change once a largescale investment is made in the host state with largely immovable assets. This is a well-known risk, often referred as the 'obsolescing bargain'. It is typically performed by the host state via different acts such as unilateral changes to the terms of the investment regarding shareholder agreements, taxes and tax rates, and may even result in de-facto expropriation of the project ( creeping expropriation ). The most effective way to decrease this risk, for a host state wishing to attract foreign investment into the sector is by increasing transparency and accountability related to a combination of national legislation and contracts that are binding under international law and arbitration. Separation of sector policy, management and supervision functions One available approach is that of the separation of sector policy, management and supervision functions: overall sector policy is best set at the Ministerial level while awards, contract negotiation, management and supervision is best handled by an independent Competent Authority (CA). Equally, an efficient NOC, if one exists, should be made to compete for awards along with IOC investors. Ideally, the NOC should not fulfil the roles of an independent CA. It often creates an inefficient, monopolistic monolith that can discourage desired foreign direct investment.

9 Explore Petroleum Institutions topic overview for more detailed explanation of different functions of petroleum institutions. 9. Key policy considerations Depending on the size of the proved reserves and hence potential of competition and cash generation, a key consideration for policy makers within the host state is the kind of partnership envisaged between the state and foreign investors. The horizon of resource exploitation which also depends on the level of knowledge of the reserves is another local point of contemplation for the policy maker as there may be a need to prioritise profit maximisation, oil recovery, and encouragement of the investments. From the early stages of discovery, tools of resource management therefore need to be crafted. This means the establishment and maintenance of a petroleum policy that ensures a transparent and informative legislative framework and an award system with effective and efficient public consultation. As such, copies of all data should be submitted to the host state to enable the policy maker to have all the geological knowledge and an upper hand in negotiations with the foreign investor.