Fundamental Legal Issues in the Oil and Gas Industry

III: A Brief Discussion of Production Sharing Contracts

The last paper we introduced the concept of licensing in the

oil and gas industry. This article focuses on the production

sharing contract (“PSC ”) as a mode of licensing. The paper

describes the PSC and examines some of its key elements.

Background

The PSC emerged as a mineral development agreement in the

60s and originated from Indonesia. This contractual form has

now emerged as the dominant petroleum development

regime in the world and is utilised in countries like Egypt,

Malaysia, Russia, Nigeria, Iran, Uganda amongst others.

In a PSC, the holder or holders of a license or petroleum

development rights enter(s) into a contract with an

exploration and production company to explore for and to

exploit petroleum in a specified area. Typically the holder of

the petroleum development rights would be a state entity - a

National Oil Company (“NOC ”), which may hold the rights

with respect to all acreage in the country or in specific areas.

The exploration and production company (or “Contractor ”) is

responsible for funding and carrying out the operations. It

does not acquire any rights to the petroleum deposit. Where

oil is discovered, the Contractor would be entitled to recover

its costs and profit in the form of a share of the production.

The NOC would also be entitled to share in the profits. In the

position that exploration is unsuccessful, the Contractor is

typically unable to recoup its investment.

The PSC thus provides a means by which the State through

its NOC is able to leverage on its ownership of acreage to

acquire the funding and technical skill required to exploit

petroleum resources. It also relieves the State from making

monetary contributions to the direct costs of operations.

Key Terms/Elements

PSCs are as diverse as the countries which utilise them as

tools of petroleum development. The details of the terms of a

PSC and the balance reflected in these terms would be

influenced by several factors including prospectivity, political

risk and negotiating skills to name a few. For example, some

PSCs place significant emphasis on the right of the NOC to

manage the operations. The Indonesian PSCs are an example

of where such a requirement is made. On the other hand,

under the recent Nigerian PSCs, the responsibility for the

management of operations is jointly shared by the NOC and

the Contractor.
Nevertheless, there are certain common elements, which are

expected to be addressed in a PSC. These are discussed

briefly below.

Royalty Oil

Where there is a requirement under the law of the country to

pay royalty for oil produced, a certain potion of all oil

produced under the PSC must be set aside to meet this

obligation. This is called the royalty oil.

Cost Recovery & Cost Oil

Cost oil refers to the oil allocated to meet cost recovery by

the Contractor. This element would differ from contract to

contract. Needless to say it is a highly contentious area. The

recovery formula incorporated to the contract determines

how quickly or otherwise a Contractor may recover its costs.

On the one hand the Contractor would want to achieve this

as quickly as possible, whilst on the other hand the

Government/NOC would be concerned that it is able to reap

returns early in the production cycle. It should also be

mentioned that this element needs to be monitored closely

post the award of the contract. The NOC would need to

examine closely the cost elements to ensure that there is no

transfer pricing.
Tax Oil

Tax oil is the portion of oil set aside for the purpose of

meeting the tax obligations of the Contractor and the NOC. In

certain jurisdictions, the tax oil is allocated to the state

entity to pay taxes on behalf of itself and the Contractor.

Profit Oil

The profit oil is the remainder of available crude oil after

deductions of the royalty oil, cost oil and tax oil. The profit

oil split may be a fixed ratio or maybe on a graduated basis

depending on the level of production.

Unique Provisions in Different Jurisdictions

Egypt

In Egypt, the PSC must receive legislative approval for it to

be come operational. By the award of the legislative

approval, the PSC is granted a special status as a law by

itself and its provisions prevail over existing legislation in

the event of any conflict.

Malaysia

Under the Malaysian regime, the Contractor is required to

enter into a joint venture with a wholly owned subsidiary of

Petronas the NOC. The subsidiary acquires an undivided

interest in all rights , interests and privileges of the

Contractor at no cost to it.

Indonesia

Indonesian PSCs now include a domestic market obligation.

This imposes on an obligation on the Contractor to supply or

utilise a portion of its oil proceeds in the domestic market.

Concluding Remarks

The PSC regime provides a tool by which governments can

participate in the development of their petroleum resources

without incurring significant upfront expenses. In Nigeria,

where the costs of funding the joint venture arrangements

have proved difficult for the government, the PSC has been a

welcome alternative. This petroleum development regime is

now the contract of choice and has led commentators to

suggest that the joint venture arrangements should be

converted to PSCs. Such a conversion is not a straight

forward issue and involves the consideration of complex legal

and commercial issues, which may be the subject of another

article.

Whilst the PSC provides a useful tool for government, it is

still necessary to pay close attention whilst negotiating and

monitoring its key terms. The issue of cost recovery is

particularly important and requires a keen consideration of

its short and long term impact on total government take.

Adeoye Adefulu holds a Ph.D in oil and gas industry reform

from the Centre for Energy, Petroleum and Mineral Law &

Policy, University of Dundee. He is a partner in the law firm

of Odujinrin & Adefulu e s t 1972.