Society of PetroleumEngineers

SPE 24242

Trends in Production-Sharing Contracts in Nigeria

E.P. Ofoh, Nigerian Natl. Petroleum Corp.
SPE Member

I Copyright 1992,Society of Petroleum Engineers, Inc.

I This paper was prepared for presentation at the SPE Oil & Gas Economics, Finance and Management Conference held in London, England, 28-29 April 1992.

This paper was selected for presentation by an SPE Program Committee following review of information contained in an abstract submitted by the author(s). Contents of the paper,
as presented, have not been reviewed by the Society of Petroleum Engineers and are subject to correction by the author(s). The material, as presented, does not necessarily reflect
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of where and by whom the paper is presented. Write Librarian, SPE, P.O. Box 833836,Richardson, TX 75083-3836U S A . Telex, 730989 SPEDAL.

INTRODUCTION
Nigeria, as a member of the Oil Producing and In recent times, worldwide investment opportunities
Exporting Countries (OPEC), today operates various appear to have out-numbered the availability of
forms of Joint Venture arrangements. From 1908, funds. As a consequence, international oil
when oil exploration first began in Nigeria by companies may have to choose between highly ranked
a German company, the Nigerian Bitumen Corporation ventures to commit their scarce capitals. Usually
(NBC), through 1937 when Shell D'Arcy took concession oil and gas (0 & G) ventures with very high
of the entire country as a single block to 1972 potentials for profits would have to be compared
when more than 13 international companies joined with highly attractive ventures in other sectors
the entrepreneurship, the Nigeria Petroleum Industry of the economy around the globe. Several factors
has witnessed numerous forms of Production Sharing are usually considered before a decision to commit
Contract agreements. These arrangements which capital to 0 & G venture is made. These include
reflected state of the art of industry at the time, among others: the anticipated price of oil or
, the technical cost of Exploration and Production
ranged from simply Tax and Royalty only through
"Equity Sharing" to "PRODUCTION SHARING" AGREEMENTS.
In addition, each phase of these agreements partly
TaS
E & P) activities and the existing fiscal regimes
that determine the economic environment. The
reflected the following: oil industry worldwide has for over one decade
now witnessed a number of uncertainties in the
1) Prevai ling Fiscal and Economic Environment global oil market. The first significant crude
in the Country. oil price increase occurred in 1973 when prices
more than quadrupled due to the Arab oil embargo
2) National Development and International that year. Many oil investors as a consequence
Obligations/Needs. reaped potential profits. The second world oil
1 3) State of Global Economy.
I
price increase which occurred in 1980 led to a
dramatic decrease in demand, and in 1986, the
I This Paper will discuss among other things:
I
collapse in the oil price, trigged by over-supply
of crude oil drove many investors out of jobs.
Thus market realisations in the industry worldwide
- The Economic implications of each arrangement dropped on several occasions to levels well below
to both Joint Venture partners. the official price expectations. In Nigeria,
the effect was tremendous. Oil contributed over
I -- The possible future trends and their implications.
The salient points in each arrangement shall
I 90% of Nigeria's foreign exchange earnings, and
about 80% of the nation's recurrent and capital
expenditures. The effect of the market uncertainties
be highlighted. was felt by both industry and government alike.
As a developing nation, Nigeria had the noble
national objective to increase its reserve and
production potentials, if only to obtain more
References and illustrations at end of paper. funds to tackle its national development programs
2 TRENDS IN PRODUCTION SHARING
as well as service its foreign debts. Towards the
background of these objectives, government had to
regularly review its policies in line with the
state-of-the-art in the industry.
HISTORIC REVIEW OF THE NIGERIAN OIL INDUSTRY
Mineral exploration in Nigeria started in 1908,
when a German company, the Nigerian Bitumen
Corporation (NBC) unsuccessfully explored for
Bitumen deposits along the coastal fringes of the
Niger Delta. In 1937, Shell D'Arcy (the forerunner
of the present day Shell, Nigeria) was granted an
exclusive right to take concession of the entire
country as a single block. In 1956, Shell D'Arcy
in partnership with the British Petroleum (BP)
made a comercial discovery at Oloibiri field,
some 80 kilometers west of Port Harcourt. Nigeria
made its first overseas crude shipment of
6,000 barrels of oi 1 per day (BOPD) in
February 1958.
At that time, the prevailing Royalty and Petroleum
Prof its Tax (PPT) were pegged at 12.5 percent
and 50 percent respectively. Thus the revenue from
the oi 1 sector began to play increasingly significant
role in the Nation's economic life. The attainment
of Nigeria's independence in 1960 significantly
influenced government perception of the industry
in many ways: The independent Nigeria started to
"Open Up" to the rest of the world outside of
Common Wealth.
With production increased to 17,000 bopd, Nigeria
became a major attraction to the multinational oil
companies; thus more than 13 multinationals
obtained licences to prospect for oil in Nigeria.
In 1971, a National Oil Company, the Nigerian
National Oi 1 Corporation (NNOC now called NNPC)
was formed to protect government's interests in
oil ventures. The government through NNPC entered
into participation agreement with all the
international oil companies operating in Nigeria,
and obtain 35% equity share in almost all of them.
In July 1971, Nigeria joined the Or anization of
Petroleum Exporting Countries (OPEC7 and by 1979
increased its equity share to 60%. As the industry
matured, government continued to seek for more
effective policies to control and regulate its
activities.
REVIEW OF NIGERIA'S PETROLEUM POLICIES
Prior to the commencement of oil production in
1958, policies passed by government were those
aimed at restricting the search for minerals only
to the Common Wealth. The Mineral Ordinance Act
1950 allowed the rights to prospect for oil in
Nigeria to companies registered in Great Britain
or any of its Protectorates. It further provided
that the principal officers of such companies
must be British subjects. More realistic
Petroleum Policies were enacted after 1958 when
Nigeria made its first crude shipment abroad.
INTRACTS IN NIGERIA SPE 24242
In 1959 government passed a legislation known as
"the 1959 Mineral Oil Ordinance (MOO) and the
Petroleum Profits Tax (PPT)". This law was
designed to enable the government formulate
procedure for granting concessions and government
share of profits. Thus government sought for ways
of assessing the following: sales based on
Realistic Market prices, Royalty as a fraction
of the value of crude, depreciation rate, etc.
As proceeds from crude petroleum increased,
government in 1967 amended the 1959 MOO and PPT
Acts as follows:
(a) The Posted Price (PP) was chosen as the
basis for Tax Calculation.
(b) Royalties were to be assessed as operating
expenditure.
(c) Reduction in capital a1 lowance was effected.
Petroleum Decree 51 of 1969
This regulation called for a concession type of
arrangement with Royalty set at 12.5 percent for
oil, 10 percent for gas and PPT at 50 percent.
The "Decree 15" of April 1973
This decree was essentially an amendment to the
1959 PPT Ordinance. Under this provision, PPT
was raised from 50 percent to 55 percent,
Royalty stayed at 12.5 percent.
A Production Sharing Contract (PSC) was signed
in 1973 between Ashland Oil (Nigeria) and the
Nigerian government. The Agreement provided for
Ashland: 40 percent "Cost Oil" recoupment, PPT
55 percent and a Profit Sharing of 70130 in
favour of government. The "Cost Oil" fund was
subject to future negotiations.
In order to fasten the pace of transfer of
Technology and also to increase the financial
benefits from the sale of petroleum, government
took steps to implement the OPEC resolutions
which enjoined member nations to acquire
participating interests in the operations of the
oil companies. Thus, in 1974 Nigeria acquired
a 35 percent equity in the activities of the oil
companies operating in Nigeria. PPT and Royalty
were raised to 67.75 percent and 16.67 percent
(for oil) respectively. In 1975 the PPT and
Royalty figures were increased to 85 percent and
20 percent respectively.
1977 Tax Incentive Package
As a result of decline in exploration resulting
from the 1973 oil embargo, government in 1977
granted its first tax incentive package to the
oil companies so that they can invest more
profitably in exploration activities. The
provisions of this incentive are:
SPE 24242
(a) A profit margin of 80 centslbbl was
granted to Operators to defray the cost
of operations. It will be mentioned
that the technical cost of operations
prevailing at the time was $l/bbl.
(b) Royalty was 20 percent onshore,
18.5 percent offshore to 100 meters of
water depth and 16.67 percent beyond
100 meters of water depth.
(c) PPT was reduced to 65.75 percent for
pre-production costs on new fields
operations. After amortization, PPT
would revert to 85 percent.
(d) Companies were also granted tax incentives
to explore both onshore and offshore areas.
Thus, it was 10 percent for 100 meters of
water depth, 15 percent of 100 - 200 meters
and 20 percent for offshore water depths
greater than 200 meters. The onshore tax
incentive was 5 percent.
In 1982 government reviewed the above profit
margin upwards to the value of technical cost
which stood at $1.6/bbl. Thus government
demonstrated that she is realistically concerned
to realistically work together with the oil
companies.
EVALUATION OF INCENTIVES
In February 1983, a $2/bbl tax incentive was
granted to all oil producing companies in Nigeria.
The provision of this incentive package allows
fiscal valuation to be based on Posted Price (PP).
The PP was made to be a function of Technical Cost
and the Prof it Margin (PM).
Under this provision, three economic scenerioscan
be analysed as shown in Figure 1:
(a) When the Official Selling Price (OSP) is
realisable in the market (i.e. OSP = Rp):
(i) A Profit Margin of $2/bbl is made
when the actual Technical Cost (TC)
is $2/bbl.
(ii) When TC is greater than $2/bbl,
Profit Margin declines on a defined
trend: Thus, for every $l/bbl
increase in TC, the Profit Margin
decreases by 15%.
For example, the PM was $2/bbl and
$1.85/bbl when TCs were $2/bbl and $3/bbl
respectively.
(b) As prices drop much below $30/bbl, Profit
Margin drops below $2/bbl. For example,
the figure shows that the PM was $2/bbl and
$1.32/bbl when prices were $30/bbl and
$23/bbl respectively.
(c) However, when market prices fall short of OSP,
expected Profit Margin would drop drastically.
The government in effect used the analysis in (a)
to both control the technical cost of operations
in the comoanies and at the same time leave them
with enough incentive to search for oil and gas.
Government was also concerned about the outcomes
of items (b) and (c). It was government's
interest that oil producing companies should be
granted a guaranteed Profit Margin. Thus the
1986 Review of Incentives.
1986 Review of Incentives
The shortcomings in the 1983 incentive package
as seen in items (b) and (c) above, made the
realised Profit Margin much less than the actual
Technical Cost. Also, the Profit Margins were not
guaranteed due to price fluctuations. As such,
oil producing companies cried out to government
for an improved incentive package. In response
to this outcry, government introduced in 1986,
a document known as, "The Memorandum of
Understanding (MOU)" , whose provisions are
summarised as follows:
$2/bbl after-tax prof it margin is
guaranteed to all producing companies
by the introduction of an offset pricing
formula in which a Revised Government
Take (&TI is pegged to a fixed percentage
of economic rent.
The K-factor was introduced as a mechanism to peg
the company's prof it margin to $2/bbl in
the event of wider positive variations in realised
prices. The K-factor guarantees the minimum
$2/bbl margin even when prices drop as low as
$23/bbl. Figure 2 shows the relationship
between the Revised Government Take and the
Realisable Price. When however the realisable
price falls below $23/bbl a new fomular whereby
Government Take is pegged to a fixed percentage
of economic rent is also used. Figure 3
shows the relationship plot for K-factor,
RGT and offset price. The value of K is used
as an adjusting mechanism to peg Government Take
to a fixed value. This relationship is valid
for prices less than $23/bbl but greater than
$l2.5O/bbl. Thus, this profit protection at
low prices depended on the Operator's ability to
keep Operating Costs not higher than $2/bbl.
Prices Below $12.5/bbl
When however prices fa1 1 below $12.5/bbl, a
self adjusting K-factor is once again applied.
Figure 4 shows that a relationship between
profit margin and realisable price is possible.
However, when two scenerios (TC = $2.5/bbl
and TC = $3.5/bbl) are compared, the relationship
seemed to have some problems: when the price of
crude falls between $9/bbl and $12/bbl, a bigger
Profit Margin is obtained with a higher Technical
Cost of $3.5/bbl than with lower Technical Cost
($2.5/bbl). Thus it will be in government's
interest to review this portion of the agreement
before the next price crash which may see crude
prices going below $12/bbl.
4 TRENDS I N PRODUCTION SHARING CO 'RACTS I N NIGERIA
Government reviewed t h e e x i s t i n g 1991 MOU which
sought t o improve t h e guaranteed n o t i o n a l p r o f i t
margin t o $2.30/bbl f o r small/medium l e v e l
i n v e s t o r s and $2.50/bbl f o r h i g h l e v e l i n v e s t o r s .
The agreement a l s o i n t r o d u c e d new i n c e n t i v e s t o
encourage t h e d i s c o v e r y o f new Reserves and t h e
commitment o f h i g h l e v e l c a p i t a l s t o 0 & G
p r o j e c t s . I t has been observed t h a t t h e MOU
p r o v i s i o n s a r e r e w a r d i n g o n l y t o companies t h a t
have on-going p r o d u c t i o n o p e r a t i o n s . Industry
e x p e r t s 2 have a l s o observed t h a t t h e f i s c a l Regime
n e i t h e r reduces t h e r i s k o f d r y h o l e s n o r i s i t
s u i t a b l e f o r t h e necessary u p f r o n t investment
capital required f o r starting fresh E & P
activities.
PETROLEUM POLICY STRUCTURE I N NIGERIA
Petroleum P o l i c y i n N i g e r i a comprises o f t h e
F i s c a l System and t h e Petroleum arrangements.
The F i s c a l System i s made up o f Economics and
Operations.
The economic aspects o f t h e f i s c a l regime d e a l s
w i t h government t a k e (Tax + R o y a l t y ) , and
f a c t o r s r e l a t e d t o investment economics; w h i l e
o p e r a t i o n s r e f e r t o t h e r e g u l a t i o n and c o n t r o l
o f industry activities.
The Petroleum arrangement i s made up o f concession
and c o n t r a c t s arrangement.
Concession Arrangement
I n t h i s set-up, government and company go i n t o
J o i n t Venture Agreement, whereby funds f o r
e x p l o r a t i o n and development a r e c o n t r i b u t e d
p r o p o r t i o n a l l y i n l i n e w i t h an agreed e q u i t y
shares.
Government i n a d d i t i o n c o l l e c t s Taxes, R o y a l t i e s ,
Commissions, e t c e t e r a . D u r i n g t h e pre-independence
p e r i o d t h e N i g e r i a n government l i m i t e d i t s
i n t e r e s t s o n l y t o Tax and R o y a l t y due t o t h e f a c t
t h a t t h e i n d u s t r y was young and revenues f r o m i t
were i n s i g n i f i c a n t . T h i s p e r i o d saw v e r y low
l e v e l s o f government take.
The 1 9 7 0 ' s saw N i g e r i a ' s a c t i v e p a r t i c i p a t i o n i n
t h e i n d u s t r y . T h i s was evidenced by many p o l i c i e s
and l e g i s l a t i o n s which r e v e r t e d t h e c o n t r o l o f
t h e business i n t o government's hands. N i g e r i a
j o i n e d t h e O r g a n i z a t i o n o f Petroleum E x p o r t i n g
C o u n t r i e s (OPEC) i n 1973 and by 1979 i t had
a c q u i r e d 60% e q u i t y share i n t h e o p e r a t i o n s o f
t h e o i l p r o d u c i n g companies i n N i g e r i a .
CONTRACTS AGREEMENT
T h i s i s made up o f :
(a) P r o d u c t i o n Sharing C o n t r a c t (PSC) and
(b) R i s k S e r v i c e C o n t r a c t (RSC).
SPE 24242
P r o d u c t i o n Sharing C o n t r a c t (PSC)
I n 1973, government i n t r o d u c e d t h e PSC i n t o
t h e N i g e r i a n O i l I n d u s t r y and a c t u a l l y executed
a PSC w i t h Ashland O i l N i g e r i a (AON). B a s i c
p r o v i s i o n s o f t h i s c o n t r a c t are:
( i) Government owns 100% o f reserves.
(ii) Operator p u t s up a l l t h e funds f o r
e x p l o r a t i o n and p r o d u c t i o n (E&P).
(iii) Operator r e c o v e r s i t s E & P expenses
through "Cost O i l " . Cost O i l i s a
n e g o t i a t e d f i x e d percentage o f t h e
proceeds s e t a s i d e t o r e c o v e r t h e
cost o f operations.
(iv) A f t e r Tax P r o f i t i s s p l i t between t h e
government and Operator.
Today, government p l a n s t o s i g n a l l f u t u r e
J o i n t Ventures under t h i s p r o v i s i o n .
R i s k S e r v i c e C o n t r a c t Agreement (RSC)
I n 1979 government e n t e r e d i n t o R i s k S e r v i c e
C o n t r a c t agreements w i t h some new o i l companies
under t h e f o l l o w i n g p r o v i s i o n s :
(i) The C o n t r a c t o r p u t s up a l l t h e funds
f o r E & P and has between two t o f i v e
y e a r s t o make commercial d i s c o v e r y .
I f a t t h e end o f f i v e y e a r s t h e
C o n t r a c t o r makes no commercial d i s c o v e r y
on t h e b l o c k s assigned t o him, t h e
contract automatically terminates.
( i i) The Government owns 100% o f t h e
Concessions and Reserves.
( i i i) I f t h e C o n t r a c t o r makes a commercial
d i s c o v e r y , he i s p a i d back a l l h i s
expenses and i n a d d i t i o n , he i s rewarded
a p p r o p r i a t e l y through n e g o t i a t i o n s f o r
his risks.
(iv) The C o n t r a c t o r has t h e f i r s t o p t i o n t o
purchase government's crude.
DISCUSSIONS
N i g e r i a n government i s aware o f t h e g r e a t i n f l u e n c e
which i t s p o l i c i e s and r e g u l a t i o n s have e x e r t e d
on t h e development o f i t s Petroleum I n d u s t r y .
Thus she has r e g u l a r l y reviewed h e r f i s c a l regimes
t o be i n t u n e w i t h i t s N a t i o n a l O b j e c t i v e s which
i n c l u d e d among o t h e r s :
(i) I n c r e a s e d ownership o f Reserves.
( i i) I n c r e a s e d Reserve base and P r o d u c t i v i t y
levels.
The Memorandum o f Understanding has o f f e r e d
O p e r a t i n g Companies g r e a t i n c e n t i v e s i n t h e f o r m
o f P r o f i t Margins t o c o u n t e r t h e u n c e r t a i n t i e s
i n the Price o f O i l .
The revenue f r o m t h e s a l e o f Petroleum f o r
government belongs t o t h e F e d e r a t i o n Account
which i s used t o s e r v i c e t h e e n t i r e p u b l i c
r e c u r r e n t and c a p i t a l expenditures. Thus t h e
c a p i t a l i n f l o w f r o m f o r e i g n i n v e s t o r s i s necessary
t o meet government's o b j e c t i v e s . It i s i n t h e
l i g h t o f t h i s t h a t government would p r e f e r t h a t
f u t u r e J o i n t Venture Agreements s h o u l d be one
i n which t h e C o n t r a c t o r would bear a l l t h e c o s t s
o f E x p l o r a t i o n and Production. Even then, t h e
m u l t i n a t i o n a l i n v e s t o r s w i l l have n o t h i n g t o
r e g r e t about t h e arrangement s i n c e n e g o t i a t i o n s
r e g a r d i n g t h e "Cost O i l " a r e open ended.
I n a d d i t i o n , Operators can t a k e advantage o f
" T r i p l e " i n c e n t i v e package f o r t h e same
"Nor k Program" :
(i) The C a p i t a l Investment I n c e n t i v e which
guarantees t h e i n v e s t o r a P r o f i t Margin
o f $2.5/bbl.
(ii) A d d i t i o n a l Reserves I n c e n t i v e - which
i s formulated t o give notional P r o f i t
Margin on a l l r e s e r v e a d d i t i o n s o v e r
the previous year.
(iii) P r o d u c t i o n and L i f t i n g o f Crude:
Government i n 1991 g r a n t e d t o a l l O i l
Producing Companies-a n o t i o n a l P r o f i t
Margin o f $2.3/bbl on t h e i r p r o d u c t i o n s .
4. F u t u r e J o i n t Venture arrangements a r e f o r e c a s t
t o t a k e t h e f o r m o f P r o d u c t i o n Sharing
C o n t r a c t (PSC). Government may wish t o
c o n s o l i d a t e ownership o f 100% o f t h e Reserves
w h i l e a t t h e same t i m e s h i f t i n g a l l t h e
R i s k s and Funding o f E & P t o t h e C o n t r a c t o r
who w i l l be adequately compensated through
"Cost O i l " and t h e e x i s t i n g f i s c a l regime.
5. The e f f e c t i v e n e s s o f t h e i n c e n t i v e s a r e
more s i g n i f i c a n t t o Operators a t t i m e s o f
Low Crude P r i c e s .
ACKNOWLEDGEMENT
The a u t h o r i s g r a t e f u l t o NNPC Management f o r
p e r m i s s i o n t o p u b l i s h t h i s paper.
REFERENCES
1991 MOU Agreement: I n t e r n a l document
f o r t h e N i g e r i a n N a t i o n a l Petroleum Corp.,
1991.
A.O.R. Oladele: Budgeting and F i n a n c i n g i n
an O i l O p e r a t i n g Company i n N i g e r i a :
Paper presented a t t h e 9 t h Annual Conference
o f NAPE. p. 8.

However, t h e 1991 Revised Government Take (RGT) Etekerentse, G.: N i g e r i a n Petroleum Laws:
b r i n g s about 2% o f economic r e n t more t h a n t h e Henemann P u b l i c a t i o n , Ibadan (1985),
former Government Take (GT) which i t replaced. pp. 1 - 163.
Government i s t h u s f a v o u r e d i n t h i s b a r g a i n ( f i g . 5 ) .
4 P.O. Chukwu and C.U. Ikoku: A Comparative
A study c a r r i e d o u t i n 1991 comparing a l l
t h e P o l i c y arrangements showed t h a t t h e PSC and E v a l u a t i o n o f E v o l v i n g N i g e r i a n Petroleum
t h e RSC a r e l e s s s e ~ s i t i v et o O i l P r i c e s t h a n Development P o l i c i e s , SPE Paper 22029.
o t h e r s . The study .,lso concluded t h a t a l l t h e
government p o l i c i e s a r e designed t o l e a v e
a decreasing p r o p o r t i o n a l o i l revenue t o an
i n v e s t o r as p r i c e s go up.

CONCLUSIONS

1. Fiscal Policies i n Nigeria r e f l e c t the

state-of-the-art o f the industry a t the
time, and were m i n d f u l o f t h e s t r a t e g i c
National Objectives.

2. Through c o n s t a n t r e v i e w o f i t s P o l i c i e s
t h e N i g e r i a n Government has p o s i t i v e l y
r e g u l a t e d t h e Petroleum I n d u s t r y w h i l e
a t same t i m e l e a v i n g Operators w i t h
s u r p l u s i n c e n t i v e s t o i n v e s t more
profitably i n E & P activities.

3. The government P r o f i t Margin on Reserve

a d d i t i o n i s a " W i n d f a l l bonanza" t o
Operators who have a l r e a d y been compensated
f o r same t h r o u g h t h e r e c e n t l y r e v i s e d
MOU on P r o d u c t i o n / L i f t i n g s , e t c .
 I I

n.m 28.05 24.00 26.00 27.00 28.00

REAUSABE PRICE, $/BBL REAUSABLEPRICE, $BBL

FIG 1: COMPARISON OF GOVT. TAKE(GT) AND FlG 2: !=LOTOF RMSED GOVT. TAKE
REVISED GOVT. TAKE (RGT) VERSUS REAUSABLE PRICE (FP)
FOR RP>$23/EBL

FIG 3: PLOT OF K-FACTOR. RMSED GOVT. TAKE. OFFSET PRICE

VERSUS REAUSABLE PRICE (RP)
PRICE RANGE $23/8BL >RP>$IZ.WBBC
 I I
4.00 9.00 11.00 12.50
REAUSABLE PRICE, $/BBL

FIG 4: PLOTOF PROFIT MARGIN VERSUS REAUSABLE PRICE

FOR RP<$12.50/BBL

I I
30.00 28.05 23.00
REAMSABLE PRICE, $/BBL

FIG 5: COMPARISON OF GOVT. TAKE (GT) AND REVISED GOVT. TAKE (RGT)