ABSTRACT
This article explains the purposes and specifications of Product Sharing Agreements and ultimately explains that the objective of Product Sharing Agreement is to create a consensus for the benefit of all stakeholders.
I. INTRODUCTION
Product Sharing Agreements provide unity of interest between the parties by eliminating the opposition of interests between the host state and the company that will perform the activities in the production and development of natural resources.
Product Sharing Agreements are one of the three main types of agreements for the exploration and production of oil and gas resources under foreign investment agreements. Foreign investment agreements consist of consensus and license agreements, Product Sharing Agreements and risk-service agreements. All of the three types of agreements may be related to partnership or joint-venture agreements1. In another categorization, Product Sharing Agreements are a sub-type of upstream agreements which deal with the extraction of natural resources such as oil and natural gas from underground. “Upstream agreements are commonly referred to as petroleum exploration and production agreements (e.g., petroleum exploration and production agreements, E&P Agreements)”2.
In developing countries, the desire to convert natural resources into income leads to a desire to see the oil industry succeed. The success of the oil industry requires cooperation with international oil companies in terms of both capital and technical expertise. In accordance with this purpose, an agreement should be reached in a way that benefits all counterparties. This agreement can be formed through different forms of agreements in compliance with the expectations and interests of the parties. Herein Product Sharing Agreements comes into prominence3.
There are generally three models which are available to the host state for the exploration and development of the oil industry. The first of them is the model of nationalization of industry, which has largely been in effect since 1970 in Iraq. In this model, the state assumes all responsibilities and takes all profits. Under this model, international oil companies work under a technical service agreement for a fixed fee for a limited period of time, and this model is used in the majority of the Gulf countries. In the second model, the concession model, the host state licenses a foreign company or a consortium of foreign companies to extract oil. After the oil is extracted, it becomes the property of the foreign company and the foreign oil company pays taxes and royalties to the host state as a result of its activities. The third and final model is the Product Sharing Agreements, which is the preferred model of our article. Product Sharing Agreements are more complex than the other models, which will be explained in detail below4.
Production Sharing Contracts are a type of private law agreement that are frequently signed by the governments of nations that possess oil and businesses that possess the necessary capital and technical resources to extract the oil. Under these agreements, one party makes a commitment and pays the other’s costs in the event that any revenue is made from the transaction. The remaining funds are then divided between the parties. One party to Product Sharing Agreements is the national oil companies, sometimes the government itself and sometimes an extension of the government, and the other party is the companies that will provide the technical equipment and facilities required for the extraction of the oil and have the capital required to do likewise. Through Product Sharing Agreements, governments have the option to occupy different positions in oil production and development5.
Product Sharing Agreements remain the dominant form of agreement for the exploration and development of petroleum resources in developing countries. In this form of agreement, the state remains the primary owner of the oil resources, but interacts with the international oil company, which provides both financial and technical expertise in the development and exploration process6.
II. THE HISTORICAL BACKGROUND OF PRODUCT SHARING AGREEMENTS
Product Sharing Agreements have their origins in the Napoleonic Era and the French legal philosophy that the ownership of minerals should belong to the state and not to individuals for the benefit of all citizens. This philosophy is stated in Article 33 of the Indonesian Constitution of 1945 as follows7:
“All-natural wealth on the land and in water is under the jurisdiction of the state and should be used for the benefit and the welfare of the people”8.
Historically, Product Sharing Agreements were first used in Indonesia in 1966. Independent Indonesia American Petroleum Company (IIAPC) signed an agreement with Indonesia in 1966. It is possible to suggest that this agreement was the first production sharing agreement in the oil industry in real terms. This agreement is very important as it is considered as a turning point in the development of Indonesia’s and the world’s oil agreements9. Considering the political conjuncture of Indonesia at the time, foreign-owned companies were the target of criticism due to rising nationalism, while Product Sharing Agreements were considered as a solution to the disadvantageous situation of not extracting the resources for both the state and international companies, as they enabled the state to retain ownership of the resources. Following Indonesia, Product Sharing Agreements have become globally widespread in all oil producing regions except Western Europe10.
III. THE RELEVANCE OF PRODUCT SHARING AGREEMENTS
A. The Development of Natural Resources
The most specific characteristic of the natural minerals sector is the location of the mines where the activities such as exploration, development and production subject to the agreement will be performed. Nonetheless, initiatives in this sector are inherently high risk due to the unpredictability of mineral prices in the world market, the unpredictability of costs and the variability of the political conjuncture affecting related activities. Due to these risks, it is usually not possible for local companies to make these investments, especially in developing countries. The development of natural minerals is usually subject to a long-term program and often forms part of the overall economic program for the host state11. In order to serve this purpose, the host state benefits from the technical and capital competence of foreign oil companies under Product Sharing Agreements.
B. The Development Rights of Natural Resources and Ownership
There are two methods for negotiating Product Sharing Agreements: bilateral negotiations and competitive bidding. When an agreement is negotiated bilaterally, usually a multinational company applies to the government of the host state for a royalty for the development, exploration and export of a mineral deposit. Conventionally, the agreement is established by the company paying a royalty to the government12.
Frequently, agreement negotiations take place between a national company and an international company rather than between the international company and the government. The national company usually has negotiating power either because of legislation and regulations or because it controls natural resource reserves. Three reasons can be given as to why a national company replaces the government in agreement negotiations with a foreign contractor. The first reason is that the national company has more and better information about natural resources, which is one of the reasons why the national company is involved in agreement negotiations. The second is that a national company is less politically motivated than the government. Finally, the involvement of the national company in cooperation with the foreign company in controlling the process of exploration and development of natural resources will contribute to the development of national expertise13.
IV. THE CHARACTERISTICS OF PRODUCT SHARING AGREEMENTS
Product Sharing Agreements, which replace concession agreements, a type of administrative agreement generally concluded by the administration with a private person, are a type of agreement in which the power over natural resources has been transferred from oil-producing international companies to states. While the state retains the property rights over natural resources, Product Sharing Agreements authorize international oil companies to carry out exploration and production activities on natural resources. Hence, the host state or national oil company has the authority to exercise administrative control over the international oil company. In contrast to other risk agreements, it gives the host state the opportunity to enforce its policy on natural resources while at the same time creating the potential for the international oil exploration company to profit. For all stakeholders of Product Sharing Agreements, it can be said that a win-win relationship is created between them.
Product Sharing Agreements, which are a type of upstream agreements mentioned in the introduction of this article, are investment agreements due to their characteristics such as being long-term and allowing profit-income sharing in different ways, rather than being commercial agreements.
Frequently, contract negotiations take place between a national company and an international company, rather than between the international company and the government. The national company usually has negotiating power either because of legislation and regulations or because it controls natural resource reserves. There are three reasons why a national company might replace the government in agreement negotiations with a foreign contractor. The first is that the national company has more and better information about natural resources. Second, a national company is less politically motivated than the government. Finally, the national company’s cooperation with the foreign company in controlling the process of exploration and development of natural resources will contribute to the development of national expertise14.
Product Sharing Agreements differ from other types of agreements by their nature. The first aspect that distinguishes Product Sharing Agreements from other types of agreements is that the host state owns all the equipment and hardware, and the second aspect is that the international oil company assumes all the risk. However, this basic structure varies according to the configuration of the contracting parties. For instance, under the Indonesian Product Sharing Agreement, the host state is responsible for all exploration and production costs once the oil and gas field are discovered to be sufficient for commercial purposes. In the case of Peru, the risk burden in the exploration and production process was assumed by the international oil company in exchange for a significant amount of oil revenue compared to the terms of the agreement in Indonesia. These companies included Chevron Pacific Indonesia, Pertamina EP, CNOOC, ExxonMobil Cepu Limited and Pertamina Hulu Mahakam15.
In addition to these features, the financial features of Product Sharing Agreements require international oil companies to pay royalties to host states on total production. Following the payment of royalties, the international oil company is entitled to receive a predetermined amount of profit oil to cover its expenses. The remaining production is shared between the host state and the international oil company on a certain ratio. At the end of the process, the international oil company may be obliged to pay royalties on the oil profits16.
Product Sharing Agreements are prepared and used as model agreements in developing countries that do not have the necessary capital adequacy and technical equipment to produce natural resources, or in countries trying to rise to this category. Examples include oil producing host countries such as Qatar, Azerbaijan and Nigeria17.
A. Negotiations of Product Sharing Agreements
When drafting Product Sharing Agreements, the host state must first decide which parameters should be included in the agreement. It then needs to decide which of these parameters will remain fixed and which will be open to tender or negotiation. These decisions are often made at a time when the host state haslimited information about the potential size of oil deposits, extraction costs and oil or gas prices at the time of extraction. In addition, in seeking to maximize its share of production, the state must make offers to foreign oil companies that are attractive enough for them to bear the risks of production18.
B. Key Articles of Product Sharing Agreements
Product Sharing Agreements are separated from other types of agreements due to the nature of the agreement, and due to this feature, it is important to include the provisions required by the nature of the agreement in the agreement. Due to the opposing interests between the parties, it is necessary to include provisions aimed at balancing the opposing interests in its content, and these features should be taken into consideration when drafting Product Sharing Agreements.
1. Counterparties of Product Sharing Agreements
As mentioned in the introduction of this study, the parties to the Product Sharing Agreements are, on one hand, the government or a national company that is an extension of the government and has obtained a license from the state through legislation and legal provisions, and on the other hand, an international company.
2. State Warranty
Through Product Sharing Agreements, states guarantee that foreign companies investing and taking on significant risks will not face legal obstacles to their authorized exploration, development, and production activities. This gives the companies a “monopoly” right over other companies and prevents them from suing to stop the activities from happening.
3. The Rights of State
Host states receive a share of profits from the production, as one of the purposes for entering into Product Sharing Agreements. “The state may also request additional services from the oil company, such as the marketing of the product, the cost of which must be agreed in the agreement”19.
4. Duration of Agreement
Product Sharing Agreements, which are often concluded as a long-term investment agreement due to the nature of the business, might sometimes carry a short-term renewal clause that comes into effect after a successful discovery of the mine. If the reserves are commercially profitable and successful, the agreements can be extended20.
5. Cost Recovery and Profitability
The main provisions at the essence of Product Sharing Agreements are cost recovery and profitability. It is important for both parties that the cost items are written in a comprehensive manner. After the output of the cost items, the remaining part determines the profitability of the oil. With this provision, the parties define production, profit and revenue shares. The determination of production shares can be direct or indirect in favor of the state, or it can be in a way to increase the share of the host state through the tax rates that the state will regulate depending on the level of production21.
6. Royalty
In Product Sharing Agreements, a royalty is paid by the investment company to the host state. This fee is charged over gross revenue in certain periods. The investor production company pays this fee to the host state at varying rates depending on the project and production volume22.
Although the royalty can be determined in oil or cash, it can also be adjusted according to the average daily production. This rate varies between 6% and 15%. Prior to the commencement of production sharing, the contracting parties are allowed to cover the costs of exploration, development and operation of the oil field through a predetermined proportion of production called cost oil. Most Product Sharing Agreements have a cost oil cap of 60% and allow costs not covered in a given period to be carried forward and covered in the following period23.
7. Profit Oil
Profit oil is the allocation of the remaining production between the foreign investors and the host after subtracting the concession fee and the investor company’s cost oil24. The foreign oil company’s share of the profit oil is usually taxable. Researchers focus on how to balance geopotential with the cost of doing business and fiscal conditions. In assessing fiscal conditions, the focus is on the sharing of profits between the host state and the foreign oil company. Geopotential, costs, infrastructure and other key factors are factored into the foreign oil company’s earnings. In most countries, the distribution of profit oil ranges from 15% to 55% for the foreign oil company25.
8. Ownership
Product Sharing Agreements’ implications for natural resources make them acceptable for developing countries. Under Product Sharing Agreements, the state may retain ownership of reserves and the facilities and factories built by foreign companies. The agreement stipulates that ownership of the agreed production share passes to the oil company at a certain point. The state, on the other hand, has the option to retain ownership of certain assets and equipment26.
9. Tax Exemptions
In the taxation clause to be included in the Product Sharing Agreements, exemptions or exceptions from certain taxes are provided to the foreign investor through regulations made by the state in favor of the foreign oil company in relation to tax laws. The host state - assuming that these states are developing countries - provides tax exemptions to foreign investors for many years in order to encourage investment. It is sometimes possible to see that a contractual provision allows the foreign investor company to be exempt for the first five years. Nevertheless, if this exemption period includes the period of extraction and processing of the oil, for example, if we assume that this period lasts for three years, it can be said that there will be an exemption for only two years. For this reason, it is important that the exemption is granted after the commencement of production27.
10. The Domestic Market Regulations
The host state may sometimes make demands on foreign companies in order to meet the demands of the domestic market and impose this demand through regulations on the domestic market. As with other contractual provisions, there are variables in this provision. It is possible to encounter different forms for the amount demanded and the fee to be paid28. These arrangements usually include the condition that a certain percentage of the foreign oil company’s oil profits will be sold to the host state. Usually, the host state can pay in local currency at a predetermined exchange rate for domestic crude oil29.
11. Bonuses
The bonuses are for the host state. The premiums to be paid by the international oil company usually consist of signature and production bonuses, but sometimes also include exploration bonuses. Signature bonuses are one-off payments that are independent of economic success. These payments reduce the economic value of the project. On the other hand, production bonuses are recurring as production reaches certain levels, as agreed in the relevant clause of the agreement. The majority of Product Sharing Agreements recognize that the bonuses are tax deductible30.
12. Stability Clause
Stabilization clauses in Product Sharing Agreements are a way for the parties to allocate the risks of a long-term investment. With a stabilization clause, the host state agrees that its legislative and administrative powers will not have the effect of changing the agreed contractual terms to the detriment of the foreign oil company. Stabilization clauses limit the host state’s legislative and administrative authority, which serves as the legislature within its own legal system, in an effort to safeguard the private company31.
The stabilization clause is inserted into the agreements to provide the oil company with certainty regarding the uncertainties that new legislation may bring. This clause includes provisions to ensure that the oil company is entitled to additional production to the extent necessary to maintain its economic position once the new laws come into force32.
13. Adaptation Clause
An adaptation/renegotiation clause, which can be used as an alternative to or in conjunction with a stabilization clause, can provide both parties with protection against difficulties that may arise if the conditions existing at the time of signing the agreement change. With the adaptation clause, the investor is obliged to negotiate with the foreign investor if the host state (or state-owned company) changes the terms of the agreement, rather than unilaterally changing them33.
14. Force-Majeure
In the force majeure provisions of the Product Sharing Agreements, it is seen that special force majeure provisions are also included in addition to general force majeure provisions. In particular, it is seen that a force majeure clause is included in which the foreign oil company will be released from its obligations in the event that the activity is prevented by the host state. In practice, this situation is “limited to delays caused by inaction such as exceeding time limits arising from excessive bureaucracy in the host state”34.
15. Termination of Agreement
Standard Product Sharing Agreements do not include a provision that the agreement can be terminated in the first years following the effective date. There are three situations in which the agreement can be terminated. These three situations are i) voluntary termination of the agreement by the contractor by giving written notice if the contractor considers that conditions do not allow for the continuation of the oil operation, ii) failure to discover oil and the contractor does not find oil by the end of the extended period under the agreement or if the contractor does not choose to extend the agreement, the agreement is automatically terminated in its entirety, iii) in the event of a material breach of the agreement by one of the parties, the agreement may be terminated upon proof of such breach by arbitration or final court decision by conclusive evidence or upon written notice given by one of the parties prior to the period specified in the agreement35.
16. Applicable Law and Solution of Disputes
In Product Sharing Agreements it is considered that the law of the host state is mostly determined as the applicable law. However, the possibility that the balance of power between international companies and the host state will change this situation is high, especially if the host country is classified as underdeveloped or developing. In these cases, whether the host state has an investor incentive objective usually plays an important role. Leaving the resolution of disputes to the state judiciary in countries where the rule of law is not fully ensured would mean an extra burden for the international company, especially in Product Sharing Agreements concluded on a long-term basis. For this reason, international companies try to guarantee the resolution of disputes within the scope of independent and impartial arbitration within the framework of internationally recognized rules.
V. CONCLUSION
The contribution of Product Sharing Agreements to the extraction, production and development of natural resources is gaining importance in the energy sector, as they resolve the conflict of interest of the contracting parties in the parallel equation of the host state and the foreign company, which is the counterparty to the agreement, and provide flexibility in determining the profit-revenue sharing.
The host state, which does not want to compromise its property rights over natural resources while also increasing the host state’s income from the production and development of the natural resources it owns, and foreign companies acting with the ultimate goal of increasing their profits on the other side, unity of interest is ensured through Product Sharing Agreements, and Product Sharing Agreements act as a node in maximizing the interests of all stakeholders.
Product Sharing Agreements have gained importance for underdeveloped and developing countries in the last fifty years due to the host state’s ability to maintain control over natural resources and their flexibility in profit and revenue sharing and have been distinguished from other oil and natural gas investment agreements by their widespread use, especially in oil production.
BIBLIOGRAPHY
CENTRAL BANK OF RUSSIA, “Production Sharing Agreements”, Twenty-Fourth Meeting of the IMF Committee on Balance of Payments Statistics, 2011.
DANIEL JOHNSTON, “Production Sharing Contracts”, in: International Petroleum Fıscal Systems and Production Sharing Contracts, PennWell Publishing Company, First Edition, 1994.
GREG MUTTITT, “Production sharing agreements: oil privatization by another name?”, General Union of Oil Employees’ conference on privatization Basrah Iraq,
PLATFORM www.carbonweb. org , 2005.
DR. HASSAN SHAFIQUL/ DR. AMUDA YUSUFF JELİLİ, “Contract structure of production sharing agreement by international oil company in exploration of petroleum resources in developing countries”, International Journal of Energy Economics and Policy, Vol. 13 No. 3, 2023.
KRISTEN BINDEMANN, “Production Sharing Agreements: An Economic Analysis”, Oxford Institute for Energy Study, Series WPM 25, 1999.
KYLA TIENHAARA, Foreign Investment Contracts in the Oil & Gas Sector: A Survey of Environmentally Relevant Clauses, Sustainable Development Law & Policy, Vol. 11 No. 3, 2011.
MAJD OLLEIK/ HANS AUER/ RAWAD NASR, “A petroleum upstream production sharing contract with investments in renewable energy: The case of Lebanon”, Energy Policy, Volume 154, 112325, 2021.
PIERO BERNARDINI, “Stabilization and adaptation in oil and gas investments”, Journal of World Energy Law & Business, Vol. 1, No. 1, 2008.
SEMA TAŞVEREN, “Upstream Sözleşmeleri”, in: Uluslararası Doğalgaz Sözleşmelerinden Kaynaklanan Uyuşmazlıkların Tahkim Yolu ile Çözümünde Esasa Uygulanacak Hukuk, Oniki Levha Yayınları, İstanbul 2022.
SHAMARAN PETROLEUM CORP., How Oil Production Sharing Contracts Work, https://shamaranpetroleum.com/operations/ how-oil-production-sharing-agreements-work/ (Date of Access, 09.01.2024).
VERONICA WIGWE CHIZINDU, “Joint Venture and Production Sharing Contracts In Less Developed Countries – A Critical Analysis”, University of Wolverhampton PhD Thesis, 2019.
FOOTNOTE
1 Kyla Tienhaara, “Foreign Investment Agreements in the Oil & Gas Sector: A Survey of Environmentally Relevant Clauses”, Sustainable Development Law & Policy, Vol.11, No. 3, 2011, p. 16.
2 Sema Taşveren, Uluslararası Doğal Gaz Sözleşmelerinden Kaynaklanan Uyuşmazlıkların Tahkim Yolu ile Çözümünde Esasa Uygulanacak Hukuk, Oniki Levha Yayınları, 1. Baskı, İstanbul 2022, p. 9.
3 Hassan Shafiqul/ Amuda Yusuff Jelili, “Agreement structure of production sharing agreement by international oil company in exploration of petroleum resources in developing countries”, International Journal of Energy Economics and Policy, Vol. 13 No 3, 2023, p. 3.
4 Greg Muttitt, “Production sharing agreements: oil privatization by another name?”, General Union of Oil Employees’ conference on privatization Basrah Iraq, PLATFORM www.carbonweb.org , 2005, p. 5.
5 Kirsten Bindemann, “Production-Sharing Agreements: An Economic Analysis”, Oxford Institute for Energy Studies, Series WPM 25, 1999, p. 1.
6 Shafiqul / Jelili, p. 4.
7 Wigwe Chizindu, “Joint Venture and Production Sharing Agreements In Less Developed Countries – A Critical Analysis”, University of Wolverhampton PhD Thesis, 2019, p. 171.
8 “All-natural wealth on the land and in water is under the jurisdiction of the state and should be used for the benefit and the welfare of the people.”.
9 Wigve Chizindu, p. 173.
10 Bindemann, Production-Sharing Agreements: An Economic Analysis, Oxford Institute for Energy Studies, Series WPM 25, 1999, p. 1.
11 Bindemann, p. 5.
12 Bindemann, p. 7.
13 Bindemann, p. 5-6.
14 Bindemann, p. 5-6.
15 Shafiqul/ Jelili, p. 9.
16 Shafiqul/ Jelili, p. 4.
17 Taşveren, p. 27.
18 Majd Olleik/ Hans Auer/ Rawad Nasr, “A petroleum upstream production sharing agreement with investments in renewable energy: The case of Lebanon, Energy Policy”, Volume 154, 112325, 2021.
19 Taşveren, p. 29.
20 Taşveren, p. 29.
21 Taşveren, p. 30.
22 Central Bank of Russia, “Production Sharing Agreements”, Twenty-Fourth Meeting of the IMF Committee on Balance of Payments Statistics, 2011, p. 3-4.
23 Taşveren, p. 31.
24 Shamaran Petroleum, “How Oil Production Sharing Agreements Work”, https://shamaranpetroleum.com/operations/how-oil-production-sharingagreements-work/ (09.01.2024).
25 Daniel Johnston, International Petroleum Fıscal Systems and Production Sharing Agreements, PennWell Publishing Company, First Edition, 1994, p. 63.
26 Bindemann, p. 85.
27 Bindemann, p. 16.
28 Bindemann, p. 16.
29 Johnston, p. 68.
30 Bindemann, p. 16.
31 Piero Bernardini, “Stabilization and adaptation in oil and gas investments”, Journal of World Energy Law & Business, Vol. 1, No. 1, 2008, p. 100.
32 Taşveren, p. 33.
33 Benardini, p. 101-102.
34 Bindemann, p. 34.
35 Wigwe Chizindu, p. 199-200.
