When a land is suspected to contain hydrocarbons, international oil companies (IOCs) who have interest in this area of land will have to enter into an agreement with the host government or landowner. These agreements or contracts are called leases and will be granting permission to the IOCs to explore, develop and produce hydrocarbons from the land. In this article, we’ll be exploring the various kinds of lease agreements used in the oil and gas industry to grant mineral rights to oil and gas companies.
Firstly, it is important to note the meanings IOC and NOC, as they will be used frequently. International oil companies (IOCs) are privately owned companies operating globally like ExxonMobil, Royal Dutch Shell, Total, BP etc while national oil companies (NOCs) are state owned companies.
Different Contracts Agreements
This kind of contract involves ownership transfer. A concession contract is based on the American system of land ownership, which grants total ownership of everything in the land to anyone who owns a piece of land. Where the owner of this land is an individual, then they own not just surface land rights but also rights to any minerals within the land. In some other regions of the earth, only the government owns mineral rights. Individuals only own rights to the surface of the land but not to the minerals found in the land.
Now, in concession contracts, this ownership, either individual or government is transferred to the operating oil and gas company. A concession contract does not go on forever, there is a time limit given to the operating company to explore, develop and produce any oil and gas reserves found on the land. It usually lasts 20 years in most countries. If after 20 years, the operating company is yet to find any oil in the land, they can choose to renew the contract and get some time extension to continue to search for hydrocarbons. There is really no guarantee that they will find oil in the land. But, whether or not they find oil or gas, the owner of the land will be paid for the right to explore hydrocarbons on the land, which is non-refundable. It is important to note, that the owner of the land will not make any financial or technical contribution to the exploration, development or production of this lease area. All forms of financial burden strictly lies on the operating company. But as soon as any hydrocarbon is discovered in commercial quantities, then the concession agreement will specify the percentage of revenue generated from sales that will go to the owner of the land. Yes, the owner of the land has transferred ownership of mineral right to the operating company; yet, they will get a percentage of revenue from the sales of every barrel of oil or thousand standard cubic feet of gas, in the form of royalties. Royalties can be 1/32, 1/16 or even 1/8 of every barrel of oil or thousand standard cubic feet of gas sold, depending on what both parties agreed upon.
Concession contracts are very common in the US, Canada and North Sea, Kuwait and some other regions of the earth. Note, however that the operating companies mentioned here are usually international oil companies (IOCs). These oil and gas companies have a global reach and are attracted to countries with oil and gas reserves. IOCs have been there from the birth of the modern oil and gas industry and over time have gathered expertise and financial power which is a requirement in this risky venture. However, host countries do not always favor the idea of transferring ownership of their minerals to foreign companies, even though they get a portion of revenue from sales of every oil barrel or natural gas. Host countries may prefer to have a portion of the oil or gas instead. Not a portion of sales revenue. This leads us to production sharing contracts.
Production sharing contracts (PSC):
In this kind of contract, the land owner does not entirely transfer ownership rights of the hydrocarbons found on the land to the operating company. Both parties will share a portion of the hydrocarbons in barrels or standard cubic feet. Not in the sales of the oil barrels or natural gas. The production sharing contract is similar to the concession contract in that the operating company will still shoulder all the responsibilities and risks involved in exploring, developing, and producing any oil and gas, if any, found on the land. At the same time, they still bear the full risk in the case the land does not contain any hydrocarbon. And they still get to pay for the contract rights from the onset. So no matter the outcome, the land owner still gets to keep something for granting the company the right to explore develop and produce from the land. Royalties are not paid here but instead the production volumes are shared. So it’s not about the cash from sales, but about sharing the oil and gas.
Host nations have their own national oil companies called NOCs. Furthermore, host countries have their own refineries. The crude oil or natural gas is either sent to the country’s refineries, sent to the NOCs or even sold. The major advantage here is that the country can choose to do whatever they like with the hydrocarbons. This control over the hydrocarbons may lead to higher financial returns. But firstly, the operating company has to recover money spent on exploration until production. This is called the ‘cost oil’. The operating company may recover this through getting a very large portion of production from the start of production until they recover their invested capital. After this, the rest of the production is termed ‘profit oil’ and the sharing ratio will have to be adjusted now and the host nation gets a higher portion.
It is important to note at this point, that whether for concession contracts or production sharing contracts, the host nation can and will still tax the operating company from their profits. This has nothing to do with royalties or hydrocarbon production sharing. In some other cases, the host nation does not want to share at all. They want it all but they may not have all the expertise required to get the oil or gas from the ground. This leads us to the next type of contract.
Here, the host government employs the oil and gas company to help explore, develop and produce hydrocarbons, if any, from the land. Now, remember that in the other contracts the companies shouldered the entire technical and financial burden, and if they did not find any oil or gas at the end, then it was their own loss. In service contracts, this burden now rests squarely on the shoulders of the host government. They invite the oil and gas companies simply as operating contractors. The operation may be supervised by the national oil company of the host nation. If hydrocarbons are found, the operating contractor (IOC) will be paid for their service while the host government retains full ownership of their hydrocarbons. As can be seen, service contracts are hard to pull off as IOCs earn less than they would with other contracts. However, the good news is the company will still get paid whether or not hydrocarbons are found on the land and bear zero financial risk. Some other times, the host nation wants to share the financial burden and risk. Remember that in concession and PSC the operating company bears all the financial and technical burden. In service contracts, this burden is transferred to the host nation. But there is yet another form of contract, in which both the host nation and the companies share both risk and profit.
Joint ventures (JV):
In joint ventures both parties enter into a partnership. Both the national oil company of the host nation and the international oil company will be contributing technical expertise and everyone gets to contribute financially towards exploration until production. Joint ventures have the advantage of knowledge sharing between the IOCs and NOCs as they get to work together and both have stakes in the contract. Usually the host government holds a higher percentage of this venture. More than one international oil company may enter the joint venture with the host country’s national oil company but mostly the NOC will still retain the highest percentage in this partnership. The implication of this higher percentage is that a higher financial commitment will be required from the host government. Profit and cost are shared based on percentage ownership in the venture.
Now, this is where it could get messy as decision making process could slow down since both the IOCs and host government have a say. At the same time, the government of the host nation will find it difficult to regulate the compliance of operations to standard environmental procedures. Normally, the IOCs usually come with more expertise, so they become the operating company. The government on the other hand is both a player and a referee (regulator). It could be difficult to regulate your own operations.
Mineral rights have to be given to international oil companies before they can operate in any country. Minerals found beneath the land belong to the government of the land but could also belong to individuals. There are several contract options that can be entered into between the host government and the international oil companies. Each of them has their own advantages and drawbacks and the legal processes involved in each of them vary. The best choice will be the one that benefits both the international oil companies and the host government.