Informational Rents in Oil and Gas Concession Auctions

Question: Describe about research the reasons and justification behind host governments moving away from Concessions and replacing with PSAs/PSCs, and why IOCs have accepted such a dramatic change in their own share and profits from Exploration and Production activity in resource-rich countries. Answer: Introduction Traditionally, concession agreements were one of the most important instruments which the host governments used to guarantee foreign investors over oil resources. In the agreement, the International Oil Companies (IOCs) were given exclusive rights to explore, produce, and market oil for a finite period (Herkenhoff, 2014). The first concession right was in the United States in 1859 between Colonel Edwin, Titusville, Drake, and Pennsylvania oil. Concessions became popular in the early 20 th century when most developing countries, especially in the Middle East, were under colonial rule. Since most developing countries were at that time under the British and French rule, Britain and France were the first to obtain concession rights. In the 1960s, concessionary agreements were replaced by Public Sharing Contracts (PSCs) and Public Sharing Agreements (PSAs) due to the rise of nationalism, among other reasons. Reasons and Justification behind Host Governments Moving Away From Concessions to PSAs and PSCs The agreement granted the host government no rights apart from receiving payments based on production. The amount paid by International Oil Companies for the rights over natural resources was mostly uneven and was not tied to the value of resources, but the volume produced (Brasil and Postali, 2014). Since companies determined the amount of production, the interests of host governments (that of revenue maximization) and IOC (profit maximization) often diverged. With total control over the manner and the schedule in which the mineral deposits were explored, companies could reduce production in times of low oil prices without incurring some penalties. The concession agreement was broad, regarding geography and location. The wide limit meant that the interests of the host governments were not always congruent with the companies interests. Foreign companies were granted exclusive rights over large tracts of land, which in most cases extended over the entire country. A prime example is the concessions given by Abu Dhabi and Kuwait rulers, which was regardless of the companies financial interests in comprehensive exploration (Herkenhoff, 2014). International Oil Companies held significant leaseholds and with minimal production until such a time when the producer had the finances or the interests to develop the property further. The concession was signed for longer periods, which was sometimes more than 70 years. A good example is the oil contract between the British millionaire William Knox Darcy and the king of Iran on 29 March 1901, where William Knox Darcys company was given concession rights for exploration, exploitation, transportation and selling, and these rights continued for more than 60 years (Brasil and Postali, 2014). Due to the nature of the contract, the host governments could not seek out thirstier companies, thereby denying them of any potential sources of revenue. Though the host governments were justified to move away from concession agreements, its important to note that the contracts helped oil producing countries to discover oil for the first time. For example, in Iraq 1923, and Iran in 1908, the oil was found, and despite the many criticisms, the host countries have continued to enjoy many benefits later on. Concession agreement thrived because the host countries were unable to do the discovery by themselves because of financial and professional limitation, and most importantly, they had no power over exploration because they were colonies. Reasons that Explains the Willingness of Foreign Companies to Renegotiate Contracts that initially served them well Knowing that the original terms were unreasonable, companies feared that their refusal to negotiate would increase hostility with the locals and host government, potentially leading to more nationalism in the oil industry and the loss of valuable resource. Since the concession agreements were highly profitable, the less favorable terms would still mean profitable production. Therefore, any agreement allowing companies to tap into the benefits this vast resource was deemed as acceptable. Since the oil companies were becoming more vertically integrated- they produced, refined, and marketed nearly 100% of their product- access to resources was becoming more important than a reduction in returns, provided that the profits were guaranteed. Another reason companies were willing to move from concession agreement is that although they assumed all the rewards, they also assumed all the risks. They were overly cautious when bidding for virgin or non-productive areas because of production uncertainties. This was, however, to change under PSAs and PSCs where some countries share risks with the IOC. The formation of OPEC in the 1960s forced International Oil Companies to abandon the concession agreement. OPEC shifted the bargaining power from large oil companies to Oil producing companies. Failure to comply with the terms of this cartel would mean a complete loss of oil reserves to competitors. Furthermore, some countries engaged in direct negotiations with potential licenses when granting the concessions, thereby making concession system unfavorable due to alleged subject to undue influence and corruption (Herkenhoff, 2014). Fundamental Differences between the Concession Systems and PSA/PSC Systems Product Sharing Agreement was first practiced in Indonesia in 1966 as a bridge between concession agreement that gives resource sovereignty to a foreign firm and establishment of National Oil Companies that required some technical know-how (Polyakevich, 2010). Today, more than 10% of gas and oil production is done through the agreement. Furthermore, more than half of countries with oil potential have a tax system that is based on PSC/PSA. The agreement gives IOC the right to explore for natural resources. If the resources are found, the company has rights to recoup sunk costs and share in profits. If the resources are not found, then the company is out of pocket. The PSA incentive shoulders the risk of non-discovery. The major differences between PSC and the concession agreement are the levels of control given to International Oil Companies, levels of involvement by the host government, reward sharing schemes, and the compensation terms. On concessionary system, the IOC gets the license from the host government to take out and own a hydrocarbon in a specific area, and then in return, the state receives income taxation and a royalty payment from the IOC (Heilbrunn, 2014). In PSC/PSA, the state owns all the oil production and the IOCs only serves as contractors to provide financial and technical services for development and exploration operations. In return, production is shared between the IOC and the state as per the stipulation of the PSC. PSA is also different from the concession in that since it doesnt grant the company the ownership of the resource and the government may take an interest in technology transfer, as it prepares for the turning over of the resources to its hands (Goltelova, 2014). Unlike concession that grants the company rights to ownership of resources over specified period, PSA/PSC gives ownership of resources that is tied to recouping of sunk costs and the garnering of profits. It is only in PSC where there is sharing of oil profit. The portion of production left after the cost of oil has been deducted is shared between the IOC and the host government using a predetermined formula. Many countries have a production sharing mechanism that is based on the rate of return or any other assessment to the contractor on a given date (Pongsiri, 2004). These are countries like Tunisia, Libya, Liberia, Equatorial Guinea, India, and Azerbaijan. Unlike in concession, PSA/PSC gives the host government varying degrees of oversight over the decision making (Polyakevich, 2010). The projects life is crucial here. If the venture shifts to government control after the IOC has recouped the sunk costs and garnered the profits, the host must resume for this eventuality right from the start (Polyakevich, 2010). In simple terms, the decision control is to some extent reserved for the host government even in periods of robust private involvement. In comparison to concessionary agreements, PSC/PSA is involving in nature. The foreign company pays a royalty on gross production to the host government. After the deduction of the royalty, the foreign company is entitled to a pre-destined share (e.g. 45 percent) of the production to cater for cost recovery. The remainder (the profit oil), is shared between the host government and the IOC at a specified share (e.g. 70 percent for the government and 30 percent for the International Oil Company). The contractor is then supposed to pay an income tax from its share of profit oil. PSAs have substantially changed over the years and today they take different forms. There is a change of language in PSC/PSA. The state is described as the owner and the foreign company as the contractor, even though the practice is almost equivalent to the classical concessionary agreements (Polyakevich, 2010). PSA/PSC often contains a stabilization clause restricting future governments to pass any new law or change the tax rates, which can be detrimental to the companys future profits. Stabilization clause is very rare in concessionary agreements. The rationale behind producer countries favoring the greater economic rentals they receive through PSAs/PSCs The aim of the government is revenue maximization. Since the international oil industry is an industry in which, normally, huge economic rents can be received, for the reason that the market price exceeds the price required to keep the factor of production in active use and is above the price required to generate profits, host governments can receive more rentals without interfering with the profits. In the past, there has been recurring transformations in the comparative stability of power between host states, major IOCs and their National Oil Companies (NOCs), is insightful of the cyclical character of the gas and oil industry. Some periods, such as the 1970- the 1980s and the 2000s can be grouped as conflicting (Polyakevich, 2010). During these epochs, the rising and fairly high oil prices gifted the host countries with more revenues, which assisted them to re-negotiate their agreements with the International Oil Companies and to gain a bigger share of the economic rent. Depending on the local competencies, International Oil Companies have better knowledge of the actual production costs can inflate the current production cost and capture some of the rent. In such situations, the host governments are justified to seek out for more economic rent from IOCs. Furthermore, the rise of nationalism, sovereignty issues, environmental factors such as air, land and water pollution, externalities and the fact that oil is a non-renewable resource call for greater economic rental. The host governments favor PSAs/PSCs because despite them receiving royalties from the foreign companies, companies also share their profits with the government and pay income tax on their shares of profits (Heilbrunn, 2014). Production Sharing Contract is one of the most attractive models in inviting high investments particularly in virgin or non-productive areas. The government is on the safe side. Unexplored areas can be explored without the governments direct investment. Furthermore, the government can play off companies against each other to get one with the most attractive terms. Depending on the agreement, the contract may specify that all the project related equipment brought by the contractor be passed over to the host government and the cost of equipment be recovered as the operating cost. The contract may further specify that all geological data be the host governments property as was the case with the Pertamina agreement. By keeping the geological data, the host country may begin to see the nationwide picture of its basins. Why host governments have succeeded in extracting more money from the IOCs Some developing nations have succeeded in extracting more money from the International Oil Companies because some countries now have the ability to evaluate the oil assets on their own, independently access on the production costs, and more significantly, develop the oil reserves on their own (Goltelova, 2014). Many of the developing nations have a take it or leave it attitude since they have nothing to lose in the case when IOCs fails to play to their terms. Furthermore, the ever rising competition between the IOC always favors the host governments. They have many options available, and when one company fails to comply with the set terms, they can always seek another until they get the company with most attractive terms. Many countries have recently discovered some oil reserves. The overall availability of larger oil reserves in the host country, the stronger the bargaining power. IOCs know that they need to come back for more transactions, and they need to be seen as fair. In a context of repeat businesses, countries with a reputation for reliability and stability in sticking to the contract (even if unfavorable), can attach these qualities to their oil prices (Heilbrunn, 2014). IOC have often valued and accepted to do business with dictatorial regimes because they provide the much-needed stability (Heilbrunn, 2014). Another reason the host governments have succeeded in extracting more money from International Oil Companies is the emergence on OPEC- which is a sort of a cartel that determines the oil prices and fights for the welfare of the oil producing states (Heilbrunn, 2014). Since the oil-rich countries act like some form of monopoly, IOCs have nothing to do but to comply with the terms or be out of the business. Why the IOCs have continued to explore for, and exploit mineral, assets now their financial share of the profits has been severely reduced? International oil companies have continued to explore and exploit mineral assets despite their share of profits being eroded because under PSC, they enjoy autonomy and can optimize the EP to ensure cost recovery. The rise of OPEC, the vertical integration of IOC, and the rise of nationalism as stated before, also explains why IOC have continued to explore for, and exploit oil now their financial share of profits have been severely reduced. References Brasil, E. and Postali, F. (2014). Informational rents in oil and gas concession auctions in Brazil. Energy Economics, 46, pp.93-101. Goltelova, S. (2014). Production Sharing Agreement As a Special Technique in the Provision of the State Guarantees For Oil and Gas Projects Financing in Russia, (5), pp.324-336. Heilbrunn, J. (2014). Oil, democracy, and development in Africa. New York: Cambridge University Press. Herkenhoff, L. (2014). A Profile of the Oil and Gas Industry: Resources, Market Forces, Geopolitics, and Technology, Business Expert Press, New York [ISBN: 978-1-60649-500-1] Polyakevich, V. (2010). Sustainable development and evolution of production sharing agreements. Ottawa: Library and Archives Canada = Bibliotheque et Archives Canada. Pongsiri, N. (2004). Partnerships in oil and gas production sharing contracts. International Journal of Public Sector Management, 17(5), pp.431-442.