Production Sharing Contracts

A Production Sharing Contract (PSC or Production Sharing Agreement – PSA) is a system where the government retains ownership of the resources, and the contractor holds the license. The contractor works for the government and recovers its costs from the production. The government permits the contractor to share in the profit from the oil remaining after cost recovery.

Although PSCs and Royalty/Tax systems appear fundamentally different, they are essentially similar from a mathematical perspective. The distinctions lie in the symbolism and rationale behind the structures of the two regime types. Legally, in a PSC, the government maintains ownership of the resources, whereas in a Royalty/Tax system, the contractor obtains ownership at the wellhead of the entire crude. In a PSC, the contractor is entitled only to Cost Oil and Profit Oil.

It is important to note that a PSC may include royalty within its structure. Generally, tax rates are lower in a PSC compared to a Royalty/Tax regime. A disadvantage of a PSC is its increased sensitivity to oil prices relative to a Royalty/Tax regime. The contractor may receive substantial compensation or penalties depending on the fluctuations in oil prices.

The company designated as the contractor receives a license from the government to conduct exploration, development, and production. The contractor bears all associated costs and is compensated by the government through crude oil sales or production.

Crude oil production is allocated as Cost Oil, with the remainder designated as Profit Oil. Cost Oil is used by the contractor to recoup its expenses. Sales proceeds from Profit Oil are then shared between the contractor and the government according to a predefined mechanism. This sharing basis can be determined by factors such as level of production, cumulative production, R-factor, ROR, or any metrics specified within the PSC.

A flow diagram representing a generic PSC is shown below. Occasionally, a tax is applied to the contractor’s share of the Profit Oil.

The royalty is deducted from the top, similar to any Royalty/Tax regime. Prior to distribution of production, the contractor is permitted to recover costs from revenues remaining after royalty payments. Typically, there is a cap on the portion of net revenue that can be allocated to cost recovery. For instance, if a PSC stipulates a 70% limit for Cost Oil, it means that if recoverable costs exceed 70% of the net revenue, the surplus will be carried forward for future cost recovery periods.

The cost recovery mechanism enables the contractor to recoup expenses related to exploration, development, and operations from sales proceeds. Generally, PSCs place a ceiling on the revenue amount that contractors can claim for cost recovery but permit unrecovered costs to be deferred and recovered in subsequent periods. Cost recovery limits usually range between 30% and 60%.

The objective of the cost recovery limit is to ensure that the government receives at least a minimal profit in all conceivable production scenarios, even when the project itself does not generate profit. Mathematically speaking, the cost recovery limit is the fundamental distinguishing factor between a PSC and a Royalty/Tax system.

The concept of 'cost recovery' is well-established. Those who provide the capital should be allowed to recover their investment. The cost recovery mechanism is one of the most prevalent features of a PSC and is comparable to mechanisms in Royalty/Tax regimes.

Given that there are multiple categories of costs, not all costs may be eligible for recovery at the same time. There may be a hierarchy of cost items that must be recovered in a specific order. This can impact cash flows, particularly if certain cost recovery items are taxable.

Revenues remaining after royalty payments and cost recovery are referred to as Profit Oil or Profit Gas. This is similar to pre-tax income under a Royalty/Tax regime. The contractor's share of the profit oil is subject to applicable taxation. In a service contract, this revenue is termed as the service fee instead of profit oil. Under a Royalty Tax system, the government receives income tax and/or other special taxes.

In a PSC, cash flows can be computed using various methods. It is advisable to verify calculations by performing alternate computations. Below is a general cash flow algorithm.

This discussion will cover the concepts of “Contractor Take”, “State Take”, and “Government Take”.

In general usage, "State" and "Government" often refer to the same entity. However, in the context of an Oil and Gas fiscal regime, they refer to two different entities. The National Oil Company represents the “State”. A National Oil Company (NOC) typically participates in upstream projects as one of the partner companies within the Contractor group. The Government represents the federal government of the host country.

Here is an example case with just one company in the contractor group. Assume an oil price of $100 per barrel and a production volume of 10 barrels. All figures are in dollars. Additional assumptions are outlined below:

Excess Cost Oil, as referenced in the terms above, refers to the additional revenue that remains after cost recovery if the recoverable cost is less than the maximum revenue allowed for cost recovery in a Production Sharing Contract (PSC). This excess revenue can be distributed between the government and the contractor in any agreed proportion. The distribution of the cash flow for the example provided is illustrated below:

The calculation presented above has been elucidated using the following formula:

Revenue before Cost Recovery = Gross Revenue – Royalty

Maximum Revenue Available for Cost Recovery = Revenue before Cost Recovery 

                                                                             X Cost Oil Limit

Cost Recovered = Minimum of Capex + Opex or Max Revenue Available for Cost Recovery

Excess Cost Oil = Max Revenue Available for Cost Recovery – Cost Recovered

Contractor’s Excess Cost Oil = Excess Cost Oil X Contractor’s share in Excess Cost Oil

Govt. Excess Cost Oil = Excess Cost Oil X (1- Contractor’s share in Excess Cost Oil)

Profit Oil = Revenue – Royalty – Cost Oil – Excess Cost Oil

Contractor’s Profit Oil = Profit Oil x Contractor’s share in Profit Oil

Govt. Profit Oil = Profit Oil x Govt. share in Profit Oil

Bonus: Cash bonuses may be required to be paid to the government upon signing the contract terms (license agreement). This is known as a Signature Bonus. Bonuses may also be paid in kind, such as tools and technology. Additionally, Production Bonuses are tied to production metrics. The basis of this bonus payment is governed by specific rules linked to production rate, volume, or other measures of production.

Royalties: Similar to concessionary regimes, many Production Sharing Contracts (PSCs) include provisions for royalties. These royalties are based on the gross revenue of the field or license area. In some cases, specific costs such as transportation expenses may be deducted for the purpose of royalty calculation, particularly when the point of crude oil valuation differs from the point of crude oil sales. The royalty rate can be linked to various factors including production rate, volume, or cumulative production volume.

It is crucial to explain the use of Sliding Scales or Incremental Scales. Many fiscal regimes employ sliding scales for royalties, profit oil splits, taxes, and other items. The most common approach involves an incremental sliding scale based on average production rates. The following example provides clarification:

In a sliding scale royalty that increases from 10% to 15% for every 10,000 barrels of oil per day (BOPD) tranche of production, any production less than 10,000 BOPD will incur a 10% royalty rate. Production exceeding 10,000 BOPD will incur a 15% royalty rate, but only on production above 10,000 BOPD. For instance, if the average daily production is 15,000 BOPD, the effective royalty paid by the contractor would be 11.67% (10,000 BOPD at 10% + 5,000 BOPD at 15%).

Confusion often arises when analysts think that exceeding a production threshold subjects all production to a higher rate. Sliding scales are incremental, ensuring contractors don't pay higher rates on all volumes just because production shifts tranches.

Cost recovery functions similarly to deductions in a Royalty/Tax regime. Government profit shares in oil act as a tax on contractors, though it's framed as sharing profits for services rendered. Under PSCs, the government reimburses contractors for costs and then shares the remaining production or revenues. Some PSCs impose limits on cost recovery, while others do not. For example, older Peruvian regimes made no allowance for cost recovery before splitting profit oil; the government simply granted the contractor a share of production.

Generally most PSC allows for the following to be cost recoverable:

• Unrecovered costs carried over from previous years
• Opex
• Expensed capital costs
• Current year DD&A
• Financing charges with certain cap
• Investment credit (uplift)
• Abandonment cost recovery fund

Sometimes no distinction is made between tangible and intangible Capex. All Capex may be allowed to be recovered in the period incurred instead of allowing on the depreciated portion in the period concerned.

Generally, unrecovered costs are carried forward indefinitely and are available for recovery in future periods. However, there may be instances where carry forwards are not allowed (especially for sunk costs) or there is a limit to the number of years or the amount of carry forwards in future periods.

Some fiscal regimes may offer incentives, such as investment credits (or uplifts). Uplift allows contractors to recover an extra percentage of capital costs through cost recovery. For example, an uplift of 25% on Capex of $100 would allow the contractor to recover $125 ($100 + $25).

Under most PSCs, the contractor transfers ownership rights to the government for equipment, platforms, pipelines, and facilities at the start of the project. Therefore, it is the government's responsibility as owner to handle the abandonment expenditure. However, the responsibility for field abandonment provision typically falls on the contractor. The government then allows this abandonment provision to be cost-recoverable. Projected abandonment cost is accumulated through a reserve fund that matures at the time of abandonment. These costs are recovered prior to the actual abandonment.

Profit Oil & Taxation: Profit oil is allocated between the contractor and the government according to pre-defined terms outlined in the signed Production Sharing Contract (PSC). These terms may be negotiable, depending on the specific agreement. The contractor's share of profit oil may be subject to additional taxation. In certain cases, the contractor is not required to pay taxes directly to the government. Instead, the National Oil Company (NOC) that partners with the contractor is deemed to have paid the tax on behalf of the contractor. This arrangement is referred to as Deemed or Imputed Tax.

The assessment of whether a PSC is favorable from the contractor's perspective can be based on "Take" statistics. A common benchmark for evaluating a PSC is the contractor take, which represents the contractor's cash flow as a percentage of the project's operating profit. Generally, if the geological conditions and supporting infrastructure are favorable, the terms of the PSC become more stringent, and vice versa.

DMO (Domestic Market Obligations): Sometimes, a PSC may require the contractor to fulfill certain domestic market needs of the host country at a discounted price. This often means that a certain percentage of the contractor's profit oil must be sold to the government at a discount to market price. Occasionally, the exchange rate of the currency in which the government reimburses the contractor for fulfilling this obligation may be predetermined and not market-based.

Ring-fencing: The recovery or deductibility of costs, profit oil, and taxation depends on the revenue base from which costs can be deducted. Typically, all costs associated with a given block or license must be recovered from the revenues generated within that block. In fiscal regime terms, this is known as ring-fencing. Ring-fencing prohibits the consolidation of costs or profits across different blocks or licenses operated by the same company. Some countries permit certain classes of costs associated with one field or license to be recovered from revenues generated by another field or license.

Ring-fencing may affect the tax base and tax payments as well as the carry-forward of losses and cost recovery. For instance, if a company has two blocks and both are ring-fenced for cost recovery and tax purposes, any loss or profit generated by each block is calculated individually. If one block generates a loss of $50 while the other generates a profit of $100, the total profit of the company operating these two blocks will be $50 ($100 profit from one block - $50 loss from another block). Suppose the tax rate is 30%. Without ring-fencing for tax computation, the total tax liability would be $15 ($50 x 30%). However, if the two blocks are ring-fenced, the tax liability will be $30.

Tax & Royalty Holidays: In some fiscal regimes, there is a provision for tax holidays or royalty holidays. These allow the contractor not to pay any taxes or royalty (in the case of royalty holidays) to the government during the holiday years. These holidays aim to attract additional investment in exploration and development.

Let’s show you a worked out example for a simple PSC now. The inputs for the case is shown below: