Sound petroleum contracts are about building relationships

Such agreements play such a pivotal role in exploration, and must clearly define terms of engagement between players before they can be reflected on paper

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Elsie Oyoo

Each petroleum sector functions within an environment called a petroleum regime. At the top of this regime stands the constitution of that country. The relevant petroleum laws, policies and regulations come in at the second level, and after these, the petroleum contract features with the various sub-contracts that depend on it.  Only these contracts can deal with the finer issues that may arise between the State and the International Oil Companies (IOCs) during exploration. These contracts, especially the petroleum contracts, form an integral part of exploration.

The petroleum contract is deemed the most important of the various agreements as it regulates the relationship between the state and the IOC in such a way that each party knows what to expect from the other. In the worst case scenario, petroleum agreements safeguard the interests of each party from abuse by the other. The biggest interests in such agreements are normally the apportionment of profit, risk and costs.

For instance, the petroleum contract acts as a buffer from the financial and political risks faced by the IOC. It gives them comfort against volatile environments; governments may sometimes create a sudden change in law. They additionally protect IOCs from the ever fluctuating oil prices. States on the other hand, use contracts to get the revenue due to the country. They also attempt to ensure that petroleum wealth does more than improve the financial position of the IOC and the Government itself. For this reason, governments sometimes work clauses into contracts that oblige IOCs to transfer technology and act in an environmentally responsible manner.

Four main types of petroleum contracts have emerged since the beginning of modern petroleum exploration in the mid 1800s. They are the concession, service, production sharing and joint venture agreements.

Concessions predominated the early years of modern petroleum exploration. Though the use of the traditional concession has gone down, a modern form with more balanced provisions for both parties has arisen. Countries like Argentina use this modern concession.
Under traditional concessions, the State donated ownership of large tracts of land to IOCs, also called concessionaires. This concession meant much more in those days because property in land followed the ad coelum doctrine, that is, as Zollman in “the Law of the Air” put it, “he who owns the soil owns everything above and below, from heaven to hell.”

Those who negotiated these agreements had little consciousness of sound environmental principles which  assert that natural resources are the common heritage of mankind, both those present and those yet to be born.  Strictly speaking, no one can place unreasonable claims over natural resources. The State still did manage to benefit from concessions through royalties and rent paid by the explorers.

In those earlier concessions, IOCs enjoyed the full benefit of petroleum exploration but also bore the full risk for any possible loss that may have occurred. As the deal was so good with just the exploration, the IOCs were not motivated to go further and pursue any other objectives. By the 1950s however, that had changed. Governments began to limit the time and other rights the concessionaire enjoyed. Currently, the modern concession agreements are elaborate documents which provide for aspects of the state-concessionaire relationship, such as the sourcing of goods and services for the project and environmental matters, among others.

Nigeria reflects the evolution of concessions. It started off with concessions made on very broad terms. After independence and acceding to the Organisation of Oil Exporting Countries, Nigeria curtailed the rights of IOCs under the concessions declaring the natural resources the property of the state.

The service agreement runs on different principles altogether. Whereas with concessions the IOC has ownership of the land and the petroleum, under service agreements, the State retains ownership of both. In a sense, you can liken an IOC exploring under this contract to any other service provider. The Government contracts them to explore for the petroleum in exchange for the payment of an agreed fee.  While the ad coelum principle underpinned concessions, service agreements hinge on the doctrine of state sovereignty. Natural resources are so important to the state that it is untenable to cede ownership of them to foreigners.

Under service agreements, the state many a time retains the risk but, in particular cases, known as risk service agreement, the explorer shoulders the whole weight of the risk. Service contracts can never come with the perks that concessions did. In fact, they were met with resistance by the IOCs. However, as Governments have grown wiser, service contracts, and their variant, the production sharing agreements, constitute the terms upon which the state will engage with IOCs in the exploration of petroleum. Thus, IOCs have been forced to accommodate them.

The production sharing agreement (PSA) has Indonesia to thank for its being. Resource nationalism moved in tandem with the process of decolonisation in the 1960s. In this setting, states only offered a production sharing agreement to explorers instead of the full rights previously offered under concessions. PSAs give the contractor partial rights to the ownership of the petroleum once it has been extracted from the ground. As noted earlier, PSAs possess features in common with service agreement. They differ from service agreements however, in that the IOC can own part of the petroleum after extraction.

PSAs tend to be treated like one more law which regulates petroleum. In Kenya, for instance, there exists a model PSA. Even the proposed petroleum laws provide for a model PSA. Such treatment affects contractual negotiations in that it may be harder for IOCs to insert clauses that had been left out of the model PSA. For instance, once the Kenyan Government discovered just how disadvantageous stabilisation clauses could be to it, it scrapped them off from the standard contracts.

Despite the great promise PSAs possess, they also bring with them their own set of problems such as the one mentioned above. In short, as the relationship progresses, sometimes governments realise that they are not getting as much as they had bargained for. They thus can change the rules in the middle of the game as Russia did – when it realised that it was not making as much as it could out of the production sharing agreements, it amended the law governing PSAs, forcing IOCs to switch to another regime of exploration or abandon the exploit altogether. Despite all this, PSAs are currently the most common type of petroleum contracts around the world.

The joint venture agreement is the fourth type of petroleum contract. In it, the state, through its own national oil company, enters into a partnership with the IOC. This joint venture is then awarded the right to explore. Joint venture agreements require complex preparatory negotiations. However, they enable the state to benefit more directly from the expertise of the IOC as they are working in partnership with them. They also allow the state more involvement in the exploration.

Literature on petroleum contracts points out that in practice, it is difficult to make clear cut distinctions between the different contract types. This makes sense as the most important thing is whether the contract accurately captures the rights and duties of the parties.

Whether the players achieve this by using a contract type purely of one type or a hybrid is of secondary importance. Though categorisation does serve its purposes of conceptual clarification, all parties must concentrate above all, on what the contracts contain. Would they represent the interests of the parties? Would they stand the test of time and volatile environments? Would they be struck out by arbitrators or the courts? Meticulous work produces documents that answer to these tests.

As a first step, the players themselves must clearly define their relationship before it can be reflected on paper. The lawyers, in their turn, need a sound understanding of petroleum law in general and the specific relationship which they need to capture. Since petroleum contracts play such a pivotal role in petroleum exploration, they cannot be prepared on a trial and error basis. Regardless of which form of agreement the players choose, the contents of the document must be crafted to protect that relationship and see it through to its logical end.

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