INTERNATIONAL PETROLEUM AGREEMENTS-1: Politics, oil prices steer evolution of deal forms
International petroleum agreements (IPAs) have structures that are well-established yet strongly influenced by changes in political relationships and markets. The large swings of oil prices in recent years and the related pressures on existing agreements call attention to the need for IPAs to be flexible if not fundamentally changed (OGJ, Aug. 24, 2009, p. 20).
Modern IPAs are generally either production-sharing contracts or modernized concession agreements—with more host-country (HC) control over petroleum operations and state participation—although risk service contracts also exist on a more limited scale. Those structures have evolved both to accommodate the political ambitions of HC governments and to adapt to gyrations in the price of oil.In years of oil scarcity and high prices (particularly in 1979 and 1980), international oil companies (IOCs) competed fiercely among themselves and were forced to accept very harsh terms, even on marginally attractive prospects.
With the advent of low prices in the 1980s and 1990s and the perception of increased political risk in many developing countries, the respective bargaining power of HCs and IOCs shifted. Many IOCs redirected their new investments to exploration ventures in the US and Canada or in other politically stable areas, and many HCs renegotiated their earlier agreements at the request of IOCs, leading to less stringent contractual terms in order to encourage exploration and production (E&P) investments in a low-price environment.
A clearly opposite trend was observed in the 2003-July 2008 period as a result of increasing oil prices.
This review of the evolution of IPAs shows how changes in IPAs have followed closely the political evolution of relationships between countries, especially relationships between the industrialized world and developing countries. Still, economic considerations, especially the increasing volatility of oil prices, are obviously important to the particular fiscal terms imposed on, or offered by, investors over time.
Early concessions
At the beginning of the petroleum industry in the US in 1857, deal-making parties adopted the traditional concession agreement, derived from contracts used in the mining industry. The lease issued on Dec. 30, 1857, to Col. Edwin L. Drake on the tract of land in Titusville, Pa., where oil was first discovered in 1859 follows the pattern (see box).
Brief as it is, the Drake lease contains core elements that exist in basic petroleum concession agreements today, namely:
- The award by the lessor to the lessee (or "licensee" or "concessionaire") of exclusive exploration and production rights in a specific area for a given term with a possible time extension (although Drake's rights also covered coal and other minerals, which is not common in modern petroleum contracts).
- Payment of a royalty (called a "rental" in the Drake lease) corresponding to a fractional share of the production (one-eighth or 12.5% was traditional at that time for mining activity), payable in cash or in kind to the lessor.
- The obligation of the lessee to carry out the operations as soon as practicable, without undue delay, or otherwise the lease could be terminated.
Legal instruments used for petroleum exploration and exploitation have undergone far-reaching changes since the days of Col. Drake. Although a wide variety of agreements now exists, IPAs can still be reduced to a few different types of legal documents and contractual arrangements used throughout the world today. There is, however, one paramount difference: The modern concession agreement (like other international agreements) is now usually 100 pages long, not a mere paragraph as in the 1857 contract.
Profit-sharing principle
In 1948, Venezuela took the lead in instituting the 50-50 profit-sharing principle, which is the idea that the IOCs and the HC should share equally in the profits from oil development in the host country.
Saudi Arabia followed suit in 1950 and negotiated an agreement with Aramco which was signed on Dec. 31 of that year. For the first time in the Middle East, an income tax on petroleum revenues was instituted and the principle of 50-50 profit-sharing established. The royalty hitherto paid by Aramco continued to be paid and was credited against a 50% income tax as an advance payment for the tax. As a result of that arrangement, Saudi Arabia nearly quadrupled its petroleum revenues.
Because other Middle East producers were in a similar situation, the new system rapidly spread to other countries. However, the IOCs retained complete control over both the conduct of operations and the pricing of petroleum; in particular, the control of production schedules remained their exclusive prerogative.
The respective positions and relative strength of HCs and IOCs nevertheless underwent a steady and gradual change. As early as 1952, the 50-50 profit-sharing principle was applied in most countries, except in Iran. There, the more radical approach of nationalizing the oil industry was taken in 1951 by the Mossadegh government. At that time, however, the dominance of the oil market by the major IOCs was such that they succeeded in imposing an embargo on Iranian oil.
This eventually led to the downfall of Mossadegh and the reinstatement of the shah. Nationalization of the oil industry was nevertheless preserved, and the Anglo-Iranian concession was replaced by an agreement between the National Iranian Oil Co. (NIOC) and an international consortium dominated by US companies that became major players in Iran for the first time, along with the Cie. Francaise des Petroles (CFP), now called Total.
Evolving relationships
The events in Iran accelerated the evolution of the relationship between HCs and IOCs. On Aug. 24, 1957, NIOC entered into a joint venture with AGIP, the Italian national oil company. AGIP sought new forms of joint venture agreements with HCs in an effort to challenge the dominance of the seven sisters, as the seven largest IOCs were collectively named, contending that AGIP had been excluded from their marketing systems.
Thus, somewhat ironically, it was the arrangement between the national oil company of a western nation and the national oil company of a developing HC that led to the advent of "association" (the so-called state participation) between IOCs and HCs. The AGIP/NIOC agreement led for the first time to a 75% HC-25% IOC profit-sharing split through two mechanisms: first, a 50%-50% participation in the venture to take effect upon declaration of a commercial discovery and, second, imposition on net income of the 50-50 profit-sharing principle.
The AGIP contract was followed in 1958 by similar agreements made by NIOC with Pan American and Sapphire. Similar state participation schemes were introduced by AGIP in Tunisia in 1960 and in Egypt in 1961. The introduction of HC participation in most Middle East countries took place later in the 1970s.
Risk service agreements
The risk service agreement differs significantly from the traditional concession. Under this type of agreement, the IOC is no longer a concessionaire but a contractor of the HC, performing at its own risk exploration and, in the event of commercial discovery, the development and production of oil and gas.
Risk service contracts were first used in Latin America, where concession arrangements became unacceptable to several countries that had created their own NOCs and granted them a monopoly on oil exploration and exploitation. For example, Brazil created Petrobras in 1953, and Argentina created Yacimientos Petroliferos Fiscales (YPF) in 1958. Some Middle Eastern countries began using risk service contracts, such as those signed by the French national oil company ERAP-Elf (now merged into Total) with NIOC in 1966 and with Iraq National Oil Co. in 1968.
Under the terms of these contracts in Iran and Iraq, the IOC acted as a general contractor, not as a concessionaire owner of petroleum. The IOC was obligated to render technical, financial, and commercial services, taking all the exploration risk. The IOC's risk was rewarded, if successful production was obtained, by reimbursement of its costs by means of a discounted price for petroleum that it was entitled to purchase from the HC, up to a given percentage of the total production.
For the first time, a major oil company accepted an agreement under which it did not own even a small part of the production. The IOC acted as a mere contractor to the national oil company of the HC. The risk service contracts were rather coldly received by the oil industry, yet the industry was later ready to accept even more stringent terms from certain producing countries.
Production sharing
The stage was thus progressively set for a departure from the traditional concession agreements. An important move in that direction took place in 1960 with Indonesian Law No. 44, which ultimately led to the introduction in 1966 of the production-sharing agreement (PSA).
Indonesia signed the first of a series of more than 100 PSAs with US independents from Denver. The first PSA was signed with Independent Indonesian American Petroleum Co. (IIAPCO) on Aug. 18, 1966, on an area offshore Northwest Sumatra; it is expected to expire in 2017 after an agreed time extension.
The main principle of this new system is that ownership and control of national resources are entrusted to the state, and the IOCs assume the status of risk-taking contractors, entitled to reimbursement of their costs only in the event of commercial production plus a share of production to remunerate their efforts. The initial Indonesian PSAs of 1966 amounted to a 65% (HC)-35% (IOC) profit-oil split after cost recovery.
This new relationship embodied a new political orientation and maturing of national goals. From the HC perspective, the extraction of natural resources is no longer a simple revenue-raising scheme with the state waiting for payments as a sleeping partner in the oil venture. Rather, the new agreements express the modern goals and values of the HC: exercising sovereign control over the nation's natural resources, obtaining a share in the production and the financial benefits of these wealth-producing assets, speeding the achievement of financial self-reliance, providing resources for improvement of other national programs, acquiring technology and expertise, and raising the levels of national employment and training, all to ensure the long-term welfare of the country.
A critical step in the evolution from HC participation contracts to the HC's status of "employer" under the PSA was the element of control. Transition from the shared responsibility of equity ownership under the state participation scheme to the concept of full HC authority was consistent with growing national aspirations. The Indonesian model PSA contains explicit language providing for control by stating that the HC "retains and is responsible for the management of the operations."
This bold modification of the standard contract form by Indonesia expressed the country's underlying mandate to assert control over its natural resources, stated in constitutional provisions which required that "natural resources...be controlled by the state." This effort to elevate the HC's position by means of a management clause vesting managerial control in the HC was initially a source of deep concern to many IOCs because it suggested a radical and unsound departure from existing relationships. Managerial control should not be separated from capital risk accountability. In practice, however, the HC's need for sovereignty was balanced by the practical necessity that the IOC retains managerial functions.
The decade of the 1960s was thus characterized by the development of HC-IOC participation agreements and production sharing agreements as well as new forms of risk service agreements in the Middle East.
OPEC's role
An event of utmost importance occurred in 1960 with the establishment of the Organization of Petroleum Exporting Countries. OPEC was created in Baghdad in September 1960 by the major oil-exporting countries of Venezuela, Saudi Arabia, Iran, Iraq, and Kuwait. Current membership includes those countries and Algeria, Libya, Nigeria, Qatar, the United Arab Emirates, Angola, and Ecuador.
The original objective of OPEC was to prevent the continuing drop in crude oil prices which had resulted from the discovery of huge reserves by new entrants lacking marketing systems. The OPEC founders sought to forestall a reduction in their income. However, events led OPEC to enlarge its role. The individual countries in OPEC, with the support of their organization, began challenging IOCs on such matters as ownership rights, pricing of oil, production levels, and types of agreements.
An example of the challenge was the Declaration of Sovereigns and Chiefs of State of OPEC countries in Algiers on Mar. 6, 1975: "The sovereigns and heads of states reaffirm the solidarity which unites their countries in safeguarding the legitimate rights and interests of their people; reasserting the sovereign and inalienable right of their countries to the ownership, exploitation, and pricing of their national resources; and rejecting any idea or thought that challenges these fundamental rights and, thereby, the sovereignty of their countries."
During the 1970s, OPEC's leverage strengthened as its combined production went from 9 million b/d in 1961 to 30 million b/d in 1973. As a result, OPEC enjoyed a near monopoly on the external supply of crude oil to the industrialized world.
The remaining traditional concession agreements were to undergo important changes after Sept. 1, 1969, in the wake of the coup d'etat by Col. Moammar Qaddafi of Libya. Libya demanded a substantial increase in the posted price of petroleum.1
The major IOCs recognized the leapfrog implications of Libya's demand and its effect on their production in the Persian Gulf area. After Shell's Libyan production of 150,000 b/d was shut in when the company refused to accede to Libyan demands, Occidental Petroleum, an independent oil company almost entirely dependent on Libyan production, entered into a settlement with Libya. Other independents like Marathon, Amerada Hess, and Continental followed suit. Libya then turned to the large IOCs with an ultimatum: Settle within a week, or be nationalized. Like wildfire, other HCs copied Libya's demands.
In February 1971, Iran sought the same terms Libya had obtained from Occidental. After seeking assistance from the US State Department, Texaco and Standard Oil of California agreed to Tehran's terms.2 Sheikh Ahmed Zaki Yamani, the Saudi Arabian minister of petroleum and minerals, noted the shift in bargaining power brought about by the Tehran agreement of 1971, which resulted in a substantial increase in the government take.3 This agreement raised posted prices used for tax assessment and generally established a 55% tax rate on profits as well as an expensed-royalty scheme (in lieu of the previous credited-royalty scheme against profit tax).
The 50-50 principle was a relic of the past in the major Middle Eastern oil-exporting countries. In the future, HCs would receive a majority share of the profits from production.
Next week: How the 1973 embargo and later political and economic developments changed international petroleum agreements.
Acknowledgment
This article is adapted from International Petroleum Exploration and Exploitation Agreements, Second Edition, published by Barrows Co. Inc., New York. It contains contributions by Prof. Owen L. Anderson, R. Doak Bishop, and John P. Bowman.
References
- "The Libyan Expropriations; Further Developments on the Remedy of Invalidation of Title," 11 Houston Law Review, p. 924, 1974.
- "When Texaco Broke Ranks," Forbes, Apr. 17, 1978.
- Yamani, A., "The Oil Industry in Transition," Natural Resources Law, pp. 391, 394, 1975; Smith, D.N., "Mining the Resources of the Third World—From Concession Agreements to Service Contracts," 67 American Society of International Law Proceedings pp. 227, 230, 1973.
The authors
Modern host-country goals and values
- Exercising sovereign control over the nation's natural resources
- Obtaining a share in production and financial benefits of wealth-producing assets
- Speeding the achievement of financial self-reliance
- Providing resources for improvement of other national programs
- Acquiring technology and expertise
- Raising the levels of national employment and training
- Ensuring long-term welfare of the country
