Oil and gas are economically important finite natural resources that require strong collaborative efforts between the rights owners and developers for their efficient exploration, extraction, production, and processing. The scope and limits of this collaboration through oil and gas agreements are a critical upstream activity within the oil and gas industry.
Countries with proven or suspected oil and gas reserves, particularly those that do not have production capabilities, have developed and implemented a legal structure that defines the roles and responsibilities of the mineral rights owner or lessor and the developer or lessee. Most of these developers or lessees are international foreign entities or multinational companies capitalizing on the oil and gas reserves of a particular country. Several countries or experienced oil and gas exporters have locally owned national companies.
The agreements between main parties in the oil and gas industry are also called fiscal contract regimes, fiscal regimes, or licensing systems. This article lists and describes or explains the different types of oil and gas agreements or fiscal regimes between states or mineral rights owners and developers or lessees, as well as the advantages and disadvantages of each.
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 within the legal territories of the latter based on negotiated terms and conditions. It is the oldest type of contract within the realms of oil and gas agreements that first emerged during the 1800s oil boom in the United States and became pervasive in the Middle East starting with the oil exploration and subsequent oil boom in Saudi Arabia.
This 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.
Nevertheless, in the case of oil and gas concession, the company is the lessee and the state or mineral rights owner is the lessor. The primary benefit to the lessee comes in the form of ownership over oil or gas while the main benefit to the lessor comes in the form of tax and royalties derived from productive economic activities. This means that the country or the owner of the land in which the oil or gas is deposited receives income through economic rent paid by the company responsible for extracting the resources.
2. Production Sharing Agreement
A production sharing agreement or PSA is another type of oil and gas agreement that was first introduced by Indonesia in 1966 as part of its resource nationalism movement. It is also known as a production sharing contract. Indonesia regarded concession agreements as a legacy of imperialistic and colonial periods. The development and eventual promotion of production sharing agreements mark the attempt of countries with proven oil or gas reserves to have better control and maximize the benefits of their natural resources.
These agreements have become preferable among the different types of oil and gas agreements in Asia and Caucasus since the 1960s. A specific PSA centers on a government granting an oil and gas company or contractor exploration rights and a priority right to recover the costs from exploration and other activities needed to start oil or gas extraction and production. The earnings after the costs are recovered are then shared between the government and the contractor on an agreed percentage division. This is called profit sharing.
It is interesting to note that this fiscal regime stands in stark contrast with concession agreements because it does not grant a lessee ownership over the oil or gas resource. Ownership and rights remain within the state. This ownership is still considered technically partial. This comes from the fact that the agreement allocates part of the oil or gas income to the cost of exploration, extraction, and production. Hence, once these costs are covered, the state and the company split the rest of the income based on the agreed percentage division.
1. Risk Service Contracts
A risk service contract does not confer ownership of oil or gas deposits to the involved oil and gas company. This makes it similar to a production sharing agreement and different from a concession agreement. However, unlike a production sharing agreement, the involved oil and gas company is not considered a lessee but a mere service contractor or service provider that does not have any right over the economic gains from oil or gas production. The entire setup is similar to agreements used in the construction of public infrastructure.
The owner of the land where the oil or gas reserves are deposited essentially hires a company for exploration, extraction, and production purposes. More managerial and technical risks and responsibilities are also placed on the service provider in exchange for a considerable amount of service fee. This means that the government or landowner has limited involvement in all the decision-making requirements related to all exploration efforts and even in all activities related to the operations of productive oil and gas fields.
Nevertheless, based on the setup, a risk service contract is a fiscal regime that gives the involved oil and gas company the task of developing a particular property for productive economic activity. The capital needed for the exploration, extraction, and processing of natural resources is shouldered by the government or landowner. This capital is used to hire the expertise, technical capabilities, and other resources of the service provider. The income of this company is still subject to corporate income tax or is given special oil taxes.
Advantages and Disadvantages of These Oil and Gas Agreements
1. Advantages and Disadvantages of Concession Agreement
The primary advantage of this type of oil and gas agreement is that it is simpler. The negotiation process is less complex compared to production sharing agreements and risk service contracts. A government or the mineral rights owner benefits from this fiscal regime due to its straightforward nature that requires less oversight and technical capabilities.
Another advantage of a concession is that the lessee absorbs all financial risks. These include the costs of exploration and field development. Furthermore, in case of failure to prove productive oil or gas reserves, the financial burden is shouldered by the lessee.
This system has undesirable offshoots. One disadvantage of concession is that a lessor may find a hard time looking for a company that is willing to provide exploration, extraction, and 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
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 is similar to a concession system. This also makes this fiscal regime relatively disadvantageous to a lessee because it shoulders all risks associated with the exploration and operation of productive fields.
Another advantage of this type of oil and gas agreement is that it promotes and secures resource nationalism. Local groups that oppose substantial foreign influence over an economy readily promote this fiscal regime because it is inherently pro-nationalism.
One notable disadvantage of a production sharing agreement 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 a high level of negotiation. A lessor must have access to financial and commercial, legal, environmental, and technical expertise.
3. Advantages and Disadvantages of Risk Service Contracts
Absolute ownership over the land and oil or gas resources or reserves is the major advantage of risk service contracts. This advantage benefits the state or the mineral rights owner. Hence, due to the ownership over the land and resources or reserves, this fiscal regime promotes resource nationalism similar to a production sharing agreement.
This is not for everyone. A primary disadvantage of risk service contracts is that they place substantial operational and financial risks on the state or mineral rights owner. The lessor shoulders the exploration and production capital.
It is also important to underscore the fact that the high capital requirements and substantial financial risks make this type of oil and gas agreement accessible to deep-pocketed countries or rights owners. Those who do not have a considerable amount of financial resources cannot operate their oil or gas industries under this fiscal regime. Their options are limited between a concession system and a production sharing agreement.
