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The Decision to Explore for Petroleum Resources The first crucial set of decisions a government faces is whether or not to explore for petroleum, at what pace to explore, and who should undertake such exploration. On this basis only, we could conclude that information on the existence, likely size, and distribution of petroleum reserves is valuable to the society at large.

This holds true even if exploration proves unsuccessful. Because the cost of inefficient exploration and production translates into lower economic rent available to the public, the more efficient the exploration, the higher the social benefit. These will be discussed further in this paper. The sequence would depend on the distribution of exploration and extraction costs across different basins. Exploration can—through surveys and drilling—reduce uncertainty regarding the location and size of petroleum accumulations as well as their likely development costs.

The accumulation of a stock of proved reserves8 would—at least in theory—permit the more efficient scheduling of production of various deposits Gilbert, This is particularly important if the depletion of some deposits leads to tight constraints induced by scarce capacity in production and transport, or if infrastructure needs to be in place for certain projects to be commercially viable. But generating a stock of proven oil and gas reserves ahead of time can be very expensive—especially when the time value of money is factored into the calculus.

In addition, although contractual agreements usually provide for government approval of development plans submitted by the operator, the instances when such approval can be denied or delayed are clearly defined. It is difficult to assess the impact of market, regulatory, and political incentives on the optimal pace and pattern of exploration activity. In practice, policy makers often end up formulating their policy objectives in a more simplistic manner such as i ensuring a stable level of exploration and development; ii fostering the development of more remote regions; and iii promoting efficient development.

Particularly in poor countries in need of development spending—or where political instability puts a premium on patronage expenditures—governments may simply aim to maximize revenue over the short term. Exploration and Inter-Generational Equity Three aspects related to the existence of petroleum revenue pose special problems for decision makers: i petroleum revenue may be quite large in relation to the rest of the economy, but will not be permanent because the resource is exhaustible; ii the revenue size may be so large in relation to the economy itself that it would be difficult to identify productive uses for all of it, were it to be immediately spent; and iii the volatility of resource prices and the variability of production volumes can result in substantial changes in government resource revenue from year to year.

Better knowledge of the size of petroleum reserves provides an input for the design of sustainable macroeconomic policies and for improving intergenerational equity through the choice of current consumption rates. Updating this knowledge may allow a country to devise fiscally sustainable consumption and savings policies, and adjust them over time. For example, countries with a high social discount rate at the outset may require very large oil revenue before that rate falls to a point that would favor deferring potential spending. Exploration and the Maximization of the Resource Rent Information is an important aspect of any market and plays a crucial role in policy design.

Exploration threshold analysis helps to decide whether or not to attempt exploration efforts. The threshold is estimated by making assumptions about the probability of success and the value of the reserves that may result from successful efforts. Due to the different level of risk, exploration thresholds are several orders of magnitude larger than development field size thresholds. Reducing the geological risk—or rather the perception of risk—will reduce the exploration and development thresholds, and the risk premium required by investors.

It is worth noting that negative exploration results would not necessarily reduce exploration interest in an area. This is because the interpretation of exploration results entails a certain level of subjectivity and can vary substantially across companies, depending on factors such as previous experience in working in similar geological settings, new data or new theories, and the ability of the interpreters.

This type of information has important externalities for neighboring areas as well as for the overall perception of geological risk. Given the high expense of obtaining technical data and its value to potential competitors, access to it is normally restricted to the license holders and the government. But press announcements by the government and the license holders, with respect to drilling results, often provide useful indicators and are closely monitored by market participants.

Studies of competitive bidding rounds in the U. Bidders overpay for wildcat tracts for the first product only. Who Carries the Risk of Exploration? Although the chance of exploration drilling success has been steadily rising over the last 50 years—mainly driven by advances in seismic imaging technology—exploration remains a risky business. The average exploration success rate worldwide is approximately one in three wells 33 percent.

In the s the average was one in six 17 percent.

Upstream Oil & Gas Exploration and Production with SUEZ

There is ample variation among countries and across basins within the same country. For example, in the U. Continental Shelf UKCS , the average exploration drilling success rate in the Southern Basin is about 28 percent, while in the remaining areas it is around 10 percent. Governments have basically four alternatives; they can: i develop the resource themselves; ii pay an oil company to develop the resource for a fee; iii sell the right to develop the resource to an oil company; or iv implement a combination of the three previous options.

If a government chooses to develop the resource directly or to hire oil companies to develop the resource on its behalf, it will have to bear the risk of exploration and development entirely. Risk management is an important feature of the oil industry. Companies hedge against risk by investing in a diverse portfolio of projects, often in several countries, and by involving partners. It is therefore not surprising that governments, even when they participate in commercial activities through a national oil company, often choose to bear the risks of direct exploration.

Usually, governments hedge against exploration risk by transferring part of it to the investors through contract and fiscal system design. Usually, the investors bear the costs and risks of exploration. If a discovery is made, the government, often through its national oil company, has the option to participate in a petroleum project for, or up to, a set percentage participating interest. In any case, if no commercial discovery occurs, the cost of exploration is borne solely by the investors. For governments, this strategy translates into the need to design efficient policies for the allocation of petroleum exploration, development, and production rights to investors.

Risk considerations involve the size of investment with regard to budget, potential gain or loss, and probability of outcome. Uncertainty refers to the range of probabilities that some conditions may exist or occur Suslick and Schiozer, Ample literature exists on risk analysis applied to petroleum exploration, development, and production. A synopsis of advances in risk analysis for petroleum exploration can be found in Suslick and Schiozer Hyne For a classification of reserves,.

The cost is. Classifications vary widely across regions and are usually based on the availability of geological and geophysical data, the number of wells drilled, and the probability of success. Johnston These data, once interpreted, are used to construct maps, cross-sections, and models that allow analysts to infer or to actually depict subsurface configurations that might contain petroleum. Such depictions are prospects for drilling. This type of arrangement is known as a multi-client survey and is further discussed in Chapter 2, endnote It is worth noting that.

A carried interest is an agreement under which one party agrees to pay for a portion or all of the pre-production costs of another party the carried party on a license in which both own a portion of the working interest, and subject to contractual terms for recovering its costs. S tates have sovereign jurisdiction over their natural resources and are responsible for maintaining a legal regime for regulating petroleum operations.

In addition, poorly conceived legal, regulatory, and fiscal frameworks may lead to inefficiency and loss of economic rent, which may not be mitigated through the allocation system. These are usually classified into two main categories:. Although these arrangements are conceptually different from each other— particularly in terms of levels of control exercised by the government, ownership rights, and compensation arrangements—they can be used to accomplish the same purpose.

There is often substantial variation between concessions or contracts within a. Concessions A concession grants an exclusive license to a qualified investor. The original concession i granted rights to petroleum development over a vast area; ii had a relatively long duration; iii granted extensive control over the schedule and manner in which petroleum reserves were developed to the investor; and iv reserved few rights for the sovereign, except the right to receive a payment based on production.

The provisions of modern concession agreements are much different from the original model. In addition to reducing the area coverage and the duration of the agreement, modern concessions also contain relinquishment clauses and express obligations to enter into a work program. One of the main characteristics of concessions is that the state retains considerable liberty to modify, at any time, those terms and conditions that are not negotiated but fixed by legislation.

A concession grants an oil company or a consortium the exclusive right to explore for and produce hydrocarbons within a specific area called the license area, block, or tract, depending on local laws for a given time. The company assumes all risks and costs associated with the exploration, development, and production of petroleum in the area covered by concession.

Often a license fee or bonus is paid to the government. Nearly half of the countries worldwide use a concession-type regime. Under a concession, the ownership of petroleum in situ remains with the state, until and unless petroleum is produced and reaches the wellhead, at which point it passes to the investor.

The investor is not exposed to changes in its reserves and production entitlements when the oil price changes. Production Sharing Contracts A contract-based regime envisages an agreement concluded between one or more usually foreign oil companies contractors and a state party. The state party may be the state itself—represented by its government—or a state authority such as a government ministry or a special department or agency or the national oil company.

The national oil company may be granted general authority to engage in petroleum operations or the sole right to receive an exclusive license, and the authority to engage the assistance of oil companies. The contractor assumes all exploration risks and costs in exchange for a share of petroleum produced from the contract area.

Production is shared among the parties according to formulas defined in the relevant PSC and applicable legislation. Unlike a concession, a PSC provides the investor with the ownership of its share of production only at the delivery point or export point as defined in the contract. Contractor services are compensated by a fixed or variable fee. The state maintains ownership of petroleum at all times, whether in situ or produced. Pure SAs are rare, but some do exist such as the Iranian buy-backs , and are similar to engineering, procurement, and construction EPC contracts.

Most industry SAs contain elements of risk for the contractor. Table 2. These objectives can be largely accommodated through appropriate fiscal system design. Objectives of Fiscal Systems Government Investor. Notes: a. The neutrality of a tax can be assessed by its impact on the resource allocation. With respect to the investing company, a tax is neutral when it leaves the pre-tax ranking of possible investment outcomes equal to the post-tax ranking.

With respect to a particular industry, a tax is neutral when it does not divert investments to or from that industry. Taxation Instruments and Methods Petroleum activities around the world are subject to a great variety of taxation instruments. These include taxes that apply to all other sectors of the economy as well as taxes that are specific to the oil industry. In addition, nontax forms of rent collection such as surface fees, bonuses, and production sharing are common. Accelerated capital cost allowances, depletion allowances, interest deduction rules, loss carry-forwards, investment credits, and royalty or tax holidays are among the most commonly used special provisions.

A variety of conditions and obligations are also imposed on companies that affect the cost of operation. These include inter-company services, valuation of oil and gas, foreign exchange regulations, domestic market obligations, government equity participation, performance bonds, landowner compensations, local content obligations, and requirements intended to ensure good environmental practices and adequate site reclamation funding.

Evaluating the impact of these costs on different investors can be a complex exercise. A fiscal system can be assessed in terms of its impact on investment decisions7 in either the short run capital allocation within an existing portfolio of assets or the long run the decision to reject or invest in a project ; in other words, by its neutrality. This can be expressed in terms of the net present value NPV of the expected project cash flows.

Therefore, the higher the level of taxation, the lower the number of possible investments under prevailing market conditions. Therefore, fiscal systems that reduce the perceived political or economic risks are preferred. An overview of the main tax and non-tax instruments commonly used in the oil industry and an evaluation of their effects on government revenues and investment decisions are given in Appendix II and Appendix III.

Theoretically, it is possible to replicate a particular fiscal regime using different combinations of fiscal instruments; for example, a PSC can be replicated by a combination of royalties and taxes. Each category has advantages and disadvantages in terms of transparency and economic efficiency. Within each category, countries use various allocation mechanisms. Some countries use rather rigid mechanisms with limited biddable items that affect the division of profit between government and investors. In other countries, everything is negotiable.

In its most variable fee for the such as operating costs, basic form, a PSC has two services performed. Basic depreciation, depletion and components: cost recovery and Corporate income taxes elements amortization, and intangible the division of profit oil. However, may apply. The royalty is normally a Similar to concessionary systems. Not applicable. Royalty scale, the terms of which may be negotiable or biddable or statutory, and paid in cash or in kind.

The royalty is tax deductible. The definition of fiscal costs is Fiscal costs are defined and rules Fiscal costs are defined described in the legislation of for amortization and depreciation and rules for amortization the country or in the particular are established in the legislation of and depreciation are concessionary agreement.

After payment of royalties, agreement. The applicable legislation. There are no cost recovery Usually, costs can be recovered Cost recovery limits are Cost limits. Special of the contractor. Income tax is national oil company on investment incentive programs calculated on taxable income behalf of the contractor. Tax losses may be allowable costs, and government on the difference between income carried forward until full recovery share of profit oil. Tax losses may the service fees and the or for a limited period of time. Tax recovery or for a limited period of losses may be carried time.

Source: Adapted from Tordo, In some cases, the royalty is calculated on net production. Some countries use fiscal prices for the purpose of royalty and corporate tax calculation. These prices are defined periodically and are normally linked to international market prices. Whether or not a country uses fiscal prices, deductions or additions are normally allowed to account for differences in quality between the reference crude gas and the particular crude gas as well as transport costs.

The exact manner in which costs are capitalized or expensed depends on the tax regime of the country and the manner in which rules for integrated and independent producers vary. Open-Door Systems In open-door systems also known as negotiated procedures , the government may or may not invite investors to submit offers within a specified deadline.

Rather, interested investors are allowed to submit expressions of interest—normally to the Ministry of Petroleum or its equivalent or the relevant regulatory agency—with respect to specific areas at any time. Negotiations may then start between the government and the applicant, if the government so chooses. In fact, the process can be designed so as to approximate the effects of an auction. In other words, the open-door system could be incentive compatible; that is, structured so that each bidder finds it in its interest to honestly report its valuation McAfee and McMillan, In some countries, the law specifically provides for the possibility to resort to direct negotiations when licensing rounds result in single bids, in which case negotiations are conducted with the sole applicant.

For this reason, direct negotiations are often criticized for their lack of transparency, insufficient competition, and potential for corruption. Licensing Rounds Licensing rounds can be more or less market-based depending on the degree of government discretion involved in the process. Administrative procedures Licenses are awarded to investors by way of administrative processes on the basis of criteria defined by the government. The government has ample latitude to define whatever criteria it deems appropriate. Thus, administrative processes can be very flexible and allow the government to pursue multiple policy objectives.

But decision criteria are sometimes vague or not publicly stated. As such, it may be difficult for bidders to know the reasons for government selection, which may not respond to the logic of efficient allocation or rent maximization. The public is often unable to judge whether the award was done fairly. In general terms, in countries that lack a tradition of good governance, administrative processes may leave more room for corrupt or collusive practices.

An example of this type of arrangement can be found in the United Kingdom, where licenses are awarded on the basis of work programs typically seismic and exploration drilling proposed by the bidders. This allows the government to retain some control over the level of exploration investment in the industry, but it does require a certain level of technical capacity and resources to evaluate the proposals. Auctions can be designed as pure market-based systems where licenses and contracts are awarded to the highest bidder.

Bidding parameters can be single or multiple. There are four basic forms of auctions:. The price is raised until only one bidder remains. Prices may be announced by an auctioneer, or may be called by the bidders, or may be posted electronically. With this type of auction, each bidder knows the level of the current best bid at any point in time and can adjust its bidding strategy accordingly.

As opposed to the English auction, the price is lowered from an initial high called by the auctioneer until one bidder accepts the current price. Bidders submit sealed bids and the highest bidder is awarded the item for the price he bid. Each bidder has only one chance to submit its bid and cannot observe the behavior of other bidders until the auction is closed and results are announced.

Bidders submit sealed bids and the highest bidder wins the item but pays a price equal to the second-highest bid Vickrey, In practice, many variations of the basic forms exist. These are discussed further in this paper. Those that do, normally use first-price sealed-bid auctions. Administrative procedures versus auctions Auctions are thought to be more effective in capturing rent than administrative procedures. Although this may be generally true for most industries, some of the assumptions that are required to make auctions efficient may not be realistic in the context of oil and gas exploration.


In particular, uncertainty is a key element of petroleum exploration: both governments and companies do not know if oil will be found, where it will be found, in what quantity, at what cost it will be produced, and at what price it will be sold. Hence, each bidder has a view of the risk and expected value of the acreage on offer, and bids accordingly.

Bidders operating in adjacent blocks or that otherwise have access to private information may have a more accurate view of the true value of the asset, but may still be able to secure the award of the exploration rights with a low bid. In this case, the auction would have failed to maximize rent extraction. Because exploration is a risky and expensive activity, it is not unusual for companies to form long-term alliances for example, to pursue common strategic objectives or special-purpose alliances for example, to bid for a particular block to spread their risk.

These alliances take various forms 20 and can be very complex— sometimes involving service companies, or companies that are otherwise competitors in other markets or blocks. The effect of these alliances on the ability of a government to maximize rent extraction through the allocation mechanism depends on the market structure, information asymmetries, as well as rent extraction mechanisms. In general terms, the number of competitors affects the efficiency of an auction. By reducing the number of competitors, joint bidding may reduce the efficiency of the auction as a rent extraction mechanism.

Perhaps also for this reason, some governments prohibit or restrict this practice. In fact, joint bidding appeared to be associated with higher bonus bids for better quality tracts. In addition, it was also observed that joint bidding enabled small companies to pool their resources in order to compete for better quality tracts; that is, to become more competitive. These studies concluded that concerns over whether joint bidding reduced competition for leases were overrated.

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This conclusion may, however, not be generalized, as the effect of joint bidding would also depend on the type of allocation mechanism. Auctions can be designed in such a way as to make them robust to political and lobbying pressure as well as corruption. In some contexts, this could be an important consideration.

The transparency of the procedure and awarding criteria would make it more difficult for the government to unfairly favor one investor or consortium over others. Finally, auctions offer advantages over other resource allocation systems in that they convey information about how valuable bidders believe the block to be, and which bidder values it most Afualo and McMillan, This may be important in under-explored or frontier areas, where information is scarce and the government may not be reasonably confident of the precision of its value estimate.

Biddable or Negotiable Factors A wide range of contractual elements may be negotiable or biddable. A description of the biddable parameters most commonly used as allocation mechanisms is provided in the following paragraphs. Signature bonuses Under a bonus bidding allocation system, the right to develop the resource in a particular area is granted to the investor that offers the highest up-front cash payment.

Under hypothetical ideal competitive circumstances, pure bonus bidding schemes would result in the government receiving the present value of the expected economic rents produced by the resource, since different bidders, in trying to win the right to develop the resource, would bid up to the point where their bid the cash bonus equals the economic rent they expect to receive from developing the resource.

In practice, as discussed further in this paper, this may not always be true. Bonus bidding is attractive for governments because it provides an early source of revenue whether or not hydrocarbons are discovered. But it has some downsides, too. As discussed earlier in this paper, although the license being bid for has only one true value, at the time of bidding, nobody knows this value. The more uncertainty there is about the true value, the more likely it is that bidders will reduce their bids.

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Either way, the allocation process would have been inefficient. Because the value of the rent could potentially be large, an allocation system based on pure bonus bidding would also limit the number of possible bidders, as smaller companies would not have the financial strength to offer winning bids. Fewer competitors would translate into lower rent capture for the government. Mitigation mechanisms such as joint bidding and reserve prices are discussed further in this paper. In practice, signature bonuses are not the sole rent extraction mechanism used by governments. As discussed earlier in this paper, even in the USGoM, where a significant portion of the economic rent is received through signature bonuses, the government also receives royalties and corporate income taxes.

Furthermore, in countries with less stable investment environments, major reliance on bonus bidding may result in lower rent capture, as investors are likely to discount the bonuses to reflect the perceived risk of contract renegotiation. This is particularly true if a change in government is expected.

Work programs In work program bidding, oil companies bid a commitment to undertake a specific exploration activity 24 during a set period of time. Usually, exploration periods vary between six and nine years, and may be divided in two or three sub-periods. Work program bidding is almost exclusively limited to exploration. Other examples can be found in non-exploration projects, such as rehabilitation or redevelopment and EOR projects.

From the viewpoint of the investor, work program bidding has some similarities to cash bonus bidding since it represents a cash outflow prior to a discovery. The sum of work program obligations and bonuses represent the risked capital: investors do not know if they will be able to recover their investment. Furthermore, high signature bonuses and high work program commitments increase the exploration thresholds; this is particularly important in frontier areas.

For the government, although work program bidding does not generate early revenue, it helps ensure that a certain level of exploration will take place. When the work program is the determining factor in contract or license awards, investors have an incentive to bid more than they would otherwise, relative to the technical requirements of a block.

This means that the winning bid may be much larger than the optimal bid from a technical point of view. In general terms, the optimal work program is based on factors such as the prospectivity of the area, the technology available, and the expected price of the resource. However, the actual bid submitted will also be a function of the perceived competitiveness of the licensing round. Competitive pressure tends to push bids toward the point where the value of the winning work program bid equals the expected economic rent.

Conversely, lack of or low competitive pressure will result in sub-optimal winning work programs. Finally, it is worth noting that the optimal work program is characterized by flexibility, where the next optimal step is based on new information resulting from the preceding step. This flexibility should be embedded in work program bidding and related minimum guaranteed work program commitments. In other words, work program commitments should be firm but flexible. Royalties In royalty bidding, the investor that offers the highest royalty rate is awarded the rights to explore for and develop the resource in a specific area.

From the viewpoint of investors, royalties are less risky than bonus or work program because they are only paid if a discovery is made that results in production. Because no large up-front payment is required, smaller investors are more likely to prefer royalty bidding to pure cash bonus bidding. Royalties provide an early source of revenue to the government, but they are a rather regressive form of taxation: they are paid by investors as production starts, and usually long before profits are generated.

Royalties are often criticized because they can lead to the premature termination of production. If the royalty rate is particularly high, production may be precluded entirely, or the block may be relinquished and turned over to the government. The use of progressive royalties—that is, royalty rates that are linked to certain parameters and increase or decrease in response to variations in these parameters—may help to mitigate these risks, especially if the parameters closely reflect project profitability.

In profit share bidding, the investor that offers to pay the highest share of potential future profits is awarded the rights to explore for and develop the resource. Profit share bidding is less likely to distort production decisions than royalty bidding. However, the neutrality of the mechanism and its efficiency in targeting and capturing the economic rent depends on its design. As such, it allows investors to transfer part of the risk to the resource owner. Because no up-front payment is required, smaller companies are more likely to bid. Competitive pressure and lower risks will increase the economic rent Leland, A problem with profit share bidding is that tax level differentials between leases will inevitably create incentives to move income and expenses between leases.

This can be mitigated through ring-fencing and accounting rules. However, profit shares are more complex to oversee and control than royalties, and require adequate administrative capacity of the government. This can be mitigated through cost recovery limits and accounting rules. Bundle bids have also been used to expedite the development of particular geographical areas or geological basins, or to facilitate the transfer of technology and know-how to small or indigenous companies, or to satisfy the demands of local constituencies. In general terms, because less bidders may be interested in bidding for the bundle, this policy may result in less efficient allocation a lower level of competition and cost inefficiency than its unbundled alternative.

Finally, the complexity of these arrangements makes it more challenging to evaluate the fairness of the award, and may make them more vulnerable to political and lobbying pressure. This, in turn, may increase the risk of future renegotiation, as the experience of Angola Box 3. This type of information is typically not publicly available with respect to developing countries.

But specific aspects of allocation policies and practice in select developing countries are discussed in Chapter 3. Geological Large portion of setting immature, and s areas. Large nat reserves potentia. Objective Primarily to sign of advance the exp allocation status o f the are policy. Legal Exploration perm agreement production licens. Large natural g reserves potential. Objective Primarily to significantly of advance the exploration allocation status o f the area.

Legal Exploration permit and agreement production license. Lessons learned The experience of the countries analyzed in Appendix IV offers lessons of broader applicability. These are summarized below. All things being equal, the availability of information on the geology and drilling success in a specific area allows market participants to better assess the associated level of exploration risk.

As a result, risk-averse bidders are encouraged to bid more aggressively, and asymmetry of information between existing players and new entrants is reduced. The majority of the sample countries have made active use of geological, geophysical, and petrophysical knowledge in defining their licensing strategy, including the timing of allocation, the selection of areas to be included in each allocation cycle, the choice of allocation parameters, the definition of reserve prices, the minimum technical and financial requirement for participation by bidders, and so on.

Countries do not normally acquire new surveys at their risk and expense. For example, in Brazil, multi-client surveys29 are normally used. Generally, this holds true for both administrative procedures and auctions. However, the magnitude of this effect is greatly affected by the choice of bidding parameters and the type of fiscal system.

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As the experience of all countries in the sample suggests, particularly in frontier and sub-mature areas, bonus bidding and work program bidding are less attractive during economic downturns and in periods of expected high volatility in oil and gas prices. The expected trend and volatility of oil and gas prices are less relevant in allocation systems that rely mostly on a progressive fiscal system to maximize rent capture. Multiple allocation parameters allow governments to pursue multiple objectives at the same time.

Some of the selected countries have used multiple biddable parameters to increase the flexibility in commercial and fiscal terms for different geological basins. Yemen is an extreme example of this practice. Clarity of award criteria improves the transparency and objectivity of the award and allows bidders to structure their offers accordingly. However, a certain level of flexibility in the criteria may be necessary.

For example, in work program bidding, an efficient allocation system needs to ensure that blocks are awarded to companies that submit the most appropriate work program bids, not necessarily the most optimistic ones. This is the case for both administrative procedures and auctions. This, however, requires a certain level of technical capacity and resources to screen the applicants and evaluate what constitutes an acceptable work program. It is important to note that none of the selected countries uses explicit reserve prices.

Even when minimum work programs are defined and disclosed, governments reserve the right to reject bids that equal or better the minimum work program if these are considered inadequate. This is particularly true where entry barriers to small firms or joint bidding restrictions apply. None of the selected countries uses cash bonus bidding as their primary or sole mechanism to maximize rent capture. Rather, they mostly rely on the fiscal regime to correct inefficiencies at allocation due to uncertainty about the true value of the blocks.

It often represents a substantial part of total bids in both administrative procedure and auctions. This is particularly true in frontier areas and deep-water exploration areas. Joint bidding is also used to facilitate entry, especially by smaller firms. In the U. The experience of Brazil and the United Kingdom clearly illustrate this point.

Notes 1 The consistency of the legal framework with the constitutional foundation is an important factor affecting the security and stability of the legal framework. This issue is significant, in particular because the constitutions of many countries differ significantly in the degree to which they i recognize or guarantee private property rights or prohibit private parties or foreigners from acquiring property rights in general, and mineral rights in particular; ii vest the authority to grant petroleum rights in the state or provincial governments or agencies rather than the national government; and iii vest the authority to regulate specific matters in special agencies that is, environment protection or in the executive branch for example, taxation, foreign exchange, employment, and so on or in the judiciary settlement of disputes.

Because of the capital-intensive and long-term nature of petroleum projects, the certainty of rights is particularly important for private investors. Convention on the Continental Shelf. A few countries, most notably the United States and Canada, recognize private ownership of underlying minerals. In these countries, determination of mineral ownership depends upon rules of property. In virtually all other countries, valuable minerals belong to the sovereign. Certain petroleum regimes recognize the owner of the land as the owner of the subsoil, and allow it to grant licenses within the context of existing legislation.

The contractual or regulatory nature of an agreement is of extreme significance in evaluating its stability and predictability. This is because, although they share the general objective of maximizing the revenue generated by a project, they also pursue a number of different objectives and face different constraints.

Analyzing these objectives and constraints and the related system measures is beyond the scope of this paper. For an in-depth analysis, see Johnston and Tordo For an overview of auction types and their application, see McAfee and McMillan Pre-qualification criteria may also be used to safeguard special interests. For example, a portion of the area to be licensed or a percentage participating interest in the license could be reserved for local oil companies.

Reserve prices are discussed later in this paper. However, this depends on the tax and cost recovery treatment of bonuses. Petroleum agreements usually oblige the license holder or the contractor, as the case may be to undertake the minimum work program or pay the correspondent monetary amount to the host government. When the minimum work program is a bidding parameter, the standard monetary value of each unit of work may be defined in the bidding procedure to improve the transparency of the bid evaluation see, for example, the case of Brazil, discussed in Appendix IV.

In the absence of royalties, ceteris paribus, production would last longer. Yet, for some countries,. The various tax methods that have been designed to achieve neutrality—based on the rate of return RoR and R-factor—may come close to the objective even if not perfect. It is important to note that investors have different appetites for risk and different exposures to it. Therefore, universal neutrality is quite difficult to achieve. The data are then licensed to interested oil companies for a fee.

The proceeds of the sale of data licenses are shared between the service company and the government according to the terms of the relevant agreement. These arrangements are often used by governments to improve the market knowledge of the geological potential of areas that are earmarked for inclusion in licensing rounds.

The government does not incur any cost related to the acquisition, processing, and marketing of the data especially when data licensing fees ahead of the area award are not tax deductible or cost recoverable, as the case may be. The Design of Appropriate Allocation Systems. License allocation is, however, only one of the policy tools that can be used to achieve these objectives. Although broad principles of general application can guide the choice of allocation system, the design needs to be tailored to reflect the set of objectives, constraints, and concerns that are unique to each country.

Figure 3. Indeed, because social and political objectives are so country specific, it is difficult to identify general principles that apply to all countries. Therefore, this chapter will focus on the design of allocation systems to achieve economic objectives. Allocation System Objectives From an economic perspective, the government would want an allocation system that:. Appendix V provides a simplified example of choice of allocation parameters to achieve a specific policy objective, given a specific set of constraints geological settings, level of government capacity, market structure and exogenous factors price expectations.

In reality, governments simultaneously pursue a variety of objectives over time, and face a complex set of changing constraints and exogenous factors. The relative priorities among objectives and the interaction among the various constraints and exogenous factors influence the optimal design of allocation systems including the form of allocation, bidding parameters, bidding procedure.

Consistency with Petroleum Sector Policy Sector policies include a wide range of objectives. The maximization of the net present value NPV of the economic rent from the exploitation of petroleum reserves is among the most common objectives. The government would need to ensure coherence among these different policy tools. A clear definition of the objectives that the government intends to achieve through the allocation system is the first step toward its effective design and implementation.

Clarity and transparency of objectives would also facilitate the regular assessment of system performance, and allow adjustment to the relevant parameters as needed to reflect changes in market conditions, government policy, and geological and country risks. Furthermore, the government would need to periodically reassess the impact of its allocation system on the overall macro-economic framework to ensure it encourages the efficient and effective use of resources. As discussed in Chapter 1, the preferred alternative for most resource owners is to sell the right to develop the resource.

There are a number of ways to do so, for example: i the resource owner can sell the right to develop the resource outright, for example, by awarding the right to the investor that is willing to pay the highest pure cash bonus; or ii the resource owner can license the right for an agreed-upon share of the revenue to be produced from the resource, for example, by awarding the right to the investor that is willing to offer the highest share of profit from the exploitation of the resource—or the highest royalty, or the highest combination of profit share, royalty and bonus, and so on.

Hence, there is a risk that the right to develop the resource in a specific area may be sold for a price that is well below—or well above—the true value of the resource extracted from that area. Thus, the system is vulnerable to allocative distortions. Box 3. Local content refers to the development of local skills, technology transfer, use of local manpower, and local manufacturing.

The value of pursuing political goals through a lease allocation policy must be weighted against a potential reduction in efficiency. In addition, training and local employment obligations were included in petroleum contracts.

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The local content requirements became more stringent in the marginal fields licensing round: bidders were required to associate their bids with local content vehicles LCVs in the form of Nigerian companies that is, locally incorporated companies with a majority—usually 60 percent—of Nigerian shareholders. The Nigerian company would provide local goods and services, while the international company would be the technical partner.

However, the low uptake by the market may be an indicator of the ambition of the restriction, given local capacity levels. Results are not satisfactory. In Venezuela launched its third licensing round. Twenty fields were offered under operating service agreement. Five fields were, however, reserved for Venezuelan companies or consortia with a Venezuelan operator. This is a particularly important consideration for countries that do not ring-fence at the license or field level. This mitigation would not occur, of course, if non-competitive licensing procedures were used as a primary allocation mechanism.

Tax gains can, therefore, be shared among companies at the expense of the government. To avoid this, Norwegian authorities require that all trade be tax neutral section 10, Petroleum Tax Act. In a regulatory reform was introduced to allow companies to carry forward their losses with an interest.

This should reduce the administrative burden, given that, in principle, the rule equalizes the position of companies in a tax-paying position with companies that are not. Keeping Compliance and Administrative Costs Down Complex allocation systems may be difficult to administer, and will translate into additional costs that may not be justified by the potential increase in rent capture or may, in fact, decrease rent capture.

Furthermore, in determining the NPV of the asset being offered by the government, potential bidders will consider the cost of compliance with the licensing system designed by the government including requirements related to the conduct of oil and gas operations that may be defined in model contracts.

Ultimately, this will translate into lower economic rent. Therefore, the government should be mindful of introducing regulations for which the cost of compliance exceeds the social benefit Kalu, Host governments have a clear interest in ensuring that costs are kept as low as possible. Normally, contracts provide for various forms of oversight and control mechanisms. Management committees, procurement procedures, budget approval, and audits are examples of these mechanisms.

The thresholds for approval of expenditures are particularly important: low thresholds affect the efficiency of a operations. Other cost-control and b supervision mechanisms are provided for in the contract and in the cost recovery mechanism. During the exploration period, there is a clear incentive for the contractor to keep costs down: if no discovery is made, exploration expenditure will not be recovered.

If a discovery is made, the cost recovery mechanism allows the contractor to recover its investment if sufficient revenue is generated. A cost recovery limit is imposed, which provides an additional incentive to control costs. For details on the structure of oversight committees and levels of approval thresholds, see Gerner and Tordo Administrative complexity should also be avoided in the choice of the bidding parameters: comparing competing bids where a large number of fiscal and commercial parameters are negotiable may be difficult, time consuming, and less objective.

The cost and time involved in preparing the bid may discourage participation, especially from new entrants, which may affect the level of competition. In Yemen, blocks are awarded to the highest bidder following an administrative process. A model memorandum of understanding MOU sets the fixed and biddable terms—up to 33 in the most recent bidding rounds—and the reserve price minimum requirement for each biddable term.

Offers that are not at least equal to the minimum requirements are rejected. The criteria for evaluation of the proposals are not publicly stated, and the ministry reserves the right to reject offers without justification. In the United States, tracts are awarded to the bidders that offer the highest cash bonus. The evaluation criteria are clearly stated.

The Minerals Management Service MMS reserves the right to reject any or all bids and the right to withdraw any block from the sale. Each high bid is first examined for technical and legal adequacy; then each valid high bid is analyzed from a fair market value perspective. Although bonus bidding with fixed royalty is the main allocation procedure, the Secretary of the Interior can propose other systems of bid variables and terms and conditions as appropriate to achieve the policy objective.

However, the legislation forbids the use of more than one bid variable. Discouraging participation is not necessarily a bad policy. Pre-qualification of bidders in licensing rounds is therefore necessary. Non- refundable bidding fees are sometimes used to discourage participation from companies that are not serious market players. Guarantees may be used to discourage frivolous bids.

In Yemen, companies interested in participating in a licensing round are required to submit a letter of intent, technical and financial reports for the last two years, their latest audit report, and a completed and signed company profile. A guarantee irrevocable letter of credit or check payable to the PEPA equal to 3 percent of the work program obligation proposed for the first exploration period is also required.

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Angola uses a similar approach. Bidders have to pre-qualify. Pre-qualified bidders obtain access to data packages, subject to the payment of a fee specified in the licensing round rules. Each bidder must submit a financial guarantee issued by an Angolan Commercial Bank or a reputable, first-class international bank. In the United States, bidders are not asked to submit a guarantee upon submission of the bid. But each high bid submitted must include payment of one-fifth of the bonus bid by a deadline established by the Minerals Management Service MMS on the day after bid opening.

This issue relates to both the allocation procedure and the rent capture mechanisms bidding parameters and fiscal system.

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For example, allocation systems that encourage bidders to offer high royalty rates may: i lead to premature abandonment of productive blocks; ii render secondary and tertiary recovery uneconomical; and iii prevent the development of marginal fields. In , the government of the United States experimentally sold eight leases under royalty bid conditions. One bid was received at Save in the case of a giant discovery, it would have been economically impossible for production to be successful under such conditions. In fact, only one of these leases was ever produced and this occurred because the royalty rate was renegotiated downward in from the This case will familiarize students with the petroleum value chain and the operations of global oil companies.

However, the underlying concepts will help students relate to the dynamics of vertical integration in any capital-intensive, high-risk, globalized industry. General management, Manufacturing, Strategy. Skip to Main Content. Krishnakumar, Sanjeev Pillai, P. Teaching Note. Add to Coursepack. Add to Collection. Add to Cart for purchases and permissions. Add to Cart. Learning Objective This case provides insights into an industry that is highly globalized, risk- and capital-intensive, involves multiple partners and alliances, and is strongly influenced by governments.

Details Pub Date: Jan 14, Revision Date: Feb 3, Discipline: General Management. Subjects: General management, Manufacturing, Strategy. Geography: India. Length: 17 page s. Professors Also Used.