After the prior post on land leasing in the USA, I thought I'd also do another post on a typical contract structure used in other countries where the government owns the mineral resources but foreign oil companies produce the oil. Under the structure of a Production Sharing Contract (hereafter PSC), first used in the 1960s, the foreign oil company recieves a share of future production as remuneration for exploration and development of the oil resources in a certain area. There are several other structures that have also been used, such as the concession, the joint venture, and the service contract. But these are less relevant for Exploration and Production companies, and I'm not going to go into details about them here.
In a PSC, a foreign oil company is awarded a concession for
a particular geographic area, and they are responsible for the costs of
drilling exploration wells. If and when
production of oil and gas commences, these costs are generally paid for
out of the first oil that is produced.
This is called “cost recovery”.
Then profits are split between the government and the contractor
according to some formula. In certain
countries, like Indonesia, the formula is incredibly complex. In Egypt, where Apache operates it is quite
simple.
In the case of Egypt, first the oil is divided 60-40, with
40% of the oil going into a cost recovery pool.
Capital costs from the drilling are then paid back to the company out of
this cost recovery pool. In some
countries they are paid back as fast as money flows into the cost recovery
pool, but in the case of Egypt, they are paid out at a pre-determined 20-25%
per year rate of depreciation. So if
Apache spends $100mm drilling, then they get $25mm/year for four years out of
the cost recovery pool. If there isn’t
enough money in the pool, then they get an IOU from the pool to be paid out if
and when money becomes available. They
also receive operating costs out of this pool.
Extra amounts left over in the recovery pool flow over to the profit
pool. In the case of Egypt, the profit
oil is then split 80-20 with the government receiving 80%. The 20% is free and clear of any Egyptian
taxes though. Each concession area is “ring
fenced” so the contractor can’t recover money from another concession, if
exploration is unsuccessful.
Although these terms may not seem particularly generous, it
is actually a great deal for Apache, because this is relatively easy oil to
get, and capex costs are quite moderate since it is all on-shore. Offshore PSCs can be a bit more fraught with
risk because of the huge amounts of capital involved.
It is also worth noting that the risk profile of a PSC like
this is totally different than drilling for expensive oil on-shore in the
USA. For instance, take a Bakken well
that costs $8mm to drill. If the price
of oil was cut in half tomorrow, it would be very difficult indeed to recover
the costs spent drilling the well.
Unless the company had sold their oil forward in the futures market,
they would most likely have lost money drilling this well. But in the case of Egypt, Apache receives money
out of two sources, from cost recovery oil and from profit oil. The cost recovery portion of their revenues
might not be effected at all by the decline in oil prices, since at present only
about half of the available money for cost recovery is actually used, the rest
is sent over into the profit pool (see image above). The profit-oil payments might go down by
2/3s, but overall Apache is at much less risk of actually losing money than
someone drilling for expensive oil onshore in the USA. They might make less profit than they had
hoped, but they would still not lose money.
Because of this type of contract structure the large international oil
majors can still make a profit when the price of oil goes way down.
Although there is less risk of losing money due to resource
price volatility in a production sharing contract, there are sometimes big
political risks. Contract terms have
been cancelled or altered to the disadvantage of the company at times in the
past. After the contractor spends the
upfront money to get things going, there may be a big temptation for the
government to take a bigger portion of the resulting revenues than they had promised
the company to lure them there.
For an investor there is another difference between on-shore US exploration for
expensive oil vs doing large foreign oil projects under production sharing
contracts. The foreign PSCs and
particularly offshore contracts favor companies with lower capital costs while
on-shore US projects favor companies with more efficient (lower cost)
operations. Because of the cost recovery
provisions in international contracts, there is less incentive for the
contractor to skimp on spending. They
only care about getting the project done as fast as possible for the oil to
start flowing. All their high costs will
be paid out of the cost recovery pool, and so will really be borne by the government. For on-shore US, every dollar of cost comes
out of the company’s profits, since tax revenues and landowner royalties are
paid out of gross production.
An explanation of the Egypt structure is available from Apache here:
Here is a nice (very long) history of the PSC, which I haven't read all of:
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