Production Sharing Contract: A Comparison with Concessionary System from the Political, Financial and Functional Point of View

I. Introduction

Oil and gas legislations are varies in every country, they depend on the purpose and the intention of regulating the countries’ strategic assets. However, the main objectives of each State party are the same, to take control of its assets and to get revenue for the economic development. In order to develop and to make use of its assets, the State will cooperate with International Oil Companies (IOCs) which has the ability, knowledge and experience in this industry. There are two basic contract types between the State and IOCs. Firstly is by giving concession licenses to the IOCs and secondly is by making contractual arrangement[1] between the State and the IOCs, which is widely known as Production Sharing Contract (PSC).

The major differences between them are the levels of control granted to the IOCs, levels of involvement by the State, compensation and the reward sharing schemes.[2] On concessionary system, the IOCs will get a license from the State for a period of time to take out and to own the oil and gas in certain area, and then in return the State will receive royalty payments and income taxation from the IOCs. Whereas in PSC system, the State will own all of the oil and gas production and the IOCs only act as the contractors who will provide technical and financial services for exploration and development operations, and in return, the production will be shared between the IOCs and the State according to the provision in the PSC.[3]

Widely used in developing countries, PSC system is the most dominant form of granting access to oil and gas exploration and development to IOCs on contractual basis. According to Johnston[4], the differences of PSC and concessionary system are served more for political function than anything else. In this case, to verify this statement, the historical and political backgrounds of the development of the PSC system are the most important elements in the discussion of this paper. From the functional and financial point of view, the PSC system is not that different than the concessionary system, the differences between them are only laid in the management control and the implementation,[5] which later will be discussed.

II. Historical and Political Backgrounds of PSC

PSC, introduced in Indonesia in year 1966, was created under the influence of nationalistic feelings after its independence from Dutch colonialism.[6] After its independence many foreign companies’ concessions were expropriated for nationalisation, and there were no new oil concession given by the government.[7] In the meantime, the Indonesian people did not have the ability and financial support to develop these assets, therefore there was stagnation in the oil and gas development. This condition caused disadvantages for both the country, due the fact that the new born country needed income to recover and to develop its economy, and IOCs intended to invest their assets in Indonesia.[8]

In order to overcome this situation, in 1960 a new regulation in oil and gas was enacted under the spirit of Article 33 of the 1945 Indonesian Constitution which emphasizes that "Land, water and their containing natural resources are possessed by the State and are used for people's utmost wellbeing".[9] Under the Government Decree No. 44/1960, oil and gas exploration and exploitation were the responsibility of the State, and this responsibility was delegated to the National Oil Company (NOC), which then cooperate with IOCs. At first, the existing concessions were turned into contracts of work which was made between the NOC now known as Perusahaan Pertambangan Minyak dan Gas Bumi Negara (Pertamina) and IOCs. Yet, many people still criticized that it was considered as the same system in a different form.[10]

This issue was finally resolved by the introduction of PSC. PSC allows government to take control of the State’s natural assets and Pertamina as the NOC had full managerial control. In brief, the main principles of the first generation PSC are:[11]

(a) Pertamina is responsible for the management of petroleum operations. The IOC (as the Contractor) is responsible to Pertamina for the execution of the operations and provides the necessary funds. As Pertamina held the management for the operation, the Contractor would have to consult with Pertamina and seek its approval on certain operational decisions including the Work Program and budget, plan of development and exploration program. This clause is intended to create a long term sustainable development for the country, and one of the driving forces of PSC is to learn and master the petroleum business.[12] This system, called ‘approval-process-cum-learning-procedure’, allowed Pertamina and the government officials to learn how to run this business and would create a learning process in situ.[13]

(b) The government hold the ownership of the oil and gas. The mining rights are vested in Pertamina, based on an authority to mine, and the economic right to the Contractor’s share will be passed to the Contractor at the point of export and remaining production is split on the basis of a mutually agreed production sharing mechanism. This clause was regarded acceptable and in line with the State’s constitution and regulation because the government still upholds national ownership of the resources.[14]

(c) The Contractor furnishes all the necessary risk capital based on a mutually agreed Work Program, including technical assistance. With this clause, the needs of huge amount of fund and technology including the high skilled and professional workers at that time were able to overcome. Moreover the government did not have to bear the exploration risks, and the contract would be terminated if somehow the oil reserves were failed to be found.

(d) Ownership of all project-related equipment brought by the Contractor will be passed to Pertamina upon being placed in service after its entry into the country; the cost of this equipment is to be recovered as Operating Cost and all geological and other field data become Pertamina’s property. According to Machmud[15], as another advantage of PSC, by keeping the geological data and field data, Indonesia began to see a nationwide picture of its geological basins. It was a strategy of Indonesian government to control its assets, so in the future the country can be independent in developing its assets.

Beside all the advantages mentioned above, as a result of contractual relationship between the Contractor and Pertamina, PSC treated both parties on the same side and shared the production. It means that the bigger production was produced, the larger the party’s profit, and it would benefit both parties equally. PSC was created in order to grow the ability of the national oil company to become as big as the IOC.[16]

After PSC were successfully applied in Indonesia, many developing countries, especially countries with potential oil reserves but high extraction costs (especially from offshore fields) and high exploration or technical risks started to adopt PSC. As they still own all of the oil and gas production, PSC was regarded quite appropriate for developing countries to solve their problems, to avoid the financial and technical risk and also to learn how to run oil and gas industry by themselves in the future.

III. Functional and financial aspect of PSC in comparison with concession system.

In contrast with the PSC system, concession license grants property right of the natural resources to the IOC. Under the concession licence, the government is excluded from any participation to the business, as well as the management of petroleum operation and profits.[17] In return the state will receive royalty payments on production volume, income taxation, and similar payments from the concessionaire.

Even though these systems seem contrast, but in the end the intention of both PSC and concession system, is to give revenue to the State and the IOC. Johnston describes[18] that, whether using royalty as in concessionary system or profit oil split in PSC system, the financial result for the IOCs and the government is quite similar. In a PSC where royalty does not exist, for instance in Indonesian PSC, profit oil split 85%/15% is simply replacing royalty.[19]

Furthermore Johnston also states that, “Many of the other features of a PSC are similar to those found under other systems.”[20] For explanation of this statement, Indonesian PSC as a model has been compared to concessionary system. From such comparison, similarities have been found but with different technical terms, i.e.:

1. Double layer of taxation.

Both systems put two layers of taxation. The taxations on the concession methods are divided to provincial and federal taxes,[21] while the Indonesian PSC is using other mechanism known as effective tax rate which is resulted from income tax and withholding tax levied after income tax.[22]

2. Cost recovery.

Cost recovery is needed by the contractor to recover the costs of exploration, development and operation out of gross revenue.[23] It is one of the most common features in PSC.[24] In the concession system, taxable income is resulted from net revenue which is already being deducted from operating costs, depreciation, depletion and amortization (DD&A), and intangible drilling costs (IDCs). These elements of deductions in concession system can be assumed as cost recovery, but the difference with the cost recovery in PSC that there is ‘no cost recovery limit’ in the concession system.[25] It is also must be noted that some PSCs also have no limit on cost recovery.[26]

3. Work commitment, relinquishment, and other operational aspects.

These operational aspects are found in PSC and concessionary system. For example is work commitment which outlines penalties for nonperformance in exploration. As it is a critical aspect of exploration, therefore both PSC and concessionary system will have this feature.[27]

It can be seen that the differences of the features as mentioned above are laid on how these features are implemented, but the basic principles are similar. From the IOCs point of view, whichever system is used, they will decide to make investment only if they foresee a profitable outcome taking into account its own particular economic standards and methods of calculation.[28] In addition, PSC can be a perfect vehicle for IOCs to invest their assets in some countries which do not allow oil and gas privatisation in their constitution.

PSC system simply fulfils what IOCs need to invest their assets.[29] From financial point of view, PSC system does not have huge differences with concessionary system. Moreover although in PSC the reserves are owned by the state, but the accounting procedures permit the companies to book the reserves in their accounts.[30] PSC gives IOCs a right to oil reserves and guarantee while they are extracting the reserves for many years and also gives opportunity for IOCs to make huge profits, even though IOCs have to invest and risk their capital.

As a contractual relationship, PSC could bring disadvantage for the state, because it will bind the government for many years without changing tax and regulation as they extract the oil and make profits, so then they can predict and maintain the stability of their business and profit. This relationship makes their position equal one to another, while in contrast concessionary system will create vertical relationship which put the government as the superior and the IOCs as the inferior.

IV. Conclusion

PSC system has been effectively used by developing countries with potential oil reserves but high extraction costs (especially from offshore fields) and high exploration or technical risks. With PSC, the problems of financial resources and technical expertise can be solved by these countries. On the other hand, IOCs can predict and manage the risks by doing geological and seismic research and will not precede any development if it is not profitable.[31]

It is true that from the financial and functional point of view, PSC and concession system is not very different, but by giving an assumption that ‘the government still upholds the national ownership of the resource’, PSC serves more ‘political function’ than anything else. Moreover, Thomas Wälde describes that PSC as a tool which “gives to the government political and to the company commercial satisfaction. The government can be seen to be running the show – and the company can run it behind the camouflage of legal title symbolizing the assertion of national sovereignty.”[32]

In practice, the advantage of PSC for the host state is that PSC system may be used as a highly effective foreign investment tool. If this system has been managed properly by the host country, it may bring large amounts of foreign capital and expertise without relinquishing excessive control and profits to outside interests.[33] By transfer of technology and good financial systems, it gives an opportunity for NOC to grow and develop the state’s assets.

From different perspective, the disadvantage of PSC is that the state will be tied by the restrictions in the contract for a long time.[34] Therefore, if the government or political climate changes, the terms of PSC cannot be changed to reflect the state’s new priorities. However, this negative side of PSC system can be avoided by the state by drafting and negotiating PSC system which can maximize the state’s revenue and limiting the IOCs’ access to oil, while at the same time creating a legal regime that allows the state the flexibility to modify the terms of the project.[35]

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[1] Pongsiri, Nutavoot. Partnerships in oil and gas production-sharing contracts. (Centre on Regulation and Competition (CRC), University of Manchester, UK, 2002), pp. 432.

[2] Ibid. pp. 432.

[3] Ibid. pp. 432.

[4] Johnston, Daniel. International petroleum fiscal systems and production sharing contracts (Tulsa, Okla. : PennWell Books, c1994), pp. 39.

[5] Ibid. pp. 40.

[6] Bindemann, Kirsten. Production Sharing Agreements. (Oxford Institute for Energy Studies WPM 25, 1999), pp. 1.

[7] History of PERTAMINA. http://www.pertamina.com/index.php?option=com_content&task=view&id= 13&Itemid=78 viewed on 1 November 2007.

[8] Bindemann, pp. 1.

[9] Undang – Undang Dasar Negara Republik Indonesia tahun 1945 (The original version of Indonesian Constitution 1945).

[10] Bindemann, pp. 68.

[11] Machmud, Tengku Nathan. The Indonesian Production Sharing Contract: An Investor’s Perspective. (Kluwer Law International (2000)), pp. 62.

[12] Machmud, pp. 60.

[13] Ibid.

[14] Bindemann, pp. 1.

[15] Ibid., pp. 61.

[16] Ibid.

[17] Machmud, pp. 36.

[18] Johnston, pp. 45.

[19] Ibid.

[20] Ibid., pp. 39.

[21] Ibid.

[22] Ibid., pp. 45.

[23] Ibid., pp. 56.

[24] Ibid.

[25] Ibid., pp. 49.

[26] Ibid., pp. 57.

[27] Ibid., pp. 52.

[28] Taverne, Bernard. Production Sharing Agreements in Principle and in Practice. (Delft University of Technology), pp. 52.

[29] Muttitt, Greg. Production sharing agreements: oil privatisation by another name? (Paper presented to the General Union of Oil Employes’ conference on privatisation: Basrah, Iraq, 26 May 2005), pp. 6.

[30] US State Department. Future of Iraq Project, Oil and Energy Working Group (Oil Policy Subgroup). (Middle East Economic Survey, 'Iraqi oil policy recommendations after regime change April 2003), pp.D1-D11.

[31] D. Babusiaux et al. Oil and Gas Exploration and Production: Reserves, Costs, Contracts. (Editions Technip (2004)), pp. 199.

[32] Wälde, Thomas W. The Current Status of International Petroleum Investment: Regulating, Licensing, Taxing and Contracting. (CEPMLP Journal, University of Dundee, Vol. 1, No. 5 (July 1995)).

[33] Schiffrin, Svetlana Tsalik & Anya. Covering Oil: A Reporter’s Guide to Energy and Development. (Open Society Institute, 2005), pp. 14.

[34] Muttitt, pp. 12.

[35] Babusiaux et al., pp. 202.