Production Sharing Agreements (PSAs) for oil and gas exploration are seen as a characteristic of developing countries that “seek to exploit their resources for economic rents but lack the experience or technical expertise to bear the financial burden,” wrote energy law expert Marcia Ashong in her 2010 Dundee University study on cost recovery. While international oil companies (IOCs), desire for swift recovery of costs and profit maximization, delayed payments to contractors have caused frustration for IOCs as national debt mounts in Egypt. However, there is a general concern surrounding the inherent shortcomings of PSAs and the cost recovery structure itself, especially considering the advent of expensive, high-risk forms of exploration such as deep-water or hydraulic fracturing.

For oil-producing countries like Egypt that don’t possess massive amounts of wealth and resources, one of the main appeals of the production sharing contract (PSC) is that “unlike its predecessor (the traditional Concession) they have turned the balance of ownership of reservoirs from the IOC to the host countries, allowing host governments more control of their natural resources and benefits from production without transfer of investment risks,” said Ashong. In production-sharing contracts, IOCs undertake costs and all exploration risks, and the exact terms of the contract regarding cost recovery are open to negotiation. The cost is then recovered in the form of cost oil or cost gas after production profits are made available, and the PSA determines how the remaining production is divided between the contractor and EGPC or EGAS.

As a result of the tight control Egypt wills over its national resources, a long road of negotiations and administrative procedures are imposed upon the IOC to ensure that the cost of every item and expense is eligible for recovery. Yet the risk for Egypt as a host country, as Ashong notes, “is the potential for the IOC to be over compensated” in cost recovery.

Negotiating Contract Terms
According to Mohamad Talaat, partner at Helmy, Hamza & Partners, a member of Baker & McKenzie International, the terms of the PSA are negotiated by a Vice Chairman of either EGPC, EGAS, or GANOPE on the government side, and a team of financial, legal, and technical advisors from the IOC. The terms are negotiated before the concession is awarded “given the fact that each concession requires a new law to be passed to authorize the Minister of Petroleum to enter into the Concession agreement,” and concerning the percentage of cost recovery in particular, “this is reached during the negotiations phase depending upon the nature of the project itself, whether the project is onshore, offshore, or deep waters,” he explained.

A report published in January 2013 by Wood Mackenzie stipulates, “Bonuses, cost recovery ceilings, the treatment of excess cost recovery and profit oil/gas shares are all negotiable. Negotiated terms have varied over time but within a relatively narrow range.” According to Talaat, individual costs include exploration expenditures and development expenditures (both recoverable at a rate of 20% per annum), and operating expenses, where no specified recovery percentage rate exists.

Beyond these fundamental expenditures, the IOC seeks recovery for a range of costs, which include living expenses, travel expenses, and even education fees for expatriate workers and their families, where negotiation can become particularly cumbersome. “Issues arise between the petroleum government entities and the contractor regarding the classification of certain expenditures and costs and the amount of each expenditure and cost,” informs Talaat. Ahmed Moaaz, Country Manager and Director of Sea Dragon Egypt says that in some cases, negotiating a single commodity can take approximately six months, and the IOC could have spend ten times the value of the actual item after processing fees and forming the necessary committees. Moaaz believes focusing on details of recovery for individual items can be counterproductive, and advocates a cap be set for all costs surrounding individual expats.

Despite valid frustration over exhaustive negotiations, IOCs are also capable of taking advantage of cost recovery. While Egypt follows international standards for accounting procedures, “the challenge is always deciding what costs actually meet the standard,” informs Christopher Gunson, an oil and gas lawyer at Pillsbury Winthrop Shaw Pittman LLP. Egypt’s economic and political circumstances pose unique challenges concerning cost recovery for expenses of expatriate partners, expenses that of course aren’t covered for the Egyptian partner, as Moaaz points out. Gunson details that, “In Egypt, what if the engineers are evacuated because of the security situation—are those costs reimbursable?  What if the engineers are living with family in Dubai, and fly into Egypt only as needed—is the cost of living at the Arabian Ranch villas in Dubai still reimbursable?  What about the plane tickets to and from Egypt while they are stationed in Dubai?  What if the engineers have kids who go to expensive private school in Dubai?   These are the types of cost recovery issues that get contentiously debated and negotiated between a host government and a contractor.”

Renegotiation and Post-contractual Terms
According to Talaat, “renegotiation of the initial terms is highly likely after a project is underway.” In addition to the preliminary negotiations, every expense during work on a particularly concession needs to pass through the administrative channels if the IOC wants to see those costs recovered. “Renegotiation throughout the life of a project is common even if there is not a contractual basis for such negotiations,” says Gunson.

In the event of renegotiation, “the contractor is entitled to notify EGPC of such change and its impact on stabilization,” so that negotiation can commence “for the purpose of restoring the economic balance, which existed on the effective date of the agreement,” says Talaat. An agreement must be reached within 90 days from the date of notification to EGPC and “shall not in any way diminish or increase the rights and obligations of the contractor as these were agreed upon on the effective date of the concession,” he added.

Once terms are set and agreed upon, the degree to which they are faithfully and accurately followed is “always an issue of discussion, and it can often be contentious,” said Gunson, adding that the current political situation in Egypt is exacerbating the existing shortcomings of the negotiation process. According to Gunson, formal disputes in the international oil and gas market are rare. Despite this, he noted “we are seeing a number of companies take Egypt to international arbitration due to the situation in Egypt.  This is unusual.”

Payments and Excess Cost Recovery
“Typically the payment to the government/state partner will be high during cost recovery, and then very high after cost recovery,” said Gunson, and explaining that EGPC commonly sees revenue before the IOC recovers costs. Based Article VII of the Concession Agreement, Talaat explains that “cost recovery and production sharing is a parallel process,” due to the fact that “an IOC may only recover costs to the extent of the percentage specified in the agreement on quarterly basis from the cost recovery petroleum, and any recoverable costs and expenses not recovered in one quarter are carried forward for recovery in the next quarter.”

In the case that there is excess cost oil, in theory this is also to be shared by the IOC and EGPC, according to the percentages set in the concession agreement, according to Talaat. “However,” he adds, “practice wise, in most concession agreements, EGPC/EGAS/Gaboub El Wadi Holding Petroleum Company are entitled to 100% of the excess cost recovery petroleum. However, there are some cases where the contactor may be entitled to share excess cost recovery petroleum of specific blocks.” As a result, it is rare for an IOC to have a substantial share of this excess, if at all.

Weakness and Possible Solutions
In a previous interview, Moaaz told Egypt Oil and Gas, “There are weaknesses in the current agreement, and everybody knows it,” citing the example of the freeze in cost recovery that occurs during the final five years of the concession. Since any expenditure made in the final phase of the concession doesn’t get reimbursed by the government body, work on the concession is usually inactive during this time unless the concession has been renewed.  Speaking of the fact that most operators in Egypt in the last four five years of the concession “pull the brakes and do nothing” Moaaz asks, “Who’s losing? Egypt—because there is no new investing and no new projects. Can we ratify this? Yes we can.” He believes that costs during this period should be recovered immediately, saying that current practice has “a tremendous impact on newcomers in Egypt and discourages investment.”

However, there are ways to influence swift cost recovery within the terms of the PSA, informs Talaat, including, “Increasing the percentage of cost recovery in the agreement or allowing a percentage of 100% of the cost recovery petroleum.” However, since Egypt is currently a net importer rather than exporter of petroleum products, these options “will be very difficult to apply as it does not serve Egypt’s main interests.” Here again do IOCs interests conflict with Egypt’s, and according to Talaat, these can only be “reconciled when Egypt recovers from recent turmoil events and increases its production of petroleum to cover domestic needs and increase its petroleum exports.”

Any significant changes or alternatives to the current structure are unlikely given the restrictions in Egypt’s current constitution and natural resources law, which attributes such property exclusively to the state. “Therefore, the application of a license arrangement or an agreement of a true concessionary nature which gives complete ownership and control to the contractor over any oil and gas it successfully produces shall not be possible under the current legislations,” Talaat informs. However, the “risk service contracts” used in Kuwait, Iraq, and Iran could serve as a potential model for Egypt. In these oil-producing economies, the state still retains ownership of commercially successful exploration, “whereas the contractors recover costs through sale of the oil and gas and receives a fixed payment (usually in cash) from the government,” says Talaat.

Besides the efficacy of Egypt’s fiscal structure in the oil and gas sector, a general culture of administrative wariness between the foreign contractor and governmental body lies at the root, in a country where economic and political tensions run high. In order to build trust between EGPC and foreign companies, Moaaz says, “We need to rebuild, reengineer, and reeducate.”

By Lily Leach