Production Sharing Contract

Where under a concession system the concession holder has the economic right to all of the oil produced within the concession but is liable
to pay tax and royalty on the proceeds, in a production sharing contract the mineral resource remains the property of the state. As such, the PSC agreement lays down the terms under which the barrels produced from a development project will be allocated between the resource holder and contractor i.e. the contractors entitlement to the resource produced. Amongst others, these terms will typically indicate how the oil produced will be allocated to cover the capital and operating costs of the project (so called ‘‘cost oil’’) and in what proportions the remaining ‘‘profit’’ oil will be allocated between contractor and state.

PSCs –– Progressive yes, but not loved by stock market investors

In an era when the major international oil companies are being asked to take increasing political, financial and technical risk by developing resources in often remote and hostile environments, PSC agreements make considerable sense. For the oil companies, they provide the sanctity of an internationally recognised legal contract and the comfort that the early revenues will in large part be applied to recovering invested capital so providing them with a healthy level of return on investment and minimizing project downside. For the host nation, they allow a valuable, but often difficult to extract, resource to be monetized, exposing them to upside risk from oil markets but with limited downside to their own finances. Indeed, there can be little doubt that without agreements of this nature much of the oil now arising from Angola and Nigeria’’s deepwater, the Caspian region or more hostile environs in Russia would not be in production.

Cost recovery generally a priority

Under most PSCs, a significant proportion of the revenues achieved from the sale of the oil or gas produced are available for cost recovery. For example in Angola, Azerbaijan and Malaysia amongst others, 50% of revenues are available for cost recovery whilst up to 100% is available in some Nigerian deepwater projects. To the extent that these ‘‘cost oil’’ barrels do not cover all the costs incurred to date, unrecovered costs may be carried forwards to subsequent periods, often accruing interest or some other form of value uplift. Importantly, at times of industry cost inflation, this emphasis on cost recovery upon the commencement of revenues can be very protective of project economics.
The remaining profit oil is then allocated between the state and the contractors in accordance with the terms of the contract, the contractors taking their equity share of the profit oil. This will generally be subject to corporation tax.

A simple example of a PSC

This is illustrated by the schematic below which shows a $100 revenue project with costs of $40. Under the terms of the agreement up to 50% of revenues can be allocated for cost recovery (the cost oil) with the balance of revenues (the profit oil) allocated between contractor and state in a 40/60 ratio. The contractor is then liable for tax at 50% on its share of the profit oil. As can be seen, at $40, all costs are recovered with the contractor retaining some $24 of remaining $60 of revenues. On this a further $12 is then paid as taxation, the result being that of the net revenues of $60 the state achieves an income of $48 and the contractor $12.



Trigger points –– PSCs use various schemes

Key within the PSCs is the allocation of profit oil between state and contractor. In most PSCs this allocation will alter as certain contractual ‘‘trigger points’’ are attained. Invariably these trigger points will differ from contract to contract. In general, however, the variables used to determine the allocation of barrels tends towards four or so generic types. These are IRR based, production based, those based on a fixed share of profits (pre or post tax) and those based on the ratio of revenues to costs (the so called R-factor). Each of which is discussed below with the different PSC structures adopted by various different geographies also highlighted in the subsequent table.

• IRR based PSCs: IRR based contracts are structured such that, depending upon the internal rate of return that the project has achieved, the share of profit oil barrels will alter. As with most PSCs they typically allocate a higher share of revenues to the contractor through the early phases of a project but a greater share to the state as the contractors’’ capital is recouped and the rate of return on the project rises. Indeed, as their name suggests, changes in the allocation of barrels between state and contractor (trigger points) tend to be associated with the achievement of different internal rates of return. Countries which commonly use IRR-based contracts as a mechanism for determining share include Angola, Russia, Kazakhstan, and Azerbaijan, amongst others. In our opinion, the advantages of IRR based contracts are that they are generally geared towards rewarding the contractor first and directed at the achievement of an acceptable level of return. As such they are very protective of a company’’s upfront capital investment (particularly at times of cost inflation). The disadvantage, however, is that once that return has been achieved the change in barrel allocation tends to be quite severe. Equally, depending on the proportion of initial revenues that are available for cost recovery they can mean that the state receives little by way of revenue through the early years of a project. This has led to conflicts between state and contractor, particularly where cost increases have also been evident (e.g. Sakhalin and Kashagan).

•  Production based PSCs. These contracts generally tend to be written around cumulative production, with changes in total oil or gas produced driving the change in allocation (e.g. Nigeria Deepwater, Malaysian offshore, Egypt, etc). In some cases they may, however, be based on the absolute volume of daily production planned (e.g. Qatar). In our opinion, production based contracts are particularly profitable for the contractor given an upwards shift in the oil price (from that at the time the contract was written) but have the potential to be quite painful given a downward shift. In aggregate they are certainly less sensitive to upwards changes in the oil price than IRR based contracts because the change in allocation is based upon time to produce rather return achieved. Again, the State’’s delayed exposure to oil price rises can result in conflict (Nigeria DW).

• R-Factor (revenue) based PSCs. PSCs of this nature are based around trigger points that come into effect as certain ratios of revenue to cost are attained. As a consequence they are quite sensitive to the impact of rising oil prices, an event that is almost certain to ensure that trigger points are more rapidly attained. At the same time, however, because revenue allocation will almost certainly remain biased towards the contractor as long as the revenue/cost ratio is low they afford good cost protection at times of industry cost inflation. Examples of countries that tend towards R-factor based contracts include Yemen, Qatar and Libya.

• Fixed share PSCs. Although PSCs of this nature share profits between the state and the contractor, in reality because the allocation of profit oil is fixed they have much in common with tax and royalty arrangements. For the contractor, the advantage is that recovery of cost oil is given a priority - again providing protection at times of rising cost. That aside, given that the government’’s share of profit oil is fixed, they are not dissimilar to a concession. Examples of a fixed-share PSC include many of those written in Indonesia.

Source: Deutsche Bank "Oil and Gas for beginners"