Legal Aspects of Oil and Gas Contracts

1.1 There are several contractual concepts used around the world by governments to permit international oil companies (‘IOC’) to carry out petroleum explorations and, in the event of a commercial discovery, development and production operations. The type of contract selected by a government and the terms and conditions agreed between the signing parties depend mainly on the government policy and the relative bargaining strengths of host countries, which are directly linked to the petroleum potential of the offered acreage and the international oil market situation [1] .

1.1.2 Production Sharing Contracts (PSC) and Licensing Systems are among the most common types of contractual arrangements used for petroleum exploration and development. The differences between the types of contracts are of a conceptual nature mainly with regard to the levels of control granted to the foreign contractor, compensation arrangements, and levels of involvement by the National Oil Companies (NOCs) [2] . The main features of the PSC and Licensing systems, including differences and similarities, are explored in the discussions that follow.

1.2 Production Sharing Contracts (PSCs) and Licensing Systems

1.2.0 Production Sharing Contracts

1.2.1 The concept of production sharing originated in Indonesia where the first agreement of this type was signed in 1966 between Pertamina, the Indonesian state-owned company, and an American company [3] .

1.2.2 A production Sharing Contract (PSC) is a contract for cooperation between a National Oil Company (‘NOC’) and an international oil company (‘IOC’). The foreign investor assumes all the pre-production risks and recovers both his cost and his profit share from production, in predetermined proportions, once commercial production from the contract area commences [4] .

1.2.3 Typically, the term of a PSC is between 20 to 30 years, with an option to extend. The contract terminates, unless extended under agreed conditions, if no petroleum that can be developed commercially is found within a pre-determined exploration period [5] .

1.2.4 From the state’s perspective, according to Ahmadov [6] , obtaining direct foreign investment, freeing up scarce capital resources for other activities, obtaining long term technology and skills transfer; and retaining control over and ownership of oil and gas in the ground are among the reasons for using PSCs.

Key features of PSC

1.2.5 PSCs are also adopted by some governments because of its flexibility and adaptability. Under this concept, it is very easy to ‘tailor’ the production split to the real petroleum interest of each country and to local conditions; and thus to have a flexible split by varying the IOC’s share of production. The traditional license agreement does not have the same flexibility [7] .

1.2.6 A feature of PSC that distinguishes it from the licensing system is that under a PSC, contractual relations arise between two legally equal parties, each having rights and obligations, the violation of which shall entail their legal liability [8] .

1.2.7 Whilst some contracts may provide an option that allows the NOC to participate directly in the development process, the oilfield is operated by the IOC. For example, in Indonesia, Pertamina may decide to take a 10% participating interest upon notice of the commercial discovery, whilst in some countries, governments may elect to participate up to 50% or more [9] . The participation scheme is identical to the ‘concession’ joint venture [10] . NOC participation is, however, considered unappealing by IOCs as the NOC can interfere with the day-to-day management of the operation and conflicting views may lead to a less efficient running of the project [11] .

1.2.8 Under the PSC, the agreed programme of the parties for the extraction of mineral resources is the subject of the given contract [12] . Such programme includes the type, costs and period of performance and outlines, among other things, the IOC’s commitment with regard to seismic, drilling, information dissemination, financial obligations and employment of local workforce [13] .

1.2.9 Parts of the contract area must be relinquished during the contract term. This is a feature similar to the concession system whereby Licensees are entitled to ‘determine’ (i.e. surrender) a Licence, or part of the acreage covered by it, at any time (unless the Licence is still in its Initial Term and the Work Programme has not been completed) [14] . Typically, the relinquishment under a PSC can be for as much as 50% of the initial contract area. Examples include the Gabon Deepwater 1997 Model PSC (the Gabon Model PSC), the Nigeria/ São-Tomé e Principe joint development zone (JDZ) Model PSC of 2004, and Egypt’s Concession Agreement of 2000 [15] .

1.2.10 The ownership of the mineral resources under the PSC establishes an important difference to Licensing systems. Whereas under the Licensing system the licensees are entitled to 100% of the production at the wellhead, under the PSCs it is owned by the host government, and the share of production allocated to the IOC can be regarded as payment or compensation for the risk taken and services rendered [16] . The IOC’s title to the mineral resources passes at the point of export or at an agreed point of delivery [17] .

1.2.11 Another aspect of this ownership issue is that in most PSC contractual systems, equipment and facilities purchased by the IOC to be used within the country become the property of the host government either the moment they are landed in the country or upon start up or commissioning [18] .

1.2.12 PSC thus allows governments to be in charge while still offering attractive terms to investors and to free governments from the budgetary burden of having to finance – as in 100% state-owned operations or in true joint ventures and association contracts – exploration and in particular the huge costs of development [19] .

1.2.13 The main distinguishing characteristic of PSCs is production sharing which forms the central part a PSC [20] . The system is based on the principle of a sharing of the production between the state (or the NOC), holder of the mining rights, and the oil company, which is the operator and the source of the necessary funds [21] .

1.2.14 The production sharing usually follows the following procedure which represents two of the key features of the PSC:

Cost Oil – PSCs will usually specify a portion of total production, which can be retained by the contractor to recover costs;

Profit Oil – The remaining oil production after cost oil deductions and is termed “profit oil” and is shared between the state and the contractor per predefined, negotiated percentage as provided in the PSC [22] .

1.2.15 Under close supervision of the NOC, work is carried out by the IOC in accordance with a work programme, annual budget and management committee. The Joint Management Committee (JMC) is the forum that attempts to resolve potential conflicts that may arise between the parties. The JMC is normally made up of equal number of NOC and IOC representatives [23] .

1.2.16 The PSC system guarantees tax stability and offers the potential investor the opportunity to evaluate a project and to ascertain the taxes that it would have pay during the course of the project. This results from the fact that within the term of the PSC, the taxes and other obligatory statutory charges are replaced with a portion of profit production, meaning that the investor enjoys special tax treatment. This does not imply, however, that tax benefits are granted to investors. It is the tax system that exists in the host state that is simply replaced by production-sharing under the PSA [24] . Thus when the agreement is properly drafted, the PSC concept on the one hand fully secures the interests of the state, and on the other hand makes the investor immune to the state’s changing tax policies [25] .

1.3 Licensing Systems

1.3.1 The Licensing system can be described as an agreement between government and an IOC whereby the government grants the IOC the exclusive right to explore for, develop, produce, transport and market the petroleum resource at its own risk and expense within a fixed area for a specific period of time [26] . The investor pays to the state fees and other taxes and other obligatory statutory charges [27] .

Key Features of the Licensing System

1.3.2 Under the old Licence system, the state was not directly involved in petroleum operations and its petroleum revenues were only generated through taxation. In the modern form of licensing system, the relationship between the government and the licensee has been modified:

new provisions permit the government to exercise a direct control on petroleum operations (e.g. submission to the government by the licensee of an annual programme and budget, of a development plan);

the government may participate with the licensee in case of a commercial discovery, to jointly develop and produce such a field [28] .

1.3.3 In addition to matters of control, state participation enables the NOC and its personnel to gather the needed experience and expertise to be able to take over operations in the future [29] .

1.3.4 The payment of royalties, income tax and, if any, an excess profit tax and participation revenues are the most important sources of revenues through taxation under a Licence system [30] .

1.3.5 In terms of disposition of production, the licensees are entitled to 100% of the production at the wellhead but must, upon request (and in accordance with the terms of the Licence) pay royalties and must supply domestic needs. The government only receives in kind part, if any, of production through royalties, domestic supply obligation and state participation [31] .

1.3.6 Rentals, which are the annual charges a Licence carries, fall due each year on the Licence anniversary and are charged at an escalating rate on each square kilometre that the Licence covers at that date. The purpose of rentals is to encourage licensees to surrender acreage they do not want to exploit and to enable Licensees to concentrate on the acreage they actually decide to keep [32] .

1.3.7 Seaward Production Licences and Petroleum Exploration and Development Licences are valid for a sequence of periods, called Terms, which are designed to follow the typical lifecycle of a field: exploration, appraisal, production. At the end of each Term, each Licence expires automatically, unless the Licensee has made enough progress to earn the chance to move into the next Term [33] .

1.3.8 Licensees are entitled to ‘determine’ (i.e. surrender) a Licence, or part of the acreage covered by it, at any time (unless the Licence is still in its Initial Term and the Work Programme has not been completed). In the UK, the surrender of acreage is encouraged by the Department of Energy and Climate Change (‘DECC’), subject to restrictions, unless the Licensee intends to work it, and a minimum relinquishment of acreage at the end of the Initial Term is, in fact, a condition of most Licences [34] .

1.3.9 The Licensing system is adopted by some governments since it is relatively risk free. A common feature of the licensing system and one that is also similar to the PSC system is that, in both cases, the oil company carries all the financial risks and provides all necessary capital, equipment, technical assistance and personnel [35] .

2.0 Part 2 – Response to the preferred contractual arrangement

2.1.1 According Le Leuch [36] , the comparison of a modern license agreement with a PSC shows that, from a purely economic point of view, it is theoretically possible to arrive at a similar government take in the revenues of a commercial field, whatever the type of contract in force. The terms of the contract must be modulated against the characteristics of possible discoveries to obtain these results.

2.1.2 Le Leuch [37] points out that whilst the production sharing concept was designed to give the government a greater degree of control over the operations of oil companies, there is, in fact, no significant difference in respect of the degree of control between the said agreement and the modern Licence agreement. The reason for this is that under the two systems, the oil company, which assumes the financial risks, is generally responsible for the management of the petroleum operations.

Preferred contractual arrangement

2.1.3 Having considered the features of the PSC and Licensing systems, I would recommend the PSC system as the preferred contractual arrangement between Glenmordich Limited (‘GL’) and the government (or NOC).

2.1.4 Of particular importance to the investor is the stability of legal relations between the state and itself in the time-period of validity of the agreement, which are mostly long-term and require considerable costs on the part of the investor [38] . The set-up of the Licensing system makes it administrative and authoritative. By granting a license, the state by its authoritative act allows the investor to exploit subsoil resources on conditions unilaterally established by the state. The state may also unilaterally cancel its decisions: e.g. by restricting the investor’s rights or completely depriving the investor of its rights and cancelling a license. This feature is in sharp contrast to the PSC system whereby the relations of the investor with the state under a PSC are in large part structured on a civil-legal basis and in most cases cannot be changed unilaterally by the state [39] .

2.1.5 One of the reasons for recommending the adoption of the PSC system is that PSCs permit the conditions governing petroleum exploration and development to be consolidated in one document. Since GL are newcomers to the operating environment in Zarubia, this may be particularly helpful since the necessary provisions (including fiscal stabilization) can be consolidated in the PSC and the way in which the law will be applied can be clarified. The PSC is a straightforward way in which contractual assurances, additional to statutory rights, can be offered to investors [40] .

2.1.6 Almost all PSCs provide for international arbitration should conflicts arise [41] . Disputes are typically settled by arbitration, often (but not always) with the seat of arbitration in the host country [42] . One of the reasons for selecting the PSC system is the issue of confidence in Zarubia’s legislative system. Since very little is known of Zarubia’s legislative system and its status as a society founded on the rule of law, it is considered more appropriate for GL to enter into a contractual relationship with Zarubia since this will enable GL to have access to independent international arbitration in case of interpretation disputes.

3.0 Part 3: Adoption of the standardised contracting system

3.1.1 For a country deciding to promote petroleum activities, contractual terms have to be designed in order to encourage the participation of international oil companies willing to quickly commit meaningful exploration budgets, while safeguarding the country’s long-term interests [43] . If the contract is efficiently and appropriately crafted, there should be substantial alignment of mutuality of interest as soon as the contract is signed. A well balanced, efficient and flexible contract will theoretically provide greater contract stability [44] .

3.1.3 I would recommend the adoption in Zubaria of the CRINE/LOGIC standardised contracts developed by and used widely in the UK Oil and Gas industry. These standard contracts contain standard contract clauses tailored to the general need for some sort of specific arrangement leaving only the insertion of special terms and particular requirements.

3.1.4 The adoption of standard contracts reduces costs and increases efficiency. It further ensures that all contractors tender their services by using the same terms and conditions. It avoids or mitigates lengthy negotiations required each time a contractual and commercial arrangement is needed.

3.1.5 One of the issues which the standardised contracts seek to address is risk allocation by introducing contractual indemnification clauses. Indemnification is the right of one party who is legally responsible for a loss – the indemnitee- to shift that loss to another party – the indemnitor. The risk of loss is shifted by virtue of the indemnitor’s obligation to make the indemnitee whole for any loss the indemnitee sustains [45] . These clauses are employed in the allocation of risks in contracts and is based on the ideology that liability should be borne by the party in the best position to insure against or otherwise absorb the particular loss in question.

3.1.6 It is also recommended that the parties consider adopting the standard LOGIC CRINE “knock-for-knock” liability framework, whereby each party is responsible for, and shall indemnify the other in respect of, any damage to its own property, the injury/death of its own employees, pollution emanating from its own property/equipment/reservoir and its own consequential losses, regardless of fault.

3.1.7 I would also recommend that the GL specifically negotiates and insert into the contract a clause seeking to cap GL’s liability under the contract. This would help limit the amount of money GL would have to pay in economic damages in the event of a spill. For example, because of the liability cap clause in its contract, British Petroleum, the company responsible for the disastrous spill in the Gulf Coast of the USA, would face limited responsibility for covering costs beyond cleanup and containment. Federal Law sets a limit of $75 million as the amount an oil company has to pay for damages such as lost wages and economic suffering. However, analysts say that in a region like the Gulf Coast the cost to local industry of a massive oil spill can easily skyrocket well beyond that total [46] .

4.0 Conclusion

4.1 The comparison of a modern license agreement with a PSC shows that, from a purely economic point of view, it is theoretically possible to arrive at a similar government take in the revenues of a commercial field, whatever the type of contract in force. The terms of the contract must be modulated against the characteristics of possible discoveries to obtain these results [47] .

4.2 It is considered more appropriate for GL to enter into a contractual relationship with Zarubia since this would enable GL to have access to independent arbitration in case of disputes. The PSC system guarantees the investor stability of legal relations with the state as well tax stability.

4.3 The adoption of standard contracts reduces costs and increases efficiency. It further ensures that all contractors tender their services by using the same terms and conditions.