The worse the deal, the more likely it is to be renegotiated- Oxford Energy

Dec 08, 2024 News

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“Bad deals spell trouble. The worse the deal, or the more imbalanced the deal, the more likely it is to be renegotiated. That goes for both sides.”

-three countries successfully changed terms to increase government’s share

Kaieteur News- Without an understanding of the facts underlying a renegotiation, one can easily jump to the wrong conclusions, and that is precisely what seems to have been happening with alarming frequency on the conference/ seminar circuit, where conclusions are too often drawn from incomplete information derived from press releases or press reports.

Oxford Energy Forum in an August 2010 research paper documented the events that led up to renegotiated oil contracts in three countries, Venezuela, Bolivia and Kazakhstan.

According to the document, many of those contracts were not only economically indefensible, but they also purported to cede control over petroleum operations to private parties, often in a manner that raised serious legal issues going to the heart of the contracts.

All this has led to contract renegotiations, and in some cases, complete national industry restructurings, in the last few years. In many countries, this has involved fundamental issues of structure and governance; all cases involved adjustments in government take.

Host countries that have taken measures in this direction include Algeria, Bolivia, Canada, China, Ecuador, Kazakhstan and Venezuela, all of which imposed new taxes and royalties on production, exports or windfall profits. Bolivia and Venezuela also mandated structural changes for all contracts in their hydrocarbons industries. In Alberta, Canada, the provincial government announced a 20 percent increase in oil and gas royalties.

The US Government provided Congress with a report in May 2007 on the question of increasing oil and gas royalties, including a comparison of royalty rates under fiscal regimes around the world, in response to concerns that government take was not keeping pace with record oil company profits. Oil executives were called before Congress to defend windfall profits, and Sarah Palin’s Alaska collected billions in additional revenue from a new windfall profits tax.

Three Case Studies

Three of the best-known renegotiations or industry restructurings of the last few years involved the operating service agreements (convenios operativos) in Venezuela, the gas production contracts in Bolivia, and the renegotiation of the world’s largest production sharing agreement, the one covering the Kashagan field in Kazakhstan.

Venezuela

In Venezuela, approximately 500,000 barrels per day were being produced under the operating service agreements, which were supposed to be pure service contracts. The 1975 Law Regulating the Industry and Trade of Hydrocarbons did not allow, except in certain cases approved by Congress, any private participation in production. Service contracts were allowed for basic services, such as drilling and seismic survey, but these were supposed to be pure service contracts, not contracts mimicking production sharing agreements that effectively granted the contractors a participation in the business.

The Venezuelan operating service agreements, although structured as service contracts, were in substance anything but pure service contracts. They ceded control over petroleum operations in huge areas for 20 years, and compensation was based on the volume and value of production. Many of the service providers were in effect senior partners in the business, on average taking more than half the value of production.

In some cases, the state company actually lost money for each barrel of oil produced, after accounting for the royalty owed to the State. Making matters worse, the contractors, claiming to be only service providers, argued that they were subject to the non-oil income tax rate of 34 percent rather than the rate applicable to oil producers, 50 percent. In April 2005, the Venezuelan Government intervened to require migration of the operating service agreements to the new structure of mixed company (empresa mixta) under the 2001 Organic Hydrocarbons Law, and 30 out of 32 contracts were successfully migrated over a one-year period. The other two resulted in negotiated settlements.

The new mixed companies emerging from the migration of the operating service agreements are all subject to combined royalties and special advantages (ventajas especiales) of 33 1/3 percent, as well as the 50 percent oil income tax rate. A special assessment for extraordinary prices also applies when the price of crude oil exceeds $70 per barrel. Apart from the fiscal regime, a state company is by law the owner of at least 60 percent of the shares of each of the new mixed companies. Basic minority protections are included in the by-laws, but the legal issue of control has been resolved.

Bolivia

Turning to Bolivia, we again hear a lot of talk about resource nationalism, but little about the facts of the old agreements. Prior to 2005, contractors were taking 82 percent of production from Bolivia’s giant gas fields, paying only an 18 percent royalty. This was after all investment that had long ago been recovered. The contracts had never been approved by Congress, as appeared to have been required by the Constitution. By 2005, the situation had become untenable. A new Hydrocarbons Law was enacted in May of that year, imposing a 32 percent tax on the gross value of hydrocarbons (Impuesto Directo a los Hidrocarburos) in addition to the 18 percent royalty, thereby reducing the private party’s share to 50 percent. The Hydrocarbons Law also provided a six-month period for migration of all existing contracts to one of the new legally-sanctioned forms of contract. That six-month period expired with no progress on the migration. On May 1, 2006, the new administration again nationalised the industry, granting another six-month period for the conversion of the old contracts. While the new operating contracts were being negotiated, the state company was given a provisional 32 percent share, reversing the old 18/82 split to 82/18. Six months later, all of the contractors executed the operating contracts, which are structured as service contracts with the service providers receiving remuneration in cash, not oil.

Kazakhstan

The third case study is the renegotiation of the PSA covering the world’s largest discovery in three decades: Kashagan in Kazakhstan. There the heart of the problem was the concept of cost recovery, under which a large percentage of production, known as ‘Cost Oil,’ is allocated off the top to the contractors to recover their costs. In the case of Kashagan, that percentage was 80 percent. After allocation of that 80 percent to the contractor, the remaining production, known as ‘Profit Oil,’ was allocated initially 90 percent to the contractor and 10 percent to the State, a ratio that was eventually supposed to change in favour of the State based on a set of complicated triggers set forth in the agreement.

Until then, the contractor would continue to receive 80 percent of the Cost Oil and 90 percent of the Profit Oil, or 98 percent of total production. Despite what many feel is a textbook alignment of interests in a contract including such cost recovery provisions, experience shows that this structure is often a recipe for disaster, and that is exactly what happened in Kashagan. Overall costs of the project increased by more than 100 billion dollars, and production, originally scheduled to start in 2005 or 2006, now is scheduled for 2012.

The net result was that in the world’s largest discovery in recent times, which is expected eventually to produce 1.5 million barrels per day, the state would have received a grand total of only 2 percent of the oil produced for at least the first decade of production, not including the relatively small participation of a subsidiary of the national oil company in the contractor consortium. That was obviously an unacceptable situation, which most people with knowledge of the facts fully recognised. In the renegotiation, the national oil company’s subsidiary doubled its stake in the project, a new ‘priority share’ was allotted to the Government off the top, and new cost and schedule control mechanisms were introduced to help guard against future cost increases and delays.

What lessons can be drawn from these experiences?

First, bad deals spell trouble. The worse the deal, or the more imbalanced the deal, the more likely it is to be renegotiated. That goes for both sides. One might say that the best form of stabilisation is an equitable deal. Second, don’t believe everything you read in the papers. Most of the renegotiations or industry transformations have ended in success, which says something about the reasonableness of the processes. The objective has not been to exclude private participation from the petroleum industry or to make it economically non-viable, but rather to put it on a sound legal and economic footing. Third, most renegotiations take place without adversarial proceedings, another indication that reason tends to prevail on both sides. There is a school of thought that favours adversarial proceedings, mainly arbitration, as a negotiating tactic, but the wisdom of using that tactic would not appear to be borne out by experience. Finally, terms such as ‘resource nationalism’ are an over simplification of what has been happening on the ground and are no substitute for informed analysis of both the facts and the legal issues underlying the major renegotiations of the last five years.

(Note: The case studies have been reported verbatim from the Oxford Energy report)

(The worse the deal, the more likely it is to be renegotiated- Oxford Energy)

(The worse the deal)

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• ceded, Contract, control, oil, Oxford Energy, renegotiation

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