The Comptroller and Auditor General of India (CAG) was asked by the petroleum ministry in 2007 to audit a sample 20 production sharing contracts (PSCs) to evaluate how fair, equitable and transparent was the regulatory regime for the oil and gas exploration sector. The purpose was also to find whether the government?s revenue interests were being protected.

The auditor has found some serious irregularities in the PSCs and recommended measures to tighten the regulations.

In its draft performance audit report on hydrocarbon PSCs, the official auditor has done extensive study of three oil and gas blocks operated by Reliance Industries (RIL), Cairn Energy and a consortium of private operators under a joint venture with ONGC.

The petroleum ministry and Directorate-General of Hydrocarbons (DGH) are yet to respond to the CAG observations. A final audit report containing responses of the ministry and DGH will be tabled in Parliament.

Following are the edited excerpts from the block-wise findings of CAG in its draft performance audit report on hydrocarbon PSCs:

KG-DWN-98/3 block (Operator RIL)

This block operated by RIL was awarded in the first round of New Exploration Licensing Policy (Nelp). It has the country?s largest gas discoveries from the Dhirubhai 1 and 3 fields and also oil discovery from the MA oilfield.

CAG?s findings & recommendations:

– The operator received undue benefit on being irregularly allowed by the petroleum ministry and DGH to enter successive exploration phases in its contract area without stipulated relinquishment of area. This meant that the entire contract area could be declared as ?discovery area? even though drilling of wells and consequential discoveries, which is primary requirement for discovery and discovery area, had not taken place in a major portion of the contract area. The undue benefit granted to the operator is huge, but cannot be quantified.

Recommendations: Government should re-examine delineation of the entire contract area as ?discovery area? and take steps for relinquishment of excess area in line with the PSC. It should also fix accountability for those responsible for this decision.

– In case of 13 out of 19 discoveries made between October 2002 and July 2008, the operator directly gave written notifications on potential commerciality of the discoveries in violation of the PSC that requires the operator to furnish particulars of discoveries in writing to the management committee and the government.

– No appraisal programme conducted in respect of 14 out of 19 discoveries, notably the D1-D3 gas discoveries and the D-26 oil discovery.

– In respect of D1-D3 gas discovery, the operator submitted an initial development plan (IDP) in May 2004 (with estimated capex of $2.4 billion) and followed it up with an `Addendum? to IDP in October 2006 ($5.2 billion for Phase-I and $3.3 billion for Phase-II). In CAG?s opinion:

I) DP and AIDP are not PSC complaint as it requires a comprehensive development plan.

II) Intent of the operator clear from the very beginning as it submitted an IDP rather than a comprehensive development plan.

III) Most procurement activities were undertaken late in line with the schedules of the IDP of May 2004, clearly showing that the operator had no intention of complying with these timelines. By contrast, activities in respect of items in the AIDP were initiated even before the submission/approval of AIDP.

IV) Submission of Addendum to IDP and lack of details for Phase-II (estimated cost $3.3 billion) makes it virtually certain that the operator will file more addendums to this development plan in the course of time rather than presenting a comprehensive development plan.

V)The increase in cost from IDP to AIDP is likely to have a significant adverse impact on the government?s financial take.

– There were unreasonable high value procurement activities involving payments by the operator during 2006-07 and 2007-08. Due to lack of competition, huge procurement contracts were awarded on single financial bids with repeated extensions, substantial variation in orders and revisions in specifications. This had an adverse implication on the cost recovery and the government?s financial take.

– With respect to the MA oil field, the operator placed orders for various items required for field development activities from October 2006 itself, well before submission of field development plan and mining lease application.

The audit also found serious deficiencies in the award, on a single financial bid, of a 10-year hiring contract for $1.1 billion for a floating production storage and offloading vessel from Aker Floating Production.

RJ-ON-90/1 Block (Operator Cairn Energy)

This onland block (mainly in Rajasthan) was awarded under the pre-Nelp exploratory rounds and is currently operated by Cairn Energy. It has now the country?s largest onland oil discoveries and also significant gas discoveries.

CAG?s findings & recommendations:

– The grant of additional area of 1708.20 sq km beyond the contract area by government was not in line with the provisions of the PSC.

– Thirteen discoveries were made during/between the appraisal phase and in the development phase in areas already delineated as development areas, which implied the following:

I) This represented back-door method for further exploration activities, when the exploration period had concluded.

II) The development area was, evidently, irregularly delineated and included excess area beyond that properly associated with the declared commercial discoveries and the associated development plans.

– There were numerous instances of non-compliance with regard to the PSC provisions for notifications of potential commercial interest, appraisal programme, submission of filed development plan etc.

Panna-Mukta and Mid and South Tapti fields

The Panna-Mukta and Mid and South Tapti fields are offshore shallow water fields in the offshore Bombay basin. These fields were initially discovered and operated by ONGC. In 1994, these were awarded to a consortium of private operators under a joint venture arrangement with ONGC.

CAG?s findings & recommendations:

– The government incurred a substantial loss on account of royalty because of its failure to finalise the norms for post-wellhead costs of gas, and consequentially, gas wellhead prices. Even the norms for post-wellhead costs notified in August 2007 had significant deficiencies

– The petroleum ministry and its nominee for gas purchase, GAIL India, failed to comply with the terms of the PSC during 2005-08 for the pre-determined gas pricing formula. It is difficult to set off the clear loss in royalty and the government?s share of profit petroleum (estimated by CAG at R584.31 crore) as well as ONGC?s share of profit petroleum vis-a-vis gains, if any, to the government on account of reduced fertiliser subsidy (on account of reduced gas prices) as well as to the power sector consumer (on account of reduced electricity tariffs due to lower gas prices).

– The PMT JV had not completed key work programme in the Mukta field, which remained undeveloped with very low volumes of oil and gas production. Excess cost recovery of $6.2 million and short remittance of $6.2 million had been directed by the petroleum ministry, but had not been acted upon by the JV.

– The committed work programme in the Mid and South Tapti fields was incomplete, yet the cost recovery limit under the PSC had been exceeded, and there was excess cost recovery of $324 million under this PSC.

– Compliance and control issues:

I) Non/delayed relinquishment of the area at the end of the exploration phases

II) Unjustified extension of exploratory phases

III) Deficiencies in recovery of penalty for unfinished exploratory work programme

IV) Non-compliance with PSC provisions for notification of discovery and submission of test reports

Conclusion & general recommendations

There is considerable scope for improvement in the management of the hydrocarbon exploration and production with private sector participation.

CAG?s recommendations for future PSCs

The stated strength of the profit-sharing mechanism is the sharing of the risks between the contractor and the government. A royalty mechanism linked only to quantity of production and/or value might appear to be regressive from an economist?s perspective since exploration risks, especially in the case of no hydrocarbon discoveries or discoveries of marginal commerciality, might fall largely on the private sector.

However, this can be altered by introducing a sliding scale for royalty linked to different slabs of production of crude oil/gas ? the lower the production from a block, the lesser the royalty rate (perhaps zero up to a particular limit). This is administratively far easier to control from the government?s perspective. This will also adequately incentivise the private operators to optimise the costs, keeping in view their own financial interests.

For future PSCs, we recommend the replacement of the profit-sharing formula based on investment multiple with a royalty formula (based on either quantity or ad valorem) with a sliding scale linked to different slabs of production. This is the best formula, given the current context for harmonising the financial interests of both the government and the private contractors.

In such a situation, the PSC could be considerably simplified as the requirement for control/oversight by the management committee at different stages of the E&P process could be considerably reduced.