Types of oil and gas agreements

Fiscal Regimes: Types of Oil and Gas Agreements

Oil and gas are important finite natural resources that require strong collaborative efforts between the rights owners and developers for efficient exploration, extraction, production, and processing. Take note that these activities are subjected under considerable government regulations. In addition, determining the scope and limits of this collaboration is a critical upstream activity within the oil and gas industry.

Countries with proven or suspected oil and gas reserves, particularly those that not have production capabilities, have developed and implemented legal structure that defines the roles and responsibilities of the mineral rights owner or lessor and the developer or lessee. On the other hand, most of these developers or lessees are international foreign entities or multinational companies capitalizing on the oil and gas reserves of a particular country. However, some countries, especially experienced oil and gas exporters, have locally-owned national companies.

This article lists down and describes the types of oil and gas agreements between states or mineral rights owner and developers or lessees, as well as the advantages and disadvantages of each. Take note that oil and gas agreements are also referred to as licensing systems or fiscal regimes.

Fiscal regimes: Three major types of oil and gas agreements

1. Concession System

A concession or a concession agreement is a type of contract between a state or mineral rights owner and a company that provides the former with the right to operate a business with the jurisdiction of the latter based on negotiated terms and conditions.

Within the realms of oil and gas agreements, concessions are the oldest type of contracts that first emerged during the 1800s oil boom in the United States and became pervasive in the Middle East starting with the oil boom in Saudi Arabia.

A concession agreement is theoretically based on the American concept of land ownership in which resources on the surface and under the ground are owned by the recognized landowner. In a specific concession agreement, the landowner grants another entity or company exclusive rights to explore and own the resources and reserves. This company is responsible for providing capital and capabilities needed to explore, extract or produce, and process oil or gas deposits.

In the case of an oil and gas concession, the company is the lessee and the state or mineral rights owner is the lessor. Primary benefit to the lessee comes in the form of ownership over the oil or gas reserves while benefit to the lessor comes in the form of tax and royalties derived from productive economic activities.

2. Production sharing agreement

A production sharing agreement or PSA, which is also known as a production sharing contract or PSC, is another type of oil and gas agreement, specifically a type of a contractual system that was first introduced by Indonesia in 1966.

Indonesia has regarded concession agreements as a legacy of imperialistic and colonial periods and it has promoted and positioned PSA as part of its resource nationalism movement. Subsequently, since the 1960s, PSAs have become a preferable type of oil and gas agreements in different countries in Asia and Caucasus.

Unlike concessions nonetheless, a PSA does not grant a lessee with ownership over the oil or gas resources and reserves. Ownership and rights remain within the state. However, this ownership is considerably partial. This is because PSA allocates part of the oil or gas income to the cost of exploration, extraction, and production. Once these costs are covered, the state and the company split the rest of the income based on agreed percentage division.

3. Service contracts

Similar to a PSA and unlike a concession, a service contract or service agreement is another type of a contractual system that does not confer ownership of oil or gas resources and reserves to an involved hydrocarbon company. However, unlike a PSA, the involved company is not actually a lessee but a mere service contractor that does not have any right over the economic gains from oil or gas production.

In other words, a service contract tasks a involved or contracted company to develop a particular land area for productive economic activity. This company provides capabilities for exploration, extraction, and processing of oil or gas, thus receiving payment from the state for providing such services. Note that the income received by this company can still be subjected under a corporate income tax and a special tax arrangement.

This setup was first introduced in Argentina during the 1950s. Two subsets of service contracts later emerged: pure service contracts and risk service contracts. Pure service contracts involve fixed contract price as the only source of revenues for the contracted company. A state essentially commissions a company to provide capabilities for oil or gas exploration, extraction, and production. Meanwhile, risk service contracts involve giving the contracted company a share of oil or gas revenues, granted that it is solely responsible for shouldering oil or gas exploration expenses.

Advantages and disadvantages of each oil and gas agreement

1. Advantages and disadvantages of concession

The primary advantage of this type of oil and gas agreement or fiscal regime is that it is straightforward. Unlike PSAs and risk service contracts, negotiation is less complex. Simply put, a state or mineral rights owner benefits from a concession due to the simplicity of the agreement.

Another advantage of a concession is that the lessee absorbs all financial risks, including the costs of oil exploration. In case there is a failure to determine the existence of an economically viable oil or gas reserve, financial burden is largely shouldered by the lessee.

There are undesirable offshoots, however. One disadvantage of concession is that a lessor may have a hard time looking for a company that is willing to provide exploration, extraction, and/or processing capabilities due to the high financial risks. Another disadvantage is that nationalists deem concessions as a form of Western exploitation and a remnant of imperialism.

2. Advantages and disadvantages of production sharing agreement

Similar to a concession, one of the major advantages of a production sharing agreement is that the lessor does not need to make a significant amount of investment. This also means that a PSA can be relatively disadvantageous to a lessee. After all, under this type of oil and gas agreement, the lessee shoulders all operational and financial risks.

Resource nationalism is another advantage of PSA. Sectors that oppose substantial foreign influence over an economy and control over critical natural resources readily endorse a production sharing agreement because of its inherent pro-nationalism characteristics.

One notable disadvantage of a PSA that concerns a state or mineral rights owner is the involved complexity. This type of oil and gas agreement is very complex in structure and it requires high level of negotiation. A lessor must have access to financial and commercial, legal, environmental, and technical expertise.

3. Advantages and disadvantages of service contracts

Absolute ownership over the land and oil or gas deposits is the major advantage of service contracts. Similar with a PSA, this type of fiscal regime favors resource nationalism.

However, service contracts are not for everyone. A primary disadvantage of a pure service contract is that it places substantial operational and financial risks on the state or mineral rights owner. On the other hand, a primary disadvantage of a risk service contract is that the involved oil company or contractor shoulders all exploration expenses. This means that if no oil or gas is found, the contractor bears the cost.

A note on the different types of licensing systems or fiscal regimes

Remember that the aforementioned types of oil and gas agreements between a country or state and an oil and gas company are also referred to as licensing systems or fiscal regimes. In general, these systems or regimes are categorized either as a concessionary system or a contractual system. Obviously, all concession agreements fall under a concessionary system while product sharing agreements or product sharing contracts, pure service contracts, and risk service contracts are categorized under a contractual system.