What You Should Know About The Different Types of Oil and Gas Contracts

Posted on Jan 29, 2024 at 08:01 PM

At the beginning of the twentieth century, we saw that the types of oil and gas contracts and public & private arrangements through which companies obtain the required licenses to start the stage of investing and producing oil and natural gas have gone through various phases. This seems clear since the emergence of oil for the first time as one of the most essential commodities traded internationally. 

In light of this, different oil and gas contracts have emerged with different names. Our article for today will highlight the most important types of oil and gas contract standards in the oil field.

What are the most critical types of oil and gas contracts?

There is no specific number of types of oil and gas contracts. But we will explain one of the most common types in the oil industry. They are below:

1- Concession or License Agreements:

Concession or license Agreements have evolved considerably since their introduction in the early 1900s as one-sided contracts when many of the resource-rich nations of today were dependencies, colonies, or protectorates of other states. 

The modern form of such agreements often grants an oil company exclusive rights to explore oil or minerals extracted from a specified area. 

So that the processing stage comes to sell and export its derivatives at a specific time.

We see that the competition between the oil companies is intensifying to own these rights through offering bids, often coupled with signing bonuses, to procure a license for such rights. This type of agreement is common worldwide and used in nations as diverse as Sudan, Kuwait, Ecuador, and Angola.

Modern concession agreements replaced the traditional concession regime in the 1940s. Specifically, Venezuela imposed additional financial burdens on the investing companies, such as a profit-sharing scheme in the form of taxes.

It is worth noting that the new modernised concession can be differentiated from the old traditional concession through several features. These include smaller concession areas, increased state control and the possibility of participation in the petroleum investment project, a bonus system and income tax, rentals, and others.

The modern concession system is far more dynamic and flexible in accommodating different perspectives and interests of the contracting parties.

2- Production-sharing agreements (PSA):

With this type of oil and gas contracts and agreements, the state retains ownership of the resources. Still, it permits Investing companies to manage and operate the development of the oil field, thereby negotiating a profit-sharing system.

Under a PSA, an oil company carries the most financial risks of exploration and development, with the state also facing some risks. The National Oil Company (Ministry of Oil) often joins the consortium as an interest holder in the PSA, contributing some of its profits as share capital in the form of shares.

Often, the government has the cost of its initial contribution “carried” by the other companies in the case of concession contracts. This carried cost is repaid to the companies from the host government’s future profits under the PSA. If the government refuses to contribute to the share capital, the investing companies try to negotiate a more significant share.

There are no fixed determinants for determining the profits and shares for each country and the investing company. Instead, the division of those profits depends on the bargaining principle to reach an agreement.

However, the financial terms of the PSAs are similar to those of the license agreement, although the different structures may lead to other commercial results. The host government often earns a signing bonus, regularly waived or traded for a more significant share of future profits. 

The investing company is first entitled to cost recovery for current operating expenses, expenses for materials consumed or used in the year they were acquired, and capital investment—expenditures for assets such as buildings, equipment, and electronic devices, which have a longer shelf life. Cost recovery for current spending is immediate in the year the expenditure is incurred, and cost recovery for capital investment is spread over many years.

Here, the intelligence of the financial accountant appears in trying to distribute expenses according to the differences. Will it be distributed as operating or investment expenses? After all costs have been paid, the Government and the Company shall share the remainder of the annual profits according to a previously agreed percentage.

The investing company must pay taxes on its share to the government, which the host government often waives and includes in the company’s portion of the agreed percentage split.

PSAs have developed throughout history in a way that today, many different versions resemble each other only in the basic concept of sharing. This variation is not surprising as they are a product of intense negotiations, and the interests of each party naturally differ with the circumstances.

However, the hybrid variations of a PSA about the distribution of financial revenues are also possible. It could be a sharing scheme where

• If commercially valuable oil reserves were discovered, the investor's costs (for exploration, development, and exploitation) should be refunded by the so-called compensation oil

• The remaining part of the extracted oil shall be distributed between the investor and the state (proportions differ from country to country);

• The share obtained by the investing company shall become the object of the income-taxation

•  Royalties based on the value of production shall also be included.

PSAs were criticised mainly by the investing companies, which had no choice but to follow. PSAs are now widely used globally and are a common form of business, especially in Central Asia and the Caucasus.

3- Joint Ventures (“JV”):

The joint venture (“JV”) typically implies a commercial arrangement between two or more parties willing to pursue a joint undertaking in some still-to-be-clarified form, which has a courtship period and requires the parties to know and understand each other’s goals, interests, and ways of doing business.  

Given the open-ended nature of the JV structure, it is not surprising that JVs are less commonly used as the underlying agreement between an investing company and a host government. 

Nigeria was an exception: The national oil company favoured this format until it could no longer meet its share of the JV's financial commitments by contact. Now, new agreements in Nigeria are mostly PSAs.

Since a JVs demands parties to execute business goals jointly, by not resolving material issues before entering into a project, the parties only postpone a potential disagreement or a stalemate, especially if a project is a 50–50 deal. 

JVs require a wide range of negotiations over an extended time to ensure that all issues are thoughtfully addressed.

The joint ventures may be created between the recipient country and the investing oil company or several investors. Unlike the traditional concessions and PSAs, JVs allow host country partners to exert greater control over the ventures.

Besides sharing the high financial costs of the international petroleum project, JVs are also very helpful in minimising possible risks.  For example, the geological hazard of not discovering an oil reserve after the exploration procedures; the technical risk of performing in brutal or even extreme conditions (including terrain,  weather, and temperature);  the development risk that the found petroleum reservoir will have such characteristics as to hamper the extraction activities; and the political risk that riots or uprisings affect the petroleum project.

The joint venture helps developing nations increase their knowledge, obtain new petroleum technologies, and provide professional training through the best oil and gas courses from a more developed foreign investor.

Alongside the advantages, JVs also have potential flipsides such as, in the event the project fails, the host country partner may incur substantial losses,

JVs can be classified into two main categories. 

• Incorporated JVs:  the parties set up a jointly owned company incorporated in the host state and managed by a board jointly represented by both parties.  

•  Unincorporated JVs: run based on contractual agreement alone, without creating a separate legal entity.
  
  

4- Service Contracts:

The government often seeks to exert greater control over exploiting its resources. It may do this through service contracts. The government licenses companies to perform a carefully delimited service or task in this case. The Company does not participate in any part of the revenue produced. Thus, the government conserves the resource in a meaningful way.

There are three main categories of service contracts. Which: 

1. Risk Service Contracts. 

It is a type of oil and gas where an investing company is engaged as a contractor to infuse the entire risk capital for the exploration and production of petroleum. If the company fails to make any discovery of an oil reservoir, the contract is frustrated without any obligation on any of the parties.

However, if the company is successful in oil exploration, it is entitled to recoup expenses and remuneration and a possible stake in the subsequent enterprise. In this case, the government has preserved its resources.

Risk service contracts can be structured in primarily two forms.

1- Contract where the exploration risk is not distributed among the parties. 

Under such a structure, investing in oil companies entirely bears the amount of risk and obligation to fund exploration activities. If the commercially valuable petroleum reserves are not discovered during the agreed term, the contract is usually terminated without any compensation from the host state for exploration costs.

2- Contract where the exploration risk is jointly and severally distributed among the parties. 

This contract form is usually used by the governments of the recipient countries expecting high production capacity from a potential oil field. In this structure, the host Government shares a part of the exploration risk with the investing oil company to reduce compensation payments to the investor after discovering the oil reserves.

2. Pure Service Contracts. 

In this contract, the State provides risk capital for petroleum exploration. The contracting company performs its stipulated services and is paid a flat fee whether or not there is discovery. 

This contract is very suitable for oil-producing countries and those with a high desire for permanent discoveries, such as Saudi Arabia, Kuwait, Bahrain, and the UAE.   

3. Technical assistance contracts.  

This contract is a modern form of the traditional pure service contract. The contracting company in addition to providing all services related to exploration and production, transfers the technology and techniques used in exploration and operation to the indigenous people to achieve self-sufficiency in the future.

The country is exclusively responsible for financing the project in all its aspects, owns the crude oil, equipment, tools, and facilities relating to the project, and manages it through the national oil company. The investing company delegates its employees to operate the project under the management of the National Oil Company by providing all technical services. And all this without having any authority over the resources.

At the end of our article, the previous types of oil and gas contracts can be summarised as follows:

• Under the modern concession contract, the concessionaire company works for itself. 

• Under the production-sharing and risk service contracts, the contractors work primarily for the government.

• Under the hybrid or joint venture contract, the foreign company works in association with the state oil companies on the principle of partnership in their rights.
  
  

Let us conclude by advising you to attend the Upstream Oil and Gas Contracts the London Premier Centre offers. You can easily register for one to learn more about the types of oil and gas contracts.