Example Of Argumentative Essay On Drafting Challenges In E&P Contracts
Choosing between production sharing contracts, joint ventures, and service contracts presents formidable intellectual challenges as to optimal commercial and legal drafting considerations. Critically discuss, citing typical clauses and risk issues that may arise
In the realm of petroleum exploration and development (E&P hereafter), much has changed since the early 20th century and the present. The exhalation brought about by independence has spurred an era of nationalism that triggered the disgorgement of foreign elements from local soil. In E&P, the impact of nationalistic fever forced the diminution of traditional agreements that totally left to foreign companies the management and even ownership of production of natural resources. In the wake of the retirement of traditional agreements, the contractual system era in E&P emerged. In the new system, host countries limit the participation of foreign companies to capital, technology and operational aspects, the degree of limitation dependent on the contractual vehicle used. There are currently three types of contractual systems being used today in E&P, namely: production-sharing contracts, joint venture contracts, and service contracts. The close participation of the host state in the E&P has complicated the matter of drafting these contracts because now, there are at least two parties who may or may not share the risks involved in the undertaking. This report attempts to present the various challenges and risks entailed in the drafting of these types of contracts. For this purpose, the contracts are introduced one by one to provide an overview of their similarities and differences, and an idea of the difficulty entailed in drafting them. A subsequent section of the report details the challenges and risks of drafting, by exemplifying specific and chosen clauses commonly found in these types of contracts.
II Contractual System and their Features
A. Production-Sharing Contracts
Production-sharing contracts or agreements (PSC hereafter) are agreements typically used in petroleum exploration and development between the government and a foreign oil company (FOC hereafter). Under the PSC, however, the state represented by the government or any of its authorised agencies, typically the national oil company, retains control of management over the exploration and development of the resources. The usual process under this type of agreement is for the government to engage the services of a contractor to provide the state with technical and financial services for the operations. In return, the contractor receives a stipulated amount of shares of the oil produced. Like concessionary agreements, PSCs also typically require contractors to pay an upfront bonus, called signing bonus, to the government. Signing bonus may take the form of a lump sum of money or equipment for the exploration. PSCs usually cover periods from 25 to 30 years, or even longer. In the Kashagan oil field in Kazakhstan, for example, the parties entered into a PSC for 40 years.
The first PSC was introduced in Indonesia in 1966, which had regained its independence just two decades earlier. The exhilaration of newfound independence, spurred high feelings of nationalism and concessions often became the object of resentment and criticisms. This public sentiment constrained the government from granting new concessions and the PSC became the new focus of interest because of its upholding of its emphasis on national interest. Today, the PSC is primarily used in the countries of Angola, Algeria, Azerbaijan, China, Congo, Egypt, Gabon, Indonesia, Kazakhstan, Libya, Malaysia, Nigeria, Peru, Qatar, Russia, Turkmenistan, and Trinidad and Tobago. PSCs or PCAs are not usually used in states or territories that are dominated by national oil companies (NOCs).
B. Joint Ventures
The concept of joint venture as a contract originated from business, particularly in the countries of the USA and Scotland. Domestic companies pooled their resources, skills and operations to generate a business atmosphere that is more efficient, better-funded and able to expand to newer markets. Although there is no legal structure or legal definition of joint ventures, it is commonly understood that the term involved parties that are unrelated to each other, but united by a common business goal that is usually limited to a “single undertaking or ad hoc enterprise.” The main objective of joint ventures is typically to spread the risk of a business undertaking, thus reducing the risk for each participant. Each of the participants in a JVC is an individual legal entity and the JVC as a whole need not incorporate itself as a new legal entity.
In the area of petroleum exploration and development, joint ventures contracts (JVCs hereafter) first appeared as interest for concession agreements began to wane. Between the employment of the JVCs in oil exploration and the demise of the dominance of concession agreements, some oil producing countries resorted to participation agreements or PAs, which sought to increase the participation of governments in the exploration and development of petroleum resources in their jurisdictions by amending their respective CAs. Nonetheless, PAs did not really give these countries what they wanted, which was to exercise full sovereignty over such explorations. The JVCs were introduced. Still based on the principles of PAs, JVCs were seen as more effective in wresting control of management from IOCs to the states. This type of contract is being used in Algeria, Iran, Qatar, and Venezuela.
C. Service Contracts
Introduced in Nigeria in 1979, service contracts (SCs hereafter) have very similar features to those of production sharing contracts. Like the PSC, the state engages an international oil company (IOC hereafter) to explore and develop the nation’s petroleum resources. In addition, the state maintains ownership of their natural resources while the IOC brings in the equipment and technology and only a little control is surrendered by the state to the IOC. Instead, however, of sharing the oil production generated by the exploration and development of the state’s resources, the IOC is granted a predetermined return or fee. The payment of the flat fee takes place after the sale of the produce of the E&P – oil or gas - and the recovery of costs. The fee is taken as a percentage of the net profits. The fee is usually subject to tax and all production inures to the government. The service contract is also referred as risk service contract or risk contract. There are also several variations of SCs, such as, amongst others: the Technical Service Contract, the Technical Service Agreement, and the Engineering, Procurement and Construction contract.
III Challenges and Risks in Drafting in the Contractual System
A relinquishment clause is a provision in the contractual system in E&P where a contractor agrees to gradually surrender portions of the area under E&P back to the host state. Relinquishment clause is found in both PCAs and SC, but not in JVCs. The relinquishment clause obliges the IOC to gradually surrender parts of the contractual area in stages of the exploration and development. Drafting this clause requires knowledge and accuracy in the determination of the percentage of the area subject to the exploration that can be completed within a given time. For example, under the Kurdistan Model PSC, the first relinquishment takes place after the end of the first sub-period of the exploration period, the second at the end of the second-sub period, the third at the end of the third sub-period and the last one, at the end of fourth sub-period of the exploration period. On the other hand, in the Iraqi service contract model the relinquishment clause entails the surrender of reservoirs that have not qualified under the agreed plan of the properties upon reaching certain periods of time within the contract period.
Drafting the relinquishment clause for both PSC and SC, thus, poses quite a challenge. The need to accurately predict the period required to conduct the entire exploration period is important to calculate in advance the four stages at which surrender of acreage or reservoirs must be made. Sometimes, however, exploratory drillings may not go or bear immediate results as planned and may take longer than expected. In drafting the relinquishment clause, therefore, the drafter must take into account these possibilities and integrate provisions that could provide relief to the contractor in the event the exploration forecast does not go as planned.
The provision on the recovery of costs expended by the contractor in E&P is very important because this determines ultimately, whether the investment is profitable or totally a losing proposition. For JVCs, the pooling of the resources of the participants result in the spread of the risks involved. For example, in Nigerian JVCs the participatory interests of the government is 60%, whilst that of the FOC is 40%. The implication of this is that the FOC does not shoulder all of the risks involved in the E&P.
In both the PSC and SC, however, cost recovery is very important. In the former, the cost oil regime refers to the costs incurred in exploration, development, production costs and expenses and all these are recoverable by the IOC from the gross revenues or from a share of production. Under the Indonesian model, cost oil is recoverable from a predetermined percentage of production, or from a cost ceiling, as indicated in the agreement. The latter could be typically anywhere between 30% and 60%, but in the Indonesian case it was originally pegged at 40% and later increased to 100%. Cost ceilings can be made dependent on the type of recoverable expenses, the size of the production area and other grounds. The contractor bears all the risks in the case of PSCs because the government usually does not have any participatory interest in the process of E&P. In risk-free service contracts, cost recovery clauses are not important because it simply provides service to the host agreement for a flat fee without shouldering any of the risks. This kind of service contract, however, is not widely used and only in states with big financial capabilities. In the more widely used risk service contracts, the contractor brings into the contract the capital, technology and equipment to provide service to the E&P. In the PSC, there is usually separate clause for cost recovery, but in the latter recovery is allowed through the sale of gas, aside from its fee.
The drafting of the cost recovery clause in the case of PSCs and the relevant clause in risk-service contracts is a great challenge because of its potential for very big risks. The drafting of cost oil aspect of the contract, for example, should take into account the risks involved in explorations involving deep seas and other cost intensive operations, such as ‘enhanced oil recovery techniques,’ new fields and for new entrants into the industry. Care in drafting must also be followed in E&P in oil-rich, but developing nations which lack funds for supply side investments. The contract must, therefore, be drafted in such as a way as to amply protect the IOC from the risks as well ensure maximum profits for the host government. In the case of SCs, the drafting process is not dried and cut. In the Iraqi case, for example, the remuneration fee is based on R-Factor calculated by dividing the total value of all cash receipts for the relevant period with total expenditures for the same period. The total value of cash receipts include all petroleum costs and fees paid to the contractor, whilst total expenditures include petroleum costs, signature bonus and fund used for training, technology and scholarship. The dividend is the R-Factor and remuneration is based on its graduating scale.
JVCs are easier to draft and write because recovery costs are dependent on participation interest of the parties and any losses from risk incurred are recovered from the share of the production owing to them on the basis of such interest. The cost recovery in PSCs and SCs, on the other hand, depends upon the agreement of the parties, principally dictated by the host government. In the Nigerian case, for example, the cost recovery has a ceiling of 80%. In other jurisdictions, cost recovery is pegged to a percentage of the production as in the Indonesian case.
Calculating and forecasting risks complicate and render the drafting of contracts difficult so that between a JVC, on one hand, and PSC and SC, on the other, drafting the former is a less complicated task because risks are outright attributed to the participants on the basis of their participatory interests, a calculation that can be made after the fact. Drafting a PSC and SC, on the other hand, is a formidable and delicate task with respect to risk forecasting and calculation because of the fact that only one party shoulders them and the designation of costs recoverable from such risks need to be threshed out beforehand
The profits owing to the contractor is perhaps, the most important provision in the contract and its drafting must be carefully thought out and worded leaving no vague or uncertain terms. PSCs is dependent on profit oil split, JVCs base profits of participants on participatory interests, and SCs make use of fees. The SC remuneration has already been discussed in the previous paragraph and as can be seen is a complicated system despite the fact that it does not entail a determination of division of profits between the host government and the contractor. As there is no shared profit oil in JVCs because participants are granted their share of the production in accordance to their interests, this aspect does not present a big problem in the drafting of this type of contract. In the PSC, however, profit oil is an underpinning element and thus, its determination at the outset is important. Since there are many factors involved in profit oil, such as the terms agreed to by the parties or imposed by the host state, the drafting of the PSC with regard to this aspect is not an easy task. Taking this aspect of the contracts into account, JVCs remain to be an easier task to draft than the PSC. In the case of the PSC, taxes may apply before or after the split or even shouldered by the host state. The Ethiopian model, for example, defines profit oil split as “the balance of crude oil remaining in any calendar year after deduction” of royalties and recoverable costs. Although the division of profits is often negotiable, most governments prefer the sliding scale profit based on production. In determining the method to be used for profit oil split, care must be taken as to local conditions and to the possibility of changes in crude oil and natural gas prices.
The royalty clause is common to PSC, but is not so in JVC and SC Although the title of the natural resources never passes to the IOC from the host state in a PSC, a royalty provision commonly found in concession contracts may also be included in the PSC. Typically, royalty rates fall between 0% to 15% and most often a graduated scale of royalty rates is integrated into the contract. The challenge to the drafting of this provision entails the foresight to appropriately adjust the scale in accordance with possible conditions that may occur during the E&P. Such sliding scale may either be grounded on the depth of the area or water being explored as in Nigeria, the average daily production or some other basis. The IOC must choose the basis for such scale carefully having regard to the condition of the local area and other relevant concerns.
In crafting the provisions of a PSC, it is important to balance between the interests of the parties. In the Malaysian case, for example, its PSC terms are considered as some of the toughest. An example of this is the depletion provision, which provides that the government can demand that the IOC stop production in the event the government determines that continued production no longer inures to the interest of the nation. Despite this, however, investors’ interests have not waned. Aside from the availability of good acreage, the reason for this sustained interest is that these tough provisions are balanced by provisions that grants fair terms to investors and sustains the stability of PSCs.
The absence of many features common to both PSC and SC that pose a challenge to any drafter of those types of contracts in the JVC does not mean that the complication is entirely absent in the latter. The first challenge in drafting JVCs is the choice of the vehicle under which the business collaboration is to operate. Contemporary JVCs between a host country and FOC or IOC may be created under certain vehicles, namely a contract between the co-venturers, through incorporation, and by forming a partnership. The various features of each of this type of JVCs are illustrated in the Table 1. As can be seen, with respect to risk, the joint venture corporation is the most optimal form because of its limited liability, but when it comes to control, the host state does not directly figure in any of the three forms.
HS=Host State; FOC=Foreign Oil Company;
BOD=Board of Directors; MC=Management Committee)
The contractual system in contemporary E&P includes the production sharing contract, the joint venture contract and the service contract. Of all types of contracts, the production sharing contract potentially presents the most complication and risk in legal drafting. The JVC is simply a collaboration of the host state and an oil company pooling their resources together to make the venture less risky by spreading the risks. The costs and losses of the venture is thus, shouldered by the both of them. In service contracts, the host state may simply remunerate the contractor to an agreed fee, but in the production sharing contract, the host state and contractor both split the oil profit, whilst the latter alone bears the costs of the E&P. This arrangement complicates the contract drafting because profit oil splitting is made dependent on certain conditions that can occur during the exploration and development. In addition, other clauses mandated by the host state, such as the relinquishment clause, calls for the ability to accurately predict future conditions, further complicating the drafting matter.
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