Copyright © Gulf Research Center 2010 All rights reserved Giacomo Luciani Director Gulf Research Center Foundation, Geneva Dar es Salaam, July Negotiating with International Companies for Oil and Gas Production

Copyright © Gulf Research Center 2010 All rights reserved Negotiations and Outcomes Properly conducting negotiations for attracting oil and gas companies and properly regulating their activities is essential to the final outcome Indeed, resources may go undiscovered and certainly unexploited if the appropriate approach is not followed If the country does not yet have an oil and gas law, one should be passed The law may or may not restrict the scope of administrative decision making

Copyright © Gulf Research Center 2010 All rights reserved Acquire Information The first step in any attempt to attract oil and gas investment is to acquire as much information as possible on the potential of the country This is today possible, as specialized companies conduct the seismic surveys and data collection campaigns that are needed to judge prospectivity Data acquisition may be expensive, so there will always be a limit to it. The better are the available data, the more successful can the bidding round be International organizations and financial institutions may help in the process, but limitedly

Copyright © Gulf Research Center 2010 All rights reserved The Bidding Round Acquisition of data allows the government to set up a bidding round This means: –Defining areas for exploration and production that will be opened up for bidding –Setting up a data room where potentially interested companies can view or acquire the information –Defining the parameters for adjudication of licences

Copyright © Gulf Research Center 2010 All rights reserved An Inferior Solution: Direct Negotiations It is possible to avoid a bidding round and enter into direct negotiations with a specific company or consortium of companies This is more frequently the case when the government has very little understanding of the prospectivity and the company initiates the process This is almost invariably an inferior solution, as the governments bargaining position is undermined It is also a much less transparent approach

Copyright © Gulf Research Center 2010 All rights reserved The key parameters of a bidding round Areas to be allocated Minimum obligations Type of license Adjudication parameter(s)

Copyright © Gulf Research Center 2010 All rights reserved Areas to be allocated Generally it is preferable to allocate numerous small areas to different players – but obviously companies prefer larger areas. A balance needs to be struck. Rules about relinquishment are essential: after a set period of time companies must relinquish all areas where they have made no commercial discoveries, allowing for re-bidding Do not allocate all promising areas in a single bidding round – the government learns in the process

Copyright © Gulf Research Center 2010 All rights reserved Minimum Obligations Certain minimum obligations may be imposed on the company concerning investment in further data collection, and minimum number of exploratory wells to be drilled. Generally the company is required to share with the government all collected data and geological information

Copyright © Gulf Research Center 2010 All rights reserved Types of licence The decision on the kind of contractual relationship that will be established with the foreign company is the most important item in the list Three main types of contract: –Concession –Production sharing agreement –Service contract

Copyright © Gulf Research Center 2010 All rights reserved Concession The concession is the kind of contract that creates the greates distance between the government and oil operations The company is responsible for all operational and investment decisions, within the minimum requirements The company is responsible for decisions concerning production, although the government may request that a production plan be submitted and approved

Copyright © Gulf Research Center 2010 All rights reserved Concession (2) The company owns and markets the extracted oil and/or gas The government receives a royalty – generally in cash but possibly in kind – which is a fixed percent of production The company pays an income tax on realized profits

Copyright © Gulf Research Center 2010 All rights reserved Production Sharing Agreement In a Production Sharing Agreement, the company is initially responsible for all exploration and development costs When production begins, the oil is shared between the company and the government (or the national oil company) The oil stream is first of all divided in two parts: cost oil and profit oil

Copyright © Gulf Research Center 2010 All rights reserved Production Sharing Agreement (2) Cost oil is meant to reimburse the company of all expenses incurred initially. Therefore, cost oil is a large share of initial production (in some cases even 100%), and declines after certain milestones of production are reached. The division of cost oil is in favour of the company (in some cases even 100% to the company)

Copyright © Gulf Research Center 2010 All rights reserved Production Sharing Agreement (3) Once certain production milestones are passed, the share of cost oil declines drastically, and profit oil becomes dominant The division of profit oil is in favour of the government (sometimes even 90-95%)

Copyright © Gulf Research Center 2010 All rights reserved National Oil Company The marketing of the governments share of production is generally entrusted to a national oil company The Production Sharing Agreement may also require that the NOC is a partner in the producing company. This allows the NOC to have a direct say in operations. The NOC may even have a majority of the shares of the producing company and appoint the Chairman The NOC may either contribute its own funds or be carried by the IOC, which will then be repaid out of future profits

Copyright © Gulf Research Center 2010 All rights reserved Boundaries are not rigid The boundaries between a concession and a PSA are not rigid: –There can be royalties and income taxes also under a PSA – although in a sense this may be viewed as overkill –There can be mandatory participation of the NOC in the equity of the producing company also under a concession – which then has outcomes close to those of a PSA

Copyright © Gulf Research Center 2010 All rights reserved Service Contract Under a service contract the foreign company performs a service to the national oil company The service may be paid for on a cost plus or fixed sum basis, with no link to production; or it may be paid as a fixed (or variable) fee on volumes produced In the latter case, the foreign company is responsible for operations Yet the foreign oil company has no right to the oil produced

Copyright © Gulf Research Center 2010 All rights reserved Booking Reserves International Oil Companies generally do not like service contracts because they cannot book reserves Per se, oil in the ground always remains the property of the producing government (except in the US) However under a concession or a PSA the company has title to all or a share of the production and can accordingly book all or part of the estimated reserves of the field(s) This is considered important for the value of the company

Copyright © Gulf Research Center 2010 All rights reserved Booking Reserves (2) The same consideration is not important for service companies: indeed the difference between a service company and an oil company is that the former is not expected to have reserves Some service contracts have envisaged payment in kind (a stream of oil), and allowed companies to book virtual reserves accordingly

Copyright © Gulf Research Center 2010 All rights reserved Choosing the type of contract The choice of contract typology depends on circumstances: –How well technically versed is the government? –Is there a national oil company and how competent is it? –What does the government wish to achieve? (Maximise short term revenue vs extending the life of reserves? Exporting vs maximising domestic value added?) Preferably a model contract should be prepared by the government containing a good many details

Copyright © Gulf Research Center 2010 All rights reserved Back to the Bidding Round When launching a bidding round, the government will need to specify the type of contract on offer and most of the numerous parameters that are required. These details will be in the model contract One or two parameters will be left open and will be used for adjudicating the contract For example, the companys share of profit oil may be used as the bidding parameter for a PSA, and the contract will be adjudicated to the company bidding the lowest share However, in some cases it may be preferable to allow greater latitude to bidders to define their preferred cocktail of conditions, then choose the combination that the government finds most suitable ex post

Copyright © Gulf Research Center 2010 All rights reserved Setting up a successful bidding round is not easy! It is necessary to properly evaluate the countrys bargaining position Generally this is possible only with repeated experience, and surprises are possible Good independent professional advice should be sought

Copyright © Gulf Research Center 2010 All rights reserved Will there be enough interest? Governments should be aware that the universe of foreign oil companies is very diverse: –Major international oil companies –Smaller independent upstream companies –National oil companies of importing or other exporting countries If numerous participants are attracted, this is not necessarily a sign of too generous conditions

Copyright © Gulf Research Center 2010 All rights reserved Further Negotiations Even when a contract contains a lot of details and the bidding takes place on a single parameter, further negotiations might be necessary All the more so if multiple parameters are left vague and the preference order of bids may not be immediately clear

Copyright © Gulf Research Center 2010 All rights reserved Negotiations and Renegotiations The bargaining position of the two sides changes in the process If a discovery is made, the bargaining position of the government is enhanced; if the model contract is well designed, this should be already taken care of More importantly, commercial conditions, notably prices, may change It is extremely difficult or plainly impossible to design a contract that will appear equally fair under any circumstances Hence ropeners should be included and new negotiations expected If the two sides are pragmatic and in good faith, conflict may frequently be avoided

Copyright © Gulf Research Center 2010 All rights reserved Disputes Resolution If disputes erupt, extensive technical negotiations should be envisaged as first step Foreign companies will generally be suspicious of local courts and will prefer international arbitration Compliance with international arbitration in the host countrys jurisdiction will normally be voluntary. However, refusal of the outcome of arbitration may lead to serious loss of reputation for the country