EXPLORATION/PRODUCTION AGREEMENT STRUCTURE

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1 EXPLORATION/PRODUCTION AGREEMENT STRUCTURE The exploration & production (E&P) agreement is the block on which all production of oil and gas is based. Even LNG contracts, the massive accords for production of liquefied natural gas, are based initially on E&P contracts. Having established their importance, let us look at their structure from a long prospective. "I do not care if the cat is black or white as long as he catches mice" said the Communist leader of China, Chairman Mao. His statement remains true. It makes no difference what structure is used - production sharing, concession, risk contract - they can all do the job. But if we look closer at the details of each structure - the duration, the management, the royalty then we begin to sense that detail makes the difference, and we will examine these details to see what works and what does not. History Of Petroleum Arrangements The history of exploration and production (E&P) contracts begins in the United States and Romania with contracts between producers and buyers, but internationally it can trace its origins back to countries where petroleum fell under the general mining legislation as in Indonesia, Germany, and others. The industry grew steadily under those arrangements until World War I where the allies "floated to victory on a sea of oil." After that war international attention focused with laser intensity on the Middle East. Long-term contracts, called concessions, were granted by Middle Eastern nations such as Iraq, Iran, Saudi Arabia and Kuwait to international companies. With some small changes these arrangements, mostly royalty-based with royalty paid in gold, lasted until the end of World War II. Following World War II the was introduced in Venezuela. It involved increasing the income tax until the tax plus royalty was 50% of net profits, This survived until the price of oil increased in the 1970's. When the oil price rise occurred, the increase in company profits made it possible for them to pay more than and they did. Taxes and royalties increased until the OPEC standard became 85% income tax and 20% royalty.

2 Participation & Nationalization The ,, concept spread around the world from Venezuela to Saudi Arabia and to other countries of the middle East. As stated, it became a sacred cow for the oil companies, but it was a barrier that new oil competitors longed to break. This first occurred in what is now Yemen. Pan American (now Amoco) went in and offered 55% to the government for two large areas. At about the same time the same Pa n American company went into Iran and offered, for the first time in the Middle East, "Participation". This meant bringing the government's oil company in as a partner. From the oil company point of view this left the company in the same profitability stance, just adding a partner, as is so commonly done in company-to-company deals. But from the government's standpoint it increased the revenues from oil considerably. Aided by rising oil prices, the participation idea grew and grew. 100% participation, which could also be called nationalization,became the rule in producing countries of the middle East and elsewhere, including Venezuela. Oil Prices & Their Effect On Oil Contracts The principal determinate of contractual change has been oil prices. As oil prices go down, so do company profits. They can then afford to pay less tax to the host government. As oil prices rise, profits rise too. Then royalty and tax (and other aspects of the Contract) change again. Taxes can go up and the balance sheet of the international company looks the same due to the increased oil price. Of course there is a great difference in whether oil taxes go up or oil royalties go up. These are two very different subjects and have to be treated separately. The influence of rising or declining oil price is noticeable in other aspects of petroleum contracts, such as participation. In times of rising oil prices government participation in the contract or concession is high. As prices decline, participation declines with it - a trend remarked in recent years as important producing nations such as the United Kingdom abandoned participation altogether. Of course, the cost of participation has had a lot 'to do with the matter. Government participating in oil development are often staggered by their share of costs which they are required to put up. In some cases this has led to a change in the type of petroleum structure, such as in Nigeria which in 1992 announced if would henceforth grant production sharing contracts which do not entail any government contribution for participation.

3 Comparison Of Petroleum Arrangements Before we go into the trends in fiscal and other requirements for international exploration let us take a quick look at the types of arrangements that exist today. Major types of petroleum E&P arrangements in the world number only about a half-dozen. With the caveat that one country may employ several of these types of arrangements, or that some countries (such as China) may combine them to form a hybrid, the major types are given below. 1. Concession. If formalized into law the concession may be known as a Permit, "License, or "Lease". It is the oldest and still most widely used petroleum agreement, often referred to as an "Equity, or "Tax & Royalty" arrangement. 2. Production sharing Contract. This concept originated in Indonesia in the early 1960's. It is increasingly used around the world. 3. Risk Service Contract. This concept is of comparatively recent vintage, having come into vogue during the 1970's. It is Latin Americas version of production sharing. 4. Service Contract. This is a form of petroleum arrangement used principally for risk-free operations It is of lesser importance in exploration.. 5. Joint Venture. Overlying all these arrangements and accompanying any of them is the joint venture.. The joint venture is not a type of petroleum arrangement but only a partnership between a company having a concession or contract and another company (frequently a government company) by which they agree to jointly operate the venture. They do this under their agreed partnership rules, - the "operating agreement". 6. Nationalization. As a final category in the types of world petroleum arrangements there is the option of complete nationalization of the domestic petroleum industry and its operations by a national oil company (NOC) without participation by international oil companies (IOCS). In may instances, however, it has been necessary to enter into petroleum concessions or contracts with international companies following nationalization in order to have - access to their expertise or for financial reasons. Thus, in Chile production sharing contracts have been entered into, in China the government has entered into a type of production sharing joint venture with international groups, Brazil in the 1980's signed risk service contracts, and Venezuela signed equity arrangement in 1996.

4 World Model Agreement: There have been serious efforts to devise an universal model agreement, flexible enough to take into account differences in the chance of finding petroleum (risk factor), or differences affecting the cost of operations such as differences in the physical characteristics of the contract area (e.g. deepwater, polar conditions, etc). Despite the obvious advantages of having such an universal model the world has seen only a growing divergence of agreement forms. The explanation for this phenomenon must be sought in the differences in political and socioeconomical development and technical sophistication between the various countries and in the clear need for national solutions" in the matter of petroleum agreements. Basic Aspects: The basic aspects of a petroleum arrangement between an international company (be it public or private) and a government are: 1. Risk & Financing: It is common to all forms of petroleum agreement to place the risk on the international company. As professional risk-takers, international oil companies (IOCS) are willing to provide financial and technical resources for exploration and to assume the risk of failure. They expect form of recovery of their initial investment, and profit - either in a monetary sense - or in oil and gas. 2. Economic Return (Profit): In the event of success, as stated above, the international partner expects to earn a profit commensurate with risk. This is the least variable of all the basic aspects. The same economic return can be achieved through the use of concession, production sharing contract, or risk service contract through parameters such as varying taxation rates, the financial aspects of production sharing, depreciation/amortization rules, equity shares, oil purchase prices, and fees. Given a sufficient number of such parameters, and considering exposure to risk as a factor to be considered separately, it is possible to achieve the same financial outcome with different forms of petroleum arrangements.

5 3 Management: This is the amount of influence and direction that the international company is allowed to exercise in the conduct of its operations and on the planning of its development and exploration investment schedules - The degree of freedom in management allowed the international company is closely defined in the petroleum law or contract. It may be very wide or very restricted with regard to one or every stage of an operation. In practice, however, the international company is generally designated the operator of the venture and, subject to supervision by government inspectors and (occasionally) a management committee with government representatives, exercises de facto control over activities. The amount of control various with the capabilities of the international company and of the government or its NOC and the amount of confidence which the government or its NOC place in their partner. 4. Division Of Production: The division of oil or gas production is the fundamental difference between the various types of petroleum arrangements- By this is meant the proportions in which the quantity of petroleum produced is physically divided between the - government and the international company. Furher detail is given below. Participation & Privatizatinn: Participation is the partnership of a private company and government in a venture. Privatization is the return of such venture interest to private hands - the opposite of participation. As opposites go often hand in hand, so have participation and privatization. Participation began in the 1970's with the entry of new oil hungry companies in the Middle East. It flourished as oil prices increased. Then, as oil prices began to decline in 1985 many of the advantages of participation disappeared. Putting up the State share of development expense became an intolerable burden for some countries. Privatization, the opposite of participation, rose as participation declined. The 1990's was the decade of privatization in oil (and many other industries). A tidal wave of privatization swept over the world from Argentina (where the national oil company was privatized) to the United Kingdom where the national oil company (and its participation) was abolished entirely after some embarrassing problems of management and substantial losses. Sometimes privatization is accomplished by selling stock in the existing State enterprise to private parties - as in Argentina. sometimes it is done by abolishing the State owned company entirely - as in the United Kingdom, or by total collapse of the government and reestablishment- of government companies as privately-owned enterprises, as is taking place today in the former USSR.

6 Internationalization - Pros And Cons: From a national viewpoint, the advantages of admitting international companies into oil exploration and development would appear to be substantial. They include capital, technology and other important reasons. Some of the advantages (and disadvantages) of international participation in national petroleum development are discussed below.