Government Take & Reported Reserves – Part 2

In an effort to provide clarity and boost comprehension of the listed column title in this series, last week’s column introduced my re-visit of Government Take under Production Sharing Agreements, PSAs, with a summary re-statement of the intellectual origins of PSAs in legal theory, behavioral economics, and institutional theory. Based on these fields of research and analysis, PSAs have been, from the time of their earliest introduction to the oil and gas sector, subjected to generic critical dissections, from economic, legal, and institutional perspectives.

Indeed I had advised readers five years ago that, among the most rigorous and perceptive of these evaluations are: 1) K. Bindemann, Production-Sharing Agreements: An Economic Analysis, (Oxford Institute for Energy Studies, October 1999); 2) T.A. Ogunleye, A Legal Analysis of Production Sharing Contract Arrangements in the Nigerian Petroleum Industry, (Journal of Energy Studies and Policy, 2015); and 3) Y. Omorogbe, Contractual Forms in the Oil Industry: The Nigerian Experience with Production Sharing Contracts, 1986.

For readers benefit, I advise: 1) the first of the above listed studies is an empirical evaluation of a dataset of as many as 268 PSAs, worldwide! And 2) the second and third studies have focused, selectively, on Nigerian PSAs.

In what follows I highlight four generic critiques of PSAs as a social construct that have evolved over the years.

Generic Critiques

First, one finds quite often in PSAs that the Owner (State) and Contractor (Foreign Oil Company, FOC) hold differing objectives, aims, and goals. Empirically, they incentivize Contractors to explore the immediately lucrative petroleum fields in the pursuit of early benefit, thereby deferring riskier fields. Such incentivization is not surprising, even in cases where, over the long run, riskier fields generate greater profit. Risk-reward theorems posit: the greater the risk, the more must be the expected immediate benefit required to incentivize petroleum investors.

Second, under PSAs” Contractors are able to claim specified accrued costs incurred in exploration and production. This feature dis-incentivizes Contractors from resolutely pursuing cost reduction. The reason being, part of such cost efficiency gains would have to be given up to the Principal, in keeping with the pre-agreed profit-oil split. It is logical therefore, to presume that, if Contractors are not able to benefit entirely from their efforts to secure cost efficiencies, they would not be as motivated to work at this as if they received the entire benefit.

Third, PSAs often create the potential for Contractors to obtain “windfall profits”, Such profits occur, where after the contract is signed, crude oil prices rise greatly; like now.

Fourth, moral hazard refers to: “the risk that a party to a transaction (PSA) has not entered into the contract in good faith” (Investopedia). In the literature, evidence is regularly adduced showing that FOCs routinely inflate (gold plate) their accrued costs. This often occurs because such costs can be claimed against the gross revenues that are obtained from the production and sale of crude. Indeed, such accusations border on claims of “fraud”! Further, FOCs have been directly accused of procurement fraud and related abuses due to the non-arms- length relations, which they hold with affiliated companies.

Sometimes this last critique is characterized as adverse selection. This basically means that Contractors have information, which the Principal (State) in the PSAs do not possess. Both “adverse selection” and “moral hazard” indicate that, underlying the contract/agreement there is an asymmetric information flow, or information failure. That is, one party to the PSA (Owner/Contractor) has more material knowledge of the economics of oil and gas exploration and production than the other party.)

This latter economic theorem was developed over the past six decades for the specific purpose of explaining how such imbalances in material knowledge can lead to inefficient economic outcomes, even in environments of supposedly competitive markets!

PSAs as disruptive

As I shall develop at the start of next week’s column, readers should keep in mind constantly that, when originally introduced to crude oil exploration, production, and marketing, PSAs were viewed as a solution to foreign ownership, control, and domination of developing countries’ oil and gas resources. PSAs were considered to be very disruptive to the prevailing contractual relations between States, as Owners of hydrocarbon resources, and foreign Contractors, as operators of these resources during the 1960s/1970s and after. For sure, the established traditional transnational oil majors were dead set against the surrender of their legal ownership to the subsurface rights of a country’s oil and gas reserves. The wave of nationalizations of oil wealth, as well as growing anti-colonial and anti-imperialist sentiment was making concessionary contracts obsolete. The Organization of Petroleum Exporting Countries (OPEC) had been created by 1960.

Conclusion: Contracts as Unique Instruments

One can argue that, in the final analysis each PSA constitutes a unique contract, with its own fingerprints . This is the case, even though PSAs represent one of four typologies of oil contracts between States and Foreign Corporations. Readers can appreciate this apparent contradiction by recognizing that PSAs are both unique and simultaneously a recognized typology of oil contracts. This feature indicates that, ultimately, Guyana’s PSA would need to be examined as both unique and common, if its analysis is to be fully enriched.

I continue the discussion next week starting with a summary amplification of this feature of PSAs.