Production sharing agreements (PSAs) are one of a number of legal structures used between countries with oil and gas reserves and international oil companies keen to develop those reserves. However, the agreements are often complicated and disputes are not uncommon.
In this article, we analyse some of the potential pitfalls of PSAs and encourage you to get in touch should you wish to discuss any concerns you may have.
As widely known, a PSA is a legal contract between a state and an investor willing to risk its capital on behalf of the state. If oil or gas is then discovered in economic quantities, the reward to the investor, usually known as the contractor, is the recovery of its costs of exploration and production, as well as the right to share in any further profits from the sale of the oil or gas.
Contractors inevitably wish to recover both as much of their upfront costs as possible and as quickly as possible, as well as access as much future profit as they can, and will appreciate the optimum mechanisms to achieve these goals. In many cases, the end contract is a very complicated series of interdependent agreements and arrangements, with the result that it is open to different legal and financial interpretations based on the respective understandings upon which the contract was signed. This in turn can lead to disputes which, in some cases, can last years. For example, in one particular dispute, we were engaged to comment on the disputed nature of costs that had been incurred by the contractor over 15 years prior to our involvement.
Such potential disputes can be exacerbated by a multitude of other factors, for instance changes in both counterparties’ personnel and practices over time, changes in fiscal regimes and geopolitical backdrops, non-aligned operating or sub-contractor agreements, and even the passage of time across a sector that often experiences swingeing economic cycles and regular consolidation.
Issues arising from Cost Oil
To recover upfront investment costs, PSAs provide for an early allocation of any oil or gas produced, which is known as “Cost Recovery” or “Cost Oil”. However, whilst contractors will wish to ensure that all their upfront investment costs are recovered, the host government will wish only to allow the recovery of those costs which it sees as being properly incurred in a diligent and efficient manner, or otherwise in accordance with the PSA.
Issues arising from Profit Oil
Following the allocation of Cost Oil, the allocation of remaining production between the parties, known as “Profit Oil”, will also be governed by the PSA. These allocations themselves can often become very complicated under formulas embedded in the PSA. Once again, tensions can also arise, particularly concerning the amounts of revenue and profits available to each party and the timing of receipt of those revenues.
For example, the host government will want to reach Profit Oil as soon as possible, despite any ongoing dispute regarding Cost Oil, because not only will it receive its own allocation, but it will also likely receive the benefit of specific windfall tax and/or royalty arrangements previously agreed with the contractor. In some PSAs, such tax rates can be as high as 60-80%. As a result, contractors often seek stabilisation agreements to ensure that the tax and fiscal arrangements negotiated within the PSA are not later replaced by additional attempts to bolster government revenues.
Because of the amounts at stake, however, even these stabilisation agreements are often challenged with, for example, tax authority investigations to probe the contractor’s tax accounting.
The incidents of Profit Oil may also trigger other types of tension. For instance, contractors will be conscious of the limited duration of their PSA and will therefore want to extract as much profit as possible for themselves during the remaining life of the agreement. However, this may conflict with the host government’s view of the most appropriate long term development of the field.
Finally, the imminent expiry of a PSA also brings its own issues, whether it is on the basis of a handover of ongoing operations, or otherwise. For example, issues can arise around the maintained condition of the assets, environmental impact, accuracy of asset register or termination cost accruals. Each of these is potentially made more difficult for a contractor by an end of PSA handover of documentary records.
PSA arrangements as a whole can therefore give rise to a whole series of potential issues and it is important to understand what those are and how they can be resolved. At BDO we have experience working with both host governments and contractors advising on PSAs. Please do get in touch if you wish to discuss any such potential issues, or any other issues arising, with us.