In the fast-changing world of international upstream oil and gas, two recent and related developments are particularly noteworthy. Firstly, the Iraqi Government announced in July that, in its otherwise unsuccessful first upstream round, a consortium of BP/CNPC has won the right to operate the giant Rumaila oilfield (estimated resources 15-20 billion barrels). Incredibly, BP/CNPC envisage enhanced production from Rumaila of 2.85 million barrels of oil a day, more than that cumulatively produced by the UK or Venezuela.
Secondly, Mexico is proceeding with another onshore gas round in the Burgos area. The goal is to rapidly prove up onshore non-associated gas reserves. There is also serious talk of holding an offshore oil round. The opening of the Mexican oil business to private companies is a process of "seismic" (pun intended) importance.
But what is the connection between Iraqi and Mexican development? The answer lies with the granting instrument used by the Iraqi and Mexican governments.
The granting instrument is the document, issued by a governmental authority, which gives an oil company contractor an exclusive right to explore for and produce hydrocarbons from a defined area, or ‘block’. This right, which can only be taken away by lawful expropriation with compensation, can loosely be termed a “real” right. In the case of Iraq and Mexico, the chosen granting instrument is the Service or Risk Contract.
While granting instruments come in many forms, there are three main types.
The Licence/Concession/Lease, often simply called the Licence, is used in jurisdictions like the UK, USA, Norway and Brazil. It allows the Licensee full equity in both oil and gas produced at the wellhead – subject to royalty and other government fiscal take – and in infrastructure constructed or upgraded under the terms of the Licence.
The Production Sharing Agreement (PSA), is typically used in less developed jurisdictions such as an India, Indonesia, much of Africa. Like the Licence, it a full equity system, but is structured to compensate the contractor’s investment through Cost Oil and then divide Profit Oil through an algebraic production sharing formula.
Finally, the Service or Risk Contract is radically different. Usually, a Service Contract is between a national oil company (NOC) and an international oil company (IOC). It is often used in marginal fields, or even old producing fields where the NOC lacks capital, people and technology to maximise production. The NOC continues to own the block, any infrastructure and any resulting production. There is therefore no technical change of ownership as far as the State or the NOC are concerned. The field, however, is taken over by the contractor as operator, often along with an additional exploratory area.
Under a service contract, the contractor will be obligated to act as a reasonable prudent operator, subject to international oil industry standards. Normally, as in a standard PSA, the contractor will be obligated to carry out a Minimum Work Programme, supported by a parent company guarantee and, perhaps, also a bank guarantee. It will be obliged to deliver the hydrocarbons to the NOC at defined quality specifications – the meeting of which can sometimes represent the contractor's largest investment.
For all of this, the contractor is paid a fee per barrel of oil, or MCF (1000 cubic feet) of gas, delivered. Methods for calculating the fee range from the very simple – as in the Venezuelan Second Reactivation Round, 1993 – to highly sophisticated – the Venezuelan Third Reactivation Round, 1997. A key issue will be how the fee per barrel relates to world oil prices. This is often a delicate political matter. Frequently, the fee per barrel will also be tied to production enhancement.
Various bidding methods have been used for Service Contracts. Sometimes a work programme bid is used, sometimes a low production fee (Opfee). On other occasions, such as the “block-buster” Venezuelan Third Reactivation Round, a straight signature bonus is used.
The Risk Contract, which resembles the Service Contract, is used in an exploratory context, rather than production-based. The Risk Contract was used in Venezuela in the late sixties, in Argentina post-1978 and famously in Brazil in the 1970s-80. The essential principles are the same.
So why is the Service Contract preferable to the Licence or even the PSA in some situations? The usual answer is that it is politically more acceptable. In many countries, a full equity regime such as the Licence or the PSA gives rise to nativist fears that “the foreigners are stealing our oil”. The Service or Risk Contract can assuage these fears. While the contractor invests money on behalf of the NOC, it does not take ownership of infrastructure or crude oil production and its investments will only be reimbursed out of future production. That can look like a good deal to governments.
The reality, of course, is that the contractor will be looking at rate of return, just as it would with a Licence or PSA. As a Service Contract also confers the same operator role onto the contractor, a cynic might claim the term itself is a misnomer, designed to suggest operations are similar to those carried out under genuine traditional oil service contracts, such as drilling and well servicing.
What then are some of the major problems associated with Service Contracts as a granting instrument? On a strategic level, Service Contracts often appear in jurisdictions where there is a strong constituency for resource nationalism. As is the case in Mexico, they reconcile political antipathy toward concessions with the need for new investment in the oil industry. In such circumstances, there is always the risk that resource nationalists, far from being appeased, will claim Service Contracts are concessions in disguise and demand their termination or transformation. This is precisely what happened in Venezuela under the Chavez regime.
Secondly, even if the Service Contract is not the victim of resource nationalism, the contractor is typically dealing with a NOC. While the Contractor can rarely be forced to spend more than it wants in any given year – except for Minumum Work Programme expenditures – it can still be prevented from spending all it wants, at the speed it wants, on the particular projects it wishes to pursue. The NOC may simply not approve annual budgets, or a new deep exploratory well. Again, as happened in Venezuela, it may also shut-in or postpone production – which it continues to own under the Service Contract - to comply with, for example, OPEC obligations or national planning. In fairness, similar constraints may exist in PSAs.
The key economic elements of the agreement will be fee per barrel, quality specifications, proximity of delivery points and, of course, government fiscal take. Logically, a contractor should not be paying items like royalty, surface fees or oil and gas taxes in a Service Contract, as these should be levied against the party which owns production - i.e. the NOC. But the world is not always logical.
Lastly, a particularly disheartening feature of Service Contracts is that contractors, very often with an eye to equity markets, cannot book reserves.
What is our conclusion on Service Contracts? The international oil and gas business is inherently risky. There is no reason why Service Contracts should be rejected as a class. It is even possible that Service Contracts can be more remunerative on a per barrel basis than Licences – Peruvian friends have assured me that this was the case in the Peru of the 1980s. Like all granting instruments, Service Contract opportunities should be subject to a full oil and gas due diligence. Everything depends on the circumstances of each particular case.
On balance, however, it is preferable for IOCs, for legal and economic reasons, to enter a jurisdiction on a full-equity regime. In fact, that seems to have been the approach taken by the large majority of pre-qualified bidders in the recent Iraq Round. Only one field, Rumaila, was “licensed” out of the six oil and two gas fields on offer. As reported in the Oil & Gas Journal* there was a wide divergence between the expectations of the Government and that of the IOCs. For example, a Chinese consortium of CNOOC and Sinopec offered a US$25.40 fee per barrel for Maysan field, while Iraq would have accepted just US$2.30 per barrel.
Uisdean Vass is a partner and head of the Oil & Gas unit at Maclay Murray & Spens LLP