Is revenue-sharing the way to go

Updated: Jan 17 2014, 08:31am hrs
The government is about to offer oil and gas blocks for exploration licensing. As per the prevailing practice under the New Exploration Licensing Policy (NELP), the blocks are offered on the basis of profit-sharing. Firms first recover the cost of exploration and production and after that offer a proportion of their profit to the government. The firms bid for what share of profit they are offering the government. This requires that the government determine the costs of exploration and production. This is done by the Director General, Hydrocarbons, appointed by the Ministry of Petroleum and Natural Gas (MoPNG).

This has led to disputes about what the cost has been. Thus, the Rangarajan Committee has recommended that instead of profit, the government should consider a revenue-share. This would eliminate the need to determine the cost. Following this, recently, the Kelkar Committee has argued that there is no need to change the profit-sharing mechanism as it has been practised for some time and the disputes have been few.

While I do not know the specific arguments offered by the Kelkar Committee, I think the Rangarajan recommendation has some merit. Any self-respecting businessman, given an opportunity to gold-plate his investment, would do it and overstate it. Revenue-sharing will eliminate the need to assess the costs incurred. It is, however, argued that some auditing will be needed, even with revenue-sharing, to determine the strategy of exploration. Is the firm delaying production to benefit from higher prices in the future

This can happen if the prices are government-controlled and there are indications that prices may increase in the future. For example, the natural gas price is $ 4.2/mmBtu and is expected to increase to $8.2/mmBtu by April 2014. In such a situation, it would make sense from the firms point of view to delay production. Such gaming should be expected. I dont think this would have been a serious issue if the petroleum sector prices were free and market-determined, as predicting future prices would not have been easy with the firms preferring to get money as soon as they could. Revenue-sharing is more transparent and these days transparency will trump any other argument.

However, revenue-sharing increases the risk that the firm faces. It does not know what the cost would be and does not know if it would be able to recover it. Given this, the firm would offer a lower share of revenue to the government than would be the case if there were no uncertainty.

In fact, the total value of the share of government is likely to be lower than in a profit-sharing mechanism, which did not involve any gold-plating.

The case for profit-sharing rests on the belief that with lower risk, more firms will be willing to bid for exploration. However, our experience so far with NELP rounds have not been very encouraging when it comes to attracting large global players to bid. Their reluctance to come to India may have other reasons.

Political risk may be perceived as high in India as the government frequently changes policy. As long as this perception persists, foreign firms will be reluctant to come to India whether we have a profit-sharing model or a revenue-sharing model in place. We need to create confidence that no retroactive change in policy will be made.

I hope that the Kelkar committee considers these points and gives persuasive arguments for its recommendation.

Kirit S Parikh

The author is chairman, Integrated Research and Action for Development and former member, Planning Commission

For all the brouhaha about profit-sharing vs revenue-sharing, both regimes are essentially revenue-sharing arrangements where the government and the contractor share revenues from oil or gas production on a moving scale.

Originating in the humble rice fields of Indonesia, the production sharing contract (PSC) was a more sophisticated version of the classic batai system where the landowner instead of insisting on a fixed share of revenue from the toiling bataidar, agreed to temper his own earnings by allowing for the serfs weather risks and input cost. The aim was to raise productivity by giving the serf (in this case, the contractor) incentives to invest in order to raise output.

Oil and gas exploration has always been considered too risky by lending institutions. So, countries with uncertain prospects found this the ideal model to adopt for this high-cost and technology-driven industry. All exploration risks pass on to companies, who invest, bringing in the latest technologies to explore and produce from uncertain areas with low prospectivity. In case the contractor gets lucky and discovers a gusher, the PSC adjusts revenue-sharing to ensure that the government collects the bulk of the windfall. But should the venture prove unduly risky and the field turn out to be a cash-guzzler with marginal returns, the contractor is assured of first right to recover what he can of his risk investment.

The debate here is not about PSC versus revenue-sharing but rather between two kinds of revenue-sharingone in which costs are considered and the other in which they are not. It is the latter cost-insulated model which is being peddled in some quarters as the more desirable arrangement. This arrangement makes revenue-sharing subject only to the two variables of production and price, with no reference to costs. The only argument given in its favour is that it does not burden the people responsible for contract administration with the responsibility of monitoring and approving costs.

The PSC, it is argued, is prone to gaming. Contractors inflate or gold-plate costs to lock the government in the lower tranche of profit-sharing. The question is whether there is any any incentive to do this

Costs can never become profits unless the costs themselves are fraudulent. And to check fraudulent spending, PSCs provide for a series of approvals and audits, unmatched by any other private-public arrangement. So, the desire to move away from the PSC springs more from the desire to be not held accountable for approvals and audits rather than any motive of increasing oil and gas production. As far as profit-sharing is concerned, let us not forget that 10% of 100 is more than 80% of 10. So, there is every reason to increase, not shrink, the size of the pie to be shared, even if it ends up increasing the government share.

The cost recovered is always the nominal costR500 crore spent drilling a well in 2001 could have doubled by now sitting in a bank. But the PSC permits the contractor to recover the bare R500 crore when cost recovery becomes possible, say, in 2012. To recover the cost of capital spent, the contractor must recover the nominal cost at least twice over. Doing that again nudges the government into a higher profit share tranche. Oil and gas contracts run for decades. Disruptive technologies appear driving down costs. A revenue-sharing arrangement that ignores cost cant capture the huge upsides from these disruptions.

Eventually, capital and technology move globally. India is neither Saudi Arabia nor Venezuela as far as petroleum resources go. The chosen regime must compete to attract investors who will choose the best risk-reward matrixand revenue-sharing is certainly not the one.

Sunjoy Joshi

The author is director, Observer Research Foundation