TCS Daily


Misunderstanding Production Sharing Agreements

By Tim Newman - March 7, 2007 12:00 AM

Much outrage has been howled and many teeth have been gnashed in the last few days as a new law regarding Iraq's oil and gas reserves has been passed by the fledgling Iraqi government. The law grants Iraq's Federal Oil and Gas Council the power to enter into Production Sharing Agreements (PSAs) with foreign oil companies. For many of those who opposed the American-led invasion of Iraq in the first place, this serves as evidence that the war was all about placing Iraq's immense oil and gas reserves under the control of American oil companies.

The new law "represents no less than institutionalized raping and pillaging of Iraq's oil wealth," screamed one columnist in the Asia Times, and according to the Guardian newspaper in backing the new law the US is pursuing an "agenda of privatising and selling off Iraq's oil resources" to major oil corporations. The reasoning goes that in passing this new law, Iraq's Federal Oil and Gas Council is a puppet organisation doing the bidding of its masters, who are the usual band of unnamed "Big Oil" executives of the major US oil companies Exxon-Mobil, Chevron-Texaco, Conoco-Philips, and - if the journalist in question really wishes to reveal his or her ignorance - Shell and BP, who aren't American but fit nicely into the roll-call of evil corporations stripping ordinary Iraqis of their oil wealth.

These articles denouncing the new law are numerous and can be found in any left-leaning newspaper or website you care to consult, but where they are long on passion and outrage they are short on basic understanding of Production Sharing Agreements.

PSAs are essentially a vehicle to enable a country with proven hydrocarbon reserves but not the means to extract them to entice foreign capital investment into the country when the risks to ordinary investors are higher than normal. They were first set up in the 1960s but grew to prominence in Russia during the Yeltsin years when several major western oil companies signed PSAs to extract oil and gas in Siberia and the Russian Far East.

At the time they were signed in the mid-1990s, Russia's currency was highly unstable, its businessmen were being gunned down on the street, the mafia ran both the police and the law courts, and it was not the place where a western company would invest enormous sums of money in the normal manner.

However, Russia desperately needed foreign money and expertise to kick-start its creaking oil and gas industry by building several large, new facilities for the development of new fields. It looked to do so, and did so successfully, using PSAs with western oil companies.

The similarities with Iraq are obvious: Iraq has proven oil reserves but decades of war and crippling sanctions has left the country with decrepit infrastructure and without the means to extract its oil safely, efficiently, and to the maximum potential. The Iraqi government desperately needs the revenues that oil production and exportation would bring, but does not have the capital to rebuild the infrastructure itself. Furthermore, the sectarian violence and threat of civil war dissuade foreign money and expertise from being invested in Iraq in the normal manner. Therefore, like Russia a decade before it, Iraq is turning to PSAs as a solution to their predicament.

Under the terms of a PSA, a foreign oil company is granted access to a country's oilfield and allowed to build the necessary infrastructure to allow it to extract, process, and export the hydrocarbon product. The foreign company pays for the construction of the facilities, which often runs to the tune of several billion dollars, although usually the construction activities are exempt from normal taxes and customs duties for the import of material and equipment. Once built, the foreign company then owns, operates and maintains the facility for an agreed period of time.

Crucially, and this is what most of the outraged commentators don't understand, under the terms of a PSA the country - not the oil company - retains ownership of all production and the entire oilfield throughout the agreement. In return for building and operating the facility essentially for free, the country in question then grants the oil company a share of the production and keeps the rest for itself: hence the name Production Sharing Agreement.

The size of the share is agreed in advance, and is calculated depending on the size and cost of the facilities being built and the longevity of the agreement. But whatever the size of the respective shares, one thing is guaranteed: if the oil company can make enormous profits by selling its share of the production, the country can do exactly the same with its own share - and indeed make even more, because it has not paid a penny for its extraction. Once the agreement has expired the facility is handed over to the country lock, stock, and barrel and they assume responsibility for its continued operation and maintenance. The oil company, under the terms of the agreement, simply walks away.

Many of the critics of PSAs point to Russia's insistence on their own PSAs being renegotiated mid-way through the contract period as proof that they serve the interests of big oil companies at the expense of the country in question. However, when such cases are examined in detail it becomes apparent that the lesson learned from the Russian PSAs are not that they unfairly reward the oil company at the expense of the country, but that oil companies must be extremely careful about which countries they enter into such agreements.

As has been said, at the time the Russian PSAs were signed, ordinary investors were giving Russia a wide berth and the government was becoming increasingly desperate to attract the necessary foreign capital and expertise to get its oil and gas industry up and running. Ten years on, Russia is a very different place: the currency is stable, government institutions have matured, law and order has been restored (to a point), and in addition the oil price has risen considerably from the prevailing price on which the PSAs were originally made. The Russian government has noticed that the bulk of foreign investment has already been made with the enormous production and processing facilities nearing completion, and decided that in light of current conditions it is getting a raw deal out of the agreements it signed some ten years ago. Certainly, Russia would have no need to enter into a PSA with a foreign oil company at the present time, but at the time the agreements were made they were the only available option to an ailing Russian state. In any normal country it would be expected that the government would honour its prior agreements regardless of how they are viewed with hindsight. But this being Russia the government has tried, successfully, to strong-arm its way into renegotiating the agreements on terms more favourable to itself. It is understandable why this may be construed as an effort to right previous wrongs carried out in the Yeltsin years, but this view would be mistaken. Russia did not do badly out of the PSAs, it has simply realised that now the foreign investment has been made it can do a whole lot better if it does not have to uphold its end of the bargain and hand over the agreed share of the production.

By their very nature PSAs are complex affairs and much of the finer details are based on speculation as to what may happen in the country and with the oil price, leaving ample room for disgruntled parties in the future. It is therefore very important that they are handled correctly and competently, and their form and purpose are fully understood before judgement is passed as to their suitability in a given situation, such as Iraq. The notion that a PSA represents a foreign oil company being handed complete control and ownership of a country's oilfields is spurious nonsense; it is an agreement from which both parties benefit and serves as a useful method of bringing in essential foreign investment and expertise in a relatively short period of time.

Tim Newman is a writer living in Russia. Find more of his writing here.


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8 Comments

big oil
Good article but even after reading it we will still here the left wingers say that big oil is out to steal. But I've got a good example of a place where even socialists will believe big oil isn't stealing; Iran, since there are no western oil companies there, the oil business is in a shambles, producing only a fraction of what they have. They also have to suffer the humiliation of importing about half of their gasoline/petrol, because the idiots won't let any foreign firms do it in Iran, and they're too dumb to do it themselves. Is this the model the the lefties from the Guardian rag want? Or maybe they prefer the Venezuelan model where they also produce only about half of what they did before those idiots kicked out the foreign companies.

checks and balances?
So who then is in a position to keep the country signing the agreement to hold to such an agreement? If you can't trust the gov't (and just about anywhere/time there's an oil agreement like this you can't because the area is too volatile) than how can a company make such an investment (beyond "in good faith")
Seems to me as though the country/gov't signing the agreement is holding all the cards, especially once the facilities are up and running

Good point
It always has beena situation where the only ones getting potentially raped are the oil companies and, of course, their customers.

Thats not a good point
Indeed, why would a company invest in such a volatile country with such circumstances? Hmmmm, why do companies invest, why oh why would they go into such an ustable situation as Russia or Iraq? Gee, do you think its for money? Do you think the oil companies would make those investments if it didn't pay off? My first thought is you guys are either naive or dumb, but I know there is a bigger influence, you're ideological, blinded by it.

This sentence makes it clear that I'm right:
"Seems to me as though the country/gov't signing the agreement is holding all the cards, especially once the facilities are up and running "

Right, so the country that is so poor and stupid they are unable to utilize those oil fields, hence desperate because they are unable to get revenue from it, THEY are the ones holding all cards.

But I'm balanced, I'm not intending to bash oil companies, its true that the country holds the cards once the infrastructure is up and going. Thats a huge risk the oil companies take, that the country will reneg and take control regardless. Its a huge risk mostly because of the volatile nature of countries that NEED to partner with someone in the first place.

Lets be realistic though. The oil companies can make a few billion in investment to get things going, they have their agreement and they will make a lot of money from it. Does anyone know the details of these contracts? Do we know actually how much money they're getting from these agreements? How quickly do they recoup their investment? 3 months? A year? We could get a clue from common sense at least, that they ARE making money because they made the agreement in the first place. An agreement where the oil company holds the cards initially because the country has no other options. Are the oil companies that stupid to keep entering agreements where they don't make money? No. Well, maybe you guys think so because you are arguing that point.

So it makes sense the impression would spread that the oil companies are taking advantage of poor countries to make money. Maybe they are, I don't think anyone but them really knows. Regardless, they enter the contracts, it has much risk, and it has much payoff, or I doubt the oil companies would do it.

Political Risk
They were commenting on political risk, you seem to be talking about technical risk.

You also seem to overlooking the bidding process that *almost* always takes place. The exceptions are generally those cases where nobody else is interested or the very rare case where only one company has the needed expertise. You can bet that all oil companies with available cash are interested in investing in Iraq, Iran and the rest of the Middle East. You can also bet that the countries will hire international experts to ensure that the contracts are reasonable given the risk (technical only as the country doesn't recognize political risk), the nature of the play, and the type and size of investment needed.

Finally, in most PSCs the production is split into "cost oil" and "profit oil" and the percentages that the company receives are on a sliding scale. As the investment is recouped the company gets a smaller share. Ideally the company wants 100% cost oil (all of the production is diverted to repaying the investment) and 100% "profit oil" (the company gets all of the profits) the country wants 0% "cost oil" and 0% "profit oil" (all of the production goes into the country's account). Protracted bidding, negotiations and assorted threats move the terms to something that both the country and company can live with while both complain that they got hosed.

prices
I'm sure mhoward is right about the various price prceedures. The only instances where they are kept secret apparently is where you have local kleptocratic elites that don't want the world to know how much money they're stealing. Yes, they are the ones stealing, not big oil. I think they usually pay about 45 or 50% of the sale price to the local govn't. And because of the high risk involved, it one of the reasons that companies have to be rewarded to take the troble to invest in those crappy tin pot places. Disclaimer: I am a heavy investor in PetroChina and Gazprom, amongst others.

re:bobjones
so let me get this straight, you bash me, and then agree with my statement.... profound.
you mean its about money? really? wow, you should like teach or something

The nature of foreign investment...
Global companies always accept some risk when they operate an entity organized under the laws of a nation with a weak or unstable central government. The company simply factors such risks into each deal.

Successful global players do this for a living. Every day and for their entire careers. There is a global culture of such players generations deep. Their counterparts in the host nations are extraordinarily sophisticated, educated and honorable. Everyone already knows everyone else.

Major oil companies have no direct investments in Iran, Dietmar, because the Western governments (especially the United States) won't allow it. The Iranian professional diplomats themselves could surely be trusted to behave.

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