SCHOOL OF PETROLEUM MANAGEMENT, GANDHINAGAR

Clauses of Production
Sharing Contract
Legal Aspects of Business Assignment

Submitted By:
Hetal Patel (20091016)
Submitted to:
Prof. Mayuri Pandya

23rd January, 2011

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Content

Introduction ..................................................................................................................................................... 4
Standard Clauses ............................................................................................................................................ 6
Description of Parties............................................................................................................................... 6
Scope of Contract ....................................................................................................................................... 7
Contract Area .............................................................................................................................................. 7
License and Exploration Period ........................................................................................................... 7
Relinquishment .......................................................................................................................................... 8
Operatorship, Joint Operating Agreement and Operating Committee.................................. 9
Conduct of Operations ......................................................................................................................... 9
Obligations of Host Country or its nominee.............................................................................. 10
Discovery, Development and Production ....................................................................................... 10
Protection of the Environment........................................................................................................... 10
Important Concepts .................................................................................................................................... 11
Recoverable Costs ................................................................................................................................... 11
Profit Petroleum....................................................................................................................................... 12
Share of Profit Petroleum ..................................................................................................................... 12
Standard Clauses .......................................................................................................................................... 13
Production Sharing of Petroleum ...................................................................................................... 13
Cost Petroleum ......................................................................................................................................... 14
Recovery of Cost Petroleum ................................................................................................................ 15
Profit Petroleum....................................................................................................................................... 16
Taxation, Duty and Levies .................................................................................................................... 16
Domestic Supply Requirement ........................................................................................................... 16
Valuation of Petroleum.......................................................................................................................... 16
Employment, Training and Transfer of Technology .................................................................. 17
Local Goods and Services ..................................................................................................................... 17
Insurance and Indemnification .......................................................................................................... 18
Records, Reports, Accounts and Audit ............................................................................................ 18
Information, Data, Confidentiality, Inspection and Security................................................... 19

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Title to Petroleum, Data and Assets ................................................................................................. 19

Assignment of Participating Interest ............................................................................................... 20
Force Majeure ........................................................................................................................................... 20
Termination ............................................................................................................................................... 20
Local Office and Notice .......................................................................................................................... 20
Arbitration.................................................................................................................................................. 20
Effective Date ............................................................................................................................................ 20
Governing Law and Language............................................................................................................. 21
Order of Importance ................................................................................................................................... 21
A. Highly Critical for Host Country’s Interest ............................................................................... 21
B. Critical to both Host Country and International Oil Companies’ interest..................... 21
C. Important to both Host Country and International Oil Companies’ interest............... 22
Conclusion....................................................................................................................................................... 23

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Introduction

Production Sharing Contracts (PSCs) are a common type of contract signed between a
government and a resource extraction company (or group of companies) concerning
how much of the resource (usually petroleum) extracted from the country each will
receive. Production sharing agreement is the most contractually complex form of oil
contract. It is their complexity, not their simplicity, which is advantageous to oil
companies.

The PSC requires the constitution of a management committee consisting of

representatives from the government and the contractor, who would be entitled to take
many decisions regarding exploration, development and production. The PSC stipulates
certain maximum timeframes available to the contractor for different exploration
phases. It also stipulates the extent of area the contractor has to relinquish after each
exploration phase, in case it is not successful in finding oil or gas.

One of the critical sections of the PSC is the detail of how profit will be shared between
the contractor and Government. It describes the notion of ‘profit petroleum’, which is
the surplus obtained from the sale of gas in a year after recovering operating and
exploration costs, and government taxes and royalty together described as ‘cost
petroleum’.

Thus, the PSC describes the procedures to be followed if the contractor finds a reserve
of oil or gas regarding how it should be exploited further.

Agreements representing the various conditions agreed to by the parties mentioned in

the form of certain ‘clauses’ form the foundation of rights and liabilities of the parties.

The important clauses of any contract are:

• Description of Parties
• Recitals of Subject
• Consideration
• Covenants and Undertaking

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• Signature and Attestation

• Endorsement and Supplemental Deeds
• Stamp Duty
• Applicable Law
• Force Majeure
• Notice
• Arbitration Clause

The checklists for the standard clauses are:

• Preamble
• Parties
• Definitions
• Offer and Acceptance
• Obligations
• Conditions
• Environmental Responsibility
• Security
• Delivery
• Insurance
• Risk of Loss
• Price and Currency Indexes
• Force Majeure
• Default
• Termination and Expiration
• Intellectual Property Rights
• Confidentiality
• Penalties and Liquidated Damages
• Delay
• Notice Clause
• Choice of Law and Venue

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The Contractual Framework can be shown as follow.

Standard Clauses

The clauses of production sharing contract are as follow.

Description of Parties

The parties involved in the contract are as follow:

For offshore areas – Grant of license and lease by the Central Government

For onshore areas – Grant of license and lease by the State Government, with
prior approval of the Central Government

Every license or lease granted to contain additional terms and conditions as

provided for in an agreement between the Central Government and the licensee
or the lessee (the PSC)

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Where license or lease to be granted by a State Government – merely an

obligation to ‘consult’ the State Government

Issues in the case of onshore PSCs are:

(1) Delays in post contract clearances; and
(2) Procurement of mining leases from the State Government seen as a major bottle
neck
Though ‘concurrence’ already received, States should be better involved by:
(1) Involvement at bidding stage;
(2) Involvement as confirming parties to contracts

Scope of Contract

A clause describing in broad terms: the relationship between Host Country (whether it
is represented by a Ministry or a National State Owned Oil Company) and the
Contractor, appointment of the Contractor to carry out - at sole risk - exploration,
development and production on behalf of State and to supply the technical expertise
and the funds required for such operations and receive reimbursement, in accordance
with the terms of the PSC.

Contract Area

This clause gives a definition of the area covered by the PSC (to be progressively
reduced in accordance with the relinquishment provisions).

License and Exploration Period

The different phases of the exploration can be divided into three different phases and
the share of contractor and government can be described by following model
production sharing contract arrangement.

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For example, the Exploration Period shall begin on the Effective Date and shall be for a
period not exceeding seven (7) consecutive Contract Years consisting of Initial
Exploration Period and Subsequent Exploration Period. The Initial Exploration Period
shall consist of the first four consecutive Contract Years with provision to proceed to the
Subsequent Exploration Period of maximum three consecutive years subject to
provisions contained in Article 3. During the initial exploration period, the contractor
has to complete minimum work program, or else it can be extended for required period
not exceeding six months.

Thus Licence and Exploration Period clause mentions about the Initial Exploration
Period, Minimum Work Program, Subsequent Exploration Period, Discovery Area,
Development Area, Development Operations, Production Operations, Commercial
Discovery and Contract Area.

Relinquishment

At the end of the Initial Exploration Period, the Contractor shall have option to
relinquish entire area after completion of Minimum Work Programme or proceed to the
Subsequent Exploration Period and retain the block by committing to carry out drilling
of one well each year in Contract Area. The entire area (excluding Discovery and
Development area) shall be relinquished at the end of 7 consecutive years of

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Exploration Period. At the end of the total Exploration Period, the Contractor shall
retain only Development Areas and Discovery Areas.

The liability of the Contractor shall be limited to any liability undertaken or incurred in
respect of, relating to or connected with the Contract, and/or any claim arising out of or
in relation to the act of negligence, misconduct, commission or omission in carrying out
Petroleum Operations during the period between the Effective Date and the date of
relinquishment of the Contract Area or termination or expiry of the Contract, as the case
may be.

Thus, this standard clause presents the requirements for the Contractor to
progressively reduce the size of the contract area at stated intervals during the
exploration period. By the end of the exploration period only development and
production areas will remain. The clause also states rules regarding the form and size of
areas to be relinquished.

Operatorship, Joint Operating Agreement and Operating Committee

This clause establishes an Operations Committee or Management Committee, on which

both Host Country and the Contractor will be represented on an equal basis. The
Operations Committee will be responsible (inter alia) for approval of work programs
and budgets approval of development plans, approval of development and production
areas, review of any assessment of commerciality of a discovery, approval of programs
for training and technology transfer, review of the Contractor’s operations etc.

Conduct of Operations

This clause states the requirements for the Contractor to carry out operations according
to the local laws and regulations and good oil industry practice and to maintain accurate
records and books. The clause specifically sets out procedures for submission by
Contractor of and approval by Operations Committee or Host Country’s nominees of
annual work programs and budgets and procedures for Contractor to make
expenditures in excess of approved budgets.

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Obligations of Host Country or its nominee (Ministry or National Oil Company

owned by the State)

This clause obligates Host Country to assist the Contractor in such matters as
establishing of necessary facilities in the country, obtaining supplies and equipment,
securing entry permits for foreign employees, clearing equipment through customs,
complying with foreign exchange regulations, dealing with government agencies, etc.,
and in identifying qualified local personnel for work in the Contractor’s operations.

Discovery, Development and Production

This clause requires prompt economic evaluation of any deposit which the Contractor
discovers and sets out a procedure by which the Contractor and Host Country can agree,
within a defined, reasonable period of time, as to whether the discovery can be
developed commercially. If a discovery is determined not to be commercial, the
Contractor will relinquish rights to it. If a discovery is proven to be commercial, the
Contractor will be required to submit a development plan for consideration to the
Operations Committee. Guidelines are set forth to assess the commerciality of a
discovery. Work Programmes and Budgets for Development and Production Operations
shall be submitted to the Management Committee as soon as possible after the approval
of a Development Plan.

Protection of the Environment

The Contractor will be required to conform to health and safety standards adopted by
the local Host Country’s Government under the authority of the Petroleum Law. Host
Country and or the Government can appoint inspectors to ensure that these standards
are being enforced. The Contractor will be required to conform to environmental
protection standards adopted under the Petroleum Law and relevant good oil field
standards and practice to ensure that no damage is done to the environment. This
clause also provides for compensation in the event of damage, and for the right of Host
Country to take action, at the Contractor’s expense, if the Contractor fails the Law to
stop pollution.

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Important Concepts

Recoverable Costs

Only costs and expenses incurred by the Operator in carrying on Petroleum Operations,
and (unless the Contractor is only one person and the Contractor and the Operator are
that person) properly charged to the Contractor under an agreement made between
them and consented to by the Ministry, are Recoverable Costs, but without prejudice to
any other provision of this Agreement which would result in any such cost or expense
not being a Recoverable Cost.

In any Calendar Year, Recoverable Costs are, the sum of those of the following that are
not ineligible costs:

(a) The sum of:

i. Recoverable Exploration Costs;
ii. Recoverable Appraisal Costs;
iii. Recoverable Capital Costs; and
iv. Recoverable Operating Costs;

(b) Decommissioning Costs Reserve, allowable in that Year;

(c) Recoverable Costs in the previous Calendar Year, to the extent in excess of the value
of the Contractor’s share of Petroleum in that previous Calendar Year; and

(d) Beginning in the Calendar Year seven (7) years prior to the Calendar Year in which
Ministry approval has been given for the first Development Plan, a Quarterly amount
equal to the product of the rate of Uplift and the Quarterly balance of outstanding
Recoverable Costs;

Less Miscellaneous Receipts and less any deductions.

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Profit Petroleum

The calculation for Profit Petroleum follows this formula:

Profit Petroleum = Gross Production of Petroleum – Recoverable Costs Petroleum

Profit Petroleum is the bulk of Income that is Taxable under Timor-Leste’s Petroleum
Tax Law (income tax). If Uplift is included in the Recoverable Costs provision; first, it
will add-up to the amount of Recoverable Costs – therefore reduces the bulk of Profit
Petroleum; second, it will not be taxable – therefore reduces Host Country’s income
from taxes; third, it will allow inefficiency in costs because Contractor make more
money from this end than from Profit Petroleum and such the Contractor will tend to
blow-up the cost.

Share of Profit Petroleum

This provision disregards the differences of exploration, development, difficulties, costs

of petroleum operations in different environment such as Onshore, Offshore Shallow
Water (0-200 meters), Offshore Deep Water (200-1000 meters) and Offshore Ultra
Deep Water (>1000 meters). As the hardship of petroleum operations is different from
one environment to another, the share of Profit Petroleum shall also vary from one
environment to another. Furthermore, as the development cost of Oil and Gas is
different, the share of Profit Petroleum shall also be different. It is therefore, suggested
that the Share of Profit Petroleum should follow the formula presented below to reflect
the different environment and petroleum component.

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Thus, the total revenue will be shared as follow.

Standard Clauses

Production Sharing of Petroleum

Petroleum production will be divided into the following amounts:

a) Cost Petroleum (with/without a maximum ceiling of x% of gross production) payable

to the Contractor for recovery of exploration, development and operating costs. If Host
Country or its nominees participates in supplying development and production
expenditures, it will also share accordingly in this cost recovery;

b) Profit Petroleum; any amount remaining after (a) and (b) will be divided between
Host Country and the Contractor according to an agreed formula. The amount payable
to the Contractor under this formula will be considered as profit and as such will be
subject to the Host Country’s income tax.
c) Royalty; currently in international standard ranging from 5% to 15% of gross
production, payable to the State;

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This clause mentions about the sharing of the Profit Petroleum by the partied of
production sharing contract. A Party's share of Profit Petroleum in any Year, shall be
calculated on the basis of the Investment Multiple actually achieved by the Contractor at
the end of the preceding Year for the Contract Area.

The government’s share and contractor’s share depends on the investment multiple at
the end of the year. When the Investment Multiple of the Contractor at the end of any
Year is more than one and one half (1.500) but is less than three and one half (3.500),
the Government shall be entitled to take and receive Z%, and the Contractor shall be
entitled to take and receive (100-Z)% of the total Profit Petroleum from the Contract
Area with effect from the start of the succeeding Year. The Government share Z% shall
be calculated by interpolation as under:

Z = a + [(b – a) * (X – 1.5)/2]

Where
'a' denotes Government share;
'b' denotes Government share
'b' should always be higher than 'a';
'X' denotes Investment Multiple of Contractor at the end of preceding Year, rounded off
to three decimal places.

These figures shall be as per the bid of the Contractor and accepted by the Government.
The Profit Petroleum due to the Contractor in any Year from the Contract Area shall be
divided amongst the Parties constituting the Contractor, in proportion to their
respective Participating Interest.

Cost Petroleum

(a) All expenses incurred by the Contractor in carrying out Petroleum Exploration,
Appraisals, Development and Operations and Decommissioning Cost Reserve
consistent with the Approved Work Programmes and Budgets are hereto
considered as Cost Petroleum for the purpose of this Agreement

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(b) The Contractor is entitle to recover the Cost Petroleum

(c) The Contractor’s accounts shall be prepared and maintained in accordance with
Annex C
(d) Recoverable Costs

In any Calendar Year, Recoverable Costs are, subject as further provided in Annex C, the
sum of those of the following that are eligible costs:

(i) The sum of

i. Recoverable Exploration Costs;

ii. Recoverable Appraisal Costs;
iii. Recoverable Capital Costs; and
iv. Recoverable Operating Costs;

(ii) Decommissioning Costs Reserve, allowable in that Year;

(iii) Recoverable Costs in the previous Calendar Year, to the extent in excess of the
value of the Contractor’s share of Petroleum in that previous Calendar Year; and

Recovery of Cost Petroleum

In accordance with this clause, the Contractor shall be entitled to recover Contract Costs
out of a percentage of the total value of Petroleum Produced and Saved from the
Contract Area in the respective Year.

If during any Year the Cost Petroleum is not sufficient to enable the Contractor to
recover in full the Contract Costs due for recovery then,
(i) Recovery shall first be made of royalty payments; and
(ii) Recovery shall next be made of the Production Costs; and
(iii) Recovery shall next be made of the Exploration Costs; and
(iv) Recovery shall then be made of the Development Costs.

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Profit Petroleum

In each Calendar Year the remaining Petroleum available after deduction for Cost
Petroleum shall be considered as Profit Petroleum, and shall be shared between the
Government and Contractor as per the contract.

Taxation, Duty and Levies

This clause specifies the Contractor’s liability to pay income tax, etc as well as all other
taxes, fees and duties that are generally applicable in Host Country. There are no
discriminatory fees, taxes and duties applicable in the Host Country. The clause also
makes clear that material and equipment used in the operations are excluded from
import duties and that there are no taxes and duties on the export of petroleum.

Domestic Supply Requirement

This clause states that in the event that petroleum available to the State from its
entitlements and those of Host Country are insufficient for domestic needs, Contractor
and any other third party producing oil in the country will be required to supply a
volume of oil.

Valuation of Petroleum

For the purpose of this Contract, the value of Crude Oil, Condensate and Natural Gas
shall be based on the price determined as provided in the contract. A price for Crude Oil
shall be determined for each Month or such other period as the Parties may agree in
terms of United States Dollars per Barrel, on import parity basis (with marine freight
being determined on the basis of nearest port to the Contract Area) for Crude Oil
produced and sold or otherwise disposed of from Contract Area, for each Delivery
Period, in accordance with the appropriate basis for that type of sale or disposal
specified below. The actual prices invoiced by the Company(ies) for the sales will form
the basis for the purposes of cost recovery, Profit Petroleum sharing and payment of

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royalty. Thus, this clause majorly deals with the determination of the price of natural
gas and crude oil.

Employment, Training and Transfer of Technology

The Contractor will give preference to hiring Host Country’s nationals, in accordance
with an agreed timetable for localization, and will establish appropriate training
programs. The Operator shall offer a mutually agreed number of Indian nationals the
opportunity for on-the-job training and practical experience in Petroleum Operations
during the Exploration Period.

At the request of the Government, the Foreign Companies shall separately endeavour to
negotiate, in good faith, technical assistance agreements with the Government or a
company nominated by Government for this purpose setting forth the terms by which
each Foreign Company constituting the Contractor may render technical assistance and
make available commercially proven technical information of a proprietary nature for
use in India by the Government or the company nominated by Government. The issues
to be addressed in negotiating such technical assistance agreements shall include, but
not be limited to, licensing issues, royalty conditions, confidentiality restrictions,
liabilities, costs and method of payment.

Local Goods and Services

The Contractor will give preference in purchasing goods and services produced or
provided in the Country, provided such goods and services are comparable to imports.
Contractor shall employ Indian Subcontractors having the required skills or expertise,
to the maximum extent possible, insofar as their services are available on comparable
standards with those obtained elsewhere and at competitive prices and on competitive
terms.

The Contractor shall establish appropriate procedures, including tender procedures, for
the acquisition of goods and services which shall ensure that suppliers and
Subcontractors in India are given adequate opportunity to compete for the supply of

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goods and services. The tender procedures shall include, inter alia, the financial
amounts or value of contracts which will be awarded on the basis of selective bidding or
open competitive bidding, the procedures for such bidding, and the exceptions to
bidding in cases of emergency, and shall be subject to the approval of the Management
Committee.

Insurance and Indemnification

The Contractor shall, during the term of this Contract, maintain and obtain insurance
coverage for and in relation to Petroleum Operations for such amounts and against such
risks as are customarily or prudently insured in the international petroleum industry in
accordance with modern oilfield and petroleum industry practices, and shall within two
months of the date of policy or renewal furnish to the Government, certificates
evidencing that such coverage is in effect. Such insurance policies shall include the
Government as additional insured and shall waive subrogation against the Government.
Insurance shall cover all the possible losses and damages as would be mentioned in the
clause.

The Contractor shall indemnify, defend and hold the Government, and the State
Government harmless against all claims, losses and damages of any nature whatsoever,
including, without limitation, claims for loss or damage to property or injury or death to
persons caused by or resulting from any Petroleum Operations conducted by or on
behalf of the Contractor.

Records, Reports, Accounts and Audit

This clause contains requirements for maintaining financial records, in accordance with
an agreed accounting procedure and for filing of periodic financial reports by the
Contractor.

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Information, Data, Confidentiality, Inspection and Security

This clause requires the Contractor to supply timely and complete information to Host
Country on all aspects of the Contractor’s work. The clause also specifies that samples
and original data collected by the Contractor are the property of Host Country, and
provides for inspection of Contractor’s facilities and records by representatives of Host
Country. The Contractor will also be required to supply periodic reports describing
work done to date. All information received by Host Country from the Contractor will be
subject to appropriate confidentiality provisions.

Title to Petroleum, Data and Assets

This clause specifies that the Government is the sole owner of Petroleum underlying the
Contract Area and shall remain the sole owner of Petroleum produced pursuant to the
provisions of this Contract except as regards that part of Crude Oil, Condensate or Gas
the title whereof has passed to the Contractor or any other person in accordance with
the provisions of this Contract.

Title to all Data shall be vested in the Government and the Contractor shall have the
right to use thereof as therein provided. Assets purchased by the Contractor for use in
Petroleum Operations shall be owned by the Parties comprising the Contractor in
proportion to their Participating Interest provided that the Government shall have the
right to require vesting of full title and ownership in it, free of charge and
encumbrances, of any or all assets, whether fixed or movable, acquired and owned by
the Contractor for use in Petroleum Operations inside or outside the Contract Area, such
right to be exercisable at the Government's option upon expiry or earlier termination of
the Contract.

Thus, the Contractor shall be responsible for proper maintenance, insurance and safety
of all assets acquired for Petroleum Operations and for keeping them in good repair,
order and working condition at all times,

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Assignment of Participating Interest

The Contractor may not assign rights under the PSC to any other parties without the
consent of Host Country.

Force Majeure

This clause is the standard force majeure clause suspending the parties’ obligations to
the extent that they are unable to fulfil them because of events outside their sphere of
influence.

Termination

This clause provides for termination of the PSC in the event of certain specified
occurrences, e.g. failure to make a commercial discovery within the exploration period,
serious failure by the Contractor to perform its responsibilities. The clause will also set
out a procedure for termination.

Local Office and Notice

The Contractor will be required to establish a local office to carry out its development
and production responsibilities.

Arbitration

This clause permits arbitration of disputes between the Contractor and Host Country
(but not disputes over taxation and other State fiscal impositions, which would be
resolved under the appropriate law). Arbitration will be conducted under an agreed
procedure providing for an internationally appointed arbitrator.

Effective Date

This is a formal clause specifying when the PSC will come into force (e.g., following
signing and Ministerial approval).
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Governing Law and Language

The governing law of the contract will be the law of Host Country. The contract will be
executed in X Country and parties may decide to make a working text for the day to day
operations in English.

Order of Importance

Depending on the situation and condition of the Host Country or the Host Government
the order of importance of the above sections/provisions may vary from one country to
another. However, normally they can be classified into three categories:

A. Highly Critical for Host Country’s Interest

This means, the provisions below shall exist in the PSC and shall be emphasized as
such to really ascertaining the Host Country’s interest and position:

1) Recoverable Cost/Cost Reimbursement and share of Profit Petroleum

2) Local Purchase and Procurement
3) Local Employment, Training and Transfer of Technology
4) Local Office and Notice
5) Title to and control of Facilities and Equipments
6) Domestic Supply Requirement
7) Inspection Safety and Environment Protection

B. Critical to both Host Country and International Oil Companies’

interest

This means, the provisions below shall exist to serve equally the interest and position of
the Host Country or its nominee, the resource Owner, and the International Oil
Companies, the Contractors. These provisions shall be well defined in every PSC.

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1) Definitions
2) Scope of Contract
3) Term of Contract
4) Contract Area
5) Minimum Exploration Program
6) Relinquishment
7) Operations Committee (optional)
8) Conduct of Operations
9) Obligations of Host Country or its nominee (Ministry or National Oil Company
owned by the State)
10) Commercial Discovery
11) Financing
12) Measurement and Pricing of Petroleum
13) Taxation, Duty and Levies
14) Associated Gas
15) Information
16) Accounting and Auditing
17) Assignment

C. Important to both Host Country and International Oil Companies’

interest

This means, the provisions below are necessary to make the contract more certain and
not to be ambiguous in the case of problems or disputes arisen during the contract
period, etc, as such it is an important part of every PSC.

1) Force Majeure
2) Termination
3) Arbitration
4) Good Faith
5) Effective Date
6) Governing Law and Language

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Conclusion

The report mentions all the important clauses of the production sharing contract. The
most important clauses for negotiation remains the sharing of petroleum production,
that is cost petroleum, profit petroleum, taxation, royalty and other duty. Also the
importance of the above discussed clauses to the government as well as the contractor
are analysed and stated above.

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