Of all the legal contracts in the oil and gas industry, one of the most significant is the production sharing agreement. It’s used as an instrument by all parties to realize a quick return on their investments and increase revenue as much as possible while sharing out the risks.
PSAs got their start in Asia and Africa, where the national oil companies (NOC) and the international oil companies (IOC) wanted to partner up to develop new gas and oil fields, particularly offshore. Now they are increasingly used with horizontal drilling and for unit-line or leased-line allocation wells.
Let’s dig a little deeper into the definition of a production sharing agreement (PSA), its purpose, key elements, benefits, and issues.
Defining a Production Sharing Agreement
A production sharing agreement (PSA) is a legal contract between one or more investors and any governmental entities to lay out the rights, duties, and obligations of each party for exploration, development, and production of mineral resources in a specific location for a specific time.
Typically, the agreement is between the host country, where the minerals are located, and the parties who wish to drill and operate in that country. The contract regulates the percentage of oil and gas production that each party receives after the recovery of a specific amount of cost and expense by all parties.
PSAs grant certain rights, such as exploration and production, from the host government to an international oil company to prospect and develop resources.
The Purpose of a PSA
Also known as PSCs (production sharing contracts), PSAs allow the host country, sometimes called the national oil company or NOC, to maintain a certain amount of control over the development of oil and gas within the country. The agreement also helps NOCs gain the expertise they may lack for exploration and development of hydrocarbons within their borders.
NOCs gain the expertise they need through the international oil companies (IOCs) with whom the agreement is signed. IOCs typically bring the technology and expertise in strategic decision making to the table. In many ways, most of the risks of oil and gas development within these agreements fall on the IOC.
The PSA also outlines how costs and profits are to be shared from a particular oil or gas field from the very start.
- Capital expenditures for exploration
- Development and operational expenditure for normal operations
- Profits once production begins
Although the IOC shoulders most of the risks, the more the IOC contributes in the early phases, the higher the share it can expect in return.
Types of PSAs
PSAs come in four types:
- Full cost recovery, deferred profit shares.
- Full cost recovery, deferred profit shares, with first tranche (one-third of awarded) hydrocarbons.
- Capped cost recovery, simultaneous profit shares.
- First tranche hydrocarbons, capped cost recovery, simultaneous profit shares.
Each party to the contract must agree on the best cost recovery strategy. The primary differences are in the way gross revenues are shared and how the profit pool is split between parties. These decisions add to the complexity of the contract, with many decisions required before signing.
NOCs prefer agreements that specify the work commitment and financial obligations while the IOCs prefer maximum discretion in such obligations.
Key Element of a PSA
The IOC takes on most or all of the costs and risks of exploration. The NOC begins or increases its contribution after minerals are found, and the site is developed into a production unit with normal operations.
The PSA is most beneficial to the NOC because it provides time to generate momentum for project management. Also, the NOC can develop new fields and reservoirs with no risk and little cost to itself.
Benefits of PSAs
The host country (NOC) hires the international oil company (IOC) to perform the exploration and production work at its own expense. If no hydrocarbons are found, the NOC loses little to nothing and owes nothing to the IOC.
It sounds like PSAs are a lousy deal for IOCs, but there are benefits for oil companies as well as host countries.
- A variety of cost recovery strategies for both NOC and IOC.
- The transfer of knowledge from the IOC to the NOC, meaning all the strategic decisions and technology are brought to the table by the IOC.
- Reduced risk for the NOC.
In countries where expertise in the oil and gas industry is sparse, oil companies provide the muscle and know-how while the host country provides the place.
Issues with Production Sharing Agreements
As noted before, PSAs can be complicated. Parties often disagree about various parts of the contract. Because both parties are trying to maximize revenue and minimize risk, it isn’t surprising that agreements that seemed pretty clear at signing receive differing interpretations from a party under stress.
Some of the arguments stem from the amount of time the agreements are in place. Personnel and process changes on both sides can change the understanding of the contract language. Changes in fiscal practices or political problems in-country can create other issues. Non-aligned operating or subcontractor agreements and economic cycles cause a few.
Tensions from what may be called “cost oil” develop from the difference in desires of the IOC and NOC. The IOC wants a guarantee that upfront costs are recovered. The NOC doesn’t want to allow cost recovery unless it sees these costs as having been “properly incurred.” The NOC wants proof of efficiency and due diligence on the part of the OIC before awarding any money.
So-called “profit oil,” which is the allocation of production left after “cost oil,” is also controlled by the PSA. The NOC wants profit oil right as soon as possible, regardless of what is going on with cost oil. Usually, a tax windfall or oil and gas royalty arrangement has something to do with it. Since tax rates can be 60% to 80%, it isn’t surprising the parties would like a hedge against taxes.
For example, IOCs prefer a stabilization agreement to buffer such early profit-taking to make sure taxes and other financial arrangements already in the PSA are not replaced by NOCs trying to puff up government revenues.
The expiration of the PSA can cause problems as well. There may be disagreements about everything from the transfer of operations to the accuracy of asset register or termination cost accruals. Most of the problem lands on the IOC in these cases, so the contractor typically works to get the most possible out of a field before the PSA ends.
Production sharing agreements within the United States are also possible, between the lessor (acting in place of a NOC) and the lessee (operating in place of an IOC). However, these agreements don't have the same track record as they do internationally, and they are poorly understood. Typically, a PSA is introduced for an allocation well that royalty owners of tracts crossed by the wells have agreed to share production.
All the same issues are still there - the complexity of the agreement and disputes about money. There isn’t even agreement in some states about whether allocation well drilling is allowed by a lease. In all cases, a good deal of money is at stake. If you decide to enter into a PSA, talk with a knowledgeable attorney.