Types of Oil Contracts

Several types of oil contracts are in use throughout the world: concessions, in which the contractor owns the oil in the ground; production sharing agreements (PSA), in which the contractor owns a share of oil once it is out of the ground; service contracts, in which the contractor receives a fee for extracting the oil from the ground (service contracts are often depicted as a subset of PSAs); and joint ventures (JVs), in which the state enters into partnership with one or more oil companies. The book "Oil Contracts: How to read and understand them" notes that it is rare to find any contract that fits cleanly into any one of these categories, however, and in reality most contracts combine some elements of each.

All oil contracts must address two key issues, according to Revenue Watch Institute (RWI): how profits, often called "rents", are divided between the government and participating companies and how costs are to be treated.

Concessions

Concessions are the oldest form of a petroleum contract, having first been developed during the oil boom in the United States in the 1800s. When they were introduced around the world, concessions were one-sided contracts favoring companies, according to Revenue Watch, when many of the resource-rich nations of today were dependencies, colonies, or protectorates of other states or empires.

Concessions are based on the American system of land ownership, in which a land owner owns all resources in the ground under the land he owns and theoretically all resources in the air above it. Concessions grant an area of land, sub-soil resources included, to a company so that if a company discovers oil on a piece of land, it owns that oil. In concession contracts the contractor also has exclusive rights to explore and prospect for oil in that pre-defined area. While the benefit to companies comes directly in the form of ownership over any oil and gas found, governments granting concessions benefit in the form of taxes and royalties on oil and gas produced. Companies compete by offering bids, often coupled with signing bonuses, for the license to these rights. This type of agreement is quite common throughout the world and is used in Kuwait, Sudan, Angola, and Ecuador, among other countries.

Advantages and Disadvantages

For governments, concession contracts have the advantage of being more straightforward than other kinds of agreements, and the degree of professional support and expertise required is often less complex than that needed to negotiate joint ventures or PSAs. Also, the host government keeps the fees paid by the contractor regardless of whether oil is found and commercial production takes place. All financial risks of development, including the costs of exploration, are absorbed by the contractor. The main disadvantage, for governments, of concession contracts is that companies bidding for the contract tend to be more cautious in their bids. If oil and gas reserves are not proven then there is no guarantee that a company's costs will be covered, so the host government may not maximize its potential return.

Production Sharing Agreements

Production sharing agreements (PSAs), sometimes called production sharing contracts (PSCs), do not vest a contractor with ownership over the oil in the ground; ownership of the resource lies with the state. In this situation the PSA is drafted so that a contractor can extract the government's oil on behalf of the government. The PSA was first used in Indonesia in 1966, when the government decided to maintain ownership of the oil in the ground, so that the international company had the right to explore for oil but gained the right to own it and sell it (or a portion of it) once it had been extracted. In Indonesia, according to Revenue Watch, the concession licensing method had been discredited as a legacy of imperialistic and colonial periods and the PSA system was developed in the context of a broader movement of "resource nationalism" among oil-producing countries worldwide. Since that time PSAs have spread globally and are now a common form of doing business, especially in Central Asia and the Caucasus.

Oil companies are entitled to cost recovery for operating expenses and capital investment, and receive money from annual earnings - "cost oil" - to this effect. Once the companies have used annual earnings to repay themselves, the rest - "profit oil" - is shared according to the agreed percentage division with the host government.

Advantages and Disadvantages

All financial and operational risk rests with the international oil companies in the PSA arrangement, and a host government has the added advantage that it shares any potential profits without having to make an investment, unless it agreed to do so.

A disadvantage of the PSA for host governments is that it puts a premium on highly professional negotiations, and the government must have access to technical, environmental, financial, commercial, and legal expertise. This is more feasible for some oil-rich countries than others.

Service Contracts

Like a PSA, a service contract does not give an ownership right to oil in the ground. Unlike a PSA, in a service contract the international company never actually gains ownership, or "title", to the oil produced either. In these cases the company is simply paid a fee for its services in extracting the government's oil.

Joint Ventures

Another arrangement, sometimes considered to be a fourth type of contractual arrangement, is the joint venture (JV), which involves the state, through a national oil company, entering into a partnership with an oil company or a group of companies. The JV itself is in this case awarded the rights to explore, develop, produce and sell petroleum. Because there is no commonly-accepted form or structure for JVs, they are less commonly used as the basic agreement between an oil company and a host government. JVs require host governments and companies to do things jointly, so if the parties fail to work together the negotiations can be painstaking and disagreement common.

Advantages and Disadvantages

For the government, the only advantage of a JV is that it is not alone in decision-making on oil and gas matters and can count on the expertise and shared stake of a major international company. One of the main disadvantages of JVs is that they require more extended negotiations and require much more legal advice because their format is so ambiguous. Additionally, costs must also be shared between the parties, meaning that the host government is a direct and responsible participant in the natural resource extraction, and responsibility also brings with it liability, including for environmental damage.