(Bret-Rouzaut, Nadine, Favennec, Jean-Pierre) Oil PDF

Nadine BRET-ROUZAUT and Jean-Pierre FAVENNEC
Oil and Gas

Exploration and
Production
Reserves, costs, contracts
Third edition revised and updated
With contributions by
D. Babusiaux (IFP Energies nouvelles) S. Barreau (IFP Energies nouvelles)
P.R. Bauquis (Total) N. Bret-Rouzaut (IFP Energies nouvelles) A. Chtrit (Total)
P. Copinschi (IFP Energies nouvelles) J.P. Favennec (IFP Energies nouvelles)
R. Festor (Total) E. Feuillet-Midrier (IFP Energies nouvelles) M. Grossin (Total)
D. Guirauden (Beicip) V. Lepez (Total) P. Sigonney (Total) M. Valette (Total)
The first edition of this book has been selected for inclusion in Choices annual
Outstanding Academic titles list. It has been rewarded for its excellence in scholarship
and presentation, the significance of its contribution to the field, and its value as
important treatment of the subject.
Translated by
Bowne Global Solutions
Mr Jonathan PEARSE
2011
Editions TECHNIP 25 rue Ginoux, 75015 PARIS, FRANCE

FROM THE SAME PUBLISHER
The Geopolitics of Energy

J.P. FAVENNEC
The Oil & Gas Engineering Guide

H. BARON
Project Management Guide

M. DUCROS, G. FERNET
Petroleum Refining. Vol. 5: Refinery Operation and Management

J.P. FAVENNEC
Petroleum Economics
J. MASSERON
Manual of Process Economic Evaluation

A. CHAUVEL, G. FOURNIER, C. RAIMBAULT
Translation of
Recherche et production du ptrole et du gaz.
Rserves, cots, contrats / 2e dition
N. BRET-ROUZAUT, J.P. FAVENNEC
2011, ditions Technip, Paris
for the second edition
All rights reserved.

No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechan-
ical, including photocopy, recording, or any information storage and retrieval system, without the prior written per-
mission of the publisher.
Editions Technip, Paris, 2011.
ISBN 978-2-7108-0975-3
Printed in France
Preface to the rst edition
It has been a long time since a reference book on the exploration and production of oil and
gas was last published. This book therefore meets a genuine need: to explain to a well-
informed readership (teachers, students, researchers, journalists, engineers, industrial and
political decision-makers) the key activities of this sector so vital to the world economy both
now and in the future. It also provides essential information for the public at large on the
relationships between energy and the environment, which involve many complex issues and
stir public debate.
This book stresses the economic aspect of petroleum activities and provides a solid under-
standing of the technical and contractual issues which underpin relations between the
petroleum industry and the producing countries, a wise choice since the economics of the
sector cannot be understood without a solid grounding in the technical, legal and political
aspects.
I should like to pay tribute to the IFP and the IFP School for having taken the initiative
to compile this book, particularly valuable because of two features: it brought together, at
both conception and realisation stages, authors from both the IFP and the Total group,
thereby linking the visions of a large research institute and a commercial petroleum group,
and it features authors of varied backgrounds and ages, including young engineers as well
as recognised academic and industrial experts.
The book therefore sets a ne example in our rapidly changing world, and should be
instrumental in attracting new talents to a sector which will remain exciting and vital for at
least the next 50 years and probably longer.
I hope this book is rewarded with the success it deserves.
Thierry Desmarest
Chairman
Total
V
Glossary
Arbitrage Financial operation which seeks to exploit geographical or temporal price

differences. Arbitrage operations tend to reduce price differences and stabilise markets.
Bonus Fixed sum payable by the holder of exploration and production rights to the state.
There are three types of bonus: signature bonus, payable when the contract is signed,
discovery bonus, payable when the discovery of a commercially viable eld of hydrocarbons
is announced and production bonus payable when certain production thresholds are exceeded.
Brent A crude oil produced in the North Sea. Brent prices (both physical and paper prices)
and the associated quotations serve as a reference in Europe and many other regions for deter-
mining the prices of other crudes.
Broker Intermediary in the purchase or sale of crude oil and other petroleum products.
Calcimetry Measure of carbonate content.
Cash ow Receipts (cash in) less disbursements (cash out).
Casing Piping cemented into the internal wall of a well in order to maintain it.
CIF (Cost, insurance, freight) Cost of crude oil or product which includes insurance and
sea freight to the destination port.
Club of Rome Think tank in the 1970s renowned for publicising the risks of depletion of
natural resources due to over rapid economic growth.
Commercial discovery A discovery of hydrocarbons the commercial potential of which
has been demonstrated by an operator based on technical, economic, contractual and scal
parameters. A discovery cannot be developed and exploited until it has been declared
commercial.
Completion The operation of deploying production equipment in an oil well.
Concession An arrangement by which the state grants the exploration and production
rights within a given zone to the concessionaire who, in the case of commercial production,
becomes the benecial owner of the entire production in exchange for payment of the appro-
priate taxes (essentially a royalty on production and a tax on prots). The term also means,
in some countries, the legal title to mineral hydrocarbons authorising exploitation, or in some
countries, the contract associated with this mineral title.
299
Glossary
Consolidated prot Accumulated net prot/loss, both national and international, of the
parent company and all its branches and subsidiaries in which it holds a signicant share of
the voting rights.
Constant money Notional monetary unit based on the purchasing power of the money in
a reference year.
Conventional hydrocarbons Hydrocarbons which can be produced by conventional
methods and have standard characteristics in terms of viscosity, density, etc. Conventional
oils are supposed to be between 10 and 45 API in gravity.
Coring Operation involving taking a cylindrical sample of rock, carried out by means of
a special tool a core barrel in a probe.
Cost oil In a Production Sharing Contract the fraction of the production allocated to
recover the contractors costs (capital and operating costs).
Current money Monetary unit applying in the year under consideration.
Day rate contract Type of contract made between an oil company and a petroleum
industry service company by which the former controls the operations and the contractor
receives a xed daily remuneration.
Delineation After preliminary drilling has demonstrated the presence of hydrocarbons in
a structure under exploration, the subsequent drilling programme which allows the poten-
tially productive formations to be dened and delimited.
Derivatives On futures markets a distinction is made between contracts (rm commitments
to buy or sell a quantity of crude or a product) and derivatives: options, swaps, Many
derivatives are OTC (over the counter) transactions carried out between two parties by
mutual agreement, without the intercession of an organised market.
Derrick Tower like lattice structure in the form of a truncated, elongated pyramid. In
drilling equipment a derrick is used for hoisting and lowering.
Development costs Costs associated with the drilling of the production wells (and if
applicable the injection wells), the construction of the surface facilities (collection network,
separation and processing plant, storage tanks, pumping and metering equipment) and
transport infrastructure (pipelines, loading terminals).
Diesel oil (diesel) Fuel used by diesel engines.
Discount factor Factor applied to cash ows occurring at different dates to render them
comparable. The discount factor for year n relative to year 0 is 1/(1 + i)n (where i is the
discount rate).
Discount rate Cost of capital (effective cost or opportunity cost), the internal rate at
which the nancial department requires remuneration from departments responsible for
investment projects. A company usually denes the effective cost of capital as the weighted
average cost of nance from different sources (assuming the capital to debt ratio is given).
When capital is rationed, the discount rate may be higher than the average effective cost of
capital to reect a scarcity premium.
Discounted value See Net present value.
Discounting A decision maker does not place the same value on a given receipt or expen-
diture in a number of years as on the same sum now. Discounting consists of applying a given
300
annual rate (this rate is specic to the company) to future receipts and expenditures to
Glossary
estimate their present value. Discounting tends to reduce the importance of future cash ows.
Dubai Reference crude for trade East of the Suez Canal.
Economic rent The difference between the value of production (gross revenue) and the
technical costs (capital and operating costs), before tax.
Equivalent cost When the equivalent cost (annual or unit) can be assumed stable over
time, we have:
Equivalent annual cost: the annuity equivalent to the discounted capital and operating
expenditure.
Equivalent unit cost: the ratio of the total discounted expenditure to the total discounted
production.
Exploration costs Costs incurred before the discovery of a eld, including costs related
to the seismic/geophysical programme, the geological and geophysical interpretation, the
exploration drilling including the test wells.
Extra heavy crude Very heavy crude (specic gravity greater than 1, so API less than
10), found particularly in Venezuela in the Orinoco basin. The Orinoco crude is a non
conventional one since, before use, it needs a special treatment to make it suitable for
processing in a traditional renery
Field A eld can be dened as a receptacle comprising a permeable rock reservoir sealed by
a cap made of impermeable rock and a favourable subsoil conguration referred to as a trap.
There are different types of trap, including structural traps, stratigraphic traps and mixed traps.
Fiscal regime or Taxation system The totality of scal and contractual conditions which
determine how the oil prots are shared between the state and the holder of exploration and
production rights
FOB (free on board) The FOB price is the price of a crude oil or of a product when loaded
onto a ship at the port of embarkation. In principle at any given time there is only one FOB
price for a port (Ras Tanura for Arabian Light, Sullom Voe for Brent, Bonny for the Nigerian
crude of that name) whereas there are as many CIF see CIF prices as there are desti-
nation ports.
Foot rate contract Type of contract signed between a petroleum industry service
company and an oil company where the latter controls the operations and the former is remu-
nerated according to some measurable unit of activity (for example per metre drilled in the
case of a drilling company).
Full cost method Accounting method dened by SFAS 19 and applying to exploration
and production expenditure. All expenditures (exploration and development) are capitalised.
Futures markets Financial markets on which normalised contracts for crude or petroleum
products are exchanged. They meet the needs of operators to protect themselves or exploit price
uctuations using hedging, arbitrage and speculation. Physical deliveries account for only a
small part of the transactions effected on futures markets. Orders are transmitted by a broker
and the security of operations is guaranteed by means of deposits to a clearing house. The main
markets are the NYMEX (New York) the ICE (London) and the SIMEX (Singapore).
Gas cap Gas already separated from the oil in an oileld, most often situated close to the
top of the structure.
301
Glossary
Gas lift Production process involving gas injection which serves to emulsify and lighten
the oil column.
Gas oil A petroleum cut which can be used for diesel oil or heating oil manufacturing
Gearing Ratio of debt to equity.
Geneva Agreements Agreements (signed in 1972) between OPEC and the oil companies
which provided for an increase in oil prices to allow for the devaluation of the dollar.
GOSP (government ofcial selling price) Between the rst oil shock (1973) and the
beginning of the eighties, the prices of the various crude oils GOSP were xed by the
OPEC governments. These prices replaced posted prices.
Government take The total revenues accruing to the government including the earnings
of the national oil company. It can be expressed as a percentage of the economic rent, and
measures the severity (from the investors point of view) of the scal regime.
Heating oil Petroleum product used for space heating in residential and commercial
buildings.
Heavy fuel oil Fuel used by heavy industry, power stations and marine shipping.
Hydrocarbon tenement Legal document, often in the form of a decree, which assigns
exploration rights (exploration licence) or production rights (production licence or
concession) to a party.
IFP (now IFP Energies nouvelles) French Petroleum Institute, a scientic institute devoted
to research, training and documentation, founded in 1944, from which has emerged an
extensive structure of companies and consultancy services.
Internal rate of return (IRR) Discount rate at which the net present value of a project is
nil. When unique, this is the maximum rate for which the project revenues allow the invested
capital to be remunerated without the project going into decit. In this case a project for
which the IRR is greater than the discount rate has a positive net present value. On the other
hand in choosing between several competing projects, it is not necessarily that with the
highest IRR which is the best (highest net present value is a better criterion).
Jet fuel Fuel used by aircraft powered by turbines.
Kerosene Petroleum product from distillation which can be used for lighting or as jet fuel.
Logging while drilling (LWD) Technique consisting of recording, at the bottom of the well
during drilling, by means of sensors deployed in the drilling equipment, physical parameters
which allow the nature of the formations, their pressure regimes and the uids of which they
are composed to be characterised.
Logging The recording of certain electrical, acoustic and radioactive characteristics of
geological formations.
Migration A physical process in which hydrocarbons move from a source rock to a
reservoir.
Monte Carlo Simulation method used, in particular, to determine the probability distrib-
ution function of a variable (e.g. net present value) which is a function of other variables
with given probability distribution functions.
302
Mud logging A technique which involves the acquisition and interpretation at the surface
Glossary
of samples, data and information, making use of the mud circuit.
National oil company Oil company fully owned by the state or in which the state has a
majority holding, to which the government delegates the role of supervising oil operations
and managing that part of the production accruing to the state where applicable.
Net present value (NPV) The sum of the present values of the cash ows associated with
a project. An investment project with a positive NPV will repay the investment giving a
return equal to the discount rate and produce a surplus whose present value is equal to the
NPV.
Netback The netback value of a crude is equal to the value of the products obtained from
its processing less rening and transport costs. The netback value of a crude can be compared
with its FOB price. If the netback value exceeds the FOB price the rener will make a prot,
otherwise he will make a loss.
Nominal value Value expressed in current money.
Non conventional hydrocarbons These are hydrocarbons which, unlike conventional
hydrocarbons, are difcult and costly to produce, and whose physical characteristics and
geographical situation are exceptional. Non conventional oils include extra heavy oil (from
Orinoco) and tar sands (from Athabasca Canada) which both need a special processing
before treatment in traditional reneries. Non conventional oil includes also ultra deep
offshore elds.
Offshore Refers to any exploration or production activity at sea, in contrast with onshore
activities. The term ultradeep offshore refers to petroleum activities carried out at great depth.
Oil quotas In 1982 the OPEC countries established quotas, or production ceilings, as a
means of regulating prices. Since that date, each OPEC member state has had to remain
within a production ceiling, adjusted periodically in the light of market conditions.
Oil sands Very heavy crude oil of specic gravity around 1 (or 10 API), close to tar, in
sand reservoirs. There are very large deposits of tar sands in Athabasca, Canada. The
production of oil from these sands is currently being developed.
OPEC Organisation of petroleum exporting countries, created on 14 September 1960 by
Saudi Arabia, Iraq, Iran, Kuwait and Venezuela.
Opening up Many producing countries nationalised their oilelds in the 1970s. Now
certain countries are reopening their doors, allowing foreign companies to operate in their
territory.
Operating cash ow Cash ow excluding ows related to loans used to nance the
project.
Operating expenditures (OPEX) Total expenditure which relates to the operation of a
production facility.
Options Financial instrument giving the holder the option to buy (call) or sell (put) a
contract at a given price until a given date. If the option is not exercised before it expires,
the holders loss is limited to the price paid, whereas there is no limit to his possible gain.
The price of the option represents the market value of the option.
Parafn Petroleum product used for lighting (also known as kerosene).
303
Glossary
Petrol (gasolineUS) Fuel used by sparkignition engines.

Petroleum price shock Term used to describe a large increase in oil prices, particularly
the rst price shock of 1973 and the second price shock of 1979 1981.
Petroleum system Designates the interplay of the geochemical, geological and physical
parameters, the processes and the genetically related hydrocarbons which lead to seepage and
accumulations of hydrocarbons originating from a given source rock.
Production plateau See production prole.
Production prole The way the production level of an oil or gaseld varies over time.
Early in the production phase there is a steep build up in production, after which there is
usually a period of stable production (plateau) followed by a progressive decline.
Production Sharing Contract Arrangement by which exploration and production rights
in a given zone are granted by the state to a contractor who, in the event of commercial
production, can recover his costs from a part of the production (cost oil) and obtain a return
on part of the remaining production (prot oil), the balance accruing to the state.
Prot oil In a Production Sharing Contract, that part of production remaining after the cost
oil. This part is shared between the contractor and the state on the terms agreed in the
contract.
R/P Ratio of remaining reserves to annual production (expressed in years).
Real value Value corrected for ination, expressed in constant money.
Recovery rate Ratio of reserves to resources. Recovery rate is between 5 and 80 % for
crude oil depending upon eld and oil characteristics. Average value (for crude oil) is
around 35 %. For natural gas recovery rate is around 80 %.
Red line Line drawn on the map of the Middle East in 1928 in discussions between the
partners in the Iraq Petroleum Company. This line marked a region within which the partner
companies in the IPC were obliged to act in concert.
Reserves There are many denitions of hydrocarbon reserves. The reader is referred to the
index, which cross references these various denitions. In general when the term reserves
is used as such, it is synonymous with the term proven reserves.
Resources Total quantity of hydrocarbons physically present in the ground.
Riser Pipe connecting the seaoor with the surface during submarine drilling.
Royalties Under a concession system, the owner of land mineral rights (generally the state)
grants an operator the right to produce oil in exchange for the payment of royalties equal to
a percentage of the crude price. This royalty, often xed at 12.5% of the crude price, can
vary depending on the price of the crude and the characteristics of the eld.
SEC Securities and Exchange Commission.
Seismic reection Seismic prospecting technique in which seismic waves caused by
explosions are reected by the subsoil strata.
Sensitivity analysis Analysis of the impact on the protability of a project of possible vari-
ations in the different project parameters (e.g. investment costs, selling price, etc.).
SFAS 69 Amendment dening how exploration and production costs should be dealt with.
Companies may choose between the successful efforts and the full costs methods.
304
SFAS
Glossary
Statement of Financial Accounting Standards.
Spot market A market in which deals are struck on the day itself, with prices being xed
at the time. The products traded are physical cargoes of crude and rened products. There
is no ofcial record of transactions effected between operators, but estimates are published
by specialised journals such as Platts. There are spot price estimates for both crudes and
for the principal products for the main consuming and rening regions: Rotterdam or North
West Europe, the Mediterranean, the Gulf, Singapore, the Caribbean, the U.S. The spot price
of the main crudes (Brent, WTI, Duba) act as indicators of crude prices and as reference
price in certain indexation clauses. There is also a spot market for vessel charter.
Spot See Spot market.
State participation Contractual provision by which the state has the option to participate
in the contract in partnership with the contractor, to the extent of its participation.
Success rate Ratio of nondry wells drilled to the total number drilled.
Successful efforts method The accounting method dened in SFAS 19 applying to the
expenditure associated with exploration and production. The costs of the geology geophysics
and unsuccessful exploration are expensed.
Swaps A type of paper contract in which the difference is bought between its values
quoted on the spot and forward markets. This instrument allows oil companies to make sales
to their customers for delivery several months hence (up to one year) at a guaranteed xed
price.
Tax In a concessionary system, the operator pays the owner of the eld not only royalties
but also a tax on prots.
Technical cost Total costs : exploration + development + production costs
Teheran Agreements Agreements (signed in 1971) between OPEC and the oil companies
which provided for programmed increases in oil prices for the Gulf producers.
Traders Persons who buy and sell commodities, currencies or nancial instruments. Unlike
a broker, whose function is merely to act as an intermediary between a buyer and a seller,
traders buy and sell cargoes on their own account and therefore are exposed to signicant
risk. A petroleum trader may be attached to a producing country, belong to an oil company
or a nancial group or be an independent. See also Broker.
Trading Buying and selling.
Tripoli Agreements Agreements (signed in 1971) between OPEC and the oil companies
which provided for programmed increases in the price of oil available in the Mediterranean.
Turnkey contract, rm price contract Type of contract made between an oil company
and a petroleum industry service company. Unlike a cost reimbursement contract or a contract
based on a work specication, the contractor is responsible for the operations and is paid for
services rendered (a drilling project, for example) at a contractually agreed overall price.
Unitisation Contractual clause providing for the unied operations for a eld extending
over several contractual zones exploited by different operators.
Uplift Device equivalent to an investment credit authorising the holder of production
rights to write off (in the case of a concession) or recover (in the case of shared production)
a sum in excess of the actual investments.
305
Glossary
Wire line logging A technique which involves using sensors lowered on the end of an
electric cable to record physical parameters such that the nature of the formations, their
pressure regimes, the uids of which they are composed can be characterised.
WTI (West Texas Intermediate) Reference crude in the U.S., on both the spot and NYMEX
markets.
306
Table of contents
Preface to the first edition ................................................................... V
Foreword to the third edition ............................................................... VII
1 Petroleum: a strategic product ................................................... 1

1.1 Uses, importance, future . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1.1 Uses of petroleum through the centuries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1.2 The importance of oil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.2 Historical background 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2.1 The large oil companies up until the First World War, early competition . . . . . 5
1.2.2 Between the wars: the role of the state . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.2.3 Between the wars (2): cooperation and competition between oil
companies. The example of the Turkish Petroleum Company .................. 17
1.2.4 After WWII: increasing oil consumption, new oil companies, creation and
development of OPEC ............................................................ 20
1.2.5 Weakening of OPEC and fall in prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
1.2.6 The 1990s: market forces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
1.2.7 The twenty first century: sustained high prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
1.3 The oil market and the oil price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
1.3.1 Physical parameters which affect the price of crude oil . . . . . . . . . . . . . . . . . . . . . . . . 44
1.3.2 Mechanisms for setting the price of crude: history . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
1.3.3 Economic analysis of price formation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
1.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
2 Oil and gas exploration and production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

2.1 How hydrocarbons are formed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
2.1.1 Sedimentary basins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
2.1.2 Petroleum geology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
2.1.3 Petroleum system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
IX
Table of contents
2.2 Exploration for hydrocarbons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

2.2.1 Prospecting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
2.2.2 Geology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
2.2.3 Geophysics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
2.2.4 Exploration drilling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
2.2.5 Appraisal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
2.3 Development and production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
2.3.1 Reservoir management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
2.3.2 Reservoir simulation models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
2.4 Development drilling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
2.4.1 Directional drilling, horizontal drilling, multidrains . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
2.4.2 Completion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
2.4.3 Well productivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
2.4.4 Well interventions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
2.5 Processing of effluents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
2.5.1 Separation process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
2.5.2 Oil treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
2.5.3 Water treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
2.5.4 Gas treatment: sweetening and dehydration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
3 Hydrocarbon reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
3.1 Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
3.1.1 Political and technico-economic constraints . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
3.1.2 Deterministic and probabilistic estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
3.1.3 P90, P50, P10, etc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
3.1.4 1P, 2P and 3P reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
3.1.5 Proven, probable and possible reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
3.1.6 Need for caution in using definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
3.2 Characteristics of reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
3.2.1 Conventional and non-conventional hydrocarbons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
3.2.2 Deep and ultra-deep offshore . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
3.2.3 Heavy, extra-heavy oils and oil sands . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
3.2.4 Oil shales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
3.2.5 Synthetic oils (Fig. 3.3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
3.2.6 Non-conventional gas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
3.2.7 The polar zones . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
3.2.8 Other types of non-conventional hydrocarbons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
3.3 The production of reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
3.3.1 The decision to produce . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
3.3.2 Production profiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
3.3.3 Hubbert theory of decline (Fig. 3.6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
3.3.4 The impact of technical progress on the production profile . . . . . . . . . . . . . . . . . . . . 107
3.4 Optimists and pessimists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
3.4.1 Two schools of thought . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
3.4.2 Naturalists or economists? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
3.4.3 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
3.5 Geographical distribution of reserves and production . . . . . . . . . . . . . . . . . . . . . . . . . . 112
3.5.1 North America . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
3.5.2 South America . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
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3.5.3 Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.5.4 Africa . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
3.5.5 Middle East . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
3.5.6 Former USSR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
3.5.7 AsiaOceania . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
4 Investments and costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

4.1 Introduction ........................................................................... 121
4.2 Costs classification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
4.2.1 Types of costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
4.2.2 Examples of cost breakdowns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
4.3 Exploration costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
4.3.1 Geophysics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
4.3.2 Exploration drilling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
4.4 Development costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
4.4.1 The key stages prior to project authorisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
4.4.2 Development drilling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
4.4.3 Production and transport installations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
4.4.4 Methodology for estimating development costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
4.4.5 Examples of developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
4.5 Operating costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
4.5.1 Classification of operating costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
4.5.2 Controlling operating costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
4.6 Mastering costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
4.6.1 Impact of technological progress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
4.6.2 Impact of the economic cycle and the contractual strategy on project costs . 163
4.7 The petroleum services sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
4.7.1 Historical background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
4.7.2 Investment in exploration and production: the market for petroleum services 167
5 Legal, fiscal and contractual framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171

5.1 The key issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
5.1.1 Ownership of hydrocarbons and the sovereignty of the State over natural
resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
5.1.2 Forms in which exploration and production can be undertaken . . . . . . . . . . . . . . . 174
5.1.3 Regulatory options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
5.1.4 The content of petroleum legislation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
5.1.5 The objectives of the parties involved . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
5.1.6 Reconciling objectives and sharing the economic rent . . . . . . . . . . . . . . . . . . . . . . . . . 178
5.1.7 Types of contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
5.1.8 Breakdown of petroleum contracts by type . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
5.2 Main provisions of a petroleum exploration and production contract . . . . . . . 178
5.2.1 General structure of a contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
5.2.2 Technical, operational and administrative provisions . . . . . . . . . . . . . . . . . . . . . . . . . . 182
5.2.3 Economic, fiscal, financial and commercial provisions . . . . . . . . . . . . . . . . . . . . . . . . . 188
5.2.4 Legal provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
5.2.5 Gas clause . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
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5.3 Concession regimes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

5.3.1 General framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
5.3.2 The main features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
5.4 Production sharing contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
5.4.1 General framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
5.4.2 The main components . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
5.5 Other contractual forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
5.5.1 Service contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
5.6 Impact of the economic rent sharing on exploration and production
activities ............................................................................... 204
5.6.1 Flexibility and investment incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
5.6.2 Comparison between systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
5.6.3 Perspectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
6 Decision-making on exploration and production . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211

6.1 Strategic analysis and definition of the objectives of the company . . . . . . . . . . . 211
6.1.1 Understanding the environment in which the company is operating . . . . . . . . . . 211
6.1.2 Strengths and weaknesses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
6.1.3 The portfolio of activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
6.1.4 Alliances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
6.1.5 Strategy Department: organisation and functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
6.2 Economic evaluation (deterministic) and short-term decision-making ....... 214
6.3 Decision-making in relation to development and the deterministic
calculation of the return ............................................................ 216
6.3.1 Discount rate and the cost of capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
6.3.2 Constructing a schedule of cash flows, operating cash flows, general
remarks .......................................................................... 218
6.3.3 Evaluation criteria for investment projects: net present value (NPV)
and rate of return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
6.3.4 Equivalent cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
6.3.5 Financing mix and the equity residual method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
6.3.6 Acquiring participations, valuing a project . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
6.3.7 Another approach to calculating the return on exploration/production
projects: the Arditti method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
6.3.8 A new approach: the generalized ATWACC method . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
6.3.9 A first step in dealing with uncertainty: sensitivity analysis . . . . . . . . . . . . . . . . . . . . 229
6.3.10 An empirical criterion: payback period (duration of financial exposure) . . . . . . 231
6.4 The decision to explore: introduction to probability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
6.4.1 The exploration data sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
6.4.2 Expected value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
6.4.3 Sequential decisions and conditional values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
6.4.4 Limitations applying to the expected value of NPV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238
7 Information, accounting and competition analysis ........................ 243

7.1 Accounting principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
7.1.1 Capital and operating costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
7.1.2 Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
7.1.3 Depreciation and provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
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7.2.1 Supplemental information on oil and gas producing activities appended
to the balance sheet ............................................................. 254
7.2.2 Indicators ........................................................................ 258
Annexe to Chapter 7
Basic principles of financial accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265
7A.1 The balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
7A.2 Profit and loss account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
7A.3 Cash flow statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
7A.4 The consolidated accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272
8 Health, safety, the environment, ethics ........................................ 277

8.1 Risk in the industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
8.2 Safety management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
8.2.1 The Piper Alpha accident . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
8.2.2 Reducing risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
8.2.3 Safety management systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
8.3 Taking account of the environment ............................................... 280
8.4 The stages of environmental management: before during after . . . . . . . . . 282
8.4.1 Before: the preparatory phase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
8.4.2 During: the operating phase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
8.4.3 After: the aftercare phase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
8.5 The integration of health, safety and the environment ........................ 285
8.6 Oil and ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
8.6.1 Ethical issues within the oil community . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
8.6.2 Ethical issues involved in relations with host countries . . . . . . . . . . . . . . . . . . . . . . . . . 288
8.6.3 Major ethical issues: the environment and human rights . . . . . . . . . . . . . . . . . . . . . . 291
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
Index ............................................................................................. 307
XIII
1 Petroleum:
a strategic product
1.1 USES, IMPORTANCE, FUTURE
1.1.1 Uses of petroleum through the centuries

References to petroleum (literally oil from stone) or more precisely bitumen, asphalt or even
pitch, can be found in writings going back to earliest antiquity. These texts effectively
describe the heavy and viscous residue which remains when petroleum reaches the earths
surface and loses its lighter fractions as a result of natural evaporation. This residue has many
uses, in particular the caulking of ships. It is said that Mosescradle may have been tarred
to prevent it from sinking on its journey down the Nile.
Over the centuries up until the dawn of the modern era petroleum was used for two other
important purposes: as a medicine it was considered a panacea (see Box 1.1 and Fig. 1.1).
Figure 1.1 Oil, a universal remedy.
1
Chapter 1 Petroleum: a strategic product
Box 1.1 The balsam of the Senecas
He continued:
In those days, the sons of our warriors did not learn how to read. They did not go to
school but they understood the language of the birds and of all the animals that the Great Spirit
had created in the sky, the waters, the prairie and the forest. They learned without a teacher
everything they needed to live. Often, in the forest or in the mountains, they came across black
lakes, whose waters seemed to be poisonous. Yet, the hunters claimed that, in the evening,
many animals would come to drink from these thick waters. It was as if they were attracted
from afar by the smell which rose above these lakes and spread far away through the air.
Our brothers, the Senecas, were the rst to think:
Why not do like these birds and these mooses? The bears that want to live through the
harsh winter without feeling the cold lick the grease from their paws; for us, if we drink these
oily waters, we will gain much strength for walking, hunting, ghting and to combat the cold.
The Great Spirit, who placed these waters in our path, did not do it just to tempt us.
They drank and they found that indeed the water from the black lakes proved to be a
powerful remedy against all the ailments which threaten a warrior during his lifetime. Those
who drank from these waters no longer suffered headaches or stomach aches; they saw the
worms which incessantly gnawed away at mans liver and entrails leave their bodies. Those
who poured it over their heads felt their hair grow longer; those who applied it to their wounds
were cured more quickly than with the balsams of our medicine men. Those who rubbed it
on their bodies were protected against snakebite; even the Iroquois claimed that if they mixed
a little of the water from the black lakes with their tattoos, they would never again fear arrows.
The Indians had repeated these wonderful tales from one side of the continent to the other.
Now, they were ghting with each other over the black lakes. They dug holes in the ground
where salt was plentiful, on the surface of the earth. They threw their woollen blankets in these
holes. At sunset, they prayed to the Great Spirit for mercy. And often, in the morning, they
would nd their blankets soaked with miraculous oil. They would offer them to their friends.
My father often told me that one of our ancestors had shown one of these black lakes to a
paleface who came to this country, many years ago, when the Indians knew no other master
than the Great Spirit, between earth and sky.
The land of oil
Hugues Le Roux, Flix Juven Publishers, 1901.
The ailments which it was supposed to cure were numerous: scurvy, gout, toothache,
rheumatism, even ingrowing toenails according to Morris and Goscinny, authors of the
cartoon Lucky Luke.
Petroleum is also combustible, and therefore an instrument of war: the Greeks knew it as
medical re, the Romans as incendiary oil, the Byzantines as Greek re, all fore-
runners of modern-day napalm.
But the modern development of petroleum is mainly attributable to the invention of the
oil lamp (Fig. 1.2) by the physicist Argand, later improved by Quinquet, a Parisian phar-
macist. This lamp provided exceptional lighting, and caught on very quickly. From our
vantage point in the new millennium, these lamps, very varied in size and shape, testify
vividly to the daily life of our forefathers. Originally they often used whale oil. But apart
from endangering the survival of their prey, whalers were not able to meet the needs of
consumers. It was replaced by parafn, or kerosene, a petroleum product. However natural
seepage rapidly became insufcient to meet growing demand, prompting subsurface explo-
ration to increase production. On 27 August 1859 Colonel Drake carried out the rst drilling
2
at Titusville, Pennsylvania. This was successful. At a depth of 23 metres the bottom of the

pit lled with precious petroleum (see Fig. 1.5, Section 1.2.1.1).
The methods used to manufacture kerosene from crude oil were rudimentary. The distil-
lation techniques practised at that time allowed the heavy fractions to be separated and used
as lubricants, but part of the crude was deliberately discarded; environmental constraints were
not yet what they were to become a century later!
Increases in the consumption of kerosene led to a rapid growth in the demand for crude
oil. By the turn of the century oil lamps were being progressively replaced by the electric
light bulb, and the consumption of kerosene began to decline. But declining demand for
kerosene was offset by growing demand for petrol for cars, and later diesel. This was of
course the time when the automobile industry was expanding. Some time later the heavy fuel
oil market became an important outlet for the rening industry. Winston Churchill, rst Lord
of the Admiralty 1911-1915, urged the adoption of this fuel by the British eet whose
eventual agreement made an important contribution to the development of petroleum.
Figure 1.2 Oil lamp.
Figure 1.3 Delivery van in the 1920s (by kind permission of BP).
3
Until the Second World War, however, the consumption of petroleum remained limited
(Fig. 1.3): outside of the United States the consumption was small, and worldwide, coal was
still the dominant source of energy. It was only after the war ended in 1945 that oil was to
become the energy of reference. Consumption rose from 350 Mt in 1945 to over 1 Gt in
1960, over 2 Gt in 1970 and over 3 Gt in 1990. Now at the beginning of the 21st century
consumption is close to 3.5 Gt/y.
1.1.2 The importance of oil

Yves Lacoste claimed that geography is used to make wars. We could paraphrase him by
adding that so does oil. It would be possible to do without metals or certain agricultural
products for a fairly long period. It would be unthinkable to do without petroleum products.
Indispensable in the transport sector, petrol is of vital national importance in times of peace,
but also in times of war.
During the Second World War the German army tried to take control of oilelds (Fig. 1.4).
The purpose of the 1941 offensive on the Eastern front was to gain control of the Russian
oilelds of the Volga. Berlin later directed its forces towards the Middle East where large
deposits of oil had been discovered in Saudi Arabia and Kuwait just before the onset of war.
Petroleum is therefore a strategic commodity, i.e. a commodity on which not only mans
prosperity but even his survival may depend. Georges Clemenceau declared at the end of
Finland
way
en
USSR
Nor
Swed
Moscow
Soviet
counter-offensive
Stalingrad
Turkey
Iran
Morocco Iraq
El Alamein
Algeria
British
Libya Egypt counter-offensive
Figure 1.4 German army advances towards the Volga and the Middle East.
4
WW1 Petroleum is as necessary to the economy as blood to the human body. But the

examples of Japanese and Korean industrialisation show that it is control over the supply of
petrol rather than its possession as such which is really the issue.
Oil is likely to maintain its vital role in the future, particularly in the transport sector,
where its hegemony is virtually unchallenged. Alcohols and gas (LPG, compressed natural
gas and LNG) may make some inroads into the market for auto fuels, but the only serious
rival is electricity. However technological and economic problems mean that it is likely to
be many years or even several decades before electricity begins to make major headway in
the auto fuel market. It should also be noted that, even if electricity were to become a serious
contender, it would probably still be necessary to have recourse to petroleum or gas as energy
source in the fuel cells. For the moment there is no prospect of replacing oil products. Mean-
while another oil product is likely to continue to grow: the fractions which are used as feed-
stocks for petrochemicals. The demand for petroleum is likely to go on increasing in the
coming years to attain a level in excess of 4 Gt/y.
1.2 HISTORICAL BACKGROUND 1
1.2.1 The large oil companies up until the First World War,
early competition
1.2.1.1 Standard oil
The history of petroleum from 1859 (see Fig. 1.5) up to about 1960 is inseparable from that
of the big oil companies which formed and grew rapidly in order to seek, produce, transform,
transport and sell this precious liquid. The rst company to become very large in the oil
sector belonged to John D. Rockefeller. He initially headed up a wholesale business, one of
whose products was petroleum, and built the rst renery in Pennsylvania, then a second,
progressively extending his activities to cover the entire range of activities of the burgeoning
petroleum industry. He acted according to a number of simple but effective principles:
control the various links in the petroleum chain (storage, rening, transport, distribution infra-
structure) and ensure that they operate at minimum cost. Rockefeller eschewed production,
which he considered anarchical, preferring to buy in his crude, which was then available on
the market at a very competitive price.
On 10 January 1870, he created Standard Oil together with his brother and some friends.
The name Standard reected the desire to sell a product of constant and high quality. After
a decade of erce struggle with his competitors Standard Oil achieved a dominant position
in the market, controlling 80% of the distribution of the principal oil products, and in
particular kerosene.
But the successand sizeof Standard Oil provoked deance and hostility not only
amongst its competitors but also amongst some sections of the public and the authorities. In
order to defuse these attacks the company formed itself into a trust in 1882. The shares in
the various operating companies in the group were presented as being no longer the property
of a single company but rather as being held in trust on behalf of their owners, the share-
holders of the main company. The Standard Oil Trust issued 700 000 shares, distributed
1. This section was inspired particularly by tienne Dalemont and Jean Carri: Histoire du ptrole. Presses
Universitaires de France, 1993.
5
Figure 1.5 The rst oil drilling, as seen by Morris. The cartoonist was
carried away by his enthusiasm here, showing oil gushing forth from a
drillhole, whereas the oil actually only owed out slowly into the bottom
of the hole drilled by Colonel Drake. (From: lombre des derricks,
Lucky Comics, by Morris and Goscinny).
* and on 27 August 1859, having drilled to a depth of 23 metres, Drake
discovered oil, lots of it. This was the dawn of a new era for mankind
amongst its members; it received, in trust, the shares of all the companies in the group (14
were totally controlled and 26 partially controlled). The group continued to be run by a small
team led by Rockefeller.
Against a background of rapid growth in the demand for lighting, heating, lubricants and
greases, Standard Oil continued to grow, maintaining its rm grip on the rening, transport,
distribution and retail of petroleum. After 1880 it felt the need to increase its presence in oil
production in order to guarantee its supplies of crude. This strategy of developing its
production capacity proved particularly judicious when in 1888 a chemist employed by
Standard Oil perfected a rening process which permitted sulphur to be removed from oil
products, particularly kerosene. Hitherto kerosene with a high sulphur content had been
impossible to sell because of the odour produced when it burned. This invention meant that
new high-sulphur crudes could be used.
Having become a trust in 1882, Standard Oil was forced to transform itself after anti-trust
legislation was enacted (Sherman Act, 1890). In 1899 a new holding company, the Standard
Oil Company of New Jersey, was created, bringing under its umbrella all the companies then
constituting the group.
The new company continued to represent a great concentration of power, attracting
hostility not only from the authorities, who sought to promote competition, but also from
6
some journalists and writers who probed the mechanisms used by the group in its operations,

criticising its harmful aspects. A series of articles published at the turn of the century by the
journalist Ida Tarbell, subsequently compiled into a book, The history of Standard Oil, had
a tremendous impact. Eventually action was taken in the courts, and in 1909 the Federal
Court ordered the break-up of Standard Oil. Despite delaying tactics employed by the
company, the ruling was conrmed in 1911. The group divided up into 34 separate
companies (see Box 1.2).
Box 1.2 The companies which emerged from the break-up of Standard Oil.
Of the 34 companies which made up the Standard Oil group, 5 ceased operations, 8
turned to other activities and 21 continued their development, in some cases buying out
their competitors. Amongst the companies still recently in existence were:
Standard Oil of New Jersey (now Exxon);
Standard Oil of New York (Mobil, after merger with Vacuum and until its merger
with Exxon);
Standard Oil of California (now Chevron);
Standard Oil of Indiana (Amoco until its merger with BP in 1998;
Atlantic Petroleum Company (Arco until its merger with BP);
Continental Oil Company (now Continental);
Ohio Oil Company (now Marathon Oil Company);
Standard Oil Company (Ohio) (bought by BP, and now BP USA);
Ashland Oil Company (now Ashland);
Pennzoil Company (now Pennzoil).
It should be noted that the mergers between Exxon and Mobil, and between BP,
Amoco and Arco further reduced by several companies the number of offspring
companies of Standard Oil.
The strategy adopted by Standard Oil illustrates the constant concern of industry to
control the entire chain of its activity. Furthermore this desire for control rapidly translated
itself into a nancial obligation, the demands of technological and industrial development
imposing investments on companies which only the largest could bear. This was conducive
to the emergence of a vertically integrated and oligopolistic industry. Although in the rst
twenty years of its existence the petroleum industry was American, and dominated by
Standard Oil, it rapidly became an international industry, even though the U.S. continued to
account for more than half of world production until 1950. The growth in the consumption
of kerosene, followed by gasoline, diesel-oil, and fuel oil was a worldwide phenomenon. Not
only Europe but also Russia and Asia became important markets. New oil companies were
created (e.g. Shell, Royal Dutch, Texaco, Gulf, Anglo-Persian, later to become BP).
Standard Oil of New Jersey (later Esso, then Exxon), Standard Oil of New York (Mobil),
Standard Oil of California (now Chevron), Texaco, Gulf, Royal Dutch Shell and BP became
the majors (also known as the seven sisters).
7
1.2.1.2 The oil industry in Russia

It had long been known that the Baku region was rich in oil. Travellers had been struck by
the permanent res fuelled by natural sources of petroleum. There was a thriving trade in
naphtha (nefte is the Russian word for petroleum) between the shores of the Caspian and
the Far East. It was transported by camel in goatskins.
The early discoveries of oil in the U.S. rekindled interest in the Baku resources, and
drilling commenced there in 1872 (Fig. 1.6). Oil production grew rapidly, attaining 1 Mt in
1889, 4 Mt in 1890 and 10 Mt in 1900. At that time this was half of world production, and
exceeded U.S. production. Among the rst to buy up land on the banks of the Caspian were
Robert and Ludwig Nobel, brothers of Alfred, the inventor of nitroglycerine and dynamite,
and creator of the prize which bears his name. They rapidly developed oilelds, reneries
and transport facilities. They arranged for the bulk transport of oil across the Caspian Sea,
launching the rst oil tanker, the Zoroastra, in 1878, and became the largest producers in
the region. Of course a problem which rapidly presented itself was how the oil was to be
transported out of Azerbaijan, across Georgia to the Black Sea. The isolation of the oil
resources in the Caspian, already a critical problem at the end of the nineteenth century,
continues to be relevant to this day. In 1893 a railway was proposed to connect Baku to
Batum on the Black Sea, and a French nancier Alphonse de Rothschild was approached.
The latter already had interests in the oil industry: the import of kerosene from the U.S. and
a renery on the Adriatic. He agreed to participate in nancing the pipeline, and went on to
establish a company, BNITO, which was to become one of the largest in the region.
Figure 1.6 Baku Oileld (by kind permission of BP).
The Nobels and the Rothschilds rapidly sought to sell their product to external markets:
Europe and the East. While the Nobel brothers controlled much of the Russian market, the
Rothschilds were much more dependent on foreign markets. The latter therefore turned to
Marcus Samuel (Fig. 1.7), a London businessman specialising in imports and exports, partic-
ularly the import of antiques and sea shells from the Far East, in regard to the transportation
of their products.
8
Figure 1.7 Marcus Samuel, founder of Shell (by kind permission of Shell).
For many years there was erce competition between Standard Oil and the Caspian
producers. But there was a rapid deterioration in economic and social conditions in Russia,
the Tsarist administration proving weak and inept. A revolution in 1905 failed, but in 1917
the Bolsheviks took power and overthrew the Tsar. During this whole period the Baku region
was being shaken by a whole series of strikes and industrial unrest caused by the deplorable
working conditions. One of the leaders of these actions was a certain Jossef Djugashvili, later
to become the notorious Stalin. In the face of this situation, the Rothschilds decided in 1912
to sell most of their interests to Royal Dutch Shell, which had been set up in 1907. In 1918
the new Soviet regime nationalised the entire oil industry. Royal Dutch Shell lost 50% of its
oil supplies at a stroke. The last remaining Nobel was stripped of all his assets, which Standard
Oil of New Jersey nevertheless bought from him, doubtless convinced that it would one day
be able to resume operations on Russian territory. This hope was dashed, because despite the
adoption of a new and more liberal New Economic Policy in the 1920s, none of the companies
which had been nationalised ever managed to resume any signicant activity. Standard Oil
of New York, on the other hand, was later to contract to purchase Russian products.
By 1920, Russian oil production had fallen to 3 Mt/y, compared with 10 Mt/y at the turn
of the century. By 1930, however, it had regained the level it had enjoyed before the outbreak
of the 1914 1918 war, the government being in dire need of foreign currency earnings from
oil exports. These exports beneted from a small discount relative to the international price.
1.2.1.3 Shell and Royal Dutch

As already mentioned, competition on the oil products market was stiff at the end of the nine-
teenth century, and there was particularly erce competition between Standard Oil, the
Nobel brothers and the Rothschild family.
9
In order to nd new markets in the East the Rothschilds, seeking new transport possibil-
ities, turned, as we saw, to Marcus Samuel. In 1892 Samuel turned his hand to the oil sector,
providing bulk transport of kerosene bought from Rothschild in Batum on the Black Sea to
Asia (Singapore and Bangkok via the Suez Canal (Fig. 1.8)). Marcus Samuel gradually built
up his oil interests, and in 1897 he created the Shell Transport and Trading Company
Limited to manage these activities. The company prospered, trading not only kerosene but
also, after 1885 when Karl Benz invented the internal combustion engine, gasoline.
Figure 1.8 One of the rst oil tankers, the Murex (by kind permission of
Shell).
In order to diversify his sources of supply, Marcus Samuel acquired concessions in the
Dutch East Indies (East of Borneo), where he produced crude which was rened in a factory
in the Balikpapan region. He also acquired interests in oil produced in Texas from the
Spindletop oileld, discovered in 1901. Shell therefore became the rst company with oil
sources throughout the world. Aware of the threat posed by its competitor, Standard Oil
attempted to buy Shell out, but was turned down by Marcus Samuel.
The company Royal Dutch was developing at the same time. It was created in 1890 by
Aeilko Gans Zijlker, a former head of the East Sumatra Tobacco Company who, on discov-
ering traces of a parafn-rich petroleum on the island, decided to throw himself into oil
exploration.
After rst drilling a dry well (without oil), he was successful on his second drilling
attempt. In June 1885 there was a gusher from the Telaga Tunggal 1 well in Sumatra, which
had been drilled to a depth of 121 metres; the oilwell continued to produce oil for another
50 years. Supported by powerful allies (including the Dutch King Willem III, who granted
him a royal seal), Zijlker founded the Royal Dutch Company. When he died, several years
later, his mantle was taken on by Jean-Baptiste Auguste Kessler. A renery with a capacity
of 8000 bbl/d (400 000 t/y), about 50% of the production of which was kerosene, was
commissioned in the vicinity of the well (Fig. 1.9). Part of the production was exported,
putting Royal Dutch into direct competition with Standard Oil. From 1894, the latter made
10
attempts to capture Asian markets. It introduced millions of oil lamps onto Asian markets

(particularly China) at derisory prices, or even gave them away. Competition was also
intense with Marcus Samuel who owned a renery virtually next door to that of the Royal
Dutch in Balikpapan.
Figure 1.9 Telaga Sad oileld, Netherlands East Indies (Indonesia),

around 1900 (by kind permission of Shell).
Many attempts were made to combine Royal Dutch and Shell; and in 1902 a working rela-
tionship was established whereby. Marcus Samuel became the Chairman and Henry
Deterding, who had taken over from Kessler on the latters death in 1899, became Managing
Director. Deterding also took on the day-to-day management, which was his wish. The
Rothschilds became associated with this new organisation when the Asiatic Petroleum
Company was created also in 1902, bringing together these three interests who nevertheless
retained their autonomy. It was not until 1907 that a more comprehensive agreement was
signed between Royal Dutch and Shell. In fact this made Royal Dutch, based in the Nether-
lands, the senior partner, with 60% of the shares in the new company, Shell Transport and
Trading, based in the UK owning 40%. The formation of this new Anglo-Dutch group
ushered in a new chapter in the competition with Standard Oil. In order to avoid falling
victim to the power of the American company, Henry Deterding decided to gain a foothold
in the American market by buying the American Gasoline Company and the Roxane
Petroleum Company.
11
1.2.1.4 The other American oil companies: Gulf, Texaco

Many companies were formed in the United States at the end of the 19th century. Two of
them played a particularly important role: Gulf (which disappeared in 1984 when it was
bought out by Chevron) and Texaco.
Gulf was created by the Mellon family around 1890. From 1889 they began to buy up
oilwells in the West of Pennsylvania, using these as the basis for an integrated operation.
But in 1893 the family decided to sell all its installations to Standard Oil, which showed
every sign of wishing to achieve an unchallenged position in the American oil industry. The
Mellon family resumed its interest in oil when the rst explorations were being conducted
in Texas, nancing a drilling operation. This was at Spindletop in 1900, and on 10 January
1901, when a depth of 300 metres had been reached, an oil gusher destroyed all the drilling
equipment, hurling rocks, sand and earth into the air! The well produced several tens of thou-
sands of barrels per day, and it took weeks to staunch the ow of hydrocarbons.
This discovery had a number of consequences. First of all the resulting glut of oil led to
a fall in prices. The large oil companies, including Standard Oil and Shell, bought oil from
Texas in order to take advantage of the low prices. But after 18 months the ow from
Spindletop collapsed. In 1902 the Mellons raised further capital and founded another inte-
grated company, also called the Gulf Oil Corporation. Their efforts were rewarded, because
Gulf went on to become one of the worlds largest oil companies.
Another company, the Texas Company or Texaco, was formed in 1901, based on a
production facility in Texas. Like its competitors, Texaco developed an integrated structure,
with a renery in Port Arthur, a number of sources of crude and a distribution network. The
lone red star logo (the symbol of Texas) was increasingly seen throughout the U.S. before
embarking on the conquest of the world.
1.2.1.5 The creation of Anglo-Persian: the role of the British government

At the turn of the century oil production was dominated by three regions: the U.S., Russia
and the Dutch East Indies. But there were many indications that the Middle East was poten-
tially rich in hydrocarbons. Exploration started in Persia (now Iran), followed by Turkey.
The Shah of Persia was very keen to develop his countrys hydrocarbon resources. At the
beginning of the century, William dArcy negotiated the rights of exploration in Persia. The
project got off to a bad start. The rst four exploration wells all proved dry, also drying up
the funds which had been made available by the promoters of the operation. A new capital
injection by Burmah Oil, a company which developed in India, allowed work to continue.
The fth attempt, which lasted many months, was successful. In 1908, oil gushed forth from
the exploration well (see Figs. 1.10 and 1.11). But in order to turn a discovery of oil into a
commercial venture, major investments are needed for the production, transport and rening
facilities. More capital was needed. In 1909 the Anglo-Persian Company was established to
realise this objective. Burmah Oil remained a partner. The new company went on to become
the Anglo-Iranian Company, and later, in 1951, the British Petroleum Company.
The new company required considerable capital to nance its development in consumer
markets. Ultimately the British government, nally responding to the campaign of the rst
Sea Lord, Admiral Sir John Fisher, (1904 1910) and subsequently, Churchill, to use fuel
oil for the eet, provided the necessary nance. The British government acquired a 51%
participation in the company, and two government directors with the right of veto sat on the
board of directors.
12
Figure 1.10 First oil discovery in Persia (Iran) at Masjid-I-Suleiman (by
kind permission of BP).
Figure 1.11 Steam production at Masjid-I-Suleiman (by kind permission

of BP).
1.2.1.6 The development of production in Mexico and Venezuela

Oil production in Latin America followed rapidly in the footsteps of the U.S., Russia, the
Dutch East Indies and Persia. Oil was rst discovered in Mexico in 1901, and in 1908 there
was a spectacular gusher in the Dos Bocas oileld. Royal Dutch Shell, Standard Oil of New
Jersey and Gulf successively developed oilelds in Mexico, leading to a production which
exceeded that of Russia: Mexico became the worlds second largest producer.
But in the 1930s a number of conicts between the Mexican government and the oil
companies set back production. In 1938 the oil industry was nationalised. Pemex (Petroleos
Mexicanos) was created and took control of all oil-related activities in Mexico. However
13
production fell to a very low level (6 Mt/y) and never really recovered until the 1970s. It
was at that time that large new discoveries allowed Mexico to become one of the worlds
leading exporters.
Venezuela followed close behind Mexico, and in the 1920s became the second oil
producer in Latin America. The rst discovery was made in 1914, in Mene Grande.
Venezuela rapidly became the worlds second largest oil producer, in front of the USSR,
retaining this ranking until 1961. At the beginning, Royal Dutch, Shell, Gulf and a small
company, Pan American, were the main producers. After various incidents, Pan American
was bought out by Standard Oil of Indiana, and later by Standard Oil of New Jersey.
1.2.2 Between the wars: the role of the state

1.2.2.1 Oil, a strategic product
The links between Anglo-Persian and the UK government were established in order to safe-
guard the regular supply of heavy fuel oil to the British eet. It also served as a clear
reminder of the strategic importance of oil (another example is the support given to Royal
Dutch by the Netherlands government when it was created). For consumer countries the
problem is to secure reliable supplies of a vital product. France is another good illustration
of the concern and the energy which a major industrial country largely devoid of hydro-
carbons will mobilise in developing and protecting an industry capable of ensuring its
national independence.
During the rst world war there was a rapid motorisation of the troops, mainly unmo-
torised at the outset of the war. Motor-driven vehicles replaced the horse for transport,
assault tanks appeared in 1916 and aviation began to show its military potential. The battle
of the Marne was a decisive episode which revealed how important motorised vehicles
could be (Fig. 1.12). It was only by mobilising the famous Marne taxis that the troops could
be conducted to the front, thereby avoiding a German breakthrough which could have endan-
gered Paris. The importance which oil assumed in the rst world war is encapsulated in two
quotations. Lord Curzon, President of the Inter-Allied Petroleum Conference, declared: The
allied cause oated to victory on a sea of oil. Senator Henry Branger, who controlled the
import and distribution of oil in France during the war, concluded a speech with a phrase
which continues to resonate: The blood of the earth was the blood of victory.
Figure 1.12 The taxis of the Marne (Photo Monde et Camra).
14
Until the Great War, French oil supplies depended on private, independent companies

linked to the major American, British, Russian and Romanian producers. Before the war,
France was one of the largest oil consumers in Europe. But the onset of war caught the
government by surprise. On the one hand the oil companies sought to maintain the regime
of competition characteristic of the sector. On the other hand, the international situation
meant that French supplies of Russian and Romanian oil were interrupted. The only source
was therefore American. Furthermore the attacks by the German navy on oil tankers in the
Atlantic were interfering with fuel supplies, to the point that in 1917 the private companies
were not able to meet French needs. Clemenceau had to make an appeal directly to Wilson
for the necessary shipments to be increased.
The war therefore demonstrated to France that the outcome of the war depended on the
large oil companies, mainly American and British: Standard Oil, Anglo-Persian, Royal
Dutch Shell. The French government realised that it was crucial to increase French inde-
pendence in relation to energy supplies, in particular by ensuring that it participated in inter-
national oil concessions such as those in Mesopotamia, where the British were very active
and the Germans also had active interests.
Following new negotiations between Clemenceau and Lloyd George in December 1918,
agreement was reached about the transfer to France of the shares of the Deutsche Bank in
the Turkish Petroleum Company TPC (see Section 1.2.3.1).
The British were fairly favourably disposed to France participating in the TPC, as this
would act as a counterbalance to the inuence of the American companies. This agreement
proved particularly useful to Paris since the American companies decided after the war to
stop supplying France, based on the decision of the authorities to maintain control over oil
activities after the end of hostilities. During the war the efforts of these same companies, as
members of the Petroleum War Service Committee, had allowed France to satisfy its needs.
But once the war ended, the French government concentrated on trying to eliminate this
dependence. Apart from its efforts to gain direct access to crude oil, the French government
took other measures relating to the transport, rening and sale of products. Important deci-
sions were also taken with regard to scientic research and training.
1.2.2.2 Creation of the CFP (Fig. 1.13)

France secured its supplies of crude by creating the CFP (Compagnie Franaise des Ptroles,
later to become Total) which later acquired the Germans shares in the Turkish Petroleum
Company (see Section 1.2.3).
In 1923, at the request of the French government, Ernest Mercier set up a private, inde-
pendent company, funded mainly by French capital. This company, with a capital of
25 million francs, was founded on 28 March 1924, the main shareholders being a number
of large banks and the main French petroleum distributors, of which Desmarais was the most
important. The state had a 25% stake. The CFP also received the shares in the TPC.
Despite the scepticism of the industrial community about the nancial viability of enter-
prises of this kind, the direct involvement of the government considerably modied the nature
of the market. The French state became a participant in a market expanding rapidly in
response to the rise of the automobile, but which was largely being driven by developments
beyond Frances national frontiers. After the Second World War there was a tendency for
the state to continue its support, direct or indirect, for the national oil industry in importing
countries, both in Europe (with the creation of ENI in Italy (1953) and Elf Aquitaine in
France (1976)) and in the U.S.
15
Figure 1.13 The Compagnie Franaise des Ptroles was created in 1924
(by kind permission of Total).
1.2.2.3 The protection of the French petroleum industry

As well as setting up the CFP, France protected its domestic petroleum industry with the help
of various laws designed to foster petroleum rening and distribution. The National Ofce
for Liquid Fuels, set up by an Act of Parliament of 10 January 1925, sought to regulate the
industry without actually nationalising it. Its aim was not only to promote oil exploration in
other countries by French companies, but also to encourage exploration in France. At the
same time the Act encouraged the development of the French rening industry and allowed
the expansion of a eet of tankers which would guarantee national supplies in the event of
war.
Figure 1.14 The Gonfreville (Normandy) renery around 1930.
16
Figure 1.15 The same renery today (by kind permission of Total).
Laws enacted in 1928 provided for monopolies on rening and distribution to be granted
by the state. The state authorised companies, either private or public, French or foreign, to
import and rene crude for a term of ten years, and to import and distribute oil products for
a period of three years.
Protected in this way, the CFP created, in 1929, the Compagnie Franaise de Rafnage,
which built its rst two reneries in Gonfreville, near Le Havre, in 1933 (Figs. 1.14 and 1.15)
and in La Mde, close to Marseilles, in 1935. These two reneries, with a combined capacity
of 2 Mt/y, represented one-quarter of the total rening capacity in France at that time. Other
reneries were also built, in Port-Jrme by Esso, in Petit-Couronne by Shell, in Lavra by
BP and in Donges by Antar.
1.2.3 Between the wars (2):

cooperation and competition between oil companies.
The example of the Turkish Petroleum Company
1.2.3.1 The Turkish Petroleum Company
The Turkish Petroleum Company (TPC) was established around 1910, with three share-
holders: a subsidiary of the Anglo-Persian Company, a subsidiary of Royal Dutch Shell and
Deutsche Bank. Amongst its concessions, those for the regions of Mosul and Baghdad were
the most promising.
During the 1914 1918 war the Deutsche Bank shares were frozen by the British
government and at the same time discussions started between the British and French govern-
ments. These negotiations resulted in the French acquiring the Deutsche Bank shares in 1920.
Moreover the United States, desirous of gaining access to oil resources outside its own
territory acquired, by invoking the open doors policy (oil concessions throughout the
world must be open to all the allies), shares for Standard Oil of New Jersey and Standard
Oil of New York in the TPC. The shareholdings were then distributed as follows:
Compagnie Franaise des Ptroles: 23.75%;
DArcy Exploration Company (Anglo-Persian): 23.75%;
Anglo-Saxon (Royal Dutch Shell): 23.75%;
17
Near East Development Corporation (50% Standard Oil of New York, 50% Standard Oil
of New Jersey): 23.75%;
Participation and Investment (C. Gulbenkian): 5%.
Exploration got underway rapidly, and led to the discovery at Bala Gurgur, on 14 October
1927, of the very large Kirkuk oileld (Fig. 1.16). In 1928 the Turkish Petroleum Company
became the Iraq Petroleum Company (IPC), underlining its association with the newly
created independent kingdom of Iraq, which included the former Mesopotamia.
The Company ran rapidly into serious difculties. There proved to be a divergence of
interests between the CFP (for which the IPC was the only source of crude) and its American
partners in particular. The so-called Red Line agreement, which stipulated that the partners
in the IPC should act in concert in all the former Ottoman Empire territories, resolved these
difculties in 19282. However the problem resurfaced in 1948.
1.2.3.2 The Achnacarry Agreement

The Achnacarry Agreement was signed in 1928, the same year as the Red Line agreement.
It reected the desire of the oil companies to avoid competing so ercely that their interests
would be harmed, and established a form of cooperation between them. We will consider
this agreement in greater detail in Section 1.3.
Figure 1.16 The discovery of oil at Kirkuk (Iraq) in 1927 (by kind
permission of Total).
2. The agreement is so named because, after long discussions, C.S. Gulbenkian grabbed a map and drew a
red line around the territories within which the partners in the TPC (later the IPC) would be obliged to act
in concert.
18
1.2.3.3 Oil in the Arabian peninsula (Fig. 1.17)

Around 1920 the geologist Frank Holmes published evidence pointing to the presence of oil
in the Bahrain region, and obtained concessions in that Emirate, as well as in Kuwait and
Saudi Arabia. However, short of money, he sold all these concessions to Gulf in 1927. In
Bahrain, Gulf sold these interests on to Standard Oil of California (Socal). The rst discovery
was made in 1932. This was fairly modest in size, and the production of the Emirate did not
exceed several million tonnes per year, but it conrmed the promise of this zone.
Kuwait was the only country situated outside the Red Line. Gulf and Anglo-Persian
jointly obtained a concession for 75 years. In 1938 the Burgan oileld was discovered. Its
initial reserves were estimated at 10 billion tonnes, making it at the time by far the largest
oileld yet discovered.
In Saudi Arabia IPC was competing with Socal. The new king, Sultan Ibn Saud preferred
to negotiate with the Americans and granted Socal a 60-year concession in 1933. In 1948
the Ghawar oileld was discovered, still the largest ever discovered.
At an early stage Socal formed a joint venture with Texaco in order to develop its
resources in Bahrain. The latter controlled major outlets in Europe and Asia, whereas Socal
Black Sea
USSR
Ca
sp
ian
Turkey
Se
a
Syria
Mediterranean Iraq Iran
Sea
Palestine
Suez
Canal Transjordan
Kuwait
Egypt
Neutral Zone
Persian
Bahrain Gulf
Qatar
Red Sea Trucial Oman

Saudi Arabia States
Figure 1.17 The Middle East in the 1930s. This region accounts for two-
thirds of the worlds oil reserves.
19
had an excess of crude. Socal and Texaco established two new companies: Casoc (California
Arabian Standard Oil Company), which looked after Socals production interests in Bahrain
and Saudi Arabia, and Caltex (California Texas Oil Company), which looked after the
Texaco distribution networks in Europe and the East.
The 1939-1945 war interrupted oil extraction activities in Saudi Arabia. The full potential
of the Arabian peninsula only became fully apparent after the war. But the investments
needed to develop the resources of the Wahhabite kingdom were considerable. Socal and
Texaco sought partners. After lengthy discussions, Esso and Mobil joined Socal and Texaco
to form Aramco (Arabian American Oil Company). The other IPC partners, who could have
demanded to participate in Aramco, obtained increased interests in Iraqi production.
1.2.4 After WWII: increasing oil consumption, new oil companies,

creation and development of OPEC
After the Second World War, and particularly in the 1950s, oil consumption grew at a rate
of about 7% per year. Automobile transport was developing rapidly, and demand for
domestic and heavy fuel oil was increasing steeply. These two fuels were making major
inroads into the traditional markets of coal.
Supply remained abundant, however, thanks to large discoveries not only in the Middle
East (Fig. 1.18) but also in Africa (Algeria, Libya and Nigeria) and in Venezuela. Russian
exports were also increasing. However the entry of new producersthe American inde-
pendentsonto a market hitherto controlled by the majors (current term used to designate
the large oil companies) increased and modied the nature of the competition. These new
companies sought to counter the declining protability of American operations by interna-
tionalising their operations and gaining a foothold in Libya, in particular.
European governments were also taking an increasing stake in oil and creating national
companies such as ENI (Ente Nazionale Idrocarburi), Elf and Fina, intended to increase
national energy-independence. These companies grew rapidly.
Figure 1.18 Another major Middle East producer: Abu Dhabi.
20
1.2.4.1 After 1945: a new relationship

The Second World War changed the nature of the relationship between the producers and
the international oil companies: the producing countries were no longer content to grant
concessions in the traditional way. They wanted a greater share of the rewards arising from
the extraction of their oil wealth.
Negotiations in Iran in 1949 to revise the terms of the Anglo-Iranian concession got off
to a difcult start. The young Shah had to contend simultaneously with the very inuential
religious community and a powerful communist party. The rst proposals for modifying the
concession were rejected by the Iranian parliament, which demanded nationalisation. The
then Prime Minister announced to parliament that he rejected nationalisation, and urged
instead modication of the concession. He was assassinated several days later. The new
Prime Minister, Muhammad Mossadegh, had Parliament conrm nationalisation. After many
troubled months the Iranian authorities negotiated an agreement with the oil companies (led
by the American companies): the oil companies recognised the ownership by the Iranian state
of the Iranian land and mineral resources. The National Iranian Oil Company (NIOC) was
formed. It became the owner of the resources, with production being entrusted to a
consortium in which Anglo-Iranian would hold 40% of the shares, the ve American majors
(Standard Oil of New Jersey, Mobil, Standard Oil of California, Gulf and Texaco) 7% each,
Shell 14%, a group of American independents 5% and CFP 6%. Production, rose rapidly to
achieve 300 Mt in 1973.
Figure 1.19 Lacq: the major French gaseld (by kind permission of Total).
21
Figure 1.20 The gas treatment plant at Lacq ( Roux, Total).
Figure 1.21 1956: the discovery of oil in Algeria ( Dumas, Total).
22
1.2.4.2 New entrants into the oil sector

A. The creation of ENI by Enrico Mattei
In the 1920s, Italy formed a national rening company, the AGIP (Azienda Generali Italiana
Petroli) based on the model adopted in other countries. By the outbreak of war, this company
was of comparable size to the local subsidiaries of foreign companies operating in Italy. At
the end of the war Enrico Mattei, an industrialist who had fought with the Resistance, was
appointed to head up AGIP, whose installations had suffered severe war damage. Dynamic
and ambitious, Mattei sought to develop AGIP and allow it to play a major role in guaran-
teeing Italys oil supply. However capital was needed. The discovery of major reserves of
natural gas in the Po valley met this need. SNAM (Societa Nazionale Metanodotti), the
company formed to produce this gas, would generate the necessary capital. The ENI was
formed in 1953, bringing together various companies in the hydrocarbons sector, most of
which were run by Mattei.
In order to guarantee access to petroleum resources, Mattei pursued a policy of main-
taining active contacts with producing countries. Failing to secure an interest in the major
oilelds of the Middle East from the seven sisters (Mattei is reputed to have coined this
sobriquet himself) he negotiated an agreement with Iran. Although Mossadegh had partially
failed, several years earlier, in his assault against the oil companies, the oilelds had still
been nationalised, and the state had more exibility in its negotiations with foreign
companies. Mattei signed an agreement with the Shah which envisaged a 75% share of the
prots for the state and 25% for ENI. This was a rst in the oil sector. Until his death in
1962 in an aircraft accident, Mattei sought to diversify his companys supply sources.
B. The creation of ELF, a second national French oil company

In addition to supporting the CFP the French government was anxious, particularly after
1945, to promote exploration and production in France and other territories under its sover-
eignty. Several companies were created and oil and gas discoveries were made in the south
of France, in Gabon and in Algeria. These companies progressively merged into the Elf group
(today part of Total).
C. The Institut Franais du Ptrole (now IFP Energies nouvelles)

Although not an oil company, the formation of the Institut Franais du Ptrole (IFP) in 1944
should be mentioned here (Fig. 1.22). The IFP arose out of the desire of the French
government to support its national petroleum industry and to limit its dependence on
imported processes, equipment and technology, particularly from the U.S. The brief of the
IFP is to foster scientic and technical research into all aspects of exploration, production,
transformation (rening and petrochemicals), applications (e.g. engines), including training
and documentation.
The IFP developed rapidly, reaching something like its present size in the early 1980s.
Its success in realising its objectives can be measured in terms of the number of its propri-
etary rening and petrochemical processes it has sold. In 2003 more than 1500 process units
in many countries including Japan and the U.S. were using IFP processes, making it the
second largest licenser in the world in this eld. The inuence enjoyed by the IFP School,
half of whose students are non-French, testies further to the success of the IFP. The IFP
has also played a major part in the creation of a world-class petroleum services industry in
France. Technip and Coexip, for example, originally set up by the IFP, and which recently
merged, are amongst the worlds leaders in their respective elds.
23
Figure 1.22 The rst ofces of the IFP (now IFP Energies nouvelles).
1.2.4.3 Developments in the U.S.: quotas, isolation of U.S. market

The U.S. has always played a key role in the oil industry. Until 1950 it accounted for half
the worlds crude production. But consumption grew much faster than production. The U.S.
began to import oil in 1948, and by 1962 annual imports had reached 100 Mt. By 1971 this
gure had doubled. These imports were attractive because the price of Middle Eastern oil
in New York was lower than that of American oil. The American authorities, worried about
this competition, started by calling for voluntary restrictions, and in 1959 imposed
compulsory restrictions: import quotas. The American market was therefore partially
protected from the world market, leading to price rises. Prices outside the U.S., on the other
hand, were falling because of the abundance of crude oil.
1.2.4.4 Falling prices and the creation of OPEC

The isolation of the American market led to increased competition on other markets, notably
the European and Japanese markets. In order to increase their crude sales, oil companies
widely adopted the practice of discounting the posted prices, which continued to be the
reference price for the calculation of royalties and taxes. But competition also led to
companies seeking to reduce the posted prices. Two reductions were made, by 18 ct/bbl in
February 1959 and 10 ct/bbl in August 1960. These reductions produced an automatic
reduction in the incomes of producing countries per barrel sold. Unhappy with this devel-
opment, the main producing countries (Venezuela, Saudi Arabia, Iran, Iraq, Kuwait) met in
Baghdad in September 1960 and agreed to form the Organisation of Petroleum Exporting
Countries (OPEC). The main objective of this new organisation was successfully achieved:
posted prices remained stable for 10 years, until the increases of the 1970s.
1.2.4.5 Early signs of the oil shocks

From the late 1950s there were a number of political and economic events which were to
transform the oil industry hitherto dominated by the international oil companies and, more
discretely, a certain number of consuming countries, above all the U.S.
24
A. Political events

In 1956 the nationalisation of the Suez Canal resulted in its closure. As a gesture of support
for Egypt, Syria interrupted the shipment of IPC oil. While everything was restored to
normal within several months, and good cooperation between the consuming countries
limited the effects of the crisis, these events marked the emergence of third world countries
as a political force.
Two years later, in 1958, a military coup dtat in Iraq swept General Kassem to power.
In 1961 the new government decided to withdraw IPCs concessions except where there were
already productive wells. The following year the Iraqi government created the INOC (Iraq
National Oil Company) which replaced the IPC.
In 1967, during the Six Day War, the Arab countries imposed an embargo on oil deliv-
eries to the U.S., the UK and Western Germany. While this embargo only lasted a few weeks,
it marked a new stage in the use by producing countries of oil as a weapon. Furthermore the
reclosure of the Suez Canal (see Fig. 1.27 and Section 1.2.4.10) led to an explosive growth
in the demand for transport, i.e. tankers, because Middle Eastern oil destined for Europe and
the U.S. henceforth had to be routed via the Cape of Good Hope. North African oil was
therefore at a premium because of its transport advantage, a factor which would become
signicant in the following years.
During the 1960s Algeria and Libya became important oil producers. In Libya, where not
only the majors (Exxon, Mobil, Gulf, BP, Shell) but also several independents (Occidental,
Oasis, etc.) were active, production reached almost 60 Mt in 1965 and almost 160 Mt in
1970. But in 1969 King Idris of Libya was replaced by Colonel Gadda, who became the
rst leader of a producing country to seek to cut production in order to conserve resources.
B. Economic climate
Oil consumption had increased (Figs. 1.23 and 1.24) to the point where liquid hydrocarbons
accounted for half the energy needs of Europe and three-quarters of those of Japan, two
regions virtually devoid of their own oil. There was another cause for disquiet: the worlds
oil reserves were equivalent to only 30 years production at current levels in 1970, compared
with 140 years production 20 years earlier (Fig. 1.25) 3. It was feared that oil resources might
be largely exhausted by 2000. This was the backdrop against which the famous report of the
Club of Rome entitled Limits to Growth was published in 1972. This report warned of the
dangers of the depletion of natural, non-renewable resources, as a result of economic devel-
opment. The report called for economic growth to be slowed so as to save raw materials and
protect the environment. Of course there was no simpler way to limit consumption than to
increase prices.
At the same time, new air quality legislation in the U.S. made it more difcult to burn
coal, and encouraged the use of oil. But initiatives to open up new resources situated in
ecologically fragile areas (Alaska, California coast, Gulf of Mexico) were delayed following
actions taken by environmental protection groups. This led to a somewhat paradoxical situ-
ation, since it made the U.S. dependent on foreign oil. In order to protect the interests of
domestic producers, who were at a cost disadvantage compared with their foreign
competitors, quotas were introduced. But these proved difcult to administer. In 1969 Pres-
ident Johnson, who had been very close to Texan oil interests, was replaced by the Nixon
3. By 2000 the R/P ratio (reserves to annual production) was back to over 40, for conventional oil alone.
25
Figure 1.23 Service station in Senegal in the 1950s. Sales were increasing
and equipment was being modernised all over the world (by kind
permission of BP).
4 000
3 500
3 000
2 500
Billion tonnes
World production
2 000
1 500
1 000
500 OPEC
0
1850 1875 1900 1925 1950 1975 2000
Figure 1.24 Production and consumption of oil, showing the steep increase
in the 1960s.
26
Oil reserves / Annual production (years) 150
125
100
75
50
25
0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Figure 1.25 Ratio of reserves to production, illustrating the sharp drop

from 1950 to 1980 and then the stabilization.
Administration, which decided to change course. American producers would be protected

by raising prices; this would not only allow quotas to be abolished because it would make
American producers protable, but it would also guarantee adequate revenues to the
producing countries (Venezuela, Gulf states), thereby stabilising the existing regimes, which
were necessary partners of the U.S.
By 1970, the politico-economic climate was at last turning favourable to an increase in
oil prices. The main actors (with the important exception of the major consuming countries
without oil resources) saw nothing but benet from such a development. The event which
actually triggered the price rise was the decision by Libya, which demanded that the oil
companies reduce production by more than one million barrels per day. At the same time,
Algeria nationalised the six oil companies and unilaterally set the price of its oil. Libya
obtained higher tax rates and an increase in the posted prices from the oil companies. And
Venezuela decided to increase its tax rate to 60% and enacted a law allowing the posted price
of oil to be set unilaterally. But most was still to come.
1.2.4.6 The rst oil shock

The oil companies, concerned at the course of events, invited OPEC to enter into negotia-
tions. In practice, two separate negotiations led to signicant price increases, which in turn
produced an increase in the incomeper barrelfor producing countries. The Teheran
Agreement (February 1971) related to the Gulf countries. The Tripoli Agreement
(April 1971) related to Algeria and Libya, but also to that part of the production of Saudi
Arabia and Iraq output into the Mediterranean. Finally, following the devaluation of the
dollar in August 1971, two successive conferences in Geneva in 1972 and 1973, led to
increases in posted prices to compensate for the loss in value of the American currency.
Even more importantly, a fourth conict broke out between Israel and the Arab countries.
This time the war was started by Egypt and Syria, who attacked Israel during the festival of
Yom Kippur, on 6 October. Initially events moved against Israel before reaching a balance
of force. The war ended on 25 October 1973 without a victor.
27
$/b
140
Economic
130 crisis
120 Hurricanes
Katrina and
110 Rita
Attack on personnel
100 in Saudi Arabia,
90 trouble in Iraq
and Nigeria
80
OPEC 11th September
70
quota policy Iraq/Kuwait Iraq
60 war war
Iran/Iraq Netback
50 Nationalisation war contracts
40 of oil fields Oil Cold winter
counter- New
30 OPEC
shock OPEC
Second quotas
20 domination oil shock
Agreement between
10 First oil shock
Iranian OPEC quotas Mexico, Venezuela
Yom Kippur war revolution Asian crisis and Saudi Arabia
0
1970 1980 1990 2000 2010
Figure 1.26 The oil shocks.
This war nonetheless had a considerable impact on the oil industry:

On 16 October 1973 the six Gulf states decided on an enormous increase in the posted
prices. The price of Arab light, the reference crude, rose from $2.989 to $5.119/bbl
(Fig. 1.26).
On 17 October all the member states of the OAPEC (Organisation of Arab Petroleum
Exporting Countries: Abu Dhabi, Algeria, Saudi Arabia, Bahrain, Dubai, Egypt, Iraq,
Libya, Kuwait, Qatar) except Iraq decided to reduce their exports by 5% per month until
Israel withdrew completely from occupied territories and the rights of the Palestinian
people had been restored. On 4 November this reduction was increased to 25%.
On 25 October the same OAPEC members imposed an embargo on the deliveries of oil
to the U.S., Portugal, the Netherlands, South Africa and Rhodesia, which were accused
of favouring Israel. The spectacle of Dutch motorways closed to trafc at weekends to
save fuel was a powerful image which remained engraved on European imaginations for
long thereafter.
Finally at a meeting in Teheran in December, OPEC took advantage of the turbulence to
again raise posted prices. The posted price of Arab Light rose to $11.651/bbl, the real price
was of the order of $7.
1.2.4.7 Nationalisations
Another consequence of the increasing power of OPEC, perhaps even more important than
the price rises, rock the oil world to its core: the main producing countries decided, one after
the other, to nationalise their oilelds (see Box 1.3).
During the 1970s a wave of nationalisations by OPEC member countries gathered
momentum. Over a few years most of these countries nationalised the assets of foreign
companies, and in most cases declared a state monopoly on all activities related to petroleum.
OPEC, by providing its members with the opportunity to take concerted action to strengthen
their negotiating position, acted as a catalyst to a movement which arose from age-old demands.
28
Box 1.3 Nationalisations.

In producing countries petroleum has often been considered a natural resource which
belongs to the people, and must be used in their interests. This is sometimes actually written
into the national constitution. During the period between the Second World War and 1970
this concept reached its climax. Many countries became independent either after the war or
during the 1960s, and acquiring control over their natural resources, particularly oil,
symbolised national sovereignty.
Although several countries: Russia (1918), Mexico (1938), Iran (1952), India (1958)
nationalised their oil industry earlier, the great wave of nationalisations occurred between 1970
and 1980. In the Mediterranean countries nationalisations often occurred on a company-by-
company basis: in 1971 Algeria took control of 51% of the concessions of the French
companies. Starting in 1971 Libya successively nationalised BP and then ENI (50%) and the
other companies (51%), and Iraq nationalised the last IPC concessions. In 1972 negotiations
between the oil companies and OPEC led to the participation agreements (New York
Agreements), which envisaged the progressive acquisition of concessions by producing coun-
tries. The participation percentage, initially xed at 25%, was supposed to be increased to 51%
in 1983. Only some of the Gulf States signed this agreement, and the nationalisations in fact
occurred much faster than envisaged in the agreement: Kuwait and Qatar in 1975, Venezuela
in 1976 and Saudi Arabia in stages between 1974 and 1980.
One clear consequence of the concept of petroleum as the property of the people is that
the national public should have access to oil products at as low a price as possible. In
Venezuela, Nigeria and Saudi Arabia petrol prices are very low, often below the international
price excluding taxes and distribution costs. This encourages very high consumption, to the
detriment of exports, and therefore of vital foreign currency earnings. These concepts only
changed at the end of the 1980s, with the fall of the Berlin Wall and the collapse of
communism.
The oil shock of 1973 marked the start of an economic crisis in Western countries as well
as a major turning-point in the development of the petroleum market. Firstly, a new type of
actor in the oil market began to emerge beside the Western oil companies and the major
importing countries: the producing, exporting countries themselves. These countries acted
either individually or in some cases through OPEC. In 1973 these countries controlled over
50% of the worlds production of crude and more than 80% of its reserves. Secondly, a split
developed in the oil industry at the global level, with oil production, now under the control
of state companies, remaining separate from rening and distribution, most of which was
still in the hands of the Western oil companies.
1.2.4.8 The creation of the IEA

After the rst oil shock, which led to real shortages in the countries subject to the embargo,
the industrialised countries founded the International Energy Agency (IEA) in 1974. This
Agency was set up within the OECD (Organisation for Economic Cooperation and Devel-
opment), with just over 20 members, including the U.S. and Canada, Western Europe (with
the exception of France, which did not join until 1992) and Japan, to mention the largest oil-
consuming countries. The objectives of the IEA were:
To promote cooperation between participating countries in reducing their excessive
dependence on oil through energy conservation, the development of substitute energy
sources and relevant R&D.
29
Chapter 1 Petroleum: a strategic product Next Page
To set up an information system on the international oil market, as well as consultations

with the oil companies.
To cooperate with producing countries and other oil-consuming countries in stabilising
international energy markets to ensure that the worlds energy resources are managed
and used rationally, in the interests of all countries.
To create a plan which would prepare countries for a possible major disruption of
supplies and for sharing the available oil in the event of a crisis.
The IEA is also an important centre for publications on the energy sector
1.2.4.9 Price stability 1974 to 1978

During the period 1974-1978 the price of petroleum rose only slightly (from $11.65/bbl in
December 1973 to $12.70 in December 1978 for Arab Light, then the reference for pricing
all crudes). Prices were xed by OPEC at periodical meetings. The prices of other crudes
were derived from that for Arab light as a function of their quality (API, sulphur content)
and location.
Figure 1.27 The Suez Canal was closed from 1967 to 1974, following the
Six Day War ( Ren Burri/Magnum photos).
1.2.4.10 Second oil shock 1979-1981

The second large price rise, or second oil shock, was associated with the Iranian crisis. At
the end of 1978 political and social discontent in Iran (Fig. 1.28) led to strikes in most sectors
of the economy and particularly in the oil sector. Iranian production fell from 6 Mbbl/d in
September 1978 to 2.4 Mbbl/d in December and to 0.4 Mbbl/d in January 1979 when the
Shah departed, to be replaced by the Ayatollah Khomeini.
At rst other counties increased their production to make good the Iranian shortfall. But
Saudi Arabia subsequently decided to place a ceiling on its production signicantly lower
than its level of December 1978. The free market, still relatively undeveloped, spiralled out
of control. Demand far exceeded supply, exacerbated by the scramble by operators to
30
2 Oil and gas exploration
and production
2.1 HOW HYDROCARBONS ARE FORMED
2.1.1 Sedimentary basins

A hydrocarbon deposit consists of an accumulation of oil or gas in the pores of a sedimentary
rock, which forms the reservoir. They therefore occur in sedimentary basins, that is, in
depressions which were lled with sediments millions of years ago (Fig. 2.1).
These sediments were produced either by the erosion and weathering of rock close to these
depressions (clays, sands), by bio-chemical activity (calcareous rock) or by evaporation
from lagoons (salt, gypsum). These sediments formed in successive layers, millions of years
ago, older layers being buried by more recent layers. Once buried, these layers became
compressed, the water was driven out and the density increased according to the phenomenon
of compaction. A process of subsidence then occurs in which the thickness of the layers
decreases over time and there is a natural packing of the rock. Furthermore variations in
pressure, temperature and the ionic balance due to the process of sedimentation cause the
mineral salts dissolved in the interstitial water to precipitate, leading to the formation of
cement. The cumulative effect of compaction and cementation eventually results in a trans-
formation in which the sediments, initially loose, become solid rock.
Sedimentary rocks settle rst into horizontal layers known as strata, but can be deformed
by geological processes related to tectonics, that is, movements in the earths crust. The
largest such movement of this type is continental drift, known as plate tectonics. The sliding
motion of oceanic and continental plates produces folding which can lead to the formation
of mountain ranges and the major ocean trenches (Fig. 2.2). They lead to the formation of
anticlines (folds), synclines (basins) and faults (fractures) if the strata are brittle. When
these structures undergo erosion for thousands of years and are then covered by more recent
layers the process is known as discordance.
61
Chapter 2 Oil and gas exploration and production
Billions Main Atmo

My ERA PERIOD Period -sphere
years events
HOLOCENE Homo sapiens;
IVre
0,01 CENOZOIC
PLEISTOCENE Glaciations; Primates 21 %
1,65
Proto-hominoids; 0,06
PLIOCENE MESOZOIC Mammals
NEOGENE
5,3 Formation of O2
the Red Sea;
0,20 Reptiles
MIOCENE Subduction of India
under Asia; PALEOZOIC
CENOZOIC
23,5 Anthropoids; Fish

PALEOGENE
OLIGOCENE Separation 0,6

34 of Australia from First N2
HADRYNIAN
Antarctica; microscopic algae
EOCENE
53 Emergence of
PALEOCENE mammals;
65 Macroscopic
eukaryotes
CRETACEOUS
Disappearance of
UPPER dinausaurus and
PROTEROZOIC
ammonites; Primate; 1,0
96 Formation of North Development
Atlantic, of sexual
reproduction
LOWER
Flowering plants;
HELIKIAN
MESOZOIC
135 Glaciation
UPPER
Formation of South
(MALM)
154
ALGONKIAN
Atlantic; Origin
JURASSIC
MIDDLE of eukaryotes
(DOGGER) Birds; Diversification
180 des prokaryotes
LOWER First mammals;
(LIAS) 1,7
205
UPPER Aerobic couche
Breakup of Pangea;
TRIAS
respiration O3
MIDDLE
First dinausaurs
245 LOWER
APHEBIAN
ARCHEOZOIC
oxygenated O2
PRECAMBIAN
Glaciation atmosphere
PERMIAN
295 Conifers
Development of CO2
aerobic
photosynthesis
Reptiles
CARBONIFEROUS 2,6 N2
Insects
LAURENTIAN
Firts H 2O
stromatolites
360
PALEOZOIC
KATARCHEOZOIC
Amphibians
ARCHEAN
DEVONIAN Anaerobic NH3

fems bacteria CH4
410 Bony fish 3,2

HCN
KEEWATINIAN
Terrestrial flora
SILURIAN
435 First sedimentary

rocks
Glaciation
3,9 First known

ORDOVICIAN igneous rocks
Armour-plated
fish Formation
500 of oceans and
continents H2
4,6 Formation of the Earth
He
CAMBRIAN 4,7 Formation of the Sun
molluscs
15 Formation of the Universe
540
Figure 2.1 Stratigraphic scale.
62
Figure 2.2 Mountain folds and faults.
2.1.2 Petroleum geology

When animals and plants die, they leave an organic residue composed of carbon, hydrogen,
nitrogen and oxygen. Most of this material is broken down by bacteria. Some, however, is
deposited in aquatic environments low in oxygen on the beds of inland seas, lagoons, lakes
or deltas and is therefore protected from the action of aerobic bacteria. These residues are
mixed with sediments (sand, clay, salt, etc.), accumulate, are compressed, and undergo a rst
transformation under the action of anaerobic micro-organisms. This rst stage in the decom-
position of the organic matter gives rise to kerogen, solid organic molecules entrapped
within a rock known as the source rock.
The mechanism of subsidence causes sediments to be entrained to great depths, where they
are exposed to high temperatures and pressures. The kerogen is then transformed into hydro-
carbons by thermal cracking: the long molecular chains are broken down, expelling the
oxygen and nitrogen, leaving molecules made up only of carbon and hydrogen. When
temperatures exceed around 60C (140F), kerogen is transformed into petroleum (also
referred to as oil). From 90C (194F) the oil is itself subjected to cracking, to give wet gas,
then dry gas, as indicated in Fig. 2.3.
The higher the temperature and the longer it is maintained, the shorter are the resulting
molecules, and therefore the lighter the hydrocarbons. In some cases, all the hydrocarbons
are broken down into the lightest hydrocarbon component, methane (CH4).
During their primary migration, due mainly to the effect of pressure, the oil and gas
generated from the kerogen are expelled from the ne-grained source rock in which they
formed. Lighter than water, they tend to rise towards the earths surface, making their way
upwards along permeable conduits and fractures during secondary migration. Unless stopped
they escape and seep away at the surface or lose their volatile components and solidify into
bitumen. If on their path they encounter an impermeable layer, referred to as a seal, they
cannot migrate further. In order for a deposit to form, the hydrocarbons also need to be trapped
under this seal, in the pores and ssures of a rock reservoir where they can accumulate.
63
Hydrocarbons formed
0
Immature
Biochemical CH4
zone
1
Depth (km)
2
Oil
Oil
3
Wet
gas
Gas
gas
Dry
Figure 2.3 Formation of hydrocarbons. Oil window, gas window.
A B
C D
Figure 2.4 Structural (A, B) and stratigraphic (C, D) traps. A. Anticlinal

trap. B. Fault trap. C. Sand lens and wedge deposit under discordance.
D. Reef.
There are two main types of trap: structural traps and stratigraphic traps (Fig. 2.4). Struc-
tural traps are created by folds and fractures in the earths crust. The most common are anti-
clinal traps, which contain two-thirds of the worlds hydrocarbon reserves, and fault traps,
in which the accumulated hydrocarbons are retained by an impermeable rock formation lying
adjacent to the reservoir rock. A trap is referred to as stratigraphic, on the other hand, if at
least one of its boundaries comprises a change of physical properties, i.e. a signicant
change in porosity or permeability within the rock.
64
The capacity of the reservoir rock to contain hydrocarbons is determined by its porosity,

that is the ratio of the pore volume in a sample of the rock to its total volume. A reservoir
of fair quality has a porosity in the range 1020%. Moreover, it must be permeable, i.e. the
pores must be connected in such a manner that the uids can ow through the pores, so that
they can be extracted. Most reservoir rocks are composed of sandstone or carbonates. Sand-
stone reservoirs account for some 80% of all reservoirs and 60% of oil reserves. Within the
reservoirs the uids arrange themselves in layers from the lightest to the heaviest, the gas
lying above the oil, which itself lies above the water.
A eld comprises one or more reservoirs superposed over one another or in close lateral
proximity. Some formations may contain many tens or hundreds of reservoirs: they are then
described as being multilayered.
2.1.3 Petroleum system

The term petroleum system refers to the combination of the main geological attributes which
have led to the accumulation of hydrocarbons (Fig. 2.5). Firstly, there has to be a source rock
for hydrocarbons to be generated. A porous and permeable reservoir rock is needed to
contain the hydrocarbons and allow them to accumulate. The reservoir must be surmounted
by an impermeable cap which acts as a barrier to the natural upward movement of uids.
The system must be sealed by a trap in order to permit the hydrocarbons to accumulate. And
nally, the succession of geological events, referred to as the timing, must be favourable and,
in particular, it is crucial that the trap forms before the hydrocarbons migrate.
During the so-called phase of hydrocarbon exploration, prospectors try to assess the like-
lihood of occurrence of each of these events in order to estimate the chance of nding an
accumulation of hydrocarbons at a given subsurface location.
2.2 EXPLORATION FOR HYDROCARBONS

The rst stage in the exploration-production cycle is of course to look for deposits of hydro-
carbons, which will then be produced if the technico-economic conditions permit.
2.2.1 Prospecting
The exploration phase is subject to uncertainties more or less great according to the regions.
The purpose of exploration is to discover accumulations of hydrocarbons situated thousands
of metres below ground, so quite indiscernible visually or otherwise. Furthermore, these
accumulations themselves only occur under very precise and restrictive conjunctions of
geological circumstances. An exploration programme involves formulating a certain number
of hypotheses which are either more or less rapidly conrmed or have to be rejected given
the indicators commonly adopted. Chance plays a non-negligible role, even though spec-
tacular advances in prospecting methodology have taken place since oil exploration began
150 years ago. At one time the most effective method of nding oil consisted of drilling close
to surface indicators. Hydrocarbon resources are now becoming increasingly difcult to
discover because they are found at depths of up to 5 000 or even 6 000 m (16 00020 000 ft),
increasingly frequently offshore, so that sophisticated tools are needed to locate them.
Even today, however, drilling is still the only way of denitely establishing the presence
or absence of hydrocarbons in a given subsurface formation. Furthermore it allows the
pressure of a reservoir to be measured and allows samples of rock to be brought to the surface
65
10 km
50-100 m
3
1 1
2
2 1
2
1
50-100 m
Rock pores
Oil
Salt water
Figure 2.5 Petroleum system.
for analysis. Because drilling is costly, however, it is essential that geological, geochemical
and geophysical studies are carried out beforehand.
In the rst place it is up to the geologists to identify general areas which, on the basis of
geological criteria, are likely to conceal accumulations of hydrocarbons. They work with
geophysicists who study the physical properties of the subsoil, in particular with the help of
seismic reection. For offshore exploration since general ground reconnaissance is simply
not feasible, seismic methods are used right from the outset.
At this stage the presence of a deposit is still uncertain, and the term prospect is used.
Using the rst set of data collected, a prospect is evaluated, and if appropriate, a decision is
66
taken to drill an exploration well. Whether or not the drilling is successful, it provides the

geologist with valuable information in the form of core samples, cuttings and electrical
records from the wellbore. By examining, cross-correlating and interpreting these data,
prospectors are able to pinpoint subsurface structures which could contain economically
viable quantities of hydrocarbons. Exploration is an iterative process, each round of results
obtained permitting more targeted exploration to be conducted.
If exploration drilling produces positive results, the next task is to delineate the reservoir
discovered and appraise it by drilling additional wells and making further measurements. At
this point, we can estimate the volumes of oil and gas in place, then the recoverable reserves.
2.2.2 Geology
There are four main branches of geology relevant in exploring for hydrocarbons:
Sedimentology, i.e. the study of sedimentary rocks;
Stratigraphy, i.e. the organisation in time and space of sedimentary rocks;
Structural geology, i.e. the study of deformations and fractures;
Organic geochemistry, i.e. the study of the potential of rocks to produce hydrocarbons.
The approach taken to prospecting in a particular sedimentary basin will depend on how
much is already known about the area. In hitherto unexplored territory the rst stage is to
narrow down the area of study and identify zones where more detailed exploration is appro-
priate. For onshore zones this involves studying satellite images, aerial photographs and radar
imagery in order to determine the main features of the sedimentary basin concerned. The next
stage is to conduct geographical studies of the surface in order to verify that the three
necessary components, i.e. source rock, reservoir rock and impermeable seal are present. If
they are, the next stage will be to try to identify possible traps.
Traces of hydrocarbons at the surface or in the subsoil can be a good indication of the
proximity of an accumulation. Geologists drill small boreholes which allow them to take core
samples for chemical analysis by a laboratory. The results provide useful information on
whether there are traces of hydrocarbons present. In a mature, more familiar region, existing
sources of information in libraries and company databases, public agencies, etc. can be
consulted. Particular efforts are made to gain a better understanding of the porosity and
permeability of potential reservoirs. Most large traps have already been discovered, so that
less obvious traps need to be identied.
Geologists synthesise the information obtained into subsurface maps on different scales,
which may be extended over an entire basin or represent just a single eld. The most
common geological maps comprise:
Contours of equal thickness (isopachs);
Contours of equal depths (isobaths);
Physical properties of rocks (lithofacies).
Every time a new well is drilled, additional data are obtained and added to the subsurface
maps. These successive elaborations require a stratigraphic correlation which involves iden-
tifying rocks of a similar age by comparing fossils and the electrical analysis from an explo-
ration well or from an outcrop with the data from another well or outcrop in the light of the
seismic results. A major variation in thickness or in the type of rock may provide an inter-
esting geological clue.
67
2.2.3 Geophysics
It is not possible to obtain an adequate picture of the subsurface properties by extrapolating
from surface characteristics. And the underground formations are not visible. It is therefore
necessary to resort to geophysical exploration methods. These consist of making measure-
ments of fundamental physical data the gravitational eld, magnetic elds, electrical resis-
tance in function of depth, and interpreting these results in geological terms.
Gault
clays
Albo-
Aptian
Barremian
Wealdean
Portlandian
Kimme-
ridgian
Sequanian
Rauracian
Figure 2.6 Principle of seismic exploration (A), 2D seismic image (B). 3D seismic image (C).
68
Geophysical methods fall into three categories:

Magnetometry, which involves measuring, usually from an aircraft, variations in the
earths magnetic eld. This provides an indication of the subsurface distribution of
crystalline formations, which have no chance of containing oil, and more promising sedi-
mentary formations.
Gravimetry, which involves measuring variations in gravitational elds which occur as
a result of the different densities of rock close to the surface, and gives indications of
the nature and depth of layers.
Seismic methods, which involve making an ultrasound image of the subsoil by studying
the way waves are propagated, thereby providing prospectors with information on the
subsurface structures and stratigraphy.
The rst two categories are in fact not used very often; seismic methods, and seismic
reection in particular, represent some 90% of geophysical operations, however.
Seismic reection involves transmitting sound waves into the subsoil which are propa-
gated through the rock mass, undergoing reection and refraction at certain geological
discontinuities, referred to as reectors. Like echoes, the reected waves return to the surface
and are recorded by sensors which convert the vibrations in the ground into electrical
voltages (Fig. 2.6). There are two types of acquisition: two dimensional (2D) and three
dimensional (3D) seismic acquisition. Traditional 2D acquisition is used for extensive explo-
ration and in zones where access is difcult, whereas 3D seismic methods are used for ner
prospecting and offshore programmes.
On land the seismic waves comprise tremors on the ground surface generated articially
by buried explosives or thumper trucks (Fig. 2.7). The receivers or geophones are
distributed at the surface in different possible congurations: in a straight line, along several
parallel lines, in a star or rectangular shape or any other geometric conguration. They are
connected to a recording truck which logs the data acquired.
Figure 2.7 Thumper trucks.
69
Source
Hydrophones
Seabed
Figure 2.8 Seismic exploration at sea.
Offshore exploration depends almost exclusively on seismic measurements made on

board a vessel equipped with two crews, one to carry out the normal navigational operations
and the other to perform the seismic measurements. The vessel generates waves by means
of air guns and tows a tube called a streamer behind it which contains hydrophones. It is
easier to collect seismic data at sea than on land because of the facility with which a boat
can move in any direction. The geophysicist is therefore able to acquire more data than on
land, and can produce, after processing the data, a more detailed 3-dimensional image at a
lower cost (Fig. 2.8).
The signals received by each sensor at the surface are then plotted graphically as a
function of the interval until the signal is returned. Isochrones i.e. lines joining subsurface
points of equal return times, can then be plotted. In order to obtain a depth section which
represents a vertical cross-section of the subsurface, the durations need to be converted to
depths using formation velocities obtained during drilling.
70
Seismic records collected by the geophysicists are then processed by powerful computers

which seek to increase the signal to noise ratio. Advances in data processing achieved in
recent years make it possible to discover new petroleum structures using old data using
higher-performance imaging techniques.
Once the seismic data have been acquired and processed, they have to be transformed into
utilisable data in the form of isobath or isopach maps and interpreted geological cross-
sections showing the faults and the main reservoir layers. In order to provide the most
accurate possible description of the subterranean structures the velocity of propagation of the
waves must be known everywhere so that the time-lapse can be converted into depths.
Preliminary assessments cannot be conrmed until a borehole has been drilled. The cali-
bration of seismic reectors using the measurements made in the wells is therefore a key step.
The results of a seismic survey provide good indications of the subsurface structures, the
inclination of the strata, their continuity and folds, thereby indicating the presence of possible
traps which would be the target of drilling. They also allow gas reservoirs to be located in
certain cases, or oil-water or gas-water contacts (oil-water contact: OWC, gas-water contact:
GWC) to be identied.
2.2.4 Exploration drilling

2.2.4.1 The exploration well
Drilling is the nal stage and the supreme arbiter of the exploration process. Knowledge of
the subsoil acquired through geological and geophysical surveys allows the potential of a
prospect to be broadly evaluated, but cannot denitely conrm the presence of suspected
hydrocarbon resources. Certainty can only be obtained by gaining direct access to the
subsurface through drilling. Drilling also provides prospectors with a range of valuable data
on the lithology and uids present.
Figure 2.9 Drill bits.
71
Drilling an exploration well can take several (2 to 6) months, but the precise duration is
difcult to predict because of geological uncertainties at this level. Important doubts will
always remain about the depths, the hardness of the rocks and interstitial pressures in the
formation, which can only be swept away by drilling. On average one drilling in ve results
in the discovery of an economically feasible hydrocarbon reservoir. This falls to 1 in between
7 and 10 in relatively unexplored zones.
2.2.4.2 Principles of drilling

The objective of drilling is to create a link between the surface and the target formation by
penetrating the various geological strata down to a depth of up to ten kilometres (35 000 ft).
The most widespread technique involves attacking the rock with a rotating drilling bit
(Fig. 2.9). Three factors are involved in this process: the weight exerted by the drilling bit on
the rock, its rotation and the removal of the cuttings using a circulating uid (the drilling mud).
Crown
block
Drilling
cable
Travelling
block
Hook
Injection
head
Drill pipe
Rotary
table
Drilling
winch
Mud
pumps
Figure 2.10 Main components of a rig.
72
The drilling bit is attached to a drillstring made up of tubular elements which are screwed

on as the drilling advances: drill-pipes and drill-collars close to the bit. This assembly is
suspended and manipulated from a derrick (Fig. 2.10). Depending on the type of well the
rotary movement is generated either:
From the surface by means of a rotary table and a transmission pipe known as a kelly,
or by a power swivel connected directly to the last drill-pipe; or
At the bottom of the well only, by means of a drilling turbine or engine (turbodrilling).
In addition to cleaning the bottom of the well, drilling mud helps to cool and lubricate
the drilling bit, to consolidate the walls of the wellbore and exercise pressure such as to
contain the ow of oil, gas or water from a drilled formation.
Drilling starts with a large bit, for example of 26 in. (66 cm) in diameter attached to a
drill-collar and a drill-pipe. When drilling has reached a certain depth a new drill-pipe is
added to the drillstring. This procedure is repeated each time the increase in drilled depth
reaches the length of a drill-pipe, until a certain depth is reached, when the wellbore is cased.
Lengths of steel casing of diameter corresponding to that of the wellbore are lowered into
the wellbore one at a time, and cemented in place so as to protect the groundwater and control
uids emitted from the well. Several items of equipment are tted to the upper extremity of
the casing to insure suspension and seal the opening. Safety devices known as blow-out
preventers are also tted at the wellhead, tted with high pressure valves which allow the
well to be sealed rapidly using remotely controlled valves in the event of a sudden surge.
The casing and other equipment are subjected to a series of pressure tests, and if the
requisite safety requirements are all met the next drilling stage can begin. A new drilling bit
of smaller diameter is lowered into the hole inside the surface casing, and operations proceed
in the same manner as before. When a certain depth has been reached the hole is again cased
using smaller casing which matches the diameter of the new hole. The size of the drilling
bit is again reduced, the procedure is repeated, and so on. As drilling progresses, successively
smaller drill bits are used and the diameter of the cased hole decreases, as shown in Fig. 2.11.
Drilling proceeds at a rate of several metres per hour, the rate declining with increasing
depth, punctuated by difculties and the need to regularly replace the drilling bit, which
involves withdrawing the entire drillstring As drilling advances a drilling log is maintained
in which information is entered regarding the drilled depth, the nature of the rock and the
uids encountered, the drilling durations and any noteworthy events. This document is of
great value to geologists and geophysicists.
2.2.4.3 Choice of drilling equipment

For onshore exploration the choice of drilling rigs depends on the target depth, access facil-
ities to the site and the availability of the derrick. Offshore there is the additional constraint
of the depth of water, climatic conditions and the remoteness from the logistical base.
The main difference between onshore and offshore drilling is related to the way in which
the rig is supported. Offshore operations are conducted from platforms which either oat or
are xed to the sea bed, and which are capable of performing all the functions normally
carried out at an onshore drilling site as well as certain other services such as diver support
and a meteorology station. The platforms may be either xed platforms resting on the sea
bed, oating structures or semi-submersibles. Self-raising or jackup rigs are generally used
in shallow waters. Barges and semi-submersibles with dynamic positioning tend to be kept
for deeper waters. These mobile units only remain stationary during drilling, which can last
between several weeks and several months (Fig. 2.12).
73
26" (660 mm)
20" (508 mm) Surface casing
250
17 1/2" (444 mm)
13 3/8" (340 mm) Technical casing 1

750
12 1/4" (311 mm)
9 5/8" (244 mm) Technical casing 2
Concrete
Depth (m)
2 500
8 1/2" (216 mm)
7" (178 mm) Production casing
Liner hanger
3 300
5 3/4" (146 mm)
5" (127 mm) Liner
3 600
Figure 2.11 Cased wellbore.
Jack-up Jack-up rig Dynamically positioned

rig semi-submersible drill vessel
500
1000
Water depth (m)
1500
2000
2500
3000
Figure 2.12 Mobile platforms for offshore drilling.
74
2.2.4.4 Logging

During drilling, prospectors keep records of a number of physical parameters of the rock and
the uids encountered, known as logs, which they represent graphically as a function of depth
or time.
The mud log comprises the various measurements provided by the mud circuit. These
include the penetration rate, the characteristics of the drilling mud and the cuttings and cores
description. The study of the cuttings brought up to the surface as the drilling progresses,
and particularly the cores obtained by replacing the drill bit by a hollow tool known as a
core barrel, provides information on the main characteristics of the formations encountered
(Fig. 2.13). These relate to the lithology, the fossils present in each stratum (which dates
them), porosity, permeability, and uids saturation.
Figure 2.13 Core samples.
Wireline logging, also commonly known as electrical logging, is carried out during inter-
ruptions to the drilling. It uses a tool known as a sonde lowered into the wellbore at the end
of an electric cable or wireline. Logging while drilling, on the other hand, is carried out with
the help of instruments included in the drillstring (Fig. 2.14).
2.2.5 Appraisal
If an exploration well leads to a discovery, it is necessary to prospect further in order to
delineate the reservoir and evaluate its potential. This appraisal stage essentially involves
carrying out the following tasks iteratively:
75
Logs Logs
55 NPH -5
GR RH08
30 140 170 270
2360
2370
2380
2390
2400
2410
2420
2430
2440
2450
2460
2470
2480
2490
Figure 2.14 Log plots.
76
Mapping (making a more accurate evaluation of the size and position of) reservoirs

using the seismic data and the information obtained from the exploration wells;
Reservoir simulation;
The drilling of additional wells several hundred or thousand metres away in order to
obtain additional data, like the limits of the eld.
When these tasks have been completed, a decision will be taken, based on the available
information, whether to develop the eld and put it into production or to shut it in until
economic prospects become more favourable or whether to abandon it.
The appraisal stage is a period of high economic risk. On one hand, a precise appraisal
programme needs to be undertaken and targeted studies need to be conducted so that suf-
cient information is obtained to take the right decision, which takes time and requires
investment. On the other hand it is important to know when to bring this phase to an end,
either to cut losses and entirely abandon the programme, or alternatively to proceed with the
development of the eld and production as quickly as possible in order to ensure the project
remains protable.
When the eld has been delineated, data are available on:
The thickness of the reservoir and its porosity at the location of the wells;
Oil and gas saturation rates;
The composition of the efuent;
The reservoir pressure.
So we know the volumes of oil and gas in place.
Several vital questions have to be answered at this stage: Is the eld commercial? Should
it be developed? If so, what should be the development scheme? Answering these questions
involves understanding the interplay of geology, geophysics and reservoir engineering. The
total recoverable resources will depend on how recovery is to be effected: the production
Box 2.1 The most common forms of wireline logging.
The spontaneous potential (SP) measures the electrical current which ows in the
formations adjacent to the hole resulting from differences in salinity between the drilling
mud and the water in the formation. The SP can be plotted on a graph against depth, and
interpreted visually in order to demarcate reservoirs and clay overlays.
Resistivity logging is essentially used to calculate saturation levels of water, oil and
gas. Depending on the type of mud used and the radius of investigation, different tools
are used to measure the resistivity of formations: induction, conventional resistivity or the
laterolog. High resistivities indicate the presence of oil and gas.
Radioactivity logging measures the natural and articial radioactivity of formations.
Gamma rays allow impermeable formations (such as clays and clayey sands with higher
natural radioactivity levels) and formations likely to comprise reservoirs to be detected.
Neutron and density logging provide data on the type of rock and on porosity, and allow
gas, oil and water zones to be distinguished.
Sonic logging provides another means of evaluating porosity. It makes use of the
differences in propagation time of a sound wave across the strata of a formation, this prop-
agation being faster through dense than through porous rock. These data also allow the
geophysicist to establish a correspondence between the geological strata and seismic
markers.
77
rate, the drainage methods adopted, the number and positioning of the wells, etc. The overall
economic context (prices, taxes, etc.) and the circumstances of the company itself (nancial
resources) are of course also relevant. These circumstances are subject to change.
For this reason the results from the exploration and appraisal stages and other sources are
studied by multidisciplinary teams comprising geologists, geophysicists, petroleum architects,
drillers, producers and reservoir engineers. They also take account of the thinking of econ-
omists and nanciers. These teams build up a detailed picture of the size of the reservoir,
its characteristics and of the resources present. This allows various development scenarios
to be considered and tested with the help of simulation models, and their value in economic
terms evaluated.
2.3 DEVELOPMENT AND PRODUCTION
If the appraisal stage demonstrates that the characteristics of the reservoir are sufcient to
justify production then the development stage begins. This involves drilling the future
production wells and installing all the associated equipment required for production.
2.3.1 Reservoir management

2.3.1.1 Characteristics of the reservoir
In order to design the production installations, information is needed on:
The composition of the efuent;
The planned rate of production and expected total production for the wells;
The number and position of wells required for the optimum production from the
reservoir;
The workovers frequency on the wells.
It can be obtained from the geological data, the seismic data, the characterisation of the
reservoir rock, the study of uids and the well tests.
The geological data, seismic data, maps and logs allow a picture to be put together of the
reservoir, its internal structure and the distribution of the uids.
Petrophysical analyses based on logs and core analysis provide information on the capacity
of the reservoir rock, i.e. its porosity and the possibility for the movement of the uids
through the rock, i.e. its permeability. By providing indications of hydrocarbon saturation,
calculated as the ratio of hydrocarbons to total uids in the pores of the rock, this allows an
estimate to be made of the total hydrocarbons present.
Studies of the uids, referred to as PVT (pressure, volume, temperature) tests, are made in
order to characterise the physical and thermodynamic properties of the efuents, based on
which the most appropriate production methods are determined.
Finally, well tests are carried out by measuring downhole pressure at the level of the
reservoir before and during production. These provide information on the nature of the
uids, the drainage area of the well and the permeability of the formation. They also provide
indications of the quality of the producing formation and the impact of the drilling on well
productivity (skin effect). The producers deduce the optimum oil or gas production rate from
these data.
78
The downhole thermodynamic conditions and the composition of the hydrocarbons present

allow the reservoir to be classied according to the way the uids will behave during
production. When brought to the surface, oil and gas often have quite different properties,
in terms of volume and quality, than while in the reservoir.
In an oileld the associated gas may be dissolved in the oil or may be present as free gas.
An oil reservoir is described as being undersaturated when the hydrocarbons are initially
single phase liquids: the natural gas present in solution is released at the surface when the
oil is produced. On the other hand if the oileld originally contains both liquid and gaseous
phases, the oil is described as being saturated and the free gas which is not dissolved in the
oil resides in a gas cap (Fig. 2.15).
2
3
1 Gas cap
4
2 1
5
3
6
5
6
Oil
4
Water
Oilfield from above Vertical cut

and placement of wells
Figure 2.15 Saturated oil reservoir (Source: Total).
In the case of a single-phase gas eld, the wet gases will generate, at the surface, conden-
sates and dry gases comprising light fractions such as methane and ethane. In gas elds
subject to retrograde condensation, liquid hydrocarbons will be deposited in the reservoir
during production, and the efuent will have a high liquids content at the surface.
Water is also associated with the hydrocarbons in the reservoirs. Most reservoirs were
formed from sediments which settled in or close to the sea. Part of the water will have been
displaced during the migration of the oil, but some remains in the form of interstitial water
adsorbed as a lm onto the rock around the pores. Water is also often found in reservoirs
below the oil or gas, forming an aquifer.
Geologists and geophysicists begin by evaluating the volume of rock impregnated by
hydrocarbons, the percentage of this volume effectively occupied by hydrocarbons and the
distribution between hydrocarbon types, in order to estimate the total tonnage. The reservoir
engineer then estimates the reserves. Capillary forces within the reservoir make it impossible
to recover all of the hydrocarbons from the eld. It is estimated that an average of 7590%
of the gas, but only 3040% of the oil, can be recovered.
79
2.3.1.2 Recovery mechanisms

The reservoir engineer studies possible production levels, eld life duration and the number
and types of wells, based on the characteristics of the eld and its efuents, and draws up
a development plan in collaboration with the petroleum architect.
At the outset of the development phase the information needed to dene the functional
sub-systems is not always known sufciently accurately for all the options to be determined
at that time. Furthermore, the information will vary over the years.
A. Primary recovery
After the wells have been completed (see Section 2.3.2.2) hydrocarbons can be produced at
the surface. They ow from the reservoir into the well under the effect of the pressure
gradient between the reservoir and the well bottom (Fig. 2.16). As production proceeds the
pressure in the reservoir falls, thus reducing the natural ow rates of the hydrocarbons, and
the oil in particular.
In the case of gas elds natural ow through single phase expansion is the most effective
recovery mechanism, allowing a recovery rate of about 80%.
For oil, primary recovery is less effective and may even prove very limited where there
is no effective source of energy such as the expansion of a gas cap, aquifer activity or the
expansion of dissolved gases. Where an oileld has a gas cap, as oil is produced and there
is a consequential pressure drop in the oil zone, the gas cap expands, driving the oil into the
production wells. There is considerable energy in the system, thereby allowing the oileld
to produce for a long period of time, depending on the size of the gas cap. In addition, when
there is a sufcient fall in the reservoir pressure, gas which was initially dissolved is freed
in the oil mass, and entrains the oil towards the producing well. When a sufciently large
aquifer lies under the oileld, the pressure is maintained for as long as the water replaces
the oil in the pores during the production. In this case the wells go on producing until the
water production becomes excessive. Primary recovery typically allows from 5-10% to
30-50% of the oil to be recovered.
B. Enhanced recovery
In most cases the volumes of crude oil extracted under primary recovery is not economically
viable. It is therefore often necessary to resort to mechanisms for enhancing the recovery rate
after a production period which can vary.
A distinction is traditionally made between secondary recovery, which involves main-
taining the pressure of the oileld, and tertiary or enhanced recovery which refers to a
number of advanced methods which improve the displacement characteristics of the oil.
Secondary recovery is effected by means of water injection and gas injection, water
injection being largely used. It involves either drilling injection wells or converting
production wells into injection wells. Water is then introduced into these wells under
pressure. This both maintains the pressure in the oileld by taking the place of the produced
oil in the pores of the reservoir rock and ushing out the oil remaining in the producing rock,
driving it towards the production wells. The injection of immiscible gas rests on the same
principle, the uid injected into the reservoir in this case being natural gas, nitrogen or ue
gases from combustion, under pressure. This can be an attractive technique in desert, remote
or offshore areas where there is no market for natural gas and where aring is forbidden.
80
Atmospheric
pressure
(AP)
Wellhead
pressure
(WHP)
Well bottom
pressure (WBP)
Reservoir
pressure
(RP)
The hydrocarbons are propelled from the reservoir to the surface

by the pressure differences RP > WBP >WHP > AP
Figure 2.16 Principle of primary recovery.
81
OIL
PRODUCTION
Water Gas Gas Water

injection injection injection injection
Figure 2.17 Maintaining pressure by injecting water into the aquifer and
gas into the gas cap.
Fewer injection wells are needed for gas than for water injection, but heavy compression
equipment is required (Fig. 2.17).
The injection of water or immiscible gas into an oileld leads to recovery rates which are
higher (4060%) but still limited because the ushing of the cavities in the reservoir is
incomplete (macroscopic sweep efciency) and because residual oil is trapped by capillary
action in the ushed areas (microscopic sweep efciency).
Tertiary recovery processes, known as EOR (enhanced oil recovery), make use of
chemical and thermal techniques, and seek to enhance the spacial sweep efciency and to
reduce the capillary forces by making the uids miscible or improving their mobility. They
can improve recovery by a further 510% of the total oil resources in the oileld (Fig. 2.18).
82
After secondary After tertiary
Outset recovery recovery
(water injection) (gas lift)
Gas
Oil
Oil
Oil
Gas
GOC Oil-water
emulsion
Oil
Oil
Water Water
WOC
Water
Percentage oil
recovered R = 0% R = 50% R = 65%
Figure 2.18 Oileld at different stages of recovery.
The behaviour of the uids during the production phase is carefully observed and analysed
so as to ensure that production continues to be optimised.
Finally after a period of, typically, 1530 years, the limits of economic recovery are
reached. The production facility is then dismantled and the site is rehabilitated.
2.3.2 Reservoir simulation models

A reservoir simulation model starts by taking a geological model, i.e. a static representation,
of the oileld. The rst stage is to synthesise the information collected by the geologists,
geophysicists and the reservoir engineer from the appraisal wells. It is advisable to analyse
these data critically because of the large uncertainties attaching to the hypotheses in the
exploration phase. The modelling phase proper involves interpreting the data in order to
construct a system which replicates the behaviour of the actual oileld.
The reservoir is represented by a grid of discrete cells. This grid may be in two or three
dimensions, and may be rectilinear, polar (around a well, for example), or irregular (in
order to show up heterogeneities, etc.). The parameters which characterise the reservoir must
be dened for each cell (Fig. 2.19).
Equations are then added to this static model which describe the uid ows between
adjacent cells, and between cells and the well, in order to obtain a dynamic model. The nal
stage consists of simulating the behaviour of the reservoir in time and space according to
different production scenarios which are subjected to a range of economic calculations.
Economic optimisation, using various hypotheses linked to the environment allows the most
appropriate development programme to be chosen.
83
Box 2.2 Enhanced oil recovery.
Chemical methods involve adding chemicals to the injection water. There are two
main types: micro-emulsions and polymers. Micro-emulsions consist of mixtures of oil,
water and surfactants, stabilised with alcohols. They enhance the displacement action of
the injected water, i.e. the ability of the water to drain the oil from the rock pores.
Dissolving polymers in the water enhances its ushing action and increases its viscosity
by a factor of 50 or more.
Thermal recovery involves increasing the temperature in the reservoir in order to
reduce the viscosity of the oil and increase the productivity of the well. This can be done
either by generating heat at the surface in the form of steam and transmitting it to the
formation via an injection well, or by injecting air into the well and inducing in situ
combustion or an oxidation front in the formation close to the injection well.
Miscibility methods promote thermodynamic exchanges between the oil in the
reservoir and the uid injected to reduce the capillary forces. The nature of the uid to
be injected depends on the type of reservoir: carbon dioxide on its own or followed by
water, LPG under pressure, methane enriched with light hydrocarbons, nitrogen under
high pressure. These methods may increase the recovery factor by 30% to 40%, but are
constrained by practical difculties in the elds and economic considerations.
Figure 2.19 Grid representation of oileld using Athos software.
Once the project has been approved, the site prepared, the production wells drilled and
completed, and the gas collection, production, processing, storage and dispatch equipment
have been installed and the living quarters built, production can begin.
Numerical simulation models are subject to continual improvement as production proceeds
and knowledge about the eld increases. Renements made in the course of production allow
more reliable studies to be made of the impact of drilling new wells, horizontal drain holes,
methods of assisted recovery, etc. This will make a signicant contribution to investment
decision-making during the different stages of the life of the eld.
84
2.4 DEVELOPMENT DRILLING

2.4.1 Directional drilling, horizontal drilling, multidrains
The principles underlying development drilling are the same as those for exploration drilling,
but more specic use is made of directional and horizontal drilling, and multidrain systems.
Modern drilling can be controlled so accurately that wells can be drilled according to a
precisely predetermined prole so as to target a precise subsurface location.
Directional drilling can be carried out in a J or an S conguration. It is normally used:
When the drilling zone is inaccessible or urbanised;
To circumvent a subterranean obstacle such as a salt dome;
To reduce the number of surface drilling installations, for example to limit the number
of platforms when drilling offshore, or to obviate the need to move them;
To test several potential reservoirs;
To deal with a well in which there has been an accident.
Horizontal drilling is a special case of directional drilling in which the borehole is hori-
zontal, parallel to the reservoir strata. As indicated in Fig. 2.20, it is used:
When the production zone is a long way from the drilling rig; this technique can even
be used to access resources under the sea bed from an onshore location, thus avoiding
the need for offshore equipment;
To enhance productivity, and therefore recovery; by draining a reservoir over a length
of, sometimes, more than a kilometre, the oil ow rate can be increased, making it
feasible to develop an oileld of small thickness or low permeability;
To prevent the local deformation of the oil-water or gas-oil contact close to a producing
well (known as coning) which occurs with traditional drilling, which results in an
excessive production of gas and water.
Multidrain wells allow production from different parts of a reservoir with a single well.
They can be used at any stage in the life of a eld.
In the exploration and appraisal stages, sidetracking provides a less risky and lower cost
means of delineating a eld in unknown areas. The protability of a production well is
assured by the main wellbore drilled into a known reservoir (Fig. 2.21).
Inaccessible
Drilling from Emergency site
Offshore operations
the coast
Multiple zones
Sidetracking
Figure 2.20 Horizontal and directional drilling.
85
Figure 2.21 Multidrain wells.
During production, multidrain systems multiply the number of wellbores and therefore
increase production while reducing the development costs per barrel. Drilling multidrain
systems in existing wells in the depletion phase slows the rundown of mature elds by
tapping into secondary reservoirs and allows a programme of water or gas injection to be
carried out for optimal ushing of producing formations.
2.4.2 Completion
Completion involves making the well ready for production. It begins when the drilling
phase comes to an end, when the last piece of casing has been cemented into place in the
producing formation. First of all a connection has to be made between the wellbore and the
reservoir, by drilling into the reservoir, treating it, equipping the well and putting it into
production.
The equipment and methods used in well completion are quite varied, depending on the
type of efuent, the kind of reservoir, the requirements to be met by the well during its
lifetime and the economic circumstances at the time of drilling. The completion must at least
ensure the integrity of the walls of the hole and the selectivity of the uid or production level
while permitting the unhampered ow of the uid. It must ensure that the well is secure,
allow measurements to be made, facilitate maintenance, allow the ow rate to be regulated
and the well to be put back into production.
Wellbore-reservoir connection
There are two types of wellbore-reservoir connection: cased hole completion and open
hole completion.
Cased hole completion is the most common. After the reservoir formation has been
drilled the last piece of casing or liner is set and cemented in place. Perforations are then
made at the level of the production zone to reestablish a connection between the reservoir
and the well. These perforations must pass through the casing and the cement sheathing
before penetrating the formation, which may then be subjected to stimulation treatments.
86
In open-hole completion the well is simply drilled into the reservoir, which produces in

an open hole. A variant of this involves placing a pre-perforated liner against the wall of the
formation, so as to maintain its general shape. This type of completion tends to be used when
there is a single zone only which is either highly consolidated or where sand control by gravel
packing is adopted. In practice this procedure is rare for oil wells, but is sometimes applied
on gas wells.
Tubing
The conguration of the tubing mainly depends on the number of production levels and
the production selectivity sought.
In conventional completion, we generally use a tubing which is totally contained in the
casing string. Completion may be single or multiple. In the latter case production can take
place at several levels selectively, allowing the eld to be developed with fewer wells and
therefore more rapidly, but maintenance costs are higher.
It should be noted that that there is a type of completion where tubing is not used. This
involves cementing and perforating a small length of casing in place at the level of the
production zone. This is appropriate for small gas elds poor in associated liquids and at low
pressure.
Once the well has been completed, the wellhead is attached to the top so as to control the
ow of uids (Fig. 2.22). The wellhead is made of:
The casinghead to which the casing is attached;
The tubinghead which supports the tubing;
The Christmas tree which comprises various valves and gauges.
Christmas tree
Tubinghead
Casinghead
Figure 2.22 The wellhead.
87
2.4.3 Well productivity

Well tests are carried out in order to evaluate the productivity or injectivity index of the well,
and any damage which may have occurred. These tests together with the results of further
laboratory testing will reveal whether any treatment is necessary. The well is then put into
service and evaluated. It will subsequently undergo measurements, maintenance, workover
or abandonment.
2.4.3.1 The drillstem test

The term drillstem test (DST) refers to all the well testing carried out during drilling. The
DST is basically a test intended to establish the production potential of a well and allow it
to be characterised.
When a DST is conducted the well is temporarily completed and a special assembly is
lowered, equipped with various valves allowing the well to be shut off both at the wellbottom
and at the surface, as well as pressure gauges. A sequence of periods of production and obser-
vation is dened and the test involves continuously monitoring the pressure of the reservoir
during this time. By comparing this with a diagram for different stabilised ow rates,
important information is obtained on the depletion of the zone in which the well is producing.
Several production tests are carried out with different wellhead settings in order to obtain
production data. This allows certain physical characteristics of the well to be derived, as well
as the maximum possible production rate.
2.4.3.2 Methods of stimulation

The productivity of the well, measured in this way, may prove to be poor because of the
petrophysical characteristics of the well, or because of damage caused by the drilling. When
the natural ow rate of the oil is weak, however, it can be improved by stimulation methods
such as acidising or hydraulic fracturing.
Acidising consists of injecting acid which inltrates the reservoir and dissolves some of
the obstructing material. Additives are included to prevent corrosion of the casing or tubing,
or blockages resulting from the reaction of the acid with certain types of crude oil.
Hydraulic fracturing is practised in the reservoir in order to open fractures in the reservoir
rock by means of high pressure produced hydraulically. These cracks are then wedged open
by introducing propping agents such as sand, shells, aluminium balls, glass or plastic.
2.4.3.3 Activation methods

When an oileld does not contain enough energy to drive the oil up to the surface treatment
facilities it is necessary to resort to activation, i.e. either gas injection or pumping. This is
necessary in more than three-quarters by number of wells worldwide, although these wells
probably account for no more than 20% of world production. When there is an economical
supply of gas and the quantities of oil justify the expense, a technique known as gas lift is
applied. Gas is injected into the uid column in a well to lighten it and make it rise as a result
of the expansion of the gas. Depending on the production characteristics of the well and the
manner in which the gas injection equipment is deployed, the gas can be injected continu-
ously or intermittently.
Various different types of pump are used for conventional pumping:
88
Figure 2.23 Pumping jack.
Sucker rod pump: a downhole volumetric pump assembly driven by a surface recipro-
cating action power source via a rod.
Centrifugal pump: an electrosubmersible pump immersed in the efuent at the bottom of
the well, the power being supplied by means of a special cable.
Hydraulic pump: a downhole reciprocating pump linked to a hydraulic motor.
2.4.4 Well interventions

There are two categories of interventions practised on a well in the production phase: well
servicing and workover. These are both intended to maintain or enhance output from
production wells.
Well servicing involves the partial replacement of equipment such as downhole pumps,
gas lift valves, production tubing and the sealing systems which may fail because of
corrosion, waxy hydrocarbons, etc. Well servicing also includes simple operations such as
cleaning and sand control.
Workover includes more major repairs such as removal of sand which has intruded into
the wellbore and recompleting the well for production from a different zone.
2.5 PROCESSING OF EFFLUENTS
The production facility includes:

The efuent processing units;
The storage, metering and dispatch facilities (Fig. 2.24);
The utilities required by the production facility, i.e. electricity, water and heat.
The production facility often uses its own gas. All the equipment is controlled from a
control room.
89
Figure 2.24 Production facility.
In the case of oil production, the wellhead efuent is often a three-phase mixture of oil,
gas and water. It may also contain sands, clays, mineral salts, the products of corrosion and
sometimes carbon dioxide, in varying proportions. The water from the well and other impu-
rities must be removed before the hydrocarbons are stored, transported and sold. The function
of the processing plant is to bring the oil or gas up to the specications required for export.
2.5.1 Separation process

The rst stage in the processing of the efuent is to separate the three phases oil, water
and gas by passing it through multi-stage separators. These are cylindrical installations
under pressure which may lie either horizontally or vertically. Within each separator water,
which tends to be retained in the lower compartment, and gas, which accumulates in the
upper part of the separator, are extracted.
2.5.2 Oil treatment

The oil separated in this way still needs further treatment to bring it to a specication where
it can be marketed. Watery emulsions must rst of all be broken down with the help of a
de-emulsier which allows the water to coalesce into larger droplets which can be separated
more easily from the oil. Inhibitors, solvents or heat are used to prevent the waxy hydro-
carbons from precipitating out. And nally the oil is desalted by washing it in soft water. It
will then be dispatched either by pipeline or tanker.
2.5.3 Water treatment

Production water is produced in quantities which are generally quite small initially but
become progressively greater as production proceeds. It is imperative, for reasons at once
technical, ecological and economic, that this water is puried before being released into the
90
environment or used in the production process. Firstly, all traces of oil must be removed and

added to the oil stream. The solids must then be removed so that the injection wells do not
become plugged. The content of dissolved gases, particularly corrosive oxygen, must also
be lowered. And nally, the sulphate-reducing bacteria in the water must be removed.
2.5.4 Gas treatment: sweetening and dehydration

The natural gas or associated gas from an oileld often contains carbon dioxide, hydrogen
sulphide (H2S) and water. Depending on how the gas is to be used and transported, more or
less processing is required, and it must be sweetened and dehydrated. Natural gas may be
transported to the area where it is to be consumed by pipeline or may be liqueed and trans-
ported in LNG tankers. The propane and butane fractions are known as liqueed petroleum
gases, and are transported in special tankers. The natural gas can either be burned to produce
electricity or heat, or it can be reinjected into the oileld as a means of effecting secondary
recovery or gas lift.
Hydrogen sulphide is very toxic. If the gas is to be used commercially the hydrogen
sulphide must be completely eliminated. If it is to be liqueed, the CO2 content needs to be
reduced, by chemical absorption, physical absorption or adsorption, in order to prevent
subsequent crystallisation. If the gas has to be transported by pipeline for processing at
another location, as this is the case for offshore production, small quantities of H2S and CO2
may be tolerated but the gas must be dehydrated using glycol, by passing it through a mole-
cular sieve or by condensation. At high pressure and low temperature the traces of water
present in the gas can lead to the formation of hydrates which can accumulate and cause
obstructions in the pipelines. But the formation of hydrates can be avoided by injecting a
hydrate inhibitor such as methanol or diethylene glycol.
In offshore production these installation have to be located on platforms with a restricted
surface area (Fig. 2.25).
Figure 2.25 Offshore plateform Visund ( yoind Hagen/Statoilttydro).
91
3 Hydrocarbon reserves
The concept of hydrocarbon reserves, absolutely fundamental to the oil industry, is a complex
one. In broad terms, the reserves are the total resources available to meet present and future
needs. In order to anticipate demand, the size of these reserves needs to be known. Very
broadly the worlds ultimate reserves of oil (i.e. past, present and foreseeable future) amount,
at the beginning of the 21st century, can be estimated at around 3 000 billion barrels (Gbbl),
which can be broken down as follows:
1 000 Gbbl of reserves already used;
1 300 Gbbl proven reserves remaining (about 40 years production at the present rate);
between 300 and 900 Gbbl reserves remaining to be discovered (conventional and
unconventional oil like oil sands);
300 Gbbl to be added to reserves by virtue of enhanced recovery techniques.
1000 Gb Consumed reserves
1300 Gb Reserves proven to consume
300 - 900 Gb Reserves to be discovered
300 Gb Enhanced recovery
Figure 3.1 Breakdown of worlds ultimate oil reserves.
The proven reserves of gas remaining are 177 Tm3 (60 years of production at the present
rate), and the ultimate reserves can be assumed to be of the order of twice this gure.
Of these gures, the only gures known with certainty are the quantities already used.
Figures announced for the reserves are essentially speculative. In practice, we do not know
93
Chapter 3 Hydrocarbon reserves
a great deal about the hydrocarbons still in the earths crust. And even where we know of
the existence of an oil- or gaseld, the reserves can rarely be recovered in their totality with
present technology or given the policy on exploration practised by the states which own the
mineral rights. Furthermore even where technical and political conditions permit production,
costs may be too high under present market conditions to permit their commercial
exploitation.
In order to dene what we really mean by reserves, three questions need to be answered:
What has already been discovered and what remains to be discovered?
What fraction of these quantities is it technically possible to recover?
And nally, are production costs low enough for the reserves to be commercially
viable?
These questions are in fact not mutually independent: the rst two are strongly affected
by the third. The price of crude greatly inuences both the level of exploration activity and
the rate of technological progress. A high price means that it is protable to recover hydro-
carbons with higher production costs. A low price, on the other hand, excludes any possi-
bility of investing in programmes whose economic viability is uncertain, such as high-risk
exploration programmes or fundamental research. The three questions above behave like
lters, narrowing down the concept from that of hydrocarbons present in the ground to that
of economically recoverable quantities. They illustrate the difculty of rigorously dening
the concept of reserves. In 1986, for example, the OPEC countries changed their denition
of reserves. Their estimates of proven remaining world reserves were increased articially
but considerably from 700 to 900 Gbbl without there being any real change in the global
stock of hydrocarbons.
In this chapter we shall begin (Section 3.1) by reviewing the denitions used by the
industry. We shall then go on, in Section 3.2, to specify the various types of hydrocarbons
extant and will look particularly at those referred to as non-conventional. Unlike so-called
conventional hydrocarbons (broadly, those that are easy to produce and market in todays
conditions) non-conventional hydrocarbons are at present unprotable to produce, but could
become protable in the future. This category includes, for example, ultra-deep offshore
resources, extra-heavy oils and synthetic petroleum. These resources, even though they may
be recoverable with present technologies, cannot strictly be classied as reserves at present,
but this situation could change in the shorter- or longer-term future. Non-conventional
hydrocarbons exist in quantities incomparably greater than the proven reserves of conven-
tional hydrocarbons, and could therefore have a major impact on the oil industry in the future
providing technologies emerge which allow them to be produced protably.
We will then go on, in Section 3.3, to consider reserves in relation to production. We will
show that hydrocarbon production curves are linked to the reserves in the relevant
geographical zones and allow the impact of technological progress in terms of creating new
reserves to be shown. The study of production proles has led many writers to try to forecast
the ultimate reserves and production rates by simple extrapolation. These theories can in fact
lead to two radically opposed visions of the future of hydrocarbons, corresponding to an opti-
mistic and a pessimistic view. Energy experts armed with the same data disagree about the
short-term future of the oil industry. This debate rages on, and will be considered in
Section 3.4 of this chapter.
And nally, in Section 3.5 we chart the main hydrocarbon-producing sedimentary basins
in the world, continent by continent, giving the reserves and production volumes for the main
producing countries.
94
3.1 DEFINITIONS

There are many different denitions of hydrocarbon reserves. The rst point to note is that
the term reserves denotes a technico-economic rather than a geological concept. A distinction
is made between:
Reserves: the volumes of hydrocarbons which are or will be recoverable, and
Resources: the volumes of hydrocarbons which are present in an oil or gaseld,
without reference to constraints as to their accessibility and/or cost. This concept is
identical to that of the hydrocarbons in place, in common use.
McKelvey (1972) and Brobst and Pratt (1973) dened the reserves of fossil fuels as being
identied deposits which can be extracted protably using present-day techniques and
under present economic conditions. The widely used term recoverable reserves is
therefore a pleonasm because broadly speaking the term reserves refers to hydrocarbons
which are destined to be produced and are economically viable.
3.1.1 Political and technico-economic constraints

The term resources refers to all the hydrocarbons present in the Earths crust, whether they
have already been identied or not. The rst stage is the identication of these resources,
i.e. exploration, so that hydrocarbon resources can be discovered.
Exploration is limited by two factors. The rst factor is political: certain geographical
zones are only partially open to exploration by the states which control them. The second is
technical: there are zones where the geological or geophysical exploration methods described
in Chapter 2 are not yet sufcient (for example ultra-deep offshore).
But there is a third barrier to resources becoming reserves: a technico-economic constraint
on production. There are in fact many accumulations of hydrocarbons for which the tech-
nology simply is not available today to put them into production. These accumulations,
although fully identied, may lie in waters which are too deep, or may comprise crudes
which are difcult to recover because their viscosity is too high, for example.
Technology is not the only obstacle to transforming resources into reserves. There are
resources for which the extraction technology exists, but where the recovery cost would
exceed the proceeds from selling the hydrocarbons extracted. Or, which boils down to the
same thing, the energy required to produce the hydrocarbons exceeds the energy content of
the products. These resources would not be economically feasible, and would therefore not
be put into production.
Resources can therefore only become reserves by passing a number of successive tests,
illustrated in Table 3.1.
Reserves are of course of political and strategic importance both to the oil companies and
the producing countries. Estimates of reserves may be intended to have a certain impact, and
should be viewed with caution. In fact estimates are beset by a lack of precision which is
intrinsic in the quantitative denition of the term reserves.
3.1.2 Deterministic and probabilistic estimates

As described above, the term reserves applies to hydrocarbons which will be put into
production within the short and medium term. Reserves are therefore hypothetical volumes
95
Tableau 3.1 From resources to reserves (by kind permission of Jean-Nol Boulard).
Accessible Identified Production Economically RESERVES

R to exploration technically viable
E feasible
S
O Not economically
viable
U
Production not
R
technically feasible
C
Not identified
E
S
Not accessible
to exploration
because they are prone to various uncertainties and depend on variables such as technological
change, the economic climate, etc. The only reserves known with certainty, i.e. determinis-
tically, are the reserves already produced. It is often said that the reserves present in a eld
are not known until production nally ceases. A deterministic approach assumes that the
value of each parameter needed for the calculation is certain. It obtains an estimate which
is assumed to be totally reliable, not subject to an error margin. Any other approach to
measuring the reserves in which there are uncertain parameters is necessarily speculative. It
provides probabilistic estimates in the form of a range, or in statistical terms, condence
intervals or, more precisely, prediction intervals.
Chapter 2 described the different stages in exploring and appraising an oil- or gaseld and
the uncertainties to which the results are subject. This approach produces a probability that
a particular prospect does indeed contain hydrocarbons. This is a probability because the esti-
mates of the uncertainties involved are themselves formulated by experts in the light of their
own experience, based on their own hypotheses. The probability estimates are therefore
described as subjective, or as a priori probabilities.
Once a formation has been declared to contain hydrocarbons, the total quantities of
hydrocarbons physically present (these gures are rarely published) are evaluated, and the
associated reserves are estimated. To do this it is necessary to evaluate the ratio of the recov-
erable hydrocarbons to the total quantity of hydrocarbons in the reservoir. This quantity is
known as the recovery ratio, and we will return to it shortly.
Modern geoscientic techniques (geology, geophysics, geochemistry and geostatistics)
allow the potential reserves in the eld to be described by means of a probability distrib-
ution function. Because of the uncertainties in the measured values it is meaningless to say
that the reserves in a eld are 100 million barrels (Mbbl). What can be said is that there is
a certain probability that its size exceeds 100 Mbbl. The size distribution of a particular eld
is generally reasonably well represented by a lognormal distribution (see Fig. 3.2)1. In
practice the reserves are represented by providing a number of the parameters of the
lognormal distribution (the mean or a number of percentiles: 10%, 50%, 90%, etc.) which
is supposed to represent the size of the eld.
1. There is however a debate on this matter. The main weakness of the lognormal distribution is that it does
not represent small elds well, and in some cases completely misrepresents them.
96
Figure 3.2 Lognormal distribution function modelling the size of an
oileld.
3.1.3 P90, P50, P10, etc.

Px is dened as a number such that there is an x% likelihood that the true reserves exceed
Px. For example if the P10 of a eld is 100 Mbbl, there is a 10% probability that the actual
size of the eld exceeds 100 Mbbl. The P50 is also called the median of the distribution,
and there is an equal probability that the actual reserves are greater or less than P50.
The percentiles most frequently used when estimating the size of a eld are P95, P90, P50,
P10 and P5. Estimates are also sometimes given in the form [minimum, mode, maximum]
or [minimum, mean, maximum]. The minimum and the maximum here are actually P5 and
P95 respectively, or P10 and P90. These are misleading terms, because the true minimum
and maximum of the lognormal distribution are 0 and +. The mode is the theoretically most
likely value of the distribution. The mean (or expected value) would be the average value
observed for a large number of elds whose size is characterised by precisely the same a
priori probability distribution. Figure 3.2 shows a typical lognormal distribution for a eld
for which the P50 is 500 Mbbl. The curve shows, for any x, the size for which the proba-
bility that that size is exceeded is x%.
This way of describing the size of the reserves is one of the most rigorous there is.
However many other methods are described in the literature.
3.1.4 1P, 2P and 3P reserves

Also widely used are the three values referred to as 1P, 2P and 3P, derived from the
percentile approach, and which also provide a probabilistic evaluation of the reserves in a
eld. These values correspond with the Px in a manner depending on the company or writer
concerned:
1P is generally equal to the P90 or P95 described above;
97
2P is always equal to P50;

3P is generally equal to the P10 or P5.
Finally the next section presents another terminology, also commonly used, which orig-
inates from an older, deterministic way of regarding reserves.
3.1.5 Proven, probable and possible reserves

The terms proven, probable and possible reserves most often correspond, although there are
many exceptions, to the values 1P, (2P 1P) and (3P 2P). Or putting this the other way
round:
1P = proven;
2P = proven + probable;
3P = proven + probable + possible.
It should be noted that these denitions were formulated and ofcially adopted in 1997
by the SPE (Society of Petroleum Engineers) and the WPC (World Petroleum Congress).
More precisely, proven reserves are those which are reasonably likely to be produced;
reasonably likely here actually generally means P90. However these denitions are by no
means universally accepted, and are contested by some in the oil community. When gures
are quoted, they usually refer to the proven reserves. However does that mean P95, P90 or
something else? It is almost impossible to answer this question properly, and often the
vagueness is intentional on the part of the users. Examples can still be found where gures
given for proven reserves may mean an unspecied value between P50 to P98. Caution
is therefore needed when using the gures variously given for the reserves.
3.1.6 Need for caution in using denitions

The probabilistic approach to quantifying the reserves in a eld is tending to become more
widespread. The approach is not without risks, however.
For example it is not as easy as it might appear to add together a set of reserves to arrive
at the reserves for an entire basin or country. This is because the gure obtained by summing
together the Px (or the modes) of the reserves for a number of elds is not generally equal
to the Px (or the mode) of the sum of those reserves.
For the record, summing the reserves 1P (proven reserves) for the elds in a basin tends
to underestimate the reserves 1P of the entire basin, and summing the reserves 3P (proven
+ probable + possible reserves) for the elds in a basin tends to overestimate the reserves
3P of the entire basin. In the case of 2P the error can go either way. Furthermore whether
they are an overestimate or an underestimate is a random process.
The only estimates which can legitimately (in mathematical terms) be summed together
are the expected values, because the sum of the means is equal the mean of the sums.
Broadly speaking, the mean is the only simple and robust statistical tool which allows a
forecast to be made. However it is important to realise that the mean only proves to be
effective when used a large number of times: taking Fig. 3.2 as an example, the expected
value of the distribution will only be achieved in 15% of cases. In concrete terms this means
that if several elds have this distribution, only 15% of them will turn out to have reserves
greater than the mean of the distribution! But it should be noted that the sum of the actual
reserves of the elds will be close to the number of elds multiplied by the expected value
98
of the distribution. This apparent paradox results from the law of large numbers, which states

that deviations from the mean will tend to cancel one another out, i.e. that the mean of the
deviations will tend to zero. It is therefore just as crucial to know the standard deviation (the
quadratic mean of deviations from the expected value). This information allows prediction
intervals to be constructed. But it should be borne in mind that the size distributions of hydro-
carbon elds are characterised by large standard deviations, giving extremely wide prediction
intervals.
Great care therefore needs to be exercised when doing calculations involving reserves.
However estimates of reserves for individual elds have to be summed in order to obtain
order of magnitude estimates of the reserves at a more macro level (region, country, elds
owned by an oil company). Usually only the proven reserves are published. These therefore
provide the only data available for statistical studies. Although summing them arithmetically
may not be mathematically correct, there is usually no alternative.
3.2 CHARACTERISTICS OF RESERVES
As mentioned earlier, a distinction is traditionally made between conventional and non-

conventional hydrocarbons. We will not deal with the case of condensates light liquids
sometimes associated with natural gas because these reserves are generally included in the
gures for the gas reserves, except, usually, in the U.S. and Canada. It should be noted
however that condensates account for up to 20%, in terms of energy content, of the reserves
of the eld.
3.2.1 Conventional and non-conventional hydrocarbons

In this area also there is not a clear and precise denition of which hydrocarbons are conven-
tional and which are not. A qualitative description of petroleum was given in Chapter 1.
Natural gas is described less in terms of quality parameters (caloric value, content of
sulphur or inert gases such as CO2, etc.) than in terms of its origin. A distinction is made,
therefore, between gases associated with oil or condensates and so-called dry gases (which
account for two-thirds of present world gas reserves). Whether a particular gas deposit is
considered conventional or not depends on how difcult it is to extract and put into
production.
Colin Campbell, Alain Perrodon and Jean Laherrre (1998) regard conventional hydro-
carbons as being hydrocarbons which can be produced in the technical and economic condi-
tions of the present and the foreseeable future. This denition, which is very close to
McKelveys denition of proven reserves (see Section 3.1), allows however for technological
progress and future economic circumstances. Non-conventional hydrocarbons therefore
become, putting it somewhat simplistically, those which are difcult and costly to produce.
But it is extremely difcult to know what the technical and economic conditions will be
in the future. The impact of a new technology on the extraction of hydrocarbons can be
measured post hoc, but how can we predict where technology will be in 20 years?
This is well exemplied by the deep offshore sector. At the end of the 1970s all offshore
hydrocarbons situated in water at a depth greater than 200 metres were considered non-
conventional (and therefore not included in estimates of proven reserves). The technology
of the time was simply not able to put these resources into production protably. Nowadays
99
we commonly envisage producing from reservoirs in depths of water 5 or 10 times as great,

i.e. at depths of 2 000 metres. The boundary between conventional and non-conventional
hydrocarbons has retreated considerably over time.
Heavy and extra-heavy hydrocarbons furnish another example. The Orinoco basin in
Venezuela, which has been known since the 1930s, contains extra-heavy crudes (810API).
In 1967 a rst evaluation of the total resources present there arrived at an estimate of
693 Gbbl (i.e. equivalent to more than half of the worlds proven reserves of conventional
oil). The position in 1967 was therefore: resources = 693 Gbbl, reserves = 0! A new evalu-
ation in 1983, however, estimated the resources to be 1 200 Gbbl and the reserves (these were
strictly speaking not proven reserves) to be of the order of 100 to 300 Gbbl.
It can be seen, therefore, that the boundary between conventional and non-conventional
tends to be pushed back over time in the direction of hydrocarbons which are more and more
difcult to produce in terms of production conditions, situation, quality and overall, in terms
of extraction costs. However geopolitical factors also come into play, modifying this picture
somewhat. In the Middle East, for example, oil tends to be easy to produce and abundant.
One of the consequences of the oil price shocks2, however, was to enable the discovery and
commercial production of less accessible petroleum throughout the world. The oil which is
cheapest to produce is therefore no longer necessarily the only or even the rst resources to
be exploited.
Non-conventional hydrocarbons are therefore the reserves of the future. This shifting of
the boundary is referred to by some authors as the fossil carbon continuum. When the
reserves of a certain type of hydrocarbon which can be produced are exhausted, other types
are sought, including non-conventional hydrocarbons. Gradually, and with the help of tech-
nological progress and political exhortation, the production of these new hydrocarbons
becomes the norm, becomes conventional or conventionalised. We have therefore grad-
uated from oils in the U.S., Algeria and the Middle East which are easy to produce, to
offshore, and are now turning to extra-heavy oils and ultra-deep offshore hydrocarbons.
The main families of non-conventional hydrocarbons are considered in the sub-sections
below.
3.2.2 Deep and ultra-deep offshore

A distinction is generally made between deep offshore (between 400 meters and 1 500 meters
water depth) and ultra-deep offshore (up to 1 500 meters). The former can nowadays be easily
accessed, thanks to advances in data processing and their application to 3D seismic data.
Deep and ultra-deep offshore reserves are estimated between 160 Gboe and 300 Gboe
(IEA, 2005). More than 70% of these reserves are located in Brazil, Angola, Nigeria and
United States. Today, most of the production comes from the Gulf of Mexico but the growth
is expected from Angola and mainly Brazil with the pre-salt discoveries.
3.2.3 Heavy, extra-heavy oils and oil sands

An oil is termed heavy if its API gravity is less than 22. Below the range 12 to 15API it
is referred to as extra-heavy. Many of these deposits are referred to as oil sands. These
2. Term referring to large and abrupt changes of price, see Chapter 1.
100
substances are genuine petroleum, having passed through the entire cycle which characterises

the formation of petroleum. They originate from hydrocarbons expelled from a source rock
into a reservoir (generally sand), often very large in size. Long oxidation and the gradual
disappearance of the lighter fractions have resulted in extra-heavy and extremely viscous oils.
The two main examples of deposits of this kind are the oil sands of Athabasca in Western
Canada and the Orinoco belt in Venezuela.
The total resources of these oils are considerable: of the order of 4 700 Gbbl, i.e. four times
the proven reserves of conventional oils! More than one-third (1 700 Gbbl) of these resources
are found in Canada, with 870 Gbbl in Athabasca alone. Russia may have 1 500 Gbbl of
heavy oil resources, although the ofcial statistics do not indicate the densities involved,
which makes classication risky. After Russia, Venezuela possesses 1 200 Gbbl in the
Orinoco belt. The U.S. and Indonesia also have large resources.
Oil sands have so far remained within the domain of non-conventional oils, despite the
vast resources involved. Today, only 5% of these resources appear to be economically
viable. By 20252035 the recovery ratio may have reached a threshold of 1520%, whereby
oil sands could be regarded as a conventional hydrocarbon.
3.2.4 Oil shales

Oil shales are not oils in the same way as the aforementioned hydrocarbons. They do not
originate from the migration of oil from source rock to a reservoir, but remain in the source
rock. The source rock is usually a clayey sedimentary rock which can produce oil after under-
going crushing and pyrolysis at a temperature of about 500C. The production of oil from
shale requires heavy industrial installations. Shale can claim a rst in petroleum history: at
the beginning of the 20th century there were numerous sites where shale was quarried
throughout the world. These shales produced surface outcrops which were of course
exploited. At a time when petroleum geology was virtually non-existent, no exploration was
needed to nd these deposits.
Shale can be found on all ve continents, as can be seen from Table 3.2, but the largest
deposits occur in the U.S.
Except in the U.S. and in Estonia, the oil produced from shales is currently condential.
The process produces large volumes of solid waste and CO2, and these will lead to additional
environmental protection costs. Furthermore, enormous quantities of water are required.
For example it has been calculated by the company Unocal that it would be necessary to use
the entire ow of the Colorado river in order to produce commercially from the Green River
Canyon shales.
Table 3.2 World resources of oil shales (Gbbl).
US South Australia Africa Former USSR Asia

America (unofcial) (unofcial)
200
Resources 2 200 800 (of which 20 of 115 1 400 2 800
Stuart shale oil)
101
3.2.5 Synthetic oils (Fig. 3.3)

The Fischer-Tropsch process for converting gas or coal into synthetic oil was developed in
Germany during the second world war (see Chapter 1), where it was the only source of motor
fuel. The process remains a difcult one. The market for synthetic oil produced from gas could
grow. Until recently, there were only a few units which convert gas into oil a production
capacity of 100 kbbl/d from 30 Mm3/d of gas notably in Malaysia (Shell experiment) and
South Africa (a remnant from a boycott by producing countries provoked by the policy of
apartheid. Things have changed with the new market conditions based on a higher crude oil
price. New projects are now under consideration. In the Pearl Gas to Liquids project, Shell and
Qatar Petroleum are investing hugely to build two 70 kbbl/d trains dedicated to convert gas into
oil. China has turned its attention to coal liquefaction technology. In 2004, Shenhua Group, the
countrys largest coal producer, was assigned a project to build a coal liquefaction plant in
northern China. The rst phase is intented to bring on stream annual production capacity of 1
Mtoe output by 2008. A second phase could then raise the project to its full design capacity
(100kbbl/d of oil equivalent output). South African Sasol sees also coal to liquids potential in
China (feasibility studies are conducted for two 80 kboe/d plants) and in the US (in Montana,
Illinois and Wyoming).
Figure 3.3 Possible applications of the Fischer-Tropsch process.
3.2.6 Non-conventional gas

The resources of non-conventional gas are thought to be considerable, but are not yet well
charted. Reservoirs of non-conventional gas are characterised by low recovery rates: of the
order of 1020%, against about 80% for conventional gaselds. These are reservoirs in which
the entrapment mechanism is very different from that of conventional reservoirs.
The three main types of non-conventional gas originate from:
Coal deposits (coalbed methane);
Shales and formations with a low permeability (tight sands);
Gas in solution in aquifers and zones of geopressure.
Gas obtained from coal deposits in the U.S. are the best known. But estimates of US
resources vary between 2.8 and 9.8 Tm3. The other countries with large resources are China
(3035 Tm3), Russia (20100 Tm3) and Canada (575 Tm3). The gures tell their own story
102
as to the uncertainty attaching to the estimates. Production remains limited but is growing

signicantly in the US where 45 Bcm were extracted in 2004 and in China where
10 Bcm could be produced in 2010.
Tight gas sand reserves gures remain unknown. Canada estimates vary in the range
2.542 Bcm. US ressources are estimated to 7 Bcm. Production is growing. In 2005,
100 Bcm of natural gas were extracted from tight gas sand reservoirs in the US.
As far as shale gas is concerned, gures of 100 Tm3 have been suggested, but 40 Tm3 is
probably a more realistic gure. In any case, production is mainly located in the US (17 Gm3
per year in 2005).
The solubility of methane in water depends greatly on pressure and temperature (for
example 17 m3 per m3 of water at a depth of 6 000 m and up to 170 m3 at 10 000 m). Because
of the sensitivity of the calculation to the conditions within the trap, estimating the resources
present can be a perilous undertaking, and the gures which follow are of a highly specu-
lative nature. Russia has estimated that its resources are 1 000 Tm3, and U.S. estimates vary
in the range 30200 Tm3 (including 150 Tm3 for the Gulf of Mexico alone). In the early
1980s an estimate of 1 000 Tm3 were made for a single reservoir in the Gulf of Mexico!
The production of non-conventional gases is growing fast in North America and China.
In any case, production remains limited compared to conventional gas extraction..
3.2.7 The polar zones

Several fruitful exploration programmes have been carried out in the Arctic, and these have
identied some 10 basins with real potential. Most of these basins are in Alaska, Greenland
and Russia, the latter looking the most promising. In the Arctic as a whole, resources of
8 700 Gbbl of oil and up to 20 Tm3 of gas have been discovered. However the elds
concerned probably contain much more gas than has been announced. It should not be
forgotten when considering these gures that production of these resources will be particu-
larly difcult given the very harsh climate, the ice cover, the lack of infrastructure and the
remoteness of the site from existing markets.
The Antarctic, on the other hand, looks very much like being the poor relation of its
Northern counterpart. The geology of Antarctica seems unpropitious for the discovery of
signicant deposits of oil. Furthermore, quite apart from the difculties associated with the
extreme climate and inaccessibility, all industrial activities on this continent have been
forbidden since 1991, in order to preserve its environment.
3.2.8 Other types of non-conventional hydrocarbons

There are many other categories of non-conventional and other hydrocarbons, for example:
Very small elds (less than 10 Mboe) are classied as non-conventional. There are very
many such elds. But their small size makes them difcult to nd. Furthermore there
needs to be pre-existing infrastructure nearby. Development costs must be kept low if very
small elds are to be remotely protable.
Oils won by assisted recovery techniques are themselves sometimes treated as being
non-conventional products, although most of these techniques are becoming standard.
High-pressure, high-temperature (HP-HT) reservoirs are subject to the same kind of
inconsistencies because the various record-keeping agencies do not use the same pressure
and temperature criteria (these vary around 700 bar and 150C) for classication. This
103
means that elds with the same pressure and temperature characteristics may sometimes
be classied as conventional and sometimes as non-conventional.
Gas hydrates are very important potential sources, and some authors consider that these may
exceed in magnitude the total known reserves of hydrocarbons. These are gases in a solid
form which occur in the form of crystalline hydrates. It is impossible to say now whether
we will one day be able to transform these resources into reserves. Two hurdles will have
to be overcome to make the production of these substances viable: their low energy density
and the considerable input of energy needed to transform them from a solid into a gas.
3.3 THE PRODUCTION OF RESERVES

3.3.1 The decision to produce
A new discovery is not put into production unless there is a protable market for the hydro-
carbons produced. This self-evident statement illustrates the extent to which the concept of
reserves is economic in nature.
However the circumstances for gas are rather different from those of oil. At present and
allowing for existing rates of consumption the reserves of gas will outlast those of oil (about
65 years, against 40 years for oil). Furthermore it is generally agreed that gas production will
peak (point at which production begins to decline) later than oil production. The demand for
gas, although real and considerable, is therefore less sustained than that for oil products, or
to put it another way, in consuming energy we tend to give priority to the most economic
option (at present oil), with their wide variation in energy content. It should be remembered
in this connection that gas is 5 times as costly to transport as oil. The oil market is rather
more demand-driven than that of gas, where supply is often waiting for demand.
This phenomenon is well known because it also applied (and still applies) to the coal
market. In practice there are very many extremely large known gaselds which will probably
never be put into production.
At the present rate of production, coal reserves will last more than 160 years. This statistic
is difcult to interpret, however, because it seems very likely that two centuries from now
coal will have all but disappeared as a source of energy. This means that some of these
reserves will deliberately not be exploited. This being the case, these latter should be clas-
sied as resources rather than reserves. The same applies, on a smaller scale, to natural gas.
In the past, large quantities of gas have been ared because there was effectively no market
for it.
In the two succeeding sections we will consider how reserves are estimated, and
production is forecast, using production proles at the level of the eld, basin or province.
3.3.2 Production proles

The production prole of a eld is a graph in which production (usually annual) is plotted
against time. A production prole can be prepared in the same way for a well, a eld or a
complete geographical zone by the same process as that applying to a petroleum system, a
basin or a country. The prole can be descriptive (i.e. historical data) or predictive. Predictive
proles are usually constructed for a well or a eld once the production tests have been
completed. Two theoretical examples are given below which are typical of production
proles for an oil or gaseld. The eld reserves are represented by the area under the curve
104
4
Mbbl
3.6 18
Mbbl
3.2 16
2.8 14
2.4 12
2 10
1.6 8
1.2 6
0.8 4
0.4 2
Years Years
0 0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 444648 50 0 4 8 12 16 20 24 28 32 36 40 44 48 50
Figure 3.4 Characteristic production prole for Figure 3.5 Characteristic production prole for
a very small oileld (20 Mbbl). a large oileld (500 Mbbl).
which denes the production prole. The preparation of a predictive production prole
therefore also involves estimating reserves (equal to the area under the curve).
At the level of the eld, there are broadly two types of prole, corresponding to small
and large elds. Small elds (Fig. 3.4) exhibit a very steep rise in production and are rapidly
exhausted, so as to reduce the production costs by concentrating them over as short a period
as possible. Conversely, the production prole of a large eld (Fig. 3.5) tends to be more
spread out in time. After an initial testing period it climbs steeply to reach a production
plateau which is maintained for a number of years, depending on the size of the eld. The
decline in production as the eld becomes depleted is generally slow.
It can be seen that production proles tend to be very asymmetric around their production
peak (or maximum). When, however, production proles are summed to give estimates for
an entire basin or country, the aggregated curve is often symmetrical about its peak, with a
rather bell-like shape. This fact was rst applied by King Hubbert at the end of the 1950s
to forecast the peak and decline of oil production in the U.S. But is this forecasting method
of universal applicability?
3.3.3 Hubbert theory of decline (Fig. 3.6)
3.5 Annual production of US

(48 states)
3
Fitted norma curve
2.5
2
1.5
1
0.5
0
1850 1900 1950 2000 2050 Years
Figure 3.6 Hubberts historic example

(Source: www.hubbertpeak.com).
105
Around 1960, King Hubbert, then an engineer at Shell, forecast, by tting a normal curve
to the production prole of 48 American states, that production would reach its peak in 1969.
Production would then decline in a manner symmetrical to the growth phase. His forecast
of the peak proved correct to within a year. This success won its author great acclaim and
recognition from his peers. There are various Internet sites which promote the work of
Hubbert and his disciples. However the fact that his theory was vindicated for one particular
example does not mean that his model has been validated generally. An entire school of fore-
casting has been erected on this solecism.
The object of this section is not to refute Hubberts conclusions or methodology but rather
to point out that there has been no valid scientic proof of the effectiveness of this method,
and still less of its universality.
The model does however have the merit of comprising a particularly simple example of
a method of forecasting production (and therefore also the ultimate reserves). As we argue
in Box 3.1, it is legitimate to make some criticisms of the tendency to force everything into
a normal distribution; there are many regions in the world, including the U.S., where aggre-
gated production proles are not distributed normally, or even symmetrically.
A model of this kind makes time the only explanatory variable for the production of a
region. This is a astonishing idea, implying an ineluctable decline mirroring the growth phase,
and does not allow the possibility of reserves being created as a result of technical progress.
Box 3.1 Hubbert and mathematics.
Even if, in several regions of the world, production proles are found to be distributed
normally, there is no reason to believe that all production proles will display this pattern.
However attempts have been made to explain or justify the Hubbert phenomenon math-
ematically. One such attempt, tenacious and false, appeals to one of the most celebrated
theorems of probability theory: the central limit theorem. This states that under certain
regularity hypotheses the sum of a large number of independent random phenomena
(even if highly asymmetric or multimodal) tends to produce a random variable with a
normal distribution, that is, symmetrical with a bell-shaped distribution, like that used in
the Hubbert approach: the distribution function of the sum of the processes is close to
being normally distributed. But the probability density of the sum is not equal to the sum
of the probability density (in this case the production proles of the elds). Furthermore
the Hubbert phenomenon does not fall within the scope of this theorem. In the rst place
the production proles summed are obviously not independent of one another, particu-
larly when they relate to the same geographical zone, and secondly the theorem relates
to numerical distributions rather than temporal distributions, as in Hubberts model.
Temporal distributions are subject to a completely different tool of probability theory,
namely time series analysis.
Great care must therefore be taken not to misuse this method which, however appealing
it may seem on the basis of a few examples, has no scientic basis. If certain aggregated
proles exhibit the characteristics of the normal distribution, these are curiosities, the real
reason for which it would be very interesting to explore, rather than a phenomenon of
general applicability as claimed by Hubbert and his numerous followers. Hubbert himself
ended up by repudiating the normal curve in favour of the logistic curve which unfortu-
nately is no more justied than the normal curve.
106
3.3.4 The impact of technical progress on the production prole

A prole is usually constructed when production commences, once the production tests have
been completed. Post mortem proles, i.e. those which can be drawn when production
comes to an end, are often very different from those initially envisaged, however. This
difference is usually caused by technological progress, which may increase the reserves
(Fig. 3.7) or permit their accelerated production (Fig. 3.8).
3.5 3.5
Mbbl
Mbbl
3 3
2.5 2.5
2 2
1.5 1.5
1 1
0.5 0.5
Years Years
0 0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40
Figure 3.7 Effect on initial production prole Figure 3.8 Effect on initial production prole
(mauve) of the creation of reserves due to tech- (mauve then white) of the accelerated
nological progress (grey). extraction of reserves due to technological
progress (grey).
The two scenarios presented below show the impact of an assisted recovery technique put
into operation after 16 years of production.
In the rst case there is no change in the resources, but additional reserves are created
(the area under the curve rises from 50 to 60 Mbbl). There is said to have been an increase
in the recovery ratio (see Box 3.2). In the second case no new reserves have been created
(the dark shaded area is exactly equal in size to the blank area under the curve corre-
sponding to the original production prole), but simply an acceleration in the extraction of
the existing reserves. Production comes to an end 10 years earlier, without any loss in the
total reserves extracted. Although there is no increase in the reserves, the acceleration is de-
nitely economically advantageous for the producer as it allows him to avoid a long period
of run-down and to receive the revenues earlier.
There are many examples of both cases. The Alwyn eld in the North Sea is a textbook
example of the rst scenario. A variety of measures were taken resulting in a succession of
signicant increases in the reserves. A number of writers have identied numerous examples
of the second scenario.
The second model of technological progress takes a pessimistic view about reserves. In
relation to conventional oil, technology simply accelerates depletion and therefore hastens
the onset of scarcity.
As already mentioned earlier, there are two schools of thought in relation to ultimate
reserves. The object of the next section is to present both sets of arguments so that the debate
can be properly understood.
107
Box 3.2 Indicators used in the upstream petroleum industry.
There are many indicators commonly used in the petroleum industry, either at company
level or for the entire sector. These may have a warning function, may be for general
management purposes or to signal scarcity.
R/P
The rst and most widely used indicates the outstanding life of the reserves at the present
rate of production assuming that no further discoveries are made: it is the ratio
reserves/production, often indicated by R/P. It is expressed as a number of years. The ratio has
uctuated considerably over the years, as the following table shows:
50 70 80 90 00
Oil 150 30 35 40 40
Gas 50 55 60 63
Since 1970, when it appeared that oil would be exhausted by 2000, the outstanding
life of the reserves has only increased.
These indices, shown above for the global level, can also be calculated by region,
company, etc. These ratios vary from 8 years (North Sea) to 80 years (Middle East),
according to region and are traditionally in the range 8 to 15 years for companies,
depending on their policy. These ratios have a certain strategic importance for the
companies, who try to keep to the value reasonably constant at approximately 10 years.
A ratio which falls too low indicates a company in poor health. It should be noted that
this ratio is very sensitive to the denition of reserves adopted. In 1986 the method used
in the Middle East to evaluate reserves changed, leading to a substantial rise in the R/P
ratio.
Success rate
This indicator, used by the upstream petroleum industry, is the ratio of non-dry wells
to the total number of wells drilled. It is therefore, at the company level, a measure of its
success in exploration. However this index must be interpreted cautiously. A non-dry well
which discovers reserves of 1 million barrels is obviously not equal in value to one
which discovers reserves of 1 billion barrels. The ratio should therefore reect the size
of the reserves involved; a high success rate in a region where the reservoirs are small is
of no great interest to the company. The success rate nevertheless provides a measure of
the effectiveness of exploration. Its value has climbed over the last 30 years, from 1/10
to 1/5 and even 1/3 nowadays.
Recovery factor
The recovery factor, dened for a eld, is the ratio of the reserves to the resources in
the eld. It varies with time, along with the estimates of reserves and resources. Average
recovery factors for conventional hydrocarbons are at the moment 3040% for oil and
80% for gas. One of the ways of increasing reserves the other being exploration is
to increase this percentage by taking advantage of technological advances. This is some-
times referred to as eld growth. The recovery factor is often used as a criterion to distin-
guish between conventional and non-conventional hydrocarbons, particularly for gas. As
far as heavy oils are concerned, recovery factors are of the order of 10% or less. There
is obviously great scope for improving these rates, and nowadays reserves are mainly
created by increasing the recovery factor from deposits of non-conventional hydrocarbons.
108
3.4 OPTIMISTS AND PESSIMISTS

It was seen in the previous section that the forecasting of reserves is particularly important
for the petroleum industry. There are several theories in this area, and these lead to schools
of thought which are radically opposed to one another.
3.4.1 Two schools of thought

It would be an oversimplication to reduce the argument between optimists and pessimists
into a debate between the defenders of the validity of this or that index (see Box 3.2). Never-
theless linking the various views with the behaviour of the indices allows ideas to be put
into perspective.
The R/P ratio is increasing over time, which appears to indicate that the point in time when
stocks will become depleted, already distant, is receding still further. Furthermore the success
rates announced by the industry tend to increase over time, indicating that explorers are
nding increasing numbers of oilelds, and that the fear of shortages is not at all justied.
This optimistic view, as we see analytically defensible, is criticised by the pessimists, who
argue that these indicators are biased: the R/P ratio does not represent the actual number of
years of reserves because production is increasing regularly by 23% per year, while oileld
discoveries are becoming less frequent. R/P is therefore an over-optimistic indicator. This
index continues to enjoy very wide use in the petroleum industry, however, and will continue
to be used regardless. It is incumbent on the analyst to be aware of the bias inherent in this
ratio and interpret the gures accordingly. Similar remarks apply to the success rate for
exploration, which by denition only allows for numbers of successes, and is not weighted
by the size of the nds. It therefore also remains a relative and biased indicator of explo-
ration performance (see Box 3.2).
But the optimistic and pessimistic theories, the main arguments for which are summarised
above, draw on two opposing economic theories.
P
P r
r i
i c
c e
e
Time
Figure 3.9 In a closed market falling prices Figure 3.10 In an open market three types of
stimulate demand until signs of scarcity begin to energy are competing. Prices fall as the current
appear, when prices rise again, thereby reducing energy type is progressively substituted by less
demand. costly alternatives (here NRJ 1 is substituted by
NRJ 2 and then NRJ 3). This process is known
as economic reproduction.
109
There are several theories of exhaustible resources, particularly Hotellings theory, for
which the reader is referred to Chapter 1. The following comments appeal to the law of
supply and demand.
Let us assume that the oil market is a closed market, that is, we only have to consider the
resource itself; there are no interactions, for example substitutions with other types of
resource. The depletion of the resource due to its consumption will lead inexorably to
increases in its price (Fig. 3.9), in accordance with the law of supply and demand. Conversely
when a market is open, other types of resource which are potential substitutes offer compe-
tition. This competition ensures that as a resource is gradually depleted there will be a tran-
sition, over time, to new sources of energy. This progressive substitution serves to stabilise
or even reduce the market price over time (Fig. 3.10). This phenomenon is sometimes
referred to as economic reproduction. Resources are depleted in physical terms, but the
reserves reproduce themselves in an economic sense.
These are the two sets of ideas which oppose one another, corresponding to the views of
the pessimists and the optimists.
The pessimists
Given that the quantities of sub-surface hydrocarbons are nite, each quantum consumed
brings the exhaustion of reserves closer. In fact, production and consumption are growing
over time (in particular because of demographic growth). The pessimists regard this devel-
opment as unsustainable, being liable to lead to shortages, and therefore sharp increases in
price.
Many scientists, industrialists and ecologists fervently espouse the pessimistic view, regu-
larly predicting the peaking and decline in the production of hydrocarbons, because for a
number of years the new reserves discovered worldwide have been less than production.
The petroleum price shocks of 1973 and 1979 were caused in part by the fear of shortages
and an articial reduction in supply. During the 1970s the economies of the industrialised
countries were very dependent on oil. A reduction in the reserves therefore contributed to
the very large increase in the prices of hydrocarbons, in accordance with the law of supply
and demand (see Chapter 1 for a presentation of the associated geopolitical issues).
However this recurrent fear led the oil companies and governments to step up their R&D
efforts in order to devise new techniques which would render feasible certain activities
which had hitherto been marginal, such as nuclear energy or the extraction of certain non-
conventional oils.
Despite these efforts, economies remain largely dependent on the production of existing
conventional hydrocarbons. The pessimists tell us that despite the technological advances
made we are heading for a third and nal price shock3.
The optimists
This school of thought began to develop in the mid-1980s, and is based on the failure of
the expected increase in prices to materialise. There is of course no denying the fact that the
reserves of conventional hydrocarbons, nite in quantity, are being consumed. However oil
prices remain stable over the long term. The vaunted price rises have not happened. This can
3. This only applies to conventional hydrocarbons. As far as non-conventional hydrocarbons are concerned,
technical progress is obviously creating new reserves because it leads us to go and explore for
hydrocarbons in hitherto unexploited zones in the world.
110
be interpreted as a refusal by the markets to accept that the shortages proclaimed by the

pessimists are imminent. As described in Section 3.2.1, there has been a gradual substitution
of conventional by non-conventional oils which can now be commercially produced, in
accordance with the concept of the fossil carbon continuum mentioned earlier (in
Section 3.2.1). Furthermore the two oil price shocks in the 1970s encouraged the emergence
of new energies (particularly nuclear energy) and new technologies which allowed certain
non-conventional oils to be made commercial. To the proponents of this view, petroleum
appears to be characterised by the open market model (Fig. 3.10) in which the process of
economic reproduction is taking place, rather than the closed market model. Furthermore this
model is in keeping with the present trend towards economic liberalism.
However economic reproduction will only occur if technology is successful in developing
new types of energy. We saw in Section 3.3.4 that technological progress can be an agent
for accelerating depletion rather than a catalyst for economic reproduction. But the risk of
depletion should be reected in a perceptible increase in prices, whereas no such increase
can yet be detected.
The argument between the two camps appears to reduce to a confrontation between a
common sense, naturalistic view that if an exhaustible resource is consumed it will become
scarcer, and the partisans of progress and economic liberalism, the openness of markets and
the theory of economic reproduction which stems from it. Does this mean that naturalists
are essentially pessimists, and economists optimists?
3.4.2 Naturalists or economists?

Whatever ones point of view, the conclusion for the long term remains the same: energy
policy for the future must focus on radically new types of energy (rst and foremost nuclear,
followed by solar, wind, biomass, etc.) or hydrocarbons which have so far not been exploited
because they were not economically feasible (e.g. non-conventional). In both cases there must
be energy substitution, economic reproduction. The vision of the pessimists differs from that
of the optimists, however, in that it assumes that a very active posture, and the building of
public awareness of the impending shortages and risk of sharp price rises, are needed to nego-
tiate the transition to the new energies. The optimists, on the other hand, believe that the tran-
sition to the new energies will occur naturally (as implied by the concept of the fossil
carbon continuum) as a result of technological progress and market forces such as the
competition between the various energy types.
3.4.3 Concluding remarks

Our intention at the end of this chapter is not to arbitrate between these two points of view.
It has to be conceded that in the short term the pessimistic view of the petroleum industry
is supported by many concrete and incontrovertible examples. On the other hand the opti-
mists can also produce evidence suggesting that the petroleum industry has been able to adapt
to change through revolutionary technologies which have made it possible to commercialise
hydrocarbons which were previously ignored or whose existence we were unaware of. This
has enabled it to increase reserves during the last 20 years.
Despite this major divergence of opinion there is consensus that the ultimate reserves,
available for consumption during the next 20 years (see introduction to this Chapter), are
close to 2 500 Gbbl. This gure is very different from the estimate of several tens of thou-
sands of Gbbl of non-conventional resources mentioned in Section 3.2. Furthermore these
111
speculations may rage, but as we saw, in the medium to long term both camps ultimately
agree that a transition to new energies or new hydrocarbons is inevitable.
The debate therefore boils down in the end to a personal conviction as to how the tran-
sition will come about: through an abrupt increase in prices for the pessimists or as an orderly
and gradual shift for the optimists.
3.5 GEOGRAPHICAL DISTRIBUTION OF RESERVES

AND PRODUCTION
This section presents a table for each geographical region summarising the proven reserves,
annual production and R/P ratios for the main producing countries, together with a map
showing the most important producing sedimentary basins. All the data quoted are taken from
the BP Statistical Review 2007. The maps are adapted from the USGS World Petroleum
Assessment.
Table 3.3 Proven reserves and annual production worldwide.
Proven Annual R/P

reserves production
(Gbbl) (Tm3) (Mbbl) (Gm3) (years)
Africa Oil 117.5 3 766 31.2

Gas 14.6 190.4 76.6
Middle East Oil 755.3 9 190 82.2
Gas 73.2 355.0 > 99
Asia-Oceania Oil 40.8 2 886 14.1
Gas 14.5 391.5 36.9
Europe Oil 16.3 1 893 8.6
Gas 5.7 274.9 20.8
Former USSR Oil 129.5 4 783 27.1
Gas 52.7 781.9 67.4
North Oil 69.3 4 988 13.9
America Gas 8.0 775.8 10.3
South Oil 111.2 2 421 45.9
America Gas 7.8 150.8 51.5
Total Oil 1 239.9 29 925 41.3
Gas 176.4 2 920.3 60.4
112
3.5.1 North America

Table 3.4 Proven reserves and annual production, North America.
Proven Annual R/P

reserves production
United States Oil 29.4 2 511 11.7

Gas 6.0 545.9 11.0
Canada Oil 27.7 1 208 22.9
Gas 1.6 183.7 8.9
Mexico Oil 12.2 1 269 9.6
Gas 0.4 46.2 8.0
Total Oil 69.3 4 988 13.9
Gas 8.0 775.8 10.3
C A N A D A
U N I T E D S TAT E S
Offshore sedimentary basin
Onshore sedimentary basin
MEXICO
Figure 3.11 Main sedimentary basins in North America (excluding U.S.).
113
3.5.2 South America

Table 3.5 Proven reserves and annual production, South America.
Proven Annual R/P

reserves production
Argentina Oil 2.6 255 10.2

Gas 0.44 44.8 9.8
Brazil Oil 12.6 669 18.8
Gas 0.36 11.3 31.9
Trinidad Oil 0.8 56 14.2
& Tobago Gas 0.48 39.0 12.3
Venezuela Oil 87.0 954 91.2
Gas 5.15 28.5 > 99
Other Oil 8.2 487 16.8
Gas 1.33 27.2 48.9
Total Oil 111.2 2 421 45.9

Gas 7.76 150.8 51.5

Main producing country
Other countries
Figure 3.12 Main sedimentary basins and hydrocarbon producing countries

in South America.
114
3.5.3 Europe

Table 3.6 Proven reserves and annual production, Europe.
Proven Annual R/P

reserves production
Norway Oil 8.2 933 8.8

Gas 3.0 89.7 33.0
Netherlands Oil
Gas 1.2 64.5 19.4
United Kingdom Oil 3.6 597 6.0
Gas 0.4 72.4 5.7
Other Oil 4.5 363 12.4
Gas 1.1 48.3 22.6
Total Oil 16.3 1 893 8.6

Gas 5.7 274.9 20.8
NORWAY
UNITED
KINGDOM Netherlands

Other countries

in Europe.
115
3.5.4 Africa
Table 3.7 Proven reserves and annual production, Africa.
Proven Annual R/P

reserves production
Algeria Oil 12.3 730 16.8

Gas 4.5 83.0 54.5
Angola Oil 9.0 629 14.3
Gas
Egypt Oil 4.1 259 15.8
Gas 2.1 46.5 44.3
Libya Oil 41.5 675 61.5
Gas 1.5 15.2 99
Nigeria Oil 36.2 860 42.1
Gas 5.3 35.0 > 99
Other Oil 14.4 613 23.5
Gas 1.2 10.7 > 99
Total Oil 117.5 3 766 31.2

Gas 14.6 190.4 76.6
Algeria Libya
Egypt
Nigeria
Offshore sedimentary basin Angola

Other countries

in Africa.
116
3.5.5 Middle East

Table 3.8 Proven reserves and annual production, Middle East.
Proven Annual R/P

reserves production
Iran Oil 138.4 1 606 86.2

Gas 27.8 111.9 > 99
Iraq Oil 115.0 783 > 99
Gas 3.2 > 99
Kuwait Oil 101.5 958 > 99
Gas 1.8 12.6 > 99
Qatar Oil 27.4 437 62.7
Gas 25.6 59.8 > 99
Saudi Oil 264.2 3 801 69.5
Arabia Gas 7.2 75.9 94
United Arab Oil 97.8 1 064 92
Emirates Gas 6.1 49.2 > 99
Other Oil 11.0 540 20.4
Gas 1.6 45.6 35.1
Total Oil 755.3 9 190 82.2

Gas 78.2 355.0 > 99
I r a q I r a n
Kuwait
Saudi
Qatar
Arabia
United Arab
Emirates

Other countries

in the Middle East
117
3.5.6 Former USSR

Table 3.9 Proven reserves and annual production, former USSR.
Proven Annual R/P

reserves production
Azerbaijan Oil 7.0 317 22.1

Gas 1.3 10.3 124,3
Kazakhstan Oil 39.8 544 73.2
Gas 1.9 27.3 69,6
Russian Oil 79.4 3 642 21.8
Federation Gas 44.6 607.4 73.5
Turkmenistan Oil 0.6 72 8.3
Gas 2.7 67.4 39.6
Uzbekistan Oil 0.6 42 14.4
Gas 1.7 58.5 29.7
Others Oil 2.1 166 12.6
Gas 0.4 11.0 39.1
Total Oil 129.5 4 783 27.1

Gas 52.7 781.9 67.4
R U S S I A N F E D E R A T I O N

Other countries

in former USSR.
118
3.5.7 AsiaOceania

Table 3.10 Proven reserves and annual production, Asia-Oceania.
Proven Annual R/P

reserves production
Australia Oil 4.2 205 20.5

Gas 2.5 40.0 62.8
China Oil 15.5 1 366 11.3
Gas 1.9 69.3 27.1
India Oil 5.5 292 18.8
Gas 1.1 30.2 35.1
Indonesia Oil 4.4 354 12.4
Gas 3.0 66.7 45.0
Malaysia Oil 5.4 276 19.6
Gas 2.5 60.5 41.0
Others Oil 5.8 393 14.8
Gas 3.5 124.8 28.3
Total Oil 40.8 2 886 14.1

Gas 14.5 391.5 36.9
China
India
Malaysia
Onshore sedimentary basin Indonesia
Other countries
Australia

in Asia-Oceania.
119
4 Investments and costs
4.1 INTRODUCTION
Due to the role of energy in the global economy, oil is a crucial global commodity, with a
world market of more than $2.0 trillion per year. Investment in oil and gas exploration and
production is very high, amounting every year to more than $300 billion. The oil and gas
sector is the biggest consumer of steel through its oil and gas pipelines. The total eet of oil
tankers amounts to more than 10,000 vessels (with around 500 very large carriers of more
than 200 thousand tons) and 350 million tonnes of oil capacity.
Oil and gas production is a very dynamic sector. The growth of demand is around 2%
per year, which is not a very high rate of growth compared to dynamic activities like elec-
tronics or telecoms. However each oil and gas eld has a limited lifespan: around 15 to 20
years for an oil eld and 20 to 30 years for a gas eld. Furthermore, this is the conventional
view as some new elds, especially offshore in the North Sea, Gulf of Mexico and even
Africa have much shorter lifespans. Thus there is a strong rate of decline of production which
varies from less than 3% per year (putting the lifespan over 30 years) in some Middle East
countries, to more than 10% in mature zones for satellite projects.
Taking a mean value of 5% per year for the rate of decline, this means that in 10 years,
more than 50% of todays production must be replaced with new production. For an oil
company, to keep its market share, the annual rate of growth is over 7% per year, so there
is a real challenge for the industry to nd and put into production enough oil and gas to
provide for the next generation.
The oil and gas upstream sector is therefore a very capital intensive sector. Globally, the
ratio of investment to revenue is around 8% for the whole sector. For the upstream segment
of international oil companies, the ratio of capital expenditure to revenue is much higher,
around 17%. This can be compared to a global industrial ratio of around 6-7% in the US
and Europe.
Today more than 150 oil and gas projects with a capital expenditure over $1 billion are
in development. Deciding to develop new E&P projects is the main task of the executive
121
Chapter 4 Investments and costs
committee of major oil and gas companies and capital discipline is a necessity to balance
technological, geological, nancial and geopolitical risks.
The decision on capital is very important because of the uncertain nature of oil and gas
production. When oil or gas is discovered, analyses of the drainage mechanisms allow
reservoir engineers to determine the nature of investments required and to establish
production proles. Using cost estimates, oil and gas price assumptions and scal and
contractual terms, oil companies can develop a revenue model for the entire life of the eld.
Oil and gas exploration and production remains a risky business, despite technological
progress. Discovering and producing new resources is a very challenging process, with
physical, environmental, technological conditions becoming even more difcult. During
exploration activity, despite constant progress in our understanding of the subsurface, a
percentage of an oil and gas exploration investment will vanish in dry wells. Over the last
ten years, globally, the rate of success in exploration activity has been around 25% (success
is measured by the ratio of discoveries with respect to exploration wells drilled, and this indi-
cator gives an optimistic view as it includes discoveries that are not yet commercial, under
todays price and technology).
When new oil is discovered, choosing the best development concept is a key decision for
an oil company, because re-engineering is very costly, as it often completely denes the oper-
ating conditions of the eld. Although the initial investment is of fundamental importance,
there is a very strong technological evolution which constantly brings marginal projects into
development. The frontiers of offshore depth, reservoir temperature, and pressure and
viscosity (i.e. heavy oils) are constantly being increased. In order to bring challenging new
resources into production, access to new technology (derived from research) is required,
while maintaining control of costs.
Between 1990 and 2003, technical costs were decreasing, accompanied by technological
improvements and strong competition in the service sector. Since 2004, with the strong surge
in oil demand, the pattern of costs has changed. With the higher oil prices, oil companies
have raced to develop new resources as quickly as possible leading to a tense situation in
the oil services sector. As demand has grown very quickly, resources like oil rigs, technical
capacities and skilled labour are in short supply. The long-term trend of decreasing costs has
been replaced by a strong increase in many of the service sectors. After a peak in 2008, the
economic crisis has provoked a small reduction. However costs will remain now much
higher than at the beginning of the century.
4.2 COSTS CLASSIFICATION
Economic evaluations of petroleum projects include, in addition to assumptions about the

value of hydrocarbons, three types of data:
Production proles, constructed by reservoir engineers from analyses of the drainage
mechanisms;
Capital and operating costs, evaluated by cost estimators and managed by the project
manager and the eld manager respectively;
Contractual and scal conditions, which can have a decisive role (they can prevent an
excellent project from ever seeing the light of day, for example).
122
The relevant importance of these three elements can of course vary depending on the

project context.
In the evaluation process these three types of data have to be analysed independently of
one another, but also subjected to an overall optimisation cycle such as to maximise value
added. This optimisation process almost always leads to a choice being made between alter-
native development options in which the minimisation of capital and operating costs is a
fundamental and ongoing requirement. The companys protability and competitiveness
depend on this. This imperative applies at all stages of the project.
Choosing the right development architecture, accurate costing and controlling expen-
diture across the board are the keys to success.
4.2.1 Types of costs

Normally speaking there are four types of costs involved in a project in the upstream
petroleum industry. These comprise:
The exploration costs incurred mainly before the discovery of a hydrocarbon deposit.
These include the seismic geophysics, the geological and geophysical interpretation,
exploration drilling including the well tests;
The investment costs incurred in the delineation and appraisal phase, necessary to gain
knowledge of the reservoir;
The development investments, which include:
Drilling the production wells and, if appropriate, the injection wells;
Construction of the surface installations such as the collecting network, separation and
treatment plant, storage tanks, pumping and metering units;
Construction of transport facilities such as pipelines and loading terminals;
Operating costs including transportation costs.
4.2.2 Examples of cost breakdowns

The relative weights of these different types of cost differ from project to project depending
on the environment, the nature of the reservoir and its uids, the export conditions and, in
a very different vein, any contractual constraints which may apply.
The exploration costs can vary enormously. They may be limited to a seismic programme
and a dry well, in the case of an unsuccessful exploration (generally between $5 and
$20 million, occasionally much more). They may represent a very small proportion of the
development cost when the discovery is clearly established and well dened. In other cases
these costs may make the economics of the project problematical when considerable appraisal
work is needed (for example several delineation wells) and the discovery is a marginal one.
Two actual examples of cost breakdowns, including delineation, are given in Figs. 4.1
and 4.2.
These examples show, and many projects exhibit a similar pattern, that the development
costs are fairly evenly divided between drilling operations, the production installations and
transport systems. Similar attention therefore needs to be devoted to each of these categories,
in terms of the technical denition and the control of implementation. The same of course
applies to the operating costs. The total operating costs over the life of a eld are of a similar
123
17%
11%
24%
22%
Drilling and completion
20%
21% Surface installations
Subsea installations
Gas export pipeline
44%
41%
Figure 4.1 Example of the cost breakdown for an offshore development

(North Sea, water depth 300 m).
30%
38% Drilling and completion
Production installations
Transport system
32%
Figure 4.2 Example of the cost breakdown for an onshore development

(South America).
magnitude to the investments, although for the decision-maker their weight is lessened by
the effects of discounting over a long period1.
The object of this chapter is to give a general overview of the orders of magnitude of each
of the main items of expenditure, to present some of the methods currently used by estimators
and project managers and, nally, to suggest a number of routes by which costs can ulti-
mately be reduced.
1. A decision-maker does not place the same value on a given receipt or expenditure in a number of years as
on the same sum now. Discounting consists of applying a given annual rate (this rate is specic to the
company) to future receipts and expenditures to estimate their present value. Discounting tends to reduce
the impact of future cash ows (see Chapter 6).
124
4.3 EXPLORATION COSTS

Exploration costs are generally less important than other items of expenditure (see Section
4.2.2). On the other hand they incur before the discovery of hydrocarbons, and will therefore
have a direct impact on the accounts of the company, the recovery of these costs being linked
to the likelihood of success of the exploration programme, in general between 10 and 30%.
4.3.1 Geophysics
Petroleum geophysics is dominated by seismic methods, both in terms of the volume of
activity and the investment costs. We will therefore conne ourselves in the present section
to considering the costs of seismic methods, since only marginal amounts are invested in
other methods (radar, potential methods, etc.).
4.3.1.1 Acquisition costs

Two-dimensional seismic methods tend to be used for large-scale exploration and in partic-
ularly difcult zones. The costs are usually expressed in $/km2.
A. Impact of type of terrain

Nowadays, companies specialised in seismic exploration are capable of operating in extreme
environments (high mountains, swamps, the Arctic, etc.) (Fig. 4.3). However the cost of
seismic methods is very dependent on the environment: 3D seismic exploration costs are
around $5000/km2 offshore, but can reach $50000/km2 in onshore difcult areas.
A B
Figure 4.3 Two examples of harsh environments. A. Borneo swamplands.
B. The Bolivian sierra.
125
Marine seismic is the least costly by virtue of a technique known as 3D multiute, which
permits the acquisition of strips 500 m wide in a single pass at a speed of about 10 km/hr.
On land it is impossible to obtain this density of data economically, and the acquisition grid
needs to be reduced.
Figure 4.4 shows a comparison of the expected costs of 2D and 3D seismic exploration
in different environments.
It can be seen that offshore there is not a great difference in costs between a 2D seismic
500 500 grid and a 3D programme, so that the latter is being used increasingly frequently.
A striking feature is the low cost of seismic for offshore exploration (particularly deep
offshore) compared with drilling exploration wells: the exploration costs for an area of
100 km2 would be around $0.5 million for 3D seismic, whereas the cost of drilling an
offshore exploration well can be more than $100 million.
B. Dominant factors
The costs of data acquisition offshore are dominated by the costs of the equipment needed
(a modern 3D seismic vessel costs around $100 million). Service providers eets are tending
to move towards larger vessels capable of sophisticated automated manoeuvring.
The movement of seismic equipment onshore cannot however yet be automated. This
means that personnel costs are signicant, and depend on the cost of local labour. When the
terrain is difcult, costs may be increased substantially by the need to use a helicopter or
specialised equipment such as thumper trucks where access allows, or oating machinery
for swampy terrain. Because of the major investments required to maintain seismic teams,
the 1980s saw the oil companies abandoning their own activities in this area, to the advantage
of specialised companies such as CGGVeritas and Schlumberger.
4.3.1.2 Data processing costs

In the same way as data acquisition, the processing of the seismic data is also subcontracted
to service companies, apart from a number of specialised processes and studies which are
still carried out by the large oil companies.
14
13
12
11
($ million/100 km2)
10
9
8
Cost
7
6
5
4
3
2
1
0
Offshore Desert Agricultural Urban Jungle Marshland Mountainous
area
3D 3D 2D seismic Cost of
seismic mini seismic maxi (500 x 500 m grid) drilling well
Figure 4.4 Effect of terrain type on seismic costs.
126
The data processing costs are lower than the data acquisition costs, being of the order of

$500/km2 for 3D seismic and $100/km for 2D. These are the costs of producing the standard
data (a 3D programme for deep offshore will involve several terabytes2 of data). When the
data require certain advanced or detailed processes which are time-consuming and labour-
intensive the processing costs may be considerably higher. This applies, for example, to a
depth migration before addition of 3D which allows three-dimensional subsurface images
to be obtained as close as possible to reality from series of images over time created from
the seismic records. This process can cost several thousand dollars per km2.
4.3.1.3 Analysis of data

Once the seismic data have been acquired and processed, they have to be transformed into
data which can be used by the decision-makers (maps, drilling prole, reservoir model, etc.),
whether in the exploration or development phase. There is as yet no technique which allows
the seismic data to be transformed directly into data which can be used to locate where a
well is to be drilled or draw up a development plan. The processing and interpretation of
the data using software therefore has to be carried out under the control of specialists.
Depending on the accuracy required or the complexity of the subsurface geology, the inter-
pretation of the seismic data can be a task of between a few months and several years. This
work will involve personnel and data processing costs which may be in the range $100 000
to $1 million for a seismic survey.
4.3.1.4 Trends in costs

A. Effect of technological progress
3D seismic techniques are in a constant state of evolution. Unit costs have fallen considerably
since the late 1970s when the technique was rst introduced.
This reduction in costs has been achieved through technological progress in the following
areas:
Optimisation of parameters so as to eliminate data redundancy;
Multiute/multisource 3D data acquisition which allows a large number of traces to
be acquired simultaneously;
On-board automation.
Signicant reductions in the length and expense of projects have indeed been achieved
thanks to the fall in the cost of information technology. However, as the projects that the oil
companies are working on today are increasingly difcult, part of these savings are de facto
absorbed by the increasingly complex operations required for the processing and analysis of data.
B. Effect of the market

If technological progress exerts a downward pressure on geophysical costs in the long term,
volatility in the prices of hydrocarbons affects costs in the short term. These costs are
subject to erce competition between the service companies operating in the local markets:
seismic contracts are awarded on the basis of competitive tenders in the countries concerned.
2. 1 Terabyte = 1012 bytes; 1 byte = 8 bits.
127
Furthermore in mature exploration zones (North Sea, U.S., etc.) the oil companies often
award contracts for off-the-shelf seismic surveys on a xed price basis. These speculative
programmes, which are the property of the contractors who bear the cost of the pre-
investment, are often offered at a cost as low as one-tenth of the price which an operating
oil company would pay for an exclusive customised survey.
For these reasons the mean costs per km2 indicated above must be adjusted to allow for
temporal and geographic factors, which can produce variations of a factor of 5 or 10 relative
to the mean value.
4.3.2 Exploration drilling

Most of the costs of an exploration programme are accounted for by the drilling. Onshore
and offshore drilling each has its own technical peculiarities; they differ particularly in
terms of cost if not duration. An offshore well typically costs between $20 and $100 million
and takes 30 to 100 days to drill. The corresponding onshore costs are $5 and $20 million,
the duration being of the same order. When the conditions are particularly difcult the costs
may be much higher, occasionally exceeding $200 million.
The main components of the cost of drilling an onshore exploration well are indicated in
Fig. 4.5.
The duration of drilling is difcult to predict due to geological uncertainties regarding the
drillability of the rock, the interstitial pressures of the formation uids, the depths, etc.
Difculties and unanticipated setbacks such as mud loss, jamming of the drill bit, etc. can
cause delays of several days.
Some 7075% of the drilling costs are proportional to the duration of the drilling:
equipment hire costs paid to petroleum service companies and the costs of supervising the
works (operating company personnel or prime contractor). Only 2530% of the drilling costs
can therefore be estimated with a reasonable degree of precision. These are the costs which
depend on the depth drilled (essentially the casing), the cost of the wellhead, etc. For this
reason it is a difcult exercise for the technicians to set a budget for an exploration well.
Petroleum services Consumables

29.5% 32.8%
Consumables
Logistics
Management
and supervision
Hire of
drilling rig
Petroleum services
Hire of Logistics
drilling rig 12.5%
20.1% Management
and supervision
5.1%
Figure 4.5 Breakdown of costs of onshore exploration drilling.
128
The hire of the drilling rig alone can represent between 20% (for the above example) and

35% of the total drilling costs. The daily cost depends on its power, which in turn depends
on the depth of the well and, for offshore drilling, the water depth involved. It will also
depend on the current availability of drilling rigs on the market, that is the relationship
between the supply of the drilling companies and the demand of the oil companies.
Daily costs for offshore rigs are usually several 10 thousand dollars but can reach several
100 thousand dollars if the market is tight. For the drilling contractor, the capital cost
involved can be between $10 and $16 million for onshore equipment, between $120 and $180
million for a jackup platform and between $300 and $380 million for a semi-submersible or
drillship with deep water capability.
Figure 4.6 illustrates the evolution of daily hire cost of offshore platforms.
700
550
500
Daily rate (thousand dollars per day)

600 450
Supply
400
Number of platforms
500 350
300
Demand
250
400
Jack-up 200
Gulf of 150
300 Mexico Semi-submersible
North Sea 100
50
200 0
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
Figure 4.6 Daily hire cost of offshore platforms expressed in thousands US$ per day.
4.3.2.1 Logging and geological parameters

The acquisition of petrophysical and petrochemical data involves logging3, core sampling and
initial production testing from the reservoir strata. The duration of this work varies from case
to case.
The monitoring and interpretation of the geological results from the drilling makes use
of two techniques practised by specialised service companies. The rst of these is mud
logging, i.e. the acquisition and surface interpretation of samples, data and information
carried via the mud circuit. The second technique involves recording physical parameters
which allow the nature of the formations, their pressure regimes and the uids which saturate
them to be characterised. These records are gathered either during drilling by means of
sensors incorporated in the drill string (in which case it is referred to as logging while
3. Logging: The recording of various electrical, acoustic and radioactive characteristics of the formations
penetrated, as a function of depth.
129
drilling, or LWD), or after drilling by means of sensors lowered into the wellbore at the end
of an electric cable (wire line logging).
Both of these techniques are usually necessary, and they produce complementary data.
Their costs are quite different, as we shall see below.
4.3.2.2 Surface geological records

Sensors situated at the surface (on the mud circuit, the pumps or the winch) are connected
to a central data processing unit located in the mud logging room which also includes a small
geological laboratory used for sample calcimetry, UV analyses, etc. (Fig. 4.7).
The costs relate to the provision of equipment and specialised personnel during drilling
operations. The magnitude of these costs depends of course on the local logistics, but
predominantly on the extent and complexity of the required measurements. For example the
characterisation of gaseous indices by gas chromatography with ame ionisation detection
requires the hire of specic equipment costing several hundred dollars.
Competition between mud logging contractors over the last decade has kept costs rela-
tively low, of the order of $1 5003 500/d. The costs of surface geological records represent
23% of the total cost of the well.
4.3.2.3 Logging
Whatever the actual contractual terms negotiated for logging, the effective costs of these
services comprise two components:
The direct costs, i.e. the sums actually billed by the service companies;
The indirect costs, arising from the enforced idleness of other services contracted for
the drilling of the well when the logging is being carried out (drilling rig, mud units,
cement units, mud logging equipment, etc.).
On average, logging operations account for about 57% of the total drilling time.
Logging costs depend on the level of activity and the type of well being drilled (explo-
ration, appraisal or development), each of these different types of well requiring more or less
Analyser Extractor Well:ML-1
Data processing
Gas logs
Interpretation
Figure 4.7 Geological records (surface).
130
sophisticated measurements. They are often expressed as a cost per metre drilled, which

allows trends over time to be evaluated and comparisons made between different zones.
Direct costs amount to around $100$120 per metre drilled, to which must be added the
indirect costs of $50$80 per metre drilled.
4.4 DEVELOPMENT COSTS
The development costs include the costs of drilling the development wells, the costs of the
production installations and any systems required for the transport of the efuent. These
investments are directly linked to the initial denition of the project. In fact the costs of
constructing the chosen system have to be met at this stage, which is why the various oppor-
tunities to appraise the project before it is authorised are so important. This subject is
considered further in the following sections.
4.4.1 The key stages prior to project authorisation

The authorisation of a project is the culmination of a process of study and evaluation, each
phase of which is intended to dene more precisely the project and its associated investment
and operating costs. Starting with exploratory studies the work proceeds through preliminary
study, the conceptual study and ending up with the preliminary design, the nal stage before
the project is authorised. The process is illustrated in Fig. 4.8.
Studies Project Operations
Preliminary Conceptual Basic Engineering,

Preliminary Start-up Operation
studies studies engineering procurement,
design
(screening, construction
feasibility) (EPC)
Go-ahead for Go-ahead Go-ahead Selection Completion of Provisional Production

more in-depth to start to proceed of contractor construction acceptance and final
studies preliminary with project and of the acceptance of
or exploration design commissioning installation the installation
Figure 4.8 The project life cycle.
4.4.1.1 Exploratory study

The purpose of the exploratory study is to evaluate whether a particular object being explored
has commercial potential. It includes a geological stage which will dene the potential
hydrocarbon resources present, evaluate the probability that an exploration well will be
successful, and estimate the development costs in the event of a discovery. By referring to
three geological scenarios, i.e. mini, mode and maxi scenarios, and often by drawing
analogies with other similar elds, the researchers will seek to dene a development archi-
tecture and the capital and operating costs involved. These data will help a decision to be
made on whether the proposed exploration programme should proceed. How relevant the
analogies and extrapolations made in this type of approach are will depend on the reliability
131
of available databases. Furthermore the usefulness of analogies may be limited when new
technologies are involved.
4.4.1.2 Preliminary studies

The preliminary study is intended to present a rst economic evaluation of a discovery so
that a decision can be taken on how to proceed, i.e. whether to abandon, sell the interest,
proceed to delineation, run a long duration production trial or, less frequently, proceed to
immediate development. The purpose of these studies is not necessarily to identify the
optimum development but to estimate, on the basis of the development concept most appro-
priate in the light of the available data and experience, the capital cost accurate to within
3040%.
4.4.1.3 Conceptual studies

This is a key phase in dening the development architecture. It is impossible to overem-
phasise that the largest reductions in investment costs are made by getting the nal concept
right. The purpose of conceptual studies is to dene the nal concept. This necessarily
involves:
An exhaustive search for basic data;
A detailed comparison of different possible technical variants (xed or oating
platform, surface (i.e. installed on a platform) or subsurface wellhead, air or water
cooling, etc.);
A reliable comparison of the costs and of the difculties involved in realisation.
If possible, the estimates for the different alternatives being considered at this stage
should all be of a similar accuracy (traditionally of the order of 2030%).
4.4.1.4 Preliminary design

The preliminary design is carried out after the conceptual studies and before the basic engi-
neering, if applicable.
Its essential objective is to allow the investors to decide whether or not to go ahead with
a development, that is, to authorise the project. This is a major decision. The decision-maker
needs not only production forecasts but also coherent, validated technical picture covering
all areas of operations. The preliminary design therefore needs to develop the nal concept
recommended by the conceptual study to a level of detail commensurate with the complexity
of the subject matter, such that the uncertainties are reduced to an acceptable level. It should
be noted that the preliminary design is the last stage at which there is still an opportunity to
make major changes in the denition.
The preliminary design usually lasts two to six months, and as a rule provides estimates
of the capital costs accurate to within 20%. In order to maximise the likelihood that the
project will be successful, the preliminary design is usually conrmed in an agreement
between the party responsible for the project conception, the party who will in future be in
charge of the project and the future operator. This agreement will set forth the parameters
and fundamental choices, as well as detailing the optimisation studies remaining to be
carried out.
In summary, therefore, the sequence of studies out lined above allows the uncertainties
in the costs to be reduced and the risks inherent in the project to be identied, as shown in
Fig. 4.9 and Table 4.1.
132
Accuracy of the estimate
(as % of total project cost)
+ 40
+ 30
+ 20
+ 10
Preliminary Conceptual Preliminary Basic Detailed
0
studies studies design engineering engineering
10
20
3
40
Project
go-ahead
Figure 4.9 Reducing uncertainty in costs as project proceeds.
Table 4.1 Different study phases before a project is authorised.
Development Objective Risk evaluation

studies
Exploratory
Establish broad feasibility Identify the risks (qualitative).
studies
First economic evaluation Identify the risks and estimate

Preliminary of a development project the degree of uncertainty
studies Basic data, attached to the economic results.
no optimisation of operating concept
Analysis of the risks associated

Choice of a development concept with the solutions studied.
Conceptual from set of alternatives studied:
studies => Choice of concept
cost, planning, economics, risk Feasibility demonstrated, subject
to clearly described uncertainties.
Technical and economic denition

sufciently accurate for: Analysis of risks
Preliminary a decision to be taken on whether
design to go ahead with the project, => Helps in dening objectives
a project action plan and project action plan.
to be drawn up.
These studies require the participation of many engineers and specialists, and are therefore
not without costs. There are no hard and fast rules for determining the costs but, as a
percentage of the total expected investment, they are of the following order of magnitude:
Preliminary studies: between 0.05 and 0.1%;
Conceptual studies: between 0.1 and 0.2%;
133
Preliminary design: between 0.2 and 0.5%;

Basic engineering: between 1 and 3%.
It should be stressed that it is as important to keep the studies on schedule as within budget.
When a study is completed there very often follows a process of negotiation and decision-
making which depends on annual programmes and requires the approval of many partners.
An objective of the studies is also to produce a timetable of the expenditure ows for the
project. This timetable should show the estimated percentage of the investments to be
disbursed each year relative to a start date and to the forecast project implementation timetable.
This timetable, known as an S-curve, is important in a number of respects. The post-
ponement of an item of expenditure to a later year can signicantly enhance the economics
of the project when the decision is made. Furthermore, optimising the timing of investments
often also gives insight into possible improvements in the project conception.
Many parameters can affect the shape of this S-curve. Due regard should be had, in
constructing this curve, to the point in the calendar year when the project will commence,
its duration, size and nature (onshore/offshore, pipeline, etc.). Also relevant are the type of
expenditure (studies, equipment, contracted activities), the country involved, the billing
basis written into the contract if known, the payment methods (in advance, milestone dates,
reimbursable, etc.).
As a rst approximation the curve in Fig. 4.10 can be used.
Project planning Year 1 Year 2 Year 3
Design
Supply
Construction
Installation/Hook up
% Investments 20% 60%
Figure 4.10 Example of S-curve.
4.4.2 Development drilling

Unlike exploration drilling, development drilling involves repeated operations, so that the
lead times involved are easier to plan and the costs are often easier to control. The time
required for the actual drilling has to be increased to allow for the time needed for well
completion, which varies according to the complexity of the completion.
In any particular environment, the development wells are generally drilled more rapidly
than the exploration wells; this effect is illustrated in Fig. 4.11.
When a series of development wells need to be drilled in the same eld, it is possible for
the technological parameters to be optimised on successive wells so that the drilling time
can be reduced. Figure 4.12 illustrates this learning curve effect. In a recent offshore devel-
opment the time taken to drill a development well (2 700 m in depth, with horizontal drains
of 1 000 m at the bottom) was reduced from 26 days for well no. 1 to 13 days for well no. 7.
134
Development drilling
drilling geology completion
Exploration or appraisal drilling

Drilling
Geology
drilling geology testing abandonment Production Testing
Completion
0 10 20 30 40 50 60 70 Abandonment
Duration (days)
Figure 4.11 Typical timings for drilling operations.
30
25
Drilling duration (days)
20
15
10
0
1 2 3 4 5 6 7
No. of wells
Installation 16 phase 12 1/4 phase 8 1/2 phase Completion
Figure 4.12 Learning curve for development drilling.
Tables 4.2 and 4.3 and Fig. 4.13 illustrate a typical breakdown of offshore development
drilling costs.
Special conditions can heavily inuence the costs of a development well, as shown by
the following examples.
Although the great majority of exploration and appraisal wells are vertical, nowadays 50%
of development wells are substantially deviated (>60) or horizontal. The cost of a horizontal
well is 2030% higher than those of a vertical well (but their productivity may be 3 times
as great).
135
Table 4.2 Cost breakdown for offshore development well. Oil-producing well South-
East Asia water depth 70 m.
Phase % of total cost
Consumables 34
Wellhead, piping, drilling bits and core barrels, mud and cement products,
accessories, energy, water.
Logistics 8
Fixed price (trucks, aircraft, removal of drilling rig).
Management and supervision 3

Studies and project management, supervisory arrangements, geology and reservoir.
Hire of drilling rig 41

Drilling contract, mobilisation/demobilisation of drilling rig.
Petroleum services 14
Mud, cement, casing, tubing, supervision, electric logging, mudlogging,
miscellaneous services, miscellaneous completion, diving team and ROV,
insurance, miscellaneous equipment hire.
Total cost 100
% of total cost 100
Duration (days) 55
Table 4.3 Duration for drilling an offshore development well (same project as in Table 4.2).
Erection and removal Drilling Geology Completion Total
Duration (days) 1 33 5 16 55
Consumables
Petroleum services 34.2% Consumables
13.8%
Logistics
Management
and supervision
Hire of
drilling rig
Petroleum services
Hire of Logistics
drilling rig 7.9%
40.7% Management
and supervision
3.4%
Figure 4.13 Cost breakdown for offshore development well.
136
Another example is a high pressure, high temperature (HP/HT) well: more sophisticated

well and completion equipment is required, so that the consumables required are more
costly, increasing the costs by up to 20%. The same applies to exploration wells where the
conditions are difcult. A well producing corrosive uids requires completion equipment
made of more sophisticated metallurgical materials, which can also increase costs by up to
20%.
Furthermore an oil producing well where subsea pumping is necessary will require
multiple workovers in order to maintain the pumps.
Environmental constraints can equally affect drilling costs. These are increased if drilling
waste such as rubble or liquid wastes have to be treated in order to comply with national
legislation. The additional costs are very variable ranging between 1 and 5% approximately.
These can be reduced if smaller diameter drilling is employed, for example in ecologically
sensitive zones such as the Paris basin; the reduction which can be achieved in this way is
of the order of 1015%.
4.4.3 Production and transport installations

It would be a vain enterprise to seek to list exhaustively the costs of all the various items of
equipment currently used in development drilling. Instead we describe below some typical
onshore and offshore project congurations and review some of the methods traditionally
used to cost these installations. We then present a set of unit costs and ratios which can be
used for very preliminary evaluations. More detailed descriptions will then be given for two
specic cases: a deep offshore development programme and an example of an LNG project.
Whether onshore or offshore, the principles of production, gathering, separation, treatment
and transport of the products remain the same. The structures and equipment will vary
according to the composition of the efuents, the product specications applying to transport
and sale, but also, obviously, according to the characteristics of the environment.
4.4.3.1 Onshore development

In an onshore oil or gas production facility the wells, whether isolated or grouped into
clusters, are linked by a network of gathering lines to a production and processing facility
from which one or more transmission lines run (Fig. 4.14). Some remarks follow on the
different components of the production facility.
A. Well cluster
Each cluster normally includes the facilities needed to test the output of each well.
B. Gathering network
The lines of this network are generally made of carbon steel, but occasionally of more sophis-
ticated alloys (Inox or Duplex steel) or composite materials. They are subject to attack both
external and internal, in the form of corrosion and erosion. They can also undergo processes
such as blocking, scaling, the deposition of minerals (sand, sulphur) or hydrocarbons
(parafns, asphaltenes) through settlement or the formation of hydrates. They are therefore
equipped with cathodic protection or systems which inject protective or preventive chem-
icals, heating and insulation systems, systems for scraping and detection pigs.
137
The processing plant:

Separation
Heating
Storage
The field: Pumping
well clusters and gathering system Power generation
The pipeline
Well cluster The loading terminal
Figure 4.14 Onshore development concept.
C. Production and processing facility

The efuent from a well is made up of gaseous and liquid hydrocarbons, usually water and
sometimes salt, sand and solid hydrocarbons. The different phases present, which sometimes
also include emulsions and foams, have to be separated. This is traditionally done in
successive phases through pressure drops, the efuent waste (water and sediments) being
separated from the oil and gas and treated, before being discharged. The specications of
the separation and treatment units touched on above will depend on the types of efuent,
their quality and the specications which need to be met.
Separation requires separators, cyclones, hydrocyclones, desalters, lters, coalescers,
decanters and, less frequently, plate columns.
Oils are treated mainly by removing the water, salt and excess gas so that they can be
stored, transported and handled by normal methods. Desalters and stabilisers are the most
common installations.
The gas is treated to remove the pollutants (CO2, H2S, water) and heavy hydrocarbon frac-
tions which can be condensed out. There are various processes for sweetening, drying and
condensing the heavy fractions: molecular sieves, adsorbent beds, chemical or physical
absorption, traps with cooling coils or self-refrigeration by expansion and recompression.
The gaseous fractions are compressed for transportation or reinjection into the reservoir
or, very occasionally, for storage.
The water treatment usually involves a treatment plant and pumping facilities which
reinject the water back into the reservoir.
The production facility may also supply the utilities required (electricity, water and other
services).
The efuents are transported to a terminal, factory, etc. by pipeline.
138
4.4.3.2 Offshore development

In an offshore installation the wellhead may either be on the platform or underwater.
Combined surface and subsurface production facilities are becoming increasingly common
in offshore development.
The production support, which may be a xed platform or a oating vessel, houses the
utilities needed for production (particularly power) and all the safety installations. For
reasons of weight, installation cost and maintenance, the offshore processing equipment is
often limited to that which is necessary to ensure that the efuents can be transported ashore.
These are transported by pipeline or, sometimes in the case of oil, stored for loading onto
tankers. The remaining processing needed to ensure that the products comply with the
delivery specications are carried out on arrival. Accommodation for personnel, the control
room and ofces and the amenities needed for life on board are situated either on the
production platform itself or on a dedicated accommodation platform.
Two common types of development are illustrated below: concepts based on xed plat-
forms and on a oating vessel.
A. Development based on xed platforms

The well, processing and accommodation platforms are linked together by walkways to form
a production complex, to which a small are platform can be added (Fig. 4.15).
B. Development based on a oating vessel

The production support consists of a FPSO (Floating, Production, Storage and Ofoading
Vessel) linked to the underwater wellheads by means of exible lines (Fig. 4.16).
ACCOMMODATION
PLATFORM
UTILITIES/PROCESSING
PLATFORM
FLARE
Pipeline
32 - 82 km
WELL PLATFORMS
PROCESSING PLANT
Figure 4.15 Offshore development conguration with xed plat-

forms.
139
Figure 4.16 Offshore development conguration with FPSO.
4.4.3.3 Key parameters of development costs

The capital cost of developing an oil or gaseld may amount to several billion dollars. It is
crucial that the key parameters are identied and evaluated so that the project can be properly
dened and its viability assessed, because some of these parameters strongly inuence the
costs.
A. Situation of the eld and constraints on exploitation

Onshore, the nature of the terrain is the main determinant of costs. Offshore it is the water
depth, which may be conventional (to 300 m), deep (to 1 500 m) or ultra-deep (over 1 500 m).
B. Oceano-meteorological conditions
Producing oil and gas in a hostile environment means costly production installations: plat-
forms must be able to withstand extreme climatic conditions, for example storms in the North
Sea, hurricanes in the Gulf of Mexico or typhoons in the Gulf of Thailand.
C. Reservoir type and behaviour

These reservoir parameters determine the number of wells required, and whether water or
gas injection will be needed during the lifetime of the eld.
D. Composition, pressure and temperature of the efuent

The processing required in order to transport and sell oil products is inuenced by the
content of H2S, CO2 and asphaltenes, by high pressure and/or temperature, by the gas/oil ratio
(GOR), by the API gravity, etc. High pressures and temperatures require heavy-duty
equipment and sometimes hi-tech materials for the piping and pressure vessels. For example,
a gathering line 10 in diameter costs about $30/m for an operating pressure of 50 bar, but
about $150/m for 300 bar.
140
4.4.3.4 Development costs summary table

Table 4.4 is an example of a typical summary made by the estimators, in this case for an
on-shore gas treatment plant. The methods used to prepare it will be explained later. The table
shows that the technical costs4, although important, are just one element in the overall
estimate. They are accompanied by a range of other costs related to the studies, surveys,
project management and insurance.
Table 4.4 Example of structure of cost: onshore gas treatment plant.
Project information
Characteristics
Gas ow: 1 000 mm.s.ft3/d
Oil ow: 90 573 bbl/d
Weight of equipment: 2 245 t
Summary of costs Ratio (%)

Direct costs
Process equipment 42%
Utilities 11%
Ancillary equipment 2%
Infrastructure 3%
Total direct costs 58%
Indirect costs
Technical facilities 1%
Construction-related costs 2%
Costs related to transport of equipment
and bulk materials 3%
Total indirect costs 6%
Technical costs (direct and indirect) 64%

Engineering 10%
EPC costs (technical costs and engineering) 74%

Basic engineering, surveys 1%
Project management 7%
Commissioning 1%
Insurance 1%
Total costs (w/o contingencies) 84%
Contingencies 16%
Total costs 100%
4. The technical costs are the sum of the direct costs (main equipment and bulk items such as pipework,
valves and ttings, electricity, instrumentation, prefabricated materials and on-site construction) and
indirect costs (equipment transport, temporary installations, etc.).
141
4.4.3.5 Unit costs and standard ratios

Table 4.5 presents various standard cost data for the main elements of the production and
transport installations, which can be used for a very preliminary costing.
4.4.4 Methodology for estimating development costs

Our object is not to present a course in cost estimating to the reader, but to give him a rapid
overview of the principal methods used by estimators during the various study phases referred
to above. Before doing so we take this opportunity to dene a number of terms and abbre-
viations which are not always understood by non-specialists in the way intended by estimators.
4.4.4.1 What is an estimate?

An estimate is a statement of the most likely cost of an industrial project, elaborated before
all the parameters of the investment have been dened.
It should be borne in mind that:
An estimate assesses the most likely, rather than the lowest, cost of a project. If the actual
costs ultimately prove lower because the competition between the suppliers and other
companies turns out to be keener than expected or because dumping is practised by some
suppliers, all well and good. But an estimator may not assume a favourable scenario of
this kind.
An estimate is an approximation rather than a precise forecast of costs: an installation
cannot be costed by referring to a price catalogue. Quantities such as the weights of struc-
tures or piping, dimensions, volumes of concrete, the length of cables, etc., are not yet
known at the preliminary, conceptual or even the preliminary design stage. This is quite
different from a contractor bidding for a job, who must begin by calculating the quantities
of materials involved, so that he can price the job with the help of unit costs or price lists.
4.4.4.2 Basis of estimate

To be complete an estimate must specify the following:
The technical denition of the project, a list of the technical documents on which it is
based, the limitations of and exclusions from the estimate;
The economic basis, i.e. date, currency, exchange rate. It should be noted that estimates
are generally expressed in constant prices, without assumptions about future ination.
The gure will be converted to current prices when the life of project budget is drawn
up by a nancial department. Other competent departments will then also add on the
nancing expenses, local taxes and customs duties so as to obtain a complete project
costing in the local currency;
The accuracy of the costing will depend essentially on the methodology adopted and
the level of the study.
4.4.4.3 Structure of a cost estimate

Broadly speaking, a cost estimate is made up of the direct and indirect costs, which sum to
give the technical costs, other general items and a reserve for contingencies. Readers are
reminded of the denitions of each of these terms below.
142
Table 4.5 Production and transport installations: standard costs and ratios (base 1st

quarter 2007).
Main equipment
Carbon steel pressure vessels (less than 5 t) 1535 $/kg
(between 5 and 20 t) 1820 $/ kg
(over 20 t) 5 $/kg
Multiplier for inox pressure vessels 3.0
Bulk materials
Carbon steel piping (including ttings) 67 $/kg
Inox piping 2022 $/kg
Duplex steel piping (including ttings) 2530 $/kg
Steel for structure 1.5 $/kg
Carbon steel pipeline 1.52.0 $/kg
Transport costs
510% of the purchase price of above items
Pipelines
Equipment 2040 $/inch/m
Laying costs: onshore desert 6 $/inch/m
plain 1012 $/inch/m
mountains 6080 $/inch/m
offshore 1030 $/inch/m
Labour ($/hr)
Region Onshore construction Engineering
France 60 100
UK ($1 = 0.5) 70 100
Norway ($1 = NOK 5.96) 80 120
Far East (Indonesia) 30 50
Gulf of Mexico 50 80
Marine vessels ($000s/day)
Supply Derrick barge Derrick barge

Region Lay barge
vessel < 2,500 t < 6,600 t
North Sea 20 1,100 1,300 4001,100

Middle East / 810 300 850 500
Far East
Gulf of Mexico 510 300 850 400
Indirect costs
Pipeline project, onshore or offshore 1520% of technical costs
Other project 2540% of technical costs
143
A. Direct costs
These consist of the cost of the main equipment (ME): columns, separators, rotary drives,
etc., required by the process plant and the utilities, and the cost of the secondary or bulk
equipment such as pipework, valves and ttings, electric cabling, instrumentation, cladding,
etc. Also included are the construction costs including the costs of onshore prefabrication
of the elements and modules of the offshore platforms, as well as the on-site construction
costs (installation and hookup).
B. Indirect costs
These include the costs of transporting the equipment, materials and the different structures,
as well as the mobilisation/demobilisation of the marine equipment where appropriate.
The general expenses, often referred to as EMS (Engineering, Management and Super-
vision) cover:
The engineering, i.e. the basic engineering and the detailed engineering, as well as
services such as audit and certication, often performed by external service-providers;
The commissioning of the structures;
The management and supervision of the team in charge of the project, mobilised at
different phases of the implementation;
The insurance of the structures during construction and installation as well as other
indirect costs such as customs duties incurred by the subsidiary company.
The term EPC (engineering, procurement and construction) cost is sometimes used. This
corresponds to the value of the contract for the construction of the infrastructure, that is, a
technical cost together with the general costs of the contractor responsible for carrying out
the work. In a contractual arrangement of this kind the EPC cost must be increased to allow
for the general costs of the prime contractor, or company costs, that is, the costs of the
basic engineering, site surveys, management, project supervision and insurance.
C. Contingencies
The accuracy of a costing will depend directly on the technical denition of the project and
on how much is known about the environment. Whatever the stage of a project, a provision
for contingencies is always included in an estimate, in order to allow for uncertainties which
cannot be identied or quantied at this stage.
4.4.4.4 Principal cost estimation methods

There are various methods of estimating costs each with its own area of application
(Fig. 4.17).
A. Analogy with known costs

This method is suitable for exploratory studies or screening studies in the widest sense. The
cost is estimated by reference to the known (or appropriately updated) cost of an existing
installation of the same type but a different capacity. It is assumed that the ratio of the costs
of the two installations is equal to the ratio of their capacities raised to a power of approx-
imately 0.6 (also known as the scale factor). This rule of thumb only applies when the
capacities concerned are not too different from one another.
144
+30%
+25%
+20%
+10%
Preliminary Conceptual Preliminary Final
studies studies design costing
10%
15%
20%
30%
Define the general List in detail the equipment,

characteristics of the installation List the main equipment bulk materials
and apply general ratios and apply specific factors and specific quantities
Global methods Factorisation methods Detailed methods
Figure 4.17 Main costing methods.
B. Factoring methods
These methods are widely used, particularly for preliminary and conceptual studies, and
sometimes even preliminary designs. They are based on the observation that there is a fairly
constant relationship between the direct installed cost of an item of processing plant or a
utility, including auxiliary equipment and construction, and the costs of the main items of
equipment. The latter are generally evaluated using small computational programmes or an
equipment database. A multiplier specic to the type of equipment involved is then applied
to obtain the direct installed cost.
To these equipment costs have to be added the site preparation costs, ancillary or offsite
installations (storage and loading facilities, reghting and utility networks, pipe connections,
industrial buildings, amenities, etc.) and the costs of the necessary infrastructure (roads,
power cables, jetty or port, etc.).
Finally the indirect costs, general costs and provision for contingencies are usually esti-
mated using percentages.
C. Detailed or semi-detailed methods

This method involves estimating each item analytically. Since the quantities of bulk mate-
rials cannot be calculated at this stage of the study, they are estimated as a proportion of the
main equipment. For example the tonnage of the supporting structure or piping associated
with a particular item of equipment is estimated by applying a specic ratio to the tonnage
of the equipment. The hours of labour spent on manufacture or construction on-site are also
145
evaluated using ratios. It is estimated, for example, that the labour required for the manu-
facture of substructures for xed platforms is between 60 and 80 h/t, or about 300 h/t for
ordinary steel piping. Finally these hours are converted into costs by using a labour cost per
hour and assumptions with regard to productivity.
The general costs will be estimated at the most detailed level possible by evaluating, for
example, the number of hours of engineering based on the numbers of items of equipment,
or the management and supervision costs from hypotheses regarding the future contractual
strategy and the organisation of the project team.
4.4.4.5 Need for feedback from projects

The great majority of estimates in the preliminary or conceptual phase use a factoring
method based on the costs of the main items of equipment; we therefore have two require-
ments:
A database, as complete as possible and regularly updated, of the main items of
equipment;
Feedback from projects on the quantities of secondary equipment associated with each
of the main items of equipment, on numbers of hours spent on manufacture and
construction as well as costs, broken down by subject area and by structure type. This
will allow the best possible estimate to be made of the ratios used in future costings.
Feedback of this kind is difcult to obtain in the context of an EPC contract. This is
because, rstly, we rarely have access to data on the cost of equipment, often purchased by
the contractor, particularly secondary equipment. And secondly, although the overall value
of the contract is known, it is difcult to break this total down into its different components:
in fact the way the contractor apportions the overall price is arbitrary.
4.4.4.6 Provision for contingencies

This provision is intended to cover the variations in the cost of the project due to events
which are probable but not certain (or which cannot be identied) when the estimate is made.
In practice, experience has shown that, statistically, a certain number of these events will
occur. It includes, for example, uncertainties relating to slight modications in the tech-
nical specication, modications in the regulations, specic building problems, supplier
delays, or variations in the cost of labour or in labour productivity.
As already mentioned, however, this item cannot cover large and costly, though unlikely,
events such as:
A signicant change in the technical specications of the project;
Provision for exceptional meteorological conditions;
A catastrophic event or natural disaster;
Political disorder, force majeure;
Extreme market turbulence, or a failure of competition;
A major change in contract strategy or in planning, etc.
4.4.5 Examples of developments

Examples are given below for two different types of development project, i.e. a deep or ultra-
deep offshore development project and a LNG (liqueed natural gas) supply system (entire
cycle including liquefaction, transport and regasication).
146
These two examples will give readers a better understanding of the orders of magnitude

of the overall costs of projects in the petroleum industry and, in particular, the technical costs
expressed per barrel of oil or per unit caloric value of gas, as appropriate.
4.4.5.1 Deep and ultra-deep offshore

This is a very topical theme: many companies are currently interested in exploration in water
depths in excess of 1 000 m and even occasionally 2 000 m.
Advances in subsea technologies mean that it now appears feasible to produce hydro-
carbons discovered at such depths at a competitive cost.
At more familiar water depths up to 300400 metres technological progress has led to
signicant reductions in costs. The cost of producing a barrel of oil (exploration, development
and exploitation) at such depths had fallen from $1315 in the 1980s to $57 in 2000 and
grew again over $20.
Extrapolating these results suggests that the development of offshore resources in deeper
waters should be economically feasible. There are many production concepts of proven
viability at moderate depths which could realistically be assumed to constitute the starting
point for evaluating deep or ultra-deep offshore development projects (Fig. 4.18).
The petroleum industry is currently focusing its efforts on very deep waters (>2 000 m),
with the objective of getting to 3 000 m.
A. Costing methodology
A possible development programme can be evaluated on the basis of two major categories
of parameters, those which describe the reservoir itself and those which describe its
geographical location.
Figure 4.18 Deep offshore production concepts.
147
Parameters associated with the reservoir are usually obtained from a speculative seismic
exploration survey and by interpreting local geological phenomena. These parameters allow
the size of the target object to be estimated, that is the reserves and the extent of the
reservoir, as well as its potential, i.e. the density of the reserves, reservoir productivity and
the types of uids.
The second category of parameters includes physical data (distance from the coast,
water depth, depth of reservoir under the seabed) and data which describe the environment.
These latter data relate to the oceanographic and meteorological conditions, the existing
petroleum infrastructure and the extent to which it would be available, the market prospects
for the production, local regulations, tax regime, etc.
The values of these parameters will point the evaluator towards the most appropriate
development plan.
B. Example of estimation of capital costs

By way of illustration the investment costs are estimated for two prospects of contrasting
size and location, both situated in 1500 m of water.
a. Prospect in the Gulf of Guinea
This prospect is situated in 1 500 m of water in the Gulf of Guinea. The hydrocarbon
deposits, of centred morphology, extend over an area of 90 km2. They consist of multilayer
reservoirs lying at depths of between 900 and 1 700 m below the sea bed. The reserves are
estimated to be 750 Mbbl of oil, and the eld would have a life of about 2025 years. The
production will plateau at 200 000 bbl/d.
Because of the lack of a local petroleum infrastructure and the remoteness of the markets,
the development is based on a FPSO acting as a gathering station for a subsea production
network (Fig. 4.19).
FPSO (capacity 200,000 bbl/d)

Multiple mooring lines (16 moorage lines) Offloads to tanker
Water depth 300 m
430 m
Cluster of
10 subsea wells
Gathering lines (length ~ 3 km) Export lines (length ~ 2 km)
production 2 x 12 3 x 12
test 1 x 6
Figure 4.19 Example of development concept, deep offshore (Gulf of

Guinea).
148
The FPSO, tethered in a xed position by 16 mooring lines, will comprise a hull 300 m

long and 60 m wide with the capacity to store 2 Mbbl of oil. The treatment plant and util-
ities will be situated in one or more independent modules on the upper deck. Their net weight
(empty) is estimated at 20 000 t.
The production wells will be connected to production manifolds which are joined to the
gathering lines. Each production line is made up of two pipes thermally insulated by means
of a layer of foam in a metallic case. The water injection wells are connected in twos to the
injection manifolds. Three water injection wells are connected to the FPSO by three inde-
pendent lines.
The production lines, water and gas injection lines are connected to the FPSO by exible,
thermally insulated connections. A control and command umbilical is attached to each
production line and water and gas injection line from the wells and the manifolds.
The oil is pumped into tankers at a loading buoy anchored at a distance of 2 km from the
FPSO. The associated gas is re-injected into the top of the reservoir.
In order to determine the sensitivity of this development scheme to the size of the recov-
erable reserves per well, two cases are considered, in which there are 48 and 63 production
and water and gas injection wells respectively.
The capital costs were estimated by reference to projects similar to the one in question
in the Gulf of Guinea and Brazil (see Table 4.6).
Table 4.6 Gulf of Guinea prospect: development investments ($M). Water

depth: 1500 m Reserves: 750 Mbbl.
Case 1 Case 2
48 wells 63 wells
Production vessel 1 700 1 700

Subsea equipment & control system 1 000 1 300
Gathering lines 1 700 1 900
Company costs1 600 700
Provisions 500 600
Drilling Wells 2 000 2 600
Total capital cost ($M) 7 500 8 800
Capital cost ($/boe) 9.9 11.7
1. Project management and supervision, studies, preliminary work, insurance.
b. Prospect in the Gulf of Mexico

This prospect is situated in 1 500 m of water in the Gulf of Mexico. The reservoir, with an
elongated morphology, has an area of 22 km2. It is multilayered, at depths of between 1 800
and 3 000 m below the sea-bed. The reserves are estimated to be 180 Mboe, and the eld
would have a life of about 1520 years. The production will plateau at 60 000 bbl/d of oil
and 100 Mft3/d of gas. This production level will be achieved by means of 15 wells.
The development concept adopted involves a spar oating production platform with a
deep draft (Fig. 4.20) with wellhead at the surface and the production being dispatched to
existing installations. In contrast with a subsea development, this design has the advantage
of carrying out the drilling and production from the same platform, allowing servicing to be
carried out on a well without having to mobilise a drilling rig. This system also overcomes
the problem of having to transport a multiphase efuent over a long distance. The spar
149
Figure 4.20 Artists impression of a spar.
comprises a oating structure with a circular cross-section at water surface level and along
the length of the otation tanks on which the production and drilling modules are placed.
The cylindrical shell is 37 m in diameter and 215 m in height, with a hollow square cavity
of 18 m square in the middle containing the risers. The spar is anchored by means of 12 semi-
taut catenary cables. The risers connecting the seabed to the wellhead at the surface are main-
tained under tension independently by means of otation modules inside the cavity in the
shell. The riser contains a special joint at the level of the spar keel in order to accommodate
movements of the riser relative to the platform.
The drilling and production module, including the living quarters for 110 persons, is made
up of 3 decks 55 m in length, providing a total surface area of the order of 9 000 m2. The
empty weight of this module is approximately 9 000 t. All the wells are pre-drilled as far as
the surface casing. Four of the wells are drilled into the target formation so that production
can commence shortly after the installations are erected and connected. The remaining wells
are drilled from the spar.
After separation, the products are exported to pre-existing installations situated in shal-
lower water by means of two independent pipelines, i.e. a 10" line, 60 km in length for gas
and a 16", 70 km line for oil.
The capital costs were estimated from available data as indicated in Table 4.7.
150
Table 4.7 Prospect in Gulf of Mexico: capital cost of development ($ millions).

Water depth: 1 500 m Reserves: 180 Mbbl.
Production platform 1 900

Subsea equipment & control system
Collection network
Export system 100
Company costs 2 180
Provisions 120
Drilling Wells 300
Total capital cost ($M) 1 600
Capital cost ($/boe) 8.9
1. Including the drilling function\equipment and the production and export risers.
2. Project management and supervision, studies, preliminary work, insurance.
These two examples of deep offshore prospects show that, depending on location, the unit
technical costs for elds of quite different sizes can be of a comparable order of magnitude.
4.4.5.2 LNG cycle

The LNG supply cycle comprises, in addition to the gas production and condensate stabili-
sation plants, the following subsystems (Fig. 4.21):
The liquefaction plant, which provides for the treatment, refrigeration and liquefaction
of the feed gas, and the storage and loading of the liqueed gas;
A eet of LNG tankers to ship the LNG from the treatment plant to the terminal;
The reception terminal where the LNG is regasied and, possibly, an associated power
station.
LNG
plant Refrigeration
Feed Pre- Sales

Precooling Liquefaction LNG Regasification
gas processing gas
LGN GPL Temperature = 160C
Losses: 2% + 8% + 2% + 1% = 13%
Figure 4.21 The LNG cycle.
A. Description
The main characteristics of each component of the cycle are reviewed below.
a. Liquefaction (Fig. 4.22)
There are strict limits on contaminants in the LNG (CO2 between 50 and 100 ppmv, total
sulphur approximately 3 ppm moles). Gas treatment units upstream of the liquefaction are
151
Fuel gas N2
Denitrification
MCR
MCR: Multi Component Refrigerant LNG
Cryogenic
exchanger
(MHE)
Propane
Preprocessing
Sour gases (CO2, H2S, mercaptans)
Feed Amine Mercury LPG

Reception Dryer Precooling Liquids
gas treatment trap removal
Fractionation
NGL
Figure 4.22 Simplied owchart of a LNG plant.
more expensive than traditional liquids removal units. Any mercury in the feed gas is treated
at this level; nally the gas is dried by means of molecular sieves before refrigeration.
Two refrigeration cycles are generally needed in order to produce the LNG. The rst
cycle, which usually produces pure propane, cools the feed gas (usually to 20/30C) and
the refrigerant for the second cycle. The second cycle, which uses a mixture of nitrogen and
light hydrocarbons, allows the gas to be condensed and cooled to 160C. These units make
use of large compressors driven by gas or steam turbines.
The natural gas is liqueed in an exchanger (just one per train) with a large heat exchange
surface. They are usually spiral tube exchangers 4 metres in diameter and some 60 metres
in height.
Depending on the nitrogen content of the feed gas, the liqueed gas will be passed to a
denitrication unit in order to reduce the nitrogen content to a level acceptable for its transport
(normally 1%). The nitrogen-rich off-gas from this unit is returned to the fuel gas stream.
The heavy hydrocarbons are separated in a fractionation unit. This unit produces a gas
rich in ethane which is routed back into the LNG stream. It also produces a propane/butane
stream which can be reinjected into the LNG or sold as a separate product and nally, a
heavier product with the characteristics of a light condensate.
The liqueed gas is then stored in cryogenic tanks at atmospheric pressure tted with
loading pumps. The gas resulting from the evaporation of the LNG (boil-off) is returned
to the fuel gas stream by means of dedicated compressors.
The LNG is transferred from the loading bay onto LNG tankers by means of cryogenic
loading arms. In view of the size and draft (approximately 14 m) of these vessels, and the
precautions which must be taken during product transfer, a dedicated jetty and associated
port facilities are needed. A large LNG factory may have several jetties. The LNG plant at
Bontang in Indonesia, for example, has three jetties.
152
The liquefaction plant requires the following facilities: a cooling circuit (generally sea

water), a heating system (steam, thermal oil or hot water) for the reboilers, fuel gas, power,
compressed air and nitrogen (for inerting), a system for gathering and treating the liquid
efuents and a system for aring and liquids burning.
Air-cooling is possible, but all the major plants (except North West Shelf in Australia)
use sea water as the coolant.
b. Transport
The LNG market is characterised by long-term contracts, and a dedicated eet of LNG
tankers is normally used to transport the product. The number and size of the tankers forming
the eet is a function of annual volumes of LNG to be transported and the transport distance.
The most common size for a tanker is 135,000 m3 or 65,000 dwt, or in energy terms, 3 TBtu
per tanker-load. Much larger ships with a 250,000 m3 capacity now exist.
A LNG tanker sails typically at 1819 knots. The longest routes (from the Middle East
to Japan) are approximately 6,300 nautical miles and the shortest (Algeria to Spain) about
350 nautical miles.
c. Regasication
On arrival at the reception terminal the LNG is transferred to storage tanks, and subsequently
vaporised, after cryogenic pumping, and made available to the end-user. The gases which
form due to the natural evaporation of LNG in the terminal installations are reincorporated
into the liqueed gas before pumping. The vaporisation is effected either in trickle evapo-
rators or in submerged ame vaporisers. If the caloric value of the gas is too high, nitrogen
or air is injected into the sales gas.
B. Size of the units
In order to estimate the capital costs it is essential to know the capacity of the plant and the
unit size of the liquefaction trains.
a. Capacity of the plant
There are 30 LNG plants throughout the world in 2011. Their capacities range from 1.1 Mt/y
(Camel, Algeria, commissioned in 1964) to several 10 Mt/y (Qatar). The capacity of a plant
depends on the size of the reserves which it will process and the market for which it will
produce.
Only one plant, in Kenai, Alaska, operates with a single liquefaction train; all the other
plants have multiple trains. The maximum number of trains is eight, in Bontang.
b. Size of the trains
The capacities of trains of recent design can reach 8 Mt/y, using more powerful mechanical
drives. The liquefaction trains are sized on the basis of the markets at which the plant is
aimed, but also on the optimum production rate associated with the power of the refriger-
ation machine (initially assumed to be 14 kW per tonne of LNG per day).
High-power industrial gas turbines come in only a limited number of sizes. The most
appropriate turbine with a power which meets the requirements is therefore chosen. When
choosing the rated capacity of the turbine, it should be borne in mind that the power actually
available depends on the temperature of the air (there is a 0.7% variation in output power
per C): the capacity of the train will therefore be a function of temperature.
153
It should also be noted that most liquefaction plants have been debottlenecked at some
stage in their lifetime, leading to an increase compared with the initial (design or name-
plate) capacity of 1040% or even more.
c. Storage capacity
As a rule of thumb, the storage capacity should be no less than the capacity of a tanker plus
a certain number of days production for the plant when operating at full capacity. This
number of days will depend on the particular circumstances of the case, particularly the avail-
ability of tanker capacity (which may be disrupted by weather conditions, for example). As
a rst approximation, 45 days should be taken.
The number and sizes of the tanks will depend on the chosen capacity, but also on the
unit cost, given that these are lower for a large than a small tank. LNG storage tanks are
large: up to 250 000 m3 for an above-ground tank.
d. Size of LNG tankers
The size of a LNG tanker can reach 250 000 m3, but smaller vessels might be chosen for short
routes depending on the limitations of the destination port.
C. Energy losses
An estimate is made in this section of the mean energy efciency of the entire LNG supply
cycle; this parameter is indispensable for any technico-economic analysis.
The liquefaction plant requires around 1012% of the feed gas for its own use. The
precise gure depends on the pre-treatment necessary, the installations used to load the LNG
onto the tankers, the source of power (gas or steam turbine) and the intrinsic efciency of
the liquefaction process.
There is some evaporative loss of LNG during transportation, and this will be burned in the
vessels boilers. In addition, some LNG will be used to keep the storage areas cold for the return
journey. The loss of saleable product is estimated at between 1 and 3%, according to the distance
involved. In addition an average of about 1% of the LNG will be used during regasication.
The total energy loss over the entire LNG supply cycle is around 13% ( 2%) of the feed gas.
D. Technical costs
One of the measures of technical costs most commonly found in the literature is the specic
project costs (limited to the turnkey or contractors cost), expressed in $ per t/y capacity.
These specic costs vary in the range $500 to $800 per t/y, according to the technical de-
nition, but also as a function of environmental factors such as the composition of the gas,
the cost of labour, the adequacy and preparation of the onshore or offshore site, the
remoteness of the site and the logistics. These costs also depend on the market conditions
at the time the construction contract is signed. For a preliminary estimate of the cost of the
LNG supply cycle it is suggested that the gures in Table 4.8 are used.
Consider a LNG project involving the transportation of 5 Mt/y over 6 000 nautical miles.
By applying the data in Table 4.8 and by making a few simplifying assumptions, we arrive
at a production cost CIF5 including regasication but excluding feedgas for LNG of approx-
imately $3/MBtu. These costs are broken down in Fig. 4.23.
5. Cost, Insurance and Freight: the price including the cost of the merchandise, insurance and maritime
freight as far as the destination port.
154
Table 4.8 Estimation of the cost of an LNG cycle using standard factors.

Plant (capacity Proposed cost % Cost range
5 Mt/y, 2 trains) ($M) of total cost ($M)
Site preparation 150 6 50200

Processing 250 10 100400
Liquefaction 900 34
Fractionation 50 2
Utilities 450 18
Storage 300 12
Transfer 50 2 30100
Port 100 4 20500
Wharf 200 8
Jetty 50 2 1550
Water supply 50 2
TOTAL 2 550 100
Reception Proposed cost % Cost range

terminal ($M) of total cost ($M)
Storage 300 33
Transfer 80 9 50100
Port 100 11 5350
Wharf 50 5
Jetty 30 3 1550
Vaporisation 200 22
Utilities/other 160 17
TOTAL 920 100
LNG tankers Unit costs

(capacity 135 000 m3) ($M)
150200
3.5
Cost structure for the LNG cycle ($/MBtu)
3 OPEX
0.5
2.5
LNG tanker
2 0.7
Terminal
1.5 0.5
1
Plant
0.5 1.4
Figure 4.23 Cost structure for the LNG cycle ($/MBtu feedgas excluded).
155
4.5 OPERATING COSTS

The operating costs are the total expenditures relating to the operation of a production plant.
The abbreviation Opex is used to refer to the operating expenditures, as distinct from Capex,
the capital expenditures. However, the boundary between these two categories is sometimes
somewhat grey, and depends on the organisation and the site. Some companies, for example,
prefer for legal or scal reasons to hire equipment rather than purchase it, thereby giving
rise to operating rather than capital costs.
About two-thirds of the operating costs consist of four major items, i.e. general support
provided by the operating companies (about 20% of total costs), well/surface operations
(about 15%), maintenance and logistics (each about 15%).
Personnel costs usually represent a large percentage of this total, but depend in the rst
instance, on the level of subcontracting. The balance includes contracts, purchases and
services.
The remaining one-third of expenditure comprises various items which account for
between 1.5 and 8% of the total costs and include, for example, inspection, security,
workovers and new works.
4.5.1 Classication of operating costs

The operating costs can be classied either by their nature (personnel, services, supplies) or
by their purpose (production, maintenance, security, etc.).
Where items are classied by their nature, they should generally conform to the
accounting conventions, which may have a statutory character in the particular country
concerned. They will include, in particular:
Personnel costs, accommodation, subsistence, transport;
Consumables (fuels, energy, lubricants, chemicals, ofce supplies, technical equipment
such as piping, drill strings, joints, catalysts, molecular sieves, cladding, laboratory
supplies, individual items of security equipment, spare parts, household supplies, food);
Telecommunications costs, miscellaneous hire charges, service and maintenance
contracts.
The classication by purpose allows the costs to be analysed in a manner which corre-
sponds more closely to the objectives of the operator. The following breakdown is an
example:
The direct costs comprise downhole (well services) and surface production, maintenance
of the wells and surface installations, new works (excluding Capex), inspection, logistics,
security, site management;
The transport costs are the costs related to the transmission pipelines and the terminals;
The indirect costs include technical assistance, operating company staff and head ofce staff.
These breakdowns must be made according to very precise rules so that costs can be moni-
tored throughout the life of the eld, compared between installations, and so that the costs
of planned installations can be estimated.
Conditions and circumstances can vary enormously. We can only give orders of
magnitude here: operating costs are subject to a very wide spread, ranging from $0.5 and
$6/boe (1 boe = 6.119 GJ), depending on:
156
The ease with which the gas, oil, heavy oil, etc. can be extracted;

The size of the eld;
The geographical situation (e.g. onshore or offshore);
The region (desert, jungle, the Arctic, temperate zones, etc.).
Two examples are given in Fig. 4.24 of the breakdown of operating costs by purpose, for
an offshore and an onshore eld respectively.
7
Head office support
6 Head office management
Technical support
Production line
Operating costs ($/boe)
5
Security
Logistic
4
New works
Maintenance
3 Surface production
Downhole production
2
0
Figure 4.24 Examples of breakdown of operating costs.
4.5.2 Controlling operating costs

In order to maintain tight control over operating costs, a rigorous approach must be taken,
initiated during the conceptual studies when the development architecture and operating
philosophy are chosen. This is the stage at which the overall optimisation, and in particular
the trade-off between Capex and Opex is virtually xed. Optimisation is achieved through
the engineering studies (detailed installation design, choice of equipment) and the prepara-
tions made (policies on recruitment and subcontracting, organisation of logistics).
Particular consideration needs to be given to the operating philosophy, because this has
a direct impact on personnel costs, preponderant in the eld. It is vital to optimise the work-
force when the units are being conceived. It would be illusory to think that savings can be
made through antiquated methods such as using operators for remote monitoring for example.
This would have the effect of inating the production workforce, decentralising maintenance
operations and ultimately straining budgets. A single operator costs in excess of $100 000/y,
not allowing for various extras, i.e. $1 million over 10 years, far in excess of the capital cost
needed to avoid this labour cost.
During the operating phase, the steps taken to control operating costs are as described
below:
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4.5.2.1 Control
In order to enable the operating costs to be controlled, they are broken down into categories,
sub-categories, equipment, components and items. A system must be established for
recording expenditure, often using automated procedures, for the same elements in this hier-
archical breakdown. By calculating costs at each hierarchical level, analyses and compar-
isons can be made.
4.5.2.2 Optimisation
An analysis of the expenditure, beginning with the largest items, will allow areas to be iden-
tied where economies are possible by reviewing current practices and technical specica-
tions. Examples of areas in which savings might be possible are:
Personnel costs (simplify organisation, mechanise, automate, sub-contract);
Consumption of chemical products (settings, change supplier, change process);
Use of spares (analyse parameters, carry out metallurgical analyses, change materials,
change supplier);
Storage costs (change supply and stock policy, standardisation);
Review maintenance policy.
At one site, for example, the frequency with which the 24 gas turbines present were recon-
ditioned (unit cost between $200 000 and $800 000) was challenged. By considering the
history of these machines it proved possible to increase the interval between reconditioning
from 3 to 5 years on average. This led to a reduction of 5% in the total maintenance costs
for the site.
Account must also be taken of future production dynamics such as the run-down of the
reservoir, the need for assisted recovery, the bringing into production of new reservoirs, etc.
Regard must also be had to changes which will affect the installations over time (ageing
equipment, obsolescence, extensions) and changes in the economic climate.
The scope for optimising operations may be inhibited by poor development prospects or
when there is an economic downturn, or may conversely be enhanced by organisational
changes, or a modernisation of the installations when there is a major extension to the
project, for example.
4.6 MASTERING COSTS
It can be a major challenge for the team charged with designing and implementing a project
to ensure that the installation is operational, secure, reliable and effective. Moreover if a
petroleum project is to be successful, these objectives have to be realised at the minimum
cost. In the past this consideration was paramount when the price of crude oil or gas was
low. For a number of years now, considerations of cost minimisation have become a
permanent feature for developers.
As a direct consequence, there have been signicant reductions in technical costs in
the petroleum industry over the nineties. Fig. 4.25 shows that overall the technical costs have
lost almost 50%, from $11/bbl in 1990 to $8/bbl or less in 2000. This reduction has affected
essentially exploration and operating costs.
158
20
18 Depreciation
Exploration costs
16 Operating costs
14
Dollars/barrel
12
10
0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
20
18 Depreciation
Exploration costs
16 Operating costs
14 9.1
8.1
Dollars/barrel
12
10 7.0
6.0 1.9
8 1.7
5.2
4.4 4.7 1.2
6
0.9
4 0.9
0.8 0.8 7.8
6.9
4.7 5.6
2 3.4 3.5 3.9
0
2002 2003 2004 2005 2006 2007 2008
Figure 4.25 Technical costs in upstream petroleum

industry (Source: Total).
Since 2000, this trend has changed: technical costs are rising and they have increased by
more than 100% between 2000 and 2008. The increase nds its explanation rst in the
economic cycle, with higher price of commodities like steel and other metals. Second the
high level of investment drove to strong constraint in the oil services sector. Exploration
equipments like oil rigs, technical capacities, skilled labour are in short supply.
4.6.1 Impact of technological progress

The cost decrease observed in the nineties is a tribute to the efforts made by the petroleum
industry to reduce its technical costs. A number of technological advances helped to make
this achievement possible.
159
Major strides forward have been made in geoscience as a result of the processing capa-
bilities of modern information technology. The systematic use of 3D, for example, has made
it possible to reduce the number of exploration wells needed to uncover economically viable
deposits of hydrocarbons. It has also allowed the wells to be positioned optimally, thereby
limiting the need for further delineation.
Advances in drilling have also helped to cut costs: deviated wells, horizontal and even
multiple borehole drilling, to name but a few, have increased the number of objectives
which could be reached from a single site (a platform, for example), as well as allowing
multiple pay zone access from a single well. These techniques have had a radical impact on
the productivity of wells by reducing the number required and, in consequence, signicantly
simplifying the linking infrastructure needed.
Another notable advance has been the simplication in gathering systems made possible
not only by reductions in the numbers of wells, but also to a great extent by advances in
multiphase transport. Because the liquid and gas phases no longer have to be separated, it
has been possible in some cases to halve the number of pipelines. In addition, separation units
have been considerably simplied or even eliminated altogether, particularly in places where
these are undesirable, such as in the vicinity of the wellhead. Of course some of these
effects are offset by developments at the reception facilities, which have necessarily become
more complex. But the overall net effect is substantially positive, a saving of the order of
1015% of the total cost of a project.
Technological advances have also led to remarkable improvements in production
equipment (power generation, instrumentation, piping, rotary drives, etc.), in terms of reli-
ability, availability, and ease-of-use. Other examples include the development and wide-
spread use of digital process control systems, the advent of high-performance private
telecommunications networks, the emergence at last of really reliable, powerful, light gas
turbines, a spin-off from ongoing progress in the aero industry. Other important develop-
ments include the advent of the variable-speed electric drive, the contribution made by
powerful electronics and technological advances in rail transport.
It is difcult to quantify the effect on costs of all these improvements, but it is certainly
considerable.
We have got to the point where diminishing returns are beginning to set in. But further
progress is always possible, and there are still many opportunities for making savings in all
areas. Some of these opportunities are described below.
4.6.1.1 Mastering drilling costs

In deep offshore work, a mastery of drilling techniques is absolutely essential. There are three
main difculties: the delicate matter of adjusting the weight of the mud, the low tempera-
tures which create problems related to the rheology of the mud, and nally the presence of
a rigid drilling riser, heavy, cumbersome and fragile. We now have a good understanding
of these problems and are reasonably able to deal with them during exploration drilling. They
now need to become routine, so that the costs of development drilling can be brought back
to an acceptable level, particularly in deep water (in excess of 1 500 m). This process is
already taking place, and there is no doubt that the petroleum industry will soon devise tech-
nically satisfactory and affordable solutions. But drilling costs are bound to remain high
(between $8 and $25 million per well, depending on water depth and drilling distance) unless
certain technological breakthroughs are made, such as drilling without a riser and drilling
with casing.
160
4.6.1.2 Mastering the costs of surface installations

It is impossible to over-emphasise the fact that 90% of the costs are determined in the de-
nition of the object to be built. This underscores the enormous importance of the conceptual
studies and the preliminary design, during which potential areas in which the costs can be
reduced should be identied (Fig. 4.26). Sufcient time and resources and the best possible
skills therefore need to be devoted to these studies to ensure an optimum project denition.
Traditional methods need to be constantly questioned and new ideas systematically
considered.
A second way of reducing capital costs is to seek to simplify and standardise the
equipment. This is not often possible because projects are usually different from one another.
But duplication pure and simple can sometimes achieve savings of the order of 40% for
structures and 25% for construction and supervision not counting savings in time, which
may be as much as 35 months. Even if two installations are not completely identical, it is
worth checking whether some of the units in the rst installation cannot also be used without
modication in the second.
A third way adopted by some companies is to put the contractual arrangements with
subcontractors on a different footing. The objective is to harness the skills of both
management and workforce as a whole towards common objectives in terms of costs, dead-
lines and even production. This approach has spawned alliances, the concept of the target
price, ventures involving prot-sharing. There is no doubt that service providers have taken
on a broader role, becoming in the process more partners than subcontractors. Many have
restructured, growing in the process, and with their technical competence considerably rein-
forced. The oil companies have relinquished entire areas which were hitherto very much their
preserve. This new modus operandi is undoubtedly acting as a mechanism for the dissemi-
nation, spread and acceleration of technological progress, and has led to a division of work
propitious to these advances, the service providers building expertise in new areas, and the
oil companies taking on the coordinating role in relation to the complex set of tasks requiring
inputs from a range of different specialities.
Cost reduction potential
Screening
studies
Conceptual
studies
Preliminary
design Basic Detailed engineering
engineering
Time
Figure 4.26 Cost reduction potential during the various study phases.
161
Quite separate from this antithesis between service providers and oil companies, it is clear
that the growing complexity of projects, together with the shortening of the development
cycle in the face of economic pressures means that there is an increasing interdependence
between the disciplines involved at an increasingly early stage. In other words, the need for
a cross-disciplinary approach is making itself keenly felt; this is certainly the case in the eld
of R&D, where efforts are being directed towards technological innovation which can be
used commercially, with attractive economics.
4.6.1.3 Mastering operating costs

Opportunities to reduce the operating costs present themselves in both the design and oper-
ating phases.
Design phase
Make use of modern techniques of installation management;
Simplify the control systems, concentrate on the instrumentation which is really necessary;
Allow rapid and easy access to machinery and equipment;
Minimise the number of machines or equipment installed (number of backup machines
corresponding to availability requirements and acceptable risk level, need for multiple
bypasses, etc.);
Select equipment based on criteria of maintainability, reliability, ease of diagnosis, and
quality.
Operating phase
Outsource all or some operating and management functions;
Increase versatility of some workers;
Optimise maintenance, plan major maintenance as a function of remaining life of project;
Limit measures on reservoir to those which are really justied;
Renegotiate contracts.
It should be said that, in the study phase, operating costs may appear to have little impact
on project economics because of the effects of tax and the effect of discounting future cash
ows. In the operating phase, however, cost reduction has a permanent effect, and becomes
increasingly necessary as declining production results in a rapid increase in the costs per
barrel. This trend can make the venture uneconomic, even while there are still substantial
reserves remaining. It is therefore important to keep operating costs under close review
throughout the life of the project right from its conception.
4.6.1.4 Mastering costs by risk-taking

Companies seek to achieve two objectives simultaneously: to increase production and cut
costs. They use all the means at their disposal, although some are bolder than others in this
regard. The petroleum industry long had a reputation for conservatism in its technical
choices, preferring methods which were tried and tested. Broadly this continues to be the
case. However some companies are increasingly demonstrating their capacity to innovate,
162
particularly where this leads to signicant rewards or where the technical parameters are such

that innovation is needed to reach new reserves. Innovation obviously involves risk of
greater or lesser magnitude, both nancial and in terms of image.
The wide use of multiphase pumps in place of the much heavier and more costly tradi-
tional system of compression pumping is an example of the industrial application of an inno-
vation resulting from prolonged R&D.
Risk used to be essentially of a geoscientic or geopolitical nature, and if considerable
technical risks were sometimes taken, for example in the North Sea in the 1970s, these were
not seeking to establish or strengthen the position or competitiveness of a particular company
in a given context.
Times have greatly changed in this regard. The oil companies differentiate themselves and
promote themselves to the competent authorities in host countries in terms of their capacity
to take technological risks and to bear the nancial consequences which ensue. There are
many reasons for this. For example there is no doubt that the technological levelling
upwards requires the ability not only to realise an activity at a particular point in time but
also to be able to bet on future performance in the short or medium term so as to retain
competitiveness. Specically the willingness is required to take risks at the moment when
agreements or contracts are signed, i.e. well before the realisation stage, and to manage these
risks subsequently.
In other words, in the past when development opportunities were technology-limited, risk-
taking remained fairly low. At present the reverse applies, and technological risk-taking has
become a consequence of commercial decisions taken on the basis of considerations of a
different nature. The perils are increased further still by the sheer physical size and therefore
nancial implications of the stakes involved.
4.6.2 Impact of the economic cycle and the contractual strategy

on project costs
4.6.2.1 The economic cycle
Although economic conditions are outside the control of the operator, an evaluation of the
level of economic activity at the moment when the main contracts are awarded can provide
useful guidance on the mean price levels likely to apply.
Since the lead times involved in decision-making and the realisation of petroleum projects
are long (3 to 5 years) investment decisions are taken on the basis of long-term economic
calculations, and there is no direct correlation between the costs of platforms under
construction and the price of crude. The costs of platforms are more sensitive to the costs
of raw materials (particularly steel), the order books of the companies concerned and the
availability of large construction yards.
Since 2003, the petroleum services sector has entered the high phase of an economic cycle
with very strong demand and insufcient capacities to answer to this demand.
Prices quoted for a given contract will vary by 2030% but can go over 100%, depending
on the state of the market. The rm awarded the contract may just be seeking to cover its
operating costs to avoid closure. Or alternatively in overheated economic conditions the rm
may have won the contract without any real competition, since the order books of its
competitors were full. This is illustrated by the example of Korea, which dropped its
163
construction prices by 3540% in 1998/1999 in order to maintain an acceptable level of

activity, whatever the cost, during the Asian crisis which began in 1997.
It should be noted that at times in the economic cycle when prices are high, labour also
tends to be in short supply, there are delays in obtaining supplies and in construction work;
these factors tend to further increase project costs.
Since 2004, the increase in costs has been very high. As we have shown in Figure 4.25,
the technical costs have reached in 2008 a level of $18 per barrel. A limited decrease has
been observed in 2009 and 2010.
Once the project has been dened, the nal capital cost can still be affected by various
factors and circumstances, in particular the contractual strategy adopted when the main
contracts are awarded, the organisation of the teams and project control.
4.6.2.2 Contractual strategy

The expertise and experience of the prime contractor will help him to develop a contractual
strategy appropriate to the nature of the project.
A petroleum development involves the award of large contracts for a variety of works
(studies, supplies, construction, civil or offshore engineering, etc.). The overall strategy for
distributing these various activities between different contractors should be the subject of a
general study by the company managing the project, so that the overall project costs and
timetable can be optimised. It should be noted that this process induces a delay between
services price rises and impacts in the cost of oil companies. This contractual arrangement
has limited the increase in the technical costs: projects decided in the last 5 years have still
an effect on these costs due to the long development phase. This strategic study, carried out
at the start of the project, is usually referred to as the Project Execution Plan (PEP). The nal
cost of the project will depend to a great extent on the choices made at this stage.
This point is illustrated by showing how two of the traditionally important parameters of
the PEP can affect the ultimate capital costs. The rst of these parameters is the method by
which the various contracts are remunerated. The second is the maintenance of competition
between contractors in all the project stages.
A. Different methods of contractual remuneration

The various contracts will be awarded within a framework which includes remuneration
terms appropriate to the circumstances.
There are traditionally three bases of remuneration, as follows:
A time and materials basis, under which the contractor is remunerated based on time
spent (day-rate contract);
A foot-rate contract, where remuneration is based on measurable outputs;
A xed price for the entire work, including the contractors prot (turnkey contract).
Each of these forms of remuneration has its particular advantages and disadvantages.
A day-rate contract gives management great exibility in the way the work is organised:
the project manager is free at all times to re-orient the work of the contractor as he sees t.
However the latter has no particular incentive to complete the work quickly and at minimum
cost because this is of no advantage to him. There is therefore a tendency for costs to mount
and timings to slip relative to the initial estimates.
164
This contractual basis is appropriate to phases of the study in which the basis of the

project, and therefore the work required of the contractor (at this stage, consulting engineers),
is still subject to great variation. These phases are not the most costly part of the overall
project, and it is vital that the necessary resources are made available and that the work does
not suffer as a result of relentless cost-cutting. This is the time when the installations to be
constructed are being dened technically, and the quality of this work provides the best guar-
antee that the project will be completed within budget and on time. For large construction
projects, on the other hand, day-rate contracts should be avoided, as overruns on multi-
million dollar projects can be extremely costly.
In a foot-rate contract the contractor is remunerated according to measurable quantities
of work carried out (volumes of earthworks, tons of piping installed, etc.) based on a unit
price schedule appended to the contract. This form of remuneration may be appropriate in
the initial phases of construction when the works have still not been fully dened and a xed
price cannot yet be set.
This form of contract only passes part of the nancial risk to the contractor. It also
presents similar risk of overruns to the day-rate contracts.
Unlike a day-rate contract, a turnkey contract remunerates the contractor for the supply
of a complete installation (where appropriate with performance guarantees) without reference
to the time spent and materials used. Only the result counts. The contractor has to estimate
the cost of the proposed works on the basis of a call for tenders prepared by the petroleum
company, and prepare a xed-price bid for carrying out all the work, including an element
which compensates him for his risk, and his prot.
For the oil company, this formula has the merit of constituting a formal commitment on
the part of the contractor to complete the work on time and at minimum cost. The fact that
the contractor has to bear the cost of an overrun gives him every incentive to keep to the
initial estimates.
The oil company needs to be aware of the fact that if a turnkey contract is to be effective
the work to be carried out must be dened in a precise, complete and denitive manner. Any
work not covered by the contract is likely to be billed at a rate which reects the fact the
contractor will be the only one able to carry out the work required.
Turnkey contracts are therefore suitable during the construction phase when the design
and technical studies have been completed and the project denition has been frozen. In
practice it is often necessary, in order to stick to the timetable, to award contracts before the
denitional studies have been fully completed. In such cases it is up to the oil company
managing the project to ensure that the timing is such as to ensure an optimum trade-off
between cost and time.
In the foregoing we have presented a simplied picture of the various contractual options
open to oil companies in implementing development projects. In reality it is up to them to
adapt, mix and coordinate these various possibilities depending on the realities of the situ-
ation, so as to optimise the overall economics. Particular attention is needed to ensuring that
the various contractual interfaces between the petroleum company managing the project and
its main subcontractors are clear and well coordinated. Special care needs to be taken that
responsibilities are well delineated, and that there are no overlaps or gaps.
B. Maintaining competition between contractors

The other vital measure in reducing the nal cost of a project is to maintain competition
between contractors when contracts are awarded.
165
The price of executing a project can vary signicantly (i.e. by 2030%) depending on
whether or not there is genuine competition between contractors or the price was imposed
by a contractor acting monopolistically. If it is not careful, such a situation may be of the
oil companys own making, as illustrated in the following examples.
a. Design of the modules of an offshore platform
The trend within the oil industry to design ever larger and heavier modules in order to
minimise the need to link up separate modules was in itself a good idea. However this idea
was taken to extreme lengths, so that modules became so large that there remained only one
contractor with the necessary equipment or a lifting barge of sufcient capacity, with the
result that prices became prohibitive.
b. LNG plants
Over the years petroleum companies have got into the habit, for reasons of technical
conformity, of using the same proprietary liquefaction process and the same contractors for
the construction of LNG plants. A quasi-monopoly has therefore arisen between a few
contractors, and this has pushed prices articially high. This situation has in turn tended to
reduce the number of new LNG projects which are economically viable. The entry of new,
or the return of existing, contractors into the market and the emergence of new proprietary
processes should lead to appreciable cost savings.
4.6.2.3 Organisation of the project team

A project is usually put in charge of a project manager whose objective it will be to erect
high-quality installations quickly (to an agreed timetable), within (if possible below!) budget,
which meet the initial specications.
Alongside this basic objective the project manager must also ensure that a number of other
ongoing requirements are met, such as workplace safety, environmental protection, plant
security, quality and reliability.
The project organisation must have regard to these different constraints, but will be
heavily inuenced by the contractual strategy adopted. The project manager will in any case
monitor the critical activities directly, as far as management is concerned, by keeping tabs
on the costs and planning, and in the key technical areas, which are often metallurgy, instru-
mentation and power.
Costs will be controlled particularly tightly. This will be achieved by using specialist
software which allows rigorous budgetary monitoring and an ongoing exchange of data with
the different groups involved with the project, whether from the client organisation or the
nancial department of the company.
The measures to control project costs will be accompanied by a series of reviews or
internal or external audits aimed at optimising the safety and the quality of the installations
under construction. Given the magnitude of the investments involved in petroleum devel-
opments, all oil companies have developed strict and planned control procedures in these
areas.
In some countries, local content policy means that much of the investment is made in the
local market. In that case, international service companies need to establish a permanent local
presence to get fully involved. However, questions exist around the ability of the supply
sector to meet demand in term of local equipment and local human resources with the
adequate skill sets.
166
4.7 THE PETROLEUM SERVICES SECTOR

The petroleum services sector, or more fully the upstream oil and gas supply and service
industry, is not easy to dene as it embraces activities of a very heterogeneous nature. It
includes geophysical activities (the acquisition, processing and interpretation of seismic
data), drilling and associated services, engineering and design, subsea engineering (pipeline
laying) and the construction of platforms (shipyards). In addition there are hosts of manu-
facturers of tools (for geophysics and drilling), metal construction and mechanical engi-
neering rms. What all these companies, whether large, medium-sized or small, have in
common is that they provide a service or services to the petroleum industry.
4.7.1 Historical background

The four major international poles of the petroleum services industry are the U.S., the UK,
Norway and France. These national industries developed alongside the efforts in each country
to develop national hydrocarbon resources. The U.S. has long set the pace for the petroleum
industry worldwide; it has developed a powerful petroleum services industry which includes
many companies which are global players.
In the United Kingdom, although drilling began in the 1960s, it was the rst oil shock in
1973 which really rendered exploration and production projects protable and permitted the
emergence of a national petroleum services industry which, on the back of its success in the
domestic market, rapidly took on an international dimension.
In Norway the rst seismic proles date back to the 1963. At that time the Norwegian
government decided it would control exploration and production on its continental shelf. The
petroleum services industry has developed in three stages: in the 1970s service companies
cooperated with other countries with petroleum experience. In the early 1980s, nurtured by
heavy protectionism and the publicly owned national oil companies (Norsk Hydro and
Statoil) the large petroleum industry players emerged. Since the late 1980s these companies
have been established themselves on the international market.
In France the state played a role in helping the home-grown petroleum services industry
to develop, despite the lack of a domestic market for these activities. But the French
companies, which cover almost the entire spectrum of activities in this sector, have become
major players in markets such as the North Sea and the Gulf of Guinea, and have thereby
succeeded in gaining access to the international market.
Apart from these main actors, China and South Korea, have signicant petroleum services
industries.
4.7.2 Investment in exploration and production:

the market for petroleum services
The market for equipment and services in the upstream petroleum industry is made up of
three components, as follows:
The rst and largest category comprises investment by the oil and gas companies in explo-
ration-production. This accounts for three-quarters of the petroleum services market.
The second category (approximately 20%) comprises the operation and maintenance of
existing installations, only part of which benets the petroleum services industry. This
market is worth roughly $50 billion/y.
167
The balance comprises the sums invested by the petroleum services companies themselves
in new equipment (construction or renovation of drilling rigs, seismic, pipe-laying or
support vessels) and data acquisition systems (seismic, logging while drilling, etc.). These
expenditures are difcult to evaluate, but vary between $10 and 15 billion/y.
500
450
400
350
300
G US$
250
200
150
100
50
0
2007 2008 2009
North America CIS
South America Africa
Europe Middle East
Rest of World Asia
Figure 4.27 Total investment in exploration and production in different

areas (Source: IFP Energies nouvelles).
400
Onshore rest of World
350 Offshore non US
Onshore North America
300 Offshore North America
Number of teams
250
200
150
100
50
0
2004 2005 2006 2007 2008 2009
Figure 4.28 Number of active seismic teams, onshore and offshore
(Source: IFP Energies nouvelles).
168
Over the last two decades the petroleum industry has undergone a transformation as a

result of factors which affect the level of investment in the upstream industry: oil shocks and
counter-shocks, major technological advances, large gains in productivity and radical restruc-
turing.
In the rst half of the 1980s upstream investments by oil and gas companies were rela-
tively high varying between $80 and $90 billion/y because of the high price of crude.
After the counter-shock of 1985/86, investment fell back sharply, settling into the range of
$45 to $52 billion/y. In the early 1990s the Gulf crisis produced a brief rebound in
investment, to $79 billion, followed by three years of retrenchment, down to a level of
$71 billion in 1994.
Between 1995 and 1998 this trend reversed and there was a sharp increase in the capital
ows in the upstream sector. In 1997 investments broke through the $100 billion barrier, an
all-time high in current dollars. During the period 19941997 there was therefore strong
growth in the upstream petroleum sector, which grew at an annual rate of 12%. In 1999,
however there was an overall fall in investment, due to weak crude prices.
From 2000, and up to 2008, the level of investment grew steadily, driven by rising oil
prices, but also, and especially, by increasing costs.
In 2009 the trend was reversed, with investments falling by an average of 16% (dropping
37% in North America but only 8% elsewhere in the world). The total of G$406 was G$80
less than in 2008, due to an economic environment that hardly encouraged companies to
invest in developing new production capacity.
This decline directly affected companies in the oil and gas supply and service sector,
which is directly dependent on oil company investment. Small companies were hit first, but
even the biggest failed to emerge unscathed. Early in 2009 for example, Schlumberger and
Baker Hughes were obliged to implement extensive redundancy plans.
Depending on the sector concerned, this fall made itself felt in different ways.
120 000
World
100 000
80 000
60 000
North America
40 000
20 000
China
0
2004 2005 2006 2007 2008 2009
Figure 4.29 Number of drilled wells (Source: IFP Energies nouvelles).
169
4 000
3 500
3 000
World
2 500
2 000
Asia excluding China
1 500
1 000
North America
500
0
2004 2005 2006 2007 2008 2009
Figure 4.30 Number of offshore wells (Source: IFP Energies nouvelles).
In the geophysical market, seismic business continued to expand, increasing by 8% over

the first nine months of 2009 but evidencing significant differences from region to region:
major decreases in North America but 16% expansion elsewhere due essentially to offshore
activity. Nevertheless, geophysics firms saw falls in their sales and profits figures due to rene-
gotiation of contracts for lower prices.
The leader in this sector continues to be CGG-Veritas (CGGV), followed by two other
sector majors, PGS and WesternGeco.
During 2009, drilling activity shrank by 32%, with 74,000 wells drilled of which 96%
were on land. This was the segment that was hardest hit with a regression of 33% in its
market. Nabors, Helmerich & Payne and Ensign, sector leaders, registered substantial reduc-
tions in their annual sales.
Conversely, rigs at sea withstood the trend well, increasing slightly by 2.5%. Transocean
remained the leader with 25% market share, ahead of Diamond Offshore and Noble Drilling.
Offshore construction has continued to progress, expanding by 7%. The projects break
down into 59% fixed platforms, 12% floating and 29% subsea. The three key actors, Saipem,
Technip and Aker Kvaener, have continued to register growth in their annual sales.
170
5 Legal, scal and contractual
framework
5.1 THE KEY ISSUES

5.1.1 Ownership of hydrocarbons and the sovereignty
of the State over natural resources
Two questions arise regarding the ownership of hydrocarbons. Firstly, who owns these
resources while they are in the ground, either before or after their discovery, but before their
extraction? And secondly, who owns them after their extraction from the subsoil, and at what
point in time and space is ownership transferred if these two are not the same.
As a general rule (except in the U.S. onshore), subsoil natural resources (and this includes
hydrocarbons) are the property of the State. The State monitors petroleum activities and inter-
venes as custodian of the public interest, in particular when it licences individuals or orga-
nisations to explore for and produce hydrocarbons.
5.1.1.1 Hydrocarbon ownership regimes,

origin of the States rights and powers
Four main ownership regimes can be distinguished. In each case the State exercises consid-
erable powers in its role as public authority.
A. Ownership by accession
Under this regime, land ownership extends both to the surface and to the subsurface, and
hydrocarbons belong to the owner of the land by accession. This is the system applying in
the United States on private land, i.e. excluding federal or state-owned lands. The owner can
grant leases to any person he chooses, and in return receives a royalty. But even under this
regime the right of ownership is limited by the powers exercised by the State in the general
interest to guarantee security and the preservation of these resources.
In all other countries, on the other hand, landowners have no rights or claims on the
subsoil resources, these being the property of the State.
171
Chapter 5 Legal, scal and contractual framework
B. Ownership by occupation
Under this regime, the mineral rights belong to the rst occupant of the land or to the
person rst applying for the right to occupy the land. This system was in force in some new
countries, but is no longer applied for hydrocarbons.
C. State discretion
In this system hydrocarbons are not owned until they are discovered. At this time the State
determines, by virtue of its power of patronage, the conditions under which the exploration
for and production of hydrocarbons, which constitute part of the national wealth, will take
place. The State grants mineral rights (leases or concessions) to the companies it chooses at
its discretion, a process which may involve competitive bidding. The companies chosen are
required to observe the conditions laid down by law, equal for all, without discrimination.
The ownership of the hydrocarbons and the rules governing the transfer of this ownership
are also laid down by the State. This is the system which applies in most industrialised coun-
tries.
D. State ownership
In this approach, which has its roots in the feudal system, hydrocarbon resources are owned
by the State (the sovereign) and form part of its estate. Hydrocarbon exploration and
production are governed by agreements or contracts made between the State and the company
it chooses. This was the system which applied in the Middle East and Latin America, and
involved applying application of the rule of the inalienable and imprescriptible property of
the State.
The principle of State ownership results in a State monopoly, companies acting as mere
contractors with the task of developing the assets of the State. This is exemplied by the
system of service contracts used in Latin America, Mexico, Brazil and Argentina until 1989.
E. Hybrid regime
In most countries today, the petroleum legislation lays down a regime which embodies the
principles of State discretion or State ownership, the State exercising its sovereign rights over
the natural resources.
5.1.1.2 Ownership of the subsoil and State sovereignty

A. State property and mineral deposits
National legislation, and occasionally the constitution, often contain explicit statements of
ownership; hydrocarbons are the property of the State, Crown property, State assets,
or belong to the State. These terms are sometimes difcult to interpret precisely. It is
tempting to assume that State ownership is analogous to the relationship between an indi-
vidual and his private property, including all the prerogatives which this confers on an
owner over his assets.
English-speaking countries use an expression difcult to render in other languages vested
in the Crown/State. This expression seems to convey a concept of management rather than
the complexity of ownership.
Other national legislations classify mines, including hydrocarbon deposits, as belonging
to the State without being too specic about it. However mineral resources do not fall easily
172
either into the States public domain (inalienable and imprescriptible) or its private domain.

Although there are issues of the common good involved, mines are not an asset held for the
benet of all citizens, but nor are mines subject to the rules of private property. Some
authors consider that mineral resources constitute a category sui generis of State assets,
referring to them as national property, intermediate between the two traditional forms of
State patrimony, or even, in the view of some South American jurists, as an eminent
domain or special domain of the State.
B. State sovereignty
Developments in the way the international community interprets the concept of the sover-
eignty of the State are particularly important in practice. Since 1952 the United Nations
General Assembly (Resolution 626) and then the United Nations Conference for Trade and
Development (UNCTAD) have repeatedly reafrmed the inalienable right of all States to
dispose of their wealth and natural resources in accordance with their national interests and
based on respect for their economic independence (1960). Resolution 1803 of 1962, restated
in the third general principle adopted by UNCTAD at its rst session in 1964, calls on States
to exercise this sovereignty in the interests of national development and the well-being of
their peoples.
Subsequent declarations have been more radical, and the Resolutions adopted on 1 May
1974 by an extraordinary session of the UN General Assembly on raw materials introduced
the notion of permanent integral sovereignty under the New International Economic Order.
The principle was restated in the Charter of Economic Rights and Obligations of States,
adopted by the General Assembly in 1974: the declaration of permanent integral sovereignty
gives states the right to safeguard their mineral resources by exercising effective control over
them.
This principle was not to apply to mineral resources in the high seas. The United Nations
designated (Resolution 2749-XXV of 1970) these as a common patrimony of man under
the stewardship of sovereign states.
The State exercises sovereignty over its national territory, the continental shelf and the 200
mile exclusive economic zone in the case of coastal nations. The UN Convention on the Law
of the Sea (UNCLOS) of 1982, signed by 135 countries, sets forth the relevant principles in
this regard. The interpretation of these principles can sometimes pose severe difculties, as
in the case of the Caspian Sea, where the determination of sovereignty has been a matter of
dispute since the creation on its shores of new states formerly part of the Soviet Union.
C. Nationalisation
The right of states to nationalise companies or requisition them in the national interest is
acknowledged in UN resolutions as a corollary of their sovereignty over their natural resources.
Certain industrialised countries once resorted to this practice. But these resolutions also require
that a public interest is demonstrated and that fair and prior compensation is paid. Nationali-
sation without or with inadequate compensation discourages new petroleum exploration.
The basis on which compensation is determined remains a moot point. In equity it could
be argued that the compensation should be based on the market value of the company, i.e.
either the estimated or accounting value of the hydrocarbon resources and the installations
or the present value of future prots derived from producing the known reserves. Such a basis
is contested, however, because the reserves are the property of the State. The most common
criterion adopted is that of the accounting value of the installations, as determined by an
173
expert, with the possibility of resorting to international arbitration, although the latter is not
accepted by all countries.
It should be noted that problems of a similar order occur where the State, while stopping
short of full-blown nationalisation, takes a share, as a partner alongside the other investors,
in the lease or contract where this was not originally provided for, even though this is of
course more acceptable to the investors than nationalisation.
In contrast, the 1990s have seen a growing tendency in many countries towards the total
or partial privatisation of certain assets and certain activities of the State or State enterprises.
These transactions are usually effected by means of a call for tenders so that a purchaser can
be selected and a value can be put on the transaction.
Facing the new context of sustained high level of oil price since the early 2000s, some
countries have decided a partial re-nationalisation (Russia, Bolivia, Venezuela).
5.1.2 Forms in which exploration and

production can be undertaken
There are two options available to the owner of underground mineral resources: direct action
or indirect action.
5.1.2.1 Direct action by the owner

The owner of the mineral rights can carry out exploration and production activities for
hydrocarbons himself/itself:
As the owner of the land (U.S.), whether a private individual, a state or the federal
government;
In its capacity as the State, through the intermediary of public bodies (former USSR
and Eastern European countries until 1990), or through national companies holding a
full or partial monopoly (Latin America, Middle East) and where necessary calling on
the assistance of service companies through technical assistance contracts.
5.1.2.2 Indirect action

The State, as owner of the mineral rights and by virtue of its discretionary powers or propri-
etary status, can decide who will conduct exploration and exploit the hydrocarbon resources,
subject to the relevant national legislation and contractual regime applying.
The two main regimes for indirect State action are commonly referred to as concession
(or licensing) and production sharing.
Under a concession regime the contract holder is granted a mining title by the State: rst
an exploration license and, in the event of the discovery of commercial hydrocarbon
resources, an exploitation license usually called concession. The license holder has the sole
exploration and production rights for a certain area and for a certain period. Furthermore he
has the benecial use of the products extracted subject to fullling certain obligations
towards the licensing authority. The State receives an income in the form of taxes.
Under a production sharing regime the contractor does not hold a licence imparting
mineral rights because the contract concluded with the State does not provide for such a title.
The rights are often vested in a national oil company, and the contract is made with this
company as representative of the State. The contractor is simply the exclusive provider of
services to the State, and bears the technical and nancial risks of exploration. In the event
174
of a discovery he has the exclusive right to develop and exploit the resources, and will receive

a remuneration equal to a proportion of the production (whence the name). The State receives
the remaining proportion of the production.
In either case, certain countries stipulate that, in addition, the State may participate
directly in the operations as a partner of the license holder or contractor, taking on the same
rights and obligations in proportion to its level of participation. Under such an arrangement,
the State is usually represented by the national oil company, and the arrangement can offer
the State a number of advantages. Until the late 1980s such arrangements were to be found
in many countries, the participation rate reaching 50% or more, but they are tending to be
reduced or even disappear completely. However since 2005, some producing countries have
re-introduced participation rates higher than 50% (Algeria, Venezuela).
5.1.3 Regulatory options

The foregoing shows that there are two opposite approaches to establishing a legal framework
for exploration and production activities, i.e. the legislative and the contractual approaches.
In the legislative approach, which is that adopted in Europe, the U.S., Canada, Australia
and Latin America, the legal framework is dened in detail and in a non-discriminatory
manner by legislation and regulations;
In the contractual approach the relations between the State and the companies are essen-
tially dened contractually, and are often discretionary. This is the system applying in
many developing countries.
In practice there are variants which involve a combination of these two approaches,
particularly licence-based systems in which a detailed contract is made.
5.1.4 The content of petroleum legislation

5.1.4.1 Purpose
The purpose of a law on petroleum exploration and production is mainly to dene:
The legal regime applying to exploration for, and the production and transport of
hydrocarbons (petroleum, natural gas and associated products), but excluding rening
and distribution, which are industrial activities of a different nature;
The objectives of petroleum policy;
The modalities of State intervention, the competent administrative authorities charged
with petroleum matters and, where applicable, the role of the national oil company;
The conditions under which petroleum contracts are approved and signed and licences
are granted;
The way in which activities are conducted and monitored;
The tax, customs and exchange regimes.
A petroleum law must be capable of continuing to apply for decades without major
amendment, although amendments may be needed in response to particular circumstances.
In a non-producing country, for example, the law needs to encourage exploration in the short
term and, in the medium term, protect the State if major discoveries are made. Modern legis-
lation provides a exible framework, conning itself to laying down the principles, leaving
the details, modalities and economic parameters to be dealt with in implementing regulations
and contracts. The delicate balance which needs to be achieved is often the subject of major
discussions between the legislature and the executive.
175
However legislation can be more or less exible, depending on the constitution of the
country concerned, particularly in relation to taxes and to contracts. In some countries,
particularly developed countries such as the United Kingdom, Norway and France, tax is a
matter for the legislature, which means that taxes are set in the law without leaving any
margin for negotiation. Under this regime, petroleum taxes can be amended periodically by
nance acts, and apply equally to all operators.
Other countries adopt a more exible approach, and make use of contracts which leave
a considerable margin for negotiation.
5.1.4.2 Relationship with the rest of the legal system

The legislation of general application in the country concerned also applies to petroleum oper-
ations unless the petroleum law provides otherwise in order to allow for particular aspects.
Some countries have a mining law and an investment law. Because of the specic nature
of this legislation, petroleum operations should be governed by specic petroleum legislation.
The mining law sometimes extends to cover petroleum operations, but this is not the most
appropriate approach. Over the last 30 years many countries have adopted a petroleum
legislation which takes the place of the mining legislation in relation to petroleum matters.
5.1.4.3 Tax regime for petroleum

Various options can be envisaged:
The petroleum law deals with the taxation of petroleum and, if appropriate, introduces a
specic regime for the taxation of the prots from petroleum exploration and production
activities.
The petroleum law only deals with certain tax matters (royalties, taxation of prots,
special petroleum tax), other taxes falling under general taxation law.
The petroleum sector is dealt with by a special chapter of the general tax law.
5.1.4.4 Competent authority charged with petroleum matters

The law must specify the competent government body charged with petroleum matters, and
particularly with negotiating and signing petroleum contracts. This body will also, either
directly or by delegation, supervise petroleum operations and monitor compliance with the
applicable legislation.
Some or all of these powers may be delegated to a national oil company. This can lead
to conicts of interest because the latter then has two theoretically separate roles: the repre-
sentative of the State in its capacity as regulator but also a partner associated with other
companies in joint petroleum ventures.
In order to avoid this kind of conicts, several countries have established separate bodies
to act as independent regulators (Brazil in 1997, Indonesia in 2002, Colombia in 2003,
Algeria in 2005).
5.1.4.5 Determining the rights and obligations of contractors

and licensees
Two approaches are possible. The rst is to dene these matters in great detail in the law
and implementing regulations. This fairly inexible approach is what happens in the indus-
176
trialised countries and older legislation inspired by the French model in Africa. An alternative

approach is to dene the broad principles, particularly in relation to taxation, by reference
to a model contract prepared by the competent authority. This is a more exible solution
which allows the regime to be established in the contract. This model contract, which does
not form part of the law, can be adapted to allow for the nature of the potential discoveries
of hydrocarbons and the petroleum context.
5.1.4.6 Implementing regulations

The petroleum law establishes the legal framework. The regulatory detail is spelt out in
implementing regulations enacted in the form of decrees and regulations. These deal with
administrative procedures, the technical aspects of operations, the environment, workplace
health and safety as well as abandonment procedures when production comes to an end. They
can be very detailed in countries such as the U.S., Canada, the United Kingdom and Norway
in order to address the specic nature of offshore operations.
5.1.5 The objectives of the parties involved

The main objectives of the State and of the oil companies can be summarised as follows:
The State
To promote petroleum-related activities at all levels:
to explore the countrys petroleum basins,
to develop and exploit the resources discovered,
to rehabilitate old elds or put into production discoveries as yet undeveloped for tech-
nical or economic reasons;
To maximise the revenues of the State while securing, if possible, returns to investors
commensurate with the risks run during exploration;
To establish an attractive, fair and stable scal and contractual regime, capable of adapting
to conditions as they evolve over the long term, thereby maintaining a satisfactory activity
level;
To supervise and monitor operations in consultation with the companies, while ensuring
that activities are not hampered by red tape;
To acquire expertise through the transfer of technology and skills.
Petroleum companies:
To obtain a return consistent with the companys objectives;
To recover the investment costs as rapidly as possible;
To gain access to oil and gas reserves;
To ensure that reserves are replaced;
To limit risk by diversifying their portfolio of exploration and production acreage.
The criteria adopted and the priorities set between these various objectives depend on
many factors, both for the State and for oil companies, and can also change over time in
response to circumstances, e.g. developments in international hydrocarbons markets, the
potential and position of the country (producer or not, exporter or not, etc.), the importance
of oil in the national economy and the companys own particular strategy.
177
5.1.6 Reconciling objectives and sharing the economic rent

Clearly the objectives of the two parties are not always totally consistent. The legal, scal and
contractual framework should be designed to create a win-win situation for the two parties.
The core issue between States and oil companies is the way the economic rent is shared (this
notion has already been considered in Chapter 4). Depending on the parameters mentioned
above, this sharing may be more or less favourable for the State or for the companies,
depending on the parameters mentioned earlier. We shall consider below the mechanisms by
which this sharing is implemented and simple instruments by which it can be assessed.
5.1.7 Types of contract

It is important to be clear about the different types of contract used in the upstream oil
industry.
A contract for petroleum exploration or production deals with the relationship between
the State (or the national oil company representing the State) and the license holder or
contractor (which may comprise a consortium of companies formed exclusively for this
purpose). This is the type of contract considered further here.
When the license holder or contractor comprises a number of partners, the association
between these partners is formalised by means of a Joint Operating Agreement (JOA) which
spells out their relationship in regard to decisions and the conduct of operations, based on
their stake in the partnership, under the responsibility of an operator chosen from amongst
the partners.
5.1.8 Breakdown of petroleum contracts by type

Tables 5.1 and 5.2 show the incidence and breakdown of petroleum exploration and
production contracts according to:
The different countries;
Geographical region.
It should be noted that several regimes may coexist in the same country. An estimate
shows that most of the volume of hydrocarbon production is still governed by concession
regimes. This is due to the fact that this type of contract predated the production-sharing
arrangements introduced more recently, in the late 1960s.
5.2 MAIN PROVISIONS OF A PETROLEUM EXPLORATION

AND PRODUCTION CONTRACT
5.2.1 General structure of a contract

A petroleum exploration and production contract (within the meaning dened in the previous
section, i.e. which confers exclusive rights on the beneciary) generally consists of a
document of, typically, about a hundred pages, with several sections: the preamble, the main
text, and appendices which form an integral part of the contract.
178
Table 5.1 Types of exploration and production contract and countries in which prac-

tised.
Type of contract Main producing countries
Concession (with possible participation by Most OECD countries (Australia, Canada,

the State or by joint companies) US, UK, Norway, etc.)
Abu Dhabi, Angola, Argentina, Colombia,
Brazil, Brunei, Gabon, Nigeria, Russia,
etc.
Production sharing contract Angola, Algeria, Azerbaijan, China, Congo,

Egypt, Gabon, Indonesia, Kazakhstan,
Libya, Malaysia, Nigeria, Peru, Qatar,
Russia, Turkmenistan, Trinidad and
Tobago, etc.
Risk service contract Algeria, Iraq, Iran, Kuwait, Qatar,

Venezuela, etc.
Production by the national oil company or a Algeria, Brazil, Iraq, Iran, Russia,
local company (in countries already open Venezuela, etc.
to foreign investment)
National oil company with absolute

monopoly Saudi Arabia, Mexico
Table 5.2 Geographical distribution of different types of contractual basis (OPEC

countries shown in italics).
1. America
Production sharing Service Absolute

Concession
contract contract monopoly
Colombia Bolivia Ecuador Mexico

Exporting
Peru Venezuela
countries
Trinidad and Tobago Trinidad and Tobago
Argentina Chile
Brazil Cuba
Producing
Barbados Guatemala
countries
Canada Surinam
US
Bahamas Antigua Honduras

Belize Aruba Jamaica
Non-producing
Costa Rica Dominican Panama
countries
Paraguay Republic Puerto Rico
Guyana Salvador
Haiti
179
2. Western Europe
Concession regime in all countries (apart from production sharing contracts in Cyprus,
Greece, Malta).
3. Central and Eastern Europe, CIS countries
Concession and Production Service contract

joint companies sharing contract or absolute monopoly
Russia Russia Most production is

Other CIS Republics: presently carried out
Exporting
Azerbaijan, Kazakhstan, by State enterprises
countries
Uzbekistan,
Turkmenistan
Hungary Albania
Producing Poland Bulgaria
countries Slovakia Croatia
Czech Republic Rumania
Non-producing
countries
4. Asia
Absolute
Production Service
Concession (or partial)
sharing contract contract
monopoly
Abu Dhabi, Dubai, Sharjah Bahrain Oman Iran Saudi

(United Arab Emirates) China Qatar Qatar Arabia
Brunei Indonesia Syria Iraq
Exporting
Oman Iraq Yemen
countries
Papua New Guinea Malaysia Vietnam Kuwait
Vietnam
Australia Bangladesh
New Zealand Burma (Myanmar)
Producing
Pakistan India
countries
Thailand Philippines
Turkey Thailand
Non-producing Fiji Cambodia Nepal

countries South Korea Laos Sri Lanka
Mongolia
180
5. Africa

Production Service Absolute
Concession
sharing contract contract monopoly
Algeria Algeria
Angola Angola
Cameroon Egypt
Chad
Congo Congo
Exporting
Gabon Gabon
countries
Equatorial Guinea
Libya Libya
Mauritania
Nigeria Nigeria Nigeria
Sudan
Tunisia Tunisia
Benin
Producing Ivory Coast
countries Ghana
Democratic Republic
of Congo
Tanzania
Burkina Faso Ethiopia

Niger Guinea
Central African
Republic Kenya
Guinea Bissau Liberia
Seychelles Madagascar
Non-producing
Madagascar Mozambique
countries
Sierra Leone Senegal
Mali Togo
Morocco Zambia
Somalia
The preamble enunciates a number of general statements (customarily beginning with the
word Whereas) whose purpose is to set the detailed provisions of the contract in their
broader context, both legal (for example references to existing legislation which provides for
the type of contract in question to be concluded) and political (for example references to the
role of the State, national policy on the development of natural resources).
The main text takes the form of a series of articles and subarticles numbered sequentially,
and often arranged in chapters. It states who the parties to the contract are, its purpose, term
of validity and the rights and obligations of the respective parties. Broadly speaking the
provisions fall into four categories:
Technical, operational and administrative provisions, which deal with practical aspects
related to the conduct of operations during the different phases;
181
Economic, taxation, nancial and commercial provisions, which deal with how the
prots will be split between the parties, how petroleum costs will be accounted for,
pricing and disposal of production;
Legal provisions, which deal with the application and modication of the contractual
relationships between the parties;
Miscellaneous provisions, which deal with any other matters.
Generally the appendices include:
a description of the contract zone in terms of its geographical coordinates including a
map, and its surface area;
the accounting procedure which provides for the methods and procedures to be used
for accounting for the petroleum operations covered by the contract;
the work commitments;
a guarantee by the parent company and/or a bank.
The following sections describe the main provisions to be found under each of the above
headings. Most of these are to be found in any petroleum contract, but some are specic to
certain types of contract only.
5.2.2 Technical, operational and administrative provisions

5.2.2.1 Term and phases of a contract
It is important to be aware of the different phases of a contract, as different provisions may
apply to different phases. The rst is the exploration phase, during which the contract holder
carries out geological and geophysical surveys and drilling operations with a view to iden-
tifying prospects within the contract zone and then to drill the most prospective of these, i.e.
those most likely to contain hydrocarbons. The second is the exploitation phase, which
occurs when hydrocarbons are found which are judged to be commercially viable. This phase
comprises a period of development followed by a period of production. As long as he has
fullled his contractual obligations, the contract holder can withdraw at any time during or
at the end of the exploration phase if a discovery judged to be commercial has not been made.
There has been a recent tendency for countries once closed to foreign operators to open
their industries up. Increasing numbers of contracts cover zones already explored and which
already contain hydrocarbons. These might be discoveries which are not yet exploited
because there is a need for technologies or funding beyond the capabilities of local oper-
ators (typically national oil companies). Or they may have been already subjected to
exploitation activities, and now be considerably depleted and in need of rehabilitation or
enhanced recovery which has not been carried out for the same reasons. In these cases the
contract will take account of this specic situation by omitting the exploration phase and
commencing the development phase immediately. When no exploration is necessary the risks
are lower, and the State may require that this fact is reected in the nancial arrangements
agreed.
The situation can be even more complex where a contract is for further exploitation from
an existing eld but when further exploration is authorised, for example at greater depths
corresponding to horizons not yet explored.
These considerations demonstrate the need to dene very clearly the terms used in a
contract and the effective operations to which they relate, so as to avoid subsequent misin-
terpretations of the contract or disputes.
182
5.2.2.2 Exploration phase

A. Term
In setting the term of the exploration phase should two conicting criteria need to be met:
It should be long enough give the contract holder the time he needs to conclude
successfully the activities needed to evaluate the petroleum or gas potential of the
exploration zone and to discover hydrocarbons;
It should be short enough discourage the contract holder from proceeding unduly
slowly, thereby occupying for too long a large area which might be of interest to other
companies.
In order to reconcile these two criteria, the normal practice is to provide for a relatively
long total exploration period (generally 510 years), but to subdivide this period up into a
number of subperiods. The contract holder therefore has an initial period, renewable for one
or two succeeding periods. At the end of each subperiod he may renew his entitlement for
a further subperiod provided he met his commitments for the period just ended.
At the end of the nal subperiod the contract expires for the entire area covered by the
contract except the zones containing commercial discoveries which will be developed.
However it is customary to provide for an optional extension (on average 36 months)
running from the expiry of the contract, to allow the contract holder to complete the explo-
ration work still in progress.
Up until 1986 the general trend was for a reduction in the duration and the size of the
exploration area. Since then this trend has been reversed as a result of the changed petroleum
environment, particularly in deep offshore locations.
The initial exploration period begins when the contract takes effect. Because this is
generally the longest of the exploration sub-periods, and in order not to quarantine a large
area without any exploration taking place, it is normally stipulated that the contract holder
must begin work within a certain period (typically 36 months) from the effective date of
the contract.
B. Contract area and relinquishment

The initial area covered by the licence or the contract zone is specied by means of a map
showing the boundaries and indicating the coordinates of reference points. It is often dened
by the State before blocks are created, rather than by the applicant, particularly where there
is an international call for tenders. Sometimes the size of a licence or a zone available for
granting is limited by legislation. This area varies considerably depending on the particular
circumstances applying.
Although in some cases large areas are still granted to contract holders, authorities
generally tend to allocate zones of medium size (of the order of 1 000 to 5 000 km2). If the
area is too large there is a risk the holder will only explore a small part of it. The rest will
therefore be frozen, thereby excluding other companies which might want to invest in that
zone. It is important that the State adopts a policy which ensures the coherency of explo-
ration programmes.
Usually the contract holder cannot hold on to the entire area indenitely. It is customary
for a minimum reduction to be made in the area of the contract zone when an application is
made to renew the exploration term. In most contracts which provide for an initial period
and two additional exploration periods, the rst and second renewals are accompanied by
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the mandatory relinquishment of up to 2550% of the initial area, except where special
circumstances justify a smaller or no relinquishment.
The contract holder is usually free to choose the zones to be relinquished. To prevent him
from relinquishing a large number of fragmented pieces, constraints can be imposed on the
shape and the number of pieces relinquished.
C. Exploration work obligations or expenditure obligations

When the contract is signed, a minimum work programme is specied for each of the explo-
ration sub-periods (initial period and additional periods) which the contract holder must carry
out if he wishes to renew his rights. This programme is normally subdivided by type of oper-
ation: geological studies, seismic surveys and exploratory drilling.
A minimum seismic programme is often only imposed for the initial period of exploration.
The programme is dened in terms of a minimum number of kilometres of 2D proles or
3D surfaces.
The minimum drilling programme is dened in terms of a minimum number of wells to
be drilled; this number will depend on the duration of the exploration period and on the area
covered by the contract. Minimum depths for the drilling (or specic objectives to be
attained) will also be specied. And nally the contract needs to state whether delineation
and appraisal wells will be considered as exploration wells for the purpose of this obligation.
The purpose of specifying minimum levels of activity is to satisfy the State that each
contract holder will undertake sufcient exploration work obligations to ensure that the
petroleum potential of the zones granted will be properly studied.
The contract usually provides that if during one of the exploration periods the contract
holder exceeds the specied minimum exploration work obligations for that period, the
additional work can be carried forward to the following period, thereby reducing the oblig-
ation in that period.
Sometimes the obligation imposed on the contract holder is dened in terms of the
minimum expenditure on exploration work, either as a total or broken down by the various
types of work.
The contract needs to specify whether the contract holder must comply with both work
and expenditure obligations or only one of these, and what the priority is. Usually work oblig-
ations take priority over expenditure obligations. In that case the only expenditure stipulated
in the contract relates to the penalties applying in the event of failure to complete the spec-
ied work.
In order to ensure that the contract holder can discharge his obligations to invest or carry
out exploration, the State can demand that the oil company provides nancial guarantees.
This guarantee can take the form of a bank guarantee or a performance bond of the company.
The contract holder may relinquish all or part of the area before the expiry of the explo-
ration period. The contract provides that where there is a partial relinquishment of the area there
is no diminution of the obligations in the current period, and that of the area is totally relin-
quished, the contract holder will be subject to the same rules and penalties as described above.
D. Evaluation of a discovery
If the contract holder discovers hydrocarbons during his exploration activities, he is required
to notify the competent authority of this fact. If he considers that the discovery is worth an
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appraisal, he must prepare an appraisal (or delineation) programme and a budget for the works.

Certain countries then create a specic appraisal zone so that the work can be carried out.
After this programme has been executed the contract holder informs the authorities of the
results obtained from the appraisal and his conclusions, and specically, whether he regards
the nd as commercial and whether he plans to develop it.
Where the contract holder concludes that the discovery is economically marginal or non-
commercial, some contracts may provide that he can propose to the State modications to
some of the provisions of the contract so that the contract holder is able to exploit the
discovery. These proposals must be accompanied by economic studies performed by the
contract holder which demonstrate the effect of the proposed changes on the project
economics. The State is of course at liberty to accept or reject the modications proposed.
If it accepts them the contract holder is required to declare the discovery commercial and to
propose and implement a development programme.
Some contracts provide that if a discovery is considered non-commercial the contract
holder must hand the discovery over to the State if the authorities wish to exploit it before
the normal expiry of the contract. Special clauses may apply to gas discoveries (see
Section 5.2.5).
5.2.2.3 Exploitation phase

A. Declaration of commerciality and submission of a development
and production plan
It must be emphasised that the judgement as to whether an oil or gas eld is commercial is
a matter for the contract holder: it is the investor who will bear the risk and who is in a
position to evaluate the protability of the project based on his assumptions and strategy.
Some countries have however sought to formulate a denition of a commercial discovery
on the basis of which a contract holder can be obliged to undertake a development
programme. This is based on certain objective criteria related to the volume of hydrocarbons
discovered or a certain productivity per well achieved over a certain period. This approach
has not really caught on, however.
When the contract holder declares a discovery to be commercial, he prepares a devel-
opment and production plan, which if necessary is submitted to the authorities for approval.
Once the plan has been accepted the contract holder must commence development within a
short period. The development plan is an important document which deals with all the tech-
nical and economic aspects: reserve estimation and future production proles; development
schedule, wells and production installations, storage and transport, timetable for completion
and commencement of production, estimates of capital and operating costs; economic eval-
uation establishing the commercial viability of production; the environment and safety; the
abandonment plan when production ends.
B. Production period
After a development plan has been adopted, the holder of the exploration rights is entitled
to exclusive rights to exploit the resources discovered. The duration of the production period
is variable, depending on the agreement. Production is usually authorised for an initial
period, typically 2025 years, which may be renewable for 10 years or more if further
production is economically viable.
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The grant of a production licence involves an obligation on the part of the contract holder
to develop the eld in question in accordance with the development plan. He is expected to
produce in accordance with best international practice, with optimal recovery of the reserves.
C. Area of production zones

When a contract holder declares that a discovery is commercial he is required to submit to
the authorities details of the precise conguration of the eld which emerges from the delin-
eation. The production zone corresponds to the extent of the eld. Within a given exploration
zone there will be as many production zones as commercial discoveries.
The area of the production zone is determined at the time that the discovery is declared
commercial. It can occur that the improved knowledge gained after several years of
production means that the production zone needs to be enlarged.
To cater for this possibility, a provision can be included allowing the production zone to
be enlarged so that it corresponds with the new area of the zone which has now been found
to be exploitable, providing that the additional area lies within the area of the exploration
zone still held by the contract holder.
D. Unitisation
When an oileld is discovered which straddles several different exploration zones granted
to different contract holders, the contract needs to contain a clause which ensures that the
recoverable reserves are exploited in a coherent manner (for example by appointing a single
operator, adopting a joint development and production plan, etc.).
Such a clause, known as a unitisation clause, has to be common to all the agreements made
between the State and the contract holders, since in the event that such a clause has to be
invoked, the rules must be identical for all.
The special case of oil and gas elds which straddle national frontiers has to be dealt with
by means of international agreements, as in the North Sea between the British and Norwegian
sectors. When a dispute arises between several countries, this can be resolved by creating
joint development zones governed by ad hoc statutory and scal arrangements, as in the cele-
brated Neutral Zone between Saudi Arabia and Kuwait, the Timor Gap between Australia
and Indonesia, and the Joint Development Zone between Nigeria and Sao Tome and Principe.
E. Obligations when production is abandoned

When production from a eld is abandoned, the obligations of the operator need to be spec-
ied. These may involve transferring all installations to the State without charge or decom-
missioning the wells and the disposal of the installations at its own cost. Contracts
increasingly specify an abandonment plan, submitted to the authorities in advance, containing
special scal provisions if appropriate, and providing for cost allowances to be set aside in
advance to fund the abandonment costs. This may be a costly operation in offshore zones
subject to stringent regulations.
5.2.2.4 Conduct of operations

A. Good oilfield practice
All holders must undertake to observe good oileld practice in their operations whether or
not there are detailed technical regulations in force. This requirement relates particularly to
186
resource conservation (optimum production) and safety. Nowadays environmental protection

has also become a very important issue, and new standards are being formulated, including
the requirement to carry out an environmental impact assessment and to monitor continu-
ously in ecologically sensitive areas.
B. Annual work programmes and budgets

Before the start of each year the contract holder must submit to government a work
programme together with a budget for the coming year, broken down by type of activity or
expenditure (exploration, evaluation, development, production). The programme is provi-
sional; and changes may be proved necessary as work proceeds. These are permissible
provided the objectives of the work programme remain the same.
C. Administrative supervision
Petroleum operations are monitored by the State, acting through the department responsible
for mining or hydrocarbons within the relevant ministry. The contract holder must inform
this department of any major petroleum operation such as a geological or seismic survey,
drilling activity, well-testing or the erection of installations so that the latter can dispatch a
representative to the site. The department can also ask the contract holder to carry out any
work necessary to safeguard health and safety during its operations.
D. Information, reports and confidentiality

As well as providing annual work programmes and budgets in advance, the contract holder
must submit, at specied intervals, activity reports detailing the work carried out, supported
by technical data where necessary.
He must also submit to the State a copy of all the data obtained during operations as well
as any information describing the subsoil: geological and geophysical data, logs, results of
analyses, measurements made in production wells, pressure trends, studies of secondary
recovery, estimates of the reserves in place and recoverable. It must also submit all the data
on the production itself: quantities produced from the eld, hydrocarbon sales, quantities of
product shipped, including data on the purchasers, countries of destination, price of each
cargo, etc.
The contract must specify the ownership of petroleum data obtained during operations:
usually the data are the joint property of the State and the contract holder.
All the data obtained must be treated as condential by the State and the contract holder
for a period specied in the agreement. This period varies considerably, ranging from
35 years from the date they were obtained to the entire period of their validity.
Finally, the contract holder must provide periodical reports on its activities and expen-
diture. These reports also allow the State to monitor the development of local employment
in the petroleum sector.
E. Training and employment of local personnel

The contract holder may be required to give priority to the employment of local personnel
for its petroleum operations. By their very nature, petroleum operations need experienced,
highly qualied personnel, not always available locally. For this reason, this clause is always
accompanied by provisions for the training of local personnel, and this involves setting up
a minimum annual budget for various programmes. In some countries employment objec-
187
tives are also set, expressed as the percentage of the workforce at a given level of quali-
cation which should be made up of local employees.
F. Priority for local products and services, and local development

As well as requirements regarding local employees, there will likewise be expectation that
local goods and services are used. Use is often made of international calls for tender in
awarding contracts, with local businesses being consulted.
Local development becomes a growing requirement in many producing countries. In
October 2009, Nigeria adopted the concept of Local Content Bill to develop the local
industry. Venezuela introduced the concept of Desarollo endogeno. In Canada, the oil
producing Provinces of Nova Scotia, Newfoundland and Labrador propose Benefit Plans
to measure employment and profits related to any oil producing project.
5.2.3 Economic, fiscal, financial and commercial provisions

5.2.3.1 Financing petroleum operations
The contract holder has exclusive responsibility for the funding of the activities. Exploration
costs are funded by means of equity capital. Development costs can be funded to a large
extent by loan capital. The contract may specify a maximum percentage to be nanced by
loan capital, as well as other conditions for approval, the conditions relating to the tax
deductibility or recovery of interest.
5.2.3.2 Determining the State revenues

The manner in which revenues are calculated depends on the regime applying. These are
dealt with in Sections 5.3 and 5.4.
5.2.3.3 State participation

During the period 19701980 some countries introduced provisions permitting the State to
itself participate directly in petroleum operations as a partner of the contract holder, taking
on the same rights and obligations in proportion to the level of its participation. The main
purposes of these provisions are to give it access to petroleum resources, to increase its net
revenues (i.e. after meeting its share of the capital and operating costs) and to increase its
involvement in petroleum operations, particularly in terms of increased control, closer super-
vision and the transfer of skills.
The State participation usually involves an incorporeal association. The State, usually
through the intermediary of a national company, becomes a partner in the contract with a
dened share. The relationship between the partners is governed by a participation agreement.
The State may enjoy certain specic advantages, for example a carried interest whereby
its share of the capital cost is borne by the other partners during the exploration phase, to
be reimbursed later from its share of any production.
The other form of participation is implemented through a joint company. Such an
arrangement is less common and can give rise to practical difculties relating particularly
to the nancing the States share of the capital, the ownership of the reserves and of the
production, the payment of dividends and the taxation basis applicable. However Venezuela
adopted in 2006 a new law aiming at converting all existing contracts into the form of
empresa mixta, where the national oil company PDVSA holds at least 51%.
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Depending on the detailed arrangements, the participation of the State can have a major

economic impact because the State does not share the initial exploration risk. And State
participation reduces the shares of the other investors in the production. The State share can
be 50% or even higher in some countries, but has generally declined considerably over the
1990s, in some cases to nil. As already mentioned, the opposite trend can be now observed
in some major producing countries (Algeria, Bolivia, Venezuela).
5.2.3.4 Determining the price of hydrocarbons

Since the revenue of each party is closely linked to the value placed on the hydrocarbons,
this clause is of crucial importance.
A. Price of crude
a. Real sale price to third parties
The price is based on the real market price for sales involving a change of ownership at a
point of delivery agreed by the parties. The price normally used is the FOB price at the export
port by tanker. Where sales are based on the CIF price (cost, insurance and freight) this price
has to be adjusted to obtain the FOB price.
Sales between afliated companies should be valued at the weighted mean price for sales
to third parties, for the same oil and during the same period, if it is possible to calculate this
price. If there were no sales to third parties during the period considered, the real market price
is established by considering the mean market price during the same period of crudes of
comparable quality sold in the country or in neighbouring geographical zones. This price is
therefore submitted for discussion and approval by the parties according to a procedure to
be agreed. Some agreements contain a detailed procedure for determining the market price,
with the possibility, in the event of disagreement, of referring the matter to an independent
expert agreed by the parties whose decision will be binding on all.
b. Posted price or fiscal reference price
These theoretical prices, higher than the real sale price, were introduced by certain countries,
notably OPEC, in 1964. Originally posted prices were negotiated with the companies, but
with effect from 16 October 1973 the OPEC countries decided to set their posted prices
unilaterally. The purpose of this reference price was to avoid discussions about the deter-
mination of the real sale price, the posted price being a scal reference price used to calculate
State revenues (royalties, taxes).
The use of posted prices not linked to the market price has now virtually been abandoned.
B. Price of natural gas

In contrast with crude oil, there is not really an international market price for natural gas
because the price of gas essentially depends on the geographical location where it is sold,
and on the level of integrated transportation infrastructure and market. However, a compet-
itive market exists in the United States with a spot price. The price to be taken into account
for the purpose of the contract is therefore the real sale price to third parties or, for direct
sales to the government or an afliated company, the price xed by agreement between the
parties. Sometimes the price of a substitute fuel such as fuel oil is referred to. The prices
xed in long-term gas sale contracts may be the subject of complex formulae based on the
indexed price of a basket of crudes and petroleum products.
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5.2.3.5 Marketing
The contract holder is responsible for the marketing of all the products extracted or of his
share of those products, depending on the type of contract applying, and is obliged to obtain
the best possible price. There is often a requirement that the domestic market should have
a rst call on national production. In this case the sale price is either the market price or a
reduced price, but the latter practice represents a hidden tax.
5.2.3.6 Auditing and accounts

During the entire period of validity of the contract, the contract holder must keep separate
accounts in accordance with accounting procedures appended to the contract. These proce-
dures are set up in accordance with the rules applying in the country concerned, but may be
subjected to slight changes to allow them to cater for specic petroleum mechanisms, for
example depreciation procedures, the period of carry-forward of losses and the denition of
petroleum costs.
The clause in the main agreement relating to the accounts of the contract holder can
therefore be quite short because it will refer to the accounting procedure in which all the prac-
tical procedures are indicated. It will specify the currency in which accounts are to be kept
(often U.S. dollars), rules for conversion and the right of the government to have the accounts
audited.
5.2.3.7 Customs regime

Because of their particular nature, petroleum operations enjoy certain customs privileges or
administrative facilities. These relate particularly to the right to import goods and services
usually free of any import duties or taxes. The import of equipment which will eventually
be re-exported is often treated as a temporary import only. The contract holder also has the
right to freely export the production, possibly after supplying the domestic market in priority,
usually free of any duty or export tax.
5.2.3.8 Tax incentives

In view of the specic nature of the tax regime applying to petroleum exploration and
production, contract holders and their subcontractors generally enjoy certain tax advantages,
such as exemption from taxes on sales (in particular value added tax on services provided).
Holders sometimes benet from an exemption from dividend withholding tax or tax on loans
raised in other countries.
In other respects, and with the exception of any other provisions in the petroleum legis-
lation, holders are subject to the normal tax regime. The taxation of service companies and
foreign suppliers presents a difculty in determining the prot resulting from one-off oper-
ations in the country. A deduction at source is often made of a xed percentage of turnover.
5.2.3.9 Exchange control

Holders are subject to exchange controls. However in order to facilitate petroleum opera-
tions, these controls are often relaxed. This will allow:
Bank accounts to be freely opened and used in other countries;
Payments to subcontractors and employees to be made in part in other countries;
190
Sales revenues to be received directly in other countries free of any constraint (i.e.

without repatriation) except for that part necessary to cover the expenditure in the
country, i.e. the operating costs, taxes, etc.;
Foreign currencies to be converted and bought in the host country.
Some exporting countries have in the past obliged companies to reinvest part of the
prots in the country, in the petroleum or in other sectors. Very often the local tax legis-
lation in a country which is already a hydrocarbon producer provides incentives for rein-
vesting, for example by making new exploration expenditure immediately tax deductible
through the consolidation of different activities or by allowing a depletion allowance.
5.2.4 Legal provisions

5.2.4.1 Parties to the agreement
An agreement is concluded on behalf of the country by the State or government, represented
by one or more ministers, the minister responsible for petroleum affairs or the national oil
company.
As far as the company is concerned (or companies in the case of a consortium), the
agreement is most often signed by a new subsidiary of the parent petroleum company
created under local law. The latter will therefore guarantee that the contractual obligations
of the signatory company are properly carried out.
In some countries a local joint company with the involvement of the State is set up when
a discovery has been made. This company is established to manage the operations but does
not interfere in the marketing and does not participate in the prots.
5.2.4.2 Assignment and transfer

The contract holder is entitled to assign or transfer all or part of his interests in the area
covered by the agreement to other persons provided he observes the conditions imposed
under this clause.
5.2.4.3 Force majeure

In the event of force majeure (an unpredictable event or act beyond the control of the
parties, such as a natural disaster, civil unrest, sabotage, war, etc.), the contracting parties
are temporarily relieved of their obligations where these are affected. Once normal opera-
tions resume, the contractual periods are adjusted to allow for the delays incurred.
5.2.4.4 Settlement of disputes and international arbitration

Arbitration is reserved for serious disputes, after attempts at reconciliation have been made.
For disagreements of an operational and technical nature, it is preferable for the matter to
be resolved by referring to technical experts, given the protracted nature of arbitration. In
other cases recourse to the national courts or international arbitration can be considered.
For agreements between developing countries and foreign investors a dispute would
normally be referred to international arbitration using procedures established by the inter-
national organisations.
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5.2.4.5 Applicable law

The applicable law is usually that of the host country. Where this national legislation is
incomplete the contract can provide for the application of the more complete legislation of
another jurisdiction, for example that of the state of Alberta in Canada (often referred to in
petroleum contracts).
5.2.4.6 Responsibility
The contract holder is responsible, with or without limitation, for any damage (including
environmental damage) resulting from his petroleum operations, whether or not due to negli-
gence or gross misconduct. The government and third parties have to be compensated for
such damage. Where a consortium of companies is involved, these companies bear joint and
several, rather than individual, liability. The contract holder is obliged to effect insurance.
5.2.4.7 Revocation of contract and withdrawal of rights

A serious default on the part of the contract holder can lead, after a formal warning has been
ignored, to the revocation of the contract and the forfeiture or withdrawal of the mineral
rights (exploration licence or lease). Penalties may be specied for some infringements.
Where such forfeiture is challenged the provisions relating to the settlement of disputes will
apply.
5.2.4.8 Date of entry into force of petroleum agreements

There are various options, depending on the country. The agreement may enter into force:
Immediately it is signed (in the case of an agreement signed by the head of State or
the minister so authorised by the petroleum legislation);
After the announcement in the appropriate ofcial journal of the signing of the contract
(the contract itself may or may not also be published) or the granting of mining rights,
in accordance with the petroleum legislation applying;
After government approval by decree;
After the agreement has been ratied by a law. This will be the case where an
agreement signed by a minister or the national oil company involves departures from
existing legislation or in countries which have not yet introduced petroleum legislation.
5.2.5 Gas clause

Natural gas can be produced either in association with crude oil (associated gas) or in its own
right as dry or wet gas (non-associated gas).
The production of natural gas has a number of specic characteristics: considerable and
therefore costly infrastructure needed, the fact that it cannot be stored, special transport and
distribution requirements, the need for a long-term and stable market. Special provisions are
therefore included in contracts designed to facilitate gaseld development and production.
As far as associated gas from a commercial oileld is concerned, the usual procedure is
as follows:
The natural gas is rst used by the production facility for its own internal needs (as energy
source, re-injected for purposes of enhanced recovery, etc.).
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If the gas cannot be used by the production facility or marketed it can be ared once the

authorities have been informed and, if necessary, have approved it. But aring is more
and more regulated to reduce the emission of greenhouse gases (GHG).
The State is entitled to use any natural gas destined for aring for its own purposes,
without payment.
Where a discovery of (non-associated) gas is made the following measures are usually
taken to develop and exploit the discovery:
The deadline for declaring a commercial discovery can be extended, provided that an engi-
neering study and a preliminary feasibility study on the development of the discovery and
the marketing of the production must be submitted to the authorities. These should demon-
strate the commercial potential of the discovery. The deadline can often be extended by
3 to 5 years.
Either the authorities or the contract holder can decide at any time during this additional
period to develop the gaseld, the other party being free to participate in this development
if it so wishes.
Economic and scal incentives may also be put in place in order to lower the commercial
threshold. Such measures have allowed small projects for supplying gas to local power
stations to get off the ground in developing countries.
In the case of associated gas, the purpose of such measures is ensure that the gas is only
ared in certain conditions dened clearly in the agreement, and where there is no prospect
of selling the gas.
In the case of non-associated gas, these measures seek to prolong the exploration period,
thus giving the contract holder more time to evaluate the commercial potential of the
discovery and identify potential markets.
5.3 CONCESSION REGIMES
5.3.1 General framework

Under a concession arrangement the State grants the contract holder exclusive exploration
rights (exploration licence), as well as an exclusive development and production right (lease
or concession) for each commercial discovery.
A contract established under a concession regime will contain the provisions described
above. This may involve an actual petroleum agreement or simply the application of general
and special conditions associated with the grant of an exploration licence or a lease within
the framework of current petroleum legislation and accompanied by a schedule of conditions
specic to the licence.
The features which distinguish a concession agreement are the ownership of the hydro-
carbons produced, the ownership of the production installations and the items of revenue to
the State, and these three aspects are dealt with below.
It should also be borne in mind that even where a legislative approach as referred to in
Section 5.1.3 is taken, a concession comprises a contract in law, and this offers some
protection to the holder in the event of subsequent changes in the petroleum law.
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5.3.2 The main features

5.3.2.1 Ownership of production
Before they are extracted from the subsoil, hydrocarbons generally belong to the State. This
State ownership of the subsoil and of the mineral resources is very common, and applies in
most countries whatever the contract type (see Section 5.1.1). In a concession regime,
however, the contract holder becomes the owner of all the hydrocarbons produced, subject
to the payment of a royalty in kind (oil and natural gas) or in cash, from the time they are
extracted from the ground and reach the wellhead.
5.3.2.2 Ownership of production installations

Under a concession regime the holder owns the installations until his lease expires. When
it expires the xed installations usually revert to the State without compensation for the
holder; the State is free to use them at its convenience if it considers this would be econom-
ically attractive. Alternatively the State can require the holder to remove at the latters
expense some or all of the installations if it does not wish to use them. The holder is entitled
to use the installations again for production from another discovery in the same country.
5.3.2.3 Items of revenue to the State

Under a concession regime the State obtains its revenues through taxes. The main revenue
categories are as follows:
Bonus (signature or production);
Surface fees;
Royalty on production;
Taxes on prots;
In some cases, excess prot tax.
Petroleum legislation in different countries recognises, to varying extents, the contractual
nature of a concession, so that the latter affords protection to the holder in the event of a
change in the petroleum tax law. In most countries therefore, even where there is not actually
a contract, some terms are xed on the date the licence is granted (royalty, excess prot tax),
but the taxation of prots is based on general tax law, and is therefore subject to change from
time to time. There have, for example, been a series of reductions in tax rates in the 1990s
in the UK, Norway and the Netherlands, and the petroleum industry has also beneted from
these reductions. However, the UK has again introduced a specic petroleum tax which
results in an overall tax rate increased to 50% in 2006.
5.3.2.4 Signature bonus

Some concession agreements provide for the holder to pay a bonus on the date the contract
is signed or the exploration licence is granted. This bonus is paid to the State in one or more
instalments, and its amount varies depending on the contract, but can amount to several
million or even hundreds of millions of dollars. This represents a major nancial commitment
for the holder, particularly since it is payable before production commences, and it will
therefore have a fundamental impact on the protability of the project. From the countrys
perspective on the other hand, it represents a very attractive immediate lump sum revenue.
Some countries do not provide for a signature bonus directly but award exploration
licences on the basis of a bidding procedure. The payment made by the eventual holder
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following this procedure is analogous to a signature bonus, however. This procedure has been

adopted when licences were granted in Federal zones in the U.S.
Between 1986 and the end of the 90s, the practice of paying a signature bonus has been
declining, indeed has largely disappeared except in countries formerly closed to the direct
involvement of the international oil companies, but which are now opening their borders.
Representative examples are Venezuela, where very high bonuses were achieved in the rst
round of bidding for exploration blocks, organised in 1998, Brazil in 1999-2000, the JDZ
between Nigeria and Sao Tome and Principe in 2004, Libya after 2000.
5.3.2.5 Exploration surface fees

The holder may be required to pay annual surface fees to the State or other specied organ-
isation proportional to the area to which the exploration licence applies. These fees usually
remain xed during each exploration period. Each time the exploration period is renewed
these fees usually rise in proportion to the mandatory relinquishment. If, for example, the
minimum mandatory relinquishment at the rst renewal is 50%, the fees per unit area for
the new period will double. The fees are also sometimes made subject to annual indexing.
These fees are generally relatively small (typically between $1 and $10 per km2 per
year), and do not impose a signicant burden on the holder unless the area covered by the
licence is very large.
5.3.2.6 Production bonus

Production bonuses are one or more sums paid to the State which are triggered when certain
production thresholds are reached on a eld. The contract sets forth the sums to be paid when
production rst reaches certain levels (usually expressed in bbl/day) for a stated period. It
can also provide for a discovery bonus to be paid.
These production bonuses are very variable in magnitude, and depend on the oil potential
of the country in question. Like the signature bonus, these bonuses can represent a
commitment on the part of the holder of millions or tens of millions of dollars.
Not all countries treat the signature and production bonuses in the same way for tax
purposes. Some treat these bonuses as being deductible while others do not consider them
to be deductible, thereby increasing their net cost to the holder.
5.3.2.7 Exploitation surface fees

During the production from a commercial discovery the State can impose an annual surface
fee on the holder proportional to the area over which the concession extends. This payment
is analogous to the fees paid during the exploration phase. Since the area over which the
concession extends is much smaller than that covered by exploration, the fees per unit area
are much higher in the production than in the exploration phase.
5.3.2.8 Royalty on production

A. Denition
A royalty is an amount equal to a percentage of the value of production, paid by the holder
to the State in cash or in kind. It is effectively a tax directly proportional to the value of
production, that is a tax on turnover, and independent of prots.
The amount of the royalty depends not only on the percentage applying, but also on a
number of other parameters which must be carefully specied.
195
B. Royalty rate
The royalty rate is usually different for crude than for natural gas, the latter being lower.
In order to ensure that the royalty is adapted to the characteristics of the eld, a sliding
scale is sometimes specied in the contract, depending on the production level. There are
various options, including:
A variable percentage which depends on the daily or annual production (per well, per
reservoir, per concession, etc.). In order to prevent abrupt changes in the calculated
amount for small changes in production, the percentages apply to incremental
production rather than the whole amount;
A variable percentage which depends on cumulative production since production
began;
A variable percentage which depends on economic criteria such as the R-ratio between
cumulative cash ow and cumulative investment.
C. Ring-fencing or consolidation
In cases where the holder produces from several concessions both resulting from the same
exploration licence, there are two ways in which production can be calculated:
For each concession separately: the holder pays a separate royalty for each concession,
and these are calculated separately;
For all the concessions together: the holder pays just one royalty, based on the total
production from all the concessions.
Where the percentage used to calculate royalties increases with increasing production it
is obviously more attractive for the State to aggregate the concessions for the purpose of the
royalty calculation, but the impact on the holder will be greater.
D. Payment procedure and frequency

The royalty can be paid in cash or in kind, as the State chooses. Payments are made quar-
terly or monthly. Where payment is made in cash, the calculated amount of the royalty will
depend on the value placed on production, on the point at which the royalty is calculated
and on the frequency of payment.
E. Point of calculation
Three points are possible: at the wellhead, at the point of departure from the eld, or at the
point of export or the point where it is made available for consumption in the host country.
F. Value of production
Production can be valued on the basis of:
The posted price or the price xed ofcially by the State, practised historically but now
rare;
The actual market price.
G. Tax treatment
The impact of the royalty for the holder will depend on the way it is treated for the purpose
of prot tax, i.e. whether as a tax credit (practised historically, but now rare), or as a charge
deductible from the holders taxable prot.
196
H. Recent trend

The royalty is independent of prot, and becomes increasingly onerous for the investor as
the technical costs rise or the oil price falls. The 1990s have seen a tendency for royalties
to be reduced or even dispensed with entirely in order to encourage new investment. The
percentage which was once typically 20% is nowadays more likely to be in the range 0 to
12%.
5.3.2.9 Direct taxation of prots

A. Consolidation of prots
The holder is taxed directly on the prots from his activities in the country. The prot is
usually calculated separately for exploration and production when the holder is also active
in other petroleum activities such as transport, rening or the liquefaction of natural gas.
In the same way as for the royalty, the prots of the holder can be calculated by aggre-
gating all his exploration and production activities in the country or each concession can be
kept separate (the latter case is referred to as ring-fencing). It is nancially benecial to the
holder to consolidate together as many activities as possible as this allows him to set off his
exploration costs under one licence against production revenue earned on another.
B. Basis for taxation: revenues and charges

The calculated revenue for the holder will depend on the value placed on all the hydrocarbons
sold and any other revenues to be counted (e.g. the hire of installations to third parties, sale
of by-products such as sulphur, etc.).
On the cost side, deductible costs need to be dened very precisely: operating costs, depre-
ciation, nancial charges, specic provisions and other permitted deductions. Certain costs
are shared with operating companies within the group but in other countries, e.g. head ofce
costs which have to be shared between all its subsidiary oil-producing companies. These
costs may also include the cost of technical assistance and non-resident personnel attributable
to the petroleum operations.
Straight-line depreciation is generally adopted, over a term of between 4 and 20 years,
depending on asset type. Other possibilities include double declining balance or depreciation
based on the unit of production. A list indicating the categories and depreciation terms for
each type of equipment can be specied in the accounting procedure appended to the
contract.
Some countries allow the holder, by way of tax relief, to write off more than 100% of
the total effective investment, by giving an investment credit, or uplift, of 20 to 50%.
Other relevant matters include:
The rules applying to the creation of provisions, for example to cover abandonment or
a depletion allowance;
The ability to carry forward losses for a number of years or even indenitely.
C. Payment procedure and frequency

Provision can be made for the dates on which taxes are paid to be different from those
applying under general taxation law so that the State receives its oil revenues without delay.
The holder may for example be required to pay regular instalments of tax in advance based
on provisional amounts, a balancing payment being made when the accounts are closed.
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D. Tax rate
The tax rate may be that set by general tax law or a specic rate may apply for petroleum
activities. Historically, the rate was typically at least 50%, and could reach up to 85%. Over
the 1990s there has been a trend for the rate to fall to a gure of about 3040%. As already
mentioned this trend has been reverted in some countries, tipically the UK with a gure of
50%. Some countries have introduced in the past, and still retain, a special additional tax
which is levied over and above the normal tax.
5.3.2.10 Additional tax on petroleum prots

Following the oil price rises of 1973 and 1979 it became apparent that the traditional
concession, involving the payment of a royalty on production and a tax on prots, no longer
met the requirements of the new economic context of the upstream petroleum industry.
Various approaches, more or less satisfactory, were adopted in order to increase the oil
revenues accruing to the State after the two price shocks, which took account of the oil price
and/or the characteristics of the oileld (see Section 5.6.1.4).
Conversely, in the situation of falling prices after 1981 modications were made to the
tax regime applying to oil companies in order to encourage investment, as described in
Section 5.6, involving greater exibility and a more progressive structure.
Since the early 2000s, some countries have re-introduced such kind of additional tax
(Alaska, Ecuador, Algeria).
Years
Royalty
Profit tax
Net profit to company
Depreciation
Operating costs
Development costs
Exploration costs
Figure 5.1 Typical breakdown of oil revenues under a concession

agreement.
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5.4 PRODUCTION SHARING CONTRACTS

5.4.1 General framework
The legal framework for the production sharing contract was devised by Indonesia in 1966,
in a contract made between the national oil company Pertamina and an American inde-
pendent, and a similar contract was developed in Peru in 1971.
Since then very many countries have adopted this basis. Some are oil exporters: Indonesia
and Egypt, where more than 100 contracts of this kind have been signed, but also Malaysia,
Syria, Oman, Angola, Gabon, Libya, Qatar, China, Algeria and Tunisia. But the approach
has also been adopted in countries which export little or no oil, such as Tanzania, the Ivory
Cost, Mauritania, Kenya, Ethiopia and Jamaica. Several countries in Eastern Europe and the
CIS countries have also adopted this system (see Section 5.1.8).
The success of this formula in developing countries and the transition economies is due
to several original features. Of interest, for example, are the nature of the contractual rela-
tionship (the oil company is not a direct holder of mining titles) and the concept of the
sharing of production. Also noteworthy are the greater control that the State can in theory
exercise over the activities of the oil company, which acts merely as a service-provider or
contractor to the State.
We shall see, however, that in practice the State can exercise as much control through a
modern concession arrangement as in a production sharing contract. In both regimes the oil
company bears the nancial risk, and is generally responsible for running and performing
operations under the supervision of the State. Some concessions may even be considered
more restrictive than production sharing contracts, in terms both of operating the facility and
the economics.
5.4.2 The main components

5.4.2.1 Principles
In legal terms the role of the State in a production sharing contract is reinforced by the
following two principles:
The State retains all the mineral rights and title, and therefore also owns the production.
This therefore creates a de jure State monopoly on hydrocarbon exploration and
production. The oil companies act merely as service-providers or contractors.
Although the State or national oil company draws on the technical skills and nancial
resources of the oil company (which lends or prenances the necessary capital), it retains
ownership of a large proportion of the production. The contractor may only receive the
lesser share of production to meet his costs and remunerate him for his services. It should
be noted that it is this share of the production which appears in the annual company reports
and not the total reserves.
This system is therefore based on the principle of production being shared between the
State or national oil company, which owns the mining title, and the oil company (or
consortium). The latter is the operator, responsible for funding and running operations, and
it is remunerated, in kind, only where a commercial discovery is developed.
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5.4.2.2 Recovery of costs: cost oil

The manner in which costs are recovered varies between countries, and within a given
country between contracts and depending on the date of signature of the contract. Only the
general principles will be discussed here.
In a production sharing contract the contractor has the right to recover his costs by appro-
priating a proportion, not exceeding a certain percentage, of the annual production in the
contract zone. This proportion is known as the cost oil. The balance not yet recovered is
carried forward for recovery in the following year(s) on the same principle. The cost oil is
valued using the market price of crude oil before being compared with the recoverable
costs.
The maximum limit on the cost oil is known as the cost stop, and varies, depending on
country and the particular contract concerned, but is typically between 30 and 60%, although
it can be as high as 100%. The value of the cost stop has a profound effect on the economics
of the project. The higher it is, the faster the contractor can recover his costs and the better
the return on his investments.
However the formula by which costs are recovered has gradually become more complex,
as can be seen from the following provisions which have been introduced in some contracts:
Investment credit (17% in Indonesia, between 33.3 and 40% in Angola): in the former
case, for example, the contractor can recover 117% (rather than 100%) of his capital costs;
this is designed to compensate him for the effect of ination (recovery is in practice based
on nominal value, without indexation).
Spreading the recovery of development costs over time: equivalent to a system of straight
line depreciation over a period of 4 to 5 years (Angola) or a double declining balance
system (Indonesia).
More precise denition of recoverable petroleum costs:
Whether or not bonuses and interest and nancial charges are excluded;
Priorities for recovery of different cost categories (exploration, development,
production, other);
Recovery of joint costs shared between the members of a consortium and the costs
incurred individually for each of these members;
Methods by which costs are split between development zones if successive discoveries
are developed.
Production sharing contracts do not generally provide for the payment of a royalty on
production, but where a royalty is paid, the cost oil is calculated on the production remaining
after the royalty.
5.4.2.3 Sharing of production (prot oil split)

The proportion of the oil left after deduction of the cost oil is known as the prot oil. The
way the prot oil is shared between the State and the contractor has changed substantially
over the last 35 years.
Originally production was split on a xed basis, negotiated per contract, independent of
the characteristics of the discovery. In Indonesia, for example, the 6535% split between
government and contractor was changed to 8515% for oil in 1976, but remained 6535%
for natural gas. These were the effective rates after payment of taxes on prots.
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Later, progressive sliding scales were introduced which depended on the daily production

rate, for example progressive sharing rates increasing from 5050% for low production
rates to 8515% for the top tier of production. In 1979 Angola introduced a progressive scale
based on the accumulated production from an oileld. These scales depend on the charac-
teristics of the discovery and in particular, the environment (onshore, shallow or deep
offshore).
Some countries have adopted adjustment mechanisms which allow for changes in the price
of crude (price capping). The government share for that part of the price which exceeds the
price cap, which is indexed, may be as high as 100% (for example Angola, Malaysia, Peru
and Indonesia before 1978).
In 1983 a number of countries introduced new production sharing mechanisms, based not
on the daily or accumulated production but on the rate of return (or some other measure of
protability) to the contractor on a given date. The countries involved were: Equatorial
Guinea, Liberia (sharing according to the rate of return), India, Libya, Tunisia, the Ivory
Coast and Azerbaijan (sharing according to the R-ratio, which seems to be a more acceptable
basis, see denition in Section 5.6).
There are quite large variations in the prot oil split between different countries and
contracts. These reect differences in the perceived petroleum potential and costs, the latter
being directly linked to the characteristics and the location of the discoveries.
The possibility of adapting the terms of a production sharing contract to the potential
exhibited by a discovery is one of the advantages, and therefore explains the success, of
production sharing contracts compared with concession, where there is less exibility during
negotiations.
Years
Profit oil (State)

Profit oil (Company)
Cost oil (recovery of capital costs)
Cost oil (recovery of operating costs)
Development costs
Exploration costs
Figure 5.2 Typical breakdown of oil revenues under a production sharing

contract.
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5.4.2.4 Taxation of prots

To compare different production sharing contracts the treatment of taxation of prots needs
to be considered. In production sharing contracts concluded up until 1976 the prot oil split
was deemed to be calculated after tax, so that the contractor was not subject to an explicit
tax on prot. His share was net of tax, the latter being assumed to be included in the
governments share. The contractor nevertheless received a tax return corresponding to this
fraction. He was therefore able to deduct this sum from his tax liability in his country of
origin thereby avoiding double taxation.
In 1976 the U.S. Internal Revenue Service (IRS) stopped allowing the notional tax
payment to the State as a tax credit. This led, at the request of the American companies, to
a change in the simple form of the original production sharing contract. This involved the
introduction of a separate procedure for determining the tax on prot, using the general rules
for the taxation of commercial and industrial companies in the host country. This procedure
did not apply to European companies.
As a result, the prot oil split negotiated in contracts was revised to a before-tax basis.
The impact of this measure where the tax rate is 50% is as follows. Consider an after-tax
prot oil split of 7030% between State and contractor. The 70% received by the State is
deemed to include 30% representing taxes on the contractors prot, because the 30% the
latter receives is free of tax. The corresponding before-tax split is therefore 4060% between
State and contractor. The contractor then has to pay tax on his 60%, i.e. 30%, so that his net
remuneration is equal to 30% of the prot oil. The States share is 40% plus 30%, i.e. 70%.
This rough calculation assumes that the depreciation used for tax purposes is precisely the
same as that adopted for the recovery of the petroleum costs, which is not always the case
in contracts. There are therefore some differences between the two sharing systems in terms
of the timing of the tax payments due to the State.
In the above example, if the tax rate is 50%, a before-tax prot oil split of 40%
(State)60% (contractor) is similar to an after-tax split of 70%30%.
The IRS subsequently adopted a more exible attitude, so that American companies can
opt for either basis.
5.4.2.5 Availability of production

In contrast with a concession system, the contractor only has access to a proportion of the
production equal to the cost oil plus his share of the prot oil. Furthermore the State is free
if it wishes to take its share of the prot oil and market it. This is an advantage when there
is a national oil company in existence.
5.5 OTHER CONTRACTUAL FORMS
5.5.1 Service contracts

These are contracts made by the national oil company in producing countries which allow oil
companies to carry out petroleum exploration, development and/or production on their behalf.
Service contracts are used mainly in the Middle East and Latin America, but their use is
not widespread. Two categories of service contract exist, depending on the degree of risk
borne by the oil company:
202
Risk service contracts (or agency contracts) in which the contractor only recovers his

investment costs where a project proceeds to production;
Technical assistance or cooperation contracts, which are non-risk-bearing, carrying out
works on the basis of an agreed remuneration.
The terms and conditions of service contracts are very variable. The main provisions are
summarised below.
5.5.1.1 Risk service contracts

These are a time-honoured form of contract between producing country and oil company for
exploration and production, originating in countries where oil was nationalised or where the
national oil company was granted a monopoly, such as Argentina, Brazil, Indonesia, Iraq and
Iran.
This form of contract could enjoy a renaissance in those Gulf OPEC countries wishing
to increase their production capacity, which may turn to the oil companies for their technical
know-how and nancial resources. It is the case of Iraq with the signature at the end of 2009
of different service contracts with companies like ExxonMobil, Shell, BP, CNPC, ENI,
Occidental, Gazprom and Lukoil.
A service contract is a contract by which a contractor undertakes to explore for hydro-
carbons at his own risk and expense on behalf of a national oil company, and by which he
is reimbursed for the costs he incurs and remunerated in cash depending on the success of
the exploration. All production accrues to the national oil company, although the contractor
may be able to purchase some of this production on agreed terms.
The contractor runs the operations under the control of the national oil company, which may
become the operator when development or production commences. The national oil company
owns the installations, but the foreign company has the right to use this infrastructure.
The fundamental difference between the risk service contract and the production sharing
contract is that the contractor is paid in cash rather than in kind. The contractor is therefore
not able to market the hydrocarbons extracted.
5.5.1.2 Buyback contracts

This type of contract was introduced in Iran in the specic context of that country. The
Iranian constitution does not allow petroleum rights to be granted in the form of concessions.
However some relaxation in this position was made by the Petroleum Act of 1987 which
permits contracts to be concluded between the Ministry of Petroleum, national companies
and local or foreign companies or persons. Conoco concluded the rst agreement in March
1995, relating to the development of the Sirri A and Sirri E oilelds. Following the cancel-
lation of this agreement by the American government, the project was taken over by Total,
and a new agreement was made in July 1995.
These are risk service contracts in which the investor meets all the capital costs, recovers
the costs incurred during production and receives a xed remuneration, negotiated before the
contract is signed and independent of any uctuations in the price.
The duration of the contract is limited to two short phases: a development phase followed
by a cost recovery and remuneration phase. The total duration of the contract is 46 years.
The timetable, the programme and the value of works are xed in a master development plan
appended to the contract. The operations are supervised by a joint management committee
203
comprising three representatives of each party, the National Iranian Oil Company (NIOC)
becoming the operator when operations start. A proportion of the expenditure must be allo-
cated to local sub-contractors.
These contracts present investors with a number of specic constraints: they are short-term
contracts, fairly inexible during the development phase, in which the plan must be followed
very closely. The share devolving to the contractor is relatively small, and they do little to
bolster his reserves. In addition the fact that the remuneration and the cost of the investment
are xed at the moment the contract is signed introduces an element of risk which has to be
managed. It is why some investors have decided to refuse any new buyback contract.
Given that, modications may be made in the future by the governments.
5.5.1.3 Non-risk-bearing technical assistance or cooperation contracts

In this type of contract the contractor does not bear the risk and does not nance the project
directly. He receives a fee for services rendered. This fee can be related more or less closely
to the results. Technical assistance contracts relate mainly to the resumption of production
from elds under depletion, and sometimes to development activities. The funding is
provided entirely by the State or its national oil company, and not by the contractor.
Examples of assistance contracts include:
Contracts to provide assistance with oil production, awarded by countries which nation-
alised their petroleum industry in the 1970s, such as Saudi Arabia, Kuwait, Qatar and
Venezuela;
Contracts by which countries of the former Soviet Union and Eastern Europe provided
assistance to developing countries up until the late 1980s, such as Cuba, India, Pakistan,
Yemen and Ethiopia;
Association agreements for the development of new elds on behalf of a national oil
company, for example in Abu Dhabi, India and Benin.
It should be noted that some technical assistance contracts give the contractor the right
to purchase a proportion of the oil produced. The contractor is usually subject to the tax law
(prot tax) of the host country.
5.6 IMPACT OF THE ECONOMIC RENT SHARING ON EXPLORATION

AND PRODUCTION ACTIVITIES
5.6.1 Flexibility and investment incentives

5.6.1.1 Specic nature of each exploration and production project
Petroleum exploration/production agreements are an expression of the commitment on the
part of the signatories to seek to develop the hydrocarbon resources in a given geographical
zone having specic characteristics.
Many provisions in a contract are independent of the characteristics of the zone to be
explored. These include, for example standard legal provisions, matters relating to the
conduct of onshore or offshore operations and the keeping of accounts.
On the other hand there will be a number of clauses which take account of the specic
characteristics of the zone to be explored: exploration risk, type of hydrocarbons, location,
204
existing infrastructure, level of costs, etc. These clauses will also have regard to the inter-

national oil market, both at the date of signature of the contract and in terms of anticipated
developments during future production. They relate to the following aspects:
The duration of the exploration programme, the area to which the licence applies and
the relinquishment terms;
Minimum exploration work or expenditure obligations;
The basis for sharing the economic rent between the State and the contract holder;
The conditions for the disposal of the production.
These issues will be the main focus of attention in the negotiations and the decisions taken
by oil companies when entering into a contract or licensing arrangement.
Fiscal and contractual provisions designed for a particular zone or in particular market
conditions cannot simply be transplanted without modication to other zones. A contract,
and more generally a rent-sharing arrangement, must be suited to the context, and be suf-
ciently exible to accommodate expected and unexpected changes.
Incentives can also be introduced to foster investment in special zones such as unexplored
basins, deep offshore, remote onshore locations, the Arctic, rain forest or the desert. Incen-
tives may also facilitate the development and exploitation of natural gas elds.
5.6.1.2 Lack of exibility in traditional contracts and tax systems

Traditional contracts and tax systems here refers to either a concession regime with a xed
royalty rate and a tax on prots or a production sharing contract with a xed rate of prot
oil split.
In both these cases the return to the oil company and the States oil revenues vary consid-
erably depending on the characteristics of the eld which directly affect costs (location, size
of reserves, well productivity), and hydrocarbon prices. The commercial viability of a
discovery of hydrocarbons is very sensitive to parameters of this kind.
Simple economic simulations show that there is a gearing effect associated with the tradi-
tional systems with xed rates. Less favourable cases are shown in an unduly harsh light,
while the attractiveness of more favourable projects tends also to be exaggerated. In the case
of a marginal discovery the unit technical costs are usually high, and the expected return
may be adjudged too low. And conversely, in the case of larger discoveries with lower unit
technical costs, the expected return may appear high, or very high where the reserves exceed
certain levels. This can lead to an imbalance in the sharing of the prots between State and
operator, making subsequent negotiations necessary to nd a fairer basis.
Producing countries realised that contractual and scal regimes needed to be devised
which properly addressed these different scenarios. Most countries have gradually adapted
their scal systems to make them more exible, introducing systems which are often original,
but are also increasingly complex and multi-staged. Practical difculties have arisen in
implementation, computational methods and audit which were not foreseen when they were
conceived, but which have often necessitated adjustments to the new contracts. The mech-
anisms used are reviewed below.
5.6.1.3 The objectives of a exible system

In economic terms, the tax formulae and parameters relevant to the sharing of the economic
rent need to be able to deal with two contrasting scenarios.
205
Firstly, they need to be capable of improving the economics of marginal discoveries,

which are becoming increasingly common, so as to encourage oil companies to explore and
develop. This involves the State being willing to assume part of the risk and give up some
potential short-term revenue. This short-term loss will be offset by long-term benet,
however, because activities are generated which would not otherwise have occurred. This
trade-off between the long and the short term is a crucial political choice for a country.
The second need is to prevent the company from reaping excessive prots, i.e. which go
beyond the limit of acceptability. In this case the State share of the revenues needs to be
increased. But at the same time the regime must be careful not to discourage investors by
removing any prospect of a healthy prot commensurate with the risks run.
During the period 19731981, when crude prices were rising, there was a swing in most
countries, both industrialised and developing, towards the second objective. This period saw
the introduction of excess prot taxes on petroleum additional to normal taxes or prot oil
splits moving in favour of the State. But circumstances have moved on since that time. There
were two subsequent new developments, already referred to earlier: a steady decline in
prices during the period 19811986 followed by a period when prices were volatile but uc-
tuated widely around a fairly moderate price until the end of 1998; and increased opportu-
nities in countries formerly closed to the international oil companies, particularly since 1990
in the CIS countries and Eastern Europe, but also Latin America and the Middle East.
There has been a steady shift in the approach of the two parties during this period:
investors have gradually come to accept the principle of a high State take in the event of
exceptional prots, and conversely host countries are conceding that they need to reduce their
take in order to foster less protable projects or compensate for a reduction in oil prices.
The sustained level of high oil price since the early 2000s has resulted in exceptional
prots, so that a growing number of producing countries have claimed a higher state take
and have introduced relevant contractual and scal provisions to reach this objective.
5.6.1.4 Instruments for exibility in concession regimes

A. Progressive rates of royalty on production
A xed rate is replaced by a rate increasing progressively to reect:
Annual production;
Type of location (onshore, shallow offshore, deep offshore);
The date of discovery (old oil, new oil);
The type of hydrocarbons (crude oil, natural gas);
The effective return on the project (such as a protability ratio recalculated each year,
a rare system introduced in Tunisia in 1985).
As was stressed in Section 5.3.2.8, the royalty on production can have a considerable
economic impact, even if progressive in structure, because it is a tax on turnover. Some coun-
tries have therefore taken the radical decision to dispense with royalties altogether in certain
conditions. For example for oilelds where the annual production is below a certain threshold
or, as in Norway, for all elds declared commercial on or after 1 January 1986, whatever
their production turns out to be. This measure was taken when a rather pessimistic view was
being taken about the prospects for crude prices, and was intended to revive activity in
Norway by encouraging the development of marginal oilelds and satellites of existing
oilelds.
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B. Investment incentives

These can take the form of investment credits, depreciation uplifts or a variety of other
devices which reduce the tax burden falling on the companies. This category includes the
consolidation for tax purposes of all the exploration and production activities in a particular
country rather than ring fencing each concession. This allows the holder to offset his explo-
ration costs at one location against his revenues arising from production at another. This
amounts to an indirect subsidy by the State, and the higher the tax rate the greater the value
of this tax relaxation.
C. Progressive prots tax rate

This mechanism is fairly rare. It was introduced in Tunisia in 1985, for example, where a
progressive tax rate applies depending on a protability ratio recalculated each year, like the
royalty. The complication lies in the fact that the scale is not the same as that established
for the royalty and, what is more, is different for oil and gas.
Another possible incentive is to allow a temporary exemption from prot tax during the
rst years of production.
D. Progressive rates of participation by the State

The rate of participation by the State can also be made progressive, depending on the same
types of parameter as those mentioned for royalties.
E. Excess prot tax

As already mentioned in Section 5.3.2.10, many countries introduced this tax in various
guises in the 1980s: the Special Tax in Norway, the Petroleum Revenue Tax in the
United Kingdom, the Windfall Prot Tax in the U.S. and the Exceptional Levy in
France. The adoption by OPEC countries of higher rates of taxes on prots up to 85% in
some countries can also be regarded as an excess prot tax.
These instruments have an impact on the protability of the holder, but experience shows
that they are not sufciently selective in achieving the necessary objectives. They are in fact
based either on the excess of the oil price over an indexed base price (in the case of the
windfall prot tax) or on a pseudo-protability criterion calculated on a purely accounting
approach (the petroleum revenue tax) rather than being based on the true economic prof-
itability of the operations in question.
Because of these considerations, some countries Papua New Guinea (1976), Mada-
gascar (1981), Somalia (1984), Guinea-Bissau (1984), Senegal (1986), Australia (1988) and
Namibia (1991) have introduced a resource rent tax, calculated directly from the
effective protability of an exploration and production project.
Most of these instruments ceased to operate after prices fell to levels well below those
applying in the 1980s. However with the increase in oil price, they may be automatically
reactivated.
As already mentioned, some countries have re-introduced this kind of excess prot tax
(UK, Alaska, Ecuador, Algeria).
5.6.1.5 Instruments for exibility in production sharing contracts

Because of the principles which underlie it, it is easier to modify the terms of a production
sharing contract than those of a concession. This can be achieved by modifying the cost
207
recovery mechanisms and dening a sliding scale for the prot oil split, because the para-
meters concerned are the result of a negotiation process rather than being enshrined in the law.
A. Modications in cost recovery mechanism

This can involve:
Adopting a variable cost stop;
Modifying the period over which investments are recovered;
Introducing an investment credit or uplift similar to that described in relation to the
concession system.
B. Modications in the prot oil split

A xed prot oil split is an overly rigid instrument which is only appropriate in zones where
operating costs remain practically constant. Using the same concept as mentioned earlier, this
parameter could be based on a sliding scale which increases with the annual production or
the cumulative production from an oileld. This mechanism would represent a worthwhile
improvement, provided a signicant relationship can be established between the production
level and the potential return to the contractor, which is not always possible. This system
does not allow changes in the price of oil to be taken into account directly.
The introduction of a price cap increases the share accruing to the State when the price
of oil rises beyond a certain threshold, indexed to allow for ination: this device is found in
certain contracts in Angola and Malaysia.
There are various types of mechanism which allow a linkage to be established between the
share accruing to the contractor and the effective protability of his operations, as follows:
The introduction of an excess prot tax (as described for concession) which the contractor
pays in cash on his share of the prot oil, the latter being determined using the same rules
as for a conventional shared production contract (Tanzania, Trinidad).
The prot oil split can be made a function of the effective rate of return. In the early years
all production with the exception of a small deduction for the State can go the contractor.
The State share then increases progressively in a manner similar to that described for
concession. This device has been adopted by two countries, i.e. Liberia and Equatorial
Guinea, but did not achieve the success hoped for because of difculties in putting into
effect the necessary calculations.
The prot oil split can be made a function of a protability ratio, or R-factor, calculated
each year as the ratio of the contractors cumulative net revenue to his cumulative invest-
ments. The amounts are calculated each year, and accumulated from the rst year of the
contract. The contractors share of the prot oil reduces as the R-factor increases according
to a scale set forth in the contract. Unlike the device described previously, and even if the
calculation and auditing procedures need to be dened precisely, the latter is far less difcult
to implement. This instrument has therefore enjoyed increasing success and has been
adopted, for example, in the following countries: India (1986), Egypt (1987), Ivory Coast
(1990), Algeria (1991), Libya (1991), Nicaragua (1998), Peru (1998) and Cameroon (2000).
5.6.2 Comparison between systems

Comparing different systems of sharing the economic rent is a delicate business, involving
several difculties. In particular, the economic calculations which underpin them are often
208
made on a stand-alone basis, with no allowance for the possibility of consolidation with other

activities in the country or region. Furthermore the technical conditions prevailing in one
country may not be reproduced in another. And nally, the fact that the contracts tend to be
strictly condential does not make it any easier to get data; those obtained from indirect
sources may not be reliable.
While bearing in mind the reservations described in the foregoing, it is possible to rank
the relative severity (from the investors point-of-view) of the economic rent sharing systems
throughout the world by reference to the simple criteria of the total Government take. This
parameter is expressed as a percentage. The word Government is taken in its widest sense,
including any national petroleum companies with a participation in the petroleum operations.
The calculation is performed for the simulated total duration of exploration and production.
It should not be confused with the marginal Government take, calculated after all investment
costs have been written off or recovered, and which is higher.
A high value for this percentage corresponds to a basis which is favourable to the State
and harsh for the investors. Obviously whether or not a system is harsh depends on the
petroleum potential of the country. However activity levels are not necessarily inhibited by
a severe system as long as the country in question has a well demonstrated potential or is
very prospective. On the other hand countries with little or no production, or where
production is declining and which are not able to renew their reserves, have no choice in
the current very competitive environment but to try to entice inward investment into the
country by offering an attractive package.
To illustrate this, a number of countries with diverse backgrounds are classied below
according to the State take. The classication is approximate, and more careful analysis might
lead to some changes.
Between 30 and 50%: Argentina, Colombia, US (Gulf of Mexico), Ireland, Morocco, New
Zealand, Peru, United Kingdom;
Between 50 and 75%: Angola (Deep offshore), Australia, Cameroon, Egypt, Ecuador,
Gabon, India, Indonesia, Malaysia, Russia, US (Alaska);
Over 75%: Algeria, Bolivia, China (offshore), Iran, Libya, Nigeria, Norway, Oman,
Yemen, Trinidad & Tobago, Venezuela. In this category, Iran (buyback contract), Libya
and Venezuela are around 90%.
Some countries appear in different categories because they offer different terms for
different zones. The countries in the rst category are largely industrialised countries which
are producers and consumers, and whose economies are not greatly dependent on their
upstream oil activities. The second category is the most numerous, and comprises a hetero-
geneous group of countries with modest or moderate production, with petroleum policies
which depend on their level of development. The countries in the third category are
producing, and in many cases exporting, countries whose economies are highly dependent
on these activities.
There is increasing competition between countries to attract investors and to offer
attractive conditions. A token of this is the periodic revisions which countries make in their
legislation, tax regimes and contractual arrangements. This was exemplied by Cameroon
and Morocco, which made major changes in their systems in 2000. Morocco introduced tax
incentives, and is hoping to be able to attract deep offshore activity to its shores. Cameroon
made sweeping changes to its systems, and also provided incentives to attract renewed
exploration so as to reverse the downward trend in its production.
209
Conservely, producing countries with expected additional upsides, have recently intro-
duced revisions aiming at increasing the State take.
5.6.3 Perspectives
In order to assess fully the upstream petroleum activities, it is vital to have knowledge of
the legislative, scal and contractual framework alongside the technical side and results of
appraisal of the petroleum potential. These aspects lie at the heart of the relationship between
petroleum-producing countries and investors, and play a crucial part in determining how the
economic rent is shared. The objective is to try to optimise the benets for both parties.
On the basis of a number of relatively simple principles, universally accepted by the inter-
national community and of a number of systems usually adopted by countries, this chapter
has outlined the huge diversity of instruments possible, both regulatory and economic.
The terms offered by countries have evolved in response to a whole range of technical,
economic and political parameters. Over the last twenty-ve years international exploration
and production have become quite competitive. New regions once closed to international
investors or inaccessible within the technological constraints then applying have been opened
up, thereby considerably increasing the choice of countries for possible investment. The oil
companies have then become more selective because of budgetary constraints when prices
are low, and there has at the same time been a reduction in the number of oil industry partic-
ipants as a result of mergers and acquisitions. These large corporations apply different
criteria with regard to the required return on investment from those used by the smaller inde-
pendent companies. One consequence of the increase of the prices is a trend followed by
the independent companies to invest in risky new areas when they made signicant discov-
eries like Tullow in Uganda, Kosmos Energy in Ghana and Noble Energy in Israel.
It seems likely that the trend towards increased competition between actual and potential
hydrocarbon-producing countries will continue, resulting in still more exible tax regimes
and contracts. This tendency is particularly discernible in regard to exploration and
production in more challenging environments. However competition also exists between oil
companies which need to secure and renew their reserves. In parallel, established producing
countries wish to benet from the sustained increase in oil price, so that they have introduced
new contractual and scal provisions to increase the global State take. Not all countries are
in the same boat, however, or carry the same weight on the international scene. It is to be
expected that a number of countries which still have enormous potential Saudi Arabia,
Iran, Iraq, Kuwait and Mexico will open up to the international industry.
210
6 Decision-making on
exploration and production
The petroleum sector is a capitalistic industry par excellence, and investment decisions in
the industry are absolutely crucial. This chapter therefore deals with the evaluation of capital
projects. Our object is not to provide the reader with a potted manual on project evaluation,
but rather to address a number of topics specic to the upstream petroleum industry, while
recalling a number of more general principles.
We shall begin by introducing the concept of strategic analysis which will help to establish
the main constraints within which the project evaluation will be performed. We shall then
touch briey on questions which arise in connection with short-term decision-making, before
turning to the techniques for estimating the return on capital. In this connection we shall rst
discuss deterministic methods before addressing, in the last section, the topic of risk analysis
and decision-making under conditions of uncertainty.
6.1 STRATEGIC ANALYSIS AND DEFINITION OF

THE OBJECTIVES OF THE COMPANY
The strategies of many smaller enterprises are based purely on the intuition of senior
management. Most large oil companies, however, use systematic procedures to determine
the broad lines of their strategic orientation, and to illuminate the context in which decisions
are taken on large investment projects. In so doing, use is made of a range of well estab-
lished concepts and methodological tools, such as M.E. Porters analytical framework, BCG
(Boston Consulting Group) matrices, etc. In this section we shall present a number of
methodologies used in the upstream oil industry, before going on to consider briey how oil
companies organize their strategy departments and strategic thinking.
6.1.1 Understanding the environment in which the company is operating

In order to dene the strategic options it is obviously necessary to have a good understanding
of the environment in which the company is operating. One of the missions of the department
211
Chapter 6 Decision-making on exploration and production
in charge of strategy is therefore to monitor constantly and analyse the markets for crude
price behaviour, the relationships between the participants, the political risks, etc. These
elements were touched on in Chapter 1, and we will not dwell on them further here. Visions
of the medium and long-term future are often expressed in the form of scenarios. Shell has
established a reputation in this area which goes back many years. Where a comprehensive
scenario is not available, it is necessary to specify a number of reference hypotheses so as
to ensure the consistency of the analyses carried out by the different sectors of the company.
Particularly important amongst these assumptions are those relating to technological
development. While forecasts are difcult in this area, they have a major impact on a certain
number of options. A decision to develop interests in natural gas inevitably involves making
forecasts of future demand and the way the market will evolve. But it will also depend on
the anticipated reduction in the costs of liquefaction and transport. Similarly, companies
involved in producing extra-heavy oil in the Orinoco Belt were not simply betting on the
eventual scarcity of conventional oil. They were undoubtedly also banking on future
processing improvements, and therefore on better recovery rates and reduced production costs
for resources of this kind in the future.
6.1.2 Strengths and weaknesses

Opportunities are usually identied by comparing the proposals of the operating companies
in the group with analyses of the external environment. A strengths and weakness analysis
is then carried out, both for the competitors and for the company itself. It is usually carried
out for each separate business, and relates to all the factors which affect competitiveness:
technology, nance, human resources, organizational aspects and political factors. In looking
at competitors, their intentions also have to be analyzed. While some are very clear to see,
others are only revealed by a closer scrutiny of their activities. The numbers of patents
applied for may be an indication of technological preoccupations, while acquisitions, divest-
ments and changes in shareholdings may provide indications of orientations, a refocusing
on core activities or geographical diversication. Presentations made at road shows may also
be a source of information.
Know thyself enjoined Socrates. It is difcult to be objective about ones own strong
and weak points. A team which has proven its worth in one country may not necessarily be
the most effective in another country or environment. This notwithstanding, it is obviously
of crucial importance to assess critically ones own company.
6.1.3 The portfolio of activities

In exploration/production the maturity of a sector is undoubtedly a more relevant criterion
than market share. In seeking a balanced portfolio a company may follow the Boston
Consulting Group in seeking balance not between products but between sectors of activity
or project types. To preserve viability in the long term, the portfolio needs to include activ-
ities which may not justify themselves on the basis of present protability only, but which
may become protable in the future as a result of changes in technology, markets, regula-
tions, etc. Deep offshore may therefore be regarded as a star, certain high-risk countries
may be viewed as question marks or even as dogs, while the cash cows are well
known: these are the projects which allow the company to participate in pioneering projects
without putting it in nancial jeopardy.
212
In this connection, the fact (actually self-evident) is that that it may be necessary to

venture beyond the connes of exploration and production activities to take full advantage
of foreseeable developments. The acquisition of rening and even distribution interests may
make it possible to gain a foothold in a producing country about to open up its upstream
activities to international companies. It was undoubtedly this desire ultimately to gain access
to the upstream oil industry that explained why so many companies expressed interest in the
gas projects announced by Mexico and Saudi Arabia in 2000 and 2001.
The desire for a balanced portfolio is also based on considerations of risk, one of the
objectives being to reduce the overall risk associated with the portfolio through diversi-
cation. This is one of the reasons why oil companies have long collaborated with one another
on projects. Generally speaking it can be assumed that there is no correlation between the
technical/geological risks, or more generally the risks related to the size of the reserves, for
different projects. By increasing the number of projects we therefore reduce the risks for the
portfolio as a whole.
It should be noted, however, that increasing the number of projects does not entirely
reduce the risks associated with variations in the price of oil because nearly all oil projects
(that is, with the exception of projects governed by service contracts) are sensitive to price
uctuations. But this sensitivity can vary signicantly between zones, depending on the cush-
ioning effect of the tax regimes in place.
The practice of sharing capital costs between competitors is characteristic of the upstream
oil industry, and is not common in other industries.
6.1.4 Alliances
Although risk reduction is the most common reason for the associations observed in most
large projects, political motivations should also be mentioned. The inclusion of certain
partners can sometimes provide an insurance policy, contributing decisively to the
successful realisation of the project. Totals choice of partners in Iran was probably not based
purely on economic considerations, but also on a desire to reduce the political risk. In
general terms, and quite apart from mergers and acquisitions, strategic alliances provide a
way of acquiring new skills and can provide an entry ticket into new activity sectors or coun-
tries. A particular focus in recent years has been the alliances between international corpo-
rations and national companies in producing countries.
6.1.5 Strategy Department: organisation and functions

The organisation of this department can vary greatly between one group and another, and
we conne ourselves to a number of observations.
Responsiveness is a very important attribute for success. A signicant proportion of the
opportunities in the upstream oil sector need to be grasped fairly quickly, either for political
or economic reasons. The organisation should therefore be geared up to take rapid decisions,
whether mainly at operating company or at group level. Most strategic projects are in new
zones or activity sectors. The latter are analyzed by a central group (which may, as in the
case of BP, be non-hierarchical), whose role is more than merely to coordinate.
A medium-term plan is usually constructed, bearing in mind that planning should not be
regarded as inconsistent with exibility. The plan for the group is obtained by aggregating
together and synthesizing the plans prepared by the different subsidiaries or operating units.
213
The preparation of these plans creates a channel of communication between head ofce and
the other companies in the group. The latter enter into commitments in some areas and, in
other areas, propose options for possible changes.
The selection criteria and project analysis tools are determined by the Strategy Department
in consultation with the Finance department: discount rate, techniques for analyzing risk,
project briefs, resource allocation when capital is rationed. There will be one or more sets
of macroeconomic hypotheses associated with these criteria and the way they are applied,
in order to ensure overall consistency.
A crucial tool in the evaluation of projects is the discount rate or rates, and determining
this rate for the company is therefore of particular importance. Its value cannot be derived
by mechanically calculating the cost of capital, which is in fact never dened very precisely.
The use of a relatively high discount rate tends to result in a creaming of projects. It
reduces the likelihood that projects will turn out post hoc to be unprotable, but leads to
opportunities being rejected which may be grasped by the competition. On the other hand
setting the discount rate to the lowest possible value consistent with the data on the cost of
capital will tend to foster development and increase market share. This can be compared with
the strategy adopted by Shell, which has grown more rapidly than Exxon in recent years.
The latter, on the other hand, has obtained a better return on its capital, preferring to buy
back its own shares rather than invest in projects not offering the desired return.
In setting its discount rate a company is therefore also expressing its own strategic orien-
tations. This is true at the level of a single company, but also for each sector of activities
within a group. The petroleum sector therefore often uses different discount rates for different
categories of activity, even within the exploration/production sector. These discrepancies may
be due to differences in the nancial methods applying, to differences in the risk prole, but
may also be an expression of strategic decisions: setting a high discount rate acts to limit
investment budgets. On the other hand, setting a relatively low discount rate can be a way
of factoring other indirect benets into the equation. When oil companies were integrated,
for example, some companies used to use low discount rates for downstream projects in order
to promote the development of the rening sector and distribution networks. This was
justied not in terms of the protability of these activities but in terms of the access it gave
to outlets for crude production. More generally, adjustments in the discount rate can be used
as a means of balancing an oil companies portfolio of activities.
6.2 ECONOMIC EVALUATION (DETERMINISTIC)

AND SHORT-TERM DECISION-MAKING
Before getting on to the appraisal of investment projects, we shall review in this section some
of the analytical principles of short term decision-making. Decisions during the operating
phase usually only have a short-term effect (one year, for example), and therefore generally
do not involve complicated methodological issues. They may involve risk analysis and
probabilistic calculations, but questions of this kind are considered in Section 6.4. We shall
conne ourselves here to deterministic calculations, that is we either assume that the conse-
quences of a particular decision are perfectly known or we make use of one or more dened
scenarios representing possible futures.
This being the case, the economic analysis is, broadly speaking, limited to making a
comparison of the expenditures and revenues involved for the different possible options. But
214
many of the decisions which need to be taken correspond to modications which may be

made at the margin of a production programme. These decisions can be usefully analyzed
by a marginal analysis, a practice we all use, whether or not we realize it! This can be
exemplied by considering a problem of secondary recovery by polymer injection during the
last year or years of production of a reservoir. The problem is to decide on the quantity of
uid to be injected. Table 6.1 shows the quantity Q of crude oil which can be recovered as
a function of the quantity of uid injected, and therefore of the corresponding cost C during
the year studied. The operation involves a declining marginal yield and increasing marginal
costs.
There is no further increase in the production of crude once the quantity injected reaches
73 000 m3.
Table 6.1 Polymer injection.
Quantity of uid injected (103m3) 25 32 40 49 60 70 73

3
Quantity of oil produced (10 bbl) 27.7 33.8 40.0 47.5 55.7 61.0 62.0
Cost ($ 000s/year) 383 500 585 660 745 840 880
CM ($/bbl) 13.8 14.8 14.6 13.9 12.9 13.8 14.2
Cm ($/bbl) 19.2 13.7 10 10.4 17.9 40
These data can be used to construct the graphs in Figure 6.1 which show how the total
cost, average cost and marginal cost of the crude produced by secondary recovery vary as
a function of the additional quantities recovered.
dC
Marginal cost Cm =
dQ
C
Average cost CM =
Q
Assume the wellhead price of crude, P, is $15/bbl. If P is independent of the volume of

production then the marginal calculation is very simple: when the quantity injected is low,
the marginal cost is less than the sale price. This means that it is worthwhile to increase the
volume injected, so increasing production. This can be increased as long as the marginal cost
Cm is less than the sale price P. Production is optimized when Cm = P.
Injection will be employed if it makes a positive contribution to prots, that is if the
average cost is less than the sale price. In accordance with the theory1, we note that the
average cost CM is a minimum when Cm = CM.
If the wellhead price of crude is $15/bbl, then prots are optimised for an additional
production of crude of about 57 000 bbl/y, obtained by injecting a volume of approximately
62 000 m3. The average cost of the additional crude will be of the order of $13/bbl, less than
1. The mathematical demonstration of this property is simple, and relies on marginal reasoning: when the
marginal cost is less than the average cost, i.e. Cm < CM, the cost of a small increment in production will
result in a reduction in the average cost. On the other hand when Cm > CM the average cost increases.
215
the sale price, so that injection is worthwhile. It should be noted, however, that this cost is
close to the sale price. It may be, therefore, that the decision will be taken on the basis of
other considerations and criteria: uncertainty as to the behaviour of the reservoir, a desire to
gain experience with injection, etc.
Box 6.1 Marginal analysis.
For a production facility which manufactures a single product, the optimum production
level is generally not that which minimises average costs.
Over a short period, and for a given set of equipment, the level which maximises prots
is that for which the marginal cost (cost of the last unit of production) is equal to the
marginal receipts (receipts procured for the last unit of production) (subject to appro-
priate assumptions regarding continuity, differentiability, increasing marginal cost being
satised).
If the sale price is independent of the level of production, production is optimised when
the marginal cost is equal to the sale price. This can readily be proved mathematically
by setting the derivative of the prot function Pr = PQ C equal to zero.
It can be seen that the curves in Fig. 6.1 have a U-form similar to that traditionally shown
in microeconomics textbooks. This is rarely the case in the rening and petrochemical
sectors, where the cost function is often best represented by considering the cost C as the
sum of a xed term and a term proportional to the volume processed, at least as long as the
capacity of the plant is not exceeded.
Annual cost Mean / marginal cost

900 30
800 Cm
25
700
20
600
15
500 CM
10
400
Additional production Additional production
300 5
20 30 40 50 60 70 20 30 40 50 60 70
Figure 6.1
6.3 DECISION-MAKING IN RELATION TO DEVELOPMENT

AND THE DETERMINISTIC CALCULATION OF THE RETURN
The chronology of upstream operations in the industry should ordain that decisions on
exploration are dealt with before decisions on development. But the former are based on
216
probabilistic calculations and on risk analysis techniques, which cannot be carried out until

we have quantied the value created (or destroyed) for the various outcomes of the decision
being studied. It is this quantication, based on deterministic calculations specic to a
particular assumption, which is the subject of the present section. In Section 6.4 we shall
look at the effect of taking account of uncertainty and applying probabilistic methods.
After making a few observations regarding the discount rate we shall present methods for
evaluating investment projects. The basic principles will be reviewed in boxes incorporated
into the text.
6.3.1 Discount rate and the cost of capital

6.3.1.1 The cost of capital
A deterministic evaluation of an investment project is primarily a matter of comparing cash
ows received and disbursed at different dates. The technique by which this is done is known
as discounted cash ow: this technique involves applying coefcients to cash ows occurring
in different years which make them comparable (see Box 6.2). The discount rate is generally
dened as the average cost of capital. The most common method outside the upstream
petroleum industry involves using a weighted average cost of capital after tax (WACC
standard method). The cost of debt is therefore calculated after tax, i.e. (1 t)d, in nominal
terms, where d is the cost of debt in current prices before tax and t is the tax rate. Since
interest is usually deductible from prots before the calculation of tax, the payment of O 1
of gross interest generates a tax saving of O t.
Box 6.2 Discounted cash ow.
If we suppose that there is no uncertainty about the future, and that there is a perfect
capital market (i.e. a market in which any economic agent can lend or borrow any sum
of money at a unique rate of interest i), then a sum S0 in year 0 is precisely equivalent to
a sum S0(1 + i)n in year n, since either can be exchanged for the other. On this basis, a
sum Sn available in year n is equivalent in year 0 to its present value (or discounted
value):
Sn
(1 + i )n
In practice, real markets are not like this. A company has different sources of nance
(retained earnings, share issues, loans, etc.). The discount rate is therefore the cost i of
all its capital. This is generally a weighted average, equal to the marginal cost of nance
assuming the proportions of the different types of capital remain the same. The discount
rate can be regarded as the price at which the nancial department is willing to provide
capital funds to the department(s) responsible for the study and for implementing the
investment project.
It should be pointed out that the above theory does not depend on the assumption that
the rates of interest applying to money lent and borrowed are equal. In practice if a
company has funds available at a given time, these funds will generally not be lent out
at the market rate, but will allow the company to reduce, during the period in question,
its need to raise capital at a cost of i. The effect of this is therefore the same as if the
money were invested at a rate i.
217
In costing equity capital, the most commonly used approach is the Capital Asset Pricing
Model (CAPM), based on nancial theory (see Box 6.3). This was the method adopted by
Elf Aquitaine in 1998 when it revised its discount rate. The parameter is obtained by econo-
metric methods. Various studies have obtained values of less than 1 for the oil industry: of
the order of 0.9. Where an oil company is active in a number of different sectors, the coef-
cient can vary signicantly between sectors. Moving downstream from traditional
petroleum activities, values for of between 0.4 and 0,5 are observed in the pharmaceuticals
and cosmetics industries.
Box 6.3 The Capital Assets Pricing Model (CAPM).
This model gives a method of quantifying the cost of equity capital as the return
expected by the shareholders, which can be considered to be equal to the return on risk-
free investments, increased by a risk premium. This risk premium relates only to
systematic risks affecting the share market as a whole. In practice, non-systematic or
specic risk, that is risks related to individual companies, can be reduced (vanishingly)
by portfolio diversication.
Based on the model, the risk premium can be expressed in the form:
(rM ro)
where:
rM is the average return offered by all shares (market return),
ro is the return on risk-free investments,
is a parameter representing the ratio of the covariance between the companys
return on capital and the average return for the market as a whole to the variance of the
latter. It can be calculated from stock market statistics.
6.3.1.2 Different discount rates

As indicated in Section 6.1, it is quite common for oil companies to use different discount
rates for different sectors, and sometimes for different geographical zones. Leaving aside
strategic considerations, these differences are mainly related to the need to allow for risk.
The coefcient , which characterizes the systematic risk to which the shareholders are
exposed, can vary between one activity and another. The same is true of debt ratios, with
the permissible debt ratio being a function of the risk involved: exploration is practically
never funded by debt, while most development projects are funded in part by debt, and
indeed the latter may exceed the equity element. This reduces the average cost of capital. It
should also be mentioned that specic risk premiums are sometimes added to the cost of
capital calculated in the manner described. Remember that this calculated cost of capital
already includes, in the estimate of the cost of equity, a systematic risk premium. This
practice will be analyzed briey in the next section.
6.3.2 Constructing a schedule of cash ows, operating cash ows,

general remarks
Economic evaluations involve determining the net cash ow in future years, i.e. cash inows
minus cash outows.
218
The cash ows are dened relative to the situation in which the project is not imple-

mented: only those future ows related to the decision being evaluated should be brought
into the calculation. A cash ow usually involves (with a few exceptions, such as the residual
value of an item of equipment remaining at the end of the period studied) a real movement
of funds, and not a mere accounting concept. An important difference between cash ows
and prot and loss accounting relates to the treatment of depreciation. Depreciation does not
involve the physical movement of funds in or out. Depreciation only has an indirect impact
on cash ow insofar as it affects tax payments: depreciation can be a deductible expense in
calculating taxable prot.
Forecast cash ows can be expressed either in nominal (current) or in real (constant)
terms. In nominal terms (current money), the receipts and expenditures in year n are entered
in terms of the money of the day. Real terms (constant money) are notional monetary units
in which the purchasing power remains constant and equal to that in a reference year. If year

0 is the reference year and we assume a constant annual rate of ination of d, the value Fk
in real terms for year 0 of a ow Fk in year k dened in nominal terms, is given by:
Fk
Fk =
(1+ d )
k
Although in practice calculations may be carried out either in real or nominal terms,
American companies generally advocate that calculations are made in nominal dollars, thus
ensuring that the monetary units used in economic evaluations and accounting and tax docu-
ments are the same.
In the rst place we shall conne ourselves to looking at operating cash ows; these
do not bring into the calculations any debt-related ows, corresponding to calculations of
the overall return on capital.
6.3.3 Evaluation criteria for investment projects:

net present value (NPV) and rate of return
6.3.3.1 Net present value or discounted cash ow
Box 6.4 Net present value.
The net present value (NPV) is the algebraic sum of the present values of all cash ows
Fk associated with the project:
N n
1+ i
Fk Fk
NPV = =
( ) (1 + i)
k k
k =0 k =0
where:
Fk : cash ows in nominal terms,

Fk : cash ows in real terms of year 0,
i : discount rate, nominal terms,

i : discount rate, real terms,

where 1 + i = (1 + i ) (1 + d ).
219
The net present value is an absolutely fundamental concept in economic evaluation. It is a

measure of the value created by an investment and is equal to the maximum sum which can
be borrowed in year 0 (by the project department from the nance department), in addition
to the capital cost of the investment, such that the revenues generated by the project will
repay the total of these amounts and give a return equal to the discount rate.
The NPV criterion: a given project which is independent of any other project will be
realized if the NPV is positive. In choosing between a number of mutually exclusive projects,
the project with the highest NPV will be chosen.
6.3.3.2 Internal rate of return

The (internal) rate of return of a project is the value of the discount rate which equates the
projects NPV to zero. When its value is unique, in particular for a simple project (i.e.
negative cash ows followed by positive cash ows) this parameter is equivalent to the
maximum rate at which the project revenues can remunerate the capital invested without the
project becoming loss-making (Fig. 6.2).
Present value
r Discount rate
F0
Figure 6.2 Graphical representation of internal rate of return.
This is equivalent to checking whether the rate of return on the project is greater than the
discount rate or whether its NPV is positive. In choosing between two exclusive projects A
and B, the project with the highest rate of return is not necessarily that with the highest NPV.
The project with the greater capital cost, B, will be preferred if the incremental rate of return
of B with respect to A is higher than the discount rate (the incremental rate of return is the
rate of return on the incremental investment involved in investing in B instead of A).
If the rate of ination d is stable during the study period, the rate of return in nominal
terms, r, and in real terms, r-, are related as follows:
1 + r = (1 + r-) (1 + d )
r r- + d
220
6.3.3.3 Early production, multiple rates of return

When studying the development of a reservoir it is usually appropriate to compare different
production alternatives (for example relating to the number and locations of wells). One of
these variants may be the option to deploy an early production system. Such a situation often
leads to multiple rates of return, a phenomenon uncommon in other sectors.
Multiple rates of return cannot occur unless forecast net cash ows display several
changes of sign over time. This is the case, however, when we are looking at a project which
involves accelerated production. What happens is that the capital expenditure (negative
cashows) leads to an accelerated or increased production in the early years (positive cash-
ows), and a loss of receipts in later years (negative cashows).
When the NPV associated with this cashow schedule is plotted against the discount rate,
there may be two zeros, indicating two rates of return (see Fig. 6.3). The net present value
of a project involving early production will be positive between these two values. Obviously
in a case such as this great caution is necessary in using the criterion of rate of return as
dened in the previous section.
NPV
I (%)
10 20 30 40 50 60 70
230
Figure 6.3 A multiple rate of return.
6.3.4 Equivalent cost

When studying an investment project, the sale price of the hydrocarbons produced may be
subject to uncertainty. It can then be very useful to determine the minimum sale price
needed to ensure that the project is protable, or in other words to calculate the equivalent
cost of production.
Determining the equivalent cost allowing for tax and recalculated to a before tax basis is
simplied when calculating an equivalent cost after tax is relevant, particularly in cases where
the project accounts are consolidated with those of other activities, the total being in prot
because a known tax allowance can be associated with every item of deductible cost.
In exploration/production it is common, due to the practice of ring fencing, for this not
to be the case, with some projects giving rise to losses which are carried forward. These
221
Box 6.5 Equivalent cost.
The equivalent cost, in annual or unit form, is an (annual or unit) equivalent of the total
costs associated with a project. It includes both the operating costs and an investment
equivalent cost. We consider here only the case where it is appropriate to regard it as
constant over time, when it can be assumed that the annual receipts or the sale price of
the products will remain stable during the study period. When an annual equivalent cost
is determined, it is a constant annuity equivalent to the sum of the present values of the
capital and operating expenditures. The unit equivalent cost, or average discounted cost,
is the ratio of the sum of the present value of expenditures to the sum of the present value
of production.
A project has a positive net present value if and only if the annual (or unit) equivalent
cost is less than the annual receipts (or the sale price of production).
Allowing for the effect of tax, the unit (or annual) equivalent cost allowing for tax and
recalculated to a before tax basis , is equal to the sale price (or annual receipt) such that
the net present value is zero.
losses engender tax savings only when the taxable prot (after carry forward of losses)
becomes positive, this depending on the price of crude. In order to calculate the precise
equivalent cost it is then necessary to proceed iteratively to arrive at the sale price such that
the present net value is equal to zero.
When the main uncertainties relate to the price of crude, the difference between this price
and the equivalent cost throws light on the acceptable degree of uctuation in the price of
crude, and is often more informative than the value of the NPV or the difference between
the rate of return and the discount rate.
6.3.5 Financing mix and the equity residual method

When the early studies are being made for an investment project and particularly for the
discussions between the partners, the calculations are generally carried out using operating
cash ows as dened above, without bringing in elements related to the loans required to
nance the project. These calculations relate to the WACC method. The data relating to the
nance are implicit in the discount rate, the internal price at which the nance department
is willing to allocate funds. This allows nancing decisions to be kept separate from
investment decisions. For small projects this overall approach (WACC method) is generally
the only one used: projects are assumed to be nanced from a common pot of capital
available. For large projects this WACC method is also adopted when the debt ratio
dened by the company for all its projects is strictly xed. In such a case, if the debt ratio
exceeds on a particular project, the debt component on other projects needs to be reduced
to a lower level. It is then appropriate to maintain a separation between the sources of
funding and their application.
For large exploration/production projects a exible approach is often taken with regard
to debt. When the studies reach a sufciently advanced stage and the nancing arrangements
have been dened it may be desirable to look at their impact. To this effect, most companies
advocate supplementing the calculations of the overall return on capital (possibly making use
of the method of Arditti, which we shall look at presently) by a calculation of the return on
equity (see Box 6.6). This will in fact be the main criterion in a case where the project nance
222
has no impact on the debt ratio applying to the companys other investments (in the case of

non-recourse nancing, for example). When the project is nanced on the same basis as the
overall portfolio of investments, the two approaches, i.e. WACC and equity residual should
lead to the same decision2.
Box 6.6 Standard WACC method and Equity Residual method.
Standard WACC method

(After Tax Weighted Average Cost of Capital, ATWACC method, overall return)
Cash ows are operating cash ows (i.e. not including any ows linked to debt). The
discount rate is dened as the after tax weighted average cost of nancing. The
standard WACC method reects the viewpoint of the department responsible for
investment projects.
Equity residual method (return on equity)
A calculation of the return on equity, on the other hand, reects the viewpoint of the
shareholders. Payments made to service debt and the associated tax shields are therefore
included in the calculation. The discount rate used is therefore that appropriate to the share-
holders, the cost of equity.
If the tax rate on company revenue, t, is stable, the relationship between the overall return
on capital ro and the rate of return on equity re, both in nominal terms, is as follows:
i = (1 t)b + (1 )ke
where:
b interest rate on debt (in nominal terms),
proportion of project capital funded by debt,
re equity rate of return .
This relationship is exact if the debt ratio for the project remains stable during the life
of the project. If this is not the case, the relationship is approximate only. This can be inter-
preted very simply: the overall return on capital is the weighted average of the cost of debt
and the return on equity.
6.3.6 Acquiring participations, valuing a project

When the purpose of a study is to decide whether or not to proceed with a given project,
and when the project nance is in line with the nancing of all the investments in the same
sector, the various different methods of evaluation overall return on capital, return on
equity but also Ardittis method all tend to indicate the same decision. In other words, the
NPV for the different methods all tend to have the same sign. But they will not have the
same value and indeed may diverge considerably. The problem of putting a value on a large
project crops up frequently in the upstream petroleum industry, where development often
involves consortia, and where companies seeking to optimize the return on their portfolios
may seek to buy into a project, or divest their interests, at any stage during development and
exploitation. Investors need to be able not just to know its net present value, but to be able
to calculate its value in any year. Based on the criterion of overall return on capital, the value
of the project in any year k in the future is the sum of the values of future cash ows
discounted to that year:
2. We only have to set the equation in the Box 6.6, assuming it holds precisely, with = , beside the
formula for the discount rate i = (1 t)b + (1 )ke, to realise that re ke if and only if ro i.
223

Fn
Vk =
(1 + i)
nk
n = k +1
In particular, once an investment I has been made in year 0, the value of the project at
the end of year 0 is:
N
1+ i
Fn
V0 = = I + NPV
( )
n
n =1
Before an investment is made the value of the project (i.e. of the right to invest) is equal
to the NPV.
But if the equity residual method produces a very different value, how can a company
determine the maximum price it is willing to pay for an interest in the project, or for that
matter, a minimum price at which it is willing to sell?
In order to address this question, we shall invoke a result which may appear theoretical,
but which can cast useful light on the question: The NPVs for the two methods are equal
not when the initial amount of the loan is equal to I0 but when it is equal to (I0 + NPV)
assuming that the debt ratio for the project remains stable for its entire duration.
To make this point clear, we observe that the capacity of a company to borrow is deter-
mined not by the capital cost of the investments but by the capacity of the company to service
the loan, that is, by its expected revenues. Suppose there is a third party with the same expec-
tations as to return and the same nancial structure, and therefore the same discount rate, as
the company we are considering. He is considering purchasing the right to carry out the
project. The maximum sum he is prepared to pay is equal to the NPV of the project. If we
add the capital cost of the project, the total acquisition costs including the construction of
the plant amount to I + NPV, a fraction of which he can nance by debt. The company
itself would only be able to borrow I, so it would benet from a lower gearing than the
imaginary third party, and its return on equity is therefore lower.
Which is in fact the correct value? The answer is related to the question of how the project
is nanced. If debt is limited by considerations of risks specic to the project, if it has no
impact on the debt ratio for other projects, it is the NPV on equity which should be used. If
on the other hand taking a smaller loan in connection with this project would result in
increased capacity to borrow elsewhere, the objective of complying with the reference ratio
for the totality of investments means that the WACC method using the relevant discount rate
should be used: the assumption that the debt ratio remains stable, and is dened by reference
to the value of projects, is implicit. It is therefore the overall NPV on capital which is the
relevant indicator.
6.3.7 Another approach to calculating the return

on exploration/production projects: the Arditti method
6.3.7.1 The nature of the problem
The standard WACC method presented above is performed using a discount rate dened as
the after tax weighted average cost of capital. But in the upstream petroleum industry, deter-
mining the after tax cost of debt can be problematic.
224
The problem is that the operating companies involved in exploration and production are

not always in prot, for example when they commence operations in a new zone. In such
circumstances they are not able to deduct any accounting loss from prots associated with
other activities. These losses must be carried forward to future years. Furthermore the
practice adopted in some countries of ring fencing the exploration licence can prevent scal
consolidation, even within a given country. Tax regimes are often complex, and generally
vary between different licences. The tax rate may depend on the rate of production, etc. All
this means that it is not possible to express the taxation of petroleum revenues (and its impact
on nancing costs) in terms of a single parameter. It is therefore not generally possible to
determine by simple calculation the cost of debt after tax. This makes the standard WACC
method an inappropriate method of evaluating a project. Even assuming the average cost of
capital after tax can be calculated, the company would have to use as many different discount
rates as there are petroleum tax treatments to consider.
Furthermore the return on equity, a parameter very sensitive to the assumptions regarding
nancing, is usually only used in the nal study phases. These various considerations have
led the oil industry to make fairly widespread use of another method, known as the Arditti-
Levy method.
6.3.7.2 The Arditti-Levy method

(before Tax Weighted Average Cost of Capital)
This method uses a discount rate equal to the average cost of capital before tax. This para-
meter is easier to calculate than the cost after tax, and its value is independent of the tax
regime. The method therefore allows the number of discount rates to be limited, possibly to
just a single rate, remembering that the cost of capital before tax varies little from one
geographical zone to another.
The cash ows to be considered therefore (hereafter referred to as the A-L ows) will
include tax allowances earned relative to interest on loans, but will not include the loan
drawings or redemptions, or interest payments. In other words, the deductibility of interest
is not allowed for in determining the discount rate (as happens in the standard
WACC method), but in calculating the cash ows in each year, by using the tax rate for the
year.
In practice the taxable prot and therefore the tax in each year are calculated by deducting
the interest from the project operating revenue. Account is taken of all the specics of the
tax regime for the project (carry forward of losses, variable tax rates depending on one or
more operating parameters, etc.) in the cash ow projection.
Apart from the tax payments, the ows considered are the after-tax operating cash ows.
The viewpoint adopted in this approach is that of investors, shareholders (the owners of
the equity) and lenders. The A-L ows effectively include the sums received or disbursed
by everyone, while the cost of capital reects the average minimum return sought by the
various providers of capital.
The A-L ow is therefore equal to:
The operating cash ow increased by the tax allowances on interest;
The sum of equity ows and ows related to debt (before tax).
The Arditti-Levy method generally results in the same decisions as the standard WACC
method (when this can be used) and the equity residual method when the nancing proposed
225
for the project is consistent with that for the rm as a whole3. In other words, there is a
convergence of the viewpoints for the different methods: between that of all the various
investors (Arditti), the shareholders (equity), the department responsible for investment
(requiring a return on invested capital equal to the average after tax cost of capital).
The Arditti-Levy method is widely used in the upstream petroleum industry. Care is
needed in its application, however. The pitfalls are known to the specialists, but they make
it difcult for decision-making to be decentralized. It is not enough to simply provide a user
with the value of the discount rate. The rst step must of course be to check that the
nancing assumptions made in determining the discount rate are compatible with the assump-
tions made in calculating the nancing costs and the corresponding tax savings. In practice
the method in its original version is only appropriate for the study of projects where the debt
component of the nancing is consistent with the overall debt ratio objective set by the
company. Even in such cases, however, the non-specialist may encounter some difculties.
These include:
Sensitivity to the rate of interest on debt: the higher the rate of interest on debt then, ceteris
paribus, the higher the internal rate of return on the project. This may come as a surprise
to an inexperienced analyst, who might be inclined to use the same discount rate.
Term of loan: This may be signicantly shorter than the life of the project. In this case
the assumption of a constant debt-to-capital ratio over the entire study period is clearly
not satised, and can lead to an underestimation, sometimes substantial, of the protability
of the project.
Economic value of a project: consider a project for which the debt-to-capital ratio is equal
to the debt ratio set by the company, i.e. B0 = I0. In this case the NPVs calculated by
the traditional method and the Arditti-Levy method (as well as the equity NPV) should
have the same sign, but be different in magnitude4. If the object is to decide whether or
not to proceed with the project, both (or all three) methods lead to the same conclusion.
But if the purpose is to determine an acceptable price at which the company can acquire
or dispose of an interest in the project, it is the economic value of the project (Vn in year
n) which should serve as the reference value. The fact that the two methods may give
different results can also give rise to the problem referred to in Section 6.3.5.
3. More precisely, convergence is ensured when the debt-to-capital ratio for the project remains constant
over its life and is equal to the debt ratio xed by the company for projects of this type. The
demonstration is similar to that for the convergence between return on capital and return on equity. The
A-L rate of return rs is a weighted average of the cost b of debt before tax (return to lenders) and the rate
of return on equity re (return to shareholders):
rs = b + (1 )re
Where the nancing arrangements are not such as to preserve a constant debt-to-capital ratio, the
formula becomes approximate rather than precisely correct. The A-L discount rate s is a weighted average
of the cost of debt (before tax) and the cost of equity ke:
s = b + (1 )ke
For a project which satises the given assumptions, i.e. = , rs is greater than s if and only if ro is
greater than ke.
4. The relationships between NPVs obtained in this case by the different methods are given by Babusiaux
[1990].
226
6.3.8 A new approach: the generalized ATWACC method

At the time of writing, a new method is being studied with a view to its possible use by the
Total group. It is described in detail by Babusiaux and Pierru [2001]. It is a generalization of
the classical return on capital method, and caters for the case where prots arising from the
project studied will be subject to a different tax rate from that considered in calculating the
discount rate. We will begin by presenting the method under a simplied set of assumptions.
6.3.8.1 The generalized ATWACC method

Consider a company subject in its country of origin to a tax rate t on its income (we shall
revisit this assumption in the following section).
It wishes to evaluate its investment projects in a sector with the standard WACC method,
and uses a discount rate based on the average cost of capital after tax and nominal terms
(using the usual notation):
i = (1 t)b + (1 )ke
We assume that all the projects of the same type must stick to a xed debt-to-capital ratio,
, which we shall refer to as the reference ratio.
The company is studying the return on an investment project in a foreign country with a
different tax regime or, more generally, where revenue will be taxed at one or more rates
different from t. We will conne ourselves to the case where there is no consolidation of
accounts for tax purposes, or to similar cases5 which are quite common in the upstream
petroleum industry. We assume further that the project can be nanced partially by loan
capital and that interest on the loans is deductible from the projects taxable revenue.
Let L be the loan obtained for the project. Whatever the amount of the loan, and whatever
the debt ratio set by the company, the loan can be considered to be taking the place of a loan
L put up by the central services of the company. The loan L, equal in amount to L, would
have been repaid over the same term and by the same method of repayment. In other words
the redemption timetable would have been the same. This assumption, though it may appear
somewhat theoretical, can be seen as a way of satisfying the requirement that the loan L must
result in the same overall debt ratio each year as the loan L (the assumption currently
adopted for project evaluation of a debt ratio xed ex ante).
The principle underlying the method is very simple: the difference in the after-tax cost
of interest payments is assigned to the project. If the interest rates are the same in the host
country and the home country this has the effect of assigning to the project the difference
in tax allowances which arises when the interest is accounted for in the host country rather
than in the companys home country.
Remarks
The procedure proposed is a generalization of that proposed by Babusiaux [1990] for
analyzing the protability of a project in order to apply for a loan at a subsidized interest
rate.
There are, on the face of it, no particular difculties in adapting the method to cater for
contractual conditions specic to the upstream oil industry. In the case, for example, of
5. When for example local taxes are higher than taxes in the companys home country, where prots
worldwide can be consolidated.
227
a production-sharing contract, in which the nancial costs are recovered in the form of
cost oil, the cost oil simply reduces by an equivalent amount the quantity of prot oil
which would have been shared between the state and the company.
6.3.8.2 Reference tax rate and optimum allocation of debt

In the section above we considered a project subject to a different rate of tax from that
applying to the company generally. An international oil company in fact has to contend with
a large number of different tax regimes. How can the rate t be determined? In theory the
company should take up loans in increasing order of after-tax cost (this would involve, for
example, allowing some subsidiaries to become more proportionally indebted than others).
The after-tax marginal cost of debt will then be the cost of the last loan to be taken up. It is
this last loan which has to serve as the reference in dening the loan which would be substi-
tuted by the loan L for a project under study, as well as the tax rate applied to the revenues
from which the appropriate interest can be deducted. The gain to be credited to the project
is calculated by reference to the cost of this marginal loan (if it can be determined by the
companys central services).
6.3.8.3 Merits of the method

In Section 6.3.7 we emphasized a number of problems posed by the use of Ardittis method.
The generalized ATWACC method does not suffer from these disadvantages, Furthermore
it has the merit of simplicity.
Once the discount rate has been determined, the formulation is independent of consid-
erations of the debt ratio to be observed for all the companys projects of the same type.
In most cases outside the upstream petroleum sector, the tax regime applying to the
revenues from a project are no different from that applying to the company as a whole.
In this case the proposed method is equivalent to the classical method. Using the proposed
method therefore allows a unied criterion to be adopted for all the activities of an oil
company, a traditional criterion which is easier to use and whose use is more widespread
than that adopted in the Arditti-Levy method.
The rst studies of the protability of a project, particularly in connection with discus-
sions between consortium partners, are usually performed without any allowance for
debt. In other words they are carried out on the basis of projected operating cash ows.
Furthermore, the ex post evaluation of the nancial results is often based on the return
on capital employed (ROCE). The accounting revenues used in this exercise exclude both
interest charges and the corresponding tax savings. The ROCE is therefore analogous to
a cost of capital after tax. Similarly, the economic value added (EVA) method denes the
value added in a year as the annual accounting revenues (excluding nancing items) less
the cost of servicing the capital. The latter therefore also requires an after tax average cost
of capital. In each of these different cases the explicit or implicit method of reference is
the classical cost of capital method rather than the Arditti-Levy method. One of the
advantages of the generalized ATWACC method is that it rests on a similar basis.
6.3.8.4 Theoretical developments

Theoretical developments with regard to the generalized ATWACC method are presented
in Pierru and Babusiaux [2000]. Although not proposing to go into detail, we present the
228
main formula which lies at the heart of the method, because it provides additional justi-

cation for the proposed method and throws fresh and instructive light on it.
We shall conne ourselves in this section to considering a project nanced in part by debt,
the amount of which is determined by the reference debt ratio . This debt ratio, dened by
reference to the economic value of the project (see Section 6.3.7), is assumed to remain constant.
In particular, the capital borrowed in year 0 is B0 = (I0 + NPV). Under these assump-
tions, Axel Pierru6 demonstrated a theorem interesting in both theoretical and applied terms.
His theorem states that the net present value of a project, and more generally its economic
value in any year, calculated using the generalized ATWACC method, is equal to the value
calculated by discounting the operating cash ows at a rate equal to the average cost after
tax of nancing the project. This property is intuitive.
The theorem has a corollary: the NPV of the project is independent of the tax rate t in
the country of origin. The parameter t can therefore take any arbitrary value. Each of the
traditional methods (standard WACC, Arditti-Levy, equity residual) corresponds to a
particular value of t, providing a very simple proof of their consistency7.
6.3.9 A rst step in dealing with uncertainty: sensitivity analysis

Sensitivity analyses are usually indispensable in economic evaluation. They involve analyzing
how the protability of a project varies in response to changes in the assumptions regarding
the different components of the cash ow calculation, such as, in the case of the development
of a hydrocarbon reservoir: the cost of capital, the price of crude and/or gas, the size of the
recoverable reserves, tax rules, etc.
The spider diagram

In presenting the results of a sensitivity analysis a graph, the spider diagram, often conveys
more than tables of numerical values.
This is constructed by representing along the x-axis the variations in the different para-
meters to which the protability of a project may be sensitive. They are usually represented
by variations relative to a base case dened beforehand. The y-axis comprises the value of
the criterion in terms of which the results are expressed: net present value, rate of return or
equivalent cost. In each analysis just one parameter is varied, the other parameters being kept
constant and equal to their values in the base case, to give a curve for that parameter.
Figure 6.4 shows by way of example the results of a sensitivity analysis carried out for
an investment project. The criterion used is NPV. The variations studied relate to the price
of crude, the volume of the reserves and the cost of capital.
The main purpose of such a graph is to display the results at a glance and to identify the
parameters to which the protability of the project is most sensitive. It also allows sensitivity
analysis to more than one independent parameter at a time to be studied The possible vari-
ation due to two independent parameters, for example, can be estimated by taking the line
segments representing the possible variations in these two parameters singly and completing
the spiders web as shown, or more accurately, by summing the two vectors represented by
these line segments.
6. Pierru and Babusiaux [2000].

7. See also Pierru and Feuillet-Midrier [2002].
229
NPV
ice
pr
e
ud
Cr
Ca
pita
l c
ost s
ve
s er
Re
Variation (%)
Figure 6.4 Spider diagram showing results of sensitivity analysis.
The same procedure can be used to consider the simultaneous variation of any number
of parameters, as long as they are independent. In the general case the curves are not neces-
sarily straight lines, and the parallelograms to be constructed are therefore curvilinear. It
should also be noted that when the chosen criterion is the rate of return, the method can only
be approximate, but can provide order of magnitude estimates.
The graph makes it easier to characterize the set of favourable cases for which the net
present value is positive, and the set of unfavourable cases (corresponding to the shaded half-
plane in Fig. 6.4, which could be regarded as the red zone for the project). If, for example,
it is considered that the investment budget could be exceeded by x%, the graph can be
quickly used to determine what change would be required in another variable (sale price, for
example) to lead to a negative NPV.
In the case of a project to develop a eld for production, the price of crude or the price
of gas is usually the parameter to which the protability of the project is particularly
sensitive. The equivalent cost, as we saw earlier, is the threshold price which determines
whether or not a project is economically viable. This criterion, which itself embodies infor-
mation on sensitivity to price, is in its turn particularly well suited to be the subject of a sensi-
tivity analysis relating to the other parameters.
A decision to invest can be taken if the unfavourable cases are regarded as being unlikely
(a subjective judgement, these probabilities not being quantied), and as long as the possible
losses do not comprise a major risk for the company. Very often the sensitivity analysis is
regarded as dealing sufciently with the question of uncertainty to present a rm proposal
to the relevant senior management.
However it also often happens that the sensitivity analysis throws up a mix of favourable
and unfavourable cases, each with their associated gains and losses, such that a decision
cannot be made. For projects of a certain size, the analysis can be carried further by
attaching probabilities to each of the various outcomes. This approach will be considered
in Section 6.4.
230
6.3.10 An empirical criterion: payback period

(duration of nancial exposure)
The pay-back or pay-out period is an empirical criterion used by the petroleum industry,
particularly in the face of major uncertainties: commercial risk, major political risk, tech-
nological risk (a technical advance may be of short duration), etc. It is dened in various
ways, and can be calculated from the start of exploitation or from when capital expenditure
starts (in the latter case we refer to the duration of nancial exposure). Payback time may
be dened in terms of discounted or non-discounted values. In any case this criterion is a
good way of formalizing the desire not to carry out projects whose protability depends on
cash ows beyond a date when it becomes difcult to make forecasts.
A drawback of this criterion is that it is rather arbitrary. To ignore project revenues
beyond the desired payback period is to assume that they will be nil, which is generally not
realistic. There are many projects of long duration in the petroleum industry (and in the
energy sector generally).
Despite these drawbacks, payback time is a criterion, albeit secondary, which many
decision-makers nd of interest. The maximum nancial exposure (accumulated expen-
diture) is another parameter to which they pay particular attention.
6.4 THE DECISION TO EXPLORE:

INTRODUCTION TO PROBABILITY
6.4.1 The exploration data sheet
When a decision needs to be taken in regard to development, it is often desirable to introduce
notions of probability. In decision-making with regard to exploration it is almost indis-
pensable, particularly when drawing up an exploration drilling programme. The decision-
maker has to contend not only with uncertainty about the volume of reserves, which applies
when a discovery is made, but also with whether or not hydrocarbons are present at all. Once
the preliminary geological and geophysical studies have been completed, the decision to drill
is generally taken on the basis of an exploration data sheet. Companies ask geologists to
make probabilistic estimates: probability of success and probabilities related to the reserves
allowing the net present value to be described as a probability distribution function.
It is general not possible to refer to historical frequencies, so the probabilities used are
subjective probabilities. They convey the degree of likelihood estimated by an expert, based
on his experience in similar situations.
6.4.2 Expected value

6.4.2.1 Denition
The main criterion used to summarise a probabilistic future is the expected value of the net
present value, i.e. the weighted average of the possible values of the NPV, the weights corre-
sponding to their probabilities. This is the value to which the average would tend if the
company were able to repeat the experience a large number of times.
Actually it is not necessary for an identical experiment to be repeated a large number of
times. The criterion of expected value is also justied by the law of large numbers if the
231
company carries out a sufcient number of similar, mutually independent projects. This is
therefore the basic criterion used for all the small projects.
Remark: It is possible to calculate the expected value of a revenue, a discounted cost or
an annual equivalent cost. It is not in general possible, on the other hand, to calculate the
expected value of a rate of return as a weighted average using probabilities.
Let us consider a very simplied example of a prospect A whose recoverable reserves may
be 250 Mbbl. This prospect could require a development with a NPV of $320 million. The
probability of nding an oileld of this size is 10%. There is also a 5% probability of
nding a larger oileld. The NPV in this case would be $400 million. The probability of
discovering a smaller oileld is 5% and the NPV in this case would be $200 million. The
probability of failure is estimated at 80%. The cost of drilling is estimated to be $50 million.
The expected value of the NPV is therefore the average of the possible values weighted by
the probabilities, i.e.:
50 + (0.10 320) + (0.05 400) + (0.05 200) = $12 million
6.4.2.2 Estimation of the probability distribution function

Whether we want to just calculate the expected value or we are interested in other charac-
teristics such as the variance, we need to have an estimate of the probability distribution
function associated with the net present value. But the latter is a function of a certain number
of parameters; it is usually easier to associate probability distribution functions with these
other parameters.
In the case of the capital costs, it may be possible to refer to historical data to estimate
the probability distribution function. It should be observed that this function is usually
asymmetric (Fig. 6.5). The probability that the cost will be substantially less than the costing
of the engineering department is nil, while the probability of major cost overruns is not nil.
The mean value may therefore be signicantly higher than the most likely value (the mode).
And when an estimate is made it is often, implicitly, the mode which is intended.
As far as the sale price and the volumes of products are concerned, subjective probabil-
ities will generally have to be used. Often a broad-brush approach is taken to representing
probability distribution functions. A uniform distribution represents a range of values within
which it is difcult to dene a most likely value. Conversely, however, when a most likely
value (the mode) can be estimated, a triangular distribution function may be adopted.
Frequent use is also made of the lognormal distribution.
Probability
Capital cost
Figure 6.5 Capital cost.
232
In the development of oil or gas elds, the parameters crucial to protability are the

volume of the reserves and the productivity of the wells. The latter depends on a number of
variables which can be considered random: the area of the reservoir, the thickness of the
reservoir bed, the porosity and permeability of the rock, the viscosity of the uids, etc. These
are the fundamental parameters which can be estimated and described in terms of probability
functions by the geologists and geophysicists. Often an estimate has already been made of
the minimum recoverable reserves required to make the development viable. The question
then reduces to ascribing a probability distribution function to the volume of the reserves.
Whether the object is to consider just the reserves or to determine a probability distrib-
ution function for the net present value (or equivalent cost), the problem is to derive this
function from assumptions about the probabilities of the fundamental parameters.
6.4.2.3 Simulation
The technique most commonly used consists of performing a simulation using Monte Carlo
methods8, and computer processing is normally required. A sample is drawn at random for
each variable considered stochastic using the appropriate distribution function. These values
are then used to calculate the corresponding possible value of the net present value (or the
volume of the reserves, as the case may be). This operation is repeated a large number of
times (several hundred), a sample set of notional values of the NPV is obtained. Statistical
operations can then be carried out on this sample: construction of a histogram, calculation
of mean, standard deviation, etc. If the sample is large enough, the method allows a proba-
bility distribution function to be derived for the NPV. In particular, the mean of the sample
is an estimate of its expected value. This method has been in use by the oil industry since
the early 1960s.
One of the disadvantages of simulation methods is they behave like a black box. The
probability distribution function of the target criterion is derived from probabilistic data for
the different parameters. But, unlike what happens in a sensitivity analysis, the effect of indi-
vidual factors is not apparent. In practice, the uncertainties attaching to the different para-
meters can be of different types. In the case of a development project for an oil or gas eld,
for example, the probability estimates for the physical and technical parameters repose on
a large number of cases studied by the company, and on the experience of specialists. It is
much more difcult, on the other hand, to obtain probabilistic data, even subjective, for the
economic parameters (price of crude, tax rules). This is one of the reasons why simulation
tends to be mainly used for evaluating the volume of the recoverable reserves. It allows the
impact of uncertainties of a technical nature to be represented, while those relating to the
price of crude are often better analyzed by means of scenarios.
More generally, it is often the case that estimates of the future prices of products are more
subjective in nature than the other parameters. Analogous to what was said in discussing
sensitivity analysis earlier, simulation can be used just to determine the equivalent cost. This
allows uncertainties related to the sale price to be kept distinct from all the other uncertainties
which affect the net present value.
Finally, the use of simulation, always a major exercise, can be avoided by using approx-
imate formulae to determine the expected value and the variance of the net present value for
a project.
8. These methods were popularised by D.B. Hertz [1964], and are sometimes referred to as the Hertz method.
233
6.4.2.4 Use of approximate formulae

Among these, the formulae related to the lognormal distribution are particularly simple.
Most of the parameters involved in a project are non-negative quantities, and they are
often distributed asymmetrically. This led R. Charreton and J.-M. Bourdaire [1985] to
suggest representing the distribution of each parameter by a lognormal distribution, with
lower bound zero, and characterized by its mode, a mini value and a maxi value. The
mini and maxi values correspond to the 5 and 95 percentile points on the probability distri-
bution function.
This approach is particularly appropriate in the case mentioned above where we are
seeking to determine the probability distribution function applying to the volume of recov-
erable reserves of oil as a function of the physical parameters. The formulae used to calculate
volumes are largely based on products of variables. We can therefore apply the central limit
theorem to the logarithm of the volume. Furthermore the lognormal distribution generally
corresponds reasonably well to the observed data relating to reservoir size.
The use of the lognormal distribution allows the mode and the mini and maxi values to
be calculated for a product of variables. The mean and the variance are therefore given by
the approximate formulae:
m = 1 (mini + mode + maxi)
3
1
(maxi mini)
3
6.4.3 Sequential decisions and conditional values

6.4.3.1 Decision trees
So far we have considered a single investment decision. Sometimes a series of decisions have
to be taken, the later decisions being a function of the (random) outcomes of earlier ones.
For example, a rst decision might be whether or not to drill an exploration well. The
decision as to whether to develop, if successful, or to continue exploration, will depend on
the outcome of the rst drilling.
The analysis therefore has to take account the subsequent chain of decisions.
In order to do this a decision tree is constructed, as shown in Fig. 6.6. A decision tree is
usually read from left to right, or sometimes from top to bottom. The connecting lines of
the graph represent either possible decisions (continuous lines) or random outcomes of deci-
sions taken (broken lines). The nodes therefore correspond either to a state of affairs or to
information obtained. The nodes corresponding to decisions are represented by a square
(decision points), while the probabilistic nodes, associated with random events, are repre-
sented by circles.
Figure 6.6 represents a whole complex of possible choices in exploration/development.
Prospect A is one which could result in the development studied earlier. Prospect B relates
to a neighbouring, smaller structure. The geologists consider that there is a 30% likelihood
of nding oil at B (10% likelihood of a small eld, 20% likelihood of a medium-sized eld)
if there is oil at A, but the likelihood is only 15% (5% likelihood of a small eld, 10% of a
medium-sized eld) if A is dry.
234
F
I
Abandon L
B D
(0.85)
Abandon Unfavourable
Abandon 0 Explore Failure 450
conditions
prospect B (0.2)
45
G (0.05) J M
Small field
A 27.5 Develop
110 610 Favourable
500
(0.8) conditions
No discovery (0.10) Medium-sized field (0.8)
Explore 650
prospect A K
235
220 Develop
50 700
Unfavourable
C conditions
64
- 600
(0.4)
(0.2) Oil discovery N
820
Develop A Failure Favourable
310 (0.7) conditions
E
45 H (0.1) (0.6)
Small field
32 0 Explore 55
prospect B (0.2) 900

Medium-sized field
Figure 6.6 Decision trees.

The diagram does not show the lower part of the decision tree, corresponding to prospect
B if A is successful. The section after node H in the lower part of the tree will be identical
to the section in the upper part after node G. It should be noted that it is possible, instead
of duplicating this part of the graph, to simply connect node G directly to nodes I, J and K,
which means that we can formulate the problem considered as a stochastic dynamic
programming problem.
In order to determine the expected value of the NPV associated with a decision studied,
calculations are carried out starting in the future and proceeding back to the present. In
Fig. 6.6 we therefore move from right to left.
A value is associated with each node (value, score or potential) which corresponds
to the expected value of subsequent revenues. The evaluation starts at the nodes at the nal
stage (M and N). The score assigned to node M, for example, is the expected value of
revenues from the development of a small eld. The probabilities are indicated in brackets
on the decision tree. The expected value is therefore:
EM = 0.2 450 + 0.8 650 = 610
Having determined the values at the nodes of the last stage, we proceed to the nodes of
the penultimate stage, i.e. J and K. While the last stage was the outcome of a random process,
the preceding stage is a decision process. The decision is of course that which corresponds
to the highest expected value. At node J abandon has an expected value of 0 while devel-
opment, which requires an investment of 500, has an expected value of 610 500 = 110.
The calculations proceed in the same manner, moving each time back to the preceding
stage until we arrive back at the initial node A.
In practice, the number of possible decisions is often large, and the number of possible
consequences is even greater. The size of decision trees can escalate rapidly, and this
imposes limits on the use of this method. Even if explicit calculations are not carried out,
the decision tree is a concept to which it is useful to refer, even if only mentally, as a means
of ensuring that consequences or possible actions are not forgotten.
6.4.3.2 Flexibility and option evaluation theory

Once a eld is discovered, a decision to develop it is often taken quickly. In some cases,
however, the decision to develop is deferred, and will only be taken if certain conditions
become favourable: a rise in the price of crude, a technical development which improves the
recovery rate, changes in the tax regime, etc. The corresponding parameters can be regarded
as random events or variables.
The value of a production licence can be determined by means of a decision tree
constructed as described above; this also allows the optimum strategy and the timetable to
be dened which lead to the highest expected value of the NPV.
Since the early 1980s a lot of research carried out and publications have referred to the
possibility of using real options theory.
An option (see Box 6.7) is a conditional asset, the value of which depends on the exercise
of a right. The investment opportunity offered by undeveloped petroleum reserves can be
compared with a call option. Proceeding with development is analogous to exercising the
option. The capital required corresponds to the call price. The value of the eld when
developed (a function of the price of crude, which can be assumed to be a stochastic process)
corresponds to the value of the underlying asset. The expiry date can correspond to the date
of expiry in the case of a limited-term lease.
236
Box 6.7 Value of an option

A call option gives its owner the right to purchase an asset at a given date or for a prede-
termined period at a xed price (the call price). The standard method for evaluating an option
is the Black and Scholes model.
If we assume that the changes in the market price of the underlying share follow a
normal distribution, the value of a European call option (i.e. a call option exercised on a xed
date) is
S N (d1 ) Xe r0t N (d 2 )
where:
S 1
Log + r0 + 2 t
X 2
d1 = ,
t
d 2 = d1 t ,
S price of underlying share,
X call price,
t time remaining before expiry,
r0 risk-free interest rate,
standard deviation of the return on the share (volatility),
N(d) probability that a standardised normal random variable is less than or equal to d.
Option valuation can be a useful tool in a situation combining exibility and uncertainty,
that is when a decision, which can be modied by changes in random factors, can be taken
in the future. Apart from opportunities to develop oilelds, there are in theory many situa-
tions in the upstream petroleum industry which meet these conditions: the acquisition of an
exploration licence, special contractual clauses, etc.
Options theory is well adapted to evaluating asset market values, and does not require
knowledge of a discount rate. It should be emphasized that models for valuing options
assume the existence of a liquid market in the underlying asset, and that there are no oppor-
tunities for arbitrage. This may be true for the price of oil, but is less so for petroleum
projects.
The value of a given asset is the sum of two components: the intrinsic value and the time
value. The intrinsic value is the value if the option were exercised immediately and can be
determined by traditional NPV methods. The time value corresponds to the potential for
appreciation in the present net value, and disappears when the option is exercised.
The value of an option is affected by a number of different parameters: the value of the
underlying asset, its volatility, the exercise price, the term and the risk-free interest rate. The
greater the variations in the value of the underlying asset the greater the value of the option.
As a result the value of undeveloped reserves will be greater ceteris paribus when the oil
price is more volatile. By holding back with the development of certain gaselds in the North
Sea, gas companies were able to change the nature of the competition in that area. As a result
prices became more volatile, which in turn increased the value of the licences held by these
companies.
237
Although tools originating from the real options theory have not, or not yet at any rate,
really caught on in the oil industry, occasional reference to them, even if only qualitatively,
can be useful in making decision-makers aware of the choices and parameters which affect
the value of certain assets which have similar characteristics to options.
6.4.4 Limitations applying to the expected value of NPV

6.4.4.1 Risk aversion
The use of the expected value is justied where the company can be assumed to carry out
a sufcient number of independent, similar projects for the law of large numbers to apply.
This is not the case when a major project is being studied requiring very large investments,
for example certain offshore development projects.
Let us return to the example of the exploration decision mentioned in Section 6.4.2. The
cost of the exploration programme is $50 million. The probability of nding a eld of
medium size is 10%. The corresponding NPV would be $320 million (excluding exploration
costs). The probability of making a large discovery is 5%, and the NPV would then be
$400 million, and the probability of making a small discovery is 5%, the NPV then being
$200 million.
The expected value of the NPV is therefore:
50 + (0.10 320) + (0.05 400) + (0.05 200) = $12 million
Now consider another exploration opportunity in a zone where access is more difcult
and less familiar. The cost of exploration there is higher: $ 160 million, but the sizes of the
possible elds are considerably larger. The values of the probabilities and the discounted
revenues (excluding exploration costs) for different possible discoveries are indicated in
Table 6.8.
Table 6.8 Characteristics of a possible discovery.
Discovery Probability (%) NPV ($ millions)
Small 5 100
Large 10 1 000
Very large 5 1 500
The expected value of the NPV is therefore:

160 + (0.05 100) + (0.10 1 000) + (0.05 1 500) = $20 million
Assume that the two opportunities studied only differ in terms of their costs and revenues
as indicated, and that a choice has to be made between them. A large company would
consider both to be small projects, and it would prefer the second to the rst because the
expected revenues are higher. For a small independent company, on the other hand, this may
not be the best decision. It has to allow for the fact that the likelihood of losing money is
higher for the second project, and that the maximum possible loss is also higher. In other
words it is a riskier project. Generally speaking, companies are averse to risk.
238
Before examining possible responses to the question posed, let us take yet another

example. Let us look at two development projects whose NPVs can be considered to be
continuous random variables. Suppose the expected values of the NPVs for the two projects
are the same. A risk-averse decision-maker will prefer the project with the smaller dispersion
of NPVs, i.e., project A in Fig. 6.7, which presents the probability distribution functions for
these two projects.
Probability
NPV
Figure 6.7 Comparison of projects.
The risk is generally characterized by the standard deviation9 (or the variance) of the
discounted revenue.
If two projects have the same expected revenue, a risk-averse decision-maker would opt
for the project with the smaller standard deviation. A problem which can arise is that one
project has a higher expected value but also greater risk. The decision-maker is then faced
with making a choice based on two different criteria.
The problem is similar when the decision is between accepting and rejecting the project.
The fact that the expected value of the discounted revenues is positive is not enough. It is
also necessary that the risk should not be too high.
In practice both of these criteria (expected value and variance) are commonly used without
their being universal agreement about the trade-off. As indicated earlier, in the oil production
sector simulation methods are often used. These methods allow the expected value and
variance of the volume of recoverable reserves, or going further, of the NPV for the devel-
opment project, to be calculated.
Nor do we necessarily rely on just the expected value and the variance, since the distri-
bution function is also available. This allows us to calculated the probability, for example,
that the project will result in a loss.
A decision can often be taken on the basis of the information described above, possibly
supplemented by considerations of a more strategic nature, without having to seek to quantify
the weights to be attached to each element, in particular to the expected value and the
variance (mean value and risk).
9. The standard deviation of a variable is the root mean square of the deviations of the variable from its
mean. It is a measure of the dispersion of the variable. The variance is equal to the square of the standard
deviation.
239
Different approaches are used to deal specically with risk. One of these involves using
an expected value/variance criterion which uses weights derived from decision theory.
Before presenting this criterion we shall look at a method widely used by companies in which
a risk premium is included in the discount rate.
6.4.4.2 Discount rate and risk premium

In Section 6.3.1.1 we mentioned the Capital Asset Pricing Model. This involves calculating
the cost of equity by incorporating a risk premium. The theory links in with the practice
adopted by many companies of incorporating a risk premium in their discount rate. A
number of points need to be made in regard to this practice.
In the rst place, the risk premium determined by the CAPM only allows for systematic
risk. In order to apply it to take account of the risks attaching to individual projects, it would
be necessary to calculate the coefcient associated with each project. But in any case, the
model seeks to maximize the utility of a shareholder who can diversify his portfolio. The
shareholder is therefore assumed to be indifferent to the risk specic to any given asset. This
is not true for a shareholder who does not hold a very diversied portfolio, and in particular
for someone holding a large proportion of the capital (as in a family business). And a
fortiori it is clearly impossible for the head of a business to ignore specic risk. When
reference is made in a company to the capital asset pricing model, it is usually in order to
determine the cost of capital for the company as a whole and not project by project. This
cost of capital is usually increased more or less explicitly by a premium which factors in the
specic risk. This method will be analyzed briey below.
We shall use the term specic risk premium to refer to the safety margin which has to
be added to the cost of capital to arrive at a discount rate. The adjective specic is used
because the systematic risk is generally allowed for in the denition of cost of capital, but
in practice the premium in question is often dened in a pragmatic manner, without there
being a real distinction between specic and systematic risk.
An increase in the discount rate reduces the impact of future cash ows, this reduction
being greater the further they are in the future. Some writers justify this by arguing that the
value of a future cash inow is subject to uncertainties which become greater the further into
the future we look. But this is not always true. When we seek modern equipment for an ultra-
deep offshore development, for example, the capital cost, which will have to be borne over
the early years, may be much more uncertain than the longer-term receipts.
A major problem inherent in this approach is obviously the fact that the denition of a
risk premium is arbitrary. A high risk premium can only be justied in very special cases.
As remarked by R. Charreton and J.-M. Bourdaire [1985], using a risk premium is equiv-
alent to applying certain probability factors. If i0 is the discount rate not including any
specic risk premium and pr is the specic risk premium, then the present value of a cash
ow Fn in year n is:
Fn
(1 + i0 ) (1 + pr )
n n
A risk premium of 10%, for example, involves applying a factor of approximately 0.6 in
year 5. This is equivalent to assuming that there is a 60% probability that the given ow will
take place, and a 40% probability that it will be nil (e.g. complete expropriation without
compensation). This would be a very high assumed risk.
240
When this method is adopted the safety margin used may vary between different divisions

within a company, as a function of the risks to which the different activities are subject. A
problem may occur if the same specic risk premium is applied to all the projects in a sector,
when risks may in fact even vary for the different projects within a single sector. A strict
application of the method may therefore lead to inconsistent decision-making.
The use of a specic risk premium has another disadvantage. We saw earlier that the
concept of the expected value is well suited to the study of small independent projects.
Account only needs to be taken of risk in the case of large projects (or when projects are
interdependent). Increasing the discount rate would lead to the same decision being taken,
whatever the multiplier which one might choose to apply to the various cash ows for the
project, on similar projects irrespective of their size.
As a result, when a discount rate is adopted which incorporates a specic risk premium,
the criteria which use this rate are never applied in a strict manner. Furthermore at present
the oil industry appears to be using this device less than it has in the past. Where it is still
being applied, lower risk premiums are being used (typically between one and a few percent).
In any case an analysis is always needed of the risks and uncertainties applying to any
project. In some cases a sensitivity analysis will sufce while in others, probabilistic calcu-
lations may be needed. There are techniques based on decision theory which permit the
analyst to go beyond the multicriterion approach mentioned earlier.
6.4.4.3 Decision theory and the expected value/variance criterion

In Section 6.4.4.1 we gave two examples where a choice between projects was modied
when account was taken of risk aversion, and which show that the satisfaction created by
an inow of money is not proportional to its value. Decision theory permits this satisfaction
to be quantied by means of a utility function. But translating theory into applications runs
into a number of difculties. Attempts to construct a utility curve (necessarily subjective)
have usually been abandoned by the oil industry.
R. Charreton and J.-M. Bourdaire1 [1985], on the other hand, have suggested a criterion
consistent with decision theory, but simple, appealing and therefore easy to put into practice.
For independent projects it consists of replacing the NPV by:
2
m
2P
where
m is the expected value of the NPV
2 is its variance
L is a parameter which characterizes the ability of the company to accept risk and which
represents the maximum acceptable loss which will not jeopardize the survival of the
company; this sum can be estimated (relatively) easily by general management.
1. Charreton R, Bourdaire JM (1985) La dcision conomique. Que sais-je ?, PUF, Paris, France.
241
CONCLUSION
Economic evaluations of investment projects using discounted cash ow are the rule in oil
companies, as in other large corporations.
It is important that these evaluations are carried out in a rigorous manner because,
although the techniques are very simple, this very simplicity can lead the novice to forget
the snares awaiting the unwary practitioner. We have mentioned a number of these traps:
going, other things being equal, for the project with the highest rate of return when choosing
between projects; unreective use of a discount rate which includes a high risk premium;
mixing values in current and constant prices, etc.
Whether one sticks to a sensitivity analysis, always a must, or goes for more sophisticated
techniques for analyzing risk, capital budgeting techniques are intended to summarise in a
single or a small number of numerical values a large set of data. They are a tool for ensuring
coherence between the assumptions used by different sectors in the company. Of course the
economic evaluation is only one of the factors to be taken into account when making a
decision, because it is never possible to quantify all the consequences of a decision. But the
object should be for it to be used by all the different actors involved in investment projects:
technical, nancial and management specialists, etc.
In this regard economic evaluation can provide a means of communication between
specialists with different backgrounds: a genuine common language.
242
7 Information, accounting and
competition analysis
In this Chapter we shall examine the issue of information on exploration and production
activities, and how oil companies deal with this information in the context of their nancial
accounting.
Management in this sector, like any other, relies on an information system so that they
can steer the enterprise on a sound course, optimise its choice of projects and provide all
the information needed for:
Investors who monitor the fortunes of the companies they intend to invest in, and who
make use of competition analysis to benchmark performance;
Creditors and suppliers, who have to evaluate nancial strength and creditworthiness;
Financial analysts, who appraise company performance with a view to advising
potential investors;
Stock exchanges, when seeking a new stock market quotation;
Regulatory bodies, whose job it is to ensure that the company is in compliance with
current regulations.
These data are provided mainly in the form of a balance sheet, a prot and loss account,
a statement of changes in equity, a cash ow statement and disclosures. These documents,
mainly based on historical data, cannot claim to give a complete picture of the company, or,
on their own, permit its worth to be measured. They must be interpreted with caution (for
example a building bought several years ago appears in the balance sheet at its cost of acqui-
sition rather its present value) and need to be supplemented with other information
including share price trends if the company is quoted on the stock exchange and by qual-
itative information regarding non-quantiable aspects.
There are specic accounting issues which arise in relation to the oil and gas explo-
ration/production sector, and it is vital to understand these so that all the information provided
by petroleum companies can be used wisely.
These specic issues result from the following characteristics of the sector:
The relationship between expenditure and revenue, both in terms of amounts and timing can
be very loose. A company may have invested $1 500 million (historical costs) in an oileld
243
Chapter 7 Information, accounting and competition analysis
of 100 Mb, the value of which could collapse when production starts if the price of oil falls
to $50/barrel or, conversely, soar if the price rises to $ 150/barrel. Furthermore the costs
are incurred early on in the process, possibly extending over a period of 510 years, while
the receipts which follow may be spread over a period of 1020 years, or even more in some
cases. The oil company will be required to provide information both in the short term (quar-
terly, yearly) and the long term (throughout the productive life of the oileld).
The intrinsic value of a petroleum exploration/production company depends largely on the
size of its reserves. And yet when the company makes a discovery, this does not affect
the assets in the balance sheet.
The sale price of hydrocarbons does not depend in any way on the seller. It is therefore
difcult for him to estimate the value of an oil or gas eld, and yet he is required to carry
out such an exercise to comply with various legal obligations.
Oil companies conduct their activities in association with other oil companies, and the
contracts that bind them to the host country are often specic, imposing particular
constraints on data structures and the management of projects. This factor inuences the
way the company organises its internal accounting system.
These difculties make it an extremely complex matter for a nancial analyst to carry out
evaluations or comparative studies of the companies in the sector. However the history of
the oil industry shows what a major role has been played by American companies, whose
leading position is to reect in the hegemony of United States of America Generally
Accepted Accounting Standards ("US GAAP"') internationally.
This situation has evolved due to the introduction of International Financial Reporting
Standards ("IFRS") since 2005. Indeed, European listed companies have had to prepare their
nancial statements in compliance with IFRS since the beginning 2005. Many other coun-
tries are also choosing to adopt IFRS as their national regulatory bodies move to converge
with the standards. The IFRS are becoming widespread and the oil and gas companies in
Europe need to comply with these new standards.
Furthermore, the leading international oil companies are all quoted on the New York Stock
Exchange and are therefore bound by the requirements of the Securities and Exchange
Commission (SEC).
In this context, the knowledge of both US GAAP and IFRS is therefore essential, when
examining non American companies' fmancial statements.
We shall begin by analysing in detail the accounting principles governing investments,
costs and oil and gas reserves, as well as depreciation and provisions.
We shall then go on to look at information specic to the upstream petroleum sector which
allows comparative studies of oil companies to be carried out. We shall begin with the infor-
mation provided by oil companies in annexes to their annual reports, and will then dene a
Box 7.1 SEC (Securities and Exchange Commission).
Companies quoted on the New York Stock Exchange have to submit a special form
(form 10-K for US companies, form 20-F for other companies) to the SEC giving the
balance sheet, prot and loss account and a statement of source and application of funds,
all consolidated.
Supplementary information is appended in annexes (analysis of xed industrial and
intangible assets, etc.) and, for oil companies, information prescribed by SFAS 69.
244
Box 7.2 FASB (Financial Accounting Standards Board), SFAS 69 (Statement of

Financial Accounting Standards).
Oil and gas activities are dealt with by specic publications based on recommenda-
tions of the FASB. Their objective is to be able to measure the repercussions on the
nancial position of a company of the cost of exploration and development of oil and gas
resources, and of the revenues from their sale.
In 1977 the FASB published for the rst time a SFAS (no. 19) requiring the oil
industry to publish information about their oil and gas production activities. The term
production includes extraction, gathering , processing and in situ storage.
The following year a new concept known as Reserve Recognition Accounting
(RRA) was introduced, based on the specications of the SEC, published in the
Accounting Series Release (ASR). This document requires that reserve data are published
in the companys nancial statement, with an indication of forecast future production and
associated expenses, accompanied by a very detailed description of past performance.
This resulted in a nancial statement not subject to standards, which led the FASB to
propose a new standard in 1982, the SFAS 69, which denes the way in which the reserves
and associated costs should be presented in an annex to the annual nancial report.
The recommendations in the SFAS 69 were accepted by the SEC. The denition of
proven reserves in this document is largely based on the requirements of the U.S.
Department of Energy.
Box 7.3 IASB (International Accounting Standards Board).
The International Accounting Standards Board was formed in 2001 and is an

independent, private-sector body that develops and approves International Financial
Reporting Standards (IFRS). The IASB operates under the oversight of the International
Accounting Standards Committee Foundation.
Concerning the European Oil and Gas companies, the IASB did not have time to develop
a comprehensive standard on extractive industries in time for the entities converting to IFRS
in 2005. Therefore, the IASB issued IFRS 6 in December 2004 and provided an interim
solution by allowing entities to continue applying their accounting policy in respect of explo-
ration and evaluation until a more comprehensive solution is developed. As a matter of fact,
European Oil and Gas Companies have maintained their previous accounting principles such
as SFAS No. 19 and SFAS No.69 as they did not conict with IFRS.
number of indicators which can be constructed from these data. And nally we shall describe
the many difculties involved in using these data.
For readers not familiar with accounting practices, an introduction to nancial accounting
is appended as an annex.
7.1 ACCOUNTING PRINCIPLES

7.1.1 Capital and operating costs
According to current usage, the term capital costs (or investment costs) is used during
the exploration and development phase and the term operating costs during the production
phase. These capital and operating costs relate to many different operations, as can be seen
in Table 7.1.
245
Table 7.1 Costs in the upstream petroleum industry.
Exploration Development (offshore) Production
Development drilling
Acquisition of mineral rights Construction/
installation platforms Operating costs related
to pumping, gathering,
Enhanced recovery: processing and
Preliminary studies
wells storage systems
Geological studies
pumping equipment
Seismic operations
other
Exploration drilling (Flowline connectors)
Production installations: Transport costs

Appraisal drilling/ separation/processing
delineation of discoveries discharge
storage facilities
The distinction between an investment and an operating cost for the purpose of the accounts
may not correspond exactly with the way these terms are used in everyday language.
According to accounting principles (GAAP: General Accepted Accounting Principles),
capital costs appear in the balance sheet and operating costs in the prot and loss account.
While economists and accountants can agree on what constitutes a cost for the purpose of
the prot and loss account, accountants may have different views about capital costs,
depending on the method they apply.
The U.S. accounting standard SFAS 19 provides for two methods of treating the explo-
ration and development costs: the successful efforts method and the full cost method.
Generally speaking the large integrated oil companies use the former method (at least for
their consolidated accounts) and other companies, for example the American independents,
prefer the latter. The two methods differ in their approach as to what is regarded as an
investment during the exploration phase.
7.1.1.1 The successful efforts method

In this method, only expenditure which leads directly to a successful discovery is capitalised.
Let us consider each of the various categories of expenditure.
A. Costs of mineral rights

The costs incurred in acquiring mineral rights, for example the purchase of the licence, the
payment of an exploration bonus, broking costs and legal costs are considered as capital
costs. If the investments made do not result in a commercial discovery, they are written off
from a provision set up for this purpose.
B. Exploration and appraisal costs

The preliminary studies and the geology and geophysics are charged directly against income
i.e. are not capitalised because although these techniques provide fundamental infor-
mation, they do not contribute directly to the discovery of oil and gas.
246
Table 7.2 Comparison of the successful efforts and full costs methods.

Successful efforts Full costs
Cost of acquiring mineral rights Capitalised Capitalised
Geology/geophysics costs Expensed Capitalised
Costs of dry exploration well Expensed Capitalised
Costs of exploration well, Capitalised Capitalised

productive or ongoing
Development costs Capitalised Capitalised

(including dry development well)
Production costs Expensed Expensed

Apart from the purely accounting aspects, these two methods lead to differences in the overall
results in terms of the annual prot/loss and the return on capital. When the full costs method
is used, all the costs of an unsuccessful exploration are capitalised. As a result the book prot
will be higher than that obtained using the successful efforts method (in which dry wells are
treated as operating costs), but the return on capital employed will be lower.
The treatment of drilling costs depends on the outcome of the drilling: if the drilling is
unsuccessful (dry well) the costs are treated as operating costs. If the results are successful,
however, the drilling costs are capitalised. During the entire drilling period, the exploratory
drilling costs are temporarily capitalized pending determination of whether the well has found
proved reserves if both of the following conditions are met:
The well has found a sufcient volume of not yet proved reserves to justify, if
appropriate, its completion as a producing well, assuming that the required capital
expenditure is made in the course of the eld development;
The company makes sufcient progress assessing the reserves and the economic and
operating viability of the project.
The nal result of any exploration well is twofold:
The well will have added proved reserves : it will therefore be classied in the category
of capitalized exploration;
The well has not found any proved reserves: its entire cost must be expensed.
C. Development costs
Development costs are the costs necessary to put the reserves discovered into production. They
include seismic 3D analysis, which allows the eld to be monitored dynamically, the drilling
of production and injection wells, the installation of production and processing plant, gath-
ering and storage systems and systems for transporting the product to the point of contractual
delivery. These costs are directly linked to the reserves discovered, and are capitalised.
7.1.1.2 Full cost method

This method provides for all exploration and development costs to be capitalised. The assets
shown in the balance sheet are greater, for this method, than for the successful efforts method.
247
7.1.2 Reserves
7.1.2.1 SFAS 69 denition of reserves
The reserves of hydrocarbons, which form the most important asset of oil companies, are
not included in the balance sheet (except for purchases of reserves, which are included at
their purchase value). Since 1982 however, the SFAS 69 species how information on
reserves should be disclosed in the companies Annual report (booked reserves). The gures
given relate to the proven reserves, i.e. the quantities of hydrocarbons the recovery of which
from known reservoirs is regarded as reasonably certain in present technical and economic
conditions.
A distinction is made between reserves of liquids (oil plus natural gas liquids) and of gas.
The units are millions of barrels (Mbbl) for liquids and billions of cubic feet for gas. Conver-
sions are based on energy equivalence, and every company uses its own ratio, depending on
the quality of its gas. The conversion rates vary between 5 300 and 6 000 ft3/bbl.
Variations in the amount of the reserves compared with the previous year must be allo-
cated between six categories:
1. Changes resulting from an improved knowledge of the reserves (due to the drilling of
a new development well, for example), or a change in the economic environment;
2. Enhanced (secondary or tertiary) recovery (injection of water, associated gases, steam,
inert gas, etc.);
3. Enlargement and discoveries resulting from the exploration of an uninvaded or virgin
zone, or from delineation beyond the perimeter of the proven reserves;
4. Acquisition of proven reserves;
5. Sales of proven reserves;
6. Production during the year.
It is not always easy to make this allocation, and in practice there is a certain degree of
freedom in the choice of category. A further complication is that a distinction has to be made
between developed proven reserves (quantities which can be produced from existing instal-
lations and wells, without any further development) and those not developed.
It should be noted that the SFAS 69 advocates identifying separately those reserves
coming from subsidiary companies fully or proportionally consolidated (rst category), and
subsidiary companies consolidated by the equity method (second category).
The SEC denition of reserves based on the notion of reasonably certain recovery, may give
rise to problems of interpretation. Each company will have its own policy on accounting for
its reserves. A very cautious company will always retain the most conservative estimate of
its reserves as knowledge develops about the eld. Others will post a best estimate , subse-
quently correcting this gure as needs be.
7.1.2.2 Reserves and the taxation/contractual basis

The concept of reserves as understood by a petroleum accountant is very different from the
physical reality of volumes of hydrocarbons discovered.
First of all, he only recognises the existence of proven reserves; the concept of probable or
possible reserves appears too uncertain for him. He therefore takes a strictly deterministic view
of reserves, forgetting that part of the probable and possible reserves may become proven
reserves in the future. Furthermore he will take account of the tax system applied to the
248
Box 7.4 Historical background to the different denitions.

The Society of Petroleum Engineers (SPE), the American Association of Petroleum
Geologists (AAPG) and the American Petroleum Institute (API) have made recommen-
dations with regard not only to proven reserves but also to probable and possible reserves.
These recommendations made by the petroleum industry are very close to those proposed
by the SEC.
Other efforts have been made at the international level to formulate acceptable den-
itions of reserves. In 1987, for example, the SPE published new denitions, including an
extended discussion of the concept of present economic conditions and the need for the
reserves to be commercially viable.
At the World Petroleum Congress (WPC) in 1983 a working party drew up a nomen-
clature for reserves, conrmed at the 1987 WPC, which resulted in the report Classi-
cation and Nomenclature Systems for Petroleum and Petroleum Reserves.
This WPC report, together with the 1987 SPE denitions, is widely used by government
agencies (Nigeria, Syria, Venezuela) and oil companies (BP, Chevron) which use it as a
reference point for their own denitions of reserves. None of these denitions permits a
probabilistic calculation of reserves. In 1997 the SPE and the WPC jointly published a set
of denitions which refer to both deterministic and probabilistic techniques.
On December 31, 2008, the SEC issued its revised disclosure requirements for oil and
gas reserves. The final rule and interpretations was published on January 14, 2009 (Final
Rule).
The Final Rule modifies the SEC s reporting and disclosure rules for oil and gas
reserves by, most notably:
changing the pricing assumptions from the prior use of single day year-end price to
the use of average prices during the 12-month period prior to the ending date of the period
covered by the SEC report;
permitting voluntary disclosure of Probable and Possible reserves;
expanding the range of acceptable technologies used to reliably estimate a
company s reserves;
requiring disclosure of reserves in each foreign country where more than 15% of a
company s global proved reserves, in barrels of oil equivalent, are situated;
requiring the disclosure of the qualifications of those persons responsible for a
company s estimates and audits.
production of the reserves in question in order to determine the amount of the reserves which
will be disclosed in the nancial statements. This means that a company operating under a lease
will not enter the same amount as one with a production-sharing agreement.
Historically, the rst system to be adopted by producer countries was the system of
leasing. The idea is only to take credit for the proportion of the reserves which it effectively
owns. A leaseholder therefore only takes account of its interest in the eld after deducting
the royalty, paid in kind as remuneration to the owner of the site. The reserves in this case
therefore correspond to proven reserves net of royalty.
In certain leasing systems royalties can be considered as a tax on production, and are therefore
not deducted from reserves. In this case the reserves are the gross gure. In this system, of
course, in addition to producing the reserves and paying the royalties, the leaseholder also pays
249
one or more petroleum taxes each year which are charged against income in the prot and
loss account; the reserves accounted for before these payments are therefore gross of tax.
The advent of new scal regimes has further complicated this system of accounting.
Production sharing contracts (PSCs) began to be developed with effect from 1966. In this
system the oil company is a contractor, and only owns part of the production; it can therefore
only bring that part of the reserves into its accounts, i.e. the cost oil (the repayment of all
its costs) and its share of the prot oil. The rest of the prot oil accrues to the State, and is
therefore not accounted for as the reserves of the oil company.
Some PSCs, however, regard the States share of the prot oil as a tax, and the company
can then include the total prot oil in its reserves. The reserves announced therefore corre-
spond to access to hydrocarbons. In order to quantify them, nancial modelling of the
contract until the end of the eld life is required.
Finally, in the case of a service contract the contractor is reimbursed his expenses and
remunerated nancially rather than in kind. He never owns the reserves, and does not
therefore include them in his nancial statement.
Contracts of mixed type are becoming more and more common, and it is not always easy
to decide in which scal category a particular set of reserves fall. In order to decide, oil
companies refer to rules laid down by the SEC to guide them as to what should be accounted
for as reserves.
These rules reiterate the matters which need to be dealt with in an international agreement
or contract if proven reserves are to be identied and disclosed. These include the right to
extract oil or gas, the right to take payment in kind, exposure to risk (technical and economic)
through its activities and a clear mineral interest. In addition, the rules draw up a list of
specic elements which do not require to be identied and disclosed as proven reserves.
These include interests limited to the right to purchase certain volumes of hydrocarbons,
supply or factoring agreements, services or nancing which do not involve any risk or in
which a clear mining interest is not involved.
The main theme in the foregoing is related to risk and reward: the reward must be linked
to a risk (technical and economic) if the company is to disclose an item as reserves.
7.1.3 Depreciation and provisions

In this section we shall only deal with those aspects of depreciation and provisions specic
to the upstream petroleum sector. More general material on depreciation, and details of
straight-line and declining balance depreciation will be given in the Annex to Chapter 7.
We shall therefore deal with depreciation by the unit-of-production method recommended
by the SEC and the FASB for investments in the upstream petroleum industry in consoli-
dated accounts. We shall then look at depreciation for projects still in the development phase
(slot ratio and reserve ratio) and will nally consider provisions for decommissioning and
site rehabilitation.
7.1.3.1 Depreciation by the unit-of-production (UOP) method

This method of depreciation considers that wear and tear to equipment is proportional to the
quantity produced by the equipment. In the case of exploration and production activities this
is not the production installation but the quantity of hydrocarbon reserves. The investments
are amortised at a rate proportional to the consumption (or depletion) of the reserves.
250
The depreciation rate is calculated according to the following formula:

production of hydrocarbons from eld in year n
Depreciation rate =
production in year n + reserves on 31 December in year n
The reserves in question are the proven reserves but, depending on the costs being depre-
ciated, a distinction must be made as follows:
Cost of acquiring licence: depreciation based on developed and undeveloped proven
reserves;
Capitalised exploration drilling and development costs: depreciation based on developed
proven reserves.
The depreciable balance or net capitalised assets are multiplied by this rate to nd the
amount of the depreciation.
Table 7.3 shows the depreciation prole obtained, based on an investment of $100 million
and initial developed proven reserves of 100 Mbbl. It is assumed that the reserves are not
re-evaluated during this time.
Table 7.3 Depreciation by the unit-of-production method.
n n+1 n+2 n+3 n+4 n+5 n+6 n+7 n+8 n+9 Total
Production (Mbbl) 10 20 20 15 10 7.5 7 5 3.5 2 100
Reserves on 31 Dec. (Mbbl) 90 70 50 35 25 17.5 10.5 5.5 2 0
Rate of depletion (%) 10.0 22.2 28.6 30.0 28.6 30.0 40.0 47.6 63.6 100
Capital cost ($ millions) 100
Net capitalisation 90.0 70.0 50.0 35.0 25.0 17.5 10.5 5.5 2.0 0.0
at 31 Dec.1 ($ millions)
Depreciation 10.0 20.0 20.0 15.0 10.0 7.5 7.0 5.0 3.5 2.0 100
($ millions)
Depreciation 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0
($/bbl)
1. The net capitalisation on 31 December in year n is equal to the net capitalisation on 31 December in year
n-1, plus new investment in the year minus depreciation in the year.
It can be seen in this example that that the depreciation in terms of its absolute value varies
tremendously over time, but is constant on a per barrel basis. In practice the exercise is
somewhat more complex because the estimated volume of the reserves is subject to constant
revision, and these changes have to be incorporated into the calculation. These variations
result not only from production but also from successive re-evaluations, due particularly to
improved knowledge of the eld as new investments are made. Some of the probable and
possible reserves, for example, will become proven reserves (there is a 90% likelihood that
actual production will exceed proven reserves).
251
Table 7.4 UOP depreciation.
n n+1 n+2 n+3 n+4 n+5 n+6 n+7 n+8 n+9 Total
Production for year (Mbbl) 10 20 20 15 10 7.5 7 5 3.5 2 100
Reserves on 31 Dec. (Mbbl) 40 45 50 35 25 17.5 10.5 5.5 2 0
Rate of depletion (%) 20.0 30.8 28.6 30.0 28.6 30.0 40.0 47.6 63.6 100
Investment ($ millions) 100
Net capitalisation on 31 Dec. 80.0 55.4 39.6 27.7 19.8 13.8 8.3 4.4 1.6 0.0
($ millions)
Depreciation 20.0 24.6 15.8 11.9 7.9 5.9 5.5 4.0 2.8 1.6 100
($ millions)
Depreciation 2.0 1.2 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 1.0
($/bbl)
These changes can also come about as a result of the impact of changes in the economic
environment on the protability of production, either forcing the company to cease
production earlier than anticipated or, conversely, allowing it to continue production. It
should not be forgotten that reserves are no more than the sum of the quantities produced
in each year from the rst year of production to the last.
Table 7.4 shows the depreciation prole obtained, based on an initial investment of
$100 million and initial developed proven reserves of 50 Mbbl. It is assumed that the esti-
mated reserves are increased by 25 Mbbl in year n+1 and a further 25 Mbbl in year n+2.
It can be seen that these upward adjustments in the estimated reserves result in higher
depreciation in the early years.
7.1.3.2 Slot ratio/reserve ratio for projects in the development phase

A problem arises in relation to development installations used to produce from a eld where
some of the reserves have already been developed and others still remain to be developed.
Typical examples of this kind of situation would be an offshore production platform ready
to start production, while development wells still remain to be drilled, or a satellite eld put
into production using installations set up for the main eld.
It is possible to apply a reduction to the value of the installations to be depreciated so as
to ensure consistency between the amount of the depreciation and the volume of the reserves
associated with the appropriate investments. The reduction coefcient can be taken:
Either as the slot ratio, i.e. the ratio of the number of the wells actually drilled to the
number expected;
Slot ratio = number of wells drilled
number of wells planned
252
Or as the reserve ratio (beginning of the year), i.e. the estimated ratio of developed

proven reserves to the total proven reserves:
Reserve ratio = developed proven reserves (end of the year n) + production year n
proven reserves (end of the year n) + production year n
These two denitions lead to different gures, as the following example shows:
An offshore production platform is constructed at a cost of $100 million;
An exploration well and two appraisal wells were drilled before development, at a total
cost of $20 million;
The number of development wells planned is 22;
The total proven reserves amount to 30 Mb;
On the 31st of December n, three development wells had been drilled;
Production began in year n, amounting to 500 000 barrels;
The developed reserves as at the 31st of December n amounted to 5 Mbbl, i.e. 5.5 Mbbl
originally, less production in year n.
The capital costs therefore amounted to $120 million (successful exploration well,
appraisal well and production platform), and have led to the discovery of oil and the
construction of production installations for the entire oileld. However since only part of the
reserves have been developed, only part of these investments will be amortised:
based on the number of wells drilled, the slot ratio is equal to:
wells drilled/wells planned = 3/22 = 13.6%, i.e. 13,6% 120 = $16.4 million.
based on the reserves, the reserve ratio is:
developed reserves/total reserves = 5.5/30 = 18.3%, i.e. 18.3% 120 = $22 million.
The capital costs adjusted by one of these two ratios are then depreciated by the unit-of-
production method based on the developed proven reserves.
7.1.3.3 Provision for decommissioning and site rehabilitation

These costs relate to the estimated costs of dismantling and removing the equipment and
rehabilitating the site less the value of any materials recovered. This work is generally
carried out after production from the eld has ceased, and the costs cannot therefore be amor-
tised from future production. In accordance with US GAAP (SFAS No.143 Accounting for
asset retirement obligations) and IFRS (IAS 37 Provisions, contingent liabilities, and
contingent assets), liabilities for decommissioning costs should be recognised in the balance
sheet when a company has an obligation to dismantle and remove a facility or an item of
plant and to restore the site on which it is located, and when a reasonable estimate of that
liability can be made. The estimate of the fair value of the retirement obligation should incor-
porate the best information available and should be discounted using a credit adjusted risk-
free interest rate for maturity dates that coincide with the expected cash ows.
A corresponding item of property plant and equipment of an amount equivalent to the
provision is also created. This is subsequently depreciated over the useful life of the facility
or item of plant
The decommissioning provisions are updated at each balance sheet date and any change
in the present value of the estimated expenditure is reected as an adjustment to the provision
and the corresponding property, plant and equipment.
253
7.2 COMPETITION ANALYSIS

IN THE UPSTREAM PETROLEUM SECTOR
Evaluating performance and benchmarking it against that of other companies in the same
sector is one of the basic tools used by management.
A comparative analysis of methods within the different divisions of a company, but also
with a sample of other comparable enterprises, permits the company to be evaluated and its
weak points identied, so that improvements can be made.
Competition analysis has been in use for many years and was formalised in the 1990s in
order to understand what others are doing and to learn from their experience. In order to carry
out a competition analysis, the following are necessary:
Decide what is going to be compared;
Dene the indicators to be used;
Decide on the internal sectors/subsidiaries and the other companies which will form
the sample for the study;
Collect the data;
Analyse the divergences between the companies in the sample, and infer areas where
improvements to ones own company can be made;
Regularly update the data used.
The most difcult task is to gather together data which are reliable and span a number of
years.
The best course is always to gather the data from source, i.e. from the company itself.
Apart from internal documents, not accessible to the outsiders, the material published by the
company and in the public domain are the most appropriate source. This includes annual
reports, published by all companies, supplements containing statistical and operational
material, produced by only some companies, and forms 10-K (American companies) or 20-
F (non-American companies), only available for companies quoted on Wall Street.
The material of particular interest in these publications is the supplemental information
on oil and gas producing activities in accordance with SFAS 69. In this document items
from companies subject to full consolidation are fully included, whereas items from
companies subject to consolidation by the equity method are included in proportion to the
percentage interest of that company in the specic area concerned.
The gures are broken down by geographical zone. It should be noted that the
geographical classication is not xed, and can differ from company to company, depending
on its area of activity and preferred presentation.
Using this information, various indicators of performance can be evaluated for a company
operating in the upstream petroleum sector.
7.2.1 Supplemental information on oil and gas producing activities

appended to the balance sheet
These include seven categories of information (unaudited).
1. Capitalised costs related to oil and gas producing activities.
2. Costs incurred in exploration, property acquisition and development.
3. Results of operations for oil and gas producing activities.
254
4. Reserve quantity information.

5. Standardised measure of discounted future net cash ows related to proven oil and gas
reserves.
6. Changes in the standardised measure of discounted future net cash ows.
7. Other information.
7.2.1.1 Capitalised costs related to oil and gas producing activities

This category comprises the capitalised costs (excluding assets disposed of) net of all past
provisions for depreciation. It begins with a statement of the gross capitalised costs, broken
down between:
The acquisition of underground reserves, successful exploration (that is the costs of all
exploration which led to the discovery of oil or gas) and development. These costs
relate to proven reserves;
The capitalised costs relating to unproven reserves (acquisition of mineral rights).
The total depreciation and past provisions are subtracted from the total of these costs in
order to obtain the net capitalised costs.
Box 7.5 Impairment test (ceiling test).
In accordance with US GAAP (SFAS No. 144 Accounting for the Impairment or
Disposal of Long Lived Assets) and IFRS (IAS 36 - Impainuent of assets), a company
needs to review the recoverable amounts of its property plant and equipment in order to
ensure they are not overvalued in the balance sheet. Indeed, the objectives of these
standards are to prescribe the procedures that an entity applies to ensure that its assets are
carried at no more than their recoverable amount. An asset is carried at more than its
recoverable amount if its carrying amount exceeds the amount to be recovered through
use or sale of the asset. If this is the case, the asset is described as impaired and the
standard requires the entity to recognise an impairment loss.
In order to measure the npairment loss, the company should calculate the economic
value based on future cash ows and on a certain number of assumptions:
The price of oil and gas from the eld (usually assumptions in the long term plan
of the company considered);
Proven and probable technical reserves;
Capital and operating costs estimated on the basis of these proven and probable
reserves including the decommissioning costs;
No allowance for cost of servicing capital or ination;
A discount rate chosen by the company (usually between 4 and 10%).
If the carrying amount exceeds the economic value, an impairment loss is recognised
in the income statement.
This test is not applied systematically. The calculation is only performed when there is a
denite risk of non-recovery of the book value of the investments (reduction in reserves, cost
overruns or changes in tax regime). Furthermore companies are allowed a lot of latitude
as to how they perform the calculation (reserves, price of hydrocarbons, discount rate).
255
7.2.1.2 Costs incurred in exploration, property acquisition and development

This category represents past expenditure, whether capitalised or expensed, broken down into
three different categories:
The acquisition of mineral rights, distinguishing between proven reserves and other
purchases;
Exploration costs;
Development costs.
All oil companies present these three categories by geographical zone, but in varying
degrees of detail.
By aggregating the values given over all the different companies, this category allows
overall trends in expenditure in the oil and gas exploration and production sector to be
monitored at the global level.
7.2.1.3 Results of operations for oil and gas producing activities

This category shows the value and direct costs of oil and gas production before capital
servicing costs and head ofce overheads. As a result, the operating result thus obtained does
not necessarily reect the contribution of these operations to the groups consolidated results
for oil and gas activities. On the other hand it has the advantage of allowing the performance
of the company to be evaluated separately from its mode of nancing (equity or debt).
The following categories are distinguished:
Revenues, including hydrocarbon sales and transport earnings (gas pipelines). Hydro-
carbon sales can be gross or net of royalties and, for a production-sharing contract,
gross or net of the States share. When the gross value is given, the royalties or the
States share are included as costs. However the gures are presented, the net value
remains the same. A distinction needs to be made between sales to third parties and
transfers between companies within the group;
Production costs, which can include not only the technical costs but also sometimes
the committed costs, and taxes on production;
Depreciation by the unit-of-production method and provisions (after recoveries) for the
year;
Exploration costs (geology, geophysics, dry exploration);
Other revenues and costs (losses or gains on transfer of assets, products and costs
related to transport activities);
Taxes, calculated arbitrarily by simply applying a mean rate (calculated in the country
concerned) to income from producing activities. These are not the amounts actually paid;
The results of oil and gas producing activities before nancing costs and overheads.
Revenues
production costs
depreciation
exploration costs
other revenues and costs
= pre-tax income from producing activities

income tax
= Results of oil and gas producing activities
256
The most difcult aspect of this calculation is calculating tax. This is purely theoretical, and

does not correspond to the real tax situation of the company (no account taken of losses in
previous years brought forward to the current exercise, tax-allowable provisions different
from book provisions, etc.). The result obtained is therefore a notional value which allows
the results of different companies to be compared independently of their tax situation and
their nancing method.
7.2.1.4 Reserve quantity information

The denition of reserves adopted here is that of SFAS 69 (see Section 7.1.2.1), consistent
with the SEC standards. It comprises the total of both the developed proven and developed
unproven reserves, and a breakdown of the annual variations. This amount will be included
in the following tables in order to calculate the standardised measure of discounted future
net cash ows and changes in this measure.
7.2.1.5 Standardised measure of discounted future net cash ows

related to proven oil and gas reserves
This category refers to the net present value, discounted at 10% p.a., of the proven reserves of
the company as at the 31st of December, based on a number of computational assumptions.
The estimates are based on the proven reserves to be produced, accompanied by a forecast
of the production prole. This calculation is carried out using the economic conditions at
the year-end, and assume that all the reserves will actually be produced.
The estimated discounted net future ows from the proven reserves are valued on the basis
of posted prices at year-end, except in cases where the existing contracts provide for xed
and determinable revaluations of the prices.
The estimated production costs (including, where appropriate, transport costs and taxes
on production), future development costs and decommissioning costs are deducted from
future ows. All estimates are based on year-end economic conditions.
The estimates of future taxes on prots are based on the legal tax rate in force locally at
the year-end.
A number of objections can be made to this calculation, for example, as follows.

The assumption regarding the price is questionable. Companies operating in seasonal gas
markets, for example particularly in the United States with prices which are higher in
winter, and therefore on 31 December, the reference date for prices will produce higher
present net values.
Only the proven reserves are allowed for. This is rather a pessimistic scenario, since the
eventual reserves are very likely to exceed the proven reserves only.
The future capital and operating costs are not those provided for in the basic scenarios used
by the oil companies. The latter allow for the development and production not only of the
proven reserves but also of a part of the probable and possible reserves, producing higher
values for production and costs.
The tax calculation is an estimate only; often the actual tax calculation is affected by activ-
ities beyond the connes of the eld being considered. The methods used for arriving at this
estimate vary between companies, which makes comparison difcult.
The use of a single discount rate does not take account of differences in the real cost of
capital to the companies holding the reserves. On the other hand the use of a standardised
value allows inter-company comparisons.
257
7.2.1.6 Changes in the standardised measure

of discounted future net cash ows
This category assists in reconciling the measure of net present value in successive years.
Apart from the turn over and the costs for the year, which have to be deducted from the net
present value in the earlier year, because they no longer form part of the future, there are
many other factors which contribute to the change. These various sources of difference fall
into two main categories.
The rst category of changes to the net present value can be regarded as constant
perimeter changes, i.e. changes which relate to the reserves as they were in the previous
year. Sources of variation in this category include:
A different price of oil and/or gas on 31 December;
A re-evaluation of future production and development costs (new technology, improved
knowledge of reservoirs);
The effect of discounting to a different reference year (one year later);
A variation in tax (not allowing for any change in production) resulting from a change
in prices or in the tax rates.
The second category of changes are related to changes the estimated size of the reserves
as a result of acquisitions or sales, enlargement and new discoveries or modied estimates.
This category demands careful application. For example it includes in the same category
variation resulting from price changes in oil and gas (which affect the size of the reserves
because of the change in the economics) and changes in costs.
7.2.2 Indicators
A number of indicators can be constructed from the supplemental information on oil and
gas producing activities in oil companies annual reports, so that their exploration and
production performance can be compared.
7.2.2.1 Reserve replacement rate

This indicator is obtained by taking the ratio of the additions to proven reserves announced
over a given period to the total production during the same period.
addition to proven reserves in period p

total production in period p
Additions to reserves include discoveries and enlargement, revisions, enhanced recovery

and, if appropriate, net purchases. The period generally adopted is ve years.
A company with a replacement rate of 100% has replaced what it has produced by an equal
number of barrels of future production. It can be said to have replenished its stocks. When
assessing this parameter at the global level, purchases and sales of reserves have to be
excluded because these are merely inter-company transfers, and do not create new reserves.
The calculation can also be performed by geographical zones, and separately for oil and gas.
The larger the reserves held by a company, the harder it is for the company to maintain
this rate at 100%.
258
7.2.2.2 Depletion rate

This indicator is the ratio of production in the year concerned to the amount of the reserves
at the beginning of the year. These reserves are calculated by adding the production in the
year to the reserves at the year-end.
production in year n
production in year n + reserves on 31 Dec. of year n
This parameter represents the rate at which the company is producing its developed
resources. In terms of equipment, this ratio comprises the depletion coefcient used in
calculating depreciation by the unit-of-production method.
7.2.2.3 Intensity of exploration and development investment

There are two ratios which express the level of investment that the company will commit
regarding its activity in a given period (usually between 3 and 5 years so as to smooth the
result). The activity is represented by the quantity of hydrocarbons produced net of royalties.
If only exploration investment is taken into account, we obtain the intensity of exploration:
exploration investment in period p
production net of royalties in period p
In the same way, the intensity of development investment can be measured by including
only development investment in the numerator.
development investment in period p
production net of royalties in period p
7.2.2.4 Finding cost

The nding cost seeks to measure the expenditure a company has had to commit to nd a
barrel of oil or its gas equivalent.
The principle appears simple, but a number of questions arise:
Which costs should be included?
Were the costs calculated according to the successful efforts or the full cost method?
Which reserves should count: discoveries, acquisitions, revisions, enhanced recovery?
If revisions and enhanced recovery are included, to which year should these quantities be
attributed: the year of discovery or the year of modication?
What time period should be taken?
What equivalence coefcient should be used between barrels and cubic feet?
Should the calculation be carried out at global level, by geographical zone or by sedi-
mentary basin?
The source information, i.e. the six categories of supplemental information on oil and
gas producing activities, was not intended for this calculation. Every company, depending
on its accounting methods or the image it wishes to project, and every nancial analyst
(depending on the information he possesses) will use a different denition of nding cost.
259
In fact there are three competing denitions:

Exploration costs/additions to reserves (excluding revisions);
Exploration costs/additions to reserves (including revisions);
Exploration and development costs/additions to reserves (including revisions and
enhanced recovery).
The last denition is very deceptive, because it includes development. Some companies
may occasionally include purchased reserves in the calculation.
Since the purpose of this ratio is to determine how efcient the company is at nding reserves
in its exploration activity, it seems illogical to include the purchase of reserves (purchase cost
in the numerator and number of barrels purchased in the denominator) or enhanced
recovery (cost of enhanced recovery in the numerator and additional number of barrels
recovered in the denominator).
7.2.2.5 Finding and development costs

This indicator is calculated by dividing the exploration and development costs for a given
period by the proven reserves associated with the discoveries, as well as enlargement,
revisions and enhanced recovery announced during the same period. This ratio is also
equal to:
exploration intensity + development intensity

reserve replacement rate (excluding purchases)
7.2.2.6 Reserve replacement cost

This cost is obtained by adding the cost of licence purchase (proven and unproven reserves)
to the items included in the calculation of the nding and development costs.
Finding costs, nding and development costs, reserve replacement costs

The main difculty in calculating these cost indicators is to ensure consistency between the
numerator and the denominator. Over a period of three to ve years we cannot hope to be
able to link directly all the expenses in the numerator with all the reserves in the denomi-
nator. Certain expenditures now will permit reserves to be found at a later date, and
conversely some of the reserves in the denominator are the result of expenditure well before
the period in question.
Finally, these ratios only make sense for fully or proportionally consolidated entities. Where
consolidation has been carried out by the equity method, the reserves will be included in
the denominator, but the corresponding costs will not be included in the numerator.
7.2.2.7 Barrel-based ratios

These involve relating various items from the prot and loss account to the number of
barrels produced (the production is expressed in accordance with the SEC standard, and is
therefore net of royalties). In the same way as the reserve-based ratios, these ratios are only
meaningful when applied to companies subject to full or proportional consolidation.
The following elements can therefore be calculated:
260
Prot and loss account items Barrel-based ratio

Turnover Mean revenue per barrel
production costs (taxes on production Production cost per barrel
generally included, as is royalty)
depreciation (the SFAS 69 standard Depreciation per barrel
advocates also including exceptional
items and provision for site rehabili-
tation)
exploration costs (in accordance with the Non-capitalised exploration costs
successful efforts method) per barrel
other revenues and costs
= operating prot / loss before tax Pre-tax prot per barrel
taxes on prots
Net operating prot / loss After-tax prot per barrel
7.2.2.8 Impact of contract types on the ratios

In the same way as for the gures for the reserves appearing in the accounts, certain items
in the prot and loss account and the corresponding per barrel ratios depend heavily on the
scal and contractual system applying: the results will differ depending on whether the
reserves are produced under a lease or a production-sharing contract (PSC).
Let us consider the following four cases, the rst a lease and the other three PSCs (for
details on how various types of petroleum contract work, see Chapter 5).
A lease, royalty 20%, tax 85%: a standard lease. The reserves (which are simply the
sum of the production each year) appear in the accounts net of royalties.
A PSC, cost oil 50%, prot oil 10%: a standard PSC. The reserves appear in the
accounts net of the States prot oil.
A PSC, cost oil 50%, prot oil 10%, the States prot oil is included in the reserves.
The prot oil is treated as a tax (tax oil), and therefore increases the gure for the
reserves which appears in a standard PSC.
A PSC, cost oil 50%, prot oil 20%, tax on prot oil 50%, States prot oil excluded
from the reserves.
We assume that in the case of the PSCs, the excess cost is shared between the State and
the company by using the same split as for the prot oil.
261
1 600
Net profit /
Company profit oil
1 400
State profit oil
1 200 Tax oil

Taxes on profit
1 000 Royalties
Depreciation
800
Production costs
600
1: Lease
400 2: Standard PSC
3: PSC (tax oil)
200
4: PSC with tax
0
1 2 3 4
Figure 7.1
Under each of the four contractual bases the companys net prot is the same. But the oper-
ating prot and all the per-barrel ratios are totally different. This means that comparisons
of these parameters will not be relevant unless the analyst has a detailed knowledge of the
contractual and tax systems used in the calculations.
Here are the other assumptions used in the analysis

production for the year ............................................................................ 100 Mbbl
sale price .................................................................................................. $15/bbl
production costs (recoverable in the year).............................................. $200 million
annual capital expenditures (CAPEX) depreciation ............................... $400 million
Table 7.5 summarises the results for the company and the per-barrel ratios calculated by
applying these contractual bases to the same eld.
CONCLUSION
All these indicators are useful in giving an appreciation of the value of a company, but they
give greater insight into the past than the future. Furthermore they are calculated on the very
conservative basis of proven reserves only.
The most appropriate method would be to calculate expected future cash ows, extended
to include all reserves, that is, allowing for:
The portfolio of elds currently under development or in production;
The portfolio of elds not yet developed;
Expected discoveries related to the companys exploration activities.
An analysis as described above needs to be complemented by a study of market-related
factors, such as the market capitalisation of the company, the market value of its reserves
262
Table 7.5 Per-barrel ratios for different contractual bases.

No. 1 No. 2 No. 3 No. 4
Lease Standard PSC PSC
PSC (tax oil) + tax
Quantities of crude sold Mb 100 463 1005 527

Net quantities sold Mb 801 46 100 52
Gross turnover $M 1 500 6904 1 500 7804
Royalties $M 300
Production costs $M 200 200 200 200
Depreciation $M 400 400 400 400
Operating prot $M 600 90 900 180
Tax (and/or tax oil) $M 5102 8106 908
Net prot $M 90 90 90 90
Production costs/bbl $/bbl 2.5 4.3 2.0 3.8

Depreciation/bbl $/bbl 5.0 8.7 4.0 7.7
Operating prot/bbl $/bbl 7.5 2.0 9.0 3.5
Net prot/bbl $/bbl 1.1 2.0 0.9 1.7
1. Total production less royalty, i.e. 100 (100 20%) = 80 Mbbl.
2. (1 500 300 200 400) 85% = $510 million.
3. Company cost oil + prot oil. Cost oil = production costs + depreciation = $200 + 400 million, which
must be converted into barrels, so divided by the sale price of $ 15/bbl = 40 Mbbl, total prot oil = (100
40) = 60 Mbbl, i.e. a prot oil for the company = 60 10% = 6 Mbbl.
4. Cost oil + prot oil by value, i.e. $600 million + 6 Mbbl $15/bbl = $90 million, i.e. $690 million in total.
5. The States prot oil (tax oil) is considered a tax, and is included in the production and reserves gures
in the companys accounts.
6. Tax oil, i.e. (100 40 6) Mbbl $15/bbl = 54 15 = $810 million.
7. Cost oil + company prot oil. Cost oil = (200 + 400)/15 = 40 Mbbl, prot oil = (100 40) 20% = 12 Mbbl.
8. 180 50% = $90 million.
as reserves if there is an active market serving as a reference, and indeed the analysis of infor-
mation from other sources such as:
Press releases of the companies circulated by press agencies such as AFP or Reuters,
and which are available on the companies Internet sites. These releases may give quar-
terly results or information on the strategies of the company;
Specialised publications produced by consulting rms or nancial analysts, in the
form of inter-company comparisons;
Computerised databases offered by consulting companies, for example giving the
reserves held by the companies.
263
Annexe
to Chapter 7
Basic principles of nancial accounting
Financial accounting collects and organises information needed by a business and compiles
it according to certain principles, as follows:
Historical costs: accounting documents are maintained in actual historical costs (current
prices), without correcting for ination or discounting.
Methodological consistency: accounting methods must remain constant over successive
accounting periods. Any change must be justied.
Continuity: The keeping of accounts is obligatory, even where a company has not had any
activity during an accounting period.
Independence of accounting periods: accounts are closed off at the end of each accounting
period, so that the results for that period can be obtained.
Due care: the accounts must allow for foreseeable future risks.
Good faith: the accountants must act in good faith.
The purpose of nancial accounting is to provide a periodical snapshot of the companys

situation in accordance with the chart of accounts or other contractual document (annexes
to accounts).
The position with regard to the assets and liabilities of the company is summarised in the
balance sheet which provides information on the overall worth of the company on the date
as at which it was drawn up. The consumption and production of the enterprise are dealt with
by accounting for the costs incurred and revenues earned in the accounting period in which
they occur, the results being shown in the prot and loss account (change in the worth) for
that accounting period. Capital operations are shown in the funds ow statement. Furthermore,
additional information can be shown in the disclosure of the Financial Statements.
The purpose of the basic accounting principles as applied in drawing up the balance sheet
and the prot and loss account (and the disclosures) is to give a true and fair view of the
companys nancial position. These accounts are veried by independent auditors.
265
7A.1 THE BALANCE SHEET
In order to carry out projects a company needs to create wealth and make the necessary
investment, allowing it to produce and market.
7A.1.1 Assets
Investment involves creating the means of production. These may be tangible, such as
purchased or constructed equipment, whether replacement, expansion or diversication; or
they may be intangible, such as know-how, patents, etc.
There are two major types of assets:
Durable assets of the company whether goods, rights or claims: land, buildings, indus-
Annexe to Chapter 7
trial equipment, vehicles, patents, mineral rights, etc. These are called xed assets. These
xed assets appear in the balance sheet at their book value, that is, their cost of acqui-
sition less depreciation (see prot and loss account). They may include securities, such
as shares in other companies, and goodwill. Goodwill is the excess of an enterprises fair
value over its book value at the date of acquisition.
Capital used in the companys operating activities or in short term operations. These are
known as the current assets. They meet various needs (a) to have a certain quantity of raw
materials, energy and services in hand in order to initiate operating activities, (b) to fund
the requirements resulting from the delay between the time when expenditure is incurred
in connection with an operation and the receipt of the corresponding revenue (working
capital) and (c) the need for liquid funds. These assets fall into the following three cate-
gories:
Stocks (non-capitalised), including raw materials, work in progress and nished
products. Stocks are generally either merchandise destined for sale or products which
will be used to manufacture this merchandise;
Accounts receivable: these are invoices issued and credited but still unpaid at the date
of the balance sheet. This amount can be considered a credit extended to customers
which needs to be nanced (trade debtors);
Liquid assets comprising cash balances or equivalent, such as cash accounts, bank
deposits and short-term investments which can be realized rapidly.
All these investments are included as assets in the balance sheet. They represent the total
assets which need to be nanced.
7A.1.2 Liabilities
Liabilities refer to all the sources of nance. There are effectively three forms of nance.
Equity capital i.e. the nancial resources provided by the shareholders. These are the funds
subscribed by investors when the shares were issued and retained earnings, i.e. earnings
which have not been distributed in the form of dividends (reserves). These funds have to
be remunerated, either by dividends or an increase in the value of the shares. Equity capital
is made up of shareholders equity and minority interests.
Long-term debt, made up of loans from banks, nancial markets and other companies, as
well as all the bonds and debentures of the company with a term greater than one year.
They include nancial debts (loans and bank overdrafts), provisions for the payment of
266
pensions, provisions for restructuring, provisions for site rehabilitation and deferred taxes

(see 7A.4).
Short-term nance, made up of all the companys debt with an outstanding term of less
than one year, also referred to as current liabilities. These are partly operating debts.
Accounts payable arise in the same way as accounts receivable from clients, but in
relation to purchases from suppliers, and therefore comprise a source of nance. Other
operating debts refer to all non-nancial debts of the company such as taxes payable to
the inland revenue authorities, salaries payable, social security outstanding, etc. There are
also short-term debts, including bank overdrafts, those long-term debts which fall due
within a year, use of credit lines, etc.
The liabilities therefore represent all the funding available on the date at which the
balance sheet applies, and the assets represent the way these funds were applied.
Annexe to Chapter 7
7A.1.3 Presentational forms of the balance sheet
7A.1.3.1 Classical presentation
Figure 7A.1 shows the classical form of the balance sheet, separating the long- and short-
term components and showing the denitions of working capital, working capital requirement
and net liquid assets.
The presentation can vary, for example French companies interchange the positions of the
short- and long term assets, the short-term assets being shown at the bottom of the balance
sheet.
ASSETS LIABILITIES
Capital employed
Equity capital
Fixed assets
Net fixed assets
Long-term debt
Working capital
Working capital requirement

Operating capital
Operating debt
liabilities
Current
Current
assets
Net liquid assets

Liquid assets
Short-term debt
Working capital (WC): the amount by which the permanent funds exceed net xed assets. It is therefore that part of the medium
and long term nancial resources which can be used to nance the operating activities.
Working capital requirement (WCR): amount of capital needed to allow the capital to nance its operating activities.
Net liquid assets (NLA): Short-term assets less short-term liabilities.
We therefore have: WC = WCR + NLA
Figure 7A.1 Balance sheet, classical format.
267
7A.1.3.2 Simplied presentation

The balance sheet can also be presented with operating items separated from items related
to the nancing (Fig. 7A.2). We then have:
net debt: long- and short-term nancial debt minus the liquid assets;
operating liabilities: long-term provisions and deferred taxation.
Assets Liabilities
Shareholders capital
Annexe to Chapter 7
Fixed assets Minority interests
Net debt
Operating liabilities
Working capital requirement
Figure 7A.2 Simplied balance sheet.
7A.2 PROFIT AND LOSS ACCOUNT
The prot and loss account is a synthesis of the accounting events during an accounting
period which increase (prot) or decrease (loss) the overall wealth of the owners. It incor-
porates all the revenues and costs during the period, the difference corresponding to the
prot/loss for the period.
The revenues are the events which add to the wealth of the owners. In the case of oil
companies these arise mainly from the sale of oil and gas. The costs, on the other hand, are
the items which deplete this wealth. The prot and loss account includes cash outows
resulting from the companys operations corresponding to the direct use of materials,
consumables and labour.
However the prot and loss account must also allow for the calculated costs associated
with the consumption, that is the wear and tear to the equipment and installations. These
installations are designed to last for a certain period. There is therefore a lag between the
time when their capital cost has to be disbursed, and therefore accounted for (this is done
in the ow of funds statement) and the times at which these capital assets are actually used.
The latter results in wear and tear which extends over time: this is depreciation, a non-cash
cost.
7A.2.1 The presentation of prot and loss account

The prot and loss account generally takes the form shown in Fig. 7A.3.
The net cash ow (after taxation) or self-nancing capacity is equal the net inow of cash
in the prot and loss account, i.e. net prot plus depreciation.
268
Operating costs
COSTS
REVENUE
Financial costs
Sales Taxes
Net Cash flow

Depreciation
Net profit / loss

Financial income
Figure 7A.3 Prot and loss account.
Annexe to Chapter 7
The net prot provides the company with resources to pay a dividend to shareholders and
increase their equity.
7A.2.2 Presentation showing intermediate balances

The prot and loss account can also show various intermediate balances (Fig. 7A.4), and can
separate, as for the balance sheet, operating and purely nancial items. Such a presentation
is often only given in an annex (analysis of the result by sector of activity).
Operating
costs
Depreciation
Operating
revenue Taxation
Gross operating
surplus Operating
profit / loss Operating Cost of net debt
profit / loss
after tax
Net profit / loss
Figure 7A.4 Prot and loss account showing intermediate balances.
The operating prot/loss represents the contribution to prot of each operating unit. It may
be before or after tax, but is always before nancial charges.
The operating prot/loss after tax: this is the operating prot/loss corrected to allow for
the effect of taxation on operating revenue. This tax is before taking credit for reliefs
relating to the servicing of debt. These reliefs are accounted for in the item cost of net
debt.
The net cost of debt is made up of costs and nancial credits directly attributable to the
items which make up the net debt (including the effect on taxation of these items).
The net prot/loss is therefore the operating prot/loss after tax less the net cost of debt.
269
7A.2.3 Depreciation
Wear and tear on the working equipment since its commissioning is reected in the balance
sheet item net xed assets, i.e. the value of the all investments less depreciation. The wear and
tear for a given year, on the other hand, appears in the prot and loss account in the form of
a debit: the allowance for depreciation. The term depreciation (instead of allowance for depre-
ciation) is often used for convenience to designate this item in the prot and loss account.
The rules for calculating depreciation are imposed from outside the company. Three
separate practices can be distinguished:
7A.2.3.1 The depreciation shown in the corporate nancial statements

This is calculated by adhering to the laws, norms and rules of the country in which the
company is operating. Its main purpose is to establish the dividend to be paid to shareholders,
Annexe to Chapter 7
but also to calculate the taxes the companies will pay.
7A.2.3.2 The depreciation shown in the tax accounts

The taxes to which the petroleum industry is subject often consist of a series of levies, each
calculated using its own amortisation rules, which can be different from those used to
calculate the corporate income tax.
In France (and countries operating on the French model) an investment can only be
written down by reference to the production generated by that investment.
In the UK and other countries which have adopted the British system, on the other hand,
amortisation can start as soon as the capital costs have been incurred. This differing treatment
has a considerable effect on project economics in cases where the petroleum assets are
aggregated for tax purposes (no ring fence), that is, the calculation can be carried out for them
all together.
In the system applying in English-speaking countries a further distinction is made
depending on the nature of the investment expenditure:
Intangibles (services or assets with no residual value) which are treated as a current
expense in the operating account. Intangibles are not capitalised and do not appear in
the balance sheet;
Tangibles (physically recoverable, or having a residual value at the end of life of the
investment), are capitalised in the balance sheet and are depreciated in the operating
account according to the rules laid down in the country concerned.
It should be noted that the distinction between tangibles and intangibles can vary
depending on the tax rules. Intangibles, for example, may comprise a specic part of an
investment: the wellhead or casing in the case of a well. They may alternatively be linked
to the physical position of the investment: platforms being tangible (on the surface) and wells
being intangible (below surface) for a development investment.
7A.2.3.3 Depreciation in the consolidated accounts

Finally, in drawing up consolidated accounts, and in particular for SFAS 69 accounts,
companies abide by the recommendations of the SEC and the FASB (Financial Accounting
Standards Board), which recommend unit-of-production depreciation on the basis of the
developed proven reserves for investments in the upstream petroleum industry (SFAS 19).
270
This recommendation complies with IFRS (IAS 16 Property, Plant, and Equipement).

Investments shared by several elds (treatment facilities, export pipelines) are amortised on
the basis of developed and undeveloped proven reserves, or even by straight-line depreci-
ation (usually over 20 years).
7A.2.3.4 Straight-line depreciation

Equipment wear and tear is assumed to be occur uniformly over its life. It is easy to see that
this does not apply to an oil or gas eld, since production declines over time.
7A.2.3.5 Declining balance depreciation

This assumes that wear and tear are very high when production begins, and reduce with time.
This basis of depreciation is more appropriate for writing down oil and gas producing instal-
Annexe to Chapter 7
lations, although it does not take account of the specic characteristics of the eld. The rate
of depreciation in this method is calculated by multiplying the straight-line depreciation rate
by a factor determined by the tax or company accounting rules applying; the straight-line depre-
ciation rate of course depends on the life of the item being depreciated. A particular case of
this rate uses a multiplier of 2, and is referred to as the double declining balance (DDB) method.
Table 7A.1 compares depreciation proles for the declining balance and straight-line
methods for an investment of 100, an asset life of 8 years and a declining balance depreci-
ation rate of 25% (so a double declining balance since 25% = 2 1/8).
Table 7A.1 Comparison of declining balance and straight-line depreciation.
DDB and straight-line depreciation

Year
Net value Depreciation Straight-line over DDB Straight-

Investment 31.12 remaining life depreciation line
(1) (2) (3) (4) 8 years
100 100
1 75.0 25 % 100 = 25.0 100.0 : 8 = 12.5 25.0 12.5
2 56.3 25 % 75.0 = 18.8 75.0 : 7 = 10.7 18.8 12.5
3 42.2 25 % 56.3 = 14.4 56.2 : 6 = 9.4 14.1 12.5
4 31.6 25 % 42.2 = 10.5 42.2 : 5 = 8.4 10.5 12.5
5 27.3 25 % 31.6 = 7.9 31.6 : 4 = 7.9 7.9 12.5
6 15.8 7.9 7.9 12.5
7 7.9 7.9 7.9 12.5
8 0.0 7.9 7.9 12.5
1. Net value at 31.12 in preceding year (1) less depreciation for the year (4).
2. 25% of net value at 31.12 in preceding year.
3. Net value at 31.12 in preceding year divided by remaining life.
4. Once the result in column (3) exceeds the result in column (2), it is taken until the end-of-life.
7A.3 CASH FLOW STATEMENT
The funds ow statement, also known as the statement of sources and application of funds
or the statement of changes in nancial position, summarises all the capital operations which
have taken place during an accounting period. It is a dynamic account of what has happened
during the period, and complements the point-in-time perspective of the balance sheet.
271
The table gives, for the period considered:

New loans contracted and any increases in capital, as well as the cash generated by the
operations (cash ow): these are the sources of cash;
Capital expenditure, repayments of loans, dividends paid and the change in working
capital requirement: these are the uses of cash.
Figure 7A.5 shows the relationship between the tax account, the prot and loss account
and the funds ow statement.
The distinction should be noted between depreciation for tax purposes (tax depreciation)
and depreciation for calculating the net prot/loss (accounting depreciation).
Tax account Profit and loss account Funds flow statement

Annexe to Chapter 7
TAXABLE REVENUES REVENUES + NET PROFIT

+ sales + sales (net of royalties) + accounting depreciation
+ nancial revenues
COSTS
= cash ow
ALLOWABLE COSTS + change in working capital requirement
royalties operating costs
operating costs accounting depreciation = operating cash ow
nancial costs investment
tax depreciation = OPERATING PROFIT (before tax)
taxes = available cash ow
= Taxable prot + change in debt
Losses brought forward = OPERATING PROFIT (after tax) + change in capital
/+ nancial costs/revenues dividends
= Adjustedtaxable prot
rate = TAX = NET PROFIT + VARIATION IN LIQUID ASSETS
Figure 7A.5 Relationship between accounts.
7A.4 THE CONSOLIDATED ACCOUNTS
There are different ways in which a company can develop its activities, particularly into other
countries: it can simply establish itself or a branch without a separate legal status, it can set
up a wholly (100%) or partly owned subsidiary, or it can take a holding in an existing
company.
When a number of companies are closely linked to one another, they form a group.
A parent company holds shares in other companies in the group: if it holds more than a
50% stake (ordinary or partnership shares) in a company, that company is called a subsidiary;
if the holding is between 10 and 50% it is called a minority holding.
Exploration/production companies are often in this situation, because they are often oper-
ating out of the national jurisdiction of the parent company.
The parent company draws up its balance sheet and corporate prot and loss account in
the normal way in accordance with the rules applying in the country in which it is based,
and its links with its subsidiaries impact on its accounts only in terms of nancial ows
(advances from and repayments to the parent company, dividends, etc.).
If a proper analysis, not only nancial but also industrial, of the group is to be made, it
is necessary to have access to the consolidated accounts of the group.
The principle of consolidation is that the nancial statements of the parent company
should give a picture of all the items which it effectively controls through its subsidiaries.
272
The method chosen depends on the level of control, essentially given by the percentage of

the voting rights owned (Fig. 7A.6).
As dened in IAS 27 Consolidated and separate nancial statements, control is dened
as the power to direct the nancial and operational policies of an entity in order to obtain
economic benets from its activities.
The parent company is presumed to have control when it holds more than 50% of the
voting rights (exclusive control) or when, if it holds 50% or less than 50% of the voting
rights, it benets from:
Control of more than half the voting rights by virtue of an agreement with other
investors;
The power to direct the fmancial and operational policies of the entity under a statute
or an agreement;
The power to appoint or remove the majority of the members of the management
Annexe to Chapter 7
bodies;
The power to cast the majority of the votes at meetings of the Board of Directors or
the equivalent administrative body.
Full integration
Integrates the accounts as to 100%
of all subsidiaries in which
the parent company
Control on company Yes has effective control
An additional item is introduced into

the liabilities in the balance sheet:
Interests of minority shareholders
No

Jointly owned company

Proportional integration
Oil/gas company held jointly Yes All items included in proportion
with other shareholders in to shareholding
the common interest
No

Equity method
Significant influence on company Holdings valued in proportion to

share of equity (including profit / loss)
of the companies
Figure 7A.6 Choosing the method of consolidation.
273
Joint control, as defmed in IAS 31 Interests in joint ventures, is the sharing of control of
an economic activity under a contractual agreement. This only exists if strategic nancial
and operational decisions in connection with that activity require the unanimous consent of
the parties who share control (co-venturers). Such a requirement ensures that no single
venturer is in a position to control the activity unilaterally.
Signicant inuence, as defmed in IAS 28 Investments in afliated companies, is the
power to participate in the nancial and operational policy decisions of the company without,
however, exercising control over these policies. This is assumed when the investor holds
directly or indirectly through subsidiaries 20% or more of the voting rights in the company
held (including potential voting rights).
The accounts of foreign subsidiaries are drawn up in the most important currency in the
particular economic environment concerned, described as the functional currency. In most
cases the functional currency is the local currency, except for a large number of subsidiaries
Annexe to Chapter 7
in the upstream petroleum sector for which the U.S. dollar is the most important currency.
The accounts are converted to the currency of the parent company at the rate applying on
the day the balance sheet is made, and at the mean annual rate for the prot and loss
accounts, conversion errors resulting being included in the equity capital.
Investments are usually depreciated in consolidated accounts by the straight-line method
over their life, with the notable exception of oil- and gas-producing assets, which are depre-
ciated by the unit-of-production method, that is as a function of the production prole of the
eld.
The fact that different depreciation bases are used for the tax calculations and in the
consolidated accounts leads to the establishment in the consolidated balance sheet of an item
for deferred taxation (with variations in this item appearing in the prot and loss account:
provision for deferred taxation). These are equal, at any particular time, to the difference
between the value for tax purposes and the book value of an asset or liability, multiplied by
the most recent tax rate. Of course this difference is one of timing rather than in the total
amount, so that the deferred taxes reduce to nil by the time an asset reaches the end of its
life.
Table 7A.2 Balance sheet and prot and loss account of parent P and subsidiary S.
Balance sheet parent P Prot and loss account parent P

ASSETS LIABILITIES COSTS REVENUES
Net xed assets 12 000 Capital 10 000 Operating costs 8 000 Sales 10 000
Shares in S 900 Reserves 2 000 Financial costs 500
Other assets 4 900 Prot for year 800 Taxes 700
Debt 5 000 Net prot 800
17 800 17 800 10 000 10 000
Balance sheet subsidiary S (90% owned by P) Prot and loss account subsidiary S
Net xed assets 900 Capital 1 000 Operating costs 3 600 Sales 4 000
Reserves Financial costs 100
Other assets 900 Prot for year 100 Taxes 200
Debt 700 Net prot 100
Total 1 800 1 800 4 000 4 000
274
An example of full integration is shown in Table 7A.2. Parent company P has a 90% stake

in a subsidiary S.
Corresponding items on the balance sheets and prot and loss accounts are rst summed.
Then:
The reference to holding of parent P in subsidiary S is removed;
The minority shareholders share in the net prot of S is entered into the prot and loss
account: Net prot (minority shareholder) = 10% 100 = 10;
The minority shareholders share in the capital and in the net prot is entered on the
liability side of the balance sheet: Minority holdings = (10% 100) + (10% 1 000)
= 110.
Table 7A.3 Consolidated accounts of P and S.
Annexe to Chapter 7
Consolidated balance sheet Consolidated prot and loss account
Net xed assets 12 900 Capital 10 000 Operating costs 11 600 Sales 14 000
Reserves 2 000 Financial costs 600
Other assets 5 800 Prot for year 890 Taxes 900
Minority holdings 110 Net prot (P) 890
Debt 5 700 Net prot
(minority shareholder) 10
Total 18 700 18 700 14 000 14 000
The consolidated balance sheet and prot and loss account are therefore as follows
(Table 7A.3):
Extract from balance sheet of company C:

Capital........................................................................................................ 1 000 000 O
Reserves ..................................................................................................... 200 000 O
Net prot.................................................................................................... 40 000 O
The example below shows how the equity method of consolidation works. Company P
has acquired a 25% interest in company C for O 200 000.
The initial value of the shares included in the assets of P is replaced by the share of equity
capital (capital + reserves + net prot) which they represent in company C. The difference
relative to the original value of the holding is broken down between the items consolidated
Extract from balance sheet of company P:

ASSETS:
Equity interest in C ...................................................................................... 310 000 O
LIABILITIES:
Consolidation surplus (in consolidated reserves) ......................................... 100 000 O
Share of prots of afliates ......................................................................... 10 000 O
Extract from consolidated prot and loss account of company P:

Share of prots of afliates ......................................................................... 10 000 O
275
8 Health, safety,
the environment, ethics
8.1 RISK IN THE INDUSTRY
Oil is often regarded by the public as a dangerous and polluting industry. This somewhat
dramatic view relates particularly to the operations traditionally perceived as the most
critical, such as drilling and transport by tanker and pipeline, which the public associates with
spectacular accidents such as oilwell blowouts and black tides which result from major
oil spills. In addition there have been several occasions when routine operations involving
long-term installations have proven to be a source of danger. Events in the North Sea such
as the capsize of the Alexander Kielland and the re on Piper Alpha were major contrib-
utors to this perception.
Exploration and production activities involve the manipulation of ammable substances
at high temperature and pressure which sometimes contain very toxic gases. The main risks
are essentially associated with uncontrolled escapes of hydrocarbons and other hazardous
substances, which can cause re, explosions and contamination. There are other dangers
inherent in the very nature of the means and processes deployed, such as ares which can
cause high levels of thermal radiation, or heavy, bulky objects which are difcult to
manoeuvre. These effects can be amplied by the working environment, which often involves
working in a constrained space in remote locations, particularly offshore.
Apart from problems occurring during operations, often due to human error, shortcomings
in the design of the structures is another major cause of loss of control in installations. In
order to prevent this, an assessment of risk must be fully integrated into the design of a devel-
opment project and all stages of the engineering.
Exploration and production induce also various effects on the environment, soil, water or
air. As all human activities, it contributes to greenhouse gas emissions, which means that
specic efforts must be taken to limit these effects.
277
8.2 SAFETY MANAGEMENT
Chapter 8 Health, safety, the environment, ethics
8.2.1 The Piper Alpha accident

The accident which befell the oil and gas production platform Piper Alpha in the North Sea
in 1988 called into question established offshore safety practices. This platform, situated
110 miles North-East of Aberdeen in Scotland, was destroyed in several hours following a
series of explosions, killing 167 persons. It led to production being stopped immediately, for
several months, at ve other elds, with a total loss of production of 300 000 bbl/d, repre-
senting 12% of the production of the North Sea. It was estimated at the time that the loss of
exports amounted to 550 million in 1988 and 800 million in 1989, with a loss of tax
revenue to the British government of 250 million in 19881989 and 520 million in
19891990.
The ndings of the enquiry conducted by Lord Cullen had a very major impact, leading
to a complete overhaul of the complex and sometimes conicting British supervisory system,
safety thereafter being overseen by a single administrative body, the Offshore Safety Division
of the HSE. The report also led to changes in the law, with greater emphasis on objectives
to be met. And nally it made clear the need for the development and application of a safety
management system (SMS) by all companies, a practise now regarded as standard in the
offshore industry.
This system is based on making a safety case demonstrating that the design, construction
and operation of every offshore installation is completely safe. It involves setting up training
and safety awareness-building programmes for both contracted personnel and others. It also
established a requirement for external safety audits. The safety case must be updated regu-
larly and submitted to the HSE, which has to assess whether the document has identied,
assessed and controlled the main risks to an acceptable degree. This notwithstanding, the
operator retains full responsibility for the safety of operations.
Legislation varies between countries, but many of the companies operating in the North
Sea have applied the new approach to safety at other elds all over the world, and these prac-
tices have been disseminated throughout the entire oil industry.
8.2.2 Reducing risk

The central production facility must be designed in a manner such as to limit risk by reducing
the frequency of malfunctions and minimising their consequences. More specically this
means:
Minimising the likelihood of a loss of control of production and particularly of escapes;
Reducing the probability of ignition/explosion where there is an escape;
Containing the consequences of any re, explosion or escape of toxic substance;
As a last resort, ensuring that there are means of evacuation for all contingencies.
In order to bring this about, safety imperatives are integrated right from the preliminary
design stage into the overall layout, ensuring safe separations are respected, and systemati-
cally separating the oil and gas treatment plant from ignition sources. The organisation of
each project therefore draws on traditional risk management methods such as quality control,
risk assessment, safety reviews and audits.
The treatment plant is equipped with specic safety facilities, most commonly reghting
systems. It is always equipped with an integrated process control system and an emergency
278
shutdown (ESD) system. Detectors continuously monitor pressure, temperature, liquid levels,

etc. As an anti-re precaution, gas detectors automatically shut down production and dispatch
the contents of processing units to the are. If a re breaks out, re detectors automatically
trigger sprinklers in the zone where re was detected. Reliability calculations are carried out
for all safety systems which depend on sensors and automatic mechanisms (safety integrity
levels or SIL).
Other systems not directly related to oil processing have an essential safety function. The
ventilation of certain conned areas, for example, ensures that the concentrations of am-
mable gases will be kept below the lower ammable limit in the event of a leak.
Finally, safety precautions are put into effect on equipment whose main function is not
safety. The accommodation quarters in dangerous areas are designed to withstand explosion
and re, and an overpressure is maintained in order to prevent gas, smoke or toxic substances
from penetrating. The gangways and means of escape must be able to maintain their integrity
for a minimum period following re or an explosion. At each stage of a project safety
reviews are conducted which are intended to ensure that processes in the treatment plant are
robust. They identify the main hazardous events which threaten the installation: blowout, res
and explosions, escapes of hydrocarbons, ship collision, helicopter crash, etc. Estimates are
made of the probability of occurrence of such events. They describe the measures taken to
minimise the risks of accidents and identify their impacts: rewalls, re-extinguishing
systems, additional ventilation or the installation of walls able to withstand explosions,
training and simulation exercises, protected shelters for personnel in the event of a serious
accident. The consequences of every potential failure are evaluated in terms of human casu-
alties, pollution and economic loss.
Safety is monitored and controlled throughout the entire lifetime of installations. Safety
systems and emergency procedures are developed by the operators. In the control room all
installations are continuously monitored; at the same time, rigorous maintenance is carried
out to prevent accidents and pollution. Those working in installations which process toxic
gases, for example hydrogen sulphide, are equipped with gas masks ready for immediate use
should there be a release. Gases no longer in their normal operating ranges are immediately
ared. Finally, all personnel must ensure, particularly offshore, that they are ready for an
emergency evacuation, a procedure practised regularly.
8.2.3 Safety management systems

Having looked at matters related to the design of installations, we shall now turn to safety
issues associated with operations.
8.2.3.1 Legal aspects

When an accident or disaster occurs, initial attention, and subsequently the investigations,
focus rst on technical defects and human error, and then turn to organisational deciencies.
Even in the nineteenth century, when there were no regulatory requirements imposed on
those running businesses to take preventive measures, case law apportioning civil liability
for accidents in the workplace often laid the blame on organisational weaknesses.
In recent years, organisation has been a central issue in criminal investigations of blame,
leading to subpoenas and indictments. This has been a feature of all the major industrial
disasters in recent years.
279
The EU Seveso II Directive, which took effect on 3 February 1999 and relates to the
prevention of major accidents, states clearly that it is the responsibility of all operating enter-
prises to practise a policy of prevention.
Management therefore has a clear responsibility to formulate a safety policy and make
organisational arrangements for safety. This legal requirement alone is sufcient argument
for the company to ensure that it has in place an effective safety management system.
8.2.3.2 Human factors

Human error is one of the major causes of accidents, and obviously has to be addressed by
ways other than merely punishing the guilty party. This is made very clear by looking at the
causes of errors. It can be seen that in most cases these are the result of underestimating the
risk, suggesting inadequate management and an inadequate appreciation of this danger in the
organisation of the work, equipment ergonomics, etc. What is more, as systems become more
complex, human error rises because it becomes more difcult for the workers concerned fully
to apprehend the danger associated with their decisions. Management studies have shown
that, since the 1960s, less than 15% of operational problems which arise, including the
prevention of accidents, can be dealt with effectively by the individual. The organisation of
work and training, and the dissemination of information is therefore critical to accident
prevention and to minimising the consequences of error.
This is why safety management is far more than a matter of merely solving technical
problems and enacting regulations.
8.2.3.3 Trading off cost and risk

Accidents impose considerable costs on the companies which sustain them; these costs are
difcult to quantify precisely because they include not only the direct costs, but also various
indirect costs such as reduced efciency and the tarnishing of the companys image.
Accident prevention equally involves costs. And because risk can never be completely
eliminated, these costs are theoretically unlimited. A limit must be imposed, however: this
is done by making use of the concept of acceptable risk.
Of course any death is unacceptable at the level of the individual concerned. But society
appears to tolerate, if perhaps not to accept, that almost 10 000 die each year on French roads.
If that were not the case, regulation and/or public pressure would ensure that vehicles were build
more solidly with technical speed limitation, that roads would be made safer, that motorists
would be subjected to more public information about the importance of their behaviour. Thus
society at present appears less concerned by deaths on the road than in the workplace.
Hence one may argue that a denition of acceptable risk is far from being widely agreed
or consensual. For this reason, it cannot be left entirely to individual discretion. This is one
of the fundamental aspects of safety management.
8.3 TAKING ACCOUNT OF THE ENVIRONMENT
Keen to maintain a positive image, oil companies endeavour to prevent or control environ-
mental problems resulting from their activities, and set clear environmental targets. These
relate mainly to reducing the aring of gas, emissions of hydrocarbons and the oil-content
of efuent, minimising the environmental impact of their operations, preserving biological
280
diversity and cleaning up the legacy of historical contamination. The companies are highly

aware of the very severe nancial consequences of accidents and pollution in terms of nes,
compensation payments and the negative impact on their image. They fully appreciate the
need for their operations to be clean and safe.
The companies have a duty to minimise the risk of oilspills, the economic, ecological
and, for many, psychological consequences of which can be enormously damaging to the
industry. Over the last 20 years, and particularly since the Exxon Valdez catastrophe in 1989
and the high-prole hearing which followed leading to the award of massive compensation
payments, a battery of regulations and a whole range of technical measures have been put
in place internationally to contain possible disasters. Since the Kyoto Protocol in 1996
greenhouse gases, and combustion gases in particular, are under scrutiny. In response to
concerns about global warming, and driven also by states desirous of making the most of
their natural resources, the practice of aring associated gases is declining, these gases
instead being reinjected into the reservoir, used for secondary recovery or, when possible,
marketed.
A global initiative led by the World Bank the Global Gas Flaring reduction has the
aim to reduce signicantly the emissions of CO2 due to aring. According to this organi-
sation, natural gas aring represents around 150 billion cubic meters every year, which is
more than the annual gas consumption of France and Germany and around 15% of
committed emission reduction by developed countries under the Kyoto protocol for 2008-
2012. Flaring takes place all over the world, rstly in Africa (30%), Middle East (25%) and
the Former Soviet Union (20%) but also in the Americas (10%), Asia (10%) and Europe
(3%). Reducing aring is not a simple task as it means limiting the emissions of associated
gas in the process where the use or reinjection is not easy. The major international oil
companies are members of this initiative and some of them have indicated that in new
projects they will study and limit, as far as possible, aring of gas (for security reasons,
some aring during installation or closure is to be maintained). For many international
companies this Global gas aring reduction initiative will mean a very signicant
reduction of GHG emissions in the next 5 to 10 years. There is surely a need to associate
better national companies in areas like the Former Soviet Union and Middle East where
there is also an important aring of natural gas. It is still difcult to measure globally the
situation but there is a strong commitment of many actors to improve the impact of explo-
ration and production in this area.
The main pollutants generated by exploration and production activities are sulphurous
gases. Nowadays measures are taken to purify these gases so that they comply with appro-
priate standards.
Liquid efuent poses a particular problem. Water is a by-product of oil production, and
the water naturally contains hydrocarbon emulsions. It is vital that the efuent is cleaned up
before being discharged. Efuent containing up to 40 ppm oil is presently tolerated, but oil
companies are seeking to impose a more stringent standard of 15 ppm. Production from
depleted reservoirs present difculties, because large quantities of water are used in the
production process.
Site rehabilitation at the end of eld life and in particular, the decommissioning of
offshore installations, are currently the focus of considerable attention. About a hundred plat-
forms are dismantled every year in the Gulf of Mexico. International regulations, which are
only indicative, are generally implemented by host governments. They are currently being
toughened in order to increase the protection offered to the environment.
281
8.4 THE STAGES OF ENVIRONMENTAL MANAGEMENT:
BEFORE DURING AFTER

This integrated approach looks at all stages of the life of a project.
8.4.1 Before: the preparatory phase

Before embarking on exploration or production activities a thorough assessment must be
made of the environmental impacts in accordance both with local statutory requirements, if
existing, and the environmental policies and procedures of the company.
In the rst place a statement must be drawn up of the regional and local constraints,
whether regulatory (protected zones, authorisation procedures), environmental (wetlands,
forests, groundwater, coral reefs) or socio-economic (sheries, sh farming, tourism,
exploitation of water resources, etc.).
The baseline study and the impact assessment are then carried out and, if the area is a
sensitive one, an intermediate stage is carried out comprising a preliminary reconnaissance
and a pre-impact study. The baseline study, which may be of a terrestrial or marine system,
documents the features of the site including the physical, climatological, geological, hydro-
logical, hydrogeological parameters as well as the chemical quality of the environment
(recording any pre-existing contamination), the biological resources, i.e. the ora and fauna,
as well as the socio-economic and local cultural context.
The impact statement will be accompanied by recommendations on technical aspects of
the project which will minimise the adverse effects, such as:
The design of the drainage network and water treatment installations;
The minimisation of visual intrusion;
The abatement of noise and emissions;
Proposed disposal of waste water: discharge or reinjection;
Waste management;
Impact on greenhouse gas emissions.
In the case of a statutory impact statement which most are proper account needs to
be taken of the lead times involved for the administrative procedures (approval may take
46 months), which means that the study needs to be carried out as early as possible. Very
often the impact statement has to be prepared and submitted for approval before the engi-
neering studies can start, so that a licence to build and operate can be obtained.
The impact statement for a project constitutes a real commitment. The recommendations
made in it represent a long-term undertaking on the part of the company to protect the envi-
ronment.
8.4.2 During: the operating phase

The approach depends on the type of operation involved, but it will any case be broadly
structured as follows.
8.4.2.1 The management plan

The management plan, which is implemented by each subsidiary, must include, in addition
to an organisation with clearly dened responsibilities which pays close attention to regu-
latory compliance, the following mechanisms:
282
Impact and risk assessments for modications or extensions of activities and installa-

tions;
Up-to-date operating procedures (management of waste and chemical products, proce-
dures for dealing with incidents);
Emergency response plans (anti-pollution plan);
A programme of self-surveillance and monitoring involving the reporting of signicant
environmental indicators;
A programme of audits and environmental reviews.
It should be remembered that the baseline study and the impact assessment comprise initial
studies of the environmental risks.
8.4.2.2 The anti-pollution plan

Each subsidiary company engaged in exploration and production must have a contingency
plan which includes:
An analysis of the sensitivity of the local environment to the potential risks, the regu-
latory framework and the resources available;
The denition of a strategy and appropriate action, a system of alert levels, lists
assigning tasks and a plan for mobilising external assistance;
An up-to-date inventory of methods and equipment for combating pollution;
The formation of teams responsible for combating pollution, with arrangements to
verify the effectiveness of the plan through regular practice and drills.
These anti-pollution plans can usually be activated at three levels, enabling a graduated
response according to the seriousness of the incident.
Anticipating crises and responding to them are the two cornerstones of the contingency
plan, which is why these exercises are of such huge importance.
8.4.2.3 Self-surveillance, monitoring and reporting

The impact study broadly sets the agenda for the monitoring programme, the indicators to
be adopted and the monitoring frequency (generally monthly). These indicators measure
emissions and discharges (emissions to air, liquid efuents, waste, etc.) and environmental
quality parameters (air, surface waters, groundwater, soil, ora and fauna). Some or all of
this information may be reported to the authorities. Major efforts have been made to reduce
the problem of waste. Special attention is also being paid to CO2 and other greenhouse gases.
8.4.2.4 Environmental audits

Audits are regularly performed at exploration and production sites, both in regard to
management issues (systems audits) and technical matters. The procedures must be clearly
established, and are based on checklists which are periodically updated.
A le is established for each aspect of the object of the audit comprising three elements:
An appraisal of the existing situation;
An assessment of the extent of compliance with a reference situation dened by the
regulatory requirements, the management system, good practice;
Recommendations seeking to improve the situation and ensure compliance.
283
8.4.3 After: the aftercare phase
Abandonment and decommissioning are dealt with by regulations. The rules governing
impact statements also often provide for account to be taken of site rehabilitation after
production has nished.
As far as onshore exploration and production are concerned, there are specic regulations
in most countries: a mining code, an oil and gas law or, as in France, an environmental law
for ICPE classied facilities or a police des mines(specic mining regulations). Offshore,
the disposal of platforms is dealt with by various international treaties and rules, including
UNCLOS (United Nations Convention on the Law of the Sea), the London Dumping
Convention, the IMO (International Maritime Organisation) and various UNEP conventions.
8.4.3.1 Well capping

It is not only production wells at the end of their productive life which have to be plugged;
the same applies to exploration wells when these prove not to have development potential.
Well capping operations are carried out on the basis of special rules and procedures, and
involve manufacturing cement plugs of different types (e.g. to isolate geological formations,
protect aquifers, etc.).
Well capping programmes involve submitting an abandonment plan to the authorities for
prior approval.
8.4.3.2 Offshore decommissioning

The IMO has issued guidelines for the decommissioning of platforms which apply to all
maritime regions except the North Sea, unless more restrictive rules apply locally. These
rules provide as follows:
All platforms of less than 4 000 tonnes and at depths of less than 75 m must be entirely
removed.
Platforms which are larger or located in deeper waters can be partially dismantled as long
as a depth of at least 55 m is left clear.
Installations erected after 1 January 1998 must be designed such that they can be totally
dismantled.
For the North Sea and North Atlantic sectors, decommissioning is governed by Decision
98/3 of the OSPAR Convention, in force since 9 February, 1999:
any unused platform must be entirely removed;
sea burial at the site and partial removal as envisaged in the IMO Convention, is
expressly banned;
exemptions may be allowed for certain categories of structure, particularly those which
satisfy certain criteria (dates, weight). This applies particularly to certain concrete struc-
tures, or steel platforms erected before 9 February, 1999 and where the infrastructure
or the jacket weighs more than 10 000 tonnes. For this last category the base or footings
can be left in place once the decommissioning report has been accepted. In any case the
superstructure (topsides) must be thoroughly cleaned, inerted and dismantled.
To date some 20 platforms have been decommissioned in the North Sea, but more than
400 more remain to be dealt with in the coming years.
284
8.4.3.3 Site rehabilitation

Some major rehabilitation exercises and, in some cases, site redevelopments, have been
carried out recently, for example:
The reforestation of the site of an exploration well in the Madidi National Park in
Bolivia;
The restoration, re-vegetation and implementation of anti-erosion measures along a
pipeline route in South-East Asia (Burma);
The decontamination of groundwater at a eld in Argentina by means of vacuum
pumping together with a biological process (bioslurping);
The decommissioning of old platforms in the North Sea.
At all three of these sites the contamination/disturbance predated the acquisition. It is
therefore impossible to stress too strongly the importance of baseline audits, which allow the
division of responsibilities to be determined when contamination is an issue.
In conclusion, in implementing an environmental management system, identication and
prioritisation of the risks is a crucial rst step. But the dynamic element in the system which
ensures that the approach will be perpetuated and improvement implemented, is the audit.
By adhering to this approach the operating companies should have no difculty in
obtaining certication under ISO 1400 or EMAS.
But apart from the quest for recognition, the environmental management system, like
the safety system, must form a permanent part of an integrated approach to the management
of the entire exploration/production activity.
8.5 THE INTEGRATION OF HEALTH,

SAFETY AND THE ENVIRONMENT
Safety and environmental matters are assuming an increasing importance for companies. The
international companies have begun to deal with these issues within a single health, safety,
environment (HSE) module.
Although safety and environmental requirements can sometimes appear to conict with one
another, an approach which tackles these two issues together proves more effective than a
piecemeal approach. It ensures that there will be an interaction between these two elements,
and provides a vehicle by which management can set strategic objectives, establish rules and
procedures specic to the company, supported by performance measures and remedial actions.
Depending on the activities involved, HSE rules need to be dened:
Relating to technical solutions, in terms either of technical specications or standards;
Procedures to be followed in emergencies.
Practical systems for managing health, safety and the environment are based on quantied
risk assessment. A guide describing best practice in industry and drawing on the principles
of ISO 9000 certication was published and circulated in 1994. Many companies adopted
these recommendations and developed a sophisticated system for the management of risk
which they have often validated through ISO 14001 certication.
The Norwegian system is an example: built on the TQM model (Total Quality
Management, developed by the European Foundation for Quality Management), the purpose
285
of which is to build awareness amongst managers and analyse the companys activity, not
only in economic terms but also in terms of safety, personnel satisfaction, environmental
results and relations with government. The system adopted by American companies, on the
other hand, emphasises the importance of motivating the personnel, cultural diversity, cost
control and the putting into practice, by management, of all the key elements.
Globalisation and technological progress have transformed the oil business, and nowadays
the public expects more of the multinationals. At present the oil industry has to operate on
the basis of three inseparable imperatives: economic development, social responsibility and
environmental protection.
The way in which the industry addresses safety and the environment has changed beyond
all recognition in the last 20 years. Safety, once considered the exclusive domain of the safety
department, has now become a concern of the company as a whole. Investment decisions
have to be based not only on economic feasibility but also have to factor in environmental
and social issues. Safety and environmental management have become an integral part of
the business. These matters become even more important when companies are operating in
harsh and sensitive environments such as deep offshore, tropical forests or the Arctic tundra,
and coming into contact with remote communities. The most apparent change in the
management of safety and the environment is probably the fact that commitments made by
the company are now publicised externally. The overall strategy and the objectives to be met
in these areas are communicated internally as well as to external partners and contractors,
who are expected to fall into line.
In many cases, oil companies try to take into account a price for CO2 in their evaluation
to measure the effects in terms of emissions. This leads to a limitation of these emissions
with regard to technical and economic conditions.
8.6 OIL AND ETHICS
The oil industry, like other large industries, cannot develop without regard to the socio-
political context in the countries in which it operates. This observation may seem a common-
place because all large industries have an impact on the environment, on the economy, on
social development, and even on a political level. What singles out the oil industry in this
regard, however, is the sheer scale of its impact: no other industry produces or transports
such large volumes of a raw material which is potentially dangerous because it is inam-
mable, and even explosive in certain conditions. Furthermore it is a raw material which can
harm the environment, that is, our biosphere and the innitely complex living world which
we subsume in the term biodiversity. These impacts can occur on land, sea or air.
The oil industry therefore interfaces directly with our most precious values: our natural
surroundings, our health, our safety. This is why public opinion is so sensitive to matters
related to the activities of the oil companies.
But it is not only in the areas of safety and the environment that the oil industry impacts
on society. Its great economic importance, in both producing and consuming countries,
means that it plays a key role in economic and social development. Since they are well
enough known, we will not repeat here the statistics showing the importance of oil and gas
in the budgets and the GNP of the major producing countries or in the trade balances of
importing countries, or indeed in the private budgets of consumers, particularly those who
own a car.
286
The vital economic role of oil and gas has a whole series of consequences which make for

a complex and potentially difcult relationship with society. Public acceptability is of course
one of the prerequisites for the harmonious development of any economic sector. An industry
can only nd and retain shareholders, employees, scientists and high-calibre managers if the
public understands its contribution to development, and believes that contribution to be
valuable, well managed, and acceptable on what might be called an ethical level.
The term ethical is one which everyone seeks to appropriate: both politicians and those
who make it their job to monitor the behaviour of politicians, both businesses and their
critics. Amongst the most important stakeholders are the organisations referred to as NGOs,
i.e. non-governmental organisations, so as to highlight their separateness from the state and
supranational bodies whose function it is to make and uphold the law.
We will not ourselves attempt to dene the term ethical. Larousse denes it as the
science of morality; it derives from the Greek , or moral. Knowing what is moral
and what is not, is one of the earliest questions to preoccupy man. Aristotle wrote three books
on the subject, which remain reference works to the present day. It should perhaps be
remembered that moral codes are not universal, and can change over time. One of the most
variable areas in this regard, also in terms of its practical consequences, is probably that of
the relative importance of individual rights over those of the community as a whole.
A book on oil is not an appropriate arena for philosophical reection, and we shall try to
approach the problem of ethics by looking in practical terms at some real problems encoun-
tered by oil companies. We shall therefore attempt to tackle the most important of these
problems at the conuence between law, morality, commerce, technology and politics. In this
brief review we shall try to look at the expectations of public opinion and political leaders
as a means of shedding light on the difculties and contradictions which questions of ethics
pose for the oil industry.
In fact the oil industry has achieved an almost unique feat: it manages to project a
negative image both in the wealthy, developed or consuming countries (home countries)
and in the often poor and undeveloped oil-producing (host) countries. This doubly
unfavourable image is due to the fact that, for their part, consumers hold the oil industry
responsible for the prices, often considered excessive, of the fuels they use. People in
producing countries, on the other hand, often perceive oil companies as veritable states
within a state exploiting their natural wealth, causing pollution and economic and social
imbalances, or even political destabilisation, in their country.
In drawing up a list of the main ethical problems faced by the oil companies, it has been
possible to refer in recent years to documents which most of them have in their possession:
ethical charters and guidelines for conduct. These documents serve to complement more
traditional texts dealing with problems of health, safety and the environment (HSE).
Health, safety and the environment have already been dealt with in this book (Sections
8.1 to 8.4), and we shall only refer to them again where, because of their social and political
consequences, they have a genuinely ethical dimension which transcends purely technical
issues of prevention, or the rehabilitation of environmental degradation.
These problems are of three kinds:
1. Ethical issues which arise relating to the oil industry and direct stakeholders: the oil
companies, their employees, customers, suppliers, shareholders and partners.
2. Ethical issues relating to the relationships between the oil companies and the countries
where they pursue their exploration and production activities.
287
3. Fundamental ethical issues: global environmental problems, biodiversity, the preser-
vation of natural resources, sustainable development and human rights.
8.6.1 Ethical issues within the oil community

These are the questions which weigh least heavily on public opinion, because they are
regarded as too specialised and of secondary importance compared with the fundamental
ethical issues, or the relations between the oil companies and host countries. Furthermore
they are not generally issues which are specic to the oil industry.
However this category includes quite a few important issues, which are indeed crucial to
the effective functioning of liberal and market economies. We shall consider a number of
examples.
First of all what should be the rights and duties of the companies in relation to the privacy
of their employees? Is it permissible, and to what extent, for a company to control how its
employees use their working time, their access to the Internet? Has it the right to limit their
political activity if this is judged potentially detrimental to or in conict with the activities of
the company? How can it be sure that none of its employees will get involved in insider dealing
on the stock exchange, or that they will not be tempted to accept some personal advantage if
their duties include procurement or the award of contracts? Will a company be able to guar-
antee that career progression and promotion to management will be purely merit-based, without
any form of discrimination based on gender, national or ethnic origin, religion or political afl-
iation? These are well and truly ethical issues, as is the issue of equity in dealings with partners
and suppliers. Clear conicts of interest can arise between practical expediency and ethics. Is
it legitimate to favour one particular supplier of goods or services at the expense of others if
relations with that supplier accord with the logic of industrial strategy, partnership or regional
development? The oil industry has a symbiotic relationship with the service industries which
supply it and a number of special factors apply in consequence.
Many more examples could be mentioned, and we see that often there are different view-
points, each in their way equally ethical, which can in practice conict with one another,
since they lead to different responses depending on which particular ethical aspect is regarded
as paramount. Consider, for example, the issue of ethical conduct towards shareholders. On
one hand there is a duty to ensure that information is transparent. On the other hand, there
is a duty to conduct commercial and industrial activities as efciently as possible. The latter
imperative, by its nature, tends to limit the transparency of information. Striking the right
balance between two ethical but conicting considerations is not a matter for detailed and
prescriptive rules. It has to be achieved by a combination of detailed knowledge and a good
understanding of the problem, a good dose of common sense and, ultimately, the moral qual-
ities of those who will make the necessary choices.
There is a strong commitment to achieve a better balance between these two objectives.
And some of the Sarbanne-Oxley rules try to avoid the excesses found in the behaviour of
some companies like Enron.
8.6.2 Ethical issues involved in relations with host countries

This subject is one which nds a much more ready response amongst the general public, and
which involves a number of risks for oil companies, sometimes difcult to deal with.
288
Central to this issue is the nature of the contracts which dene the terms under which a

foreign company often powerful and usually from a developed country will invest in a
country which is often relatively undeveloped, and will be rewarded, if successful, for the
risks it has taken.
The terms of these contracts reect the characteristics of oil and gas exploration and
production, activities in which chance plays a large part, which are highly capitalistic in
nature, and which, when successful, have a major impact on the host country. These contracts
dene how the proceeds from the production will be split between the investors and the host
country. The appropriation and use of these proceeds, often large in amount, are a major
political issue. They rapidly become central to the economic and political life of the host
country, and are the root cause of a host of ethical problems which arise. These problems
usually lead to resentment on the part of the public in that country, or of external observers.
This resentment is not without foundation. Petroleum exploration activities generate large
nancial ows, and can lead to or exacerbate factionalism, or even fuel armed banditry. It
is not always possible to make a clear distinction between these two types of destabilisation
and violent disorder.
There have been many oil-producing countries in recent years where attempts have been
or are being made to seize power: examples include Angola, Burma, the Congo, Colombia,
Sudan, Algeria, while armed banditry in various forms is rife in Nigeria and now in Algeria.
In countries where the authority of the State is being violently challenged, the oil
companies are considered by the insurgents as natural enemies in so far as they pay taxes
to the State, and are often the largest contributors to their budgets. It is of course these
budgets which provide the State with the funding needed to maintain law and order or
exercise repression, the vocabulary used depending on the point-of-view of the speaker, i.e.
pro- or anti-government.
It is possible to draw up a list of problems created in practice by the management of oil
revenues. We only mention the most common ones, which are faced both by host countries
and oil companies. For the former the problems which crop up most frequently are:
Whether to use the revenues for development or for other purposes (prestige, arms, etc.);
Division of revenues between State and producing provinces or regions;
National or local development;
Risk of appropriation or misappropriation of a part of revenues for benet of indi-
viduals or clans.
In the face of these problems the foreign investor has to manage its own interests, not
having any real inuence over the political choices of the host country. Such an inuence
would in any case be unethical, since interference in the political problems of the country
would lack legitimacy. There would be no legality or morality supporting such interference.
Is the company qualied to decide what is desirable for the development of the country and
what is not?
Some individuals and NGOs in both producing and consuming countries consider,
however, that oil companies have a duty to intervene in these debates and decisions, i.e. to
get involved in local politics, in such situations.
Faced with dilemmas of this kind, the logical attitude on the part of the oil companies
would be to refrain from interfering in local political affairs. But they then run the risk of
being held jointly responsible for the injustices and even crimes perpetrated in the name of
the State or other authorities in the country. Such problems are not new: ethical debates still
continue today about the degree of culpability of Pontius Pilate!
289
Only someone completely ignorant of the distribution of oil and gas resources throughout
the world would subscribe to the idealistic argument that oil companies should only invest
in countries with acceptable regimes. Could useable criteria of acceptability be devised?
We might doubt that. In the absence of reasonably solid criteria, could we delegate to
particular authorities, and if so which ones, the task of deciding either to boycott new
investment or to discontinue activities in countries where investments have already been
made? It is clear that such authorities would need to have considerable legitimacy and
powers if their action is to be effective:
Economic powers to provide for compensation mechanisms should activities be
stopped;
Powers of inspection and sanctions to deal with non-compliance.
In other words, the authority would have to be a powerful supranational body.
In looking at questions of ethics which arise in relations between oil companies and host
countries, we conclude that oil does not necessarily, in itself, lead to economic and social
development, nor is it necessarily a democratising factor. However it will be appreciated that
the adverse effects will be less severe where the political system is perceived by its citizens
to be legitimate, and that these systems will permit the oil revenues to be distributed in an
equitable and balanced way.
Regimes of this kind would not necessarily have to conform to the model of parliamentary
democracy, although that is probably the model best able to reconcile oil and socio-economic
development or oil and ethics.
Some recent initiatives have to be mentioned:
Chad. In order to export the crude oil produced in the Doba Basin elds, the construction
of a more than 1,000 kilometres long oil pipeline between Doba and Kribi (Cameroon)
had to be built. However the construction of such a pipe line was costly and faced a large
number of environmental problems. To make it possible, it was necessary to bring the
World Bank into the project.
In 1999 the World Bank Chad agreement introduced an innovative scheme designed to
maximize the social use of oil revenues. With this system, all direct oil revenues (royalties
and dividends) are paid into a sequestered account in the name of the Chad Government
in London. After deduction of payments relating to the debts owed to the World Bank,
the remainder of the revenues is divided up as follows:
10% is paid into a fund for Future Generations, for the period after Chad's oil reserves
are exhausted,
72% goes toward capital investment in ve "priority sectors" in the ght against
poverty: education, health and social services, rural development, infrastructure and the
environment and water supplies.
4.5% is paid over to the oil-producing region of the Southern Chad, as additional
reserve nancing;
13.5% is paid into the Chad Treasury to nance current public expenditure.
But, the rise in the crude price put a new face on the situation. In January 2006, it led the
government to denounce the agreement with the World Bank. Clearly making such a
system sustainable over time is not easy. Nevertheless, this kind of agreements present
promising solutions to provide a better use of the energy revenues.
The Extractive industries transparency initiative (EITI) has the objective to provide for a
detailed information on energy and commodity revenues, trying therefore to induce a
290
better use of these revenues. This initiative is supported by more than 30 countries and

25 big oil, gas and mining companies. It is very interesting in that among the countries
there are some of the more important oil producers in Africa or Central Asia, such as
Nigeria, Gabon, Chad, Azerbaijan and Kazakhstan, Trinidad and Tobago. All the major
international oil companies either American or European are involved in this initiative.
A dynamic process has been initiated and it should provide for a better knowledge of
commodity revenues.
8.6.3 Major ethical issues: the environment and human rights

Quite apart from ethical questions, the activities of the oil companies mean that they are
involved in a whole range of issues of a general nature.
It should be remembered that oil products and gas are produced in order to meet societys
needs for energy. Approximately 50% of this energy is generated by the oxidation of the
carbon contained in hydrocarbons (40% or more for natural gas and more than 60% for oil
products). This results in the formation of carbon dioxide. This is in the nature of the
process, and technological progress cannot change it. On the other hand technology can help
us to reduce the amount of energy we consume to achieve a certain result, or perhaps even
to sequester some of the carbon dioxide produced. However this is not in itself what the
ethical debate is about. The debate arises from the fact that there is a correlation between
the temperature in the lower atmosphere and its carbon dioxide content. This carbon dioxide
content has been rising ever since the industrial revolution, and the question is to know
whether increasing consumption of fossil energy could lead to major climate change. Such
changes could be benecial to some (Siberia, Canada, Nordic countries) but disastrous to
others (countries with semi-arid climates and low-lying coastal regions in particular). These
debates of course go far beyond the connes of the petroleum industry, but the latter
inevitably occupies centre stage in relation both to the problems and the solutions or remedial
measures which will need to be taken.
This vast problem, known as the greenhouse effect, is not the only global or local envi-
ronmental problem in which the oil industry is directly implicated. The climatic effect
caused by airborne particulate matter and the health effects of urban pollution are due in large
measure to the consumption of hydrocarbons. A number of ethical questions arise here
where political leaders have to make trade-offs, of their nature difcult to justify, between
short- and long-term effects, between public health and the economy. Although the oil
industry does not itself have to make these trade-offs, it is directly involved, at very least in
compiling technical reports which allow the facts to be established and understood before
deciding how to try to limit the impacts.
The oil industry is in particular heavily involved in transport-related problems. It has to
provide for the transport of large volumes of oil and gas by land and sea. A number of envi-
ronmental questions arise in this connection also, both local (oil spills, etc.) and global (emis-
sions of methane from urban gas distribution networks). These questions also involve
trade-offs between costs arising from the demands for ever greater safety and the implicit
and explicit costs of pollution, either local or global. This again gives rise to questions of
an ethical nature: what value should we attach, what priority should we give, to the survival
of a particular plant or animal species threatened with extinction, what value to the conser-
vation of biodiversity? What value should we attach to a human life? There are so many
questions to which there are no natural and simple answers, whatever moral or philosophical
frame of reference we adopt.
291
It is when major failures occur that these questions resurface: failures such as the wreck
of the Erika off the coast of Brittany in the last days of 1999. A detailed analysis of this
accident and its direct and indirect causes reminded all involved that only constant
improvement in international regulations will allow risks of this kind to be diminished. This
in no way means an abdication or absence of powers for national states. The latter have a
double task: to put their full weight behind ensuring that the international rules are the best
possible, and to ensure that the regulations are properly applied on their own territory as well
as by the companies under their jurisdiction.
A further point is that the objective of the oil companies is to produce fossil fuels, the
reserves of which are considerable but nite. This is not the least of the ethical problems.
To ensure that their activities are pursued within a framework of sustainable development,
the oil companies must involve themselves in developing techniques and policies for
reducing consumption so as to extend the era of oil and gas. Furthermore if they wish to
extend their role as energy suppliers into the very long term they will have to get involved
in the development of all forms of sustainable energy, whether renewable (solar, wind,
biomass, etc.) or simply durable, such as nuclear energy. This last category also poses its
own specic ethical problems.
No discussion, however brief, of the major ethical problems in which the oil industry nds
itself a participant can be complete without mentioning the question of human rights. We
have already observed, in looking at the relationships with producing countries, that although
the oil industry represents a source of wealth for these countries and therefore, potentially,
of development, it can also be associated with major breakdowns in the political and social
fabric, sometimes with tragic consequences. The oil industry therefore nds itself placed in
the dock, or even declared guilty, by public opinion when dictatorial political regimes
prosper, when civil war breaks out, or when cycles of violence and repression develop. In
situations of this kind the oil industry serves as a scapegoat, and has to face a range of conse-
quences. In such cases, as for the environmental problems discussed earlier, there are unfor-
tunately no simple rules or clear answers as to what constitutes ethical behaviour by oil
companies.
But there are areas where progress is being made, and these must be explored, in particular
through codes of conduct evolved between the governments of the countries of origin of the
large oil companies and the companies themselves. The U.S. Department of State, for
example, published an agreement of this type on 20 December, 2000, signed by the U.S. and
the UK as well as a number of oil and mining companies from these two countries. Agree-
ments of this kind cannot in themselves resolve problems of political instability or violence,
but they have the merit of recognising that these situations exist, and of trying to articulate
explicit rules of conduct for the companies in such contexts. Agreements of this kind
comprise the rst steps towards wider agreements which will also ultimately involve the
governments of producing countries. We may be about to write a new chapter in interna-
tional law, which recognises the right on the part of developed countries to interfere in the
way large international companies conduct themselves in other countries.
There is a clear movement from the oil industry to take into account the specic situation
of the host countries as they are long-term partners in extraction activity. The international
companies try increasingly to bring their contribution towards a sustainable development,
whether it is about the direct consequences of oil and gas extraction, or about the conse-
quences of economic development. It has to be a balance between the need for direct inter-
vention and the need not to interference with the central and local government of host
countries.
292
It may be only a modest start, but is a token of a growing awareness of global problems.

A global village needs global rules. In future the oil industry will not only have to comply
with the rules but also to assume an important responsibility in ensuring that these rules are
realistic, effective and ethical. If the oil industry succeeds in setting behavioural standards
for the rest of industry, it will have fully accepted the responsibilities conferred on it by its
economic weight and by the technical and human resources which it possesses.
293
UNITS FOR THE PETROLEUM INDUSTRY,
RATE CONVERSION
Symbols
k = 103 = kilo = thousand

M = 106 = mega = million
G = 109 = giga = billion
T = 1012 = tera = trillion
t = ton
m3 = cubic meter
ft3 = cubic foot (or cu ft)
bbl = barrel
oe = oil equivalent
Petroleum units Gas units
1 bbl= about 0.14 t (1 t = 7.3 bbl) 1 Tm3 = 35.3 T cu ft (1 T cu ft = 28 G m3)

1 bbl= 0.159 m3 (1 m3 = 6.3 bbl) 1 boe = 5.35 k cu ft (1 k cu ft = 0.18 boe)
XIV
INDEX
Index Terms Links
Abandonment 186 197

Achnacarry Agreement 18
AGIP 23
Agreements 302 305
geneva 302
teheran 305
tripoli 305
Alaska 25
Anglo-Iranian 12 21
Anglo-Persian 12 14 15
17 19 46
Arab Light 30 44
Aramco 20
Arbitrage 50
Arbitration 191
Azerbaijan 8
Bahrain 19
Baku 8 9
Balance sheet 266
Balikpapan 10 11
Barges 73
Benchmarking 254
Between Iraq and Iran 31
This page has been reformatted by Knovel to provide easier navigation.

Index Terms Links
Bonus 194 195

Brent 48
Brent blend 44
British Petroleum Company 12
Buyback contracts 203
C.S. Gulbenkian 18
Cash flow statement 271
Casing 73
Caspian 8 9
Caspian Sea 8
CFP 15 16 17
18
Churchill 12
CIF 45
Clemenceau 15
Club of Rome 25
Commerciality 185
Compaction 61
Compagnie Franaise des Ptroles 15 17
Competent authority 176
Completion 86
Concession 174 179 180
193 206
Consolidated accounts 272
Contract 164
day-rate 164
foot-rate 164
turnkey 164
Conventional hydrocarbons 99

Index Terms Links
Cost 221
equivalent cost 221
Cost oil 200
Costs 125 127 131
156 158 255
256
capitalised 255
development 131
exploration 125
incurred 256
operating 156
trends 127
Counter-shock 35
Decision trees 234

Decommissioning 284
Deep offshore 100
Depletion rate 259
Depreciation 250 270 271
declining balance 271
straight-line 271
UOP 250
Derivatives 49
Derrick 73
Deutsche Bank 17
Diesel 3 44
Diesel oil 44
Diesel-oil 7
Discordance 61
Discount rate 217
Dubai 49

Index Terms Links
Economic reproduction 109 110 111

Ekofisk 44
Elf 15 20
EMS 144
ENI 15 20 23
EPC 144
Expected value 231
Exploration 65
Extra-heavy oils 100
Exxon 7
FASB (Financial Accounting Standards Board) 245

Fina 20
Finding cost 259
FOB 45
Forward 49
Fossil carbon continuum 100 111
Fuel oil 7
Full cost method 247
Futures 49 50
Futures markets 48
Gas cap 79
Gas clause 192
Gas hydrates 104
Gasoline 7 44
Geneva 27

Index Terms Links
Geology 67
organic geochemistry 67
sedimentology 67
stratigraphy 67
structural geology 67
Geophysics 68
Ghawar 44
Government Official Selling 47
Government take 209
Gulf 12
Gulf of Mexico 25
Gulf Oil Corporation 12
Gulf plus 47
Heavy fuel 3
Heavy oils 100
Henry Deterding 11 46
Horizontal drilling 85
Hubbert theory 105
Hydrocarbons in place 95
recoverable 95
IEA 29 50
Incentives 193 204 207
INOC 25
Installations 137
production 137
transport 137
Institut Franais du Ptrole 23

Index Terms Links
Intensity of 259
Internal rate of return 220
Investment 259
Investment credit 197 200 208
Jackup 73
Jet-fuel 44
John D. Rockefeller 5
Jossef Djugashvili 9
Kerosene 2 5 6
7 10
Kirkuk 18
Kuwait 4 19 36
Lacq 21 22
Law 175
Legislation 175 176
LNG cycle 151
Logging 75
logging while drilling 75
mud log 75
wireline logging 75
Lognormal distribution 96
Majors 7 20
Marcus 10

Index Terms Links
Marcus Samuel 10
Marne taxis 14
Mesopotamia 15
Mexico 13
Mining title 174
Nationalisations 28
Net present value 219
Netback 35
Nobel 8
Non-conventional gas 102
Non-conventional hydrocarbons 99
Norsk Hydro 167
OAPEC 28
Oil shales 101
Oil shock 27 28 30
Oklahoma 45
OPEC 24 28 30
31 32 33
Optimists 109 110
Options 49
Ownership 171 172 194
Participation 207
Permeable 65
Pessimists 109 110
Petrol 3

Index Terms Links
Petroleum system 65
Platforms 73
Polar zones 103
Porosity 65
Production profiles 104
Production sharing 174
Production sharing contract 179 180 199
207
Profit and loss account 268
Profit oil 200 208
Quotas 34
R/P 108
Ras Tanura 45
Recovery 80
enhanced 80
primary 80
Recovery factor 108
Recovery ratio 96
Red Line 18 19
Regulations 177
Relinquishment 183
Rent 178
Reserve 258 260
Production-sharing contract (PSC) 261
replacement cost 260
replacement rate 258
Reserve ratio 252

Index Terms Links
Reserves 93 95 248
1P, 2P and 3P 97
conventional 94
non-conventional 94
P90, P50, P10 97
possible 98
probable 98
proven 98
SFAS 69 definition 248
ultimate 93
Resources 95
Rigs 73
Ring-fencing 196
Risk service contract 179
Rockefeller 5 6 45
Rothschild 8
Royal Dutch Shell 9 15
Royalty 194 195 206
Samuel 8 9 11
Saudi 4
Saudi Arabia 19
SEC 244
Sedimentary basins 61
Seismic 69
reflection 69
Semi-submersibles 73
Service contract 180 202 203
Seven sisters 23
SFAS 69 (Statement of Financial Accounting
Standards) 245

Index Terms Links
Shell 9 10 11
Sherman Act 6
Six Day War 25
Slot ratio 252
Socal 19
Sovereignty 171 173
Spar 149
Spindletop in 1900 12
Spot markets 48
Stalin 9
Standard Oil 5 6 9
10 15 18
State participation 188
State take 209
Statoil 167
Subsidence 61
Success rate 108
Successful efforts method 246
Suez Canal 25
Swaps 49
Synthetic oils 102
Tax 176 194 205

207
Tax incentives 190
Taxation 197 202
Teheran Agreement 27
Texaco 12 19
Texas 12 45
Texas Railroad Commission 46
Title 199

Index Terms Links
Traders 50
Trap 64
stratigraphic 64
structural 64
Tripoli Agreement 27
Tubing 87
Turkish Petroleum Company 17
Ultra-deep offshore 100

Unitisation 186
Uplift 197 208
Uplifts 207
Venezuela 13
Volga 4
Walter Teagle 46
Well capping 284
Wellhead 87
William dArcy 12
Winston Churchill 3
Work programme 184
Work programmes 187
Workover 89
WTI 49

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Nadine BRET-ROUZAUT and Jean-Pierre FAVENNEC

Oil and Gas

Editions TECHNIP 25 rue Ginoux, 75015 PARIS, FRANCE

The Geopolitics of Energy

The Oil & Gas Engineering Guide

Project Management Guide

Petroleum Refining. Vol. 5: Refinery Operation and Management

Manual of Process Economic Evaluation

All rights reserved.

Editions Technip, Paris, 2011.

Arbitrage Financial operation which seeks to exploit geographical or temporal price

Petrol (gasolineUS) Fuel used by sparkignition engines.

Preface to the first edition ................................................................... V

Foreword to the third edition ............................................................... VII

1 Petroleum: a strategic product ................................................... 1

2 Oil and gas exploration and production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

2.2 Exploration for hydrocarbons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

4 Investments and costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

5 Legal, fiscal and contractual framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171

5.3 Concession regimes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

6 Decision-making on exploration and production . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211

7 Information, accounting and competition analysis ........................ 243

8 Health, safety, the environment, ethics ........................................ 277

Index ............................................................................................. 307

1.1 USES, IMPORTANCE, FUTURE

1.1.1 Uses of petroleum through the centuries

Figure 1.1 Oil, a universal remedy.

Box 1.1 The balsam of the Senecas

Chapter 1 Petroleum: a strategic product

Figure 1.2 Oil lamp.

1.1.2 The importance of oil

Chapter 1 Petroleum: a strategic product

1.2 HISTORICAL BACKGROUND 1

Chapter 1 Petroleum: a strategic product

1.2.1.2 The oil industry in Russia

Figure 1.6 Baku Oileld (by kind permission of BP).

1.2.1.3 Shell and Royal Dutch

Chapter 1 Petroleum: a strategic product

Figure 1.9 Telaga Sad oileld, Netherlands East Indies (Indonesia),

1.2.1.4 The other American oil companies: Gulf, Texaco

1.2.1.5 The creation of Anglo-Persian: the role of the British government

Figure 1.11 Steam production at Masjid-I-Suleiman (by kind permission

1.2.1.6 The development of production in Mexico and Venezuela

1.2.2 Between the wars: the role of the state

Figure 1.12 The taxis of the Marne (Photo Monde et Camra).

Chapter 1 Petroleum: a strategic product

1.2.2.2 Creation of the CFP (Fig. 1.13)

1.2.2.3 The protection of the French petroleum industry

Figure 1.14 The Gonfreville (Normandy) renery around 1930.

1.2.3 Between the wars (2):

1.2.3.2 The Achnacarry Agreement

Chapter 1 Petroleum: a strategic product

Red Sea Trucial Oman

1.2.4 After WWII: increasing oil consumption, new oil companies,

Figure 1.18 Another major Middle East producer: Abu Dhabi.

Chapter 1 Petroleum: a strategic product

Figure 1.20 The gas treatment plant at Lacq ( Roux, Total).

Figure 1.21 1956: the discovery of oil in Algeria ( Dumas, Total).

Chapter 1 Petroleum: a strategic product

B. The creation of ELF, a second national French oil company

C. The Institut Franais du Ptrole (now IFP Energies nouvelles)

1.2.4.3 Developments in the U.S.: quotas, isolation of U.S. market

1.2.4.4 Falling prices and the creation of OPEC