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Oil & Gas Production Sharing Agreements – A better solution than licences for developing states?

Oil-rich countries around the world seek to exploit their natural wealth by attracting foreign capital

investments under a valid legal regime. Although the states have adopted different legal models

over time, amongst the developing countries, production sharing agreements (PSAs) are the most

common means for commercial involvement in the oil and gas industry, while developed countries

typically opt for petroleum licences.

In this regard, it is worth wondering why developing states resort to PSAs, which are often complicated and generate disputes.

Objectives of developing states

Identifying the developing nations’ priorities is a strong indicator for preferring PSAs rather than

licenses for petroleum production. Developing states’ economy is often dependent on the volatile revenue from the oil and gas industry, which leads to a desire to retain ownership and control over the development of their

hydrocarbon resources. As there are limited local resources for Research and Development (R & D),

it then becomes imperative that foreign multinationals with vast resources, provide access

to technologically advanced equipment and know-how, which will facilitate oil extraction.

The economic interests of the developing state are also important – making the maximum profit

possible with minimal expenditure, by striving to secure a fair and reliable share of the value

generated at the negotiating stage of the agreement. Promoting the national interest also means

actually retaining a percentage of the produced petroleum for domestic needs and manning the oil

rigs with local workforce, which will become progressively more sophisticated on the job.

Although developing states have clear objectives from such agreements, many times these fail to

cover their basic needs. Some have explained this to lack of experience in the industry or an over-

willingness to attract foreign investors.

Key points of comparison between PSAs and Licences

If we are to better understand why developing countries choose PSAs over licences, it is necessary to

compare key points of the two legal structures.

PSAs as legal model started in Indonesia in 1960. They can be described as a contract between an

oil company (contractor or consortium) and a state party that fosters the notion that states should

retain formal ownership of their national resources, but, permitting private investors to exploit them.

The investor usually bares most of the fiscal risks and is compensated with a share of the oil produced,

an arrangement that is defined in the provisions of the agreement - the PSA.

Following the extraction, after

paying a royalty to the state, optionally

in kind, the investor obtains a portion

of oil equal to its recovery costs

(cost oil). The amount of oil remaining

is then shared between the state

and the investor (profit oil).

Examples of countries that have

preferred PSAs are Egypt, Libya and Nigeria.

Licences, are permissions granted by a state to an investor to exploit a certain geographical area in

return for a fee or royalty. Under this regime, the investor acquires ‘proprietary rights’ and although

it bears most of the risks, it enjoys a relative freedom to pursuit its commercial interests. Countries

adopting licences are usually developed and put emphasis on taxing and auditing efficiently. Such

states are the UK and Norway.

There are important differences between PSAs and licences. Under a PSA, the state maintains

ownership over its hydrocarbons, while the investor’s rights are contractual. Under PSAs,

ownership is allocated to the contractor at a point stipulated in the contract by means of a share in

the oil produced, given as compensation for the company’s risk and services.

In contrast, in licences, the licencee may be granted ‘exclusive rights’ enjoying significant control

over the contract area and absolute ownership over any oil and gas that is produced. The title passes to

the company at the ‘wellhead’.

It is important to note, that the investor may absorb the relevant risk where the contract in both legal schemes has been carefully drafted to facilitate that end. In PSAs, though, commercial discoveries provide no entitlement to the investor towards cost recovery (payments made before the gross profit is recovered), unless the state agrees to absorb part of the commercial risk. A typical example of such agreement is Brazil, which moved to the PSAs system once their oil resources were verified.

However, under PSAs, by retaining ownership the state is in the position to proceed to hostile acts

of expropriation/nationalization: this has happened numerous times before, depriving companies of

their legitimate expectations. In this regard, national interests seem to be well served under the PSAs'

provisions on local content. Particularly, if properly drafted, they seem to ensure that a large number

of employees in such operations are locals who acquire training by the investor, minimising their disadvantage compared to international experienced workers.

On the other hand, licences commonly entail no discrimination policies regarding International Oil Companies’ (IOCs) ‘utilising infrastructure and human capital.’ Moreover, PSAs offer a longer period of time

for ‘exploration and exploitation’ making the deal attractive to investors, while in licences a short period of time is provided to examine the investor’s capability to utilize the field. In terms of regulation, PSAs appear to embody softer measures regarding taxation and auditing in order to be more attractive to potential investors,

while licences impose strict rules, which can be discouraging.

As a result, PSAs emerge as reasonably preferred by the developing nations, since they seem to

better serve their petroleum policies. However, despite the diversities of the two legal schemes, as

economists suggest, ultimately the value generated under either a PSA or a licence is the same and,

thus, these contractual legal schemes are not that different from a financial point of view.

Developing countries, traditionally elect PSA systems which allow them to retain stronger control

over their hydrocarbon resources than petroleum licences, which in turn seem to better fit developed

countries’ aspirations. However, foreign companies' desire to minimize states’ intervention by

negotiating self-adjustment contracts in order to stabilise their contractual economic position under

changing circumstances, yet states’ sovereignty remains unalienable.

Further Reading

Chukwuma Samuel Adesina Okoli, ‘Production sharing agreements and licences: a distinction without a

difference?’ [2012] I.E.L.R., 282

Daniel Johnston, International Petroleum Fiscal Systems and Production Sharing Agreements (PennWell Books 1994), 39

Dr Mohammad Alramahi, Oil and Gas Law in the UK, (Bloomsbury 2013)

Eze Emem Chioma,’Examining the crucial impact of a well-drafted stabilisation and renegotiation clause on production-sharing agreements’, [2015] I.E.L.R. 216

Geoffrey Picton-Turbenvill, Oil and Gas: A Practical Handbook, (Globe Law and Business 2009), 29

About the Author

Hello everyone! My name is Mahi Kila and I am a guest writer at Legal Compass. Currently I am a trainee lawyer in a law firm in Greece. I graduated from the Aristotle University of Thessaloniki with a Bachelor of Laws. I also have a Master of Laws in Energy Law, and a PgCert in Energy, Economics and Finance from the University of Aberdeen.

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