Tuesday, December 24, 2013

Some thoughts on a second-best contracting in oil and gas

Kazakhstan's Kashagan oil field can easily lay claim to being the most expensive infrastructure project in the world. Discovered in 2000, the off-shore oil field in the North Caspian Sea is widely considered the largest oil discovery in the past 30 years. It is estimated to hold 35 billion barrels of reserves and 10 billion barrels of recoverable oil, and 1 trillion cubic meters of natural gas.

The field is being developed by North Caspian Operating Company (NCOC), a consortium of state oil firm Kaz Munai Gas, Italy's ENI, US Exxon Mobil, Royal Dutch Shell, and France's Total, each holding 16.81% share, China National Petroleum Corporation (CNPC) with 8.3% and Japan Inpex 7.56%. Though the field is estimated to produce a staggering 8 mbpd by 2014 and 12 mbpd by 2015, it has so far not produced anything despite 13 years of development and nearly $55 bn in investment. This has to be seen against the original investment estimate of $10 bn.

The Kashagan field is a good example of the challenges with off-shore oil and gas exploration. The standard PSCs have royalty payments or taxes predicated either on a return on investment or calibrated cost recovery. Exploration firms are wary of the geological and other technical risks, apart from the various expropriation and other political risks, that can potentially cripple them. Governments become too eager to lay their hands on the massive windfall from the newly discovered reserves.

The fundamental issue with any PSC is how the royalty payments should be structured so as to provide adequate comfort for investors without compromising on the interests of the government. Too liberal an arrangement, especially those that allow developers to scoop windfall gains when oil prices rise, increases expropriation risks. A conservative PSC, with back-loaded cost recovery, increases the risks for investors and thereby discourage exploration.

The exploration firms prefer front-loaded production sharing contracts (PSCs), where they try to recover their investments as quickly as possible. Governments prefer to go the other way, back-loading royalty outflows so that they can start getting their share as soon as production starts. The commercial attractiveness of participating in large fields coupled with incentive distortions within governments (say, corruption) means that incomplete PSCs are inevitable in such environments.

Incomplete PSCs have spawned a series of re-negotiations. International experience, not just in oil and gas, shows that these re-negotiations, done when the project has run into crisis, generally benefit the concessionaire. In the final analysis, the government ends up conceding more than what the concessionaire had demanded before the original contract was signed.

Apart from its strategic value, governments are attracted to oil and gas by the large profits from it. Since the marginal cost of production of oil is often $15-20, and the prevailing market prices are in excess of $100, the business is extremely profitable. Both governments and exploration firms eye this massive differential, or oil rents. Each tries to pursue contracts which protect their interests, mostly at the cost of the other.

It is therefore no surprise that there are not too many successful examples of "fair" sharing of oil rents across the world. The more successful example comes from Australia's resource tax, which tries to reconcile the interests of both government and the exploration firm. It allows firms to make a profit of 10% return on investment before royalty payments being. After this, a progressively increasing tax/royalty kicks-in, so as to capture the windfall that comes from higher oil prices. In fact, the royalty rate is smaller in the initial years and increases with time. Its success also depends on the country's credibility with the investors as well as its strong institutional capacity to monitor investments.

This also means that its replicability to developing country contexts is limited. Country risks, especially high in the oil sector, is not very readily mitigated, if at all. Reliably assessing capital investments, especially in off-shore fields, so as to monitor PSC's is most often beyond the competence of national regulators, especially of the smaller economies.

Experience from across the world shows that simple gross production royalty-based PSCs, as in the US, are not likely to be effective. The peculiar nature of natural resource ownership (in the US, land owners own the natural resources underneath their land) that has allowed private individuals (and who prefer the simpler signing bonus plus royalty arrangements) to allow prospecting on their lands coupled with the country's strong institutional systems have been critical to the success of this model in the US.

Such PSC's, which transfers to the government a share of the revenues or output, as soon as production starts and without waiting for the investors to recover their costs, are simple to monitor. But this regulatory simplicity comes with sub-optimal risk allocation. They extend the project cost recovery period, thereby amplifying the risks borne by investors.

Oil exporting countries have tended to view the sector from the perspective of revenue maximization whereas importers have sought to incentivize investments in exploration. India belongs to the later category and this should continue to form the basis of its petroleum policy. But, as a second-best alternative, a more sophisticated PSC may be the best bet for countries like India. It should include certain features.

1. The PSC should provide adequate flexibility for investors to recover their investments within a reasonable period of time. The investment recovery schedule should be carefully structured, with annual cash-flow being distributed in some proportion between recovering investments and profits from the first year itself. Here too, the share of "profit oil" can be structured to increase slowly with time. 

2. The contract should seek to cap the upside beyond a reasonable level. This is sound economics and prudent politics. It would discourage the developer from changing production in response to global price signals, and also minimize the prospects of popular backlash if world prices rise high enough to generate windfall gains. An Australia type progressively increasing tax regime enables the government to capture a large share of the upside.

3. Given the limited competition in oil exploration and refining, most governments have sought to keep their respective national oil companies involved in exploration projects, in even those with private developers. While their role has varied widely and government's motivations have been revenue maximization, it has served to keep the private firms honest besides enabling governments retain control over the project. It may therefore be prudent to keep the ONGC involved in these projects.

4. Regulatory regimes in complex markets like oil exploration should not be cast in stone. Regulators should constantly learn from ongoing contracts and refine provisions, prospectively, to optimize the contractual outcomes for both sides. This is especially so since the underlying price signals in markets like that for natural gas are heavily distorted and can change dramatically with policy changes by important governments - imagine the impact on JCC prices due to a liberalized LNG export regime in the US west coast.

The success of such PSCs depend critically on the regulator's capacity to reliably monitor investments. For a country like India, whose bigger concern is incentivizing investments and boosting local production, an arrangement that suitably takes into account the interests of investors may be a more prudent way forward. India, which is a large fuel importer, and is therefore primed to encouraging investments, should strongly consider the establishment of a small highly competent group to help regulators enforce PSCs. In this context, the Brazilian National Petroleum Agency, which has highly competent professionals, remunerated at higher than regular public sector wages, is an example worthy of emulation.

All this is no certainty for a successful oil and gas exploration policy. But, given the complex nature of the issue, it stands a greater chance of success. 

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