AUGUST 24, 2014

By TIOL Edit Team

AVIOD 'heads I win, tails you lose' policy in oil and gas

The draft Model Revenue Sharing Contract (MRSC) for oil and gas exploration and production released by the The Ministry of Petroleum and Natural Gas (MOPNG) for soliciting views of stakeholders is extremely important for four reasons.

First, it is a radical move by the Government (which signs MRSC with winning E&P bidders) to safeguard its revenue and to keep it buoyant.

Second, it is an unintended attempt to trade off the Government revenue with national energy security. It also gives preponderance to Government revenue over the risk rewards that E&P developers expect for sinking money in a business that is as good as shooting the target in the pitch dark.

Third, it confirms the apprehension among the industries that it is 'business as usual' under the NDA Government because the draft is piecemeal initiative to reform the E&P business. And piecemeal approach was UPA's trademark.

Fourth, it confirms that the bureaucracy would never imbibe the basics of good communication.

Taking the last reason first, the Government should have preceded draft MRSC with a consultative paper listing the pros and cons of all regulatory frameworks for E&P contracts. The Government could have then built a case for MRSC after pinpointing the existing deficiencies in the production sharing contract (PSC), which has been in the existence for over 20 years.

Consultative paper is more important in this case as expert opinion is vertically split between two camps – with one pitching for MRSC and the other for either modified/reformed PSC.

Preparation of a comprehensive consultative paper loaded with comparative charts and tables of different options is a pre-requisite for good governance. And the voters and supporters expected this from the incoming Government when they were overwhelmed by the Modi wave for change and development.

There are four types of fiscal frameworks under which the Government, as the owner of natural resources, can facilitate E&P.

These are:

1) concession or leasing of oil and gas blocks under which significantly high royalty is sole element of the Government's take;

2) PSCs under which modest royalty and government share of revenue and/or minimum taxes constitute government's take;

3) joint ventures in which both risks and rewards are shared by the Government and the contractor; and

4) service contracts in which the Government primarily pays for E&P services rendered by contractors. There are variants of each of these frameworks with some variants serving as de facto hybrid approaches.

The least that MOPNG could have done was to issue a statement along with MRSC, comparing the major differences between model PSC and MRSC. It could have given the rationale for proposed jettisoning of PSC, which is still the most preferred format of E&P contracts across the world.

As regards business as usual under NDA Government, it is fact that there is hardly any change in governance after the ignoble defeat of UPA. NDA could have released a composite draft reforms package on E&P of which revenue sharing between the Government and the contractor is a major component.

The implementation of E&P projects is constrained by numerous regulatory delays, contractual deviations and a few grey areas. The removal of all these deficiencies is as important as safeguarding and hiking the Government's take from oil and gas wealth. If the extraction of oil and gas is delayed by many years or even decades, then the Government is unable to earn even a paise from hydrocarbon reserves.

The recommendations to remove regulatory constraints and contractual deviations, for instance, have made by the Boston Consulting Group (BCG), in its report on 'Review of Upstream Commercial Structures and Insights from Global Practices' submitted to the Government in September 2012.

Kelkar Committee on Roadmap for Reduction in Import Dependency in Hydrocarbon Sector by 2030 has also pitched for PSC reforms.

In its first report submitted in December 2013, the Committee recommended: “till any new contractual model is implemented, the current PSC model be further strengthened by both refining the decision criteria to eliminate some of the roadblocks and the simplifying procedures followed in its implementation. Further, the appropriate oversight on government's interest may be possible by prescribing a robust set of guidelines, checklists and accountability along with prudential and fiduciary oversight of the E&P operations.”

Similar recommendations have been made by Comptroller and Auditor General (CAG), whose draft report on draft performance audit report on PSCs in early 2011triggered the move to replace PSCs.

MOPNG should have released its stance on all recommendations by these as well as Rangarajan Committee on the PSC Mechanism in Petroleum Industry.

Rangarajan Committee's recommendation has, no doubt, played important role in release of draft MRSC. In its report submitted in December 2012, the Committee recommended “a new contractual system and fiscal regime based on a post-royalty-payment revenue-sharing to overcome the difficulties in managing the existing model based on the Pre-Tax Investment Multiple (PTIM) methodology and the cost-recovery mechanism.”

Under PSC, PTIM methodology enabled the contractor to recover its entire expenditure upfront as cost petroleum, which is arrived at after deduction of royalty payable to the States for onshore areas and to the Centre for offshore blocks. The balance profit petroleum is shared between it and the Government. This system encourages contractors to inflate costs to maximize their revenue at the expense of national exchequer.

MRSC has proposed to discard both PTIM and cost petroleum. The contractor would be allowed to recover cost as per the provisions of Income Tax Act from his share of the revenue from an E&P asset. The draft contract has also brought the so-called marketing margin on natural gas in the definition of revenue to ensure that the contractor shares the income on this count with the Government.

As rightly observed by Kelkar Committee, “Since the risk-reward balance would be more skewed under a Revenue Share as compared to a PSC, operators will need greater volumes to make the case for exploratory risk in Indian basins, and hence would need a higher minimum economic threshold of production to develop reserves. This behavior, when aggregated across all Indian basins, will lead to several fields remaining undeveloped. Hence production levels would be minimized under the Revenue Share regime (as compared to the PSC regime), leading to lesser energy security and hence, greater import dependence with further negative implications on macroeconomic parameters (current account deficit, fiscal deficit and exchange rates).”

The Government's post-royalty share of revenue from an oil and gas field would range from 45% to 80% of crude price depending on the crude price and level of production under MRSC. It has specified four price bands and five production levels in the matrix format for computation of Government's share.

MRSC defines contractor's net income as total value of petroleum minus royalty minus government's share of the revenue and minus operating expenditure, exploration expenditure and development expenditure borne by the Contractor.

MRSC has, however, not specified the Government's total take from an oil and gas field that should be sum of royalty, its revenue share, licensing fees, income tax and indirect taxes if any.

MRSC, among other things, stipulates that the contractor would “conduct all Petroleum Operations at its sole risk, cost and expense and provide all funds necessary for the conduct of Petroleum Operations.”

Put simply, MRSC retains the policy of asking the contractor to bear all risks and expenditure. It, however, proposed the Government, as sovereign owner of natural resources, to have lion's share of gross income from oil and gas fields.

MRSC is thus a perfect example of heads I win, tails you lose. The Government's wish for such game would materialize only if the potential contractors respond well to MRSC-driven bidding competition for hydrocarbons acerage as and when it organized.

As put by an international Conference on Oil and Gas in Federal Systems organized by the World Bank & two other entities in March 2010, “The design of the fiscal system is one of the main policy handles for petroleum sector development. While the fiscal regime determines how the sector will generate revenues, it also has an impact on the level of investment in the sector.”

After the Government breached PSC by resorting to administered pricing of natural gas produced by Reliance KG basin offshore assets, most of the multinationals stayed away from the Ninth round of bidding under new exploration and licensing policy (NELP) a few years back.

MRSC is devoid of any mechanism that can restrain the Government from breaching or deviating from the contract's terms and conditions.

Whatever the fiscal regime the Government chooses, it must have a mechanism that would make it impossible for it to breach the contract. This is crucial for attracting risk capital and cutting-edge technology from overseas.