An Examination of International Petroleum Contracts

As the national dialogue shifts towards the future of the Morsi administration post constitutional referendum, a dialogue of another sort is currently under way and it is one of equal complexity and significance to Egypt’s socioeconomic landscape.

Contractual agreements that govern the nature and operations of the Egyptian oil and natural gas sectors are currently under revision.  The agreements, or international petroleum contracts (IPC’s), are made between foreign oil companies (FOC’s) and the nationalized oil companies (NOC’s) governing the oil and natural gas sectors (EGPC, EGAS and GANOPE) via the Egyptian Ministry of Petroleum.  Naturally, IPC’s contractually frame the financial nature and fiduciary dynamics of the Egyptian Petroleum sector.

The contractual revisions obviously come at a crucial stage in Egypt’s political and economic landscape. Set against the backdrop of recurrent political instability and uncertainty, several flailing economic sectors, calls for subsidy reduction, and arrears estimated at seven billion dollars, the importance of the amendments cannot be understated.

In an effort to frame the current challenges facing the oil and natural gas sectors in Egypt, and in preparation for our upcoming Roundtable Discussion on January 16th , Egypt Oil and Gas Newspaper offers a comprehensive and longitudinal examination of the historical context, existing content, and future challenges for oil and gas agreements in Egypt.

Historical Context
International Petroleum Contracts (IPC’s) are contractual mechanisms that govern the dynamic relationships between Foreign Oil Companies (FOC) and host countries (HC).  Early examples of IPC’s can be found in the 1948 Venezuelan contract which initially introduced the profit sharing principle and the 1950 agreement between Saudi Arabia and Aramco.  By 1952 the product sharing principle was implemented in most oil producing countries.  Iran served a notable exception and opted for a more radical approach by nationalizing its petroleum industry. The result was an international oil embargo, the demise of the Mossadegh government and the eventual reinstatement of the Shah.  Aside from the longer term domestic political results of these events, the more general culmination of this process resulted in a spillover effect that drastically altered broader relationships between FOC and HC’s.  Specifically, nationalist sentiments rose in oil producing countries accompanied by a very palpable resentment of foreign interference in domestic economic affairs. These formative events also highlighted the importance of petroleum revenue and the inherent complexity of forging agreements between foreign oil companies and host governments. The creation of OPEC in 1960 can be clearly contextualized as a reaction to this dynamic as well as a milestone event aimed at the reevaluation and adjustment of dynamics between FOC’s and NOC’s.

Broadly speaking the nature and content of IPC’s has shifted based on the interplay of two factors: market fluctuation and political volatility in oil producing nations.  For example, during periods of low production and high prices, 1979 and 1980 being prime examples, FOC’s accepted less favourable contractual terms as competition was fierce and resources low.  In the 1980’s and 1990’s, as a result of increased political risk in host countries with natural resources, numerous IOC’s relocated investments to the industrialized world in an effort to secure increased political stability.  Consequently, host countries revised the content of the IPC’s in an effort to make investment attractive and feasible.  After 2004, this trend was reversed as oil prices peaked and calls for alternative forms of energy increased.  By chronologically examining the fluctuations in oil prices, it becomes clear that the relative negotiating power implicit in the formation of international petroleum contracts can shift depending on the abundance or scarcity of oil resources and well as the levels of political volatility in host countries.

Types of Agreements
In an effort to redefine relationships between HC’s and FOC’s, early forms of IPC’s gave to way to increasingly complex and sophisticated contractual mechanisms. In an effort to understand the current contractual amendments so vital to Egypt’s socioeconomic landscape, it is necessary to briefly explore existing forms of IPC’s.

IPC’s exist in several forms and involve varied applications most commonly resulting in a hybridized mode of construction. Content is protected but trends emerge.  Four basic contractual models exist in the petroleum industry: concession agreements, service agreements, joint ventures and production sharing.  While all forms have different merits depending upon the context, the primary distinction amongst the models concerns the degree of government control over resources, the level of involvement of FOC’s, and the mechanics of compensation.

Concession agreements (CA’s) were utilized in Kuwait, Sudan, Angola and Ecuador.  This type of IPC was commonly used in the 1940’s and 1950’s.  Under the concession model FOC’s competitively bid for certain geographic areas utilizing signing bonuses and licensing fees as additional incentives. Concession agreements grant exclusive rights to contractors for specified amount of time.  Contractors can then explore develop, sell, and export petroleum products discovered in the defined geographic area. In the event of discovery commercial production commences and HC’s earns royalties based on quantity of production in addition to income tax on profits. In certain contexts, concession agreements are advantageous. These agreements are relatively straightforward and have been used in the past to compensate for a lack of legal and judicial infrastructure or a scarcity of the expertise required to draft more sophisticated contracts.

Distinct from other forms of international petroleum contracts or agreements, service contracts were developed in order to maximize national control over petroleum development and limit foreign investment.  Investors operating under service contracts are solicited to accomplish very clearly defined tasks and rarely share in revenue or production. Service contracts are only feasible in HC’s where governments have appropriate knowledge, infrastructure, and technology to access and extract natural resources in a commercially viable manner for production. When service contracts are utilized today, they fall into three categories: risk service, pure service and technical assistance.

Joint Ventures and Product Sharing Agreements comprise the contractual bulk of IPC’s currently utilized in the Egyptian oil and gas sector. Egypt employs a hybrid model utilizing different contractual mechanisms at varying stages of exploration, development and production.

After rounds of bidding, Egyptian concession licenses are granted to FOC’s for geographically defined areas of exploration.  Signing bonuses and licensing fees may apply. If and when natural resources are discovered, a development lease is issued and a joint venture (JV) is formed between host countries and FOC’s. The JV proceeds to prepare a development plan approved by the Ministry of Petroleum.  At this juncture, the FOC operating under the umbrella of the joint venture is responsible for the operational and financial aspects of exploration and development.

Post discovery, a production – sharing agreement (PSA) is drafted between the FOC and the NOC that comprise the joint venture.  PSA’s are the most common contractual arrangement for petroleum exploration and development. Hybrid models are often employed in order to contend with country-specific issues that arise at varying stages of exploration, development, and production. The PSA model is often referred as the Indonesian model because in 1960 the Indonesian government was the first to implement product-sharing mechanisms for the petroleum sector.  In addition to Egypt, PSA’s have also been used in Malaysia, Libya, and Sudan.   Under a PSA, quite simply, host countries retain sovereign ownership of natural resources, yet solicit operational, technical and financial assistance from FOC’s.

The legal construct of a joint venture is malleable yet basic elements and trends emerge.  S. Williston in A Treastise on the Law Contracts discusses the flexibility of joint ventures as a contractual tool and highlights several core elements typified in the petroleum sector. Central elements include the expectation of profit, mutual management of the enterprise, and the limitation of the partnership to a single undertaking or objective. This last element is important as it provides contractual parameters to contain risk. After a JV is formed, the FOC effectively acquires ownership of a specified part of production. 

The Power of Pricing
The valuation of production revenue is an often-debated feature of IPC amendments.  In theory, IPC’s are drafted to balance risk and reward in consideration of a mutuality of interests.  However, theory is not practice. FOC’s desire swift recovery of costs and profit maximization, while HC’s want to maximize the economic rent they receive for their natural resources.

Under a PSA, foreign oil companies bear the majority of risk as costs are not recouped if resources are not discovered.  Under some production sharing agreements foreign oil companies may be required to pay royalties on gross production and, after royalties are paid, the FOC is entitled to a specific percentage of production revenue to recover costs. This is typically referred to as “cost recovery” or “cost oil”.  The remainder of production revenue or “profit oil” is split between the host government and the FOC. Percentage splits vary and are dependant on a variety of factors.  Foreign oil companies are entitled to sell their share of production for cost recovery and production sharing…however, again, conditions often apply.  PSA’s may also specify that priority must be granted to satisfying the demands of the domestic market.  As such, PSA’s can stipulate the preferential sale of the foreign oil company’s production share to nationalized oil companies at the negotiated price.

Pricing factors heavily into the readjustment of international petroleum contracts. The pricing of crude oil is formulaic and tied to numerous factors including immediate and actual supply / demand as well as the purveying market attitude toward futures.  According to the Egyptian Ministry of Petroleum “cost recovery crude oil is valued jointly by the FOC and the NOC at the international market price for each calendar quarter as determined by a weighted average price realized jointly by the FOC or NOC (whichever is highest).”  Also, according to the Ministry of Petroleum, the “value of cost recovery and production sharing natural gas disposed in the domestic market is based on a gas pricing formula that is a function of the price of Brent crude oil according to Platt’s Oilgram Price Report.” If recent years can tell us anything it is that “Black Swan” events, as well as speculative bubbles can dramatically impact these measures over a relatively short period of time.

Cost recovery also factors heavily into the revision and renegotiation of international petroleum contracts. Most production sharing agreements stipulate different time parameters for different expenses.  Expenditures that fall under the heading of cost recovery are first priority in recouping costs. Subcategories exist within cost recovery. Operational expenses may be recovered in annum.  Other expenditures over longer-term investments towards infrastructure and technology may offer longer time frames for repayment.  However, problems often arise as a result of classification.  Several industry insiders indicated that the accounting of expenses related to cost recovery were often disputed as their classification was questionable. 

In addition to the problem of manufactured cost recovery, the pricing of natural gas has becoming an increasingly problematic issue related to IPC’s contracts.  The subsidization of gas by the Egyptian government to the domestic market (including the industrial sector) has created a scenario that has broad implications for the future of the sector.  The Egyptian government is currently behind on payments to international oil companies stemming from a lack of liquidity.  The delayed payments are the result of the government buying natural gas at international prices and selling the gas at artificially low levels representing large subsidies.  Western media outlets report delayed payments in the range of four to seven billion dollars. While the delayed payments directly affect the bigger players in the industry, Dana Gas in particular, the peripheral impacting is starting to be felt.  Numerous industry insiders expressed anxiety at the trickle-down impact of the arrears problem on medium to small operators as well as service companies in the downstream sectors.  As rumors of suspended projects, cancelled orders, and a general decline in volume persists, it has become clear to numerous entities in the industry that delayed payments may swiftly surpass pricing as the number one issue within contractual renegotiations.

The revision of international petroleum contracts obviously comes at a precarious stage in Egypt’s period of transition. The current instability has ostensibly demonstrated little impact upon investment in the Egyptian Oil and Gas sector. Petroleum Minister Osama Kamal recently stated to Al Arabiya Newspaper that investment in the Egyptian oil and gas sector witnessed a five percent increase for the period of 2012-2013 with total investment in the Egyptian petroleum and gas sector estimated at $86 billion.  However questions remain concerning the sustainability of the industry’s status quo.  How long can the sector remain largely unaffected when broader socioeconomic and political issues factor directly into operational elements?  The current round of contractual amendments and renegotiation will simultaneously contend with recurrent problems related to subsidies, pricing, and cost transparency while set against the backdrop of socioeconomic and political uncertainty.  In short, even if instability continues to reign within the political sphere (or more obviously, on the street), some measure of predictability must be ensured as it concerns the broader political framework, the parliament, the constitution, the judiciary, and the broader business environment.

By Julie Herrick


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