Tuesday, September 27, 2022

The Production Sharing Agreement, Renegotiation, and the Stability Clause (Part 1)

Must Read

OilNOW
OilNOW is an online-based Information and Resource Centre

By Joel Bhagwandin – OilNOW

Summary

The full project lifecycle of the oil and gas business is around 30 years or more. During the exploration and development stage which may span about 20 years before production, the oil companies continuously inject capital to explore and develop the resource. Then 20 years later as in the case of Guyana, production starts to generate the revenue which, in turn, provide for recovery of the capital investment, operating cost and a decent profit for the company and the Government. If no commercial discovery is made, the capital invested in the exploration stage would be a loss for the oil companies.

The oil and gas business is capital intensive and requires taking on high investment risks. To put this into perspective, the exploration and development cost for Liza 1 alone amounted to about US$4 billion, the total estimated development cost for Liza 1, Liza 2, Payara and Yellowtail is about US$29.3 billion, representing 100% of Guyana’s pre-oil gross domestic product (GDP) in the case of Liza 1 and for the four approved projects combined represents 7.3 times Guyana’s pre-oil GDP. This simply means that the financial resources of the entire country (the sum total of private sector, households, and government) are not enough to finance even one phase of development. With this in mind, it is important to appreciate the high-risk nature of the business in general. The natural outcome for that is, it carries a higher risk premium – meaning, the investors require a decent return on their invested capital.

Major countries are already accelerating climate change policies, designed to transition from a fossil-fuel driven energy system to renewable energy. One can observe that all of the necessary projects, combined, require hundreds of billions in U.S. dollars to fuel massive investments. This ultimately means these developments are going to have a direct impact on global oil prices which will be on a downward trajectory, at some point in the future. The ultimate effect would be that global demand for crude oil will fall steadily until it will reach to a point where it may no longer be feasible.

Background

There is a group of persons both locally and abroad advocating for the renegotiation of the Production Sharing Agreement (PSA) between the Government of Guyana and the oil companies (Esso Exploration and Production Guyana Limited (EEPGL), Hess and CNOOC. More recently, proponents of this view have argued that with rising oil prices – the Government should press for renegotiation.

The Government’s position is that it will not renegotiate the current PSA for the Stabroek Block. However, future PSAs will have different fiscal terms. The oil companies on the other hand have stressed the importance of the stability clause.  Further, the Government has committed to ensuring better contract administration as an alternative, to extract more value for the country from the existing PSA framework without renegotiation. To this end, it is important to distinguish between the “Government Take” and the “Country’s Take”. In this context, it is also important to analyse whether through contract administration, the country is getting more value, as opposed to defying the odds and proceeding to renegotiation – bearing in mind the many ramifications of renegotiating the contract, especially if this is not a desirable outcome on the part of the oil companies.

This article is the first of a series of articles that will seek to address this issue and to examine, in an in-depth manner, the ramifications and different options of deriving more value for the country.

Discussion and Analysis

Project Lifecycle, Capital Investment and Risks

First, let’s understand the project lifecycle of the oil and gas business, the high capital-intensive nature and some of the key risks involved. The project lifecycle encompasses three stages: the exploration stage which can last for about 5-10 years or even 15 years, the development stage once the resource is found in commercial quantities which is another 5 years, and the production stage which could be 10 years per project. The full lifecycle is therefore around 30 years or more. More importantly, during the exploration and development stage which could span about 20 years before production, the oil companies continuously inject capital. Then 20 years later, as in the case of Guyana, production starts, to generate the revenue which in turn provides for recovery of the capital investment, operating cost and a decent profit for the company and the Government.

If no commercial discovery is made, the capital invested in the exploration stage would be a loss for the oil companies.

The oil and gas business is capital intensive and requires taking on high investment risks. To put this into perspective, the exploration and development cost for Liza 1 alone amounted to about US$4 billion, the total estimated development cost for Liza 1, Liza 2, Payara and Yellowtail is about US$29.3 billion, representing 100% of Guyana’s pre-oil GDP in the case of Liza 1. The development cost of the four approved projects combined represents 7.3 times Guyana’s pre-oil GDP.

This simply means that the financial resources of the entire country (the sum total of private sector, households, and government) are not enough to develop even one phase of the development. With this in mind, it is important to appreciate the high-risk nature of the business in general. The natural outcome is that the business carries a higher risk premium – meaning, the investors require a decent return on their invested capital.

Let’s consider the risk of an oil spill. Interestingly, the same group of advocates calling for renegotiation of the contract are also chanting for the oil companies to give some form of guarantee other than the insurance – that it has full responsibility for the liability in the worst-case event of an oil spill, which is important and not to be discounted. Just over a decade ago, the Valdez oil spill costs exceeded some US$7 billion. In today’s money, that’s roughly US$9 billion. In a worst-case scenario for Guyana, assuming an oil spill to this magnitude where the costs might exceed US$10 billion, the oil companies’ take across the four approved projects is 24% or US$41.7 billion according to an updated forecast conducted by SPHEREX Analytics. Assuming a US$10 billion oil spill lability, this will erode the cumulative profits of the oil companies by 24% across the four approved projects.

Notwithstanding the worst-case scenario of an oil spill above, it is notable that the oil and gas industry is a highly regulated global industry where health and safety is a number one priority. And the industry is so big that with any eventualities such as a catastrophic oil spill, the technology employed in the sector develops and evolves at a fast rate. The technology, equipment, and resources available today to mitigate the risks of an oil spill or at best to minimise the impact of a catastrophic oil spill, did not exist over a decade ago. Guyana is therefore fortunate to be the beneficiary of these new and advanced technologies and, therefore, the risks of an oil spill, while it is real, is low-to moderate, and should be quickly contained.

However, the insurance as well as these state-of-the-art technology and equipment to manage and contain these risks, comes at a premium cost as well, which has to be deducted from cost oil.

The Changing Dynamics of the Global Oil & Gas Industry

The global oil market has been at the centre of economic news in recent years. When one examines the degree of vast developments and richness with which oil rich countries in the Middle East, such as Dubai, among others, have attained; this certainly validates the notion of the magnitude of economic prosperity, wealth, and development this resource can bring to a country and its people.

The global oil market has undergone significant changes over the last 10 or 15 years. Underscoring this evolution – two changes have had profound impact on the economics of the oil market. The most significant impact stemmed from the United States (U.S) shale oil revolution: the rapid growth of onshore oil production in the US, typically using hydraulic fracturing techniques to extract oil from shale and other types of so-called tight rocks. The second major change has to do with increasing global concerns about carbon emissions and climate change. The momentum for increased actions is growing – with specific reference to the Paris accord or the recently concluded meeting with major global leaders which saw the US withdrawing their support for the Paris deal. Ironically, when the US temporarily withdrew its support, without much delay, many other countries, including China, strengthened their support in this regard. If this sense of urgency translates into policies, this could have significant implications for the long-term demand for fossil-fuels.

It is worthwhile to mention that while perusing and synthesizing the current body of literature that sought to address the future outlook and projections of oil prices, it was found that those analyses that were conducted by oil companies themselves, projected that global oil prices will increase at a rate of 1.25% annually, in line with a shift in demand from west to east – India and China and will largely be driven by the global transportation sector. Conversely, the inherent flaw with this analysis is that the oil companies ignored the impacts climate change policies will have on oil consumption. Technology is another key factor that will be a major threat to sustainable oil prices in the future. Already, there are developments in the creation of electric cars for example, and these developments will be accelerated and have real implications for oil prices.

The first basic principle of oil is that it is an exhaustible resource. Total stock of recoverable oil resources is assumed to be known and the main focus is on the optimal pace at which these resources should be exhausted. But empirical evidence has shown that in practice, estimates of recoverable oil are increasing all the time, as new discoveries are made and technology and understanding improve. Moreover, they are increasing at a more rapid pace than existing reserves are consumed. Over the past 35 years, in very rough terms the world has consumed over 1 trillion barrels of oil. Over that same period, proven reserves of oil have increased by more than 1 trillion barrels. Put differently, for every barrel of oil consumed, another two have been added. With reasonable certainty, total proven barrels of oil which can be economically recovered from known reservoirs – are almost two and half times greater today than in 1980.

But what is of critical importance now is the growing recognition of the impacts of carbon emissions and climate change. This means it is increasingly unlikely that the world’s reserves of oil will ever be exhausted. These trends and developments will inevitably have a bearing on the world market price for oil, which is unlikely to face an upward trajectory.

What does the changing dynamics of the global energy market mean for the future of oil prices?

With a rapidly changing global environment, there is growing recognition for climate-conscious policies to be advanced globally. This underpins the notion that crude oil will lose its value – a trend that will certainly continue to gain momentum in the foreseeable future. In recent decades, crude was often referred to as ‘black gold’ because it was a commodity known to carry high value on global markets. The highest price was recorded in the last decade in 2008 – at US$140 per barrel until recently.

The international crude oil market is the source for the primary feedstock for creating refined petroleum products using oil refineries across the world. Global production and consumption are increasing and more than 80 million barrels of crude oil are produced each day, according International Energy Agency (IEA) statistics for 2013. Notwithstanding, with the emergence of shale oil coupled with growing concerns about climate change and the environment, the traditional beliefs that were upheld in the past to analyse the oil market are outdated. A new toolkit is needed together with a new set of principles to guide analyses of the oil market. Oil is not likely to be exhausted: Therefore, there should not be a presumption that the relative price for oil will necessarily increase over time.

A key factor governing the future price of oil is whether the standardised, repeated, “manufacturing-like” processes characterising shale production, with the associated rapid gains in productivity, spread to other types of production (Dale, 2015).

The supply characteristics of shale oil are different from conventional oil: shale oil is more responsive to oil prices, which should act to dampen price volatility. It is also more dependent on the banking and financial system, increasing the exposure of the oil market to financial shocks. The Organisation of Petroleum Exporting Countries (OPEC) is a central force in the oil market with respect to one of its key roles in stabilising oil prices. However, when analysing its ability to do so, it is important to consider the nature of the shock driving the change in oil prices and, in particular, whether it is a temporary or persistent factor (Dale, 2015).

The Future of Energy

Energy is a fundamental input for economic systems. Current economic activity depends overwhelmingly on fossil fuels including oil, coal, and natural gas. These fuels are non-renewable. Renewable sources such as hydroelectric, wind, and solar power currently provide less than 10% of global energy. The speed of the transition to renewable sources will be highly influenced by policy choices. Potential policies include increasing energy research and development expenditure, feed-in tariffs, and renewable energy targets. Public policy can also aid in providing capital for renewable energy projects, and in providing a robust electricity grid for moving energy long distances (Timmons et al, 2014).

With higher energy costs, buildings, transportation networks and manufacturing would be redesigned to use less energy. Thus, a large portion of the transition to renewable energy will likely be accomplished not by providing new sources, but rather by redesigning systems to consume less energy. An eventual transition to renewable energy is unavoidable, so the question is how to best manage it, minimising total cost of energy services plus cost of damages caused by energy utilisation. A combination of conservation and renewable energy sources will eventually replace the current fossil-fuel dominated energy system. Therefore, addressing climate change suggests that this needs to happen sooner rather than later (Timmons et.al, 2014). There are currently, huge developments taking place rather rapidly by a number of countries around the world – with the leaders among them being, according to the World Economic Forum, China, India and the U.S.A – to the extent where; (1) Morocco is building a solar power farm as big as Paris, the country wants to be a major supplier of solar energy and its solar power industry is growing rapidly. Morocco will also more than quadruple its solar power by the end of 2018.

Australia was set to install a record-breaking amount of solar power in 2018, which is three times more than it did in 2017, thereby increasing its solar capacity by 70% in 2018. This outcome is driven by soaring electricity costs in Australia; (3) India has built an airport that runs on solar power; (4) Norway wants all its internal flights to be 100% electric by 2040. It will launch its first commercial electric air route by 2025; (5) the Netherlands hopes to build the largest offshore wind farm in the world by 2027, along with a 2.3-square-mile artificial island to support it; (6) China was set to invest some US$360 billion in renewable energy up to 2020 and is leading a global green revolution.

China is the largest producer of solar power; it has installed more wind capacity than the U.S, India and Germany combined and has the world’s largest hydroelectric power plant (World Economic Forum). Among the top three nations, China is the undisputed renewable growth leader, accounting for over 40% of total global clean energy by 2022. This is due to meeting various capacity targets and addressing concerns about the country’s air pollution. In recent months, China has deployed a number of novel technologies designed to clean the air, including a 100-metre-tall smog-sucking tower in the city of Xian. The country has also surpassed its solar panel target for 2020, and according to the IEA, it expects China to exceed its wind target in 2019. China is also the market leader in hydropower, bioenergy for electricity and heat, and electric vehicles (World Economic Forum). Moreover, the cost of renewable energy sources like wind and solar continue to fall drastically, and it was only a matter of time before they were cheaper than fossil fuels. The International Renewable Energy Agency (IRENA) believes that this will happen by 2020. Prices could be as low as US$0.03 per kilowatt-hour for onshore wind and solar photovoltaic projects over the next two years (World Economic Forum).

More interestingly, with respect to upstream oil costs, according to a study done on the, ‘Trends in U.S. Oil and Natural Gas Upstream Costs’ – published in March 2016 – by the U.S Department of Energy; it was found that, “the full cycle project economics, after taking into account operating cost and the fiscal system under the late 2014 cost environment, most of the deep-water current and future projects are forecast to be uneconomic at oil prices below US$50/bbl.  However, from a forward development perspective, most of the U.S. deep water projects will go forward as a significant amount of capital has been invested and operators are vigorously renegotiating their respective contracts to secure the lower rates.”

Ramifications for Guyana

Against the foregoing background, what all of this means for Guyana is that, (1) ExxonMobil and other oil companies in general, will aggressively seek to negotiate oil contracts leaning more in their favor since such investments are huge and extremely risky and, (2) there is no doubt that there exists a great degree of uncertainty surrounding future oil prices. However, with reasonable certainty, one can safely presume that there may be a safe window period of another three decades – five decades in which crude oil will remain at sustainable prices. It is within this context that the oil companies would need to scale up production capacity expeditiously to 1,000,000 barrels per day – at least within the first decade.

Conclusion

Given that major countries are already accelerating climate change policies, designed to transition from a fossil-fuel driven energy system to renewable energy, all the requisite combined investments will amount to hundreds of billions of U.S. dollars. This ultimately means these developments are going to have a direct impact on global oil prices which will be on a downward trajectory eventually. The ultimate effect would be that global demand for crude oil will fall steadily until it will reach to a point where it may no longer be feasible.

About the Author

Joel Bhagwandin is a finance professional and researcher, a junior business executive and entrepreneur, lecturer and thought leader. Joel is actively engaged in providing insights and analyses on a range of public policy, economic and macro-finance issues for the past 5+ years. In this regard, he has authored more than 300 articles covering a variety of thematic areas in public policy and macro-finance. Joel has more than fourteen years’ experience in banking, corporate finance, management, consulting, and academic research. Academically, Mr. Bhagwandin is the holder of a MSc. in Business Management (Banking) from Edinburgh Napier University. His specialties and skills include Corporate Finance, Banking, Capital Markets & Securities, Financial Risk Management, Business Intelligence & Data Analysis. Joel is currently pursuing his second MSc. in Finance (Economic Policy) through the University of London – and simultaneously, several professional financial analysts’ and risk manager certifications through the Corporate Finance Institute (CFI) and the Global Association of Risk Professionals (GARP), respectively.

spot_img

Latest News

Exxon’s biggest discoveries in Guyana to date

ExxonMobil had been on the hunt for black gold in Guyana’s offshore Stabroek Block since 2008 before it hit...

More Articles Like This

spot_img