PRODUCTION

SHARING
CONTRACTS

[email protected] www.aptaconsultingltd.com
 ABOUT APTA CONSULTING
APTA provides Financial modelling, Petroleum Economics evaluation &
analysis, and Excel training for business modelling and data analysis to
range of clients. Our clients range from blue chip to small enterprises
and individuals. Our clients have access to high quality, co st
e f f e ct i ve modelling support delivered by team of experts
around the world.

APTA FINANCIAL MODELLING TEAM

APTA’s dedicated Oil & Gas modeling team is led by Santosh Singh.
Santosh has more than 12 years of industry experience. With a technical
background in drilling engineering and further qualification in Finance
and Economics, he has worked in a number of major technical and
commercial functions and gained extensive experience in economics
evaluation, business development and commercial agreements.

Santosh’s commercial valuation and analysis experience covers Africa,

Asia, and Eurasia to name a few. He has a proven ability in the fiscal
regime modelling, investment analysis, and providing high quality
support to management for the strategic investment decisions.

SANTOSH SINGH
PRINCIPAL CONSULTANT, OIL & GAS

[email protected] www.aptaconsultingltd.com
 PRODUCTION
SHARING
CONRACTS
“Share cropping. ”

[email protected] www.aptaconsultingltd.com
 PRODUCTION SHARING
CONTRACTS

A Production Sharing Contract (PSC or Production Sharing Agreement – PSA) is a system

where by government does not transfer the ownership of the resources to the license
holder, the contractor. The contractor is supposed to work for the government and
recover its cost from the production. The government allows the contractor to share in
the profit from the oil leftover after the cost recovery.

On the surface PSCs and Royalty/Tax system looks very different. But in reality, both are
more or less the same (mathematically). The differences lie in the symbolism and the
thought process behind the structure of the two regimes types. Legally in a PSC, the
government has the ownership of the resources, in a Royalty/Tax, contractors gets the
ownership on the well head of the entire crude. In a PSC, contractor is entitled only for
the Cost Oil and Profit Oil (we will see in a minute what it means).

Be aware that a PSC can have royalty in its structure. Generally tax rate are less in a PSC
than a Royalty/Tax regime. A disadvantage of a PSC is that its sensitivity to Oil prices is
greater than a Royalty/Tax regime. The contractor may be handsomely compensated or
penalized based on which way the Oil price has moved.

Company (designated as Contractor) gets a license from the government to carry out
exploration, development and production. The contractor bears all cost. In lieu of that
it receives compensation from the government from the crude sales/production.

Crude Oil production is allocated as Cost Oil and the remaining as Profit Oil. Cost Oil is
used by the Contractor to recoup its costs. Sales proceeds from the Profit Oil are then
shared between the contractor and the government. The sharing mechanism or basis is
pre-defined. It can be based on level of production, cumulative production, R-factor,
ROR or any metrics as defined in the PSC.

The flow diagram for a generic PSC is shown below. Sometime a tax is applied on
the contractor’s share of the Profit Oil.

[email protected] www.aptaconsultingltd.com
 Royalty
Royalty Royalty
Opex

Cost Oil
Capex

Taxes

Profit Pool

Contractor Take

Govt Profit Oil

Contractor Profit Oil

Tax Oil

Contractor Take

[email protected] www.aptaconsultingltd.com
The royalty comes right off the top just like in any Royalty/Tax regime. Before splitting
the production, the contractor is allowed to recover costs out of revenues left after
payment of royalties. Most often there will be a limit on the amount of net revenue that
can be used against cost recovery. Assume a PSC has a limit of 70% for Cost Oil. It implies
if recoverable costs are more than 70% of the net revenue then , the balance would be
carried forward for future period cost recovery.

Cost recovery mechanism allows the contractor to recoup costs of exploration,

development, and operations out of sales proceeds. Generally PSCs will limit the
amount of revenues the contractor can claim for cost recovery but will allow
unrecovered costs to be carried forward and recovered in later periods. Cost recovery
limits are in the range from 30%-60%.

The purpose of the cost recovery limit is to allow the government to have at least
minimum profit in every possible production scenario even when the project itself is
not making any profit If you think about it, mathematically, the cost recovery limit is the
only true differentiating feature between PSC and a Royalty/Tax system.

The concept of ‘cost Recovery’ is nothing new. Those who put up the capital should at
least be allowed to get their investment back. The cost recovery mechanism is one of
the most common features of a PSC. It is not much different from the Royalty/Tax
regimes.

Since there are several categories of cost, not all cost may be allowed to be recovered
at same time. There may be a hierarchy cost items which has to be cost recovered in a
particular order. This may make a difference in the cash flows if certain cost recovery
items are taxable.

Net Revenues = Gross Revenues - Royalties

Profit Oil = Net Revenues – Cost Oil

Cost Oil = Opex

+ DD&A
+ Abandonment provisions
+ Investment Credits
+ Financing Charges
+ Any Unrecovered Cost Balance
+ Others

[email protected] www.aptaconsultingltd.com
Revenues left after royalty and cost recovery is called Profit Oil or Profit Gas. This is
analogous to pre-tax income of a Royalty/Tax regime. The contractor's share of the
profit oil is subject to taxation. In a service contract, this will be termed as the service
fee instead of profit oil. In a Royalty Tax system the government gets an income tax and
or special other taxes.

Contractor Profit Oil = Profit Oil x Contractors Profit Oil share

Government Profit Oil = Profit Oil - Contractor’s Profit Oil

Contractor’s NCF = Gross Revenues

- Royalties
- Opex
- Capex
- Abandonment provisions
+ Investment Credits
- Bonuses
- Government Profit Oil
- Taxes

In a PSC cash flows can be computed in several ways. And it’s always a good idea to
check one’s calculation by doing alternate calculations. A generic cash flow algorithm is
given below.

Contractor’s NCF = Cost Oil + Contractors Profit Oil

- Opex
- Capex
- Abandonment provisions
- Bonuses
- Taxes

[email protected] www.aptaconsultingltd.com
 Government Take = Royalties + Government Profit Oil + Tax on Contractor’s
Profit Oil + Bonuses

We will discuss a little bit about the concept of “Contractor Take”, “State Take”, and
“Government Take”.
In normal parlance the State and the Government signifies one ad the same entity. But
in case of Oil and Gas fiscal regime context, they refer to two different entities. National
Oil Company represents “State”. A National Oil Company (NOC) usually can participate
in the upstream project as one of the partner company within the Contractor group.
Government on the other hand represents the federal government of the host country.

Let’s show you an example case with just one company in the contractor group. Assume
Oil price of $100/bbl. and 10 barrels of productions. All figures are in $. Other
assumptions are as shown below:

Royalty Rate 10.0%

Cost Recovery Max 50.0%

Excess Oil Contractor Share 50.0%

Profit Split Contractor Share 40.0%

Tax Rate 30.0%

Revenue 1000

Signature Bonus 10

Opex 100

Capex 100

We need to explain you the meaning of Excess Cost Oil as shown in the terms above.
Usually there is limit on the Revenue that can be used for recovering the costs in a PSC.
If the recoverable cost is less than the maximum revenue allowed for cost recovery,
then the extra revenue left unused after cost recovery is called Excess Cost Oil. This
excess cost Oil may be split in any proportion between the government and the
contractor. The distribution of the cash flow for the above example is shown below:

[email protected] www.aptaconsultingltd.com
 Contractor Project Government
Gross Revenue 1000
Royalty -100 100
Revenue bf Cost Recovery 900
Max Revenue Available for Cost 450
Recovery
Cost Recovered 200 -200
Excess Cost Oil 125 250 125
Profit Oil 180 450 270

Signature Bonus -10 10

Opex -100
Capex -100
BT Cash Flow 295
Tax -89 89
AT Cash Flow 206.5 594

Contractor Take 206.5 25.81%

Government Take 593.5 74.19%
Capex + Opex 200.0
Total 1000.0
Total Revenue 1000.0

To explain the calculation above we have used the following formula:

Revenue before Cost Recovery = Gross Revenue – Royalty

Maximum Revenue Available for Cost Recovery = Revenue before Cost Recovery
X
Cost Oil Limit
Cost Recovered = Minimum of Capex + Opex or Max Revenue Available for Cost
Recovery

Excess Cost Oil = Max Revenue Available for Cost Recovery – Cost Recovered

Contractor’s Excess Cost Oil = Excess Cost Oil X Contractor’s share in Excess Cost Oil

Govt. Excess Cost Oil = Excess Cost Oil X (1- Contractor’s share in Excess Cost Oil)

Profit Oil = Revenue – Royalty – Cost Oil – Excess Cost Oil

Contractor’s Profit Oil = Profit Oil x Contractor’s share in Profit Oil

Govt. Profit Oil = Profit Oil x Govt. share in Profit Oil

[email protected] www.aptaconsultingltd.com
 Project / Field Contractor NOC Government

+ Gross Revenue

- FTP + FTP + FTP

- Royalty + Royalty

- Cost Recovery + Cost Recovery + Cost Recovery


OR
- Excess Cost Oil + Excess Cost Oil + Excess Cost Oil + Excess Cost Oil


OR
- Profit Share + Profit Share + Profit Share + Profit Share

+ Tariff Revenue + Tariff Revenue + Tariff Revenue

Contractor Gross Revenue

- Signature Bonuses + Signature Bonuses

- Share of Operating Costs - Share of Operating Costs **

- Production Bonuses + Production Bonuses

- Share of Capital Costs - Share of Capital Costs **

Contractor BT Cash Flow

- Corporate Tax + Corporate Tax

Contractor AT Cash Flow

BASIC ELEMNETS IN A PSC
Bonus: Cash bonuses may be required to be paid to the government upon signing the
contracts terms (license agreement). It’s called Signature Bonus. Bonus may be paid in
kind instead of cash such as tools and technology. Then there are Production Bonuses
which are tied to the production. The basis of this bonus payment is based on certain
rules linked to production rate or volume or some other measure of production.

Royalties: Like concessionary regimes many PSCs have the provision of royalties. It’s
based on gross revenue of the field or license area. Sometime certain costs are allowed
to be deducted for royalty calculation such as transportation cost of the crude. This
occurs when the point of valuation of the crude is different from the point of crude
sales. Royalty rate can be linked to production rate, volume, cumulative volume etc.

Here we must explain the use of Sliding Scales (Incremental Scale).A common
methodology many fiscal regimes follow is the use of sliding scale for royalties, profit
oil split, taxes, and other items. The most common approach is an incremental sliding
scale based on average production rate. The following example should clarify.

Say in sliding scale royalty that steps up from 10% to 15% on 10,000 BOPD tranches of
production. This means for any production less than 10,000 BOPD royalty rate will be
10%. For production rate greater than 10,000 BOPD to royalty rate will be 15%, but only
on production above 10,000 BOPD. Now assume the average daily production is 15,000
BOPD, the effective royalty paid by the contractor is 11.67% (10,000 BOPD at 10% +
5,000 BOPD at 15%).

Average Production ROYALTY

First Tranche Up to 20,000 BOPD 8%
Second Tranche 20,001-50,000 10%
Second Tranche Above 50,000 BOPD 15%

A general confusion arises when analysts assumed that once the production exceeds a
particular threshold all production is subjected to the higher rate. Sliding scales are
incremental in nature. It is generally used so that it does not penalize the contractor
just because production moved from one tranche to another they have to pay higher
rates on all volumes.

Cost Recovery: We have discussed this earlier as well. Cost recovery is similar to
deductions of a Royalty/Tax regime. The share in profit oil by the government is actually
just a tax to the contractor. Viewed this way PSC becomes a Royalty/Tax regime!
However due to ownership issue, instead of calling it tax, govt. pretend that its sharing
its profit with the contractor in lieu of the service provided to produce its own oil. Since
the contractor under a PSC does not own the production, government reimburses the
contractor for costs through the cost recovery mechanism and then shares a portion of
the remaining production or revenues with the contractor. There may or may not be a

[email protected] www.aptaconsultingltd.com
limit on the cost recovery amount depending on the PSC. While some PSCs have no limit
on cost recovery some may not have cost recovery at all! For e.g. older Peruvian regimes
made no allowance for cost recovery before the profit oil split. The government simply
granted the contractor a share of production.

Generally most PSC allows for the following to be cost recoverable:

 Unrecovered costs carried over from previous years

 Opex
 Expensed capital costs
 Current year DD&A
 Financing charges with certain cap
 Investment credit (uplift)
 Abandonment cost recovery fund

Sometime no distinction may be made between tangible/intangible Capex. And all

Capex may be allowed to be recovered in the period incurred instead of allowing on
depreciated portion in the period concerned.

Generally unrecovered costs are carried forward indefinitely and are available for
recovery in future periods. But there may be instances that carry forward is not allowed
(especially for Sunk Costs) or there is limit to the number of years or the amount of carry
forwards in future periods.

Some fiscal regimes may have incentives, such as investment credits (or uplifts). Uplift
allows the contractor to recover an extra percentage of capital costs through cost
recovery. For example, an uplift of 25% on Capex of $100 would allow the contractor
to recover $125 ($100 + $25).

Under most PSCs the contractor gives up ownership rights to the government for
equipment plat- forms, pipelines, and facilities on start of the project. Therefore it’s the
government as owner who should be held responsible for the abandonment
expenditure. But normally the onus is on the contractor for the field abandonment
provision. What government does then in turn is to allow this abandonment provision
to be cost recoverable. Projected abandonment cost is accumulated through a reserve
fund that matures at the time of abandonment. The costs are recovered prior to the
actual abandonment.

Profit Oil & Taxation: Profit oil is split between the contractor and the government,
based on pre-defined terms as per the signed PSC. These terms may or may not be
negotiable. The contractor’s share of profit oil may or may not be subjected to further
taxation. Sometime the contractor doesn’t have to pay the tax to government
themselves. The NOC participating with the contractor is deemed to have paid the tax
to government on behalf of the contractor. This is called Deemed or Imputed Tax.

[email protected] www.aptaconsultingltd.com
Whether a PSC is good or not so good from the contractors view point can be based on
“Take” statistics. The common benchmark to use for comparing a PSC is contractor take
(contractor’s cash flow as a percentage of project operating profit). Generally if the
geology and supporting infrastructure are good, the terms of PSC become tough and
vice versa.

High Contractor Take %

Low Contractor Take %

Not so good Geology Good geology

DMO (Domestic Market Obligations): Some time a PSC may require the contractor to
fulfil certain domestic market needs of the host country at discounted price. These they
require that a certain percentage of the contractor's profit oil be sold to the government
at discount to market price. Sometime the exchange rate of the currency in which the
government pays back the contractor for fulfilling this obligation may be predetermined
and not market based.

Ring-fencing: The issue of recovery or deductibility of costs, profit oil and taxation is
dependent on the revenue base from which costs can be deducted. Normally all costs
associated with a given block or license must be recovered from the revenues generated
within that block. In fiscal regime terms we call that the block is ring-fenced. This
prohibits cost or profits to from consolidation with another block or license operated
by same company. Some countries will allow certain classes of costs associated with a
given field or license to be recovered from revenues from another field or license.

Ring-fencing may have impact on tax base and tax payment and carry forward of losses
(and same with cost recovery). Say a company has two blocks and both are ring-fenced
for cost recovery and tax purpose. This means if one of the blocks generates a loss of
$50 while the other generates a profit of $100, the total profit of the company operating
these two blocks will be $50 ($100 profit of one block - $50 loss of another block). Let’s
say the tax rate is 30%. If there was no ring-fence for the purpose of the tax

[email protected] www.aptaconsultingltd.com
 computation, total tax liability for the period would be $15 ($50 x 30%). If the two blocks
on the other hand are ring-fenced, the tax liability of the company will be $30

Tax & Royalty Holidays: Sometime in certain fiscal regimes there is provision of tax
holidays or royalty holidays. These allow the contractor not to pay any taxes or royalty
(in case of royalty holiday) to the government during those holiday years. These holidays
are designed to attract additional investment in the field of exploration and
development.

Let’s show you a worked out example for a simple PSC now. The inputs for the case is
shown below:

Inputs
Exploration Development Abandonment
Production Oil price Opex
Capital Capital Capital

Bbl/day USD/barrel M USD M USD M USD M USD

1,080,000 324,000 1,205,000 375,000

2013 0 100 0 174,000 0 0

2014 0 100 0 150,000 15,000 0
2015 0 100 0 0 465,000 0
2016 0 100 0 0 525,000 0
2017 5,000 100 60,000 0 0 0
2018 15,000 100 60,000 0 0 0
2019 30,000 100 60,000 0 50,000 0
2020 30,000 100 60,000 0 0 0
2021 25,500 100 60,000 0 0 0
2022 21,675 100 60,000 0 50,000 0
2023 18,424 100 60,000 0 0 0
2024 15,660 100 60,000 0 0 0
2025 13,311 100 60,000 0 50,000 0
2026 11,314 100 60,000 0 0 0
2027 9,617 100 60,000 0 0 0
2028 8,175 100 60,000 0 50,000 0
2029 6,949 100 60,000 0 0 0
2030 5,906 100 60,000 0 0 0
2031 5,020 100 60,000 0 0 0
2032 4,267 100 60,000 0 0 0
2033 3,627 100 60,000 0 0 0
2034 3,083 100 60,000 0 0 0
2035 0 100 0 0 0 375,000

Other assumptions that we assumed in this case is royalty rate of flat 10% on any level
of production. Cost recovery limit of 80%. Government share of the profit Oil is assumed
to be flat 40%. For simplicity we assumed Deemed Tax scenario, i.e. tax is assumed to
be paid by NOC to the government on behalf of the contractor.

[email protected] www.aptaconsultingltd.com
 Revenue Royalty Cost Recovery
Max
Cost Cost Revenue
Oil Gross Royalty Royalty Total Cost
Royalty Recovery Costs Recovery Available Balance
Volume Revenue Rate Base Revenue Recovered
Limit Deductions For Cost
Recovery
M Bbl M USD % M USD M USD % M USD M USD M USD M USD M USD M USD
84,873 8,487,272 8,487,272 848,727 2,984,000 8,487,272 848,727 6,110,836 2,609,000
10% 80%
2013 0 0 10% 0 0 80% 174,000 0 0 0 0 174,000
2014 0 0 10% 0 0 80% 165,000 0 0 0 0 339,000
2015 0 0 10% 0 0 80% 465,000 0 0 0 0 804,000
2016 0 0 10% 0 0 80% 525,000 0 0 0 0 1,329,000
2017 1,825 182,500 10% 182,500 18,250 80% 60,000 182,500 18,250 131,400 131,400 1,257,600
2018 5,475 547,500 10% 547,500 54,750 80% 60,000 547,500 54,750 394,200 394,200 923,400
2019 10,950 1,095,000 10% 1,095,000 109,500 80% 110,000 1,095,000 109,500 788,400 788,400 245,000
2020 10,950 1,095,000 10% 1,095,000 109,500 80% 60,000 1,095,000 109,500 788,400 305,000 0
2021 9,308 930,750 10% 930,750 93,075 80% 60,000 930,750 93,075 670,140 60,000 0
2022 7,911 791,138 10% 791,138 79,114 80% 110,000 791,138 79,114 569,619 110,000 0
2023 6,725 672,476 10% 672,476 67,248 80% 60,000 672,476 67,248 484,183 60,000 0
2024 5,716 571,590 10% 571,590 57,159 80% 60,000 571,590 57,159 411,545 60,000 0
2025 4,859 485,852 10% 485,852 48,585 80% 110,000 485,852 48,585 349,813 110,000 0
2026 4,130 412,961 10% 412,961 41,296 80% 60,000 412,961 41,296 297,332 60,000 0
2027 3,510 351,021 10% 351,021 35,102 80% 60,000 351,021 35,102 252,735 60,000 0
2028 2,984 298,388 10% 298,388 29,839 80% 110,000 298,388 29,839 214,839 110,000 0
2029 2,536 253,639 10% 253,639 25,364 80% 60,000 253,639 25,364 182,620 60,000 0
2030 2,156 215,569 10% 215,569 21,557 80% 60,000 215,569 21,557 155,210 60,000 0
2031 1,832 183,230 10% 183,230 18,323 80% 60,000 183,230 18,323 131,926 60,000 0
2032 1,557 155,746 10% 155,746 15,575 80% 60,000 155,746 15,575 112,137 60,000 0
2033 1,324 132,386 10% 132,386 13,239 80% 60,000 132,386 13,239 95,318 60,000 0
2034 1,125 112,530 10% 112,530 11,253 80% 60,000 112,530 11,253 81,021 60,000 0
2035 0 0 10% 0 0 80% 375,000 0 0 0 0 375,000
 Profit Oil Profit Split Net Cash Flow
Contractor Government Contractor Government
Total Cost Profit Oil Profit Oil Contractor Government
Royalty Profit Oil Share in Share in Net Cash Net Cash
Revenue Recovery Contractor Government Take Take
Profit Oil Profit Oil Flow flow
M USD M USD M USD M USD % % M USD M USD M USD % M USD %
8,487,272 848,727 2,609,000 5,029,545 3,017,727 2,011,818 2,642,727 48% 2,860,545 52%
60% 40%
2013 0 0 0 0 60% 40% 0 0 -174,000 0
2014 0 0 0 0 60% 40% 0 0 -165,000 0
2015 0 0 0 0 60% 40% 0 0 -465,000 0
2016 0 0 0 0 60% 40% 0 0 -525,000 0
2017 182,500 18,250 131,400 32,850 60% 40% 19,710 13,140 91,110 31,390
2018 547,500 54,750 394,200 98,550 60% 40% 59,130 39,420 393,330 94,170
2019 1,095,000 109,500 788,400 197,100 60% 40% 118,260 78,840 796,660 188,340
2020 1,095,000 109,500 305,000 680,500 60% 40% 408,300 272,200 653,300 381,700
2021 930,750 93,075 60,000 777,675 60% 40% 466,605 311,070 466,605 404,145
2022 791,138 79,114 110,000 602,024 60% 40% 361,214 240,810 361,214 319,923
2023 672,476 67,248 60,000 545,228 60% 40% 327,137 218,091 327,137 285,339
2024 571,590 57,159 60,000 454,431 60% 40% 272,659 181,772 272,659 238,931
2025 485,852 48,585 110,000 327,266 60% 40% 196,360 130,907 196,360 179,492
2026 412,961 41,296 60,000 311,665 60% 40% 186,999 124,666 186,999 165,962
2027 351,021 35,102 60,000 255,918 60% 40% 153,551 102,367 153,551 137,469
2028 298,388 29,839 110,000 158,549 60% 40% 95,129 63,420 95,129 93,258
2029 253,639 25,364 60,000 168,275 60% 40% 100,965 67,310 100,965 92,674
2030 215,569 21,557 60,000 134,012 60% 40% 80,407 53,605 80,407 75,162
2031 183,230 18,323 60,000 104,907 60% 40% 62,944 41,963 62,944 60,286
2032 155,746 15,575 60,000 80,171 60% 40% 48,103 32,068 48,103 47,643
2033 132,386 13,239 60,000 59,147 60% 40% 35,488 23,659 35,488 36,897
2034 112,530 11,253 60,000 41,277 60% 40% 24,766 16,511 24,766 27,764
2035 0 0 0 0 60% 40% 0 0 -375,000 0

[email protected] www.aptaconsultingltd.com