Production sharing agreements

What Is Production Sharing Agreements?

Production sharing agreements (PSAs), also known as production sharing contracts (PSCs), are a common type of contractual arrangement in the energy finance sector that governs the relationship between a host government (or its state-owned entity) and an international oil company (IOC) or consortium for the exploration and production of crude oil and natural gas resources. Under a production sharing agreement, the foreign company undertakes the financial and technical risks associated with oil and gas exploration and development. In return, if commercial discovery is made, the company is entitled to recover its costs from a portion of the produced hydrocarbons, often referred to as "cost oil" or "cost gas." The remaining production, known as "profit oil" or "profit gas," is then shared between the government and the company according to a pre-agreed formula. This mechanism allows host countries to retain ownership of their natural resources while leveraging the capital, technology, and expertise of foreign investors.

History and Origin

The concept of production sharing agreements emerged in the mid-20th century, largely driven by the growing desire of host nations, particularly in developing countries, to exert greater control over their valuable natural resources following periods of decolonization and the rise of resource nationalism. Prior to PSAs, concession agreements were the dominant model, which granted foreign companies broad rights over specified areas in exchange for royalties and taxes. This often resulted in host countries feeling they received an inadequate share of the wealth generated from their resources.

The first modern production sharing agreement was signed in Indonesia in 1966 between the Indonesian state oil company, Pertamina, and the Independent Indonesian American Petroleum Company (IIAPCO). This pioneering agreement set a new precedent by stipulating that the host government retained ownership of the hydrocarbons, with the foreign company acting purely as a contractor. This shift provided host governments with more direct participation and a larger share of the economic benefits, inspiring widespread adoption of the PSA model across other oil-producing nations, particularly in the 1970s following global oil price shocks.⁵,⁴

Key Takeaways

Production sharing agreements are contracts between a host government and an oil company for hydrocarbon exploration and production.
The foreign company bears the financial and technical risks of capital expenditure and operations.
Costs are recovered from a portion of production ("cost oil"), and the remaining "profit oil" is shared.
PSAs allow governments to retain ownership of resources while accessing foreign expertise and capital.
They are prevalent in many resource-rich developing countries, balancing foreign direct investment with national interests.

Interpreting the Production Sharing Agreements

Interpreting a production sharing agreement involves understanding its various clauses, which dictate the allocation of risks, costs, and revenue between the host government and the international oil company. A key aspect is the "cost recovery limit," which caps the percentage of gross production that can be used by the contractor to recover its operating and capital costs in any given period. This limit is critical because it directly influences the amount of "profit oil" available for sharing. For instance, a higher cost recovery limit might allow the company to recover its investment faster, but it could delay the point at which the government receives a larger share of profit oil.

The "profit oil split" is another vital component, often tiered or subject to different rates based on production volumes, oil prices, or internal rates of return achieved by the company. These sliding scales are designed to provide the host government with an increasing share of the economic rent as project profitability or production increases. Furthermore, PSAs detail obligations regarding local content, environmental standards, and training of national personnel, all of which contribute to the overall interpretation of the agreement's fairness and long-term benefit to the host country.³

Hypothetical Example

Consider a hypothetical production sharing agreement between the government of "Petrostania" and "Global Energy Corp." for an offshore oil and gas exploration block.

Exploration Phase: Global Energy Corp. invests $500 million in seismic surveys and drilling exploratory wells. This is entirely at their risk management.
Discovery and Development: A commercial discovery is made. Global Energy Corp. invests an additional $2 billion in developing the field, including platforms, pipelines, and drilling production wells.
Production Starts: The field begins producing 100,000 barrels of crude oil per day.
Cost Recovery: The PSA stipulates a 40% cost recovery limit. This means 40,000 barrels per day (40% of 100,000) are designated as "cost oil." Global Energy Corp. takes this portion to recover its $2.5 billion ($500M + $2B) investment.
Profit Oil: The remaining 60,000 barrels per day (100,000 - 40,000) constitute "profit oil."
Profit Split: The PSA specifies a 70/30 profit split for profit oil, with 70% going to Petrostania's government and 30% to Global Energy Corp.
- Petrostania's share: 70% of 60,000 barrels = 42,000 barrels/day
- Global Energy Corp.'s share: 30% of 60,000 barrels = 18,000 barrels/day
Total Take: In this scenario, Petrostania receives 42,000 barrels/day (as profit oil), plus any royalties agreed upon, while Global Energy Corp. receives 40,000 barrels/day (cost oil) plus 18,000 barrels/day (profit oil), totaling 58,000 barrels/day, until its costs are fully recovered. After full cost recovery, the 40% "cost oil" portion becomes additional "profit oil" to be shared, significantly increasing the government's take.

Practical Applications

Production sharing agreements are widely applied in countries rich in hydrocarbon resources, particularly those seeking to develop their oil and gas sectors without shouldering the massive upfront capital expenditure and technical risks. They are a primary mechanism for attracting foreign direct investment into the energy sector.

These agreements are seen in diverse regions, from Southeast Asia to Africa and South America. For instance, countries like Guyana and Suriname are currently utilizing production sharing agreements to manage newly discovered offshore oil and gas reserves, structuring terms that include stipulations for local content and revenue management, demonstrating a modern application of the PSA model to ensure national benefit from burgeoning resource wealth.²

Furthermore, PSAs are integral to the legal framework of many national oil companies (NOCs) when entering into joint venture or contractual relationships with international companies. They define the detailed operational and financial obligations, including work programs, expenditure commitments, and environmental safeguards, ensuring a structured approach to resource development and subsequent profit sharing.

Limitations and Criticisms

Despite their widespread adoption, production sharing agreements face several limitations and criticisms. A significant concern often revolves around the transparency of costs. Since the international oil company recovers its costs from "cost oil" before the "profit oil" is shared, there is an incentive for the company to inflate reported costs, which can reduce the host government's share of profits. This opacity can make it challenging for governments and civil society to scrutinize the true economic benefits derived from the agreements.¹

Another criticism pertains to the inherent complexity of PSAs. Their elaborate structure, including varying cost recovery mechanisms, uplift factors, and multi-tiered profit splits, can make them difficult for host governments with limited technical and legal expertise to negotiate and monitor effectively. This complexity can also make it hard to assess the actual government take, leading to potential disputes or a perception of unfair distribution of benefits, especially under fluctuating commodity prices. Issues related to sovereign risk or unforeseen changes in domestic policy can also impact the stability and perceived fairness of these long-term contracts. Critics argue that these factors can sometimes lead to the "resource curse," where resource-rich nations fail to translate their natural wealth into broad-based economic development due to governance issues or unfavorable contract terms.

Production Sharing Agreements vs. Concession Agreements

Production sharing agreements (PSAs) and concession agreements represent two distinct legal and fiscal frameworks for hydrocarbon exploration and production, primarily differing in the ownership of the natural resources and the nature of the company's rights.

Under a concession agreement, the host government grants the international oil company a legal title or right to the extracted resources within a defined area for a specified period. The company essentially "owns" the hydrocarbons at the wellhead and pays the government royalties (a percentage of gross production or revenue) and various taxes, including corporate taxation. The company holds stronger proprietary rights and typically bears all risks and costs.

In contrast, under a production sharing agreement, the host government retains ownership of the hydrocarbons throughout the exploration and production process. The international oil company acts as a contractor, providing the necessary capital and expertise. In return for its investment and efforts, the company is entitled to recover its costs from a portion of the produced hydrocarbons ("cost oil"), and then shares the remaining production ("profit oil") with the government according to a pre-determined formula. This model allows the host government to maintain greater control and a more flexible share of the profits, particularly as the project matures or market conditions change. The key difference lies in the point at which ownership of the extracted resources transfers: at the wellhead for concessions, versus after cost recovery and profit sharing for PSAs.

FAQs

What is "cost oil" in a production sharing agreement?

"Cost oil" is the portion of the extracted crude oil or natural gas that the international oil company is allowed to take to recover its exploration, development, and operating expenses incurred during the project. The percentage of production allocated for cost recovery is typically capped under the agreement.

How do production sharing agreements benefit the host country?

Production sharing agreements benefit the host country by allowing it to retain ownership of its natural resources while attracting foreign capital, technology, and expertise for hydrocarbon development. This enables the country to monetize its resources without bearing the full financial risk management and technical challenges of exploration and production.

Are production sharing agreements flexible?

Yes, production sharing agreements are often highly flexible. Their terms, including cost recovery limits, profit sharing splits, and various fiscal incentives, can be tailored to specific projects, market conditions, and the host country's objectives. They can include escalation clauses based on oil prices or production volumes, allowing for adjustments over the life of the project.

What are the main risks for a company in a production sharing agreement?

The main risks for a company in a production sharing agreement include the inherent geological risk of not finding commercially viable reserves, the substantial upfront capital expenditure that may not be recovered if a discovery isn't made, and potential [sovereign risk] (https://diversification.com/term/sovereign-risk) or changes in the host country's regulatory or fiscal policies. The profitability of the venture is also sensitive to global commodity price fluctuations.