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COST RECOVERY AND HIGH OIL PRICE: HOW CAN HOST GOVERNMENTS CAPTURE ADEQUATE REVENUE?

A CASE STUDY OF NIGERIA

Omolade A. Akinwumi

ABSTRACT: Cost recovery is about the most attractive element of a Petroleum Sharing Contract to the
International Oil Companies (Contractors) as it provides an avenue for recouping sunk cost which is not a consideration in a concessionary system. Host Governments were comfortable with the concept as limits were placed on the amount of cost that can be recouped from every production. Notwithstanding, due to the recent sky rocketing oil price, Host Governments have become more concerned about how to benefit from the high oil price. This paper will highlight the impact of high oil price on cost recovery; it will consider production sharing agreements generally, its constituent parts focusing mainly on cost recovery. The paper looks at Nigeria as a case study and concludes with recommendations for host governments on how to benefit from high oil prices.

The author holds an LLB from University of Ibadan, and is admitted to the Nigerian Bar. She recently completed an LLM degree in Petroleum Taxation and Finance from the CEPMLP, University of Dundee. A student member of the Institute of Chartered Secretaries and Administrators of UK. She has a background in civil and commercial litigation. E-Mail: mollyjayy@yahoo.com

TABLE OF CONTENTS LIST OF ABBREVATIONS ................................................................................................ iii 1. INTRODUCTION............................................................................................................. 1 2. AN OVERVIEW OF PRODUCTION SHARING CONTRACTS .................................. 3 2.1 2.2 2.2.1 2.2.2 2.2.3 2.2.4 3. Definition of a PSC................................................................................................ 4 Constituent parts of a PSC ..................................................................................... 5 Royalty .............................................................................................................. 6 Cost Recovery Oil .............................................................................................. 6 Profit Oil Split ................................................................................................... 6 Income Tax ........................................................................................................ 6

COST RECOVERY OIL AND ITS ROLE IN A PSC .................................................... 7 3.1. Cost Recovery Oil Definition and Evolution ............................................................... 7 3.1.1. Definition of Cost Recovery Oil.......................................................................... 8 3.1.2. Evolution of Cost Recovery oil ........................................................................... 8 3.2. 3.3. Cost Recovery Oil in PSCs-Nigerias Experience .................................................. 9 Merits and Demerits of Cost Recovery Oil........................................................... 10

3.3.1. Merits................................................................................................................. 10 3.3.2 Demerits.............................................................................................................. 10 4. IMPACT OF HIGH OIL PRICE ON COST RECOVERY OIL .................................... 11 4.1. General Impact ......................................................................................................... 12 4.2. The Nigerian Case .................................................................................................... 13 5. CONCLUSION............................................................................................................ 14

BIBLIOGRAPHY ............................................................................................................... 15

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LIST OF ABBREVATIONS BP CEPMLP CRO DD&A DMO FGN FTP HG IIAPCO IOC JOA JVA LFN MBOPD NNPC NOC OPEC PPTA PSC SLD British Petroleum Centre for Energy, Petroleum and Mineral Law and Policy Cost Recovery Oil Depreciation, Depletion and Amortization Domestic Market Obligation Federal Government of Nigeria First Tranche Petroleum Host Government Independent Indonesian American Petroleum Company International Oil Company Joint Operating Agreement Joint Venture Agreement Laws of the Federation of Nigeria Million Barrels of Oil per Day Nigerian National Petroleum Company National Oil Company Organisation of Petroleum Exporting Countries Petroleum Profit Tax Act Production Sharing Contract Straight-Line Decline

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1. INTRODUCTION Resource rich countries are usually developing countries without the funds, technology or managerial know-how to exploit and develop their resources, thus the need for international oil companies (IOCs) to facilitate the exploration and development. Several forms of agreements exist for doing this, ranging from the traditional concessions granted to IOCs, to the modern concessions, to the more recent production sharing contracts (PSC), joint venture agreements (JVA) as well as service contracts.

Originally, IOCs come with the technology know-how and experience as well as funds lacking in the host country and the host country in return would grant the IOC exclusive rights over production. With the advent of the PSC in the 1960s in Indonesia, and OPEC directive to its members in the late 1960s to participate in the exploration of their oil resources, IOCs no longer had exclusive rights to production but shared from the production under a number of arrangements such as contractors in PSCs to the Host Governments (HG), who, in recognition of the capital and technical costs the IOC bears in the course of exploration and development, allocate a portion of production to the IOC to recover their costs. This is known as cost recovery oil (CRO).

IOCs particularly find this attractive as it serves as a guarantee of some sort that costs can be recovered from production before the payment of taxes. CRO as a percentage of the gross in cases where payment of royalty is not required and a percentage of what is left after royalty has been deducted in countries where royalty is required1, does not factor in oil price and is negotiated between the HG and IOC as part of the contract terms. At the time of entering into contractual relations, IOCs base their financial project analysis calculations on very conservative oil price estimation2 accounting for the huge profits during high oil prices.

The amount of revenue left in the hands of the IOCs as proceeds from the sale of CRO becomes very huge in periods of high oil prices, HGs now seek ways of benefiting a lot more from the high oil prices since the general rule is that the more profitable operations are to the

1 2

Countries such as Russia, Angola, New Zealand, Nigeria At the beginning of 2005, when oil price was well over $65 per barrel, BP increased its Brent price from $16 per barrel to $20 and John Browne its Chief Executive admitted that $30 per barrel would be reasonable. Source Principles of Project Evaluation: The Business Context CEPMLP Distance Learning Lecture Notes in Financial and Project Analysis of Natural Resources and Energy Ventures Module.

IOC, the more the incentives are curtailed and more financial obligations attached to the grant of petroleum rights as well as to the production obtained from the operations.

Active petroleum exploration and development activities have been going on in Nigeria since the commercial oil discovery at Oloibiri3 in 1956. Licenses for the exploration of petroleum were granted to several IOCs4 which were converted to joint operating agreements (JOAs) between the Federal Government of Nigeria (FGN) and IOCs in the early 70s to meet OPECs directive to participate directly in its oil exploration. To ensure effective functioning, several legislations governing oil and gas resources of varying degrees of complexity were enacted to meet FGNs aspirations from time to time.5

Since oil exploration is about revenue generation to the HG and IOCs, and both parties seek ways of maximising this, the problem has always been how to strike a balance between foreign exploitation and national interest. The law aspires to provide machinery for achieving this balance which varies from time to time depending on the countrys industrialisation, economic, political, technological and social needs. Before the commercial discovery of oil, the law provided very attractive incentives to potential investors as seen in the license granted to Shell DArcy in 1937 which comprised virtually the whole country.6 As soon as

commercial discovery was made, attention shifted to securing enough petroleum resources to reduce reliance on importation and when this was achieved, FGNs primary objective moved to increasing revenue through exports and national participation and generally having greater control over petroleum operations.

Consequently, the applicable laws were amended and new laws enacted to keep pace with governments changing priorities and goals giving credence to the general rule referred to

3 4

In the present Rivers State of Nigeria The first licence was granted to the Nigerian Bitumen Corporation a German Company in 1908 which commenced exploration work in Araromi area of Ondo State. Also in 1937, several oil exploration licences were granted to Shell DArcy now SPDC. Olisa, M. M., Nigerian Petroleum Law and Practice, (Lagos, Nigeria, Jonia Ventures Ltd, 1987) pg 2 5 Legislation such as the Mineral Oils Ordinance 1914, Petroleum Act 1918, Petroleum (Drilling and Production) Regulations, Petroleum Control Act 1967 all of which were amended severally and eventually repealed and replaced by the Petroleum Act 1969. Also the Oil Pipelines Act 1956 now consolidated into the Petroleum Profits Tax Act 1959, the Petroleum Production and Distribution (Anti-Sabotage) Act as well as the Special Tribunal (Miscellaneous Offences) Act and the Nigerian National Petroleum Corporation Act establishing the NNPC etc. 6 Olisa, M., M., op cit. Also, Britain, then in control of Nigeria as colonial master, granted the license and it has been accused of favouring foreign oil companies from its country.

above. The three basic arrangements - Joint Ventures (JV)7, Service contracts and PSCs - by which the national oil company, the Nigerian National Petroleum Company (NNPC), participates in petroleum operations are the focus of this paper.

This paper examines PSCs generally, its constituent parts focussing mainly on cost recovery and will highlight the impact of high oil prices on cost recovery using Nigeria as a case study. The study is important at this time when oil prices are at their peak of almost $100 per barrel as at November 20078 firstly because of the crucial role of crude oil in global political economy especially with regards energy supply. Also, the need to attract foreign direct investment without jeopardising national interest by balancing IOC needs (profit maximisation) with HG requirements (sustainable development) and finally the significance of the oil and gas sector to the Nigerian economy as its major source of revenue generation, make this study crucial.

The paper will conclude with recommendations for host governments on how to benefit during periods of high oil price.

2. AN OVERVIEW OF PRODUCTION SHARING CONTRACTS

Under a typical PSC, the contractor bears all exploration, development and production risks and costs and in return is allowed to recover its costs out of net revenues, subject to cost recovery limit conditions. 9 The first instance of PSC was in Indonesia on the 18th of August 1966 in a contract between the Independent Indonesian American Petroleum Company (IIAPCO) and the Indonesian National Oil Company, Permina (now PERTAMINA).10 IIAPCO was the contractor of Permina, with the obligation to implement the work programme as approved by Permina, bore all exploration expenses and risks which it was allowed to recover in kind up to specified limits. Title to oil remained with Permina and

JVs were the most prominent until the early 1990s when there was a shift in favor of PSCs due to the increasing difficulty of the NNPC to meet up with its share of cash calls required for JV operations. 8 By October 2007 prices had reached $92/barrel and reached a high of $99.29/barrel for December futures in New York on November 21, 2007. Source BBC News: Oil reaches new record above $99 at http://news.bbc.co.uk/1/hi/business/7105044.stm (last visited on 31st December 2007) 9 Johnston, D., International Petroleum Fiscal Systems and Production Sharing Contracts, (Tulsa, Oklahoma, United States, Penwell Publishing, 1994). 10 Ibid, pg 40

only passed to the IIAPCO at the point of export. Also, title to equipment purchased pursuant to the petroleum operations passed to Permina at the port of importation into Indonesia, and there were obligations to provide crude oil for domestic consumption and to keep proper books and accounts of the petroleum operations. In Nigeria, the first PSC was signed on 25th March 1973, between Ashland Oil Nigeria Company and the Nigerian National Oil Corporation, the predecessor of the NNPC for an initial period of twenty years renewable for another five years,11 but did not gain prominence until 1993. The Nigerian PSC is a blend of statutorily12 predetermined and contractually negotiated terms between the NNPC and the IOCs.13 NNPC holds all rights in and to the Contract area and appoints the IOC as a Contractor with exclusive right to conduct petroleum operations in the Contract area for 30 years [10 years for the exploration phase, and 20 years Oil Mining Lease (OML)] just as in other PSCs, the IOC provides funds and guarantees and bears risks of operating costs, is required to employ and train Nigerians and encourage local content utilization as a means of achieving technology transfer.14 2.1 Definition of a PSC A PSC is a contractual agreement between a contractor and the host government whereby the contractor bears all exploration costs and risk and development and production costs in return for a stipulated share of the production resulting from this effort.15

11

This PSC was terminated as a result of severe criticism which led to the setting up of a Commission of enquiry in 1980 which gave a verdict that the contract was too lopsided in favor of Ashland. Olisa, M., M., supra 12 The Constitution of the Federal Republic of Nigeria 1999, Petroleum Act 1969 and the Exclusive Economic Zone Act establish national sovereignty over petroleum, while the Petroleum Act and the Petroleum (Drilling and Production) Regulations stipulate the procedure, area and duration of the grant, as well as the rights and obligations of the parties. 13 The statutory terms include Government participation; title to Petroleum, grant of exploration licenses and Mining leases, Commerciality; fiscal issues, domestic obligations, environmental protection and safety, Arbitration and Applicable Law. Terms subject to negotiations include, duration of the grant, work commitment; relinquishment; insurance, title to equipment, certain rights and obligations of the parties, Composition functions and powers of the Management Committee; bonus payments; cost recovery limits; production sharing; accounting procedure; lifting obligations; and project implementation procedure. 14 Umar, M., B., M., Legal Issues in the Management of Nigerias Production Sharing Contracts :A Case Study of the Nigerian National Petroleum Corporation (National Petroleum Investment Management Services) Perspective, (Walde, T., W., ed. OGEL, Vol. 3, Issue 1, March 2005) 15 Johnston, D., Op cit Pg 310

The contractor may be one or more IOCs authorised by the HG (usually represented by its ministry of petroleum resources or the state oil enterprise) to conduct petroleum operations within the area specifically described in the agreement in accordance with the terms of the contract. 16 The rights and obligations of the HG and IOCs, the contract area, the fiscal and other conditions as well as the production sharing formula are predetermined and embodied in the contract terms. A PSC therefore is both a commercial and regulatory document.17 In Nigeria, the Deep Offshore and Inland Basin Production Sharing Contracts Act, 199918 defines PSC as any agreement or arrangements made between the Corporation or the Holder and any other petroleum exploration and production company or companies for the purpose of exploration and production of oil in the Deep Offshore and Inland Basins.19

2.2 Constituent parts of a PSC The clauses found in a typical PSC are Duration (exploration, production), Relinquishment, Exploration obligations, Bonuses (signature, discovery, production), Royalty rate, Cost recovery schedule, Depreciation, Profit oil split, Taxation, Ring fencing, Domestic market obligations (DMO), Investment uplift, and State participation.20 For the purpose of this paper, four components of PSC in relation to revenue (royalty21, cost recovery oil, profit oil and taxation)22 will be considered all of which are present in the Nigerian PSC. The first and last being statutorily imposed while cost oil and profit oil may be subject to negotiation.

16

Taverne B., Co-operative Agreements in the Extractive Petroleum Industry, 1 (London, United Kingdom: Kluwer Law International Limited, 1996) 17 Cameron, P., Comparison of International Petroleum Regimes, CEPMLP Distance Learning notes, Pg 2.12 18 Deep Offshore and Inland Basin Production Sharing Contracts Act, (1999) as amended ,Federal Republic of Nigeria Official Gazette,No.17,Vol.86, Lagos-23rd March ,1999 19 The corporation means NNPC, the holder means any Nigerian Company who holds an oil prospecting license or oil mining lease, deep offshore means water depth beyond 200 meters and inland basin means any of the following Basins: Anambra, Benin, Chad, Gongola, Sokoto and such other basins as may be determined from time to time by the Minister. See section 18 of the Act. 20 Tax rates, depreciation schedules, government participation, investment credits, domestic obligation, and ring fencing are normally legislated without the opportunity for negotiation, while relinquishment requirements, bonus payments, cost recovery, and profit sharing can be subject to negotiation. Johnston, D., op cit 21 Not all PSCs include royalty although it features in several countries where PSCs are in use. For instance, the Indonesian PSC has no royalty. See Johnston, D., supra pg 72 22 Kaiser, M. J., and Pulsipher, A.G., Fiscal System Analysis: Concessionary and Contractual Systems, (Centre for Energy Studies, Louisiana State University, Baton Rouge, LA. 2003).

2.2.1 Royalty The Oxford dictionary defines royalty as a sum of money that is paid by an oil or mining company to the owner of the land that they are working on.23 It is compensation for the use of property, usually copyrighted works, patented inventions, or natural resources, expressed as a percentage of receipts from using the property or as a payment for each unit produced.24 In a PSC, it is a levy calculated as a percentage of production which is paid to the HG as rent for the grant of petroleum operating rights to IOCs and the rate is determined by legislation. It is taken right off the top (gross revenue).25 2.2.2 Cost Recovery Oil This is a percentage of production allocated to the IOC under the terms of the contract to recoup its cost and will be discussed in more detail in chapter 3. 2.2.3 Profit Oil Split Profit oil is the net revenue/production after royalty oil and CRO have been deducted. It is divided between the IOC and HG. The portion of the profit oil allocated to the IOC is usually negotiable and stipulated in the agreement. The basis of the spilt varies in different countries and may differ even within the same country depending on prospectivity, the fiscal regime of the HG and also the level of production which could be a flat rate or sliding scale. In Nigeria, the spilt is 50/50% for 10 or less MBOPD and 60/40% for 10-20 MBOPD both in favour of the government.26 2.2.4 Income Tax The IOC share of the profit oil is subject to income tax the percentage of which is dependent on factors such as the geological endowment and the quality of hydrocarbons, which may be

23

Wehmeier, S., et al The Oxford Advanced Learners dictionary 6th edition , 1029 (Oxford, UK, Oxford Press, 2000) 24 Law encyclopedia 25 Johnston, D., op cit pg 40 26 Johnston, D., International Exploration Economics, Risk, and Contract Analysis, 302-312 (Tulsa, Oklahoma, USA: PennWell Corporation, 2003)

based upon a flat rate or sliding scale. Sometimes, this is paid by the NOC on behalf of the IOC.27 Other provisions of a PSC include the contract area, work programme and budgets, decommissioning, pricing, commercialisation procedure, treatment of associated gas, duties, compensation, and dispute resolution procedure (usually arbitration).28

3. COST RECOVERY OIL AND ITS ROLE IN A PSC

Apart from the fact that title to the hydrocarbons remains with the HG in a PSC, according to Daniel Johnston, ...the cost recovery limit is the only true distinction between concessionary systems and PSCs.29 The role of cost recovery is to create an avenue for compensating IOCs for the risks and expenses in exploration, development and subsequent operation cost which they have to bear alone since the NOC does not contribute towards any of these. It serves as a tool for balancing the IOC objectives of profit maximisation and HG requirements for developing its natural resources at minimal or no cost with negligible economic, environmental and social impacts.

3.1. Cost Recovery Oil Definition and Evolution

Though its purpose is to facilitate IOCs recouping investment, its composition varies from country to country. Some do not allow cost recovery at all but simply grant the IOC a share of production which may range between 44%-50% depending on the contract area30, while others have no limits on cost recovery such as the second generation Indonesian PSC. However, the general practice is that HGs place a ceiling on cost recovery and stipulate the costs that may be recovered.

27
28

In Egypt, the NOC pays taxes on behalf of oil companies. Cameron, P., Petroleum Licensing: A Comparative Study, 11 (London, United Kingdom: Financial Times Business Information Limited, 1984) 29 Johnston, D., International Petroleum Fiscal Systems and Production Sharing Contract, 42 (Tulsa, Oklahoma, USA: PennWell Publishing Company, 1994) 30 Examples of this are the1971 and 1978 Peruvian Model Contracts and also the 1975 Trinidadian offshore contract with Mobil

3.1.1. Definition of Cost Recovery Oil

Cost Recovery is the means by which the contractor recoups costs of exploration, development, and operations out of gross revenues...31 There is usually a limit or ceiling to the amount that can be claimed by the IOC. Notwithstanding, they are allowed to carry forward unrecovered costs to succeeding years. Not all countries have cost recovery limits but it ranges typically between 30%-60% where it exists. 32 Also, not all costs are recoverable while some are taxable. However, the most usual allowable costs include; unrecovered costs from previous years, operating costs (this forms the largest part of cost recovery once initial exploration and development costs have been recovered), expensed capital costs, annual depreciation, depletion and amortization (DD&A), interest on loan (usually restricted), investment credits and decommissioning fund.33

3.1.2. Evolution of Cost Recovery oil

Cost recovery is an ancient concept based on the principle of the one who put up the capital should at least get their investment back.34 It also originated from Indonesia where the first 40% of production went to IIAPCO to recover costs. The Indonesian second generation PSC did not have a cost recovery limit as 100% cost recovery was allowed provided the sum of PERTAMINAs share of profit oil and IIAPCOs income tax is at least equal to 49% of the total production.35 In 1989, a new model PSC was created which introduced the First Tranche Petroleum (FTP) 20% of total production and the remaining 80% left for recoverable costs. The FTP and whatever portion of production left after costs have been recovered is shared between PERTAMINA and IIAPCO.

Egypt and Syria adopted the concept of PSC next, which was modelled after the Indonesian PSC but with royalty, thus reducing the production out of which cost recovery can be claimed. In 1972, the Philippines government, by a Presidential Decree, published new conditions for service contracts similar to the Indonesian PSC but with proceeds sharing

31 32

Johnston, D., op cit pg 56, Ibid 33 Ibid pgs 56-57 34 Ibid 35 Tavern, B., Petroleum, Industry and Governments An Introduction to Petroleum Regulation, Economics and Government Policies,(London, United Kingdom, Kluwer Law International, 1999)

where the IOC takes up to a maximum of 70% of the gross proceeds from the sales of production in repayment of incurred costs and the Petroleum Board receives 60% of net proceeds.36

PSCs were adopted in Libya in 1974 with the NOC contributing to the operating and development costs until the date of export once a commercial discovery is made. The cost is shared between the NOC and IOC 81:19 or 85:15 just as production is shared and the IOC was not required to pay any income tax or royalty. In the Malaysian PSC, a maximum of 50% crude and 60% of the proceeds from the sale of natural gas is reserved for the purpose of crude oil and natural gas operations cost recovery separately. Following this example, other countries like Angola, China, Yemen, Myanmar, Vietnam, Ivory Coast, Ghana, Tanzania, Oman, Russia, Kazakhstan and Azerbaijan etc have also adopted PSCs with varying conditions for cost recovery.37

3.2. Cost Recovery Oil in PSCs-Nigerias Experience Under Nigerian PSCs, there is no limit on cost recovery as 100% recovery is allowed.38 However, each contract area is ring fenced.39 Thus any tax offset is restricted to costs incurred within the particular production sharing area and provisions are also included for effective control and management by NNPC to cure some of the perceived deficiencies of the first PSC. NNPC is now responsible for the management of operations while the IOC is responsible for the work programme, and expenditure limits have been set in excess of which the IOC must obtain NNPCs prior approval. This is to control excessive spending by the IOC40. Originally CRO was fixed at 40% under the Ashland PSC. CRO is specified in the accounting procedure annexed to and forming part of the agreement. It allows operating costs to be recovered in the year of expenditure and capital costs in equal instalments (SLD) over a

36 37

Ibid pg 260 Ibid 38 1994 Shell/Elf PSC See Johnston, D., op cit pg 312 39 A procedure whereby the cost of drilling a dry hole in one production sharing area will not be allowed as a deduction in computing the tax due on revenues from another production sharing area. 40 Adepetun, S., Production Sharing Contracts the Nigerian Experience, (Walde, T., ed. Journal of Energy & Natural Resources Law Vol. 13, 1, February 1995)

five year period or the remaining term of the contract whichever is less41. Some of which are tax deductable in accordance with the Petroleum Profit Tax Act (PPTA). 3.3. Merits and Demerits of Cost Recovery Oil

Just as there are two sides to a coin, CRO has its advantages and disadvantages some of which are highlighted below.

3.3.1. Merits

Once commercial discovery is made, CRO guarantees return on capital investment (preproduction cost and expenditure) to the IOC.

It is a negotiable term of the contract. It removes burden of funding from the HG. It establishes stability because it is agreed from the outset It is binding on the parties as it is a fundamental term of the contract thus reducing the potential for disputes arising there from.

It may serve as collateral for loan or basis for project financing once commercial discovery is made.

3.3.2 Demerits

Some of the drawbacks of CRO include the following The IOC may focus its attention on already existing prolific fields paying little or no attention to the exploration of new and potentially risky fields. Determination of CRO is not based on the proceeds of production (profit) but instead on production and may tend to be excessive in periods when oil prices are high. There is a potential for gold plating on the part of the IOCs especially where there is inefficient monitoring by the NOC forcing the NOC to concede increased volumes of production for cost recovery purposes.

41

Johnston, D., op cit, pg 312. It is important to point out that this may vary depending on the risk reserve ratio of each contract area and the negotiating skills of the IOC involved.

10

There may be need to renegotiate the CRO from time to time to prevent occurrence of disputes.

The existence of CRO does not mitigate the risk of drilling a dry well or the risk of failed exploration all together.

4.

IMPACT OF HIGH OIL PRICE ON COST RECOVERY OIL

2007 witnessed a departure of oil price from the normal seasonal trend in the second half of the year. Between the end of August and November, prices jumped by almost $25/b and the OPEC Reference Basket reached a record high of $91.91/b on 21 November.42 This upward trend is due mainly the deteriorating value of the US dollar, persistent refinery outages and weather related supply disruptions as well as geopolitics. Nigerias Niger Delta crisis has also been blamed for the galloping oil prices.43

42

OPEC, Review of the oil market in 2007, outlook for 2008, in OPEC Monthly Oil Market Report December 2007 at http://www.opec.org/home/Monthly%20Oil%20Market%20Reports/2007/mr122007.(Last visited on 17th January, 2008) 43 Leadership Newspaper, November 14, 2007 at http://www.leadershipnigeria.com/product_info.php?products_id=17603 (last visited on 5th January 2008)

11

Graph of OPEC Reference Basket from January 2005-December 2007

Source: OPEC, Review of the oil market in 2007, outlook for 2008, OPEC Monthly Oil Market
th

Report

December

2007,

at (Last

http://www.opec.org/home/Monthly%20Oil%20Market%20Reports/2007/mr122007. visited on 17 January, 2008)

The graph depicts the trend in oil prices from January 2006-December 2007. The unrest in Pakistan, the Niger Delta crisis in Nigeria, winter fuel demand and the weakening US dollar exchange rate prompted a flow of speculative funds in the market resulting in the high oil prices (peaking at $90.71/b before settling at $89.68/b 1st week in November), recorded between November and December 2007.44 4.1. General Impact When oil price is high as is the current situation45, consumers, airlines, utility and petrochemical companies pay more for heating oil, gasoline, jet fuel, crude oil and raw materials, and the whole economy pays more for electricity. The extra payments do not

44

OPEC, op cit $100.05 as at January 2008. Source: The Guardian, Soaring oil prices heat up global economy at http://www.guardiannewsngr.com/news/article02//indexn2_html?pdate=040108&ptitle=Soaring%20oil%20pric es%20heat%20up%20global%20economy (last visited on 11th January, 2008)
45

12

disappear but become revenue and translate into profits for some businesses and losses for others. This results in improved insulation in homes, more energy efficiency in industrial processes, more fuel efficient auto mobiles and on the part of government, various subsidies and tax relief.

Since higher energy prices shifts profit allocation from one business sector to another, and IOCs ultimately repatriate profits to their home country, the full benefit of high oil prices is not enjoyed by the HG which seeks to cushion its effects on its citizens. An increase in price will increase the value of the venture, and as cost oil is increased, the contractor can recover a greater percentage of its cost earlier in the life of the field with the potential to exceed their actual cost (a situation of windfall profits). As the HG is constrained by the terms of the PSC, it is unable to recover the excess revenue resulting from high oil prices. Any attempt by the HG to reduce CRO at such times would amount to a breach of a fundamental term of the contract which would lead to a dispute except where the PSC stipulates the sharing formula for the windfall profits.

Again, during periods of high oil prices, there is usually a decline in exploration of less viable fields by the IOCs in a bid to maximise gain focusing more on the commercially viable fields. The Angolan Government has been able to tackle this problem through the inclusion of the Price Cap clauses that retain any excess profit arising from high oil price without commensurate increase in costs46. Also, in Indonesia, the NOC sets maximum allowances above which cannot be deducted as cost. 47

4.2. The Nigerian Case Under the 1973 PSC, the Contractor paid all rents and royalties which it recovered as part of operating costs (which included interest on loan) from the proceeds of the sale of CRO.48 The Contractor was also required to market royalty oil, and tax oil on behalf of the FGN as well

46 47

Adepetun, S., supra pg 27 Ibid 48 Olisa, M., M., supra pg 135

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as cost oil. 49 NNPC is responsible for the royalty, rental and tax payments for which crude oil is allocated to it in the current PSCs.50 Asides ring fencing, relinquishment provisions and 85% petroleum tax rate (though regarded as oppressive within the oil industry) are in place. Despite the apparent ingenuity of the afore-mentioned to facilitate the capturing of as much revenue as possible for the FGN, their effectiveness comes in question in periods of high oil price. This is because of the nature of the industry which is capital intensive irrespective of oil price hence high oil prices will only increase the profit margin of the IOCs without any significant increase in cost.

A peculiar problem has been NNPCs inability to adequately monitor the expenses of the IOCs notwithstanding the expenditure limits set out in the PSCs coupled with the problem of corruption threatening the economy as a whole. Although the FGN would seem to benefit from high oil prices through the high petroleum tax51 imposed on the IOCs, it fails to capture the windfall profit on cost recovery.

5.

CONCLUSION

In spite of the apparent attractiveness of the PSC to both parties, it does have certain drawbacks which may be traceable to its cost recovery provisions. A way around this would be to set out instances in the contract when CRO can be renegotiated, especially when oil prices are high. It is not enough to have time limits for the recovery of development costs as provided in the contract. However, immediately the allowed exploration costs have been recovered, the allocation of CRO should be stopped. NNPC should be made to reimburse the IOCs for its share of operating costs in the year of expenditure and net production after deduction of royalty and tax oil should be shared between the parties in predetermined ratios in favour of the FGN.52

49 50

Ibid Ibid 51 The administration and effectiveness of which is also inadequate. 52 The problem here however would be how to determine when exploration costs have been fully recovered.

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When prices are high, costs should not be allowed to be carried forward except under exceptional circumstances as determined by the Minister. The Price Cap clause would also prove to be a useful tool in this regard. DMO obligations may be increased at such times to hasten the nationalisation process of exploration activities which is the end objective of PSCs. The above should be incorporated into the terms of PSCs especially in the light of FGNs recent decision to withdraw all oil and gas bills relating to gas exploration and production currently before the National Assembly. This decision was to allow for review of PSCs with the IOCs operating in Nigeria, to take gas production into consideration to ensure that government maximizes benefits from gas.53 Whatever measures FGN adopts in capturing adequate revenue for itself, the interest of both parties must be weighed and balanced bearing in mind that the issue of adequacy remains a relative term depending on the terrain.

BIBLIOGRAPHY

53

Statement made by the Director of the Department of Petroleum Resources (DPR), Mr. Tony Chukwueke, at the 25th annual conference of the Nigerian Association of Petroleum Explorationists (NAPE) in Abuja.

15

1.

Primary sources National Legislation Constitution of the Federal Republic of Nigeria (1999) CAP 62 LFN 1990 Deep Offshore and Inland Basin Production Sharing Contracts Decree No 26 of 1999 as amended, Federal Republic of Nigeria Official Gazette, No.17, Vol.86, Lagos, 23rd March, 1999 Exclusive Economic Zone Act Vol. VIII CAP 116 LFN 1990 Petroleum (Drilling and Production) Regulations Petroleum Act (1967) CAP P 10 LFN 2004 Petroleum Profit Tax Act, 19.. CAP LFN 2004

2. Secondary sources Books Bindermann, K., Production-Sharing Agreements: An Economic Analysis (Oxford, United Kingdom: Oxford Institute for Energy Studies, 1999) Cameron, P., Petroleum Licensing: A Comparative Study, (London, United Kingdom: Financial Times Business Information Limited, 1984) Johnston, D., International Exploration Economics, Risk, and Contract Analysis, (Tulsa, Oklahoma, USA: PennWell Corporation, 2003) Johnston, D., International Petroleum Fiscal Systems and Production Sharing Contracts, (Tulsa, Oklahoma, United States: Penwell Publishing 1994) Olisa, M. M., Nigerian Petroleum Law and Practice, (Lagos, Nigeria, Jonia Ventures Ltd, 1987) Taverne, B., Co-operative Agreements in the Extractive Petroleum Industry, 1 (London, United Kingdom: Kluwer Law International Limited, 1996) Taverne, B., Petroleum, Industry and Governments An Introduction to Petroleum Regulation, Economics and Government Policies, (London, United Kingdom, Kluwer Law International, 1999)
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Wehmeier, S., et al, The Oxford Advanced Learners dictionary, (6th ed., Oxford, UK, Oxford Press, 2000)

Articles Adepetun, S., Production Sharing Contracts the Nigerian Experience, (Walde, T., ed. Journal of Energy & Natural Resources Law Vol. 13, 1, February 1995) Andrew-Speed, P., The Structure of Fiscal Regimes, in CEPMLP Distance Learning Lecture Notes Mineral and Petroleum Taxation Module. Cameron, P., Comparison of International Petroleum Regimes, CEPMLP Distance Learning notes Umar, M., B., M., Legal Issues in the Management of Nigerias Production Sharing Contracts :A Case Study of the Nigerian National Petroleum Corporation (National Petroleum Investment Management Services) Perspective, (Walde, T., W., ed. OGEL, Vol. 3, Issue 1, March 2005)

3. Other sources Internet BBC News: Oil reaches new record


st

above

$99

at

http://news.bbc.co.uk/1/hi/business/7105044.stm (last visited on 31 December 2007) The Guardian, Soaring oil prices heat up global economy at

http://www.guardiannewsngr.com/news/article02//indexn2_html?pdate=040108&ptitle=Soari ng%20oil%20prices%20heat%20up%20global%20economy (last visited on 11th January, 2008) OPEC, Review of the oil market in 2007, outlook for 2008, at (Last

http://www.opec.org/home/Monthly%20Oil%20Market%20Reports/2007/mr122007 visited on 17th January, 2008)

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