PRODUCTION SHARING AGREEMENT AND RISK SHARING CONTRACTS

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1 PRODUCTION SHARING AGREEMENT AND RISK SHARING CONTRACTS LLB WORKING PAPER OF THE UNIVERSITY OF EAST LONDON, ENGLAND QUESTION: The Main Difference Between Product Sharing Contracts and Risk Service Contract Types Lies in the Level of Their Risks and Gains. Discuss ABSTRACT The starting point is to discuss the main differences between Production Sharing Contracts (PSCs) and Risk Service Contracts (RSCs), and aims to provide an analysis of their individual risks and gains. Over the years, petroleum resource rich countries have been using the different contract regimes as a means of achieving the economic returns that petroleum development brings, which will be briefly looked at. The anatomy of these contract regimes lays in the interests between host governments or National Oil Companies (NOCs) and the foreign private investors or otherwise known as International Oil Companies (IOCs). The outcome of this analysis will be used to outline the most attractive and appropriate between the two contract regimes. LIST OF ABBREVIATIONS FEE Foreign Exchange Earnings HC Host Country IOC International Oil Company NIOC National Iranian Oil Company NOC National Oil Company OPEC Organisation of the Oil Producing Countries PPT Petroleum Profit Tax PPTA Petroleum Profit Tax Act PSC Production Sharing Contract RRT Resource Rent Tax RSC Risk Service Contract TRR Target Rate of Return 1

2 INTRODUCTION There are different contractual concepts used in the exploration and production of petroleum around the world by different governments who through their National Oil Companies (NOCs), permits International Oil Companies (IOCs) as contractor, to explore and develop petroleum in their respective territories. The type of contract used by a Host Country (HC) or its NOC, and the terms agreed upon between the parties depends largely on the host government s policies and objectives, and also its bargaining power in relation to the IOC, taking into account the external oil markets and the commercial viability of the acreage. However, pertinent to those considerations is the fiscal and non-fiscal policies, the former of which plays a more central role, since it comprises the instruments which enables the allocation of financial and economic benefits and risks between the NOC and the IOC. This paper will address both the fiscal and non-fiscal policies in relation to the Production Sharing Contracts (PSC) and Risk Service Contract (RSC) comparatively. These two contract types share some common attributes such as, that they do not confer rights to title in the petroleum produced on the IOC. However, they are fundamentally different in their substantive provisions. This paper will then address the different contracts individually, before giving a comparative analysis as to the benefits and disadvantages of each to the HC. The PSCs which are more common in the present day oil and gas contracts, and are being used by at least 60 percent of Oil Producing Countries, were first used by Indonesia s national oil company (Pertamina) in 1966, and continues to be governed by Law No. 44 of 1960, 1 who abandoned the earlier concessions used. The production agreement has been defined as a contractual relationship between a state, a state authority, or an authorised state oil enterprise on the one part and one or more oil companies (collectively constituting the contractor) on the other, under the terms of which the contractor is authorised to conduct petroleum operations within the area as specifically described in an agreement and in accordance with its rules. 2 This concept articulates that the oil and gas resource is owned and controlled by the host country, while the contractor bears all the risks and costs involved in the exploration and production, and if successful, the contractor will be allowed to share in the resource based on cost recovery and a percentage of profit oil. Under the Indonesia s PSC, the IOC is responsible for providing all the equipment, materials and foreign exchange 1 Robert Fabrikant, Production Sharing Contracts in the Indonesian Petroleum Industry, Harvard International Law Journal, Vol. 16, (1975). 2 Taverne B, Cooperative Agreements in the Extractive Petroleum Industry (London: The Hague: Kluwer Law International, 1996). 2

3 that is needed for the operation, with the inclusion of skilled and technical foreign personnel. Since its inception, the PSC has become the most popular regime for the exploration and exploitation of oil and gas between host governments and foreign oil companies in many developing countries around the world. However, for the future of the petroleum industry, especially in the developing countries, it appears that production sharing has not yet outgrown its usefulness. 3 Earlier optimism, that in years the NOC might have developed sufficient technical expertise and financial strength to be able to take over the production areas, has proven to be less than realistic. 4 This paper aims to differentiate between the PSC and Risk Service Contract types and how one is more beneficial to the HC than the other. Thus, under both the PSC and RSC, the HC allows the foreign oil company to explore a specific area and evaluate the potential for oil discovery. The IOC pays all the expenses at its own risk, whether oil is found or not, it does not receive a payment unless a commercial discovery and a resulting production is made. The IOCs share of revenue generally is calculated on the same basis as the IOC s share of production calculated under the Production Sharing Contracts. Under the RSC, once the production is made by the contractor, it receives payment in cash only for the services it provides for the HC. The RSCs are used by a few numbers of countries around the world, but are very popular with Latin American countries such as Mexico and Venezuela, which prefer to maintain total control over production. Historically, rights in oil were granted by means of concessions which authorises a company to explore, develop and market petroleum for a specified number of years. 5 Under the traditional concession contracts, a HC wishing to have its resources developed but lacks the capital and the technical know-how to carry out the program itself, grants exclusive rights to an IOC covering an identified area for long number of years, which was usually between 20 to 99 years. The foreign company bears all the costs and risks of developing the field and exercises ownership rights in the extracted minerals. In return, the IOC agrees to pay the host government production-based royalties or a combination of royalties and taxes as the host country sees fit. The HC did not participate in the decision-making processes which rested solely on the IOC who also formulates all policies as to production, processing, marketing 3 Thomas W Walde and George K Ndi, International Oil and Gas Investment: Moving Eastward?, International Energy and Resources Law & Policy Series, (Graham & Trotman/ Martinus Nijhoff, Member of the Kluwer Academic Publishers Group, LONDON, 1994). 4 Ibid 5 Ernest E. Smith, From Concessions to Service Contracts, TULSA Law Journal, Vol. 27, (1991). 3

4 and all downstream operations. Hence, the rights granted to IOCs were enormous and usually covered large acreages. For example, the concession which William D Arcy obtained from the Shah of Persia (the present Iran) in 1901 covered 500,000 square miles, almost covered the entire country with the exception of some areas in the northern region; concessions granted by the rulers of Abu Dhabi and Kuwait covered their entire countries. 6 The concession originally granted by Saudi Arabia to Standard Oil of California, subsequently assigned to Aramco, covered an area of approximately 371,000 square miles and was further extended in 1939 to about 496,000 square miles. 7 Furthermore, all these concessions were granted for long number of years and were held by a small number of large IOCs at the time, including British Petroleum, Shell, Standard Oil, Jersey Standard, Gulf Oil, Texaco and Mobil Oil, to name a few. A decade after the Second World War, host countries started to acquire a higher level of economic awareness which led to them to demand higher financial and non-financial returns from IOCs. Their governments needed more revenues and internal economic growth than they were getting from the concessionaire under the existing regimes. There was criticism of these earlier standard concessions with characteristics such as large acreage areas granted for long periods, the lack of host government control, and the low returns in the form of royalties that the host governments were entitled to, were not satisfactory to the HC and also prompted the formation of the Organisation of the Petroleum Exporting Countries (OPEC) in 1960 as a result of oil price cuts by Standard Oil of New Jersey. Another reason why HC criticise the standard concessions was also the concept of national sovereignty. The United Nations Resolutions on Permanent Sovereignty over Natural Resources, 8 the Declaration on the Establishment of a New Economic Order, 9 and the Charter of Economic Rights and Duties of States, 10 which reflect the view in HC that the standard concessionary arrangements were flawed, under these United Nations Resolutions. This brought about the modern concession contracts which relied on legislation, authorising HCs to contract with IOCs. Hence, many host countries renegotiated concessions or nationalised petroleum exploration and production activities, some of which expropriated foreign oil companies assets in the process. An example would be Art 2.2 of the Brazilian Legislation, which states as follows: Oil and 6 Ibid 7 Kamal Hossain, Law and Policy in Petroleum Development: Changing Relations between Transnationals and Governments, (Frances Pinter (Publishers) Ltd, London, 1979). 8 G.A. Res. 1803, U.N. GAOR, 17 th Sess., Supp. No. 17, at 15, U.N. Doc. A/5344 (1962). 9 G.A. Res. 3201, U.N. GAOR, 6 th Special Sess., Supp. No. 1, at 3, U.N. Doc. A/9559 (1974). 10 G.A. Res. 3281, U.N. GAOR, 29 th Sess., Supp. No. 31, at 50, U.N. Doc. A/9631 (1974). 4

5 Natural Gas Deposit which exist in the Brazilian national territory belong to the Federal Government, in accordance with Article 3 of the Petroleum Law. The Concessionaire shall only own the Oil and Natural Gas, which are actually produced and received by it at the production Metering Point, pursuant to paragraph However, the purpose of this paper is not to describe the concessionary arrangements and the imbalance it created against host countries, but to give an analysis of the main difference between the PSCs and the RSCs as to how they come with gains in terms of profits or risks of losses. THE PRODUCTION SHARING CONTRACTS Although it must be affirmed that there is no commonly accepted definition of the PSC, it is based on a contractual relationship between the HC through its state authority or agency, or even an authorised state oil enterprise on the one hand known as the NOC, and one or more contractors known as International Oil Companies (IOCs) on the other hand. Under the terms of this agreement, the contractor is authorised to conduct petroleum operations within a specified area as described in the contract and in accordance with the rules of the agreement. As a result, the IOC bears all the contractual risks and costs involved in the exploration. Under this legal framework, the produced petroleum belongs to the host country but is shared, as the name suggests, between the HC or NOC and the Contractor or IOC. In the early 1990s, when Nigeria sought to increase its petroleum production through the exploration and development of the offshore and inland basin, the Government adopted PSC as the appropriate upstream petroleum contract that would be suitable for the award of the acreages. 12 The reason for their decision was because, it would then have no financial burden on the government to enter into this type of agreement, the burden and risks of which were entirely that of the contractor s. Initially, the PSC was brought about by the then Indonesia government as a nationalistic view towards their natural resources in relation to the earlier concessions during the colonial period. Hence, foreign participation was to be allowed only through the provisions of a foreign loan, which would be repaid out of production. 13 The control and management is the responsibility of the HC, while the daily petroleum operations rest on the Contractor. 11 Dr Priscilla Schwartz, Oil and Gas Law and Policy: Contract-Based Regimes, Concessions and Production Sharing Contracts (University of East London School of Business and Law, Lecture Notes: 26/10/2015). 12 A. Ogunlade, How Can Government Best Achieve its Objectives for Petroleum Development: Taxation and Regulation or State Participation?, Oil, Gas & Energy Law Intelligence, Vol. 8, No. 4, (2010). 13 Zhiguo Gao, International Petroleum Contracts: Current Trends and New Directions, International Energy and Resources Law & Policy Series, (Graham & Trotman/ Martinus Nijhoff, London, 1994). 5

6 Although, where the host state decides to participate in the upstream petroleum production, the obligation to contribute in the capital could arise and this may present a conflict of interest for the state NOC as it could be exercising a dual role. That is, being the host and the contractor at the same time. Therefore, at this point, the paper briefly analyses the effects of the benefits and disadvantages this participation could have on the HC under the two contract types being discussed. Participation is most easily achievable through the PSC or through the formation of a Joint Venture with a foreign oil company. However, the latter is not in contention here. The HC s participation could help assert its authority on the sovereignty and ownership of its natural resources. During the upstream operations, the pro-state participation advocates argued that the state s interest is directly protected during decision-making processes and negotiations between the foreign oil company and the government, as they will be directly involved. Moreover, equity participation also maximises the host government s control and take in production and profits, and improves the acquisition of technological and managerial skills in the course of carrying out their day-to-day activities alongside the experts of the contractor who bears these skills, thereby benefitting from the participation. Hence, in the long term, the host state s nationals will eventually be able to control and manage their natural resources through the acquisition of these technological and managerial skills. This could have been an unacceptable fact, as during colonialism, the transfer of technology and managerial skills would have been an unimaginable consequence. Finally, participation will be beneficial to the host country as it has the potential to prevent the foreign contractor from pursuing policies that will be detrimental to the host country. Hence, HC participation deserves an objective consideration. However, there will be some disadvantages of HC participation if it decides to, and therefore, needs to carefully appraise its options on whether resorting to participation is a desired fiscal strategy. A crucial burden of host government participation is the fact that the state is vulnerable to the different risks inherent in the upstream petroleum operations. Thus, in the situation where an exploration is found to be commercially unviable to the host country, then the host country bear the risk to lose its revenue in the proportion of its participatory share in the partnership. Hence, that will negatively affect the HC s other priority obligations to its citizenry, as high capital would have been lost and the government s meagre resources wasted. This, coupled with the fact that the HC or NOCs found themselves with immense and growing debt problems, coupled with a strong growth demand, decreases in petroleum production, and also tight budgetary standards, proves even more disadvantageous to the host 6

7 government to participate in the this high-risk, high-capital venture. The situation could be worsened in the event of default, whereby a private investor has to borrow at unusually high interest rates in order to keep the project going. The repayment of these loans plus interest could be crippling for the state, while simultaneously damaging the country s balance of payments position, as the loans have to remitted in foreign exchange. 14 There could also be a conflict between the NOC and the IOC with regards to decision-making. The government is usually the regulatory body that controls petroleum operations, and as a result should be responsible for making key decisions, particularly in managerial appointments. On the other hand, the foreign contractor should be responsible for strategic business decisions based on commercial realities, managerial expertise in their given field, and strategic policy. Hence, there is a platform for conflict between the host state as an equity participant and the foreign oil company as contractor. In view of the state s participation, a neutral regulatory body with adequate funding and personnel would need to be created in order to ensure transparency and probity in the discharge of its function, 15 which is another drawback for the host government. Therefore, HC representatives who negotiate these agreements, will need to identify the objectives sought by the host through participation and then make sure that these participatory arrangements are suitable for the attainment of the identified objectives. Under the PSC, the foreign oil company is given the right to exploration and production of petroleum within a particular acreage, and in doing so, it assumes all risks and costs, the latter of which will be reimbursed in the event of commercial discovery, including a share of production to remunerate their efforts, unless the state participates, for a share of the petroleum produced. In other words, under the standard Indonesian PSC, the recovery of capital costs of 40 percent is reimbursed to the contractor (referred to as cost oil ) and of the remaining 60 percent after the allocation which is usually 65/35 percent or higher shared in favour of the host government (referred to as profit oil ). Cost Oil is a term used to refer to a fixed percentage of production revenue which is made available for recovery of capital costs, operating costs and exploration costs incurred by the contractor. In the event of noncommercial discovery under the PSC, the contractor who bears the risk of exploration is therefore not reimbursed by the host government. This is mainly the risk factor under the PSCs for the IOC, as it may have invested high-capital budget, which he would have lost in 14 A. Ogunlade, How Can Government Best Achieve its Objectives for Petroleum Development: Taxation and Regulation or State Participation?, Oil, Gas & Energy Law Intelligence, Vol. 8, No. 4, (2010). 15 Ibid 7

8 this case. The clause from the 2004 Mongolia PSC illustrates the risk the Contractor bears under a typical PSC: Article IV (Costs and Expenses). 16 However, in the event of a successful venture, the resulting production is split between the parties according to participation formulas set forth in the contract. 17 The benefit to the HC is that, it receives an actual amount of petroleum which is enough to be commercialised in huge monetary terms according to its socio-economic and development plans. Hence, the host government benefits in both fulfilling its domestic supply needs and also in building up the foreign exchange reserves by its exports to the international markets. The remaining oil produced after cost oil deductions is considered as profit oil and this is split between the HC and the IOC, as contactor towards the venture according to the rules set forth in the agreement. However, developments in the world market, starting with the 1973 oil crisis which caused oil prices to escalate dramatically, made the government realised that the 65%/35% split allowed the companies far greater profits than foreseen in the 1960s. 18 As a result, in comparison to the standard Indonesian PSCs, where exists a flat-rate split, the more recent PSCs are frequently based on progressive or incremental basis with the host state s share increasing with annual production. The PSC has thus, proved to be a flexible instrument, in which improvement can, and indeed have been made, through the incorporation of additional mechanisms to deal with situations which were not adequately dealt with in the standard PSC. 19 The PSC also offers the HC the advantage of limiting it from risks, hence the IOC bears the exploration and production risks coupled with the benefit of owning all petroleum installations and equipment at the end of the contract. Furthermore, the modern PSCs have an obligation provision to supply the domestic market with a certain quantity as agreed to within the rules of the contract. 16 King and Spalding LLP, An Introduction to Upstream Government Petroleum Contracts: Their Evolution and Current Use, Edited by: Philip R. Weems and Scott C. Craig, Oil, Gas and Energy Law Intelligence, Vol. 3, No. 1, (2005). Article IV (Cost and Expenses): Except as otherwise provided herein, the Contractor shall bear all costs and expenses necessary to conduct Petroleum Operations. If such Petroleum Operations result in a Commercial Discovery of Petroleum, the Contractor may recover such costs and 40 (forty) percent oil will be used for cost recovery. Neither party hereto guarantees that any such discovery will be made, or if made, that it will be Commercial Discovery. Accordingly, there shall be no guarantee that the Contractor will achieve any reimbursement of any costs and expenses incurred hereunder. 17 Ibid. 18 T. N. Machmud, The Production Sharing Contract in Indonesia, International Oil and Gas Investment: Moving Eastward?, International Energy and Resources Law & Policy Series, Editors: Thomas W Walde & George K Ndi, (Graham & Trotman/ Martinus Nijhoff, London, 1994). 19 Kamal Hossain, Law and Policy in Petroleum Development: Changing Relations between Transnationals and Governments, (Frances Pinter (Publishers) Ltd, London, 1979). 8

9 However, the Contractor could inflate the price of his cost oil once there is a commercial discovery, and if not proven otherwise by the HC, then the host could pay the inflated cost oil. This could particularly be the case if the contract area is a high prospectivity and low risk area. Furthermore, the Contractor can influence the market price of petroleum by selling his cost oil and his share of profit oil at low-cost, which could affect the pricing of the HC, thereby causing the NOC to sell cheaply to the markets. Moreover, the effect of stabilisation clauses could also affect the HC if it wants to change the terms of its tax policies. RISK SERVICE CONTRACTS In a Risk Service Contract, the host country allows the Contractor to perform exploration and development of petroleum in a specified area for a remuneration in cash for its risk capital and services after petroleum production. The risks and costs burden is on the Contractor during the exploration phase and if there is no commercial discovery, the contractor receives no payment or reimbursement, as under the PSC. Moreover, under RSC, like the PSCs, it involves no surrender of the host country s sovereignty over its natural resources and title does not pass to the IOC. The main difference between the RSC and PSC lies in their different scope of rewarding Contractors. Under the RSC, the Contractor is normally remunerated in cash and not in barrels of petroleum, whereas under the PSC, the contractor gets a share of the petroleum produced. However, the Contractor under a RSC may have access to the petroleum produced under an arrangement known as the Buy-Back Model of risk service contract, which will be discussed later. Under the RSC, the HC through its NOC maintains ownership of the petroleum produced and assumes full control of operations once production commences. The concept underlying the service contract was slow to be accepted and did not gain favour until 1976 when Brazil, through their NOC (Petrobras) opened its offshore areas for international participation under what is known as the risk service contract (RSC). 20 Brazil adhered to the Latin American political tradition that natural resources should be the property of the state, and their development should be carried out by a state agency. 21 It is widely used in Latin American where exists a nationalistic notion that no foreign company should acquire ownership of their natural resources, and that, that ownership should rest only on the state or its national enterprise. Nevertheless, Burma and Iran developed the earlier 20 Zhiguo Gao, International Petroleum Contract: Current Trends and New Directions, International Energy and Resources Law & Policy Series, (Graham & Trotman/ Martinus Nijhoff, London, 1994). 21 Ibid 9

10 advanced RSCs with terms that were more advantageous to their countries than the early service contract provided them in 1973 and 1974 respectively. Throughout the exploration phase of the contract, the IOC solely invests all the capital outlay and therefore, bears all the risks as noted earlier, however, once there is a commercial discovery and production of petroleum starts, the IOC has the right to be reimbursed and remunerated for the invested capital and services provided. The contract agreement spells out how and in what manner the payments should be made, which differs widely in different host countries. An advantage to the host country is that reimbursement of capital invested by the Contractor in the exploration operations is with no interest. However, reimbursement of development funds for the commercial fields is reimbursed with interest at a rate agreed in the contract agreement. Once the Contractor is fully remunerated, the HC will have no further financial obligations to him, and will therefore enjoy all benefits from the production. Since 1995, upon opening its doors to the world, Iran has employed the buy-back framework for awarding upstream contracts with a total of 24 contracts (16 development, 8 exploration) awarded to Iranian and foreign oil companies. 22 The buy-back contract was devised to encourage direct foreign participation in Iran s upstream oil sector that had not existed following the Islamic revolution in A Buy-Back Contract Model is essentially a contract under which the Contractor or IOC funds all investment costs and implements the exploration and production of petroleum operations on behalf of the NIOC. The IOC in return will be remunerated for this investment and costs incurred from the produced petroleum by way of preferential purchase or shall be granted the option to buy the produced oil from the government or it s NIOC by contractual means. The HC however bears the risk of additional expenses for being unable to maintain the installations and equipment after petroleum development, because of lack of expertise, and would therefore have to rely on the IOC who will have to be paid for the service, thereby costing the HC financially. HOST COUNTRIES OBJECTIVES IN OIL AND GAS DEVELOPMENT Traditional concessions were abandoned in favour of the PSC in the early 1960s by Indonesia. Professor Omorogbe, a Nigerian Law Professor at the University of Benin, described Production Sharing Contracts as: 22 H. Farnejad, How Competitive is the Iranian Buy-Back Contracts in Comparison to Contractual Production Sharing Fiscal Systems?, Oil, Gas & Energy Law Intelligence, Vol. 7, No. 1, (2009). 23 Ibid 10

11 [A]rrangements where the foreign firm and the government share the output of the operation in predetermined propositions. This new form has been regarded as being a substantial departure from the old concessions in that the host state is theoretically the undisputed owner of the petroleum, with the foreign corporations being engage as contractors to perform certain specific tasks in return for a fee in kind. 24 Host countries have different interests in their respective countries with regards to petroleum resource exploration and development. A government s principal objective in involving a multinational oil company in petroleum exploration and development within its territory is to secure an investment of risk capital and the technical and managerial skills of a multinational to carry out as thorough and as rapid an exploration of its prospective areas as is reasonably possible, and upon any discovery being made to secure the necessary investment and the necessary skills to develop the reservoirs discovered in a manner which will ensure maximum ultimate recovery and yield maximum benefits to the national economy. 25 Most host countries lack the requisite capital, the appropriate technology and technical know-how associated with such high risk, high capital venture as petroleum exploration and development. It is against this background that host countries invite foreign oil companies to participate in different forms, in this economically lucrative resource industry. Hence, it is against this background that this paper is prescribed to unveil as to how host countries benefits under either the PSC or RSC. Once the principal objective have been realised, the HC then pursues the development of oil and gas with the desired aim to achieve economic benefits which includes the fiscal and nonfiscal objectives. The petroleum fiscal objectives under the contractual PSC and RSC of a HC is a set of laws, regulations and the agreements which governs the economic benefits derived from petroleum exploration and production, under which the HC retains ownership of petroleum resources. These includes mainly petroleum taxation, imposing import duties on imported petroleum if there is need to protect the domestic oil production against low-priced imports, work expenditures, operating cost, bonuses, royalties, and foreign exchange earnings. Below is a brief explanation of each of the above fiscal policies: I. Petroleum Taxation is one of the main fiscal objectives of many host states. There are many forms of tax instruments, and each HC adopts its own method suited to its 24 Yinka Omorogbe, The Legal Framework for the Production of Petroleum in Nigeria, Journal of Energy and Natural Resources Law, Vol. 5, No. 4, (1987). 25 Kamal Hossain, Law and Policy in Petroleum Development: Changing Relations between Transnationals and Governments, (Frances Pinter (Publishers) Ltd, London, 1979). 11

12 needs. The most common type of tax is Income Tax which is used in many parts of the world. It is essentially a percentage of the taxable income accruable to the tax payer. However, in practice, the HC often finds itself in receipt of negligible amount of revenue as a result of the various deductions and allowances which the IOC is entitle to. Another form of petroleum taxation is the Resource Rent Tax (RRT). In principle, the RRT applies after a Target Rate of Return (TRR) on the investment has been realised. In practice, the TRR is often set as a mark-up on the return from a safe alternative investment, with the mark-up representing a country-specific risk premium. 26 The reasons for introducing it by many HC is that this special tax on petroleum production is rooted in rent theory and the assumption that oil and gas resources provide an extraordinary rate of return in resource rent. In Nigeria particularly, upstream producers operate under a unique fiscal regime. The principal legislation in this respect is the Petroleum Profits Tax Act of 1959 Cap 354 of the Laws of the Federation of Nigeria 1990 (PPTA) which imposes tax on the profits from petroleum production and makes provisions for the assessment and collection thereof. 27 The Petroleum Profit Tax (PPT) is applicable to upstream operations in the oil sector. It is particularly related to rents, royalties, margins and profit-sharing elements associated with oil mining, prospecting and exploration leases. The rationale of much of this innovation was to find a fiscal regime that could adapt to the uncertainty prevailing before exploration has identified a sizeable and commercially hydrocarbon deposit. 28 II. Royalties are based on the volume of petroleum extracted under the PSC. It may be paid in either cash or kind. If the latter is used, a specified amount of oil and gas are delivered to NOC. Royalties are paid as soon as commercial production commences, thereby proving early revenue for a HC. However, royalties can deter IOCs from investing, because they ensure that IOCs make minimal payment, for example, simple royalties could be at 10 percent of the value of the oil extracted are easy to administer, but do not take into account the profitability of the project and 26 C. Ochieze, Fiscal Stability: To What Extent Can Flexibility Mitigate Changing Circumstances in a Petroleum Production Tax Regime?, Oil, Gas & Energy Law Intelligence, Vol. 5, No. 2, (2007). 27 Sena Anthony, Recent Developments in the Legal Structuring of Petroleum Investments in Nigeria: International Oil and Gas Investment: Moving Eastward? Editors: Thomas W Walde & George K Ndi, (Graham & Trotman/ Martinus Nijhoff, London, 1994). 28 Thomas W Walde, The Current Status of International Petroleum Investment: Regulating, Licencing and Contracting, CEPMLP Professional Paper 14, (1994). 12

13 hence are regressive. One way of redressing this is to make the royalty rate depend on the level of production, increasing it with increasing production. III. With regards to Work Expenditures, all PSCs specify annual minimum financial expenditures to be made by the Contractor in conducting exploration operations during the initial years of the contract. 29 Under this provision, if the IOC s expenditure exceeds the minimum amount during any contract year, then the excess may be deducted from the following contract year. IV. Imposing import duties on imported oil and gas is required when domestic production cannot compete with low-priced imports, it can be made less expensive by fiscal or administrative measures, for example, by either abolishing royalty and /or lowering the rate of the applicable income tax. But domestic production can also be protected against low-priced imports by imposing import duties or quantitative restrictions on imports. 30 A typical example is, in 1986, when as the result of the flooding-of-themarket - strategy pursued by Saudi Arabia, the world market oil price dropped to about USD 10 per barrel, the US Bush-Administration seriously considered the option to introduce an import duty in order to protect the high cost US domestic production. 31 V. Bonuses are the most regressive fiscal parameters and gives early revenue to the HC. There are different types of bonuses that a HC can benefit from, namely; signature bonuses, which are paid when the contract becomes effective, and can be considered in highly prospective areas. It can also be referred to as prospectivity bonus, where the amount should be determined on the basis of the prospects for oil and gas reserves in the particular block, the type of terrain, water depth, if applicable, and the level of technology and/or investment required for the exploration and development of the block. Signature bonuses are paid before any works starts or that in most cases the contractor is given up to 90 days to pay, and if the company fails to pay within the time frame, a revocation notice which will last for 30 days, will be issued. Failure to pay up within the 30 days will render the allocation revocable. For example, the first financial report for the Nigeria Extractive Industries Transparency Initiative showed 29 Robert Fabrikant, Production Sharing Contracts in the Indonesian Petroleum Industry, Harvard International Law Journal, Vol. 16, (1975). 30 Bernard Taverne, Petroleum, Industry, and Governments: A Study of the Involvement of Industry and Governments in the Production and Use of Petroleum, 3 rd edn, (Kluwer Law International, 2013). 31 Ibid 13

14 that Shell Nigeria Ultra Deep Limited in 2003 paid US $210 million as a signature bonus to the Federal Government, which was paid within 30 days after the effective date of the contract. The Nigerian 2005 model PSC however, stipulates that the signature bonus must be paid before the execution of the contract. 32 A criticism of this form of payment is that: A fixed signature bonus can have a disincentive effect, since unlike an auction bid, it is unrelated to the economic rent expected to be derived...it [therefore]discourages companies from seeking licences in marginal areas and is ill-designed to capture economic rent. 33 Production bonuses are paid at the start of commercial production and when production reaches specified levels. Bonuses are generally not eligible for tax relief and are not recognised as cost-recoverable expenses. The production bonus in the Nigerian PSCs, the 1993 requires cash equivalent of an indicated percentage of production, but the 2000 PSC specifies one hundred thousand barrels (100,000 bbls) or cash equivalent for the attainment of each of the cumulative level of production. 34 However, the 2005 PSC stipulates a quantity of crude oil or cash equivalent based on the attainment of a certain cumulative level of production. 35 VI. A successful oil development activity of a HC yields very high profitability, thus generating Foreign Exchange Earnings (FEE) for the HC. A government seeks to maximise its short and long term revenue from petroleum activity so as to fulfil its economic, political and social obligations to its citizens. 36 It does this by levying taxes and other charges on the international oil companies or by directly participating in petroleum activity so as to obtain returns in its capacity as partner. The above are some of the main fiscal objectives of host governments. Hence, this paper will also briefly discuss some of the non-fiscal policies of HC, which includes regional and national development, technological and managerial skills transfer, and employment of nationals, environmental sustainability, and security of resource supply. 32 Dr. Taiwo Adebola Ogunleye, A Legal Analysis of Production Sharing Contract Arrangements in the Nigerian Petroleum Industry, Journal of Energy Technologies and Policy, Vol. 5, No. 8, (2015). 33 Kamal Hossain, Law and Policy in Petroleum Development: Changing Relations between Transnationals and Governments, (Frances Pinter (Publishers) Ltd, London, 1979). 34 Ibid 35 Ibid 36 A. Ogulade, How Can Government Best Achieve its Objectives for Petroleum Development: Taxation and Regulation or State Participation?, Oil, Gas & Energy Law Intelligence, Vol. 8, No. 4, (2010). 14

15 I. The territories where petroleum activity are undertaken are usually provided with infrastructural facilities like good roads, water system, electricity, etc. by investors so as to enhance the smooth running of their operations whilst improving the quality of life of people in that region as a matter of corporate social responsibility. Suffice to add that in practice, this has not always been the case. 37 II. A HC normally lacks the technological and managerial skills required for the operation of petroleum development. Thus, it is an important objective to ensure that the Contractor for its petroleum development provides substantial transfer of the managerial and technological skills needed so as to enable it to gradually obtain more control of the petrol operations. The technological and managerial training needs of the HC are a huge burden on the IOC and as such should be included in the work programmes of Contractors which has to be managed efficiently. China has taken training and technology transfer more seriously than other developing countries with which oil transnationals have dealt in the past, where technology transfer has been simply a spin-off activity with on-the-job training being the primary transferring mode. 38 III. The employment of a HC s nationals in their petroleum operations activities is a primary objective of most petroleum developing nations. However, many IOCs fear that failure to offer employment opportunities to locals could be termed as a violation of the contract, even if these local personnel are without any qualifications. Furthermore, petroleum is a capital and not labour-intensive industry, the employment of some of the nationals will have very low efficiency levels. Hence, some of these personnel, even though not needed, may have to be employed as a means of political pressure. As a result, many personnel provided to foreign oil companies by the designated HC agency lack experience or the qualification to work in the oil and gas industry. In some HCs, many expatriate supervisors were shocked to discover that they almost have no influence over the status of their employees who were still affiliated with their work unit Ibid 38 Zhiguo Gao, International Petroleum Contracts: Current Trends and New Directions, International Energy and Resources Law and Policy Series, (Graham & Trotman/Martinus Nijhoff, London, 1994). 39 Ibid 15

16 IV. The extraction and production of oil and gas is now widely acknowledged to have significant adverse effects on the environment. It is therefore the HC s duty to ensure that, despite the vast economic benefits that petroleum production brings to a particular country; its environmental concerns must be respected for the benefit of both the present and future generations. Although, the nature and seriousness of such impacts will obviously depend on the type of activity or operation in question, downstream activities involving the use of pipelines, tankers, refineries, and other installations will on the other hand tend to pose environmental risks of a transnational character. 40 Hence, Government ensures compliance with environmental standards, compensation for environmental degradation and in some cases a Resource Fund for future generations. 41 There are often conflicts in Nigeria, particularly in the Niger Delta between IOCs and the communities where petroleum operations takes place. Nigeria burns a large percentage of gas associated with oil production, which, apart from being economically inefficient, has a huge environmental disadvantage. One of these disadvantages is, acid rain, which has stunted the growth of crops, contaminated drinking water, and corroded the corrugated iron roofing in these communities. 42 These communities see multinational oil companies and their operations as having adverse effects on their fishing and farming environments, without their communities benefiting from these resources. Hence, they lack access to safe drinking water, electricity, proper schools for their children, and poor communication network. V. A host government should safeguard and ensure the security of domestic oil and gas supply for its citizens, thus reducing the uncertainties and costs associated with the importation of petroleum. In Indonesia, the early PSCs contained no domestic supply provisions. However, as of late 1966, the contracts began to require contractors, after commencement of commercial production, to supply a portion of their production to the Indonesian domestic market. 43 Perhaps the most serious abuse of this objective is when a government fails to negotiate a source of constant supply of 40 Thomas W Walde & George K Ndi, International Oil and Gas Investment: Moving Eastward?, International Energy and Resources Law and Policy Series, (Graham & Trotman/Martinus Nijhoff, London, 1994). 41 A. Ogulade, How Can Government Best Achieve its Objectives for Petroleum Development: Taxation and Regulation or State Participation?, Oil, Gas & Energy Law Intelligence, Vol. 8, No. 4 (November 2010). 42 Emeka Duruigbo, Managing Oil Revenues for Socio-Economic Development in Nigeria: The Case for Community-Based Trust Funds, N.C.J. International Law & Com. Reg., Vol. 30, (2004). 43 Robert Fabrikant, Production Sharing Contracts in the Indonesian Petroleum Industry, Harvard International Law Journal, Vol. 16, (1975). 16

17 the hydrocarbon to its communities, who technically owns it, and also fails to protect the rights of its citizens in these communities. Hence, when there is a harm caused to these communities, they often have minimal legal remedy, if any at all. CONCLUSION As part of the drive towards permanent sovereignty over natural resources, many petroleum producing countries, particularly developing HCs, established a nationalistic notion over petroleum operations within their territories. However, due to their lack of technological means, financial capability and managerial skills for petroleum operations, invite foreign private companies in the development of their national resources. The paper looked at comparatively the two most commonly used contract regimes, namely, Product Sharing Contracts and Risk Service Contracts. They have common basic features but are different in their substantive provisions. Their significant difference should not just be looked at financially, but of their different mechanisms they embody to secure certain interests and strategic objectives. 44 Both contract regimes bestow power of ownership and management in the host government s NOC. Furthermore, the PSC and RSC both through their collaborative involvement with IOCs, acquire skills, knowledge and expertise in order to directly undertake operations from foreign contractors. The RSC ensures that the host government or its NOC has maximum national petroleum control over petroleum development with minimum foreign involvement and moreover, in technical terms there is more clarity. Hence, it is relatively simpler to administer with less administrative and bureaucratic hurdles, which is also an advantage for the IOCs. Having analysed the legal framework of the PSC and RSC, it is clear that comparatively, the PSC could be more beneficial to the HC. Furthermore, as already discussed, it is more flexible and attractive to international investors. IOCs view the PSC as a partnership contract and therefore are more willing to conclude agreements under this regime than under the RSC. BIBLIOGRAPHY BOOKS: 1. Anthony, S., Recent Developments in the Legal Structuring of Petroleum Investments in Nigeria: International Oil and Gas Investment: Moving Eastward?, 44 Kamal Hossain, Law and Policy in Petroleum Development: Changing Relations between Transnationals and Governments, (Frances Pinter (Publishers) Ltd, London, 1979). 17

18 Editors: Thomas W. Walde & George K. Ndi, (Graham & Trotman/ Martinus Nijhoff, London, 1994). 2. Gao, Z., International Petroleum Contracts: Current Trends and New Directions, International Energy and Resources Law and Policy Series (Graham & Trotman/ Martinus Nijhoff, London, 1994). 3. Hossain, K., Law and Policy in Petroleum Development: Changing Relations between Transnationals and Government (Frances Pinter (Publishers) Ltd, London, 1979). 4. Machmud, T.N., The Production Sharing Contracts in Indonesia, International Oil and Gas Investment: Moving Eastward?, International Energy and Resources Law & Policy Series, Editors: Thomas W. Walde & George K. Ndi, (Graham &Trotman/ Martinus Nijhoff, London, 1994). 5. Taverne, B., Cooperative Agreements in the Extractive Petroleum Industry (London: Kluwer Law International, 1996). 6. Taverne, B., Petroleum, Industry, and Governments: A Study of the Involvement of Industry and Governments in the Production and Use of Petroleum, 3 rd Edn. (Kluwer Law International, London, 2013). 7. Walde, T.W. and Ndi, G. K., International Oil and Gas Investment: Moving Eastward?, International Energy and Resources Law and Policy Series (Graham & Trotman/ Martinus Nijhoff, London, 1994). ARTICLES: 1. Duruigbo, E., Managing Oil Revenues for Socio-Economic Development in Nigeria: The Case for Community-Based Trust Fund, N.C.J. International Law and Com. Reg., Vol. 30, (2004). 2. Fabrikant, R., Production Sharing Contracts in the Indonesian Petroleum Industry, Harvard International Law Journal, Vol. 16 (1975). 18

19 3. Farnejad, H., How Competitive is the Iranian Buy-Back Contracts in Comparison to Contractual Production Sharing Fiscal System?, Oil, Gas and Energy Law Intelligence, Vol. 7, No.1 (2009). 4. King and Spalding LLP, An Introduction to Upstream Government Petroleum Contracts: Their Evolution and Current Use, Edited by: Philip R. Weems and Scott C. Craig, Oil, Gas and Energy Law Intelligence, Vol.3, No.1 (2005). 5. Ochieze, C., Fiscal Stability: To What Extent Can Flexibility Mitigate Changing Circumstances in a Petroleum Production Tax Regime?, Oil, Gas and Energy Law Intelligence, Vol. 5, No. 2 (2007). 6. Ogunlade, A., How Can Government Best Achieve its Objectives for Petroleum Development: Taxation and Regulation or State Participation?, Oil, Gas and Energy Law Intelligence, Vol. 8, No. 4 (2010). 7. Ogunleye, T. A. Dr., A Legal Analysis of Production Sharing Contract Arrangements in the Nigerian Petroleum Industry, Journal of Energy Technologies and Policy, Vol. 5, No. 8 (2015). 8. Omorogbe, Y., The Legal Framework for the Production of Petroleum in Nigeria, Journal of Energy and Natural Resources Law, Vol. 5, No. 4, (1987). 9. Schwartz, P. Dr., Oil and Gas Law and Policy: Contract-Based Regimes, Concessions and Production Sharing Contracts (University of East London School of Business and Law, Lecture Notes, 26/10/2015). 10. Smith, E.E., From Concessions to Service Contracts, TULSA Law Journal, Vol. 27 (1991). 11. Walde, T.W., The Current Status of International Petroleum Investment: Regulating, Licensing and Contracting, CEPMLP Professional Paper 14 (1994). 19

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