UNIVERSITY OF OKLAHOMA

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UNIVERSITY OF OKLAHOMA

• INTERNATIONAL PETROLEUM CONTRACTS
• FEBRUARY 6, 2003

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DISCLAIMER

• The views expressed in this presentation are
  solely those of the presenter. They should not
  be taken as reflecting the views of Kerr-McGee
  Corporation or any of its subsidiaries or
  affiliates (the Company) or the University of
  Oklahoma (the University). This presentation
  is presented with the understanding that neither
  the presenter, the Company nor the University is
  engaged in rendering legal, accounting or other
  professional services. In no event, including
  negligence on the part of the presenter, the
  Company or the University, will any of the
  aforementioned be liable for any direct,
  indirect, or consequential damages resulting from
  the use of this material.

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Why Have An Investor?

• In virtually every country around the world, the
  state owns the oil and gas rights.
• In many countries, exploration and development
  are carried out by private capital.
• Why does the state not develop what it owns?
• Because
• It does not have sufficient capital
• It is not the most efficient user of capital
• It does not have the technical capabilities.

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Sharing Benefits in Petroleum Investment

• Private capital is encouraged by giving investors
  the opportunity to expect returns better than
  other alternatives on offer.
• Risk/reward balance
• Returns are provided by sharing benefits.
• Sharing of benefits is a balance between
  nations rights to benefits as resource owner,
  and providing sufficient incentive to encourage
  investment.

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Sources of Government Revenue

• Bonuses
• Signature
• Commerciality
• Production Rate Based
• Participation
• Paid Government shares risks and rewards
• Carried No risk to government
• Royalty
• Rentals
• Amount
• Less significant in relation to royalties and
  bonuses
• Used to deter land banking

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Sources of Government Revenue (cont.)

• Taxes
• Corporation Income Tax
• Take based on measure of profitability and
  typically applies to all industries
• Other Tax(es) (VAT, Customs, Duties)
• Special Petroleum Tax
• May be deductible from corporation tax
• Aimed to recover profits in excess of normal
  levels.
• Taxes preferably should address full-cycle costs
  and not project-specific returns

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Petroleum Contract Legal Issues

• Establish sovereignty (Boundary Issues)
• Establish petroleum/minerals ownership
• Establish legislation framework
• Petroleum Laws
• Taxation
• Establish regulating organization(s)
• Establish license/permit type(s)
• Concession
• Production Sharing
• Recognize other prevailing national laws
• (U.S. laws also)

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Petroleum Legislation Framework-Ownership of
Hydrocarbons and Minerals National Petroleum Codes

• Facilitate Achievement of Energy Policy
  Objectives
• Prompt and thorough exploration of licensed area
• Efficient development of any discovery
• Maximization of ultimate recovery
• Disposition of petroleum in domestic and export
  markets
• Access to modern technology and training
• Obtain revenues

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Petroleum Legislation Framework

• Broad Objectives
• Provide mechanism whereby companies
• Recover their costs
• Earn an income that adequately compensates for
  risks taken
• Procure maximum income for state with mechanism
  for recovery of excess profits

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Typical Hydrocarbons Law

• Usually items are authorized in the law and then
  details are spelled out in regulations and
  contracts
• Ownership of hydrocarbons in place or after
  production
• Who has authority to set national policy,
  specific areas for bidding, award permits
• Constraints, if any, on who is eligible for
  permits and concessions
• Provision for exports and domestic requirements

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Typical Hydrocarbons Law (cont.) -Awards
Procedures

• How Will Permits and Concessions Be Awarded?
• Bidding or negotiations
• Parameters to be considered royalty rates, work
  programs, etc.
• Who determines areas to be offered, terms of
  offer, eligible bidders, timing

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Typical Hydrocarbons LawExploration Permits,
Rights and Obligations Under Such Permits

• Minimum work program
• Period of validity of exploration permit
• One or more terms, relinquishment of some area at
  end of each term
• Size and contiguity of area, possible limitation
  on how many one company can have
• Exploitation concession if successful

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Typical Hydrocarbons Law (cont.)

• Exploitation Concessions
• Rights and Obligations Under Such Concessions
• Develop and produce hydrocarbons within defined
  area
• Right of transport (e.g. Pipelines, terminals,
  roads)
• Must meet standards for work procedures and
  safety programs
• Must provide development plan and progress
  reports
• Information and technology transfer
• Production reporting and accounting required
• Period of validity of concession
• size and contiguity of area, possible
  limitations
• on how many one company can have

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Typical Hydrocarbons Law Other Rights and
Obligations

• Surface access rights, indemnification of owners
  for damages
• Must use good oil field practices, avoid damage
  to reservoirs, avoid wastage, comply with all
  rules and regulations
• Provide information on operations and production
• Make books available for audit
• Assist in inspection and control efforts
• Employ and train local personnel
• Insurance required
• Pollution and clean-up procedures

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CLASSIFICATION OF PETROLEUM FISCAL SYSTEMS

• PETROLEUM FISCAL ARRANGEMENTS

The first branch deals with the title to the
mineral resources. Concessionary systems allow
private ownership. In contractual systems, the
state retains ownership
CONCESSIONARY SYSTEMS
CONTRACTUAL SYSTEMS
The primary difference here rests upon whether
the fee is taken in cash (service) or in kind
(PSC).
Production Sharing Contracts
Service Contracts
Divided primarily upon whether fee is based upon
a flat fee (pure), or profit (risk)
Also referred to as Production Sharing Agreements
Pure Service Contracts
Risk Service Contracts
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Concession Agreement

• Key Features
• Concession company has exclusive right to explore
  for and exploit petroleum at its own risk
• Concession company owns production and can freely
  dispose of it (though it may have an obligation
  to supply the local market)
• During the exploration and exploitation phase,
  concession company pays surface rentals to host
  country
• The concession company pays taxes on profits
  derived from its exploitation operations
• The equipment and installations used for
  petroleum operations belong to the concession
  company
• Concession company pays royalty in cash or kind
  to host country

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CONCESSION/LICENSEPRODUCTION ALLOCATION DIAGRAM
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Concession/License

• Royalty Assumptions
• Alpha Field produces
• 50,000 bopd per Quarter (90 days)
• at a market price of 15/bbl
• If the royalty is a flat rate of 20, what is the
  value of the Quarterly royalty?
• If the royalty is the following sliding scale,
  what is the value of the Quarterly royalty?
• Annual average production rate
• 0 to 20,000 bopd 17.5
• 20,000 to 40,000 bopd 20
• more than 40,000 bopd 25

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Concession/License

• Royalty Calculation
• Alpha Field Quarterly Production
• 50,000 bopd x 90 4.5 mm bbls
• Flat Royalty
• In kind 4.5 mm bbls x 20 900 m bbls
• In cash 900 m bbls x 15 13.5 mm
• Sliding Scale Royalty at 50,000 bopd
• 1st 20,000 bbls x 90 x 17.5 315,000 bbls
• 2nd 20,000 bbls x 90 x 20 360,000 bbls
• 3rd 10,000 bbls x 90 x 25 225,000 bbls
• In kind Total 900,000 bbls
• In cash 900 m bbls x 15 13.5 mm

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CONCESSIONARY SYSTEM FLOW DIAGRAM
One Barrel of Oil 20.00
Contractor Share
Royalties Taxes
20 Royalty
4.00
16.00
(Net Revenue)
Deductions (Operating Costs, DA, IDCs, etc.)
9.00 3.78 12.78 64
7.00 (Taxable Income) Provincial Taxes (Ad
Valorem, Severence, Income) 10
.70 2.52 7.22 36
6.30 Federal Income Tax 40
Net Income After Tax

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The Problems With a Royalty-Based Fiscal System

• Sets an arbitrary economic threshold (cuts out
  higher cost developments)
• Will have strong negative effect on new and
  mid-life investments capital since it raises the
  economic threshold
• Increases time for investment capital recovery
• Increases cost of capital
• It discourages development of smaller fields
• It encourages earlier abandonment of producing
  fields
• Lacks flexibility to accommodate changes in the
  underlying conditions (price, cost etc.)

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Reasons for Evolution

• The Concession Form earned, and retains, a
  pejorative connotation.
• Host Countries shift away from the Concession
  Form was to redress those inequities by
• Reasserting sovereign ownership
• Introducing controls, such as equivalent of
  implied covenants
• Reallocating economic rents.
• The PSC and RSC Forms are much better than the
  Concession Form for asserting ownership,
  effecting control, and capping economic rent.

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PSCPRODUCTION ALLOCATION DIAGRAM
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Hybrid PSCProduction Allocation Diagram
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PSC Cost Recovery

• Assumptions
• Beta Field produces
• 50,000 bopd per quarter (90 days)
• at a market price of 15/bbl
• Investors unrecovered costs for Beta Field are
• Operating Costs 5/bbl
• Development Costs 200 mm
• Exploration Costs 80 mm
• Commercial terms of the PSC provide
• Cost recovery percentage 50
• Amortization rate 25
• What is the cost recovery for the Quarter?

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PSC Cost Recovery

• Calculation
• Quarterly Recoverable Costs
• 4.5 mmbo x 5 22.5 mm
• 200 mm x 25/4 12.5 mm
• 80 mm x 25/4 5.0 mm
• 40 mm
• Value of Quarterly Production Available for Cost
  Recovery
• 50 mbopd x 90 days 4.5 mmbo
• 4.5 mmbo x 50 2.25 mmbo
• 2.25 mmbo x 15/bbl 33.75 mm
• Quarterly Amount Recovered 33.75 mm (2.25
  mmbo)
• Quarterly Amount Carried Forward - 6.25 mm
• Quarterly Production Available for Profit Split -
  
• (50,000 bopd x 90 days) - (2.25 mmbo) 2.25 mmbo

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PSC Cost Recovery

• Calculation
• Quarterly Recoverable Costs
• 4.5 mmbo x 5 22.5 mm
• 200 mm x 25/4 12.5 mm
• 80 mm x 25/4 5.0 mm
• 40 mm
• Value of Quarterly Production Available for Cost
  Recovery
• 50 mbopd x 90 days 4.5 mmbo
• 4.5 mmbo x 50 2.25 mmbo
• 2.25 mmbo x 40/bbl 90 mm
• Quarterly Amount Recovered 40 mm (1 mmbo)
• Excess Cost Recovery Petroleum (50 mm/40)
  1,250,000 bbl
• Quarterly Production Available for Profit Split -
  
• (50,000 bopd x 90 days) - (1 mmbo) 3.5 mmbo

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PSC Profit

• Production Tranche Assumptions
• Beta Field produces 50,000 bopd at a market price
  of 15/bbl
• Quarterly Recoverable Costs 33.75 mm (2.25
  mmbo)
• Quarterly Production Available for Profit Split
  2.25 mmbo
• Profit Petroleum is allocated on a production
  tranche method
• Ave. Gross Production Contractor
  Government
• lt 20,000 bopd 80 20
• 20 - 40,000 bopd 50 50
• gt 40,000 bopd 20 80
• Excess Cost Petroleum is treated as Profit
  Petroleum
• What is the Quarterly allocation of Profit
  Petroleum?

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PSC Profit

• Production Tranche Calculation (15/bo)
• Quarterly Production Available for Profit Split
  2.25 mmbo
• Profit Petroleum Allocation Ration at 50,000 bopd
• Contractor Government
• 1st tranche (20 mbopd) 16 4
• 2nd tranche (20 mbopd) 10 10
• 3rd tranche (10 mbopd) 2 8
• 28 22
• Quarterly Profit Petroleum Allocation
• Contractor 2.25 x (28/50) 1.26 mmbo
• Government 2.25 x (22/50) 0.99 mmbo

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PSC Profit

• Production Tranche Calculation (40/bo)
• Quarterly Production Available for Profit Split
  3.5 mmbo
• Profit Petroleum Allocation Ratio at 50,000 bopd
• Contractor Government
• 1st tranche (20 mbopd) 16 4
• 2nd tranche (20 mbopd) 10 10
• 3rd tranche (10 mbopd) 2 8
• 28 22
• Quarterly Profit Petroleum Allocation
• Contractor 3.5 x (28/50) 1.926 mmbo
• Government 3.5 x (22/50) 1.54 mmbo

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RSCPROCEEDS ALLOCATION DIAGRAM
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Risk/Service Agreement

• Key Issue
• Similar to the PSC but cost recovery mechanism is
  different and is based on service formula (/BO)

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Risk Service

• Fee Assumptions
• Gamma Field produces
• 50,000 bopd per Quarter (90 days)
• Assume level production
• Commercial terms of the RSC provide
• Cost Recovery Rate 7.50/bbl
• Contractors Service Fee 4.00bbl
• What is the Contractor take for each Quarter?

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Risk Service

• Fee Calculation
• Gross Production
• 50,000 bopd x 90 days 4.5 mmbo
• Cost Recovery
• 4.5 mmbo x 7.50 / bbl 33.75 mm
• Service Fee
• 4.5 mmbo x 4.00 / bbl 18 mm
• 51.75 mm

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Reconnaissance/TechnicalStudy Agreement

• Key Features
• Typically for large frontier type area
• Usually will be for geology and seismic studies
  and will not include drilling obligations.
  Stratigraphic holes may be contemplated.
• May provide first refusal to participant if host
  country decides to license area after initial
  study or conversion options for
  exploration/exploitation contract
• May include provisions for later
  exploration/exploitation contract terms
• Typically for short periods
• May include provisions for training of host
  country personnel
• All expenditures borne by participating country

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Perspective

• Granting Instruments
• Exist in the Context of
• International Conventions and Treaties
• Host Country Laws and Regulations
• Contracts
• Industry Practices
• Are the Source of Rights to Explore and Exploit
• Allocate Risks and Rewards of Investment
• Establish Relationship for Investment

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Contents of a Petroleum Contract

• Scope and definitions
• Term
• Relinquishment
• Minimum work program
• Rights and obligations
• Disposition of production
• Valuation of production
• Measurement of production
• Government share, fees, taxes
• Payments

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Contents of a Petroleum Contract (cont.)

• Title to assets
• Records and reports
• Arbitration
• Training technology transfer
• Force majeure
• Termination
• Books of account, financial reporting, audit
• Other provisions
• Operating agreement

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IOC Host Country Issues

• IOC
• Stability
• Transparency
• Timeliness
• New opportunities
• Return on investment

• HOST
• Commitment
• Measure of control
• Technology transfer
• Catalyst for local industrial development
• Investment options
• Rent capture

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IssuesManagement and Control

• The foreign investor(s) will want absolute
  control.
• The host country will want its voice heard.
• Host government participation in management and
  control may occur in several ways
• Laws and Regulations
• Direct Ministry or Bureau supervision
• Representation on the Management Committee or
  Board of Control
• Equity participation in the enterprise, whether a
  joint venture, a partnership or a corporation
• If the last, participation often will be a
  carried interest through discovery or development

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IssuesEnvironmental Protection

• Fear of existing or future environmental
  legislation is a major deterrent to foreign
  investment in resource development
• In the United States, environmental laws have
  entangled remediation contractors, banks,
  lessees, etc.
• Baseline study by a neutral expert
• Photographic record signed by both parties on
  contract date
• A cross-indemnity is common Grantor as to past
  fouling, Grantee as to future. Very difficult to
  distinguish.

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IssuesSettlement of International Contract
Disputes

• Reference to the courts is viewed by private
  investors as unfavorable
• Reference to arbitration is often viewed more
  favorably

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Fiscal System Design Considerations

• A flexible structure is a stable structure
• Fiscal conditions, and the rent available for
  collection, will change from time to time.
  Fiscal structure must be flexible to accommodate
  this
• Good fiscal design without complementary
  institutional structures may still not achieve
  the desired goals
• Design needs to be within the administrative and
  audit capacity of the relevant institutions
• A simpler system may be more viable than a
  theoretically ideal but complex or contentious
  system

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Contract Types

• Style of contract usually not a material issue -
  identical economic behaviors can be induced in
  range of contracts

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