The rapidly evolving nature of the oil and gas industry makes it one of the world’s most challenging and complex sectors for understanding, assessing and negotiating contracts. The legal and regulatory framework of upstream petroleum contracts is progressively changing as the tide of deregulation laps swiftly against the aging protectionist policies of state-regulated markets. Now, governments and petroleum producers alike are trying to adapt to the new way of doing business, though some are evolving faster than others
Every country has unique political, social and economic characteristics that govern the pace of its development. Consequently, the process of creating an apposite contract, tailored to the country’s unique features, is a carefully orchestrated ballet, a highly intricate and collaborative effort that warrants meticulous examination of these characteristics before the initiation of preliminary negotiations.
Considering such unique features means drafting a customized contract, which essentially eliminating the prospect of one ideal formula for creating suitable upstream contractual agreements. Despite these challenges, there are general contractual frameworks that have shown remarkable success in mature global petroleum markets that merit serving as principal guidelines to the formation of suitable, beneficial and successful contractual agreements.
At the forefront of the crucial elements in creating an upstream contract is the type of fiscal-contractual regime chosen to govern the concession agreement; it primarily lays the foundation for a secure legal framework conducive to attracting foreign interest and boosting competitive advantage. Investors seek contracts that secure long-term investments that engender growth as the market gradually evolves. However, they also must accurately assess the economic realities of the contracting government, and ensure that social equity is not imperiled by the need for achieving sustainable development.
In-depth look into contracts
The numerous types of fiscal-contractual arrangements applied in today’s upstream oil and gas markets can be reduced to three main regimes; firstly is the Concession Contract, also known as the Royalty Regime. This type of contract stipulates granting the investor the license to conduct exploratory and production operations in a specified geographic location in exchange for making a royalty payment (often regulated) on production, in addition to income tax on profits. The amount of the royalty is determined as an incremental rate beginning with a small percentage of gross revenues until the costs of operations have been recovered, at which point the rate increases to a higher percentage of either gross or net revenue. In doing so, the risks and profits are shared between the government and the investor alike.
Comparing the neighboring countries’ systems to Egypt’s, Algeria’s fiscal regime, for example, is a concessionary system that applies several taxes, including but not limited to royalty payments, surface tax, corporate income tax, petroleum income tax and windfall profits tax. Operators under this regime must work in partnership with Algeria’s national oil company Sonatrach, which usually participates with at least 51% in the concession.
Another example of a non-neighboring country that applies the concession contracts in its upstream petroleum deals is Argentina. The country is organized into federal provincial and municipal governments. The fiscal regime that applies to the petroleum industry is mainly the federal provincial one. Federal taxes come in the form of income taxes, value added taxes, custom duties and social security taxes, while provincial ones include turnover taxes, stamp taxes and royalty payments.
The Argentinian model is applied in the African continent but with some differences. Nigeria, for instance, implements a hybrid system that combines joint ventures with the Federal Government or a sole risk investor, and contractual regimes, which comprises of Service Contracts or Production Sharing Contracts (PSCs). Companies carrying out petroleum operations are deemed to be in the upstream regime and taxed under Nigeria’s Petroleum Profits Tax Act. PSCs are used most frequently in exploration and development processes. Service Contract operators, on the other hand, are treated as not carrying out petroleum operations but rather as performance contractors and they are compensated only as service providers.
As a matter of fact, there are various examples of Concession Contract models. The elasticity of models is what essentially permits governments to successfully approach a suitable contract that tallies with their social, political and economic conditions. The Concession Contract regime is prevalent among the majority of West, along with several countries in Latin America, Middle East, Africa and Far East.
Another type of fiscal-contractual regimes, which will bare a closer examination as it is applied by the Egyptian government, is Production Sharing Contracts (PSCs). Unlike Concession Contracts, under a PSC the foreign investor is entitled to a percentage of the produced oil or gas to sufficiently recover operations costs. The remainder of production and profit is then shared between the government and the investor. Royalty and income taxes are also applicable under a PSC and its execution is usually handled by a joint venture between a national oil company on one side and an investor or more on the other side.
For many oil companies, an important part in the negotiation is securing the terms acceptable to the new potential partner (usually a government). Understanding the market and deciding which terms are realistic depends on the region’s characteristics and potentials. Nowadays, nearly half of the countries with the petroleum potential have a system based on the PSC. However, the financial results could very well be similar to those of a Concession Contract arrangement.
The economics of the petroleum sector depend primarily on division of profits or what is known as “government/investor take”; the focal point of fiscal comparisons. Investor take is the percentage of profits going to the producing company, while government take is the remaining share. Division of profits is one of the most important benchmarks for comparing fiscal systems since it correlates directly with reserve values, field size thresholds, and other measures of relative economics.
Examining the models of PSCs implemented in Egypt, government take is measured according to an array of competitive parameters ranging from percentages of production allocation and profit sharing to royalty taxes and cost recovery payments. The portion of government take is determined through a bidding process that weighs the potential levels of risk and reward the investor expects to encounter.
Once a mutually satisfactory arrangement is reached, the government grants the producer, in conjunction with one of the NOCs, an exclusive concession to explore a certain geographic location for a specified period of time. This period varies according to the findings and can range from three to four years with the option for one or two consecutive extensions that could last for a year or two.
After the conclusion of the exploration period, if the findings deem the location viable for commercialization, the concession is then converted into a development lease that extends for at least a 20-year term. The management and operations of the development lease are administered by the joint venture company, which operates as a private sector company while retaining independence from laws and regulations governing the private sector.
The method by which revenue is distributed among the involved parties under the Egyptian system is determined during the period of the development lease according to specified cost-and-expense recovery and production sharing provisions. Furthermore, The government imposes a royalty tax to be paid by the involved NOC in the amount of 10% of production or its equivalent in cash.
During the bidding round, the investor offers the government competitive options to the distribution of revenue. For example, the concept of Cost Recovery, where the producer offers to recover all the costs and expenses associated with the exploration, production and development on a quarterly basis, which is appropriated from a certain percentage of the production in addition to the cost of operations. A different but also competitive option is Production Sharing, where the remainder of production by the joint venture company is divided between the investor and the NOC according to agreed-upon percentage shares for specified increments of production.
Evidently, the dynamic nature of petroleum markets mandates a certain degree of flexibility in adjusting fiscal-contractual agreements to present the contracting parties with the opportunity of minimizing their risks. Such risks can manifest in the constant fluctuation of market prices, the increased competition for risk capital, the desire for enhancing the competitiveness of offers by both parties, or simply because the government decides to participate in the windfall profits.
The third type of regime for forming fiscal contractual-agreements, which is mostly applied in the developmental stage of an upstream operation, is the Service Contract. Under this system, the foreign contactor provides services to the government for a certain fee, which varies according to achieved rate of production and the market price. It is the only type of upstream contract in which royalty payments are not applicable, yet the government reserves the right to apply an income tax on the investor’s acquired profits.
Barriers challenging the Egyptian market
Egypt possesses the strategic and comparative advantages to be one of the leading petroleum markets in the North-African region. The flexibility offered to oil companies in designing their own fiscal conditions increases the attractiveness and competitive advantage of Egyptian exploration and production deals. However, there are significant limitations that hinder Egypt’s chance to thrive and stand out among its regional counterparts.
The first and foremost of these limitations is the transparency in the selection criteria on which bidding rounds are won. There is a degree of ambiguity surrounding the bidding processes that naturally incites reluctance among foreign investors. Therefore, it is on the government to publicly declare and explain the selection criterion that evaluates prospective.
Another problem lies in the compartmentalization of oil and gas operations, which runs counter to increasing the efficiency in production. The system can fortunately accommodate, alongside oil production, new developments to further incentivize the efficiency in exploration, production and promotion of Enhanced Oil Recovery (EOR) initiatives.
The list of limitations also arises from the turnaround of exploration acreage set by the Egyptian government. The exploration concessions in Egypt require the contractor to relinquish a specified percentage of the original concession that has not been converted into a development lease. However, exploration terms in Egypt can last up to ten years; the elongated exploration term is indeed a great attraction for investors, but it is also detrimental to the reserve replacement process as it slows down the overall exploratory activities. Hence, it is in the best interest of the government to shorten the relinquishment and extensions timeline to expedite the turnaround of exploration acreage.
Last but not least comes the issue of local participation. The government’s imposed limitations on participation of domestic suppliers and manufactured supplies may be attractive to the foreign investor, but they tend to neglect the abundance of human resources and technical expertise available in Egypt that could be properly and efficiently utilized. Enforcing stricter terms to increase local participation may indeed discourage foreign investors and force them to seek other opportunities in competing nations. Hence, the government has to find a balance that subtly maintains Egypt’s competitive attractiveness whilst paving the way developing competent human resources. Such goal could be realized by providing local participants with the platform for receiving the needed technical training and education that eventually leads them to have a highly efficient and more productive output. The aforementioned obstacles cannot be easily remedied indeed, but through a gradual introduction of the proper methods, such impediments are likely fade away.
By Mohamed El-Bahrawi