Introduction to Production Sharing Contracts

Production sharing contracts were first developed in Indonesia in 1966 to give the host government more control over their resources. This type of contract soon became popular with a number of governments when crude oil was in tight supply and the price was rising rapidly. Under this type of contract the contractor bears the exploration risk while the host government receives a share of the produced oil rather than cash from royalties and taxes. It is now used in many countries.

Production sharing between the contracting oil company and the national oil company (NOC) can create a whole series of interesting problems and negotiating trade‑offs. For example, if the host government requests a production split in which its share increases when the field reaches a certain stipulated daily, monthly or annual rate of production, the perception is that the contractor's return on his investment increases in proportion to productivity. This is not universally true. For example, consider an offshore situation in which the producing formation is encountered at a relatively shallow depth so as to preclude extensive directional drilling. This type of condition requires a large number of platforms and proportionately larger investment per barrel than for deeper production where fewer platforms can accomplish the requisite spread of producing well penetrations of the reservoir.

Splitting the Barrel

Production sharing contracts have three basic parts, each of which deserves special attention in negotiation. These are:

1. Cost Recovery

2. Division of the “profit oil”

3. Royalty and Income Taxes

As the produced barrel is split between the host government and the contractor in a production sharing contract, the first portion goes to royalty, typically a contract requirement, followed by an allocation to cost recovery to pay operating expenses and payback exploration and development costs.

Not all production sharing contracts require royalty payments, but if included they are usually in the range of 8% to 15% of gross revenue. Royalty is paid directly to the host government as oil and gas are produced and sold, irrespective of the level of profit or loss on the venture.

Production sharing contracts may differ in language and terms, but they are all based upon the same principles.

Other contract terms are of lesser importance but are also found in most production sharing contracts. During the exploration phase, the contractor is obligated to make certain expenditures within a designated geographical area and within a certain period of time. These commitments commonly include a stipulated seismic program and a specific number of exploratory wells. It may also include the construction of roads and/or schools and training for nationals of the host country. If the venture is successful these expenditures, plus development and operating expenses may be recouped from production in addition to a share of the profits from the operation. If the venture is a failure, the contractor bears the entire burden of all exploration costs. Therefore, the exploration commitments plus any signature bonus comprise the cost of failure for the venture.

The block diagram of Figure 2-1 should assist in understanding how a SUCCESSFUL production sharing contract works. The shaded portion of Figure 2‑1 represents the share of gross oil production which flows to the host government, while the unshaded boxes indicate the contractor's share. Gross production, which is the volume of hydrocarbons produced is separated into three parts 1) cost recovery oil, 2) profit oil, and 3) royalty oil. If the host government requests the contracting oil company sell the oil on behalf of the government, the agreement should specify how the price for produced oil and gas is determined. It may be pegged to some marker crude; it may be based upon some market basket of crudes, or at a price set by the government for oil marketed domestically. The contractor may also be required to make as much as 25% of their share of oil production available to the host government for the local consumption at market price or some substantially discounted price set by the government.

Figure 2-1

Declaration of commerciality is a particularly important milestone in any production sharing contract. It generally specifies what constitutes a commercial discovery and who shall make such a declaration. There also may be a series of bonuses due as production reaches certain milestones. These bonuses are costs for which the contractor is responsible and are not normally recoverable out of cost oil. This is why bonuses are shown in Figure 2-1 as a payment to the host government coming out of the contractor’s profit, after payment of income tax. They may or may not be deductible when calculating income tax in the host country or contractor's home country.

The contractor is not reimbursed for any costs until production actually begins and there is generally a limit to the amount that can be recovered each year. Figure 2-2 shows how the limitation on cost recovery affects the cash flow of the contractor. The limit is normally in the range of 40% to 60% of gross annual income, but it can be as high as 100%. While it should not affect the ultimate recovery of all allowable costs, it does affect the present value of those costs by delaying their recovery. Some contracts further delay recovery of capital investments by limiting their cost recovery to depreciation over three to five years (see Chapter 5). Since the annual limit on cost recovery will seldom permit payback on a current basis for the first few years of production, depreciation of capital expenditures may have little effect on present value. Operating expenses qualify for recovery as they are incurred. The contract may stipulate that the cost oil allocation must first pay for the project's current operating costs, then for development and exploration costs until the latter have been repaid. Any costs which are not recoverable in a given year are carried forward to a subsequent year when they can be recovered.

Figure 2-2

Cost oil may be a fixed fraction of gross revenue or equal to allowable costs up to the limit. Where cost recovery oil is a fixed fraction of gross revenue, any unused balance after full payback, commonly called “excess cost recovery oil”, is added to the profit oil. Exploration and development capital costs along with operating costs will be eventually paid out of cost recovery oil. The contract and host specific accounting standards, typically included by reference, will specifically state what expenditures are recoverable, so it is important that the host government's definition of what qualifies as a cost recoverable expense is well understood.

The shaded portions of Figure 2-2 represents the cost recovery oil paid to the contractor, with the unshaded portions representing profit oil. It can be noted that recovery of some early actual costs must be deferred for several years. Some contracts also provide for “uplift on capital expenditures,” which is another way of saying that the contractor is allowed to recover more than the actual amount of capital spent. This is nominally a provision for interest on the capital and is added to the cost oil account.

Timing of Payments

The general breakdown of cash flow for production sharing contracts shown in Figure 2-1, does not indicate the timing of those elements. Figure 2-3 shows the point in time or period of time over which the various payments are made.

As shown in Figure 2‑3, various bonuses are paid at the times specified in the contract, whereas, exploration expenditures are made following the signing of the contract and before the declaration of commerciality. All subsequent payments are made only for successful ventures. Most development expenditures are made over a period of time before the start of production but may also continue after production begins. Royalty, operating expenses, cost recovery and profit oil begin with the first production and continue over the remaining life of the contract. Income tax may not begin until sometime after production begins, because the first production usually does not produce “taxable income” due to development expenditures and large start‑up costs. Once income tax payments start, they usually continue for the remainder of the life of the contract.

Figure 2-3

To learn more about the philosophy, evolution, and fundamentals of international petroleum contracts, we recommend enrolling in an upcoming session of International Petroleum Contracts.

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