HOW PROFITABLE ARE THE

FEATURES OF PRODUCTION
SHARING CONTRACTS TO
HOST GOVERNMENTS?

Theresa Nwaefuluno Egwele1

ABSTRACT: Different fiscal regimes are available to Host Governments who want
to manage their petroleum resources and maximise economic rent. They include tax
royalty and contractual systems. This paper examines the fiscal regimes for petroleum
resources so as to compare them in particular to Production Sharing Contracts to
show how well it benefits the Host Governments especially as regards capturing
economic rents. The author concludes by explaining that there is no one best fiscal
system as they have their advantages and disadvantages but that to a large extent,
Production Sharing Contracts are profitable to Host Governments.

1
The author is a Nigerian who obtained an MSc in International Oil and Gas Management from
CEPMLP, University of Dundee, Scotland, UK. She completed her undergraduate program at the
University of Ghana where she graduated with a First Class in Geography and Resource Development.
Email: fegwele@yahoo.co.uk
 TABLE OF CONTENTS

ABBREVIATIONS. iii

1 INTRODUCTION... 1

2 HOW DO PSCS DIFFER FROM THE OTHER FISCAL SYSTEMS?................. 2

2.1 Concessions..... 2

2.2 Contracts.. 3

2.3 Service Agreements..... 3

2.3.1 Production Sharing Contracts..4

3 BENEFITS OF PRODUCTION SHARING CONTRACTS. 7

3.1 Benefits of PSC to the HC. 7

3.2 Benefits to the IOC.... 7

4. CONCLUSION.. 9

BIBLIOGRAPHY
 ABBREVIATIONS

HG Host Government

HC Host Country

IOC International Oil Company

IPA International Petroleum Agreement

PSC Production Sharing Contract

1. INTRODUCTION

In contemporary times, economic growth is propelled to a large extent by energy from fossil
fuels. 2 The extraction of these petroleum resources requires huge investments of capital,
equipment and expertise, which some countries with these resources do not have. So private
investment is needed to produce the resources for the country. It should be noted that the
Host Governments (HG) and the International Oil Companies (IOCs) do not have the exact
same goals and objectives. HG want as much economic rent as possible for developing their
countries, while private investors want maximum returns on their investment in the petroleum
project, as well as to achieve their companies objectives.3 Economic rent in the petroleum
industry is the difference between the value of production and the costs to extract it.4 HG get
economic rent from taxes, royalties, production sharing and bonuses.5

The international petroleum sector has different fiscal systems. These reflect the different tax
rules and ways in which countries manage their resources. HG design fiscal systems that take
into consideration all these issues. This influences investment decisions. IOCs prefer to invest
in countries with fiscal regimes that favour them.

Projects in the petroleum sector differ from that of other sectors because they take a long time
to complete and they have a high level of risks. It is difficult to estimate the commercial
viability of an oil field.

The prices of oil fluctuate because of changes in demand and supply. When oil prices rose
sharply in the 1970s, HGs introduced fiscal systems that were designed to capture economic
rents for them.6 HGs use fiscal systems to manage their oil and gas resources.

This paper is divided into four parts. Part One is the introduction, which gives background
information to fiscal systems in generals. Part Two compares the various fiscal systems
available to oil producing countries with Production Sharing Contracts (PSCs) in particular.
Part Three examines the benefits that both HCs and IOCs can derive from using PSCs in their
International Petroleum Agreements (IPAs). Part Four is the conclusion of the paper and Part
2
Cameron, P. D., International Energy Investment Law: The Pursuit of Stability (2010) p 1
3
Tordo, S., Fiscal systems for Hydrocarbons: design issues Vol 123 (2007) World Bank Working Paper
(www.ebrary.com last visited on January 19th 2013)]
4
Johnston, D., International Petroleum Fiscal Systems and Production Sharing Contracts (1994) p 5
5
Johnston, D., International Exploration Economics, Risk, and Contract Analysis (2003) p 3
6
Kemp, A. G., Development Risks and Petroleum Fiscal System: A Comparative Study of the UK, Norway,
Denmark and the Netherlands Vol 13 (3) The Energy Journal (1992) (www.ebscohost.com last visited January
19th 2013)

1
Five gives recommendations.

2. HOW DO PSCS DIFFER FROM THE OTHER FISCAL SYSTEMS?

There are two major types of fiscal systems- tax royalty system and contractual systems. The
tax royalty system has to do with concessions. The contractual systems can be in the form of
Service Agreements or Production Sharing Contracts (PSCs). 7 HG use fiscal systems
depending on what they negotiate with the operators. Some countries like Peru use both
concessions and PSCs. 8 Even though these systems are explained in more detail in this
section, the main focus of the paper is on PSCs.

2.1 CONCESSIONS

In most countries, the government owns the mineral resources. Concessions were used before
PSCs. When concessions are used, this title of ownership of the oil and gas resources is
transferred from the HG to the company.9

Early concessions were used in the Middle East. 10 In concessions, the right given to the
company to explore is called an exploration permit/license while the right of exploration is a
concession/lease.

Payments are made to the HC first through royalties, which are taken off from the barrel of
oil produced. Then operating and drilling costs are deducted from what is left (net revenue) to
obtain the taxable income. The HC decides on how royalties will be paid by the IOC, either
in cash or kind. Concessions are more common in developed nations.

In most countries, like in the Middle East, what the HC owns is the oil and gas in the ground
before production. Some states like Texas in the USA grant ownership of the resources in the
ground to the company the country enters into a concession with the concessionaire.11

Concessions grant the IOC the exclusive right to explore and if commercial deposits are
discovered, can exploit the oil and gas resources at its own risk- financial and otherwise in a

7
: Blake, A. J., Roberts, M. C., Comparing petroleum fiscal regimes under oil price uncertainty Vol 31 (2)
Resources Policy (2006) (www.sciencedirect.com last visited January 17th, 2013)][7: Johnston, D., (1994) p 5
8
Supra note 4
9
Supra note 5 p 21
10
Supra note 6
11
Duval, C., Le Leuch, H., Pertuzio, A., Weaver, J., International Petroleum Exploration and Exploitation
Agreements: Legal, Economic and Policy Aspects (2nd ed) (2009) p 10

2
delimited area and for a specific number of years in exchange for payment in the form of
royalties and taxes.

Modern concessions evolved from the early concessions which covered large areas, lasted for
too long, limited the economic rent the HG got through the flat rate-based royalties, gave the
IOC full control over the oil and gas field operations. An early concession in Kuwait even
reached 99 years. After the Second World War, the early concession was criticized and new
forms were developed so that the HC could go into more beneficial arrangement with the
IOCs. So in the modern concession, the concession area had a limited number of blocks, a
limited time period, royalties were paid on a percentage of what was produced so HC could
get more economic rent, and HC could participate more in the decisions of the IOCs.

Many countries like the United Kingdom, the United States of America, Brazil, Angola use
the modern concession. It is not compulsory for concessions to be used alone. Some countries
like Algeria, Nigeria, Russia use the concession system with other international petroleum
agreements. Basically, countries tailor their agreements to suit what they want and in
accordance with their political situation.12

2.2 CONTRACTS

In the contractual system, the ownership of the petroleum resources lie with the HG. When
nations got their independence, they sought control of their resources as a symbol of
sovereignty. Some only wanted their NOCs to perform petroleum operations, but since the
industry requires high risk in terms of capital and expertise; countries realised that they
needed the IOCs so that production could continue. The oil companies are only entitled to a
share of production or profits from the sale of petroleum resources as stipulated in the PSC or
service contract/agreement. Contracts are more common in developing nations unlike
concessions, which are more common in developed nations.13

2.3 SERVICE AGREEMENTS

Service Agreements are of two types- Pure Service Agreements or Risk Service Agreements.
In Pure Risk Service Agreements, the company produces the petroleum resources on behalf

12
Ibid
13
Supra note 6 p 21

3
of the government for a flat fee.14 All the government needs from the contractor is technical
expertise, which they do not have. The government bears the financial risk.15

When Risk Service Agreements are used, the contractor takes all the production risk and is
paid a cash fee per barrel of production.16 The service contract does not usually provide for
profit-sharing, even though the Iranian buy-back contract has this provision.17 Countries
usually go into service agreements when they require a particular technical skill for
producing their petroleum resources. The method in which payment is done is not fixed, but
varies among the contracts.

2.3.1 PRODUCTION SHARING CONTRACTS

Production sharing has its origins from the French legal concept of ownership of mineral
resources in the era of Napoleon, where resources were instead of being owned by the
individual were owned by the state for the benefit of the people.18

The country that PSCs were first introduced was in Indonesia in 1966. 19 Their independence
fuelled the rise in nationalism, so HGs stopped granting concessions to foreign companies
and started using PSCs, which allowed the government to own its resources.20 The Republic
of Indonesias Constitution for 1945 states that Indonesias natural resources are to be
controlled by the state and must be used for the maximum benefit of the Indonesian people.
So what the state does is to give rights to companies to exploit minerals while still retaining
ownership of the resources.

The HG/NOC appoints the IOC who becomes the contractor (and not the concessionaire as
obtains in the concessionary system) to produce the oil and gas deposits in a delimited area
and for a specific duration of time.

The petroleum resources are produced at the IOCs own risk and expense but the HC controls

14
Ibid
15
Ibid
16
Ibid
17
Ahmadov, I., Atemyev, A., Aslanly, K., Rzaev, I., Shaban, I., How to scrutinise a Production Sharing
Agreement: A guide for the oil and gas sector based on experience from the Caspian region International
Institute for Energy and Development (2012) (www.pubs.iied.org/pdfs/163031IIED.pdf last visited January
19th, 2013)
18
Supra note 4 p 39
19
Bindemann, K., Production-Sharing Agreements: An Economic Analysis Oxford Institute for Energy Studies
Vol 25
20
Supra note 11 p 69

4
the operations.21 A Nepalese mode PSC had in its agreement that the IOC would provide all
that is needed for production to take place, that is, the capital, expertise, equipment.22

The oil and gas resources produced at every point in time belongs to the HC but is shared
with the IOC in a stipulated percentage. This is the main difference between the concession
and the PSC. What belongs to the IOC is its share of the resources produced.

What distinguishes PSCs from other fiscal systems is cost-recovery by the IOC, production
sharing between the IOC and the HC, and taxes paid to the HC.

First, the IOC pays royalty on gross production to the government. After the royalty is
deducted, the IOC is entitled to a pre-specified share of production for cost recovery. This is
called cost-oil/gas.23 Ringfencing is done whereby the revenues derived from an oil block
are used to pay for the cost of producing in that block.24

Cost recovery is the costs of production and petroleum operations that the IOC gets back
(recovers from the HC). Cost recovery is simply defined as the re-imbursement of costs that
have been incurred by the IOC in the course of its operations- drilling, development.25 This
cost oil can have a limited percentage of production, which is known as cost ceiling.
Countries have different allocations for cost oil, which are based on the price and the location
of the project, whether offshore or onshore. In the Indonesian model, it was 40%.26

When cost recovery has been taken off the barrel of oil produced, what is left is shared
between the HC and the NOC in a pre-determined percentage. The IOC is paid in exchange
for its operations. This is called profit sharing and the oil is called profit oil. 27 In the
Indonesian model, the profit split was in percentages; 85% for the HC and 15% for the IOC.

After profit sharing, what is left represents the net income of the IOC. This can be taxed
depending on what the PSC prescribes. The IOC pays an income tax on its share of profit.
This tax can be included in the share of oil belonging to the HC, or the tax can be paid
directly by the IOC.

21
Supra note 6
22
Supra note 11 p 70
23
Ibid
24
Supra note 5 p 70
25
Supra note 4 p 42
26
Supra note 11 p 76
27
Supra note 6

5
The use of profitability-based splits to share production between the HC and the IOC is more
common and is based on either Rate of Return (ROR) or the R-factor. Rate of Return is the
interest rate that results in the discounted present worth of future net income being equal to
the initial investment.it is calculated using discounted cash flow techniques. The R-factor is
the ratio of accumulated revenues to accumulated costs at a particular point in time. This
profit oil-split gives allowance for the production share of the HC to be increased
automatically based on the IOCs discounted cash flow or R-factor.28 A Peruvian model PSC
related the IOCs share of production to an R-factor.

Taxes can be paid before and after the production split so long as it does not affect the
governments economic rent. A country like Libya does not have a separate income tax in its
PSC because its production split is done on a post-tax basis; what the HC gets is inclusive of
the IOCs income tax.29

When IOCs install equipment for use in the petroleum operations, these belong to the HC
either at the beginning of the contract when they are installed or as time goes on. After the
project, if the HC wants, she can request for the decommissioning of the installations and the
IOC must oblige.

The booking of reserves by IOCs is different from what obtains in a concession. The US
Securities & Exchange Commission (SEC) specifies that the contractor in a PSC is only
allowed to book a share (the number of barrels of oil or thousands of cubic feet of gas) of
total field production and reserves that is equivalent to what the IOC is entitled to receive
from production. 30 In a concession, the IOC can book for an entire field production and
reserves.

Countries have different ways of signing the PSC. In Nigeria, NNPC (Nigerian National
Petroleum Corporation) holds the Oil Prospecting License (OPL) and enters in a contract
with the appointed IOC. This also happens in Azerbaijan with their NOC, SOCAR (State Oil
Company of Azerbaijan Republic). In some other countries like Syria, Cote dIvoire, the
government represented by the Petroleum minister of an agent signs the PSC with the IOC. 31

28
Supra note 11 p 79
29
Ibid
30
Ibid
31
Ibid

6
3 BENEFITS OF PRODUCTION SHARING CONTRACTS

3.1 BENEFITS OF PSCS TO THE HC

With PSCs, the HC were able to kill two birds with one stone. The HC could get IOCs to
produce their petroleum resources and at the same time maintain ownership and control over
the resources. This reinforces the sovereignty of the state. A state that is sovereign should
control its natural resources.

The profit percentage split can be increased if production increases so the HC can get more
economic rent in times of windfall profits. The amount of production and its corresponding
level of profitability are calculated in a pre-determined formula using the Rate of Return
(ROR) or R-factor.32

If after exploration, there is no commercial discovery worth producing in the contract area,
the IOC would not be reimbursed the costs it incurred. In this way, the HG does not lose.

In a PSC, the HGs NOC controls the petroleum operations, while the IOC is in charge of the
daily operations. The NOC is able to learn from the IOC from its greater involvement in what
goes on in the field.

The taxation method, which is progressive based on the amount of oil produced using sliding
scale terms, ensures that maximum economic rent is captured. 33 So when more oil is
produced, the HC gets more rent.

3.2 BENEFITS OF PSCS TO THE IOC

Oil companies aim at getting as much profit as possible by producing resources at the lowest
possible cost and highest returns possible. When PSCs were first introduced, IOCs were
already comfortable to the concession system so at first they resisted it, but later agreed to it
when they discovered that many HG in resource-abundant countries were no longer willing to
continue with concessions. In spite of this, there are some benefits of the PSC to IOCs.

The PSCs offered a relatively simpler fiscal regime for IOCs because concessions involved

32
Ibid
33
Supra note 5 p 14

7
complex tax systems (royalties, income taxes, surface rental fees, other taxes). In
concessions, since the HC have transferred the right of ownership to the IOC, they feel the
need to tax as much as possible to ensure that they are getting maximum economic rent.

The IOCs share of cost oil makes it possible to recover its costs incurred in the petroleum
operations and also capital expenditure. This assurance can encourage them to bring in the
best technology to exploit the resources.

Morever, if all the costs cannot be recovered during the period of production sharing, for
example, if the petroleum produced is not enough to cover the costs, what is owed to the IOC
is carried forward.34

34
Supra note 11 p77

8
4. CONCLUSION

HG try to get as much wealth as possible from their petroleum resources by encouraging
investment in the oil and gas sector especially if they do not have the finance and expertise to
do this.

So the fiscal system governments design must provide maximum economic rent to the
country, limit the level of expertise needed to negotiate and seal deals, be flexible, and one
that would encourage competition among private investors and market efficiency.35

This paper has examined some fiscal systems used by countries and has come to the
conclusion that there is no one best method. This paper is not an advocate for the PSC model
but rather aimed at comparing it to the others to find out how beneficial it is to the HC.

Not all countries prefer PSCs. In 2009, Kazakhstan blamed the PSC for not enabling the
country to earn substantial rent from its oil project.36 The PSC has also been criticized for its
complexity, and that it did not work well with recent fluctuations in oil prices.37

Concessions can be easier to negotiate and even to manage because they require less
expertise (technical, legal, and financial) from the HC than PSCs.38

This paper concludes that to a large extent, PSCs are beneficial to the HG by allowing them
to capture maximum economic rent from the production of their petroleum resources. More
countries getting involved in the oil and gas sector are using PSCs instead of concessions
because of the attendant advantages.39

Using a PSC does not automatically mean that it would benefit the HC. The government
needs expertise to negotiate well and manage the agreement and the rewards should be well-
distributed.

The author would like to suggest that countries should not follow blindly in the way others
sign international petroleum agreements. Each oil-producing country is unique in terms of its
geological structure, oil and gas deposits, political system, labour so all these should be
considered carefully when selecting fiscal systems. These systems should be tailored to suit
35
Supra note 5 p 5
36
Supra note 17
37
Ibid
38
Ibid
39
Supra note 4

9
the circumstances of the country.

Resource-abundant countries should endeavour to invest in their labour force. More lawyers
are needed for negotiating contracts between the HC and the IOC so that no one is cheated.
More engineers and geologists are required for the technical expertise for petroleum
operations. More finance analysts are needed to predict future trends. Even the masses as a
whole should be informed so that they can know their rights so that the government can be
held accountable for how the economic rent is used. It is not enough to exploit these
resources. The economic rent received should be managed well so as to benefit the citizens
through investments in agriculture, industry, transport, health, and education.

10
REFERENCE LIST

SECONDARY SOURCES

Books

Bindemann, K., Production-Sharing Agreements: An Economic Analysis. Vol 25 (Oxford:

Oxford Institute for Energy Studies, 1999).

Cameron, P. D., International Energy Investment Law: The Pursuit of Stability (Oxford:
Oxford University Press, 2010).

Duval, C., Le Leuch, H., Pertuzio, A., Weaver, J., International Petroleum Exploration and
Exploitation Agreements: Legal, Economic & Policy Aspects (2nd ed.) (New York: Barrows,
2009).

Johnston, D., International Petroleum Fiscal Systems and Production Sharing Contracts
(Tulsa: PenWell, 1994).

Johnston, D., International Exploration Economics, Risk, and Contract Analysis (Tulsa:
PenWell, 2003).

Tordo, S., Fiscal systems for hydrocarbons: design issues (Washington DC: World Bank,
2007).

Articles

Ahmadov, I., Artemyev, A., Aslanly, K., Rzaev, I., Shaban, I., How to scrutinise a
Production Sharing Agreement: A guide for the oil and gas sector based on experience from
the Caspian region International Institute for Environment and Development (2012)
(www.pubs.iied.org/pdfs/163031IIED.pdf last visited January 19th, 2013)

Blake, A. J. & Roberts M. C., Comparing petroleum fiscal regimes under oil price
uncertainty. Vol 31, issue 2 (2006). Resources Policy. (www.sciencedirect.com last visited
January 17th, 2013)

Kemp, A. G., Development Risks and Petroleum Fiscal Systems: a Comparative Study of the
UK, Norway, Denmark and the Netherlands. Vol 13, issue 3 (1992). The Energy Journal.
(www.ebscohost.com last visited January 19th 2013)

11