Challenges in Balancing Government and Investor Interests Under a Production Sharing Agreement

Table of Contents

LIST OF ABREVIATION

ACKNOWLEDGEMENT

1 BACKGROUND AND GENERAL INTRODUCTION

2 PRODUCTION SHARING AGREEMENT IN CONTEXT
2.1 State and Investors concerns
2.2 The concept of PSA;
2.3 Key terms under PSA
2.4 Key factors for consideration

3 OVERVIEW OF TANZANIA PETROLEUM INDUSTRY
3.1 Status of exploration activities
3.2 Social- economic situation
3.3 Politics
3.4 Regulatory and institutional framework

4 THE MODEL PRODUCTION SHARING AGREEMENT, 2013
4.1 Exploration program and budget
4.2 Signature bonuses and rental charges
4.3 Royalty payment
4.4 Cost recovery and production sharing
4.5 Taxation
4.6 No stabilization clause
4.7 Government Participation
4.8 Local content provision
4.9 Employment, training and transfer of technology

5 A CRITICAL ANALYSIS
5.1 Challenges

6 CONCLUSION

BIBLIOGRAPHY

LIST OF ABREVIATION

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ACKNOWLEDGEMENT

I would like to take this opportunity to thank Prof. John Paterson for his advice and comments which were invaluable to this dissertation.

I also owe sincere thanks to the Government of the United Republic of Tanzania through the Ministry of Energy and Minerals for sponsoring my studies at the University of Aberdeen.

This dissertation is dedicated to my Mother Elizabeth Makula and My Father Mlyandingu Masunga; My lovely Wife; and My children Grace and Gibson for their prayers, love and patience throughout the period of we have been apart.

1 BACKGROUND AND GENERAL INTRODUCTION

A critical aspect of an oil and gas exploration and production agreement is balancing the interests of the state and investors.^[1] The broad objective of any resource rich government is to insure that it maximizes as much revenues as possible from its natural resource and insuring that there is always an appropriate level of investment in exploration and development activities in the country.^[2] The investors on the other hand are interested to maximize as much profit as possible by minimizing the costs, quick recovery of these costs and working with stable governments.^[3] In order to ensure a sustainable development of exploration and development activities in the country these varying state and investor’s interest has to be balanced.^[4]

Under the petroleum contract, the fiscal terms are understandably the common determinant in assessing how these interests have been balanced.^[5] If the fiscal terms are too generous, government returns are weakened and likewise if the terms are too tough, the incentives to the oil companies to invest in exploration and development can be severely damaged with the result that the investment flow to countries offering a more attractive fiscal regime.^[6] However the effectiveness of the fiscal terms in balancing the parties’ interests largely depends on the country specific factors including geological prospectivity, social, economic and political risks and regulatory risks.^[7]

The recent petroleum exploration success in Tanzania has been remarkable and has attracted a lot of attention from the global oil and gas industry as a new source of gas supply.^[8] Since 2010, large gas discoveries offshore Tanzania has created the potential for Tanzania to becomes a major gas exporter.^[9] The exploration efforts in the deep offshore basins resulted in discoveries of large quantities of natural gas making the current the total estimated gas reserves in place in Tanzania basins to be more than 46.5 TCF^[10] which is said could rise five-times over the next five years, putting it on par with some Middle East producers^[11].

In October, 2013 the Government of Tanzania launched the 4th Licensing in which seven deep offshore as well as the onshore North Lake Tanganyika block were offered^[12]. In the same event, the new Model Production Sharing Agreement (MPSA) to be applied for these new blocks was also pronounced.^[13] The 2013 MPSA replaces the earlier 2008 MPSA though most of the PSAs currently in effect are based under the 2004 MPSA.

The new model has incorporated various changes notably those representing a significant tightening of the fiscal screw and other conditions pertaining the new blocks.^[14] The changes are said to secure greater short and long-term fiscal benefits for the State, compared most existing PSAs.^[15] It is suggested that the government share of profits under the new PSA might be as high as 94% in certain cases.^[16]

For the first time the government has introduced the requirements for the payments of signature bonuses and production bonuses^[17]. The payments for rental charges have been increased significantly compared to 2008 MPSA^[18]. There is also significant changes to increase government take on the provisions regarding cost and expenses recovery and production sharing compared to most existing PSAs^[19]. The cost recovery is has been consistently capped at 50% as in 2008 MPSA though this was increased up to 70% by an Addendum for natural gas^[20]. The Royalty rate for offshore gas has been raised from 5% to 7.5%.

Unlike its predecessor the 2013 MPSA also provides a detailed provision for assignment of PSA rights to be subject to relevant tax law including capital gain tax. It also requires all assignment even to an affiliate has to obtain government approvals.^[21]

The provision for local content have also been significantly expanded compared to earlier PSAs certainly reflecting the government long term goal to involve local participants in the industry. The annual training expenditure has been increased from USD 150,000 under 2008 MPSA to USD 500,000 in the new PSA.^[22]

Like the previous 2008 Model the new model omits the inclusion of stabilization clause found in most existing PSAs signed under the 2004 MPSA^[23].

The pointed provisions are not intended to be exhaustive of the changes introduced by the MPSA 2013; they have been selected only for the purposes of this paper to represent the key fiscal and other commercial terms to be used in assessing the balance of contractual interests between the government and IOC.

There has been concerns and different views expressed by different analyst in the industry about the new PSA terms^[24]. Many analysts view the new PSA as representing the government confidence that there is sufficient upstream success to justify higher government take.^[25] The new terms has been labeled as onerous and does not reflect the industry reality in Tanzania and hence are likely hamper the development of the sector.^[26]

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Some other analyst however considers the new PSA terms to be somewhat unsurprisingly onerous following the recent country’s hydrocarbon exploration success and that the Government is right to strengthen the PSA terms.^[27] They argue that, although there are notable changes to the model agreement the changes are well within industry and regional norms.^[28] By introducing these changes Tanzania is joining a number of its petroleum-producing peers — Angola, Egypt, Indonesia, Libya, and Nigeria.29

It is against the brief background in this chapter this paper is prepared with an overreaching objective to making an analysis of the key changes introduced by the 2013 to assess how far these changes have considered both the interest of state and the investors, and also what is the implications and challenges associated with those changes in as far as the development of petroleum industry is concerned in Tanzania?

This paper argues that, although the government is fully confident that there has been enough exploration success to justify higher government take and increase other socio-economic benefits under the new terms, there remain challenges towards encouraging foreign investment in petroleum exploration and development activities in the country.

Chapter two talks about the concept of PSA in general by firstly highlighting the main concerns and interest of both state and investor in the petroleum contracts. It provides the key PSA terms which are particularly important in assessing the contractual balance between state and IOC. The chapter ends by providing for key factors for consideration when assessing the effectiveness of contractual terms in balancing the state and investors interests.

Chapter three generally provides for an overview of the petroleum industry in Tanzania. The current status of exploration and development activities is provided. The socio-economic and political environment underpinning the petroleum industry has been considered also. Finally the Regulatory and institutional framework for the petroleum industry has been reviewed.

Chapter four highlights and makes an analysis of key changes introduced under the 2013MPSA in Tanzania. Chapter five provides a critical analysis and highlights the challenges imposed by the new terms and finally chapters six makes a summary conclusion of the findings and provide some recommendations to overcome the challenges.

In the course of discussions, examples from global industry practice as well as specific countries practices have been drawn. Some specific examples have been drawn from petroleum potential developing countries like Nigeria, Angola, Egypt and Libya and developed countries like US, UK and Norway.

2 PRODUCTION SHARING AGREEMENT IN CONTEXT

In the exploitation of petroleum resources countries differ in approaches. While some states prefer the model based of grant of licenses or concessions others enter into contractual arrangement such as production sharing agreements or service contracts, or hybrid models which involve elements of license and contract.^[29] Whichever model is chosen, the state party expects to receive a return in the form of a share of produced hydrocarbon and/or financial benefits. The private sector involved will also expect to be rewarded for the work they have carried out and the risk they have undertaken.^[30]

This part analyses the key PSA terms which bears the primary concerns and interests of both the state and investors. It is important therefore to know these concerns before going to the details of PSA.

2.1 State and Investors concerns

The State’s primary interests are financial; it wants to make the maximum profit possible and have access to an IOC’s resources and relevant expertise, by expending minimal time and money.^[31] It will also want to ensure that the IOC undertakes a sufficient work program (including minimum expenditure) and that the land is being used efficiently.^[32] The State also has national economic considerations to be addressed. For example, domestic supply, and local content needs such as jobs and training are met.^[33]

Oil companies meanwhile want to explore in regions where there is a reasonable chance of finding oil and gas.^[34] They want to deal with stable governments and prefer contract ‘terms’ with fair, stable, and predictable fiscal terms that will allow them to minimize costs, early recovery these costs and provide a potential return-on-investment that is commensurate with the associated risks.^[35]

2.2 The concept of PSA;

“Production Sharing Agreement” is a contractual arrangement, between the designated state enterprise (state State) party and IOC (contractor) authorizing the contractor to conduct petroleum exploration and exploitation within a certain area in accordance with the rules of the contract^[36]. The discovered and produced petroleum is shared amongst parties in predetermined proportions and ratios.^[37] The contractor takes his cost (recovery) oil and share of profit oil after royalty or income tax is deducted and paid to the State.^[38] The contractor bears all the exploration risks unless the State party agrees to take up some direct participatory interests in the venture.

PSAs were first used in Indonesia in the 1960s and then spread globally more particularly in most developing countries.^[39] From the fiscal point of view PSA arrangement are basically regarded as similar to concessions despite their unique philosophical and symbolic backgrounds^[40]. The fundamental principle of these types of contracts is the notion of shared production. What is characteristic of these contracts is that the parties’ concerned share the production of the hydrocarbons produced and leave title to the unproduced oil with the state.^[41]

The enthusiasm for PSA in most developing countries is that, while retaining their sovereignty and the control over its natural resources, ‘PSA’ also offers developing countries lacking the financial resource and technical experience to build up a domestic petroleum industry on their own by giving them the possibility to engage foreign oil companies and make use of the latter’s financial and technical capabilities and resources without having to grant them exclusive licenses.^[42] PSA also enables them to transfer technology, skills and experience to locals as well as achieving other public interests goals through state participation and local content provisions.^[43]

2.3 Key terms under PSA

PSA contains a number of provisions ranging from regulatory, financial, Production sharing, cost recovery and taxes as well as legal and organizational aspects.^[44] However despite the multiplicity of goals on the part of governments and contractors, and the range of issues to be negotiated, the fiscal terms are understandably the key provision which determine the interest of both state and the investor.^[45] However as noted above the government has some other socio economic objectives; this part therefore highlights the key fiscal and other provision used to foster government socio economic interests. These provisions will be useful in assessing the alignment of party’s interests in this paper.

2.3.1 Minimum work program and expenditure

The prescription of minimum work and expenditure commitments is a crucial element of a PSA. Given that it is possible that only a small number of commercial discoveries may be made, such obligations are key to ensuring that the Contractor invests time and money in exploring the relevant area and defining the extent of the Contractor’s exploration risk.^[46] The Contractor is generally obligated to perform a specific program of works, for example drilling a certain number of wells, and in doing so, to incur a minimum level of expenditure (which will be set out in the contract). The Contractor is given a time period in which to fulfill these obligations.^[47].

The work program is particularly important as it involves financial obligation on the side of an investor such that tougher minimum work program for example requiring a certain number of wells to be drilled means more money will be spent on risk exploration works than the work program requiring few wells. More wells drilled means more data will be obtained and hence the government objective to have more data and information over its hydrocarbon resources achieved.

2.3.2 Signature and production bonuses

Signature bonus; is a one-off payment made to the government when the contract is signed.^[48] It is a payment for the right to conduct petroleum operation under the petroleum contract. Signature bonus is frequently used as a deciding factor in determining winning bids, when companies want to be awarded a contract. They can be negotiated or set by legislation.^[49] It can vary from little from as little as few dollars up to many dollars.^[50] The signature bonus tends to be small for fields where the geological data is relatively poor or nonexistent, and so exploration cost is high. Conversely, signature bonuses are high where there is good geological data and thus a higher chance that exploration will be successful.^[51]

Signature and production bonuses are common feature in PSAs of most resource-rich developing countries like Angola, Nigeria, Libya, and Egypt For example in Angola - In the 2006 offshore license round, the bids brought huge signature bonuses for Blocks 15, 17, and 18 - roughly US$1 billion for each block.^[52] The figure stunned the industry, but reflected the fierce competition and the perceived prospectivity of the region.^[53]

Signature bonus doesn’t depend on whether the IOC finds oil in commercial quantities or not and hence have a strong negative impact on the exploration economics and are particularly discouraging to smaller companies.^[54] Companies prefer to spend their limited exploration funds on data acquisition, and this is also consistent with most government objective.^[55] However the preference for signature bonus is because it involves no risk and ensures early revenue for the government.

Production Bonus; are payments made at certain point in time during the life of petroleum contract, at the time when discovery is declared, at the time that petroleum production begins, at a defined rate, or at a defined quantity of cumulative production.^[56] The Libyan model for example the production bonuses vary with production levels.^[57] Angola and Nigeria also uses the same approach.

Production bonuses are more acceptable to IOC than signature bonus and they also provide the government with a fixed amount of revenue at a certain point in time.^[58] Production bonuses are much more benign because the government also assumes the explorations risk.^[59] However, like signature bonus, production bonuses also have regressive impact on the project as they are not focused on profitability.

2.3.3 Royalty

Royalty is also a common feature in most PSAs. It is a payment made to government by reference to the amount and value of petroleum produced. The payment is made right off the gross or revenue.^[60] Royalties can be calculated through fixed percentage, sliding scale or sliding scale R-factor.

Royalties takes no account of costs of explorations, development or producing oil and gas hence have a negative impact of project profitability on the side of investor. For example depending on what costs are, a fixed royalty of say 20% could easily reduce company profits by 40%^[61]. That is way too much^[62].

Thus a high fixed royalty may result into early field abandonment even though oil and gas can still be found.^[63] Due to regressive impact of fixed scale royalty, increasingly states are creating sliding scales royalties that vary the royalty rate based on other criteria mainly the production or price levels.^[64] Nigeria is one of the countries applying this method.^[65] One thing that royalty do most effectively is to guarantee the government a share of production each and every accounting period.^[66] Studies suggest that the global range is between 7% - 17%.^[67]

For example under Nigerian PSA^[68] Royalty rates are 16.67 per cent at water depths up to 200 meters. In the United States also, the royalty rates cannot be below 12.5 per cent — they are currently at 18.75 per cent^[69].

2.3.4 Cost Recovery

Usually, the Contractor is entitled to recover its exploration and production costs from available oil production or gross revenues.

[...]

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^[1] Daniel Johnston, International Exploration , Economics, Risk, and Contract Analysis, PennWell 2004, pg 133-146

^[2] Daniel Johnston, International Petroleum Fiscal systems and Production Sharing Contracts,PennWell1994,pg 17­18

^[3] Ibid.

^[4] Daniel Johnston (n.1) 137.

^[5] Carole Nakhle, Petroleum Fiscal Regimes; “Evolution and challenges,” in Philip Daniel, Michael Keen and Charles McPherson (eds), The Taxation of Petroleum and Minerals: Principles, problems and practice, Routledge 2010, pg 89-90.

^[6] Ibid.

^[7] Ibid, 105

^[8] David Ladesma, “East Africa Gas potential for export”, Oxford Institute for energy Studies <http://www.oxfordenergv.org/2013/03/east-africa-gas-the-potential-for-export/>accessed July 15,2014

^[9] Ibid.

^[10] The Natural gas Policy of Tanzania, http://www.tanzania.go.tz/egov_uploads/documents/Natural_Gas_Policy_- _Approved_sw.pdf

^[11] Nina Howell, “Tanzania introduces new model Production Sharing Agreement and Mozambique prepares to enact new Petroleum Law” http://www.kslaw.com/librarv/newsletters/EnergvNewsletter/2014/Januarv/article3.html>accessed july22,2014.

^[12] 4th Licencing Round,< http://www.tz-licensing-round.com/> accessed June 28, 2014.

^[13] Ibid

^[14] Deloitte, “Tanzania Model Production Sharing Agreement 2013, A change of pace”? November 2013, http://www.psg.deloitte.com/ResourcesOilGasRenortsTanzaniaPSA 20131121.asp>accessed in August 2,2014.

^[15] ibid

^[16] Ibid.

^[17] 2013MPSA article 11

^[18] Ibid.

^[19] Ibid, article 12

^[20] 2010Model PSA Addendum for Natural Gas amended some key terms of 2008MPSA.

^[21] 2013MPSA, Article 74

^[22] 2013MPSA, article 21

^[23] 2004MPSA article 30.

^[24] Sara Menker and Ayenat Mersie “Tanzania right to update oil revenue-sharing” model, http://www.theeastafncan.co.ke/OpEd/comment/Tanzania-right-to-update-oil-revenue-sharing-model/- /434750/2094010/-/7wix8lz/-/index.html >accessed August 10,2014.

^[25] Deloitte(n.14)

^[26] Nina Howell (n.11)

^[27] Michael Burns and Nicolas. Bonnefoy, , “New production sharing agreement for Tanzania” Ashrust London http://www.ashurst.com/doc.aspx7id Content-9819 >accessed in July 24,2014.

^[28] Menker and Ayenat Mersie, (n.24)

^[29] Greg Gordon, “Petroleum licencing” in Gorgon, Paterson&Usenmrez(eds), oil and Gas Law: Current Practice and Emerging Trends, Dundee University Press, 2nd Ed,2011 pg 66

^[30] Ibid.

^[31] Allen and Overy, Guide to Extractive Industries Document- Oil and Gas, <http://wbi.worldbank.org/wbi/Data/wbi/wbicms/files/drupal

acquia/wbi/World%20Bank%20Extractive%20Industries%20Programme%20-%20Mining%20Guide.pdf>accessed July 29,2014.

^[32] Ibid.

^[33] Ibid.

^[34] Daniel Johnston, “Fuelling Poverty Reduction”: International Petroleum fiscal systems. <http://www.un.org.kh/undp/images/stories/special-pages/extractive-industries/docs/fiscal_systems_eng.pdf> accessed July 28, 2014.

^[35] Ibid

^[36] Benard Taverne, “Production Sharing Agreements in Principle and Practice” in M.R David (eds), Upstream oil and Gas Agreement, 1996 pg 44-58

^[37] Ibid.

^[38] Ibid.

^[39] Ibid.

^[40] Kirsten Bindemann, “Production Sharing Agreements An Economic Analysis”; Oxford Institute of Energy Studies <http://www.oxfordenergy.org/wpcms/wp-content/uploads/2010/11/WPM25- -KBindemann-1999.pdf >accessed July 18, 2014.

^[41] Ibid.

^[42] Taverne (39) 57

^[43] Ibid.

^[44] Ibid, 51

^[45] Ibid, 16-18

^[46] Allen (n 34)

^[47] Ibid.

^[48] Ibid.

^[49] Oil contracts: “How to read and understand them”.

^[50]http://openoil.net/2012/11/06/oil-contracts-how-to-read-and- understand-them-out-now/ at pg 49>accessed July 20.2014.

^[51] Ibid.

^[52] Daniel Johnston (n.36)

^[53] Christopher Brown - Wood Mackenzie “A golden decade for Angola’s deepwater” http://www.offshore- mag.com/articles/print/volume-69/issue-12/west-africa/a-golden-decade-for.html >accessed July10, 2014.

^[54] Daniel Johnston(n.l), 153-154

^[55] Ibid.

^[56] Oil Contracts (n.51) 50

^[57] Libyan EPSA-IV Model, 2005 clause.15

^[58] Daniel John(n.l) 154

^[59] Ibid.

^[60] Daniel Johnston(n.2) 53

^[61] Ibid.

^[62] Ibid.

^[63] Oil contracts(n.51) 51

^[64] Ibid.

^[65] Nigeria MPSA (n.53) article 16

^[66] Daniel Johnston(n.1) 154

^[67] Allen (n.14)

^[68] 2005 MPSA article 16.

^[69] AY Global Oil and Gas Tax Guide 2014< http://www.ey.com/GL/en/Services/Tax/Global-oil-and-gas-tax-guide-- -Country-list >pg 606.accessed July, 15, 2014.