Product Sharing Agreement

Introduction
Since the 1960s, production sharing agreements in the oil & gas industry have been a common legal agreement by which host countries and oil companies can manage the risks and rewards associated with the costs and profits of oil extraction and production (Stoleson, 1996: 672). While production sharing agreements have been viewed as being positive for host countries that have large oil reserves, the reality is that such agreements often benefit oil companies to the detriment of nations, and particularly the citizens of those nations (Muttitt, 2005: 8-9). The purpose of this paper is to examine the ways in which risk in the oil & gas industry is managed through production sharing agreements. In addition, a critical analysis is provided about the outcomes of such agreements on the part of host countries. The goal is to provide an explanation of why the status quo with the use of such agreements is generally negative for most host nations, while being greatly beneficial to international oil companies.
Production Sharing Agreements
The Basis of Production Sharing Agreements
The basis of a production sharing agreement is a contract between a foreign oil company and a host country. The host country gives permission to a foreign oil company to explore and extract oil from a specific area for a specific period of time. As part of the contract, a percentage of the revenues generated from the oil production are paid to the host country. Furthermore, a production sharing agreement contract typically includes a tax paid to the host nation. However this tax may be negotiated to be paid in actual oil rather than as a cash payment (Stoleson, 1996: 672). Other aspects of production sharing agreements can include a maximum cost recovery for the foreign oil company as a means of paying for the cost of oil exploration and production in the host country (Bindemann, 1999: 13).
Figure 1 shows the basic features of a production sharing agreement. The figure shows how the rules associated with gross production are negotiated and agreed upon by the foreign oil company (FOC) and the host country. Then, the FOC receives a cost recovery, which leads to the actual profits that are split between the FOC and the host country, and from the final profits, a tax is imposed on the FOC (Bindemann, 1999: 13).
Figure 1: Basic Production Sharing Agreement (Bindemann, 1999: 13)
Foreign oil companies generally prefer production sharing agreements in generally, and especially oil sharing agreements that allow for high recovery costs, because the host country actually assumes a great deal of the risk for the oil exploration and production (Muttitt, 2005: 8-9). In some sharing agreements, the oil recovery percentage may be as high as 60%, which means that the no royalties, profits, or taxes are paid on the first 60% of the gross revenues (Muttitt, 2005: 5). Another way of thinking about this is that foreign oil companies are able to immediate transfer as much as 60% of oil exploration and production costs to the host country.
Terms and Management of Production Sharing Agreements
On the surface, production sharing agreements seem to shift power from the foreign oil companies to the host countries (Sornarajah, 2010: 118). The reality, however, is that production sharing agreements are generally more beneficial to the foreign oil companies than to the host countries. The countries that have the oil reserves own those reserves and can enter into any agreement they desire with foreign oil companies. There are no international laws that dictate such agreements. This often means that it is the foreign oil companies that draft much of the agreements. The agreements may be hundreds of pages in length, and contain very technical language. It is often the case that such agreements contains stipulations that are not recognized or appreciated as being important to a host country until a condition arises that results in the amount of profits that are received from a foreign oil company to decline or even be non-existent (Muttitt, 2005: 8-9). However, once a host country has entered into a foreign sharing agreement, changing the terms of the agreement can be very difficult, or bring with it the risk of losing the foreign oil company and the foreign investment that the foreign oil company brings.
In addition, many countries that have oil reserves want to attract foreign oil companies as a source of foreign investment. The desire to attract foreign oil companies means that many countries are will to negotiate what is attractive terms of royalty payments, profit splits, and taxes with the oil companies. Figure 2 shows the overall government take from production sharing agreements in 2007, as well as the change in the government take from such agreements from 1998 to 2007. What is shown is that the government take from production sharing agreements range from about 40% to as high as 95%, with most somewhere between 40% and 70%. However, as the arrows indicate, many nations reduced their percentages of profits from the production sharing agreements from 1998 to 2007 (Johnston, 2008: 39).





Figure 2: Government Take of Profits from Production Sharing Agreements (Johnston, 2008: 39)
It must be understood, however, that the percentage of profit sharing for the host country is after recovery costs, and is dependent on the actual price of oil. Table 1 shows that for a host country that receives a 15% royalty and a 60% profit share, the actual amount of profit when oil is $60% a barrel is only $18.00 for each barrel. This is an effective profit sharing percentage of 33.3%. After the concessions to the foreign oil company, a 60% profit sharing agreement can provide only about 33% in actual profits to the country. Interestingly, the table also shows that even with oil price fluctuations from a hypothetical $20 per barrel to a high of $60 per barrel, the final profit percentage for the host country remains between 31% and 34% (Johnston, 2008: 42).
Table 1: Hypothetical Government Take from Production Sharing Agreement (Johnston, 2008: 42)
One other issue that makes production sharing agreements so attractive and beneficial to foreign oil companies is that such contracts are negotiated as self-contained agreements that are separate from the broader laws of a host country concerning oil and gas exploration and production (Stoleson, 1996: 672). A country such a Russia may have very strict rules regarding oil exploration, particularly on the part of foreign oil companies that compete against Russian oil companies. However, if a production sharing agreement can be negotiated, then that agreement will have power over any of the national laws concerning the oil & gas industry. In this way, a foreign oil company can negotiate terms for its oil and gas exploration and production efforts in a host country that even domestic companies may not be able to obtain.

Russia, however, is one country that seems to have taken notice of the uneven benefits that production sharing agreements bring to foreign oil companies. In 1995, Russia enacted a law that essentially stopped the country from taking part in what might be called traditional production sharing agreements. Instead, Russia can only enter into production sharing agreements when no investors in the country can be found for the development of exploration in a particular oil or gas reserve under normal Russian laws (Locatelli, 2006: 11). It seems that Russia is the only major country that has changed how the conditions under which production sharing agreements can be formed with foreign oil companies.
The Problem with the Status Quo
Benefits to the Oil Companies
As has been noted, most countries continue to enter into production sharing agreements with foreign oil companies that provide a much greater benefit to the oil companies than to the host nation and its citizens. While the discussion of the legal terms and management of production sharing agreements contained may hypothetical situations and conditions, it is possible to demonstrate through real-world examples of why the status quo with maintaining traditional production sharing agreements is often negative for host countries. In 2006, India awarded 52 agreements with foreign oil companies for oil & gas exploration in the country. The Indian government believed that the agreements would result in large inflows of capital for the developing nation. In the actual sharing agreements, the profit percentage that was supposed to go to the Indian government was high. However, the agreements contained a variety of stipulations about cost recoveries for the oil companies. The end result was that the actual percentage of profit from each production sharing agreements ended up being around 1%, and some was actually zero (Johnston, 2008: 44).
Another example of oil companies taking advantage of the terms of production sharing agreements can be seen in Sudan. The country that was formally Sudan agreed to several production sharing agreements as a means of bringing in desperately needed revenue for the impoverished nation. However, foreign oil companies began to sell oil to local refineries at a depressed price. What the reduced cost of the oil may have benefited the local refineries, it hurt the country as a whole because with reduced revenues from the sale of the oil, the overall revenues were greatly reduced. The result was that even with high profit sharing percentages in the production sharing agreements, the actual revenues generated from the profits for the country were very low. This caused particular anger in what is now South Sudan where many of the oil fields were located because large amounts of oil was being extracted from that area with little or no actual financial benefit to the local population (Patey, 2010: 10).
Information has already been provided about how Russia changed domestic laws to essentially make entering into production sharing agreements with foreign oil companies as last resort. One of the reasons that this change occurred is likely due to a situation that occurred with a production sharing agreement that has been signed with Japanese firms in the 1990s. Under the terms of the agreement, Russia would receive no profits until the costs of the project were fully recouped by the Japanese firms. As late as 2006, the Japanese firms that were part of the production sharing agreement informed the Russian government that because of rising steel prices and a weaker U.S. Dollar, the cost of the oil project would double from $11 billion to $22 billion. The result for Russia was that the country would have to continue to wait to receive any profits from the production sharing agreement. The Russian government and the Japanese firms did renegotiate the terms of the agreement so that Russia could begin receiving some profits (Chun, 2009: 338).
One other country in which the status quo in terms of continuing to rely on traditional production sharing agreements with oil & gas companies is Iraq. The country of Iraq entered into production sharing agreements that were meant to bring revenues from its large number of oil fields. However, as with many other nations, the terms of the production sharing agreements have meant that the real percentage of profits for the country has been small or even none. While the specific terms of production sharing agreements in the country are not always published, which is common in most countries, it has been estimated that foreign oil companies generate a 59% to 66% internal rate of return from the agreements in Iraq even though the terms may be as high as an 80-20 split, meaning that 80% of profits were stated as going to the country (Muttitt, 2006: 10).
Obstacle to Changes in the Status Quo
From the information about production sharing agreements that has been presented, it might seem that countries would be motivated to at least attempt to decrease the uneven nature of such agreements. The reality, however, is that some countries are less concerned about the actual percentage of revenues generated from such agreements for their nations and their citizens because of corruption. As was noted, the terms of many production sharing agreements are not made public. This can lead to corruption on the part of governments that may state that little or no revenues are being received when the revenues that are received are mismanaged.
In 2001, British Petroleum announced that it would make the terms of each of its production sharing agreements public. In response, The Angolan government actually threatened to expel BP from the country (Frynas, 2010: 167). The lesson for BP and other oil companies was that some countries want the terms of production sharing agreements to remain private even though the idea of encouraging foreign investment in oil is to improve the conditions in a country and the conditions of the people of a country. However, when corrupt government officials may be taking some or all of the oil revenues, the concern about whether the full percentage of profits stated in a production sharing agreement, or even anything close to that percentage, is likely less important than receiving at least some revenues that can be hidden from public view.
Conclusion
The purpose of this paper was to examine the ways in which risk in the oil & gas industry is managed through production sharing agreements. The legal contracts known as production sharing agreements are truly only dependent on the terms to which foreign oil companies and host countries are will to agree. In most cases, such agreements benefit oil companies and provide much less of a benefit, if any benefit at all, to a host country and its people. However, countries continue to accept the status quo with such agreements because of the desire to attract foreign investment, and from the believe that their oil fields and oil reserves will produce instant revenues. In some cases, corrupt governments and officials are only concerned about the revenues they can take for themselves to the detriment of their citizens. Because such agreements are between a single country that owns its oil and gas reserves and foreign companies, there are no real international laws or regulations that can easily change how production sharing agreements are written or carried out. Instead, more countries will have to be willing and able to take the action of Russia to essentially end production sharing agreements as a normal practice and make them an action of last resort. The problem in taking such an action for many countries will be the loss of any revenue from oil and gas reserves.




References
Bindemann, K., 1999. Production-sharing Agreements: An Economic Analysis. Oxford: Oxford
Institute for Energy Studies.
Chun, H., 2009. Russia's energy diplomacy toward Europe and Northeast Asia: a comparative
study. Asia Europe Journal, 7(2), 327-343.
Frynas, J. G. (2010). Corporate social responsibility and societal governance: Lessons from transparency in the oil and gas sector. Journal of business ethics, 93(2), 163-179.
Johnston, D., 2008. Changing fiscal landscape. The Journal of World Energy Law &
Business, 1(1), 31-54.
Locatelli, C., 2006. The Russian oil industry between public and private governance: obstacles
to international oil companies’ investment strategies. Energy Policy, 34(9), 1075-1085.
Muttitt, G., 2005. Production sharing agreements: Oil privatisation by another name?. General
Union of Oil Employees’ Conference on Privatisation, 26, 1-16
Muttitt, G. (2006). Production sharing agreements-Mortgaging Iraq's oil wealth.  Arab Studies
Quarterly, 28, 1-17.
Patey, L. A., 2010. Crude days ahead? Oil and the resource curse in Sudan. African Affairs, 
109(437), 617-636.
Sornarajah, M., 2010. The International Law on Foreign Investment. Cambridge: Cambridge University Press.
Stoleson, M. A., 1996. Investment at an impasse: Russia's production-sharing agreement law
and the continuing barriers to petroleum investment in Russia. Duke J. Comp. & Int'l L., 7, 671-689.