International (Upstream) Petroleum Agreements. Negotiating a Petroleum Contract

1. International (Upstream) Petroleum Agreements.Negotiating a Petroleum Contract

2. Summary • What are the kinds of host State-investor agreements available and their characteristics. • What are the arguments “for and against them”? • Stabilization Clauses • Unitisation Agreements • NOC-National Oil Company, HC-Host Company • IOC- International Oil Company, Contractor

3. TYPES OF CONTRACTS AGREEMENT • PSC/PSA Product Sharing Contract/Agreement • Concession (Tax-and-Royalty) • Participation/Joint Venture/Association • Service Contract WHAT IS A PSC/A? “A contractual agreement between a contractor and a host government whereby the contractor bears all of the exploration costs and risks and the development and production costs in return for a stipulated share of the production resulting from this effort”

4. THE PSC (1) • All PSC regimes share one basic aim which is to establish a balance between the host country take and the contractor take • The Oil/Gas company is named as CONTRACTOR by the host country or its NOC & is given exclusive E&P rights • Contractor operates at sole risk and expense under the control of the host country • Any resources are owned by the host country • Usually the contractor is allowed to recover all costs from the production from the Contract Area under the Cost Recovery provisions

5. THE PSC (2) • After Cost Recovery, the balance of production is shared on a predetermined % age split between host country & contractor • Profits of companies comprising contractor are taxable • Data, equipment & facilities become the property of the host country at some point (when brought into the country, on construction, on completion of costs recovery or at contract termination) • Term of contract is fixed so Govt determines extensions. WHERE ARE PSC’S USED? • India,China,Kazakhstan,Libya,Nigeria,Algeria, Angola, • Indonesia,Mauritania,Egypt,Trinidad & Tobago and Russia

6. Sharing the Barrel • Royalty “off-the-top” • Cost Recovery Oil (costs recoverable in year up to maximum) • Treatment of “excess” Cost Oil • Profit Oil: • Government share • Contractor Profit Tax • Contractor “profit” share Fixed Variable

7. ADVANTAGES OF PSCS • State • Title to hydrocarbons • Convenient • Managed return • Flexibility in event of volatile prices • Resource management • Self contained • Contractor • Stability (fiscal regime is known) • Reserves can be `booked’ • Tried and tested all over the world so is familiar • Creates own law

8. DISADVANTAGES OF PSCS • Host country inexperience in some cases • Improperly supervised cost recovery may result in “gold-plating” or worse • Even well-calibrated volumetric sliding scale fails to account for high-cost fields • Often “impure”: mixed with royalty, tax, lease, local market obligations, and/or carry of government company

9. CONCESSION CONTRACTS • Rights to oil and gas in the ground (jus in rem) • Mining Code +Licence +Civil law Contract • Fiscality usually: • Royalty = percentage of gross (“off-the-top”) production “won and saved” • Tax on Net Income • other taxes and duties

10. Conceding the barrel • Royalty • Investor gross income: • Investor profit tax • Other taxes and duties • Investor profit Fixed Variable

11. Advantages of Concessions • Familiar legal status • Simple calculations • Royalty ensures early and predictable cashflow to Government • Investor feels secure in rights to resource in the ground

12. Disadvantages of Concessions • Psychological disadvantages • foreign entity has control of national patrimony • affront to sovereignty of independent nation • Practical disadvantages • Fiscal: • Royalty is inflexible rent-sharing instrument • General Income/Profits Tax may be too low • Operational • Foreign company has free reign

13. PARTICIPATION/JOINT VENTURE ARRANGEMENTS • Meaning of “Participation” • real: creation of new legal entity with integrated staff • virtual: NOC as sleeping partner • Meaning of “Joint Venture” • old: creation of new entity • now: except in FSU, US-style unincorporated joint operation; FSU = new project company

14. PARTICIPATION Cont. • Participation or Association NOT separate contractual form • Government/NOC can “participate” in any of the usual forms • Not theoretically compatible with PS but often found (Algeria) • Association: in francophone areas investor-NOC or even investor-gov’t agreements

15. SERVICE CONTRACTS • Seen as putting State contracting party or NOC in more “Sovereign” position • Contractor has no legal or economic interest in oil reserves or even production • Exploration or development risk: contractor compensated by “fee” based on either: • Investment, or • Barrels produced (sometimes above a baseline)

16. SERVICE CONTRACTS Cont.. • Iraq (replaced by PSC) • Iran (“buy-back”, still popular for political reasons) • Nigeria (being phased out) • Americas: • “Risk Service”: Brazil, Venezuela, Ecuador • Mexico: “pure” Service

17. Service Contracts, Cont. • Government share • Contractor fee • Contractor tax

18. What Choices of Law are Possible? • In designing a choice of law clause, the parties may stipulate (1) one or more national laws such as the law of one of the parties or of a third party or a combination of national laws; (2) public international law; (3) a legal system that is sui generis and established by the contract itself (impractical); (4) transnational law such as UNIDROIT Principles, or (5) a combination of these.

19. Choices of Law are Cont... • They may elect not to make a choice however, agreeing to perform their contract in good faith or to empower the tribunal to determine the dispute ex aequo et bono or as amiable compositeurs.

20. Example 1 • LIBYA • This Concession shall be governed by and interpreted in accordance with the principles of law of Libya common to the principles of international law and in the absence of such common principles then by and in accordance with the general principles of law, including such of those principles as may have been applied by international tribunals.”

21. AZERBAIJAN • “This Agreement shall be governed and interpreted in accordance with principles of law common to the law of the Azerbaijan Republic and English law, and to the extent that no common principles exist in relation to any matter then in accordance with the principles of the common law of Alberta, Canada (except for laws regarding conflicts of laws). This Agreement shall also be subject to the international legal principle of pacta sunt servanda (agreements must be observed).”

22. Stabilization-Definition • In the context of an international petroleum agreement, stabilization means: “All of the mechanisms, contractual or otherwise, which aim to subject the contract provisions to specific economic and legal conditions which the parties considered appropriate at the time that the contract was concluded”

23. Why is Stability an Issue? (1) For the investor • Risk-reward relationship means that the investor seeks an assurance of long-term stability to secure reward for initial risk (if successful) • Vulnerability of large investments from development stage + with fixed infrastructure (pipelines) • Weakness of investor in face of host government determined to take unilateral action • History of petroleum industry shows threat is real

24. Why is Stability an Issue? (2) • For the host government • There are legitimate areas in which the State may act unilaterally, such as in non-contractual areas that are not subject to a stabilization clause – example: the fiscal environment in the UK N Sea has been unilaterally changed many times • Fashion/waves.

25. Unilateral HG ActionExamples of Direct Action • An increase in the applicable tax/royalty rate or tax base; • Imposition of new taxes/royalties; • Revisions to PSC calculation of cost petroleum/profit split; • Increase in % of HG participation • Change in allocation of management and control over operations between HG and IOC; • Increase in or imposition of restrictions on IOC’s right to monetise a discovery/right to export/obligation to market petroleum within the host country

26. UNILATERAL HG ACTIONPOTENTIAL FOR INDIRECT ACTION • Changes to overall tax environment; • Approval for field development plan; • Powers to issue other permits; • State’s right to veto proposed annual budgets; • Powers over local content; • Investor’s liability over project delay; • Use of environmental compliance powers (used in Russia 2006-2007; these are not usually stabilized)

27. HOW TO STABILIZE? • A favoured option - the Stabilization Clause i-FREEZING: “contract language which freezes the provisions of a national system of law chosen as the law of the contract as to the date of the contract in order to prevent the application to the contract of any future alterations of this system” (Amoco International Finance v Iran)

28. Example: • Mozambique • “The Government will not without the agreement of the contractor exercise its legislative authority to amend or modify the provisions of this Agreement and will not take, or permit any of its political sub-divisions, agencies and instrumentalities to take, any administrative or other action to prevent or hinder the Contractor from enjoying the rights accorded to it hereunder” • Chile: • “The tax regime, benefits, privileges and exemptions provided in any of the articles hereof… shall remain invariable for the duration thereof”

29. ii-Economic Balancing: • The more popular modern approach to stabilization in a petroleum agreement is to include a provision which states that: If the host government adopts a measure subsequent to the conclusion of the petroleum contract in which the fiscal terms are stated, that is likely to have damaging consequences to the economic benefits for one or both of the parties, a re-balancing will take place.

30. Example(Egypt) • “In case of changes in existing legislation or regulations applicable to the conduct of Exploration, Developmentand production of Petroleum, which take place after the Effective Date, and which significantly affect the economic interest of this Agreement to the detriment of CONTRACTOR or which imposes on CONTRACTOR an obligation to remit to the A.R.E. (Arab Republic of Egypt) the proceeds from sales of CONTRACTOR’s Petroleum, CONTRACTOR shall notify EGPC (the NOC) of the subject legislative or regulatory measure. In such case, the Parties shall negotiate possible modifications to this Agreement designed to restore the economic balance thereof which existed on the Effective Date.”

31. Force Majeure • For the purposes of this Agreement, “Force Majeure” shall mean circumstances which were beyond the reasonable control of the Party concerned and shall include strikes, lockouts and other industrial disturbances. TAKE OR PAY

32. UNITISATION & JOINT DEVELOPMENTDrilling at Oil Creek 1861

33. “Interfering” wells on adjoining leases

34. 1. Why does unit development happen? • Geological character of petroleum: fugacious character – it moves ‘like a wild animal’ and so can be ‘captured’ • Initial response: the rule of capture • US case of Brown v Spillman: “If an adjoining owner drills his own land and taps a deposit of oil or gas, extending under his neighbour’s field, so that it comes into his well, it becomes his property”

35. THE RULE OF CAPTURE • The owner of a tract of land acquires title to the oil and gas which he produces from wells drilled thereon, although it may be proved that part of such oil and gas migrated from adjoining lands. • In practice complex issues arise even in US law: directional drilling under another’s property is trespass, not ‘capture’

36. The Law of the Sea Act 77 & the Rule of Capture • “The coastal State exercises over the continental shelf sovereign rights for the purpose of exploring it and exploiting its natural resources • The rights referred to (above) are exclusive in the sense that if the coastal State does not explore the continental shelf or exploit its natural resources, no one may undertake these activities without the express consent of the coastal State • The natural resources referred to in this Part consist of the mineral and other non-living resources of the seabed and subsoil…”

37. But • Problems of proof • How much oil was there in place? • Is there a forum for a dispute? • State to State • Company to Neighbouring State • Company to Company

38. Solutions & Definitions • Purposes of Unitisation • The Unit Agreement • Oil versus Gas (note US differences) • Area, depth and number of fields • Voluntary and compulsory unitisation • Adaptability to changing circumstances

39. 2. Key Issues in Unitisation Agreements (1) • Unit Area and Extension • Unitised Substances • Effect of Unitisation • Timing • Passmark • Tract Participations & their determination • Unit Interests • Technical basis of determination

40. Key Issues in Unitisation Agreements (2) • Re-determinations - examples • Number and Timing • Unit Decision Making • Non-unit operations • Procedure

41. DISCRETIONARY UNITIZATION CLAUSES Thailand (1971 Petroleum Act): Section 72. For the purpose of the conservation of petroleum resources or of good petroleum industry practice, in case where concessionaires have their production areas covering the same petroleum reservoir, the Minister shall have the power to require such concessionaires to produce petroleum under the unit operation. Angola (1997 Production Sharing Agreement): Art. 27(1). In the event of there being petroleum deposits, capable of commercially viable development which extends beyond the contract area, and where other entities have agreements for the exploration and production of petroleum with a similar unitization provision, SONANGOL may . . . require that the petroleum in those deposits should be developed and produced in mutual co-operation.

42. NON-DISCRETIONARY UNITIZATION CLAUSES Indonesia (Government Decree 35, 2004) A Contractor is required to conduct unitization if it is proven that its reservoir extends into another Contractor’s Work Area. China (Model Contract 1995) 11.7 In the event of an oil field and/or gas field straddling a boundary, CNPC shall arrange for the contractor and the neighbouring parties to work out a unitized overall development program for such oilfield and to help negotiate the relevant provisions thereof

43. 4. Cross-border or International Unitisation • What does it mean? Example of Frigg • International law requirements - UNCLOS • Intergovernmental agreements • Border in dispute or not • Cross-border unitisation agreement

44. Example: Norway – UK Delimitation Treaty:

45. Frigg Gas Field – North Sea Frigg: • Discovered 1971(Norwegian licence) • Seismic survey demonstrated extension into UK • Norwegian operator (Elf) and UK operator (Total) agreed to conduct all pre-unitisation work jointly from late 1971 • Unitisation negotiations commenced 1972, and preliminary studies concluded with 57% of the field on the Norwegian side and 43% on the UK-side.

46. Frigg (2) • The problems began: • National laws considered obstacle for joint development; • UK operator wanted to develop the UK side independently, while the Norwegian Government called for a parallel development; • UK appraisal well was dry

47. Frigg (3) • Differing views • UK side: • reservoir contained between 240 and 285 Bcm (approx. 3 Tcf) gas • between 52 and 55% of the reservoir was on the NCS • Norwegian side: • reservoir contained between 234 and 291 Bcm gas • between 65 and 66% of the reservoir was on the NCS • Difference mainly based upon seismic interpretation and location of trap

48. Frigg (4) • Attempts at solving the problem • A joint work group established • Agreed to shoot new seismic profiles from discovery well • Norwegian Government renounced the demand for a parallel development • French licensees agreed to unitise, but insisted on development of the UK part first, which would require the landing of the gas in St. Fergus (UK). • Norwegian government agreed in January 1973 to land the gas in St. Fergus • But the field determination issue was still unresolved ...

49. Frigg (5) • The solution: • Although the joint work group consisted of engineers and geologists, the company loyalty prevented an agreement • All parties then agreed to hire consultants, and the US-based firm DeGoyler & MacNaughton was contracted • All parties, incl. representatives from the Norwegian and UK Governments met with the consultants on 18 May 1973 in order to further specify the objective: • The consultant would determine the boundaries of the reservoir, estimate the total volume of gas and determine the Norwegian/UK tract participation by 30 September 1974 • All partners agreed to accept the result the consultants came up with. The Norwegian and the UK Governments said they would await the results before accepting.

50. Frigg (6) • Unitisation Agreement • signed 9 July 1973 • recognised the field as one unit • the respective licencees’ final participating share dependant upon the consultants’ report • Development approved by UK and Norwegian Governments 1974