PRODUCTION SHARING CONTRACT REVIEW

The three basic elements of a production sharing, contract are cost recovery; a production'split' between the government and the oil company; and income tax.

The concept of production haring originated in Indonesia- where it was first used inagriculture. It was later adapted for petroleum and first used in the IIAPCO contract of 1966.The concept is now also used inter-alia. in Malaysia, Guatemala, Libya, Egypt, Syria,Jordan, Bangladesh, Gabon, China, Myanmar, and many other countries.

Production sharing is carried out with the government, usually through its state oil company.This would appear to give a greater degree of control over operations of the privatecontractor, but in fact production sharing contracts generally operate under the managementof the risk-taking private partner.

Participation:

The State may participate in the production sharing contract in a joint venture. This is rarebut has been done in China and Indonesia where Pertamina, the state oil company, holds 50%interest in several production-sharing contracts with Mobil 1/, Exxon, Caltex, and others.This makes Pertamina an equal partner in a joint venture. Many countries, in contracts signedwith private companies, have reserved the option to participate upon notice of commercialdiscovery. This in effect carries the State through exploration (For further discussion see'Joint Venture' below).

Cost Recovery:

The concept of cost recovery also originated in Indonesia, where the first 40% of productionwent to the contractor to cover costs The percentage varies in other countries, generallybetween 20% and 40%. For American companies the limitation of cost recovery to a fixedpercentage was disallowed in 1976 by a ruling of the United States Treasury Departmentwhich now insists on no limitation on recovery of costs, or 100% cost recovery. Onecountry (Libya) structures production sharing contracts to exclude cost recovery,compensating by giving the oil company a higher share of production, with no income tax.

____________________________________1 / See Petroleum Concession Handbook, Supplement 45, for summary Of Mobil-Pertaminajoint venture Signed 2 July 1979. For a more recent contract see the Tan Jung contract inIndonesia.

Production Split:

Following deduction of cost recovery, production is divided between the oil company and theState. This is known as the production "split", and it varys widely from Indonesia 65.9091/34.0909, to Libya 81/19, and Egypt 85/15. Some countries vary the production split withproduction levels, such as 'Angola, Bangladesh, India, and Yemen (92/8, over 200,000 b/d)

The variation between production splits around the world is not as striking as it may seem,for the oil company is subject to income tax on its share and regardless of the split the rate ofreturn to the oil company can be controlled by varying tax rates.

Tax

Around the world oil companies are generally subject to national corporate income taxes ontheir share of production, with wide variation between countries. The 85% OPEC income taxdoes not apply to production sharing contracts, but only to production under the old styleconcessions. One OPEC country, Libya, does not impose income tax on production sharingcontracts at all, but divides production 81% government/19% company free of tax. Generallya sure way to tell if income tax is imposed is to look at the “split” - if 85/15government/company (or higher) income tax ,is not paid (or is paid by the state oil company).If government share is lower and company share higher, in the vicinity of 70/30, the tax ispaid by the company.

The majority of production sharing contracts, while subject to income tax, have their tax paidby the State from the State's share of production. A tax receipt is then given to the oilcompany on which it receives a tax credit. In 1976 the United States Treasury Departmentdisallowed tax credits received in this manner. As a consequence, contracts with othercountries were renegotiated. Indonesia, for example which had hiked its production split to85115 in favor of the government with taxes paid by pertamina, lowered the production splitto approximately 65135 and irnposed taxes amounting to 48% thereby giving the same 85/15division of profits.

In 1983 the United States Treasury Department reversed course, and by a separate. tax rulingfor the Amoco Company in Egypt, once again permitted such tax credit for income tax paidby State government from its share of production.

Other:

Other provisions of the production sharing contract dealing with exploration and exploitationduration, size of area, relinquishment, employment of nationals and training, etc-, are similarto those contained in concessions, as previously reviewed.

RISK SERVICE CONTRACT REVIEW

The risk service contract shares the usual elements of duration, work obligations, etc, withconcessions and production sharing contracts, but differs in important aspects. Its basicdistinctive feature is that it pays the oil company in cash, not in crude oil (although it mayhave provisions permitting the company to buy back an -amount of crude at internationalprices from established production)

Risk:

The risk contract typically places all risk and investment on the contractor, who providescapital for exploration and production. If no discovery is made the contract ceases to exist. Ifdiscovery is made, the contractor places it on stream. Thereafter it may be operated by theState or by the contractor. Capital .is reimbursed with interest and a risk fee.

Participation

In Peru, Occidental Petroleum signed a 1980 service contract over the Talara area,renegotiating its previous secondary recovery contract. In an unusual structure, a Peruviancorporation was formed, admitting Petroperu, the government company, to 26% participationPetrolatina, as the company is called, is owned 49% by Occidental, 25% by Brid as (anArqentine drilling company) , and 26% by Petroperu. The private partners were.repaid byPetroperu for their investment (about $300 million); they then turned around and financedtheir share of Petrolatina's ($100 million capitalization, $49 million for Occidental, $24 millionfor Bridas. Petrolatina operates on a service contract basis, paid $17.50 per barrelproduced (plus inflation) , subject to Peruvian taxation. 1/

Taxation:

Contractors are subject to taxation usually at general corporate rates. Here again taxation is oflesser importance, since the service contract 'fee" or production payment also determinesprofits: the higher the fee the higher the tax.

The risk contract generally has the same specifications as the concession as regards area, sizeof contract area, relinquishments, etc.

______________________________l/ The Petrolatina arrangement was not consumated subsequently due to lack of funds.______________________________2/ The "Plieqo de Condiciones Generales" which regulates calls for tenders under Law

21778, and which was approved by Executive Decree No-2658/78, specificallystipulates in Article 16 the possibility of making payments in foreign currency (para.16.2.1.).

Similarly, specific provisions stipulate that the Argentina Central Bank will ensure thatY.P.F. will have permanent secure access to buy and freely transfer the necessary foreigncurrency to pay such high risk contracts which may have to be paid in foreign currency.

SERVICE CONTRACT REVIEW

The pure service contract is a simple contract of work wherein the contractor is paid a flat feefor his services An example, of importance is the Sisco contract in Saudi Arabia Sisco, a,group of four maj-or oil companies, carries on operations for the Saudi government(Saudi;Aramco) for a.net fee of about $136 million/yr. Similar arrangements exist in Kuwait,Qatar, and Bahrain,

Another example of a pure service contract is the Total contract in Abu Dhabi where thegovernment's offshore field (Zakum) is operated by Total for a r-barrel fee, plus the right tobuy part of its production 1.

Tax:

Service contracts are ,subject to general corporate taxation, but not to higher special petroleumtaxes.

Types Of Service Contract:

There are two categories:

1 The Service Contract running parallel, but contractually unconnected, with apurchase contract for part of the oil being produced -from the area or operationsto-which the Service Contract, relates or;

2) The Service Contract-not accompanied by any access to the oil being producedunder such Contract.

Service Contract With Crude Purchase:

The first category was established in the aftermath of the' complete take over of concessionstill then partly or still wholly owned by oil companies. -

As a matter of fact the now defunct Iranian Sale and Purchase Agreement could be consideredas a forerunner of the first category, the main difference being that in the Iranian case servicesand purchase were contractually connnected

____________________________1/ See Middle East - Basic. Oi1 Laws & Concession Contracts,Supplement 67 for text-

Service Contract Without Crude Purchase:-.

The second category concerns contracts negotiated in special cases where a NOC needstechnical assistance but is not prepared to give the Contractor access in one-form or anotherto a share of the crude oil produced as a result of the technical assistance- Such- type ofagreement is reported to have been concluded in Norway. In this country, however, a mixtureof contract forms has emerged in that a technical assistance agreement is accompanied by orbecomes part of a joint venture, allowing the technical-assistance givinq oil company anequity interest in the venture.

In 1992 Venezuela offered. EOR (Enhanced Oil Recovery) Contracts on established fields.Text of the model Contract is published in Basic Oil Laws & Concession Contracts - SouthAmerica.

JOINT VENTURE REVIEW

The joint venture has been widely misunderstood as being a separate type of petroleumagreement. It -is not usually so. It is ?, partnership arrangement wherein the State, eitherdirectly or through its national oil company (NOC) , receive., an equity or ownership interestin the rights and obligations of a contract or a concession. The State may achieve this through"participation" as in the case of Saudi Arabia1/, or nationalization, as in the many partial

nationalizations or enforced participations throughout the world (Libya, Nigeria, Algeria,Norway, to name a few). It may originate in the structure of the arrangement from the first,as with the 1980 indonesia joint venture 2/. As a partner, the State shares in the production

from the contract or concession in proportion to its interest; thus 251 joint venture interestwould accord right to 25-%.of production. In addition, the associated. oil company pays.taxes and/or production sharing on its share of production, so the benefits to the State aretwo-fold - however the corresponding participation in costs may become a burden.

Costs:

The State or. its NOC shares in the costs in depending on its equity -proportion. Frequently,however, the arrangement provides -that the private partner assume part of the government'srisk, State to asset its share of costs only after production is discovered AI-. This-arrangement is called a "carry". The State’s share of costs is repaid either directly by theState, as is done in Colombia, or through allocation of part of the State’s share of the jointventure production to the oil company. Exploration cost is rarely. repaid, however.Colombia is an exception.

______________________________________l/ 60% of the original Aramco Concession was assigned to the government, but the

concession is actually operating as .100% government-owned and under a servicecontract arrangement. For a review of this arrangement see Petroleum Legislation-.

____________________________________________2/ See-Petroleum Concession Handbook, Supplement 45.

______________________________________________3/ Frequently the government participates only after discovery, thus transferring explorationrisk to the oil company- For examples see Mobil contract in Indonesia (see 2) or theEcopetrol joint venture contracts in Colombia (South America Basic Oil Laws & ConcessionContracts, Supplement 45)

Cost Reimbursement:

Exploration costs may not be reimbursable to the oil company, i.e. as they are not in Chinaand Libya. once pi7oduction begins, however, the State normally pays its share of operatingcosts. The State may be "carried through development", in which -case the state or its NOCwill be carried to the point of production. It then becomes essential to have a -clear definitionof when commercial production begins, since from that point on the State will share in costs.

The farther the State is carried, the lower the return it must expect to obtain. Thus the Statewhen "carried through development' would normally receive a lower share in the joint ventureor the production split than if carried only through exploration- The advantage to the State inboth arrangements is that it takes no share of risk in exploration and may elect to put littlemoney in development since arrangements can frequently be made to have the State sharerepaid out of its share of production.

Interest:

In some cases,' interest is paid on exploration (rarely) and development costs advanced by theoil company. In Brazil, development moneys advanced are repaid plus interest fromproductions1/.

Participation:

The government's participation amount in production is no determined by the oil company'sestimate ok the potential t size of discoveries, costs of development, political risk, and otherfactors. The final production split may vary with these factors, but the State must decide onthe amount of 'its participation on the basis of its own financial and. technical capabilities.

Taxes:

Provision can be made in the joint venture concessions or contract to accommodate changes inproduction levels, with the State tax or royalty on a sliding scale basis rising with production.This can be done with prices as well, with the State -share rising with .crude oil prices.

__________________________-/ See South America - Basic Oil Laws & Concession Contracts, Supplement 60 for ModelBrazilian Contract text

Advantages:

The State may find advantages -In the joint venture approach. The greatest risks exist in theexploration phase, and all this is assumed by the oil company. Once a commercial discoveryhas been made there may still be some risk but it is normally not difficult to obtain financing-Major financial institutions such as the World Bank lend to governments at advantageousinterest rates, and other international and regional development institutions may makefinancing available An example is Pakistan’s former joint venture with Gulf' Oil where theWorld Bank guaranteed the Pakistani share of development costs.

Operating Agreements:

Joint ventures require mutual agreement on procedures, such as meeting costs of operations ina timely manner. The agreement to determine these procedures is known as an "operatingagreement” 1/, or a "joint venture operating agreement'. It contains detailed specifications onwho is to be the operator, what operations can be performed without special permission, etc.A joint management committee may -be established to pass on important decisions and todecide the future course of operations, and other essential details- Voting on. the managementcommittee is usually proportionate to interests held. Often the State holds the post ofpresident of the management committee, with the. oil company acting as operator.

Incorporated Vs Unincorporated Status,-

The joint venture can be a incorporated or non~incorporated vehicle. In the latter caseparticipation shares are held in undivided interest, i.e. the NOC and the oil company eachown an undivided interest in the venture embodied by a mining title and a concession contractwith the government (in its capacity as grantor of the mining title) - Each acquires its ownshare of the production and is responsible for paying taxes on his share. The assets used inthe venture are jointly owned.

________________________________________I/ The operating agreement can be incorporated in the basicconcession or in the contract itself, as done in Colombia.

The NOC and the oil company jointly supervise the operations Usually there exists a jointmanagement or operating committee for this purpose. In such committee decisions are takenun-animously or by qualified majority, providing that a 51% to 60% governmentparticipation will not automatically lead to a power of veto for the NOC. In most cases theo-11 company is the operator of the venture. Sometimes however the operations -areentrusted to the NOC or to a non-profit--making and no-assets-owning operating companywhich is jointly owned by. the NOC and the oil company in proportion to their participatinginterests. The funding of the operating company takes place in accordance with the rules offinancial participation agreed in the joint venture agreement.

Participation may also be The government or its NOC percentage interest share concessioncontract. This selling all the crude oil all the assets. This form implemented on a corporatebasis. and the oil company each own its of the shares of a company holding a will then be-aprofit making company produced by the venture and owning has been chosen in very fewcases and then only when-a joint venture has introduced at a mature stage of the venture (e.g.Brunei) .

The joint company is subject to the fiscal legislation and is responsible for the payment oftaxes.

The corporate profits after taxes are divided between the two shareholders, viz.the oilcompany and the government, and paid to them in the form of dividends.

The disadvantages of the7 incorporated Joint Venture compared to a non-incorporated JointVentur'e 'are:

1) All crude oil is sold by the joint company, which means that prices and customers haveto be agreed between the shareholders. Under an undivided interest set-up each-Participant acquires its own s-hare of the Production and is free in the disposal of thisshare, subject of course to the requirements of the applicable legislation and theconcession contract-

2) Under the corporate route the participants get their shares of the benefits of the venturein the form of dividends. The dividend policy is thus a matter that has to be settled inmutual agreement.

The disadvantages are of such importance that where an incorporated joint venture isunavoidable the shareholders usually make arrangements among themselves allowing directaccess to the crude oil, thereby reducing the joint venture to a mere operating organization.

The joint ventures formed in the Middle East Participation Agreements initially envisagedalso a varying level o anticipation, not however on the basis of production levels butprogressing with time- Participation started at 25% and would increase by steps of 5% overthe years till a final 51%.would have been reached on 1 January 1982.

This so-called "General Agreement" which was effective as from 1 January 1973, was soonsuperseded by Join t Venture Agreements' establishing a fixed 60% participation for the hostgovernment with effect from 1 January 1974- In Nigeria the ' Middle East participationexample was followed, but with a difference. The initial percentage was set at 35% from 1April 1973. When the 60/40 participation deals were made, Nigeria agreed a fixed 55%participation from 1 April 1974. The level was subsequently raised to 60%- Kuwait, SaudiArabia, and Qatar subsequently raised their participation to 100%, substituting technicalservice contracts for the former concessions.

REVIEW OF SPECIAL LEGAL & CONTRACTUALCONSIDERATIONS FOR GAS DEVELOPMENT

Utilization of natural gas within developing nations calls for special rules and contractualprovisions. The unique nature of natural gas, and its abundance worldwide, make gasproduction and use a Vital but complicated task.

World Gas Reserves:

The supply of natural gas in the world is abundant- On a calorific basis - measured by itsavailable energy - reserves of natural gas in the world exceed those of oil.

Despite this availability, utilization of indigenous gas resources for internal requirements inmost nations, particularly the developing ones, has not been well handled. Most gasdiscoveries in developing countries remain undeveloped despite the obvious need of hostgovernments.

Oil Vs Gas:

From an international oil company viewpoint, a gas discovery is disappointing even anundesirable event. This is because of the difficulty of exporting gas to world intakes and theconsequent lack of markets. into which the gas can flow.

This is 'not the case in developed countries where a large local -market exists, but it is,certainly an obstacle in roost developing nations without a gas infrastructure.

Gas Contractual Provisions:

The problems arise because most exploration and production agreements are written for oil.Gas is usually dismissed in -a few sentences or paragraphs. Such agreements certainly fail tostimulate exploration for gas in gas-prone areas and Likewise fail to provide an adequateframework on which a gas development plan can be built. This failure to stimulate gasexploration and development by good contractual provisions is a handicap and liability tomany governments. It may prove to be to the disadvantage of the company as well, sincegas development can provide a good investment opportunity over many -years as long ascontractual relationships and suitable provisions are kept in place.-

In most contracts or concessions the commercialization of natural gas is either treated thesame as oil - and this despite the many and major differences between the two - or left to beagreed upon following gas discovery, a situation that operates to the disadvantage of thecompany which is then "under the gun" and in a bad negotiating position. It would seem thatneither the government nor the international company negotiators wish to face thecomplicated and burdensome issues involved in a contract that will permit gas development

As well as oil. The purpose of -this review is to discuss these problems of gas developmentand offer a way that international oil contracts or concessions can be constructed toaccommodate both oil and gas.

Gas Exports:

As previously mentioned, oil is fungible. It can be easily transported and swapped, it issnore valuable than gas, and those characteristics make it independent of any specific market.

Gas, on the other- hand, can only be exported if a market lies within reach of a pipeline -which many gas discoveries do not or if an export project such as liquefied natural gas (LNG)or a methanol or fertilizer plant can be constructed. I These are capital intensive projects,difficult to establish within a short time, but they do have one advantage: they put thegovernment and the international company on the same side, in an alliance to strike the bestdeal possible from an international buyer. This isolates decisions from local economicdevelopment and internal political factors. If a country has gas reserves sufficient for bothinternal consumption and export, domestic market _projects can be developed in conjunctionwith or preceded by export projects. This facilitates gas project development within the hostnation. However, gas is often found in amounts that do not lend themselves to large exportprojects and must therefore be used internally.

Domestic Gas Markets:

Often domestic markets offer the only outlet for gas. These outlets may be (1) an oil/gascompany contract directly- with a. local user of major amounts of gas, i.e. a local cementplane. This is a good situation from the company's viewpoint because sales are negotiated atmarket prices -and free of the very real problem of monopsonistic pricing. or the companymay (2) wind up selling the gas to a government monopoly. This one-buyer situation(monopsony) can be a deterrent to gas development because the government i-n most LDCs(Lesser Developed Countries) has objectives which are different from the oil gas company’s.The government's pricing philosophy conflicts between the need to offer wellhead prices forgas high enough to keep the international company exploring and producing, and its desire tokeep gas prices to consumers low enough to promote local economic development byfurnishing cheap energy. This is a situation where the producer may have little assurance ofgetting a fair price from the buyer.

Risk:

Because gas markets can rarely provide the degree of price certainty or volume that isavailable for oil, gas projects are inherently more risky than oil. All transactions are carriedout within a country that has a sovereign right to carry out fiscal or regulatory changes thatcan make gas development unprofitable. This is compounded by one fact: oil generatesincome from outside the host country by selling to international customers. Gas revenues arelocal when the gas is used within the country. This inability to generate foreign exchange wasat the heart of the difficulties between Atlantic Richfield et al and the government of China in1986 when development was delayed of a major offshore find by the gas pricing problem andthe lack of foreign exchange.

There is another risk - nebulous but real. This the unenviable position of the internationalcompany being a highly visible outsider with very decided economic clout. The gas has alarge local economic impact but the international as an outsider is unable to lobby within thelocal political system. -this further increases the. risk of political action against the company.

Catch 22:

There is a traditional dilemma that arises in countries without an established gasinfrastructure. Before gas can be produced on a. large scale there must be a specific market forit. Indeed, before exploring for gas, companies must be assured that they can find outlets.This 2-s one horn of the dilemma. The other is that' the. government at. the same timecannot state with certainty what inarkets. can be developed internally until the .size of thediscovery is known, in other words the company must spend large sums proving up adiscovery without knowing it will be marketable in order to get an estimate of the market.

If this initial barrier can be overcome, the result may be a springboard for gas use throughoutthe economy. If, for example, a power station or a cement plant can provide a market ofsufficient volume and duration to justify the large capital expenditures of a gas development,this will carry the gas to other potential users. A rich mixture of condensates, 'wet gas", willhelp too (as in Thailand). by providing immediately available export earnings.

Herein lies the "Catch 2211 of gas. In the case of - an oil discovery the evaluation ofcommerciality can be made quite quickly once the physical parameters of the discovery areknown. This is because the production can be sold in the best. international market thatexists and the stipulations regarding exploration and development of oil are contained in thebasic PSC or concession. However, in the case of a gas discovery its commerciality cannot bedetermined until both (1) the size of the discovery is know-n plus (2) the market andconditions for gas use and sales have been defined for the duration of the field', life-

This means a concerted government-company effort has to be made to define both theupstream (production) and downstream (transportation and sale) potential. Gas productionmust therefore be hooked to the market so it can grow- along with the market. This leads tocertain essentials of contract and/or concession which will be discussed later.

Government Gas Institutions:

In some countries there may be a lack of appropriate government institutions. or, since gasprojects involve four major activities i.e. production of the gas, its processing, itstransmission by pipeline, and its distribution to burner-tip users or large consumer such aspower plants, each of these activities may be handled by a different government agency andeach of these agencies can and often does have its own objectives which are not related to thetotal project.

Each governmental institution or agency wants its own interests to take- precedence over theinterests of the project as a whole. For example, the agency responsible for power generationwants low gas prices, the agency responsible for transmission wants low gas tariffs o payexpenses, the regulatory agency for production want a high price that will keep theinternational company interested, and so on. But to make the agreement work, all partiesparticipating in each individual activity must be in agreement, and the difficulties of agreeingon transfer arrangements and allocation of risks and obligations are very large.

If a chain can be developed where all the links are owned by all of those that depend on thetotal chain, a balance can be achieved between needs of the users for low prices and thedesires of the transmission agency for suitable tarrifs, as well as the production agency’s needfor incentive pricing, and other needs.

NATURAL GAS PROVISIONS IN EXPLORATION/EXPLOITATION AGREMENTS

As previously mentioned, exploration/exploitation PSCs or concessions are notably deficientin their treatment of gas. This has repercussions that frequently escape the notice ofgovernment negotiators. If an oil company has no defined terms and conditions for gas, itmay consider a gas-prone prospect as having marginal profitability and will not drill thatprospect. Herein lies the essential difference for oil and gas: oil development is automaticafter commercial discovery. Gas. development must be closely coordinated with thedownstream (marketing/transportation/distribution) phases in order for gas development toproceed at all.

Before proceeding to the specific provisions that are needed in gas agreements, considerationmust be paid to the chain of activities that are necessary for successful operation.

Market Assessment - The "Downstream”

Before -development of gas can proceed the potential market must be defined. This is calledthe "Downstream" and it- encompasses an integrated series. or chain of activities flowingdownstream from the producing end. Thus the transportation, processing, marketing,- anddistribution must be sharply quantified to enable commercial sales and delivery of natural gasto the buyers in the internal market.

This can mean. scores of technical and economic studies, to say nothing of the salesagreements -and financing necessary to pay for installations. The successful implementationof a gas program can depend on these studies and agreements. All must be in a coordinatedtrustworthy chain of -integrated activities which the government, in collaboration with theproducer or contract or/concessionaire, must carry out.

These include. a comprehensive gas study for the country that answers the ma2-h questionsof (1) how much gas can be absorbed in local markets and how. much can be produced by thecontractor/concessionaire under various price/cost assumptions. These studies must extendout for long periods, up to 20 years, and are extremely difficult to do. well. There is also (2)the formulation of national economic policies that will ensure efficient development of the gas'equitably compensating the producer, the transmission and distribution companies, andmaking the product available to users at a reasonable cost. Not to be forgotten are the masterdevelopment plans within which this must take place. The development of gas is only onefacet of the government's policy. It must harmonize with the military, political, and economicrationale of the nation.

Duration:

The development of natural " as typically takes longer than that of oil. This is because of theneed for extensive studies referred to earlier,' for one thin-g, but the duration of theexploitation. phase must typically be longer than for oil due to the longer pay-back period forgas needed because of its higher investment and operation costs, as well as the long-termnature of gas sales contracts. It also takes longer to create the downstream and upstreamfacilities than for oil.

The exploration -duration for gas would seem to be the same as for oil, in fact gas is oftendiscovered as a consequence of oil exploration. However this needs to be looked at moreclosely. Once gas is found time is needed for assessment of gas markets

and for the complex downstream coordination of processing/transportation/selling/distributingthe gas. This takes time. The exploration duration must foresee these delays and probablywill need extension.

Pricing Principles For Gas:

Gas pricing is very complex. - There is no international price for gas as there is for oil. Gasprices are not quoted in the trade journals with any regularity, at least not internationally, andgas prices have to reflect the specific project. This is particularly true where the gas is usedwithin the country where found which often results in a one-buyer situation. From theinternational company standpoint it is important that the pricing definition be made prior to adiscovery being made. If the company has to negotiate after the discovery is made thegovernment holds a distinct advantage.

Additionally, the pricing mechanism must be proof against future changes. of course, no pricecan be guaranteed forever. Whatever mechanism is used,' such as being hooked to the price offuel -oil or other substitute fuel, the price will change with change in price of the referencefuel. However, the price should be insulated f'rom economc crises within the host country orchanges in government . policy.

Other considerations must be brought into the equation. For example, the right of -exportshould be given the producer, with freedom to negotiate the best possible price -for hisexports. This works to the advantage of both country and company, as previously outlined..The producer should have a clear definition 3-n general regulations of an export right withclear procedures in order to determine if certain gas reserves are surplus to domesticrequirements. This, and the right to sell to third parties generally, an help to establish an arm-length price and dilute the problems of monopsony.

Whatever the procedure, the price charged to the end user should not be subsidized by thegovernment. This question has many ramifications. The government may subsidize the priceof gasoline or fuel oil, for example. Keeping oil product prices artificially low cuts intothe market for gas, and it makes the reference price harder to establish. If the governmentsubsidizes gasoline or fuel oil users a frequent political temptation - oil companies will havereasonable doubts (as they used. to in Egypt) that the government will continue to pay thecompanies the international price when the prices charged to end users are considerably lowerthan the reference price paid to the producer. Where is the money to come from? Subsidieshave their uses but the companies fear that the government will have to continue subsidies inthe future and will then attempt to recoup its losses by interfering with the price paid to gasproducers.

Cost-Plus Pricing:There are two main ways to set gas prices. one is by paying the producer his cost plus anagreed profit. This is the time honoured cost-plus system. The buyer (government). pays aprice determined by the seller's costs, plus an agreed fee or margin with an adjustmentformula, usually based on changed. -in cost indices. This is an unrealistic system thatweakens the effect of market forces. It leads usually to inefficiency and, lack 'of incentive.Presumably, however, it can have value in certain well defined situations.

Market-Value Pricing:

The most successful pricing used internationally is market value pricing. This hooks the pricepaid to the producer to the cost of a substitute fuel. In Pakistan, f-or example, it is hooked tothe fuel oil, priced., .In Egypt it is 85%. of. the . fuel oil' price. The market value system isbased on its value to final users, and it reflects the inherent value-of the gas, as well as itssecurity .of supply, availability,- convenience, etc. If it is hooked to the right base and torelevant energy prices, gas prices will fluctuate .in a manner that reflects its natural role andprovides sufficient price incentives to producers to continue exploration and development.

Associated Vs Non-Associated Gas:

.Associated gas is that produced with ' oil. Non-associated gas is that producedindependently. That is a very general definition, but there has often been a sharp distinctionbetween them by governments. So far as price of gas is concerned, there should be nodifference between associated and non-associated gas- The price of gas, whether associated ornon-associated, should be related to the market value of an alternative. fuel (or fuels) for theuse in question.

Relinquishment Provisions For Gas:

Relinquishment provisions in a contract/concession typically reduce the subject areaprogressively during exploration. After discovery relinquishment provisions for oilagreements typically provide that the contractor can retain only the area of commercialdiscovery while surrendering the remainder of his former exploration area.

In the case of gas, however, additional time is needed to enable the company (contractor) toretain the discovery in order to assess its size, to wait for pipelines and distribution systemsto be constructed, and for the market to develop. ]In other words, as previously stated, theduration of the gas contract must be hooked to the development of the market- Provisionsmust be modified to provide additional exploration and development time before mandatoryrelinquishment.

Production Sharing For Gas:

The normal production sharing established for oil and contract commonly provides that thesame shall apply to oil and gas - This a misconception, however. The risks for natural gasdevelopment are higher, and, gas is generally less profitable than oil, a lower netback thatentails less per unit of energy than that for crude oil. Higher production split for gas iscommon practice in areas such as Indonesia, where the production split is almost completelyreversed with the contractor receiving the larger share for gas, (see KODECO Indonesiacontract, Asia & Australasia - Basic oil Laws & Concession contracts, Supplement 100).

There are other methods for achieving this objective of a larger gas share for the contractor.-Where the government has an equity participation in the development, it may decide to takeless than its equity percentage of gas at lower production levels to 'Make this specific projectprofitable for the international company. or a combination of price and production splitchanges may be used.

The production sharing may vary with different areas of the same contract, or with varyinglevels of production. Thus production sharing may be- increased in favor of -the producer forlower production levels, and increased in favor of the government with higher productionlevels as is done in several Asian countries. This system helps account for higher front-endcosts for gas developments and structures a flexible government "take' with a lower take inmarginal developments- and a higher take in very profitable developments.

Scope Of Contractor's Gas Obligations:

Because of the complexity of the gas project structure, the international company'soperations and obligations should be limited to the production facilities (the so-called"upstream" sector). This may include production and delivery of gas in saleable conditionto the pipeline or transmission facilities that connect the production to the larger customersand distribution networks to city users. Occasionally on special request, the internationalcompany will include in the contract the pipeline from its discovery to the existing principalpipeline network. In Peru the 1988 Shell agreement (now void) provided for 25% financingby Shell of the main gas transmission line from the remote jungle area of the discovery to thecoast.

Scope Of Government's Gas Obligations:

The obligations of government in exploration/exploitation arrangements is to provide the"downstream" facilities; the pipelines and distribution networks necessary to markets. Such

downstream facilities are customarily operated by the government in developing countries.This does not preclude ownership of such facilities by private companies but this is rare dueto the large front-end costs involved and other factors.

Should the cost of extending such facilities by very high, the international partner mayparticipate to a limited degree- by such means as contributing to design, financing, etc. This-.helps to ensure coordination between the upstream and downstream operations and has beenthe case in some rather logistically difficult areas of Latin America, for example, where thecost of pipelines is extremely high.

coordination committee:

To ensure that the intricate operations involved in production, processing, transportation,marketing, and distribution are coordinated, a special committee is advisable composed ofrepresentative of the international company and the government agencies----involved. oncommercial discovery this committee should go into operation to coordinate the productionoperations with the rest of the downstream. -This special gas committee should be separatefrom the joint committee that .may be called for in the exploration agreement. It would workwith that committee, however, and propose a schedule for downstream development.

Take-Or-Pay:

All gas marketing arrangements need - to be on an assured basis. This" is called a take-or-payclause and is extensively used around the world. The Egyptian gas agreements contain sucha "take-or-pay" clause.

Foreign Exchange Considerations For Gas:

The take-or-pay provisions are supplemented by other principles of sale to downstreamagencies such as delivery obligations, method and currency of payments, and limitation orguarantee of convertibility of currency. Foreign exchange convertibility must be such thatlenders and investors will be satisfied that over the life of a project no contains on remittanceswill be imposed or become difficult to obtain.

A major difficulty, as earlier mentioned, is that local markets for gas do not snake theappropriate convertible currencies available from the sales proceeds. one option may be forthe oil company to be paid in crude oil, which is freely tradeable, instead of payment in cash.Something of this nature has been used extensively. It has the distinct advantage of bypassingthe Central Bank and thus not making the contractor subject to non availability of dollars orother currency.

Model Natural Gas Clause:

The ideal natural gas clause for an exploration/exploitation agreement should form part of allcontracts and contain the following points. First, it must define the meaning of the word"gas", and define, as well, the reference value by which the gas price -is to be determined, therole of the upstream and downstream authorities, and the price to be paid the producer, the"producer transfer price.'

It should include provision for the joint committee to coordinate upstream and downstream,the extension of the exploration and exploitation term, if needed, and the heads of agreementfor t-he gas sales contract.

A number of studies must. be -provided for, including a market study of probable gas use,estimates of the cost of field development, transportation, and other downstream facilities.

Other aspects that should be Covered include provisions for gas flaring, definition ofcommercial discovery, and other aspects.

RFERENCES*

Principal references used are the texts of oil legislation and of concessions, production sharingcontracts, and risk -service contracts in Basic Oil Laws & Concession Contracts.*/, a legalreference service for the world current by monthly revision. There is a separate series for theseven geographical area of the world

Summary and analysis of legal and fiscal regulation for oil is from three primary sources:Petroleum Legislation, contains a current summary of legal requirements for every country.International Taxation Series contains an oil tax summary for each country. Where there is no-petroleum regulation Petroleum Concession Handbook contains a summary of eachconcession or contract. It has material which, due to its confidential nature, cannot bepublished in toto.

*/ Above published by Barrows, 116 East 66th Street, New York, New York 10021