Given Solicitor General Rohinton Narimans advise and Reliance Industries Limiteds (RIL) arbitration notice to the government, it was only a matter of time before the government respondedso the government notice to RIL saying it would not be allowed to recover $1.2bn of expenses on the KG Basin gas fields was only to be expected. The language of the notice is quite harsh and should frighten RIL investors since it means a significant dip in profits. The notice says RIL has repeatedly failed to live up to the terms of the Production Sharing Contract (PSC) by not drilling enough wellsit was supposed to drill 31 by April 1, 2012, but has drilled only 18, of which only 14 are in operationand so, as per the PSC, the government is disallowing $1.2bn of expenses claimed by RIL. The expenditure disallowed is in keeping with what Nariman had advised, that RILs expenses be restricted for the excess capacity it has created. As and when RIL raises production to the projected 80 mmscmdit is 38.6 mmscmd right nowpetroleum ministry officials said yesterday, it can claim these expenses.
Since both sides will cite different clauses in the PSCmaybe even the same ones!to argue their cases, it is difficult to predict which way it will go. While the government notice cites Clause 15.11 of the PSC which it says allows for adjustments to be made to what can be expensed, the same clause says these adjustments shall be agreed upon between the Government and the Contractorin other words, this can be interpreted to mean no changes can be made unless RIL agrees! Citing Clause 3.2 (ix), the government letter says certain costs can be made non-recoverable3.2 deals with costs that are not recoverable and sub-clause (ix) says these are amounts paid with respect to non-fulfilment of contractual obligations. And by not digging enough wells and achieving the necessary levels of production, the government argues, RIL is in breach of its contract.
RIL, however, argues, in its arbitration notice that any stipulation disallowing costs with reference to level of production or underutilisation of assets is conspicuous by its absence in this clause. And it adds, the geological data on the field very clearly shows the drilling of more wells will not improve the performanceon the contrary it may prove deleterious to the same.
In other words, the fight is likely to be a long one. And theres an additional problem here. If RIL is to dig the extra wells the Directorate General of Hydrocarbons wants it to, costs are going to go up considerably. That, in turn, will further lower the amount of profit-gas the government will get out the fields which is the original bone of contention, that RILs cost increasesfrom the initial $2.4bn when around 40 mmscmd of gas was to be recovered to $8.8bn when 80 mmscmd of gas was to be producedwere excessive. Will the government be willing to bear the additional costs of sinking these wells and, if they damage the structure as RIL says they will, who is to bear the cost and responsibility for this
Apart from the validity of each partys arguments, there is the issue of the underlying philosophy of the PSC. Since oil exploration is intrinsically a very high-cost-high-risk venture, the PSC allows all costs to be recovered first, before giving the government its share of profits. If the cost recovery is to be linked to how much output has been got, this would suggest RIL should have got a larger amount when, in FY10, it exceeded the projected gas output by 40%!
In which case, the fight will boil down to the government being able to prove RILs refusal to sink more wells is what has caused the fall in productionwhat the governments notice calls your lack of adequate/economical operation on facilities developed for production/extraction of gasand thats always going to be a tough call.
Which takes us back to the CAG audit report on RIL, an audit requested by the petroleum ministry when enough people suggested RILs high capex was a problem. Conscious of the fact it didnt have technical expertise in evaluation complex projects such as this one, CAG examined the data it got and pointed out that for 2006-07 and 2007-08 (CAG got data for only these two years), there seemed to be too many contracts awarded on the basis of a single bid and there were substantial variations in the original bids and the amounts given laterthe scope of work also changed significantly and while multiple bidders were pre-qualified for tenders, all except one were rejected on technical grounds in many cases. The CAG wasnt sure if this was just par for the course in a complex businesscritics like Surjit Bhalla please note!so it asked the petroleum ministry to do an in-depth review of 10 contracts, 8 of which were given to one group on a single-bid basis.
Sadly, however, there seems to have been little progress on this. In the ultimate analysis, if RIL is to be penalised, it will have to be for padding its costs, and not for failing to dig more wells, the efficacy of which is more of a technical judgment call and will vary from expert to expert. Nor has any progress been made on the other issue flagged by the CAG as well as the Ashok Chawla Committee Report, that the current investment multiple-based profit sharing contract lent itself to abuse since there was a vested interest for contractors to bring forward their expenditureboth suggested the investment-multiple be dropped. The least the government can do is to organise investor conferences to get their feedback on this. All told, the government hasnt quite covered itself in glory.