COST RECOVERY IN PRODUCTION SHARING CONTRACTS:

OPPORTUNITY FOR STRIKING IT RICH OR JUST ANOTHER RISK NOT

WORTH BEARING?

Marcia Ashong

ABSTRACT: A vital feature of the modern Production Sharing Contract has been the provision for

the recovery of costs. PSCs offer the IOCs the opportunity to recover costs where there has been

successful exploration and future production costs. Since their introduction Cost Recovery (Cost Oil)

has largely been accepted as the most attractive way for IOCs to mitigate their investment risks, but is

this accurate? The Paper will examine the extent to which cost recovery mechanisms are a sufficient

guarantee for the risks taken by the IOCs.

The Author holds a Bachelors degree in International Relations and Political Science from University of Minnesota (US), a Law degree from the University of Exeter (UK) and is currently pursuing a

Masters Degree in Energy Law and Policy from the Centre for Energy, Petroleum, Mineral Law and

Policy (CEPMLP) at University of Dundee, (Scotland). She is currently acting as research assistant on the World Bank's Extractive Industries Transparency Initiative (EITAF) Sourcebook implementation, a

collaborative project involving CEPMLP and the World Bank's EITAF. E-mail:

marciakayie@gmail.com

ii

TABLE OF CONTENTS

ABRREVIATIONS.....iii

1. INTRODUCTION..................................................................................................1

2. GENERAL FISCAL STRUCTURE OFTHE PSC.............................................3

2.1. Cost Recovery........................................................................................4

2.2. Profit Oil.................................................................................................6

3. THE ISSUES: COST RECOVERY A FURTHER ANALYSIS........................7

3.1. Is Cost Recovery a Loss to the IOC? .....................................................8

3.2. Consequences of Bad Oil.......................................................................9

3.3. Gaming Cost Oil...................................................................................10

4. COST RECOVERY: HOST COUNTRY PERSPECTIVE.............................10

4.1. Positive Aspects of Cost Recovery.......................................................11

4.2. Negative Impact of Cost Recovery.......................................................11

5. INCENTIVES.......................................................................................................13

5.1. Some Key Incentives............................................................................13

5.1.1. Investment Incentives...............................................................13

5.1.2. Tax Burden Shift.......................................................................14

5.1.3. Ringfencing...............................................................................14

5.1.4. Contract Stability......................................................................15

6. CONCLUSION.....................................................................................................15

BIBLIOGRAPHY

iii

ABRREVIATIONS

HC Host Country

HG Host Government

IC Investment Credit

IOC International Oil Company

JVA Joint Venture Agreement

NOC National Oil Company

OC Oil Company

OECD Organisation for Economic Co-operation and Development

OPEC Organization of Petroleum Exporting Countries

PSC Production Sharing Contract

1

1. INTRODUCTION

Since the introduction of the Indonesian Production Sharing Contract (PSC) in the

1960s, the modern form PSC has gained tremendous momentum1 especially in

developing countries2 with abundant resources who often times do not have the

required skills or technical know-how to manage exploration and exploitation.

Coupled with the bad press associated with the traditional concession contracts, host

governments (HGs) of these nations tend to lean in the direction of PSCs more often

as an apparatus to shield against political attack, even where a PSC might not be

completely suitable for their particular circumstances. Nevertheless, in recent years

HGs have permitted extensive debate before entering into any such petroleum

contracts, be it after first petroleum reserve discovery3 or for the exploitation of

marginal fields. The ultimate aim of any HG is to ascertain the best method through

which they can recover the most rent out of their natural resources.

Obviously, if increasing government take is the ultimate goal then PSCs are only

another method through which this can be achieved. The rival to the PSC is the

modern concession or licensing agreement, most often utilised by the Organisation for

Economic Co-operation and Development (OECD) with the governments take being

the varying degrees of tax mechanisms imposed on the Oil Companies (OC). Other

forms include Joint Venture Agreements (JVA) and more recently, service (or risk

service) contracts (e.g. Iranian Buy Back).4

A main appeal of the PSC for HGs is that unlike its predecessor (the traditional

Concession) they have turned the balance of ownership of reservoirs from the

International Oil Companies (IOC) to the host countries (HC), allowing the HGs

1 Marcel, V., Oil Titans: National Oil Companies in the Middle East, 22, (2006). This was propelled by

the establishment of the organization of Oil Producers Exporting Countries (OPEC) in 1960 which

coordinated the objectives and interests of producing countries. This was a direct and concerted

response to the foreign companies control of the oil market. 2 They are also gaining traction in transitioning economies 3 Even before full production begins in late 2010, Ghana a newcomer in the petroleum industry has

experienced intense debate with regards to the best contract model in an effort to steer the country away from the fate of its other African counterparts, namely, Nigeria, Angola and Sudan whos petroleum industries have been seen as more of a curse than a cure for national development. 4 A form of risk service contract was developed by the Iranian government, known as the Iranian Buyback Agreement, under this type of agreement the IOC invests, when production begins, the field is handed over to the government or its NOC. The IOCs share is based on costs incurred and an agreed upon share of the profit oil.

2

more control of their natural resources and benefits from production without the

transfer of investment risks. This is especially important for developing countries who

seek to exploit their resources for economic rents but lack the experience or technical

expertise to bear the financial burden. Under the current PSC structure the IOC is

appointed as contractor to undertake petroleum operations in a certain area5, it

operates at its sole risk, at its own expense and more importantly under the control of

the HG. In recognition of the cost borne by the IOC the PSC allocates a portion of

production to the IOC in order to recover costs they incur in the process, this is known

as Cost Recovery (or Cost Oil)6.

This new arrangement experienced a slow start, as the major IOCs preferred the more

traditional concession agreements. But new entrants in the form of smaller

independently owned OCs who negotiated new petroleum contracts in the form of

PSCs post OPEC started a trend which major oil companies in the wake of

concessionary grievances had to follow.7 Later the PSC became popular with the main

appeal for IOCs being its relatively simpler fiscal regime.8 The Concession became

cumbersome, the lack of direct legal control over resources produced led to an array

of complex tax systems designed to increase government take, to which extent the

PSC seemingly corrects this by placing legal ownership of production under the

control of the HG or its NOC, any subsequent taxes imposed 9 would merely be on

income made from profit oil, after the IOC receives its costs from the inbuilt cost

recovery mechanism.

In this regard the design of the Cost Recovery clause in the PSC is seen as especially

important to the IOC. Cost Recovery is unique mainly because it comprises one of

two ways through which the contractors share usually gets determined, that is, the

cost oil and the profit oil split. But at a time of risky exploration (marginal fields and

deep sea exploration) investors (Contractors) are looking for additional guarantees

5 Acreage usually smaller than concessions 6 The author will use these words interchangeably 7 Kamaruddin, M.A., Production Sharing Contracts in the Oil Industry, 7 (1980) 8 Blinn, K. W., Duval, C., Le Leuch, H., Pertuzio, A., Weaver, J., International Petroleum Exploration

and Exploitation Agreements: Legal, Economic & Policy Aspects, 69 (2nd ed. 2009) 9 Ibid, pg. 72. Though royalties are somewhat incompatible with the legal nature of the PSC, because it is hard to reconcile conceptually how a contractor that does not own any production from a contract

area can be obligated to pay a royalty on that production to an HC that is the sole owner of production

under the PSA.

3

and recovery of costs alone might not be sufficient for such prospects. Do HGs need

to design incentives with the intent on induce the IOCs to undertake actions that will

maximise their welfare?10

Or are the current arrangements sufficient enough to cover

the risks they take, and at the same time make reasonable profits to justify sound

investment? In this regard, cost recovery has been deemed as attractive mainly due the

IOCs take in profit oil, leading to recent efforts by some HGs to curtail cost oil.

Looking at PSCs generally, with key comparative examples the paper will aim at

ascertaining the true worth of Cost Oil to the IOC and HC especially in the case of

new oil producing countries.

2. GENERAL FISCAL STRUCTURE OF THE PSC

The goal of a fiscal system from a governments point of view is to attract

investment and capture the maximum economic rent given the geologic endowment

of their petroleum acreage.11 Economic rent can be defined as income earned without

any enterprise, without any cost of production, to get the excess of rental value over

and above the actual cost of production. The basic structure of the traditional PSC is

designed to capture as much economic rent as possible for the HC12

(see figure 1). In

this analysis we shall regard the fiscal system of the PSC as consisting of two

categories13

, namely, Cost Recovery (Cost Oil) and Profit oil split (under which

various tax regimes can be implemented).

10

Le Leuch, H., Contractual Flexibility in New Petroleum Investment Contracts, in Petroleum

Investment Policies in Developing Countries, 82 (Walde T., Beredjick N., ed., Kluwer, 1988). In the

wake of volatile markets, the impact of oil prices on current contractual arrangements needs to be

carefully analysed. The shape of petroleum contracts is largely dependent on the state of the oil

markets, see examples from 1970s, as a consequence of the increase in crude oil prices and the strong competition among oil companies to conclude new arrangements, there had been a general tightening

of contractual terms which showed in higher government take. Conversely, since 1982, a tendency to

grant incentives to oil companies to attract exploration capital has made itself felt because of falling oil prices. 11 Blake, J. A., Roberts, M.C., Comparing petroleum fiscal regimes under oil price uncertainty,

Resources Policy 31 (2006) 95105, at http://www.sciencedirect.com/ (last visited on 12 January, 2010) 12 Johnston, D., International Petroleum Fiscal Systems and Production Sharing Contract, 6 (Tulsa,

Oklahoma,

USA: PennWell Publishing Company, 1994) 13 Ibid, pg 40. Some PSCs include the royalty system from the concessionary system, in such a case the royalty come right off the top just as it would in a concessionary system.

4

Figure 114

2.1. Cost Recovery

Under most PSCs the cost oil regime is usually designed to allow the IOCs to

recover exploration, development, production costs and expenses from the share of

production or gross revenues. This share will usually vary depending on the country

and or the characteristics of the field in question. Cost oil can be split into two further

categories, the Indonesian model which allocates a certain percentage of production

for cost recovery, sometimes known as the cost recovery limit or, for the purpose of

this analysis cost ceiling. Originally, the Indonesian cost ceiling was 40% of

production, but this was later increased to 80%15

. In some cases the limit could go as

high as 100% (referred to as the second generation Indonesian PSC), under the 1977

model, the PSC could henceforth in the initial years of production conceivably claim

100% of production as cost recovery. PERTAMINA (the Indonesian NOC) only

started to receive a share of production whenever the PSC reached a point where less

than 100% of production was needed for cost recovery.16 Cost ceilings, however, if

they exist, typically range from 30%-60%.17

Furthermore, the valuation of cost

14 Ibid, pg 7 15 Blinn, K. W., et al, supra note 8, pg. 76 16 Machmud, T.N., The Indonesian Production Sharing Contract: An Investors Perspective, 78 (Klulwer The Hague 2000) 17 Johnston, D., supra note 12, pg. 56

5

ceiling may differ according to the category of recoverable expenses. For instance in

an Egyptian agreement, exploration expenses could only be recovered at the rate of

20% per annum, whereas operating expenses can be recovered in their entirety in the

year in which they are incurred.18

With the original Peruvian model PSC19

on the other hand, the IOC will usually be

allocated a share of the total production as the sole payment to cover costs incurred.

The share ranges from 44% -50%, this would usually depend on the size of the

production and the contract area.20

This model however, became unpopular, for the

HCs the grievance was that a fixed share of production, unrelated to price of

petroleum nor to production costs or expenses would (especially at times of high oil

prices) give an unfair bonus to the IOC in the form of windfall. For the IOC, a large

government percentage take had the same consequence as payment of high royalties

similar to that under the concession agreements, if fixed the result would be the same

irrespective of economic results of exploitation21

. For this reason the preferred

allocation is still the Indonesian model, of cost oil and profit oil split22

(See figure 2).

18 Daniels, A.W.K., A Comparative Analysis of Selected Provisions of An Egyptian and a Tanzanian

Petroleum Production-Sharing Agreement, 14 (A dissertation submitted to the Centre for Petroleum

and Mineral Law Studies, University of Dundee, in partial fulfilment of the award of a Diploma in

Petroleum Law, 1986) 19 This model was also used in Bolivia and in Trinidad and Tobago. See: 1975 Trinidadian Offshore

contract with Mobil. 20 Johnston D., supra note 12, pg. 58 21 The consequence of which is that marginal fields would be left unexploited, a situation which should

be avoided by any HG. 22 Blinn, K. W., et al, supra note 8, pg. 76

6

Figure 223

2.2. Profit Oil

The profit oil is the predetermined allocation of production after cost oil, split

between the contractor and the government. The contractors share of profit oil is

usually subject to taxation. The Indonesian model uses the simple percentage split, for

example, the contract will stipulate an 85%-15% split in favour of the HC.24

Profit

split will also be adjusted to benefit the IOC in lieu of risky offshore operations.25

The split can be sole profit oil split or a progressive split.26

Any subsequent income tax can be deducted pre-production split or like the original

Indonesian model which was taken post production split. Taxation is taken out of

income generated from the IOCs share of production. In some circumstances the

23 Johnston D., supra note 12, pg. 62 24 This split will normally vary for gas and oil respectively 25 Arif, M., Pakistan Production Sharing Agreement: Offshore Fiscal System, 4 OGEL . As

exemplified in the Pakistan model, under the Petroleum Policy 2001 and the model PSA, offshore areas are divided into three zones; (i) shallow, (ii) deep and, (iii) ultra-deep. Per Clause 6.6 of the model PSA, Contractor and State take is specified for each zone separately. 26 Nakhle, C., Petroleum Taxation: Sharing the Oil Wealth: A Study of Petroleum Taxation Yesterday,

Today and Tomorrow, 36 (Routlege, 2008). A progressive split will usually be determined according to

an incremental scale of daily production, the cumulative production from the commencement of

production or the effective profitability of the petroleum project. Countries such as Angola, Equatorial

Guinea and Nigeria, use a progressive scale based on the fields cumulative production.

7

taxes may be fully assumed by the State Company27

and the percentages negotiated

will, naturally, reflect the assignment of income tax obligation by either the contractor

or the State Company.28

3. THE ISSUES: COST RECOVERY FURTHER ANALYSIS

The world petroleum market within the past decade has been gripped with heavy

volatility, recently the sharp drop in oil prices have been largely linked to the world

financial crisis which originated in the United States, the OPEC Reference Basket

rose to a record $141/b in early July [2008] before falling to $33/b by the end of the

year, the lowest level since summer 2004.29 More generally, however, the

uncertainty in the oil markets30

have been influenced by the fears associated with the

potential end of oil, underlined by increasing demand for new energy sources, many

nations are on a rat race to find alternatives or unconventional sources of fuel.

In the petroleum sector this trend has led to high risk exploration projects such as

deep sea exploration and enhanced oil recovery techniques. Oil companies are drilling

further out into the sea and deeper in the ocean floor, at depths greater than before to

tap into the last pockets of oil reservoirs in the world.31

The success rate of these

projects32

have once again brought hope in petroleum as a fuel source which will be

around for years to come, in the wake of depleting fields in some of the largest oil

fields in the world this news for the oil companies comes at a vital time33

. For reasons

27 In which case the government share is increased to take into account the assumption of taxation,

Libya is a clear example, the PSA does not impose a separate income tax on the IOC, however, the NOCs share can be as high as 81%. 28

Walde, T.W., The Current Status of International Petroleum Investment: Regulating, Licensing and

Contracting, 18 (Centre for Petroleum and Mineral Law and Policy, 1994) 29 Organization of Petroleum Exporting Countries, World Oil Outlook 2009, 36, at

http://www.opec.org/library/World%20Oil%20Outlook/WorldOilOutlook09.htm (Last visited, 28

January, 2010) 30 The solution though may be to hedge petroleum prices with put options, however, put option

premiums can be considerably high especially when general market conditions predict a fall in future

prices. 31 U.S. Department of the Interior, Minerals Management Service, Gulf of Mexico Oil and Gas

Production Forecast 2004-2013, at, http://www.mms.gov/assets/PressConference11152004/2004-

065.pdf (Last visited 28 January, 2010) 32 The past few years have seen huge field discoveries based on offshore exploration in countries such

as Brazil, Ghana and Sierra Leon 33 Though deepwater exploration is considerably more expensive than conventional exploration, the

high oil prices of 2007 made them financially feasible. High demand for energy continues to be the

pushing factor for further deep sea projects amidst the drastic fall in oil prices since 2008.

8

of extreme high costs associated with petroleum projects in recent years alone, cost

recovery in the past few years has become even more important, where the preferred

tool for contracting is the PSC. The question which arises, however, is whether the

PSCs system if cost recovery is still the best tool for capturing the most rent from the

perspective of the IOC and the HC.

3.1. Is Cost Recovery A Loss to the IOC?

IOCs are concerned with several objectives, most important include:

Achieving a reasonable return on their investment, taking into account the

exploration risks and the long lead time between exploration and exploitation;

Enjoying an acceptable pay-out time to recover their original investment; and

Gaining long-term access to new supplies of petroleum through the unfettered

right to export production obtained from the HCs fields34

Considering that a major objective is acceptable pay-out time to recover their

original investment, a growing point of view sees cost oil as adding no benefit to

the IOC in this regard. In fact from this perspective cost oil is synonymous to bad

oil, that is, it has no potential of being of any benefit to the IOC. It is bad because

taken into account the time value of money, costs being paid at a later stage (in most

cases a year or two after costs are incurred) which do not do not take into account the

depreciation of money over time will never accurately reflect true costs. Very few

PSCs offer the opportunity for the recovery of financing costs or interest expense35 in

fact, interest expense is usually not recoverable. Some PSCs do allow unrecoverable

costs to be uplifted by an interest factor to compensate for delay in cost recovery, but

if interest expense is allowed to be recovered, then there should be no uplift for

unrecovered costs36. In a clear example of how the cost oil system works from the

contractors perspective, if for instance, the contractor spends $1.00 on recoverable

costs, the contractor will have to get a negative impact of $0.15 after cost recovery.

Essentially, there is no value as not all costs can be recovered and even those

recovered are subject to time-value depreciation. For a PSC with a cost ceiling and

34 Blinn, K. W., et al, supra note 8, pg. 224 35 Nakhle, C., supra note 26, pg. 36 36 Sunley, E.M., Baunsgaard, T., Simard, D., Revenue from the Oil and Gas Sector: Issues and Country

Experience, in Davis, J.M., Ossowski, R., Fedelino, A., Fiscal Policy Formulation and Implementation

in Oil-Producing Countries (International Monetary Fund, 2003)

9

carry forward rights, this is even more of a detriment to the IOC who will see his costs

spread out over several years, further adding to the negative impact of the recoverable

amount.

3.2 Consequences of Bad Oil

The consequence of such a structure for an IOC who is expected to bear the risk in

such capital intensive projects is surmountable. Cost oil alone could be a disincentive

for investment into new fields. For new entrants in the game, often times developing

countries with high social and political risk this is yet another risk factor from which

IOCs would analyse their chances.37 Most of these resource rich countries are

developing nations who suffer from poor annual growth, underfunded energy

ministries or poorly run NOCs.38 With the rapid pace of economic expansion over

the past decades, many developing countries experienced a sharp annual growth in

petroleum demand. Nevertheless, of those with large or potentially large petroleum

deposits, very few had sufficient financial resources for supply side investments,

especially for the development of oil and gas exploration and production.39 Keeping

this in mind the best way forward it would seem for any such HG is to design an

environment conducive enough for the IOC to conduct business keeping in mind the

risks he has to bear. According to Pongsiri the state has to offer contract terms that

are attractive enough for the IOC to enter into an agreement. At the same time, the

terms must allow the state to receive maximum economic returns from the venture.40

A cost recovery system which undermines the chances of the IOC in recovery his

entire costs it would seem should be avoided (keeping in mind that the IOCs

investments includes debts from his end to the financer (most likely a bank)).41

37 For any new prospecting country the aim is to reduce the level of risk 38 Pongsiri, N., Partnerships in Oil and Gas Production Sharing Contracts, 431 (Centre on Regulation

and Competition (CRC) University of Manchester, 2005) 39 Ibid 40 Ibid 41 But should this risk deter IOCs from undertaking these projects? Perhaps the uniqueness of the

industry also eliminates other risks borne by firms operating in other industries. For instance, since

petroleum products are normally sold on the futures market, future sales can be forecasted with a high

degree of certainty. Hence given a certain level of operating expenses , Return on Asset(ROA), and

Return on Equity (ROE) can easily be estimated

10

3.3. Gaming Cost Oil

Another consequence of limits of cost oil to the IOC is the potential for the IOC to

try to increase his gain by finding ways to game the cost oil system. One method is

through cross-subsidization. Most PSCs create provisions for ring fencing to avoid

this, ordinarily all costs associated with a given block or license must be recovered

from revenues generated within that block. The block is ringfenced.42 This has a

huge impact on the recovery of costs. Furthermore, the opportunity for exploration

costs to cross the fence can be a strong financial incentive for the IOC.43

Different

PSCs approach this in several ways, for instance, India allows exploration costs

from one area to be recovered out of revenues from another,44 however, development

costs must be from the licence it is associated with. Whether or not such an incentive

would be beneficial to the IOC or the effect of its existence will be analysed further in

part 5 of this paper.

Where ring-fencing exists, another way that the IOC can game is by proposing a

budget in which costs are higher than what they are expected to be, doing so through

higher entitlement nominations45

, thereafter, more contractor share in the production.

If this is achieved, the contractor gets the reimbursed (albeit overinflated) costs and

even if readjusted at a later date to reflect the overinflated amount the benefit to the

IOC is that the recovered amount is received earlier which takes away from the

potential of depreciating over time. The prospect of this happening is slim with a

strong HG or NOC oversight.

4. COST RECOVERY: HOST COUNTRY PERSPECTIVE

For a HC cost recovery is essential in that it is the major incentive that the HG can

give the IOC. Without cost recovery the IOC would have no impetus for investing in

42 Johnston, D., supra note 12, pg. 68 43 Fiscal Terms for Upstream Projects (Bureau of Economic Geology, Jackson School of Geosciences,

The University of Texas), at http://www.beg.utexas.edu/energyecon/new-era/case_studies/Fiscal_Terms_for_Upstream_Projects.pdf (last visited, 28 January, 2010) 44 Johnston, D., supra note 12, pg. 68 45 Ibid, pg 307, Under a lifting agreement the amount of crude oil a working-interest owner is expected to lift, each working interest partner has a specific entitlement depending upon the level of

production...each working-interest partner must notify the operator (nominate) the amount of its

entitlement that it will lift.

11

the HC. Though interpretation of objectives may differ from country to country, the

essential goal for any HC is to maximize their revenues while minimizing their

financial risk.46

For the goal of risk minimization cost recovery acts as the catalyst.

To say that oil companies provide capital and technology is an over-simplification.

Actually, to a large extent companies provide a service of procurement for and on

behalf of governments and themselves for both capital and much of the technology.47

HGs with cost recovery are shielded from having to put their limited resources at

risk,48

while at the same time benefiting from any potential revenues to be generated

where there is successful exploration.

4.1. Positive Aspects of Cost Recovery

For the HC the merits of cost recovery include:

The sole risk of exploration is borne by the IOC, the HC therefore benefits

when there is successful exploration

The IOC (in most cases) is only entitled to recover costs under the PSC from a

portion of production from the area subject to the contract (ringfenced), this is

of benefit to the HC in that costs are not

The cost ceiling is designed to ensure that the HC can have its share of profit

oil as soon as production commences. The benefit if this is essential as a late

return on revenues from production would be politically difficult to justify.

A limit to the recoverable costs shields the HG from having to pay for

frivolous expenses by the IOC.

Finally, the PSC has a relatively simpler fiscal regime compared to the

royalty/concession system, thus, the HG usually does not have to spend time

and resources designing complex taxation rules

4.2. Negative Impact of Cost Recovery

The cost recovery is therefore designed to benefit the HC. However, even with cost

recovery, the potential for the IOC to be over compensated is real. Often times a badly

46 Blinn, K. W., et al, supra note 8, pg. 224 47 Johnston, D., Changing Fiscal Landscape,31, Journal Of World Energy Law & Business, 1 (2008) 48 For many resource rich developing countries, these are just resources they do not have

12

structured fiscal regime can lead to abuse by the contractor. This has been the case for

many developing nations whose petroleum industries have been of little benefit in

terms of spurring economic growth. To couple this with an inefficiently run IOC, bad

resource management and lack of social and environmental awareness49

, could spell

more disaster for the HC. A recent report funded by the European Union describes the

extent to which a badly structured PSC in Kazakhstans Kashagan field proved more

of a detriment to the government and the local communities. Greg Muttitt, who

authored the report, commented that, the research reveals the extent to which oil

companies took advantage of Kazakhstans weakness in the 1990s (a time of very low

oil prices).50

The dispute arose after ENI the French IOC involved in the dispute,

released a statement projecting costs to be higher than they had envisaged, the

ultimate costs (amounting to a projected loss of over $20 billion dollars) would

thereby be borne by the HC through cost recovery.51

Furthermore, the design of the cost recovery structure can lead to huge contractor take

in times of high oil prices which could then lead to contract instability disputes with

the HG who is intent on finding ways to curtail the take by the IOC. For example in

2008, in an effort to increase government revenues at a time of high public scrutiny,

the Indonesian Energy and Mineral Resources Ministry proposed a regulation to

eliminate 17 expenses contractors could claim under the cost recovery mechanism,52

the Energy Ministry later issued a press release amid dropping oil prices stating its

intent on abandoning the proposed caps on cost recovery.53

This decision was no less

influenced by Indonesias inability to attract new investment to develop its oil fields.

49 Coupled with a corrupt and non-transparent public sector the situation post-oil production for many

nations has been more of a struggle than pre-production, see the Nigerian example. 50 Unravelling the Carbon web report, at

http://www.platformlondon.org/carbonweb/showitem.asp?article=308&parent=9 (Last visited, 28

January, 2010) 51 Kashagan Oil Field Development, a collaborative report, at

http://www.foeeurope.org/publications/2007/KashaganReport.pdf (Last visited, 28 January 2010). The

difficulty in rectifying the issue was further exacerbated by the stability clauses which made any changes to the provisions a legal quagmire. 52 The Jakarta Post Newspaper, September 25th, 2008, at

http://www.thejakartapost.com/news/2008/09/25/new-cost-recovery-scheme-will-save-little.html (Last

visited, 28 January 2010) 53 Reuters News, January 5th, 2010, at http://www.reuters.com/article/idUSSGE6040CF20100105 (Last

visited, 28 January, 2010)

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5. INCENTIVES

IOCs are constantly seeking new investment opportunities, they have shareholders

and being able to secure a PSC with a HG ensures that they can book reserves which

also means that their shareholders are kept happy. In this regard their main goal is

profit maximization in whichever form possible, and with any investment comes

risks, costs incurred should be one of the risks, after all costs are costs, they will

always be a detriment to any business activity. On the other hand, the IOCs do look

strictly at their ability to recover costs because unlike any other business activity, they

do not get all the benefits of production as a consequence of exploiting resources that

they do not own. The government takes an incredible amount from the exploited

resources and as a result needs to build incentives to induce the companies to want to

give up their resources. The mutual support and joint effort of each party will lay

solid foundation for the win-win situation. As long as some inclination appear in the

contract, if unfavourable to the host country, the execution of contract will be

difficult, if unfavourable to the IOC, the reinvestment will be hindered.54

5.1. Some key Incentives

It is therefore vital that the HC in an effort to increase its investment chances

considers an array of incentives as a supplement to cost recovery. They can come in

the form of:

Investment credits (IC)

Payment of taxes by the NOC as a stability mechanism

No ringfencing

Assurance of fiscal stability

5.1.1. Investment Credits

ICs are a fiscal incentive that allows the IOC to recover an added percentage of real

capital expenditure through cost recovery. In general application ICs are cost

54 Erdong, Z., Liwei, l., Research into Contract Mode in International Oil Corporations Oil Cooperative Development Projects, IEE Xplore 2008

14

recoverable but not tax deductable.55

For example where an IC applies the contractor

may recover 125 percent of the recoverable expenses as opposed to 100 percent,56

where this amount is not taxable is serves as mitigating factor for the losses than can

be made through cost recovery.

5.1.2. Tax Burden Shift

The NOC bearing the burden of taxes can either be beneficial or detrimental to the

IOC. In most cases, however, it serves to be a detriment since allowing the NOC to

assume the tax burden usually translates into a higher government percentage take in

the profit oil split. In most cases the IOC prefer to bare the tax burden and take a

higher percentage split in order to sell more barrels of oil (increasing chances of

windfall in high oil price seasons).57

5.1.3. Ringfencing

Allowing costs to cross a ringfence from the HCs perspective can result to

subsidization of unsuccessful operations.58

But it could also be a strong incentive for

the oil industry and would give some level of assurance that development of marginal

fields would be economically viable.59

In the UK such an incentive proved to work, in

the 1980s and early 1990s exploration activities in the North Sea fields reached

record levels, upon abandoning cross-rinfencing, in 1994 the government saw a

drastic decrease in exploration activities,60

it became of no economic benefit to the

OCs especially at a time of record low oil prices.

55 Nakhle, C., supra note 26, pg. 84 56 Blinn, K. W., et al, supra note 8, pg. 429 57 Ibid pg. 80 58 Johnston, D., supra note 12, pg. 69 59 Development of marginal field or future exploration for the HG is essential, in the world of depleting

energy resources they serve as a security blanket 60 Johnston, D., supra note 12, pg. 69

15

5.1.4. Contract Stability

As many low/middle income countries continuously increase their efforts to attract

foreign investment61

legal provisions to promote contractual stability is what investors

would be vying for. Stability in contractual provisions will arrive in many forms, but

most importantly contractors will be looking for fiscal stability. Under some

stabilization clauses, the HG entrusts itself not to change the legal structure in a way

that adversely alters the economic equilibrium of the project, and where it has failed

to do so provisions are included to compensate the contractor. For instance in

Moroccos 2006 Model Petroleum Agreement, it stipulates that:

The economic terms and conditions which apply to [Contractor]....In the event that a

change in Regulations has a significant adverse effect on the economic benefits that

[Contractor] would have received if such change had not been made, the terms of this

Agreement will be as soon as possible adjusted in order to compensate [Contractor]

for such adverse effect.62

In some circumstances stability clauses also protect the IOC against political risks. On

the other hand, any structure of stability in the contractual terms should not undermine

the HCs pursuit of sustainable development,63 in which case such provisions that

affect the environment and or social responsibility are usually never (and should

never) be stabilized.

6. CONCLUSION

The truth is that a PSC might not always be the best instrument for concluding

contracts even for low/middle income countries that are new on the oil stage,64

the

decision therefore of which type of contractual instrument to use is one that should

not be taken very lightly by any HG. Where a PSC is used on the other hand, as has

hopefully been demonstrated, the benefits of the cost recovery mechanism to the IOC 61 Cotula, L., Regulatory Takings, Stabilization Clauses and Sustainable Development, (Global Forum

on International Investment, 2008) 62 Blinn, K. W., et al, supra note 8, pg. 344 63 Ibid 64

Ghana a newcomer in the petroleum world with its NOC, Ghana National Petroleum Corporation (GNPC) chose the Royalty Tax System, as decision that was made in consideration of the various tax incentives the government could impose for the purposes of a higher government take

16

and the HC are not always clear cut. The cost oil system for the IOC may be a chance

to hit a gold mine and for the HG an opportunity for its resources to be abused the

situation can be reversed, ultimately, the devil is in the detail.

For the IOC though cost recovery may not amount to full recovery of costs (and may

even result to a loss to the IOC). The balance should be based on the apparent benefits

included in the other parts of the contract. If coupled with incentives to compensate

for this loss then cost recovery should be favourable to the IOC. IOCs need to bear in

mind that as the global energy demand increases, new entrants in the form of smaller

OCs (also the Chinese65 and NOCs66 who have had adequate experience) would be

concluding contracts with HGs and at a time of rising oil prices these contracts would

tend to be more favourable to the HGs. Without realising this competition IOCs

would be left behind as they continuously seek for more favourable terms.

On the other hand, while NOCs own the resources, they do not own the market,67

HCs especially those new to the industry, must be aware that to attract sound

investment the design of the fiscal regime, more specifically cost oil, would be the

essential pulling force for any IOC. There must be minimum assurances with clear

incentives in recognition of the technical ability of the contractor. The Indonesian

governments attempt to drastically reduce the cost ceiling limit should be avoided,

clearly in the Indonesian example the consequence was that investments in

Indonesias petroleum sector have stalled.

Cost recovery should therefore be viewed as a catalyst for investment and not as a

profit making mechanism. In view of its complex working a cost recovery system

should have just a few aims including:

65 Cameron, P.D., International and Comparative Petroleum Law and Policy Lecture, November 13 th,

2009, The Chinese as new market entrants are not as concerned with rate of return as might the bigger companies like Exxon Mobil and Shell, their motivations are considerably different and because of

their ability to bring in State contractors at a relatively cheaper rate than the IOCs their return rate becomes less important than securing the contract to begin with. 66 Society of Petroleum Engineers, The Way Ahead: The Magazine by and for Young Professionals in Oil and Gas, IOCs and NOCs: A New Energy Landscape (Vol.5, 3, 2009). The rise of the influence of NOCs has been tremendous an updated list of the most powerful player in Oil and Gas now includes mainly State-Owned OCs (e.g. Saudi Aramco, Gazprom, China National Petroleum Corporation (CNPC), National Iranian Company (NIOC), Petrobras (Brazil) and many more). IOCs are facing increasing challenges from NOCs. 67 Ibid

17

1. a detailed measure to ensure that exploration and production costs of the IOC

are reimbursed

2. any uplift in recognition of depreciation is calculated effectively so as to not

be a double payment

3. a careful cost ceiling implemented to avoid lack of profit for the HG in early

years but also a reasonable recovery of cost incurred by the IOC

4. and finally, any incentives designed to lure contractors should not be a

detriment to the development of the HC, this includes any stability clauses

18

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