In the universe of oil contracts, two main families of fiscal system exist. The first family includes ‘concessionary’ systems, so-called because the government grants the company the right to take control of the entire process – from exploration to marketing – within a fixed area for a specific amount of time. Since production and sale of the oil are then subject to royalties, taxes and other concessions, contracts in this family are commonly known as Royalty/Tax Systems (abbreviated here as R/T systems). ‘Contractual-based’ systems comprise the second family. Agreements in this family belong to two predominant groups: production sharing contracts (PSCs) and service agreements (SAs) (Johnston 1994).
In short, the distinguishing characteristic of each family of contract is where, when, and if ownership of the hydrocarbons transfers to the international oil company. While numerous variations and twists are found in both concessionary and contract-based systems, from a mechanical and financial point of view there are practically no differences between the various systems. Thus, these distinctions are not always clear. Some risk service agreements (agreements where fees are paid for services rendered) appear to have more of the characteristics of a royalty/tax system (Venezuela; with royalties and taxes), while some look more like a PSC (Philippines; with a cost recovery limit and profit oil split). Hence, the key calculations in both families follow the same hierarchy. Any oil agreement takes into account, in the following order:
- the generation of production and revenue;
- the royalty or royalty equivalent elements for the government;
- the cost recovery, tax deductions or reimbursement for the corporation; and
- the way profits are divided (such as profit-oil sharing and/or taxes).
While some interesting exceptions to this general rule exist, they are most likely to be found only among the SAs of this world.
In fact, preferences for one system over another and certain elements or conventions generally tend to be regional. Region also plays an important role in determining what a contract is called. Hence, in some areas, R/T systems are often simply referred to as ‘concessions.’ In other parts of the world, however, the term ‘concession’ has a negative connotation; in other words, it lacks political correctness. Political correctness also helps to explain why Personal Service Contracts are sometimes called Personal Service Agreements (PSAs).
Royalty Tax Systems (R/T)
Prior to the late 1960s, R/T Systems – or ‘concessionary systems’ – were for all practical purposes, the only arrangements available. R/T systems are characterized by a number of features:
- Oil companies are contracted for the right to explore for hydrocarbons;
- If a discovery is deemed commercially viable, the international oil company has the right to developed and produce the hydrocarbons;
- When hydrocarbons are produced, the international oil company will take title to its share at the wellhead (this “entitlement” equals gross production less royalty). If the royalty is 10% the international oil company can ‘lift’ (take physical and legal possession of its entitlement of crude oil) 90% of production. If the royalty is paid in cash from another source of funds, then the IOC can ‘lift’ 100% of production;
- Exploration and production equipment are owned by the IOC;
- The IOCs pay taxes on profits from the sale of the oil.
Production Sharing Contracts (PSCs)
The concept of production sharing is ancient and widespread. Farmers all over have been familiar with the concept for decades. The concept of the PSC, as far as the oil and gas industry is concerned, was conceived in Venezuela in the mid-1960s. The first modern Production Sharing Contract was signed in 1966 between the Independent Indonesia American Petroleum Company (IIAPCO) and Permina, Indonesia’s National Oil Company at the time. The characteristic features of this pioneering agreement, which can still be found in most PSC arrangements worldwide, included:
- Title to the hydrocarbons remained with the state (Indonesia);
- Permina maintained management control (Indeed, putting management control in the hands of Permina is what really distinguished the PSC from the Indonesian predecessors);
- Contractor submitted work programs and budgets for government approval;
- Profit Oil (P/O) split – the amount of oil remaining after allocation of royalty oil and cost oil – was 65%/35% in favour of Permina;
- Contractor bore the risk;
- Cost Recovery Limit (the limit to the amount of deductions that can be taken for cost recovery purposes) was 40%;
- Taxes paid ‘in lieu’ (i.e. taxes paid for and on behalf of the IOC by Permina);
- Purchased equipment became the property of Permina;
- Company entitlement equals cost oil (oil or revenue used to reimburse the contractor for exploration and development) plus profit oil.
Note that from a mechanical point of view the Cost Recovery Limit is the only difference between R/Ts and PSCs.
Service Agreements (SA)
Service contracts or service agreements generally use a simple formula: the contractor is paid a cash fee for performing the service of producing the resources. All production belongs to the state. The contractor is usually responsible for providing all capital associated with exploration and development (just like with R/T systems and PSCs). In return, if exploration efforts are successful, the contractor recovers costs through the sale of oil or gas plus a fee. The fee is often taxable. These agreements can be quite similar to PSCs or R/T systems except for the issue of entitlement (entitlements are not granted and fees are paid instead).
There are numerous sources that make little distinction between the families of oil contract systems other than differences regarding the transfer of title to hydrocarbons that distinguish R/T systems from PSC and SA systems.
This difference in ownership structure – where, when, and if ownership of the hydrocarbons is transferred to the IOC – is one of the distinguishing characteristics of petroleum fiscal systems. With an R/T system, title transfers to the IOC at the wellhead; the IOC takes title to gross production less royalty oil. For a PSC, title transfers at the export point or fiscalization point. The IOC takes title to cost oil and profit oil. With Service Agreements (by definition) there is no transfer of title to hydrocarbons and so this has direct implications for the IOC’s ability to book barrels.
Title to Facilities
Title to facilities remains with the oil company under R/T Systems, but, under PSCs and Service Agreements, title to facilities transfers to the NOC or government. There is some variation to when title to facilities (including production facilities, pipelines, and other associated facilities) transfers to the NOC or government but usually it transfers at the time of commissioning them. For example, in Nigeria, title to facilities transfers to the Nigerian National Oil Corporation (NNPC) when the equipment lands in-country. Some countries will wait until the facilities have achieved ‘pay-out,’ at which point title transfers to the NOC. From a financial point of view, as far as normal production operations are concerned, there is little difference to the IOC whether they or the government owns the facilities. The significant difference involves who is responsible for managing and restoring the site after production has concluded (the abandonment/site-restoration liability). In other words, the important legal implication is that the obligation for site restoration, abandonment, and clean-up is held by the owner in the absence of clear and well-crafted abandonment provisions (Johnston 2006).
Another, less evident, difference between the systems is with respect to how they handle entitlement. A PSC and an R/T system over the full cycle can be financially identical, yet contractor entitlement in the PSC system may be about half that of the R/T system and, of course, is absent in the SA agreements.
Finally, there may be a difference based on project costs. Government Take is likely to be much higher for a PSC for low profitability projects. The PSC’s payoff in some particular cases is more front-end-loaded than the R/T system. It is the cost recovery limit that makes the PSC more front-end-loaded (or regressive) than the R/T system. In the early years, government revenue is guaranteed for both systems because of the royalty. The PSC, however, also has the cost recovery limit, which guarantees the government additional revenue. In fact, the Government Take for sub-marginal fields can be extremely high. Note that once the costs are lower the two systems are the same.