Oil and Gas Contract Review…
We would be looking at the contract review of Production Sharing Contracts (PSC) in the Oil and Gas industry in Nigeria….
It seems that the Petroleum Industry Bill might soon become a reality, however till then the present regime continues.
The emergence of offshore oil and gas operations and the granting of deep water acreages to the oil producing companies witnessed a shift from the Joint Operating Agreements (JOA) regimes to Production Sharing Contracts (PSCs).
In the Nigerian PSC arrangement, IOCs bears all the cost of investment at exploration and development, recovering all the cost after successful discovery and development of the field through cost oil.
Oil and Gas operations are regulated primarily through laws and contractual provisions. PSC’S can be said to often contain provisions that are like regulations.
However PSC’S, legally speaking are basically contracts between two or more parties. Contract terms are very important because they determine how much a producing country earns from it natural resources; and the regulatory power of government to enforce environmental, health and other standards, if legal and regulatory system not well established
Typically, just like most private transactions In Nigeria, they are often guarded and subject to strict confidentiality clauses thus analysis about PSC issues in Nigeria is merely a generalization.
This analysis is based on publicly available information such as model PSC terms published in Nigeria and other countries petroleum legislation, websites and in Barrow’s world petroleum Agreements 2004.
Model Contracts represent an initial negotiating position, it is however beneficial to start on a good note as we all know that Principled negotiation provides a better way of reaching good agreements than poor initial negotiating positions.
Production Sharing Contract (PSC)
The PSC is an all-inclusive agreement between the International Oil Company (IOC) and Nigeria setting out the contractual and fiscal terms applicable.
In a PSC NNPC engages a competent contractor usually an International Oil Company (IOC) to carry out petroleum operations on NNPC’s wholly held acreage. In a PSC ownership remains with the state. The contractor undertakes the initial exploration risks and recovers his costs if and when oil is discovered in commercial quantities and extracted.
The contractor receives a share of the production in kind for services performed and in recognition of the risks undertaken especially the risk of non-commercial discovery.
The contractor has a right to only that fraction of the crude oil allocated to him under the cost oil (oil to recoup production cost) and equity oil (oil to guarantee return on investment). He can also dispose of the tax oil (oil to defray tax and royalty obligations) subject to NNPC’s approval. The balance of the oil, if any (after cost, equity, and tax), is shared between the parties (profit oil).
History of production sharing contracts
Indonesia pioneered the first PSC in 1966 through Permina, the state oil company. The contract system was evolved due to the imbalance in the traditional concessionary system regarding Government Take.
Legal Regime regulating the PSC
The main law which regulates the operation of PSCs in Nigeria is the Deep Offshore and Inland Basin Production Sharing Contracts Act No. 9, Laws of the Federation of Nigeria, 2004. This is in addition to the individual contracts signed with the individual companies. The above mentioned law contains the framework for the operation of PSCs, including tax regimes, the manner in which costs and profits are allocated between the parties and applicable royalties.
It stipulates the payment of a flat rate of 50% tax on petroleum profits by PSC operators, and sets out a royalty regime that is dependent on the water depth in which the operation is carried out, ranging from 12% for water depths of 200-500m, to 0% for water depths in excess of 1,000m. PSCs in inland basins attract a flat royalty of 10%.
In addition to royalties, taxes and its share of profit oil, the government also earns revenue from signature bonuses paid by the oil companies upon successful bids. Most forms of payments under PSCs operating in Nigeria are made in oil, as the law provides for cost oil, tax oil, royalty oil and profit oil. Investment Tax Credits and Allowances are also available to the investors at the rate of 50% of the value of such investments.
Reviewing a PSC
In reviewing a PSC, this writer prefers to use a basic checklist that covers issues like; Who are the Parties to the contract? What exactly, is the subject of the PSC? What is the Description of contract area? What is the Duration of contract? What are the terms for Obligatory Exploration, Evaluation work and Declaration of Commercial Discovery? Who is in charge of Management and Supervision of the operations? Who is responsible for Funding of the operations?
What are the arrangements for Training of personnel, Transfer of technology and the use of local suppliers? What is the format for Production Sharing: Disposition of Production?
What is the Tax rate? Is there need for a Stabilisation Clause? Where is the venue for Settlement of Disputes? What is the preferred Choice of Law?
Are the essential safety clause properly worded? What are the provisions for risk allocation and indemnity clauses? What damages to the surface is the PSC HOLDER responsible for? To what condition must the site be restored?
DEEP OFFSHORE AND INLAND BASIN PRODCUTION SHARING CONTRACTS DECREE NO 9 1999 ACT. CAP. D3. LFN 2004
Section 17 defines a PSC thus:
“Production sharing Contracts” means any agreement or arrangements made between the Corporation or the holder and any other Petroleum exploration and production company or companies for the purpose of exploration and production of Oil in the Deep offshore Inland Basins.
Examples of Key Provisions in a PSC:
Parties to the contract
The parties are usually the International Oil Company (IOC) and the national oil company (NOC). The contract requires state approval.
Description of contract area
The contract area has to be delineated into blocks and authorised for Exploration and Production (E & P) by the Federal Government.
The Model PSC defines a contract area according to the OML awarded to the contractor. Each contract has a contract area that is described in an Annex of each PSC.
Duration of contract
The PSC stipulates the validity period of the contract. The International Oil Company (IOC) is not allowed to exceed the contract period and must ensure that all commercial discoveries are exploited within the contract period.
The International Oil Company (IOC) must carry out exploration and evaluation work until commercial discovery is made and declared by the government to be made. There is a Minimum Work Programme and Expenditure clause. This clause provides for the minimum operations and expenditure.
Management and Supervision of the operations
The International Oil Company (IOC) is the operator at the exploration phase and is responsible for preparing the annual work programme (AWP). The Model PSC provides for a Management Committee to provide the direction in respect of all matters pertaining to the petroleum operations and work programs and budgets.
Funding of the operations
The International Oil Company (IOC)/contractor in a PSC is responsible for funding the exploration work. The NOC’S exploration payment obligations are often “borne” by the IOC and repaid by the NOC out of production. In addition the IOC bears exploration risk if no oil or gas is discovered then the wasted costs are suffered by the IOC. Thus it can be said that during the exploration phase there is little or no financial risk on the part of the host government or NOC. The International Oil Company (IOC)/contractor provides funding for the operations usually in convertible foreign currency.
National Interest Provisions/ local content
A PSC usually contains clauses to enhance or protect the national economic interest, by providing in some case provisions relating to the transfer of technology (The efficacy of tech transfer premised on contractual clauses is definitely a matter for another day…), training of local employees and the exercise of a clear preference for local contractors. Nigeria like most host countries take such provisions and the obligations they impose seriously and they set up audit teams to monitor compliance, a good example is the Monitoring and Inspections Department of the Nigeria/Sao-Tome Joint Development Authority.
The PSC provides for how the International Oil Company (IOC)/contractor will recover his costs, the allowable percentage of recovery and how production will be shared. Common items found in PSCs are royalty oil, cost (recovery) oil and profit oil.
Disposition of Production
It dictates how freely International Oil Company (IOC)/contractor is allowed to export his own share of production. Some PSCs tend to stipulate that a certain percentage of the contractor’s oil be used to service local demand.
The PSC provides the rate of the taxes that the International Oil Company (IOC)/contractor would be subjected to.
Under the PSC, in the event of any change or amendments to the commercial and fiscal terms of the PSC, the Treaty or the Regulations, such amendments do not apply to the International Oil Company (IOC).
A stabilisation clause is a provision in a contract seeking to freeze the law as at the time the contract was entered into, such that subsequent changes to the domestic law would be inapplicable to the contract especially regarding taxes, environmental issues and continuity of the contract to full term. Modern stabilisation clauses tend towards the attainment of a compromise and in the form of mutual agreement before legislative changes that affect the contract are carried into effect. Where a state acts contrary to its stability guarantee in the PSC, such acts are not illegal but rather justify the award of damages for contractual breaches.
Settlement of Disputes
This clause provides for how contractual disputes will be settled between the parties. Disputes between the parties arising from the PSC are settled by arbitration by an independent expert or, in the event there is no reconciliation, by arbitration, pursuant to the rules of the UNCITRAL Arbitration Rules. Some PSCs stipulate that disputes regarding certain matters be disposed of by the domestic courts.
Choice of Law
Parties are allowed to choose the law that would govern the contracts and any disputes that may arise. In choosing the law, the International Oil Company (IOC)/contractor tend towards general principles of international law which they are seemingly more familiar with.
It might be prudent to double check the essential safety clauses (Settlement of Disputes, Stabilisation Clause and Choice of Law). These essential clauses recognise the risks of the International Oil Companies (IOC’S), protect their interests and takes contractual breaches to international bodies.
The Umbrella Clause might also be useful
It is also called a mirror clause, parallel effect clause, because it is a treaty provision that requires the observance of all investment (contractual)obligations and commitments entered into by the contracting states with investors fromthe other contracting state.
This means that the contracting state is under interstate obligation to observe investment commitments, allowing the International Oil Companies (IOC’S) the right to resolve breaches of state contracts under international law by an international arbitration.
The partial or total assignments, transfer, conveyance or any other disposal of the rights and interests of the Contractor under the PSC are subject to prior written notice to the JDA and to its prior written consent.
The contractor has the right to develop, commercialize and recover the costs from and share in the production of Natural Gas discovered in a given development field. In addition, the Contractor may utilize, at no cost any proportion of the produced Natural Gas either through short term flaring forced by emergency or operational necessities or as required as fuel for production operations; gas recycling, gas injection, gas lift, or any other crude oil enhancing recovery schemes.
Abandonment / Decommissioning
The PSC provides for a Decommissioning clause for each Development Area. This is quite commendable as the IOC is under obligation to properly clean up after operations. The Management Committee estimates the costs of decommissioning the development areas as part of each Field Development Programme. The provisions for decommissioning must be secured, with the prior approval of the regulatory authority in the form of a standby letter of credit or corporate or bank guarantee or held in a Decommissioning fund.
Contract Review and the Environment
I am tempted to think that resort can be had to basic contract review and negotiation to help stem the tide of pollution and environmental degradation…
We all know that Oil and Gas contracts can be said to often contain provisions that are like regulations. However Oil and Gas contracts legally speaking are basically contracts between two or more parties.
For us Contract terms are very important because they determine how much Nigeria as a producing country earns from it natural resources; and the regulatory power of government to enforce environmental, health and other standards, if standard legal and regulatory systems are not well established…
Merits of Production Sharing Contracts
PSC’S give the host government and its National Oil Company a high degree of control and participation, (well this is in comparison to the limited control given to a non-operator under a JOA) Thus a host government is better able to manage its oil and gas reserves and possibly better plan its economic development.
Frees up cash flow
The funding arrangement is beneficial for an NOC participating in the project. It frees up cash for the host nation and allows it to increase its hydrocarbon production thereby generating more income without having to divert purportedly scarce resources away from other critical sectors of the Nigerian economy. The good thing is that even after production begins and the NOC is required to finance the project payments are made from crude oil production rather than cash.
Reliance on the technical expertise of IOC’S and perhaps Tech Transfer
In challenging operating environments like Nigeria, a PSC allows the host government (at the very most in the short term) to rely extensively on the technical expertise of IOC’S with provisions that require this know-how (purportedly in the long term) to be passed on to local contractors. However the Nigerian experience is such that our beloved country has been unable to achieve technology transfer through the use of technology transfer clauses. Not forgetting the fact that one of the key issues often neglected with transfer of technology is how to construct a receptor to capture the transferred technology and ensure that it is fully internalized to enable it blossom and grow to create similar new technologies on its own within a given time frame without external support. It is only then that technology can be said to be transferred. Without a deliberate receptor programme, technology transfer will continue to be by chance. Nigeria’s national R&D spending is very low with little verifiable statistics and little or no results to show.
Government shares potential profits
Government shares potential profits without having to make a direct investment
Demerits of PSC’S; the Nigerian Experience
Gold plated Expenses
The IOC may decide to slow down the pace of production, be wasteful or extravagant in its exploitation especially when the operator knows his expenses would be fully met by the crude produced.
Lobbying Par Excellence
Where PSC provides positive legal discrimination for oil companies; it is likely that investors in other sectors will invariably lobby the host government for similar special treatment
PSC’S are contracts. Violation of a legal statute is an offense, subjective to legislatively approved sanctions and penalties while violating a contractual provision is less costly than violation of a regulation because only in the case of a serious or material breach of contract is the termination of the agreement a possibility.
Minefield of Exceptional Situations
Making contracts into law creates a legal infrastructure of exceptional situations; little possibility of developing a coherent and comprehensive legal system as can be seen in the medley of laws regulating oil and gas in Nigeria.
PSA grants Nigerian oil companies a prominent say in environmental and other standards when these standards have been incorporated as contractual provisions; as experience has shown this not desirable.
Less Exposure for Government
Government generally has less knowledge about potential of the oil field than the oil company, even when there are lengthy tech transfer clauses.
Governmental Conflict Of Interest
Where government holds significant share, it will face a conflict of interest: it has to balance the desire for higher profits with the enforcement of environmental and other regulations, and most times it succumbs to the desire for more profit at the expenses of proper enforcement of the law, especially in the area of environmental degradation.
Emergence of Social Normative Norms in Oil Pollution?
Lax enforcement of the law in the area of environmental degradation eventually results in whiplashes and hostility from the host communities targeted at the International Oil Company.
Oil pollution has earned an I O C in Nigeria severe criticism and repeat attacks on its facilities, this might be a new vista in the regulation of oil pollution, it just might be better for Government to regulate Oil pollution in tandem with relevant stakeholders.
The PSC system has been effectively used by developing countries with potential oil reserves but high extraction costs (especially from offshore fields) and high exploration or technical risks. To a large extent the use of PSC has helped Nigeria solve the problems of financial resources and technical expertise.
Negotiating a Production Sharing Contract requires legal knowledge, foresight and common sense. No Government or International Oil Company (IOC)/contractor could possibly hope to have all these suggestions included in a model PSC.
The number of model clauses successfully incorporated in the Final Production Sharing Contract depends largely upon negotiating power of the parties involved. Even so, the information contained in this piece will enlighten the Government and International Oil Company (IOC)/contractor as to some possible alternatives, and if nothing else, possibly foster frank discussion between the Government and the Oil Company prior to signing any agreements.
Copyright © 2012
Megathos Law Practice