Upstream oil & gas blocks have been auctioned in India since the early 1990s. The winner signs a contract, termed a production sharing contract (PSC), with the government. The PSC—directly or through a mining licence issued to successful explorers—has a certain original life, which generally ranges around 20-25 years and is extendable.
Unlike other minerals which may be exploited at will, petroleum reservoirs have an optimal evacuation rate. The operator can produce faster to complete evacuation of total extractable oil within the contract period. Such exploitation may, however, lead to the collapse of a reservoir, leaving much of the oil/gas underground. Even in well-run systems, the production ranges only between 30-40% of the reserves. To ensure that the reservoir is not flogged, there is usually a regulator to monitor reservoir characteristics and regulate production rate. The actual production, therefore, maximises the country’s NPV, and not the operator’s NPV and all extractable oil may not be evacuated in the initial contract period.
Upstream is a high-risk, high-reward game. Very deep pockets are required to undertake hydrocarbon development. The fact that the world’s top oil & gas companies earn an average return that is only marginally better than a stable business, often triggers the question: Why do companies go for exploration? In addition to the euphoria of discovery, the potential scale of business, the upside of finding additional reservoirs and the hope of emerging technologies helping a company extend the life of reservoir offer an answer. Thus, extracting the maximum (economically feasible) oil/gas from a block is, in practice, a built-in assumption of every explorer. This also creates a synergistic, win-win scenario where the NPVs of the country and explorer converge, and they work together to preserve the reservoir and optimally extract an amount that is economically feasible.
The contract between an exploring company and the government is the governing framework for this industry. It is the bedrock for production of hydrocarbons. As a natural corollary, the tenure of the contract—till the end of economic life—is an important decision for all the parties, more so for the exploration and production companies, given the significant amount of investments they commit.
If the extension of a contract or licence is not assured, the probability of recovery and return on capital is diminished towards the latter part of contract life. In such scenarios, an operator may stop investing well in advance of the end of the contract. The reservoir licensed to the operator may thus produce at sub-optimal, low rates. In some cases, the operator may even cease production. This will be challenging to revive later. This is a big negative for a hydrocarbon-deficit country.
When the existing operator has to cease operation, it has terminal responsibilities towards the restoration of the site to as near the original situation as is possible and fulfil all health safety and environment obligations. When everything has been dismantled, the reservoir plugged and the site restored then (a) the restarting of production by a new contractor shall require new infrastructure at a high additional cost, which may make the new production non-commercial, and (b) once the old team is dismantled, the wealth of knowledge of this specific reservoir shall be substantially lost. This implies a new learning curve and, for a long time, sub-optimal production and a higher risk exposure.
If immediately a new operator is engaged before dismantling the current infrastructure, the new infrastructure cost issue may be tackled, but resolving liabilities of site restoration, of accidents in the old infrastructure, etc, become quite complex and challenging. Other problems as mentioned earlier also remain.
As the field becomes mature, the production ramps down to a small fraction of its peak. At the same time, in the Indian scenario, the investment multiple which drives the ‘government take’ and ‘operator take’ shoots to higher levels, and, the fiscal terms are overwhelmingly in the favour of the government. There are often significant reservoir risks associated with declining production. Facilities could be at the end of design life. It may then entail significant investments in existing infrastructure. This leads to a high operating-cost environment, which adversely affects the project’s feasibility. At a certain point, it is no longer economical for the operator to keep producing on the existing terms and it may exit even a producing field. This is the developing scenario in UK (North Sea) where platforms now require significant upgrade and refurbishing, and current contract terms shall make production unattractive or marginal.
As pointed out earlier, it is in the country’s interest to have the current operator continue. This requires a softening of the contract’s terms to make it commercially attractive. More and more hydrocarbon-deficit countries are veering towards this approach, as can be seen from the Woods Report, recently implemented by the UK government in the North Sea. International best practices highlight that numerous other governments actually incentivise production operations as field is nearing its natural decline rather than making fiscal terms unfavourable, which we understand is what our government is envisaging!
The general practice, particularly in hydrocarbon-deficit domains, is to extend the current contract in favour of the current operator. Separately, if the field is deemed mature, then through a separate policy on mature fields, softening of fiscal terms is to be extended.
Until now, most of the fields in India were nominated blocks which had been released to the national oil companies. The extension of these was routinely dealt, and the nomination periods or mining licences were extended as required by the operating company without any additional considerations. Only recently, has the need for extension arisen for private companies’ contract. The government set up a committee in early 2013 to make recommendations on this matter. The committee recommendations, though made many months back, are not yet in public domain. The stakeholders’ comments have also not been invited on any policy based on the committee’s recommendations. The principle of transparency and the involvement of all stakeholders is an important and useful practice, and should be adhered to. A decision taken in isolation may not be an optimal one.
There are serious concerns in the industry. Amongst the areas of disquiet are the restructuring of fiscal terms, higher government take, short periods of extension without consideration of residual economic life, etc.
As explained, it is not in India’s interest to change the operator. A policy based on the assumption of neutrality to ‘operator change’ shall lead to adventurous conditions being imposed on the current operator. By forcing existing operators’ exit, we will create a whole string of marginal and maturing fields with substantial oil & gas left underground. Making a “safe” policy with the objective of increasing the government take shall have similar results.
The necessity of continuing with the current operator will be played out whenever a renewal/extension is required, till the end of economic life of reservoir. Thus, there is little point in having an extension policy that does not address the need of continuing through the entire residual economic life. As per media reports on the committee report, the recommendations fall short on this.
Operators investing significant amount of capital need early clarity and fiscal terms that incentivise production from mature fields. It is already rather late and serves no purpose to delay such incentives further or to impose conditions that harm the industry and the country. Contract extension should not be seen as an opportunity to maximise government take but to maximise production and incentivise additional investments.
By Ashu Sagar
The author is secretary general, AOGO. Views are personal