International-Petroleum-Fiscal Daniel Johnston PDF

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INTERNATIONAL
PETROLEUM
FISCAL SYSTEMS
AND
PRODUCTION SHARING
CONTRACTS
INTERNATIONAL
PETROLEUM
FISCAL SYSTEMS
AND
PRODUCTION SHARING
CONTRACTS
DANIEL JOHNSTON
PennWell Publishing Company
Tulsa, Oklahoma
Disclaimer
The recommendations, advice, descriptions, and the methods in this book
are presented solely for educational purposes. The author and publisher
assume no liability whatsoever for any loss or damage that results from
the use of any of the material in this book. Use of the material in this
book is solely at the risk of the user.
Copyright© 1994 by
PennWell Corporation
1421 South Sheridan Road
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+1.918.831.9421
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www.pennwellbooks.com
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National Account Executive: Barbara McGee
Director: Mary McGee

Production / Operations Manager: Traci Huntsman
Library of Congress Cataloging-in-Publication Data

Johnston, Daniel
International petroleum fiscal systems and
production sharing contracts/Daniel Johnston
p. cm.
Includes bibliographical references and index.
ISBN 0-87814-426-9
ISBN13 978- 0-87814-426-6
1. Petroleum industry and trade — Taxation.
2. Petroleum industry and trade — Finance.
3. Oil and gas leases.
4. Petroleum — taxation — Law and legislation.
I. Title.
HD9560.8.A1J64 1994
338.2’3282 — dc20
94-33346
CIP
All rights reserved. No part of this book may be reproduced,

stored in a retrieval system, or transcribed in any form or by any means,
electronic or mechanical, including photocopying and recording,
without the prior written permission of the publisher.
Printed in the United States of America
10 11 12 13 14 11 10 09 08 07
Johnston_FM.indd 4 3/5/07 10:24:10 AM

CONTENTS
1 INTRODUCTION 1
Semantics 3
2 PETROLEUM FISCAL SYSTEMS 5
Economic Rent 5
Negotiations 16
Families of Systems 21
3 CONCESSIONARY SYSTEMS 29
Flow Diagram 29
Cash Flow Projection 30
4 PRODUCTION SHARING CONTRACTS 39
Flow Diagram 42
Sample PSC Cash Flow Projection 49
Basic Elements 51
The Indonesian PSC 71
5 RISK SERVICE CONTRACTS 87
Philippine Risk Service Contract 88
Ecuador Risk Service Contract 90
Rate of Return Contracts 92
Joint Ventures 101
Technical Assistance Contracts 107
6 THRESHOLD FIELD SIZE ANALYSIS 113
Exploration vs. Development Thresholds 114
Technical vs. Commercial Success Ratios 117
Gas Projects 124
7 GLOBAL MARKET FOR EXPLORATION ACREAGE 131
Prospectivity 135
Political Risk 136
v
8 PRODUCTION SHARING CONTRACT OUTLINE 151

PSC Components 154
9 ACCOUNTING PRINCIPLES 177
Accounting Concepts 178
Successful Efforts and Full Cost Accounting 183
Depreciation, Depletion, and Amortization (DD&A) 186
10 DOUBLE TAXATION 191
Tax Considerations 192
Branches vs. Subsidiaries 198
11 COMMENTARY 203
12 APPENDICES 207
Appendix A Sample Fiscal Systems 207
Appendix B Perspectives on Economic Rent 263
Appendix C Abbreviations and Acronyms 269
Appendix D Worldwide Production Statistics (1992) 274
Appendix E Selected U.S. Energy Statistics (1992) 277
Appendix F Conversion Factors 279
Appendix G Metric U.S. Conversions 282
Appendix H Barrels per Metric Ton vs. API Gravity 283
Appendix I Relative Oil Price vs. API Gravity 284
Appendix J Natural Gas Products 285
Appendix K H2S and Natural Gas 286
Appendix L Present Value of One Time Payment 287
Appendix M References and Sources of Information 288
13 GLOSSARY 293
Index 319
vi
FIGURES
Figure 2–1 Allocations of Revenues from Production
Figure 2–2 The Spectrum of Taxation
Figure 2–3 Comparing Fiscal Terms—FMV per Barrel
Figure 2–4 Expected Monetary Value Graph—Risk/Reward
Figure 2–5 Classification of Petroleum Fiscal Systems
Figure 3–1 Concessionary System Flow Diagram
Figure 4–1 Production Sharing Flow Diagram
Figure 4–2 Egyptian-type Production Sharing Flow Diagram
Figure 4–3 Creating a Level Playing Field
Figure 4–4 Indonesian Contract Sensitivity Analysis
Figure 5–1 Government Take vs. Project Profitability
Figure 5–2 Papua New Guinea Regime
Figure 5–3 R Factor System Sensitivity Analysis
Figure 5–4 Joint Venture, PSC
Figure 5–5 “Typical” Joint Venture in Russia
Figure 5–6 Technical Assistance/EOR Contracts
Figure 6–1 Comparing Fiscal Terms: Capital Cost Limits
Figure 6–2 Technical vs. Commercial Success Probability
Figure 6–3 Expected Value Graph
Figure 6–4 Detail: Breakeven/Threshold Exploration Target
Figure 6–5 Minimum Recoverable Reserves for Development
Figure 7–1 Comparison of Oilwell Production Rates
Figure 7–2 The Trade-off
Figure 7–3 Risk Analysis Flow Diagram
Figure 7–4 EMV Graph with Utility Curve Superimposed
Figure 7–5 Relative Bargaining Power
Figure 8–1 Legal/Regulatory/Contractual Framework
Figure 11–1 Regional Reserves Distribution
vii
ILLUSTRATIONS
Illustration 2–1 The Two-headed Beast
Illustration 4–1 Fiscal Design
Illustration 4–2 Realities of the Marketplace
Illustration 5–1 Fiscal Creativity
Illustration 7–1 A Negotiator’s Worst Nightmare—Expropriation
Illustration 8–1 The Virtue of Renegotiation Clauses
TABLES
Table 2–1 Calculation of Government/Contractor Take
Table 2–2 Comparison of Terms—Selected Countries
Table 2–3 Changing Economic Perspectives
Table 3–1 Concessionary System Structure
Table 3–2 Sample Royalty/Tax System Cash Flow Projection
Table 4–1 Production Sharing Contract Structure
Table 4–2 Classification of Reserves
Table 4–3 Sample PSC Cash Flow Projection
Table 4–4 Production Sharing Contract Structure
Table 4–5 Cost Recovery Spectrum
Table 4–6 Present Value Profile of Oil Production
Table 4–7 Sample Indonesian Cash Flow Projection
Table 4–8 Indonesian PSC Sensitivity Analysis Input Parameters
Table 4–9 Indonesian PSC Sensitivity Analysis Results
Table 5–1 Flexible Contract Terms and Conditions
Table 5–2 Sample Rate of Return Contract Cash Flow Projection
Table 6–1 Wave Height Comparison
Table 6–2 Gas Development Options
Table 7–1 Quantifying Political Risk
Table 8–1 Examples of Legal/Regulatory Frameworks
Table 9–1 Comparison of Accounting Systems
Table 9–2 Sample Depreciation Schedules
Table 10–1 Double Taxation Relief
viii
ACKNOWLEDGMENTS
This book reflects the influence and effort of a number of peo-
ple, many of whom may be surprised to know of my sincere appre-
ciation for their inspiration. Some I have not personally met, and
others are long gone. To the many who have contributed to the
body of knowledge on this delightful subject, I have deep gratitude.
Much of the material and inspiration for this book comes
from the courses I teach on this subject. I appreciate those who
have attended these courses for their numerous contributions and
encouragement.
I would like to thank the following for their reviews, com-
ments, and their helpful suggestions:
James Ahmad Jim Edwards Saddique
Richard Barry Barrie Fowke Tom Schmidt
Alfred Boulos Marvin Gearhart Sue Rhodes Sesso
Horace Brock Carroll Geddie Fatmir Shehu
Harry Campbell Bert Johnston Malvinder Singh
Joseph Cassinat Agron Kokobobo Dennis Smith
Gary Chandler Hill Mehilli Selonna Stahle
Ted Coe Du Quintono Chuck Thurmond
Ray Darnell Aziz Radwan John Vautrain
Stan Dur Madeliene Reardon Dale Wetherbee
I’m particularly grateful for the help from Rich Anderson on

Chapter 10 and for Michael Darden’s review of Chapter 8.
I really appreciate the artwork provided by David Johnston. I
have always been proud to be his twin brother.
I sincerely thank Dr. Jimmie Aung Khin for his everlasting
inspiration, encouragement, and his help.
I would especially like to express my gratitude to my sweet
friend and wife Jill for her work as an editor. I discovered that she
had a fabulous talent for this during the work on my first book.
Now I would not think of sending anything out without her
reviews, comments, and suggestions. Thank you, Jill.
ix
To my wife Jill and our children:

Erik, Lane, Jill Danielle, Julianna, and David,
and to our parents.
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INTRODUCTION
1
INTRODUCTION
T he international petroleum industry involves tremen-

dous wealth and power. In many countries petroleum, whether
exported or imported, dominates the economy. Natural resources
are the crown jewels. Few industries combine such a dramatic
contrast between risk and reward. Countries with petroleum
resources carefully guard this wealth.
Petroleum taxation is a vital aspect of the industry. Geological,
engineering, and financial principles are universal, yet in the
realm of taxation, there is added dimension. The subject is so
important that understanding at least the basics is mandatory.
One of the absolutely first things a geologist, engineer, landman,
lawyer, or economist encounters in the international sector is the
diversity of fiscal systems. Countries are unique in the way they
structure their taxes, and natural resources get special attention.
Governments have no control over the gifts of nature, but they
do control taxes.
The focus of the book is on the arithmetic and mechanics of
the various kinds of fiscal systems—the factors that drive explo-
ration economics. The emphasis is on practical aspects of petrole-
um taxation and industry/government relationships. There is also
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INTERNATIONAL PETROLEUM FISCAL SYSTEMS AND PRODUCTION SHARING CONTRACTS
fertile ground in the philosophy of petroleum taxation. It has

changed the industry. Legal and operational aspects of
contract/fiscal terms are also examined to provide a foundation in
the dynamics of international negotiations.
Both industry and government viewpoints are addressed in
this book. A complete grasp of the subject requires an under-
standing of the dilemmas and concerns of both sides. There are
few things more discouraging for a national oil company than an
unsuccessful licensing round. Yet prolonged, inconclusive negoti-
ations can be equally frustrating for oil companies.
This book is written for those interested in petroleum taxation
and international negotiations. Much of the subject has evolved
within just the last 30 years, yet some aspects of taxation are
timeless. The terminology has changed over the years and will
continue to develop. There is little standardization of terms in the
industry, and the abundance of jargon can be rather daunting.
The subjects covered in this book are often simple concepts
wrapped with buzzwords. A glossary is provided, which should
help.
Much of the material provided here was inspired by questions
most frequently asked on the subject. The best answers are forti-
fied with specific examples and many are used throughout the
book. The summaries and analysis of various fiscal terms and con-
ditions are believed to be accurate, and every effort has been
made to gather up-to-date information about the current condi-
tions in the countries cited. Examples of fiscal terms used here are
drawn from numerous public sources. Confidential information
has been carefully excluded.
Perhaps more effort could be directed toward the cultural
aspect of negotiations and doing business in the international
arena. Unfortunately it is beyond the scope of this book to cover
that ground. It is a fascinating subject. Some of the most gracious
and interesting people in the world are found in the international
oil business. They inspired this book.
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INTRODUCTION
SEMANTICS
Is it a permit, a license, a concession, an acreage position, a contract
area, a lease, or a block? Sometimes when referring to petroleum
operations in a given country, these terms are used interchange-
ably. However, the term concession implies ownership or a freehold
interest of mineral resources. The term has lost ground in the
realm of political correctness and the term royalty/tax system is
commonly substituted.
A government with a production sharing system does not
grant concessions. It grants licenses or enters into a contract with an
operator for a given contract area. The term block is fairly neutral. A
company can have a block in the United Kingdom, which has a
concessionary system, and another block in Indonesia governed
by a PSC.
The semantics of this business get stretched with the common
use of the term fiscal. Referring to a country’s petroleum taxa-
tion/contractual arrangement simply as the fiscal system is not
absolutely correct. It is a matter of convenience that is preferable
to saying the petroleum fiscal/contractual system (which would
be a step in the right direction, depending upon the country). But
it gets clumsy. The term fiscal throughout this book is used to
encompass all of the legislative, tax, contractual, and fiscal aspects
that govern petroleum operations within a sovereign nation/state
and its provinces.
The term mineral is also used in this book when referring to
natural resources. Neither oil nor gas is a mineral, but the term is
handy. This book sticks with the prevailing terminology that con-
stitutes the language of the industry today.
Host governments are usually represented by either a national
oil company or an oil ministry or both. They are collectively
referred to here as the state or the government. The term contractor
has specific connotations which are explained later, but for the
sake of convenience, this term is used to mean any company
operating in the international arena. In this book, contractor
3
#CHAP 1 4/30/04 3:02 PM Page 4
means operator, contractor, contractor group, or consortium. The

term concessionaire in reference to an oil company operating in a
concessionary system might be appropriate, but it is not part of
the industry vocabulary.
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PETROLEUM FISCAL SYSTEMS
2
PETROLEUM
FISCAL SYSTEMS
T here are more petroleum fiscal systems in the world

than there are countries. This is because many countries negotiate
terms. Thus one contractor may have different terms than anoth-
er in the same country. Furthermore, in many countries there are
numerous vintages of contract in force at any given time as a
result of the evolution of the fiscal system.
Some countries use more than one system during transition
periods when they are introducing new terms. Some countries
offer both concessionary arrangements as well as service or pro-
duction sharing contracts. Peru has this option. Regardless of the
system used, however, the bottom line is a financial issue that
boils down to how costs are recovered and profits divided. This
leads right to the heart of taxation theory and the concept of eco-
nomic rent.
ECONOMIC RENT
Economic theory focuses on the produce of the earth derived
from labor and capital. Rent theory deals with how this produce
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is divided among the laborers, owners of the capital, and

landowners through wages, profit, and rent.
Economic rent in the petroleum industry is the difference
between the value of production and the costs to extract it. These
costs consist of normal exploration, development, and operating
costs as well as an appropriate share of profit for the petroleum
industry. Rent is the surplus. Economic rent is synonymous with
excess profits. Governments attempt to capture as much econom-
ic rent as possible through various levies, taxes, royalties, and
bonuses.
Figure 2–1 illustrates the allocation of revenues from oil and
gas production for costs and the division of profits. Government
profit is equal to gross revenue minus costs. This graph shows that
governments view the contractor share of profits as a cost.
Exploration, development, and operating costs are also viewed
this way because the contractor may ultimately recover those
costs out of production. What remains is economic rent, if the
government has structured an efficient system.
The problem in determining how to capture rent efficiently is
that nine out of 10 exploration ventures are unsuccessful. The
profit margin for the petroleum industry must be large enough to
accommodate the failures. Developing fiscal terms must account
for this risk. Present value theory, expected value theory, and tax-
ation theory provide the foundation of fiscal-system design. The
contractor entitlement, share of gross revenues, or production
will ultimately consist of the recovery of exploration, develop-
ment, and operating costs as well as some of the profit.
The objective of host governments is to design a fiscal system
where exploration and development rights are acquired by those
companies who place the highest value on them. In an efficient
market, competitive bidding can help achieve this objective. The
hallmark of an efficient market is availability of information. Yet
exploration is dominated by numerous unknowns and uncertain-
ty. With sufficient competition the industry will help determine
6
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Figure 2–1 Allocations of revenues from production
what the market can bear, and profit will be allocated accordingly.
In the absence of competition, efficiency must be designed into
the fiscal terms. This is not easy to do.
Governments seek to capture economic rent at the time of the
transfer of rights through signature bonuses and during production
through royalties, production sharing, or taxes. But production is
contingent upon successful exploration efforts. The contractor and
government therefore share in the risk that production may not
occur. An important aspect as far as risk is concerned is that oil com-
panies are risk takers. They can limit risk through diversification.
Governments on the other hand are not diversified. They simply are
not able to assume as much risk as an international oil company.
This is an important dynamic in international negotiations and fiscal
design. From the government viewpoint there is a tradeoff between
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risk aversion, where bonuses and royalties are used, and risk shar-
ing, where taxation or production-sharing schemes are used.
A simple bonus bid with no subsequent royalties or taxes
would be an extreme example of a government capturing eco-
nomic rent at the time of transfer of rights. If the government and
industry had possession of all the information that ultimately
would result from a license before rights were granted, then rent
could be clearly defined. The bonus bid would equal the present
value of the economic rent. This kind of behavior is seen to some
degree in transactions between companies when oil and gas pro-
duction is purchased and sold. Unfortunately, information about
exploration acreage is characterized more by lack of information
and uncertainty.
The opposite of a pure bonus bid approach would be pure
profit-based taxation. This is more realistic. Governments base
most of their taxation on profits, and they are moving even fur-
ther in this direction.
How governments extract economic rent is important. The
industry is particularly sensitive to certain forms of rent extrac-
tion, such as bonuses and royalties that are not based on profits.
Royalties are of particular concern to the industry because the
rate base for royalties is gross revenues.
A spectrum of various elements that make up rent is illustrat-
ed in Figure 2–2. The non-profit-related elements of government
take, such as royalties and bonuses, are quite regressive—the
lower the project profitability, the higher the effective taxes and
levies. The further downstream from gross revenues a govern-
ment levies taxes, the more progressive the system becomes. This
is becoming more common. Royalties are being discarded in favor
of higher taxes. This has advantages for both governments and
the petroleum industry. However, there will always be govern-
ments that prefer some royalty. Royalties provide a guarantee that
the government will benefit in the early stages of production.
There are other ways to do this, and they are discussed further
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The further downstream from gross revenues taxes are levied, the more progressive the system.
Figure 2–2 The spectrum of taxation
under the concept of commerciality in Chapter 4. Additional per-

spectives on rent theory are provided in Appendix B.
CONTRACTOR TAKE:
THE COMMON DENOMINATOR
Division of profits boils down to what is called contractor and
government take. These are expressed as percentages. Contractor
take is the percentage of profits to which the contractor is enti-
tled. Government take is the complement of that.
Contractor take provides an important comparison between
one fiscal system and another. It focuses exclusively on the divi-
sion of profits and correlates directly with reserve values, field size
thresholds, and other measures of relative economics.
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CONTRACTOR TAKE: SYNONYMS GOVERNMENT TAKE: SYNONYMS

• Company take • State take
• Contractor marginal take • Government marginal take
• Contractor share of profits • Government share of profits
• Contractor after-tax • Government after-tax
equity split equity split
Under a system such as the Indonesian production-sharing

contract with the well-known 85%/15% split in favor of the gov-
ernment, the contractor may still end up with a 35%–50% share
of production. This is because of the reimbursement of costs, or
what is known as cost recovery, which is discussed in detail in
Chapter 4. The Indonesian 15% contractor take is a measure of
the contractor’s share of profits. It is a meaningful number. The
formulas for calculating take are as follows:
Operating income ($) = Cumulative gross revenues minus

cumulative gross costs over life of
the project
Government income ($) = All government receipts from royalties,
taxes, bonuses, production, or profit
sharing, etc.
Government take (%) = Government income ÷
operating income
Contractor take (%) = 1 – Government take
The best way to calculate take requires detailed economic

modeling using cash flow analysis. Once a cash flow projection
has been performed, the respective takes over the life of the pro-
ject can be evaluated. An example is shown in Table 2–1. It is
assumed that these values have been retrieved from a cash flow
projection. The gross revenues are $1,000, and costs over the life
of the project equal $400. The total profit, therefore, is $600. The
contractor share of profits is $250. This is equal to 42% of the
profits. Contractor take is 42%. Government take is 58%.
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Table 2-1
Calculation of Government/Contractor Take
Gross revenues $1,000

Total costs –400 Capital and operating
Operating income 600 Total profits
Royalties and taxes $350 Government share
Net after-tax income $250 Contractor share
Contractor take 42% ($250/$600)

Government take 58% ($350/$600)
Under systems with liberal cost recovery provisions, the gov-

ernment take comes at a relatively later stage of production than
under those systems with royalties and restrictions on cost recov-
ery. An even more detailed analysis of the respective takes would
include the present value dimension. But this is not ordinarily
done.
A method is outlined here for estimating government/contrac-
tor take without detailed cash flow modeling. There are limitations
to a quick-look approach, but 95% of the time, estimates of con-
tractor/government take provide extremely valuable information. It
is not difficult to estimate.
The main limitation of estimating take is that it is not always
easy to account for other aspects of a given fiscal system, such as
cost recovery limits, investment credits, royalty or tax holidays,
and domestic market obligations (DMOs). These are explained
later in Chapter 4.
Estimating Contractor Take Step-by-Step

1. It is convenient to work with percentages. Start with
100%, which represents all gross revenues, and subtract the
royalty percentage. This gives percentage net revenue.
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2. Estimate the overall development and operating costs; for

instance, 35%. Deduct this percentage from net revenue.
Over the life of a project, these costs range from 20%–40% of
gross revenues. If costs exceed this level, then it is likely a project
will be submarginal, depending on the fiscal system. A quick-look
estimate should focus on a hypothetically profitable venture.
Companies normally do not develop subeconomic fields. A cost
estimate of 35% of gross revenues is a good place to start and pro-
vides a common point of reference.
3. Subtract taxes, levies, government profit share, etc. This
gives the contractor’s share of profits.
4. Subtract the percentage of costs from 100% (gross rev-
enues). This equals total profits.
5. Divide the contractor share of profits after income tax by
total profits. This is the contractor take.
For example, assume a system with a simple 15% royalty and
40% income tax. Costs equal 35% of gross revenues. In this
example, the contractor ends up with 46.15% of profits—contrac-
tor take equals 46.15%.
STEP 1 100% Gross revenues

– 15 Royalty (15%)
85% Net revenue percentage
STEP 2 – 35 Costs
50% Taxable revenues
STEP 3 – 20 Income tax (40%)
30% Contractor after-tax share
STEP 4 100% (gross revenues) – 35% costs = 65% profits
STEP 5 30% ÷ 65% = 46.15%
= Contractor take
The fiscal terms of a number of countries are included in

Appendix A. The contractor take, cost recovery, and government
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participation of selected countries is summarized in Table 2–2. These

contractor take figures assume a level of costs on the order of 35%.
Implications of Contractor Take

In 1993 an independent U.S. oil company made a 25-MMBBL
discovery off the Northwest Shelf of Western Australia. The dis-
covery was not exactly headline news outside Western Australia.
The fiscal terms there are quite good though: over three times
better than in Indonesia or Malaysia. The discovery therefore
amounted to the equivalent of an 80-MMBBL Indonesian or
Malaysian field. The fiscal terms make a huge difference.
The level of contractor take also has a direct impact on the
value of reserves. Based on a wellhead price of $18.00/bbl, the
value of proved, developed, producing (PDP) working-interest
reserves in Indonesia is $1.10–$1.60/bbl. In the United States, the
value of similar reserves would be $4.50–$6.00/bbl. This relation-
ship is illustrated further in Figure 2–3.
Valuation Rule of Thumb

Proved, developed, producing reserves are worth from one-
half to two-thirds of the wellhead price times the contractor’s
take.
Like any rule of thumb, this one should be used with caution.
It is used to make a quick estimate of the present value of a con-
tractor’s working-interest share of proved, developed, producing
reserves, assuming there are no major sunk costs available for
cost recovery. Proved, undeveloped (PUD) reserves will be worth
much less. The value of undeveloped reserves is usually less than
half of the value of PDP reserves.
An important distinction is made here in reference to the value
of reserves in the ground. The previous example and the one in
Figure 2–3 are based upon the contractor’s working-interest share
of reserves, not the contractor’s entitlement. This subject is devel-
oped further later in the book, particularly in Chapter 4. Unless
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Table 2–2
Comparison of Terms—Selected Countries

Cost Maximum
Contractor Recovery Government
Country Take, % * Limit, % Participation, %
Abu Dhabi (OPEC Terms) 9–12 100 0

Albania 20–25 45 0
Angola 20 50 50
Australia 40–50 100 0
Brunei 28–30 100 50
Cameroon 14–16 ? 50
China 38–41 50–60 51
Colombia 30–37 100 51
Congo 30–35 100 50
Egypt 24–28 30–40 50
Gabon 20–25 40–55 10
India 30–42 100 30
Indonesia 11–13 80 151
Indonesia E. 30–33 80 151
Ireland 75 100 0
Korea 36–40 100 0
Malaysia 14–19 50–60 15
Morocco 40–44 100 0
Myanmar 21–232 40 0
New Zealand 47–51 100 0
Nigeria 10–18 40 ?
Norway 18 100 ?
Papua New Guinea 30–35 100 22.5
Philippines 44–47 70 0
Spain 60 100 0
Syria 18–22 25–35 0
Thailand 30–44 100 ?
Timor Gap 26 90 0
United States 42–53 AMT3 0
Vietnam 30 40 0
1
Indonesia seldom exercises its right to participate.
2
Tax holiday on first three years’ production
3
Alternative Minimum Tax
* Excludes Government participation — usually a carried interest.
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U.S. NET PRESENT VALUE RANGE PER BARREL

FOR PRODUCING RESERVES
bbl
Based on $18.00/bbl Wellhead Price
Figure 2–3 Comparing fiscal terms—FMV per barrel
otherwise stated, all references to reserve volumes or field sizes

deal either with gross recoverable reserves or reserves attributable
to a company’s working interest.
The economic perspective of the exploration, development,
and production phases can be quite different. Often the exact
context must be indicated. For example, when discussing thresh-
old field size, there is a huge difference between exploration and
development thresholds. Most of the science of fiscal-system
analysis deals with exploration economics and, to a lesser extent,
development and production economics. Therefore the changing
perspectives are a key consideration. Table 2–3 illustrates aspects
15
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Table 2–3
Changing Economic Perspectives

Exploration Development Production
Economics Economics Economics
Risk Analysis Feasibility
Farm-in/Farm-out Exploitation Evaluation
Focus Bidding Evaluation Acquisitions
Drilling/Finding Costs, timing, prices Mostly price risk
Risk Very High Moderate Lower
Bonuses Signature Bonus Startup Bonus Production Bonuses
Very Usually not Usually not
Sensitive sensitive too sensitive
Work Very important Huge but not as Usually not
Commitment part of risk capital risky as exploration applicable
Exploration Capital Development Costs
Key Capital Seismic, Bonuses Drilling, Facilities, Operating Costs
Requirements G&G, Drilling Transportation
Economics not Moderately Very
Operating Costs sensitive sensitive sensitive
Sunk Costs Not yet Positive impact Flow through
created on development cost recovery and
decision have present value
Threshold Huge Moderate Economic
Field Size 100 – 500 + MMBBLS 5 – 50 + MMBBLS Limit Threshold
Contractor Critical Important Important
Take concern concern concern
Can be very regressive and discourage exploration
Royalties and development, and cause premature abandonment
Cost Recovery Important Very important Not so important
Limit concern concern
Hypothetical Low Highest
Reserve Values Expected Value Discounted Cash Flow Discounted Cash Flow
that are subject to change and how they are viewed. Everything
is relative.
NEGOTIATIONS
Governments have devised numerous frameworks for extract-
ing economic rent from the petroleum sector. Some are well bal-
anced, efficient, and cleverly designed. Some will not work. The
fundamental issue is whether or not exploration and/or develop-
ment is feasible under the conditions outlined in the fiscal system.
16
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The result of government efforts are sometimes referred to as fis-

cal marksmanship—either poor or good. Structuring a fiscal system
that will be appropriate or on target under a variety of unknown
future circumstances is nearly impossible.
The purpose of fiscal structuring and taxation is to capture all
economic rent. This is consistent with giving the industry a rea-
sonable share of profit, or take. But the level of industry profit
considered to be fair and reasonable is debatable. The issue of the
division of profits lies at the heart of contract/license negotiations.
GOVERNMENT OBJECTIVES
The objective of a host government is to maximize wealth
from its natural resources by encouraging appropriate levels of
exploration and development activity. In order to accomplish this,
governments must design fiscal systems that
• Provide a fair return to the state and to the industry
• Avoid undue speculation
• Limit undue administrative burden
• Provide flexibility
• Create healthy competition and market efficiency
The design of an efficient fiscal system must take into consid-

eration the political and geological risks as well as the potential
rewards.
Malaysia has one of the toughest fiscal systems in southeast
Asia. But Malaysia has good geological potential. Many compa-
nies would love to explore in Malaysia, and the government
knows this. Governments are not the only ones who draw the
line between fair return and rent. The market works both ways.
One country may tax profits at a rate of 85% or more, like
Indonesia, while another country may have an effective tax rate of
only 40%, like Spain. Yet both countries may be efficiently extract-
ing their resource rent regardless of the kind of system that is used.
17
#CHAP 2 4/30/04 3:13 PM Page 18
Illustration 2–1
OIL COMPANY OBJECTIVES

The objectives of oil companies are to build equity and maxi-
mize wealth by finding and producing oil and gas reserves at the
lowest possible cost and highest possible profit margin. In order to
do this, they must search for huge fields. Unfortunately, the
regions where huge fields are likely to be found are often accom-
panied by tight fiscal terms. The oil industry is comfortable with
tough terms if they are justified by sufficient geological potential.
This is the birthplace of dynamic negotiations.
The primary economic aspects of contract/license negotiations
are the work commitment and the fiscal terms. These are some-
times collectively referred to as the commercial terms. The challenge
that faces negotiators is the two-headed beast shown in Illustration
2–1. The work commitment represents hard risk dollars while fiscal
terms govern the allocation of revenues that may result from suc-
cessful exploration efforts. If negotiators can get past this beast, the
legal terms are right behind it.
18
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Figure 2–4 Expected monetary value graph—risk/reward
Figure 2–4 shows how these elements influence the basic

industry risk/reward relationship. This is a graphical representation
of a simple two-outcome Expected Monetary Value Theory (EMV)
risk model. The work commitment dominates the risk side of the
equation, while the fiscal terms influence the success ratio estimate
19
#CHAP 2 4/30/04 3:13 PM Page 20
as well as the reward side of the equation. The equation represented

by the graph in Figure 2–4 is shown here:
EXPECTED MONETARY VALUE (EMV)
EMV = (Reward × SP) – [Risk capital × (1 – SP)]

where
EMV = Expected monetary value

Risk capital = Bonuses, dry hole costs, G&G, etc.
SP = Success probability
Reward = Present value of a discovery based on
discounted cash flow analysis
discounted at corporate cost of capital.
The equation effectively yields a weighted average. It is com-
posed of the value of a possible discovery multiplied by the
chance of making that discovery minus the risk capital times the
probability that there will be no discovery. The graph or the equa-
tion can be used in different ways. For example, if the dry-hole
cost for a prospect is $15 million and the probability of success is
12.5%, then the potential reward better be worth at least $120
million or more, or the prospect is not worth consideration.
Under some of the tougher fiscal systems in the world where the
present value of proved, undeveloped reserves is less than
50¢/bbl, the required recoverable reserves for a prospect like this
would exceed 240 MMBBLS. But if the risk capital were cut in
half, the required target would also be cut in half.
If the discounted present value of a prospect is $120 million and
the dry-hole costs are $15 million, then the prospect had better have
a probability of success of greater than 12.5%. This is the break-
even success ratio. If the company believed this prospect had a 20%
chance of success, then the expected value would be $12 million.
= ($120 MM × .20) – [$15 MM × (1 – .20)]
= $12 MM
20
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The expected value is influenced by both the risk capital and

the fiscal terms that partially govern the size of the reward. Notice
that the risk capital weighed much more heavily in the decision-
making process. Because of the 20% chance of success, the risk dol-
lars outweighed the reward dollars 4:1. With a success ratio of
around 10%, the relationship changes to 9:1. Risk dollars are criti-
cal. This is why so much attention is placed on work commitments
and bonuses. Bonuses in particular are hard for companies to bear
because they provide no information. At least a seismic program or
a drilling program adds to the body of information about an area.
FAMILIES OF SYSTEMS
Governments and companies negotiate their interests in one
of two basic systems: concessionary and contractual. The funda-
mental difference between them stems from different attitudes
towards the ownership of mineral resources. The Anglo-Saxon and
the French concepts of ownership of mineral wealth are the root
beginnings. This ownership issue drives not only the language
and jargon of fiscal systems, but the arithmetic as well. The classi-
fication of petroleum fiscal systems is outlined in Figure 2–5.
CONCESSIONARY SYSTEMS
Concessionary systems, as the term implies, allow private own-
ership of mineral resources. The United States, of course, is the
extreme example of such a system where individuals may own
mineral rights. This concept of ownership comes from Anglo-Saxon
legal tradition. In most countries the government owns all mineral
resources, but under concessionary systems it will transfer title of
the minerals to a company if they are produced. The company is
then subject to payment of royalties and taxes.
CONTRACTUAL SYSTEMS
Under contractual systems the government retains ownership
of minerals. Oil companies have the right to receive a share of
21
#CHAP 2 4/30/04 3:13 PM Page 22
production or revenues from the sale of oil and gas in accordance

with a production sharing contract (PSC) or a service contract.
Production sharing is rooted in the Napoleonic era French
legal concept of the ownership of minerals—that mineral wealth
should not be owned by individuals but by the state for the bene-
fit of all citizens. Indeed, this philosophy is embodied in the 1945
Indonesian Constitution Article 33, which states
All the natural wealth on land and in waters is under

the jurisdiction of the State and should be used for the
benefit and welfare of the people.
In the petroleum industry, Indonesia is the pioneer of the

PSC, with the first contracts signed in the early and mid-1960s.
Indonesia is the standard of comparison for all PSCs. Accordingly,
the Indonesian PSC is given special attention in this book. In
France, where the notion of state ownership of mineral wealth
ultimately inspired PSCs, the petroleum fiscal system is not PSC
based. France has a royalty/tax system—a bit of irony.
It is partially because of the concept of ownership of mineral
resources that the term contractor has come into such wide use.
The earliest uses of the production sharing concept occurred in
the agriculture industry. Therefore the term is used in the same
context as sharecropper, where ownership of the land and minerals
is held by the government/landlord. The contractor or
tenant/sharecropper is compensated out of production of miner-
als or grain according to a specific sharing arrangement. The term
contractor therefore applies to PSCs or service agreements only, but
with practical usage it cuts across the boundaries between PSCs
and concessionary systems.
There is another aspect to this ownership issue. In most con-
tractual systems, the facilities emplaced by the contractor within
the host government domain become the property of the state
either the moment they are landed in the country or upon
22
#CHAP 2 4/30/04 3:13 PM Page 23
startup or commissioning. Sometimes title to the assets or facili-

ties does not pass to the government until the attendant costs
have been recovered. This transfer of title on assets, facilities, and
equipment does not apply to leased equipment or to equipment
brought in by service companies.
Contractual arrangements are divided into service contracts and
production sharing contracts. The difference between them depends
on whether or not the contractor receives compensation in cash
or in kind (crude). This is a rather modest distinction and, as a
result, systems on both branches are commonly referred to as
PSCs, or sometimes production sharing agreements (PSAs).
For example, in the Philippines the government alternately
refers to their contractual arrangement as either a service contract
or a PSC. The oil community does the same thing, but more ordi-
narily refers to this system as a PSC. In a strict sense though, this
system is a risk service contract because the contractor is paid a fee
for conducting exploration and production operations.
From a legal point of view, the timing of the transfer of title and
ownership is important. If disputes arise, the closer the contractor is
to actual physical ownership, the stronger the legal position. As far
as ownership is concerned, under a PSC the contractor does ulti-
mately receive a share of production and hence takes title to the
crude. The transfer of title is effectively shifted from the wellhead
under a concessionary system to the point of export under a PSC.
With a service or risk service agreements, the issue of ownership is
removed altogether. In a service contract, the contractor gets a
share of profits, not production. With that in mind, the term revenue
sharing or profit sharing contract would be appropriate, but these
terms are not used. However, under some service agreements, the
contractor has a right to purchase crude from the government at a
discount, so ultimately the contractor ends up with title to some
crude. These ambiguities in ownership and timing of ownership
cloud the issue of categorization. In fact, there are numerous sys-
tems that practically defy classification, and the fundamental issue
23
#CHAP 2 4/30/04 3:13 PM Page 24
of ownership is the last resort. However, categorization is not the

important thing. Economics is.
Despite the differences between systems it is possible to obtain
the same economic results under a variety of systems. There are
so few material differences between one family and another as far
as the calculations are concerned that it is difficult to make gener-
alizations about any given family of systems.
The difference between risk service and pure service contracts
depends on whether the fee is based on profits or not. Pure ser-
vice contracts are quite rare. In pure (nonrisk) service contracts
the contractor carries out exploration and/or development work
on behalf of the host country for a fee. All risk is borne by the
state. This arrangement is characteristic of the Middle East where
the state often has substantial capital but seeks outside expertise
and/or technology.
Pure service agreements, rare as they are, can be quite similar
to arrangements found in the oil service industry. The contractor
is paid a fee for performing a service—no risk element. In the late
1950s, the Argentine government under President Arturo
Frondizi negotiated a number of service contracts known as “The
Frondizi Contracts.” These contracts were negotiated with oil
companies for drilling, development, and medium-risk explo-
ration services. The companies included Kerr McGee, Marathon,
Shell, Esso, Tennessee Gas Transmission, Cities Service, Amoco,
and Union Oil. The drilling service contracts were pure service
arrangements whereby the contractor was paid on a footage basis
for drilling services and an hourly basis for testing and completion
operations. The payment was usually a combination of dollars
and pesos.
While many service agreements are identical to PSCs in all but
the method of payment, many have unique contract elements
that are used in calculating the service fee. Some of these can get
rather exotic and may indicate new directions in fiscal design.
These are discussed in Chapter 5.
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CLASSIFICATION OF
PETROLEUM FISCAL ARRANGEMENTS
The first branch deals with the title to the mineral resources.
Concessionary systems allow private ownership. In contractual systems,
the state retains ownership.
CONCESSIONARY SYSTEMS CONTRACTUAL SYSTEMS
The primary difference here rests upon whether the

fee is taken in cash (service) or in kind (PSC).
Service Production Sharing

Contracts Contracts
Also referred to as
Production Sharing Agreements
Divided primarily upon whether fee is based upon a flat fee

(pure), or profit (risk).
Pure Service Risk Service

Contracts Contracts
Figure 2–5 Classification of petroleum fiscal systems
25
#CHAP 2 4/30/04 3:13 PM Page 26
VARIATION ON TWO THEMES

Numerous variations and twists are found under both the
concessionary and contractual themes. The philosophical differ-
ences between the two systems have fostered a terminology
unique to each. However, the terms are simply different names
for basic concepts common to both systems.
Because of the modest difference between service agreements
and PSCs, the study of PSCs effectively covers the whole contrac-
tual branch of the tree. Much of the language and arithmetic of
PSCs and service agreements is identical. PSCs outnumber service
agreements 5:1. As of 1994 there were only nine countries using
service agreements compared to 44 using PSCs.
Comparing and contrasting PSCs with concessionary systems
provides solid foundation for the study of petroleum fiscal sys-
tems. This book concentrates on the terminology and arithmetic
of these two families. Most of the differences—especially from a
practical and financial point of view—are purely semantic. The
most dramatic differences between one fiscal system and another
have to do with just how much taxation is imposed.
In addition to the two main families, there are a few arrange-
ments that appear to be a type of fiscal system. Each of them are
discussed in detail in Chapter 5. They include
• Joint ventures
• Technical assistance contracts, EOR contracts
• Rate of return contracts
Joint ventures (JVs) are not a type of fiscal/contractual sys-

tem. They are common in the industry through standard joint
operating agreements (JOAs) and working-interest arrangements
between companies. Governments also get directly involved
through joint ventures. The term is primarily used to describe
arrangements where the national oil company is in partnership
with the contractor. Government/industry joint ventures are also
referred to as government participation. This is found in both
26
#CHAP 2 4/30/04 3:13 PM Page 27
concessionary and contractual systems. However, some joint ven-

ture arrangements so strongly characterize the operating environ-
ment that special attention is given to them in Chapter 5.
Technical assistance contracts (TACs) are used for enhanced
oil recovery (EOR) projects or rehabilitation/redevelopment
schemes administered under a PSC or a concessionary system.
These normally involve proved reserves that are beyond the pri-
mary recovery stage. This creates quite a different setting than
normal exploration and development economics. The critical
aspect of exploration risk is missing.
Rate of return (ROR) features are also found in both systems.
ROR is more a descriptive term to identify further the nature of a
particular system. For example, the Papua New Guinea (PNG) fis-
cal system is a concessionary-based ROR system. Equatorial
Guinea, on the other hand, uses a PSC-based ROR contract. The
ROR concept can get slightly exotic. And it appears to be a new
direction for the industry.
Specific examples of JVs, TACs, and ROR contracts are given
in Chapter 5.
27
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#CHAP 3 4/30/04 3:31 PM Page 29
3
CONCESSIONARY
SYSTEMS
C oncessionary arrangements predominated through

the early 1960s. The earliest agreements consisted of only a royal-
ty payment to the state. The simple royalty arrangements were
followed by larger royalties. Taxes were added once governments
gained more bargaining power. In the late 1970s and early 1980s,
a number of governments created additional taxes to capture
excess profits from unexpectedly high oil prices. Now there are
numerous fiscal devices, layers of taxation, and sophisticated for-
mulas found in concessionary systems.
FLOW DIAGRAM
Figure 3–1 depicts revenue distribution under a simple conces-
sionary system. This example is provided to develop further the
concept of contractor take and to compare with other systems. The
diagram illustrates the hierarchy of royalties, deductions, and (in
this example) two layers of taxation. For illustration purposes, a
single barrel of oil is forced through the system.
29
#CHAP 3 4/30/04 3:31 PM Page 30
CONCESSIONARY SYSTEM FLOW DIAGRAM
One Barrel of Oil

$20.00
Contractor Royalties
Share & Taxes
20%
Royalty ————> $4.00
$16.00 (Net revenue)
Deductions
(Operating costs, DD&A, IDCs, etc.)
$9.00 <——— ————————-
$ 7.00 (Taxable income)
Provincial Taxes
(Ad valorem, severance, income)
10% ———> $ .70
$6.30
Federal income tax

40% ———> $2.52
$3.78 <——— Net income after tax
$12.78 $7.22
64% 36%
Figure 3–1 Concessionary system flow diagram
30
#CHAP 3 4/30/04 3:31 PM Page 31
FIRST: ROYALTIES
The royalty comes right off the top. In this example a 20%
royalty is used. Gross revenues less royalty equals net revenue.
SECOND: DEDUCTIONS
Operating costs; depreciation, depletion, and amortization
(DD&A); and intangible drilling costs (IDCs) are deducted from
net revenue to arrive at taxable income. DD&A is the common
terminology, but depletion is seldom allowed. When the term is
used, it is assumed that it applies to depreciation and amortiza-
tion. Most countries follow this format but will have different
allowed rates of depreciation or amortization for various costs.
Some countries are liberal in allowing capital costs to be expensed
and not forced through DD&A.
THIRD: TAXATION
Revenue remaining after royalty and deductions is called taxable
income. In this example, it is subjected to two layers of taxation:
10% provincial and 40% federal taxes. Provincial taxes are
deductible against federal taxes. The effective tax rate therefore is
46%.
With tax deductions the contractor share of gross revenues is
64%. The profit in this example is $11.00 ($20.00 minus $9.00 in
costs). The contractor’s share of profits is $3.78. Contractor take
therefore is 34.36%. This is different than profit margin, which in
this example is 18.9% ($3.78/$20.00).
CASH FLOW PROJECTION

Table 3–1 outlines further the terminology and hierarchy of
arithmetic for calculating contractor cash flow. This example is
more of a financial perspective, but the arithmetic is consistent
with the basic equations that are included in this chapter. Table
3–2 is a cash flow projection for a concessionary system. It
includes a detailed explanation of the operations involved in
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#CHAP 3 4/30/04 3:31 PM Page 32
arriving at a year-by-year cash flow calculation. The royalty in

this example is 12.5%, and the income tax rate is 35%. This is the
usual format for cash flow analysis of a possible field develop-
ment. In this case, the discovery is assumed to be a 40-MMBBL
field, and production is profiled each year. The last column (N) is
the contractor net after-tax cash flow. The next steps in economic
modeling are to calculate the present value of the cash flow
stream and to estimate the internal rate of return (IRR).
The cash flow projection is based on the assumption that some
classes of capital cost are intangible and are immediately deductible.
The tangible capital costs are depreciated over five years.
The development scenario outlined in this projection is for a
40-MMBBL field with a projected 11-year life. Total capital costs
are $101 million, and estimated operating costs during the life of
the project are $117 million. The following calculation of the
respective takes comes from the cash flow projection. The con-
tractor take is 53.3%. A quick-look estimate using a 35% cost
assumption yields a contractor take of 52.5%.
CALCULATION OF GOVERNMENT/CONTRACTOR TAKE

Total costs – 217,993
Total profit $501,884

Royalties – 89,985
Taxes – 144,165
Contractor take $267,734
Contractor take 53% ($267,734 ÷ $501,884)
Government take 47%
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#CHAP 3 4/30/04 3:31 PM Page 33
BASIC EQUATIONS, ROYALTY/TAX SYSTEMS
Gross revenues = Total oil and gas revenues
Net revenues = Gross revenues

– royalties
Net revenue (%) = 100% – Royalty rate (%)
Taxable income = Gross revenues

– Royalties
– Operating costs
– Intangible capital costs1
– DD&A (including abandonment costs)
Deductions — – Investment credits (if allowed)
– Interest on financing (if allowed)
– Tax loss carry forward
– Bonuses2
Net cash flow = Gross revenues

(aftertax) – Royalties
– Tangible capital costs
– Operating costs
– Bonuses
– Taxes
1
In many systems no distinction is made between operating costs
and intangible capital costs, and both are expensed.
2
Bonuses are not always deductible.
33
#CHAP 3 4/30/04 3:31 PM Page 34
Table 3-1
Concessionary System Structure

Oil Company Perspective
Terminology $/bbl Royalties, Costs, and Taxes
Wellhead price $20.00

–3.75 18.75% (3/16) Royalty
Net revenue 16.25
–1.63 10% Severance, ad valorem,
and production taxes
–4.15 Operating costs
–1.45 General & administrative costs
Before-tax operating 9.02
income
–5.15 Depreciation, depletion,
& amortization
Before-tax net income 3.87
– .31 8% State income tax
3.56
–1.21 34% Federal income tax
After-tax net income $2.35
+5.15 Depreciation, depletion,
& amortization
–1.25 Tangible capital costs
After-tax cash flow $6.25
34
#CHAP 3
Table 3–2
4/30/04
Sample Royalty/Tax System Cash Flow Projection

Total 35.0% Net
OIL OIL Gross 12.5% Net Intangible Tangible Operating Applied Tax Loss Taxable Income Cash
Production Price Revenues Royalty Revenues Cap Ex Cap Ex Expense DD&A Deductions C/F Income Tax Flow
Year (MBBLS) ($/bbl) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M)
3:31 PM
(A) (B) (C) (D) (E) (F) (G) (H) (I) (J) (K) (L) (M) (N)
1994 0 $18.00 0 0 0 10,000 10,000 0 0 0 0 (10,000) 0 (20,000)

1995 0 18.00 0 0 0 5,000 8,000 0 0 0 10,000 (15,000) 0 (13,000)
1996 0 18.00 0 0 0 3,000 40,000 0 0 0 15,000 (18,000) 0 (43,000)
Page 35
1997 4,500 18.00 81,000 10,125 70,875 0 25,000 11,500 16,600 46,100 18,000 24,775 8,671 25,704
1998 7,000 18.00 126,000 15,750 110,250 0 0 14,000 16,600 30,600 0 79,650 27,878 68,373
1999 5,600 18.00 100,800 12,600 88,200 0 0 12,600 16,600 29,200 0 59,000 20,650 54,950
2000 4,760 18.00 85,680 10,710 74,970 0 0 11,760 16,600 28,360 0 46,610 16,314 46,897
2001 4,046 18.00 72,828 9,104 63,725 0 0 11,046 16,600 27,646 0 36,079 12,627 40,051
2002 3,439 18.00 61,904 7,738 54,166 0 0 10,439 0 10,439 0 43,727 15,304 28,422
2003 2,923 18.00 52,618 6,577 46,041 0 0 9,923 0 9,923 0 36,118 12,641 23,477
2004 2,485 18.00 44,725 5,591 39,135 0 0 9,485 0 9,485 0 29,650 10,378 19,273
2005 2,087 18.00 37,569 4,696 32,873 0 0 9,087 0 9,087 0 23,786 8,325 15,461
2006 1,732 18.00 31,183 3,898 27,285 0 0 8,732 0 8,732 0 18,552 6,493 12,059
2007 1,427 18.00 25,570 3,196 22,374 0 0 8,421 0 8,421 0 13,953 4,884 9,069
2008 0 18.00 0 0 0 0 0 0 0 0 0 0 0 0
40,000 719,877 89,985 629,893 18,000 83,000 116,993 83,000 217,993 368,899 144,165 267,735
(A) Production Profile (Thousands of barrels per year) (H) Operating Costs [Expensed]
(B) Crude Price ($/bbl) (I) Depreciation of Tangible Capital Costs: 5-Year Straight Line Decline
(C) Gross Revenues = (A) x (B) (J) Total Applied Deductions = If (F) + (H) + (I) + (K) is greater than or = to (E) then (E) Otherwise (F) + (H) + (I) + (K)
(D) Royalty = 12.5% = (C) x .125 (K) Tax Loss Carry Forward = If (L) from previous year is negative then it is brought forward otherwise (zero)
(E) Net Revenues = (C) – (D) (L) Taxable Income = (E) − (F) − (H) − (I) − (K)
(F) Intangible Capital Costs [Expensed] (M) Income Tax = 35% = If (L) is positive .35 x (L), otherwise (zero)
(G) Tangible Capital Costs [Capitalized, see Column (I)] (N) After Tax Net Cash Flow = (C) − (D) − (F) − (G) − (H) − (M)
35
#CHAP 3 4/30/04 3:31 PM Page 36
Another dimension of contractor take comes from the effect of

royalties or any taxes that are levied on gross revenues instead of
profits. With different levels of profitability, fiscal systems with
royalties can yield different government/contractor takes.
The contractor take calculation using the U.S. federal offshore
example illustrates the impact of a royalty. The step-by-step allo-
cation of revenues under a high- and low-cost case is based on
the following assumptions:
Gross revenues = $100 million

Royalty = 1/6 = 16.67%
Costs eligible for deduction =
$50 million – high cost case
$20 million – low cost case
U.S. FEDERAL OFFSHORE FISCAL STRUCTURE

Low Cost High Cost
Case Case
$100.00 MM $100.00 MM Gross revenues

–16.67 – 16.67 Royalty
83.33 83.33 Net revenues

–20.00 –50.00 Deductions
63.33 33.33 Taxable income

–21.53 –11.33 Federal income tax 34%
41.80 22.00 Contractor net income after tax

+20.00 +50.00 Deductions
$61.80 MM $72.00 MM Contractor total
52.25% 44.0% Contractor take

Contractor net income after tax
÷ Gross revenues – Costs
36
#CHAP 3 4/30/04 3:31 PM Page 37
The government share of revenues in the low-cost case is only

$38.2 million, or 38.2%. The contractor’s share of gross revenues
was $61.8 million. The taxable profit is $80 million ($100 MM –
$20 MM deductions). Of this, the contractor’s share is $41.8 mil-
lion. The contractor take therefore is 52.25% ($41.8 MM/$80
MM). Contractor take under the high-cost regime is only 44.0%.
This is a regressive fiscal structure. The lower the profitability,
the higher the effective tax rate. This is because of the royalty. It
is based on gross revenues.
37
#CHAP 3 4/30/04 3:31 PM Page 38
#CHAP 4 4/30/04 3:40 PM Page 39
PRODUCTION SHARING CONTRACTS
4
PRODUCTION
SHARING
CONTRACTS
A t first PSCs and concessionary systems appear to

be quite different. They have major symbolic and philosophical
differences, but these serve more of a political function than any-
thing else. The terminology is certainly distinct, but these systems
are really not that different from a financial point of view. There
is a general view that PSCs are more complex and onerous than
concessionary systems. This is not a fair generalization. Too much
diversity exists on both sides.
The arithmetic of a simple PSC is evaluated first. Many of the
other features of a PSC are similar to those found under other sys-
tems. Therefore, these common elements are discussed in detail later.
In the numerous production sharing arrangements, there are
common elements. The essential characteristic, of course, is that
of state ownership of the resources. The contractor receives a
share of production for services performed.
As more countries open their doors to the petroleum industry,
they are using the PSC as opposed to concessionary systems. The
39
#CHAP 4 4/30/04 3:40 PM Page 40
first PSC was signed by IIAPCO in August 1966 with Permina, the
Indonesian National Oil Company at that time (now Pertamina).
This is when oil companies started becoming contractors. This con-
tract embodied the basic features of the production sharing concept:
• Title to the hydrocarbons remained with the state.
• Permina maintained management control, and the contrac-
tor was responsible to Permina for execution of petroleum
operations in accordance with the terms of the contract.
• The contractor was required to submit annual work pro-
grams and budgets for scrutiny and approval by Permina.
• The contract was based on production sharing and not a
profit-sharing basis.
• The contractor provided all financing and technology
required for the operations and bore the risks.
• During the term of the contract, after allowance for up to a
maximum of 40% of annual oil production for recovery of
costs, the remaining production was shared 65%/35% in
favor of Permina. The contractor’s taxes were paid out of
Permina’s share of profit oil.
• All equipment purchased and imported into Indonesia by the
contractor became the property of Permina. Service compa-
ny equipment and leased equipment were exempt.
These features continue to outline the nature of the govern-

ment/contractor relationships under PSCs or service agreements.
It is a formula that is popular with many governments.
FLOW DIAGRAM
Figure 4–1 shows a flow diagram of a PSC with a royalty. It
illustrates the terminology and arithmetic hierarchy of a typical
PSC. For illustration one barrel of oil is used.
FIRST: ROYALTY
The royalty comes right off the top just as it would in a con-
cessionary system. This example uses a 10% royalty.
40
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BASIC EQUATIONS, CONTRACTUAL SYSTEMS
Gross revenues = Total oil and gas revenues

Net revenues = Gross revenues – Royalties
Net revenue (%) = 100% – Royalty rate (%)
Cost recovery = Operating costs
“Cost oil” + Intangible capital costs1
+ DD&A (including abandonment costs)
+ Investment credits (if allowed)
+ Interest on financing (if allowed)
+ Unrecovered costs carried forward
Profit oil = Net revenue – Cost recovery
Contractor profit oil = Profit oil × Contractor percentage share
Government profit oil = Profit oil × Government percentage
share
Net cash flow = Gross revenues
(aftertax) – Royalties
– Tangible capital costs
– Operating costs
+ Investment credits
– Bonuses
– Government profit oil
– Taxes
Taxable income = Gross revenues
– Royalties
– Operating costs
+ Investment credits
– Government profit oil
– DD&A (including abandonment costs)
– Bonuses2
1
In many systems no distinction is made between operating costs
and intangible capital costs. Both are expensed.
2
Bonuses are not always deductible.
41
#CHAP 4 4/30/04 3:40 PM Page 42
SECOND: COST RECOVERY

Before sharing of production, the contractor is allowed to
recover costs out of net revenues. However, most PSCs will place a
limit on cost recovery. For example, in the flow diagram, cost
recovery is limited to 40% of gross revenues. If operating costs
and DD&A amounted to more than that, the balance would be
carried forward and recovered later. From a mechanical point of
view, the cost recovery limit is the only true distinction between
concessionary systems and PSCs.
THIRD: PROFIT OIL SPLIT

Revenues remaining after royalty and cost recovery are referred
to as profit oil or profit gas. The analog in a concessionary system
would be taxable income. The terminology is precise because of the
ownership issue. The term taxable income implies ownership that
does not exist yet under a PSC. The contractor has nothing to tax.
In this example, the contractor’s share of profit oil is 40%. The
contractor’s share of the profit oil is subject to taxation. If this
were a service agreement with the contractor’s share of revenues
equal to 40%, it would be called the service fee—not profit oil.
FOURTH: TAXES
The contractor’s share of profit oil in this example is taxed at a
rate of 40%.
CONTRACTOR TAKE
With cost recovery the contractor’s gross share of production
comes to 52%. Total profit is $12.00. Considering the 10% royalty,
profit oil split, and taxation, the contractor share of profits is $2.40.
Contractor take therefore is 20%. The profit margin here looks as
though it were 12%. But there may not have been any true profits
in the ordinary accounting sense. The cost recovery limit forces
some profit sharing under all circumstances where there is produc-
tion. The important number is the 20% contractor take.
Table 4–1 gives a slightly different perspective on the termi-
42
#CHAP 4 4/30/04 3:40 PM Page 43
$ $
Figure 4–1 Production sharing flow diagram
nology. It focuses on the hierarchy of calculations for contractor

cash flow under a PSC.
THE INDONESIAN 85%/15% SPLIT

The most famous government/contractor take statistic is the
Indonesian 85%/15% split. There is an important reason for
this—Indonesia has no royalty. The calculation is based on two
43
#CHAP 4 4/30/04 3:40 PM Page 44
Table 4-1
Production Sharing Contract Structure

Contractor’s Perspective
Terminology $/bbl Royalties, Costs, Taxes

Sharing
Wellhead price $20.00

– 2.00 10.0% Royalty
Net revenue 18.00
0 Local taxes (usually)

Cost recovery
elements
–4.15 Operating costs
–1.45 General & administrative costs
–5.15 Depreciation, depletion

& amortization
Total cost recovery –10.75
Profit oil 7.25 Sharable oil

Government share (60%) –4.35 60%/40% Split in favor of Gvt.
Contractor share (40%) 2.90 60%/40% Split in favor of Gvt.

–1.45 50% Income tax
After-tax net income $1.45
+5.15 Depreciation, depletion

& amortization
–1.25 Tangible capital costs
After-tax cash flow $5.35
44
#CHAP 4 4/30/04 3:40 PM Page 45
mechanisms: (1) a profit oil split of 71.1538%/28.8462% in favor

of the government and (2) an effective tax rate of 48%. This is the
result of a double layer of taxation: 35% income tax and 20%
withholding tax levied after income tax.
The effect of this production sharing/tax arrangement in
Indonesia is that of an aggregate 85% tax rate. The government share
of profit oil could simply be viewed as another layer of taxation.
Because there is no royalty, the division of production is the same
regardless of the amount of costs as long as the contractor is able to
recover all costs. This is why the 85%/15% split in Indonesia is so
well known. It does not change with variations in the level of costs.
Gross production = 100 MMBBLS

Royalty = 0%
Costs oil for recovery of costs = 35 MMBBLS
INDONESIAN PSC ENTITLEMENT CALCULATION
100.00 MM Gross production

–35.00 Cost recovery
65.00 Total share oil

–46.25 Government share 71.1538%
18.75 Contractor share 28.8462%

– 9.00 Aggregate tax rate 48%
9.75 Contractor after-tax share

+35.00 Cost recovery
44.75 MM Contractor total financial entitlement

53.75 MM Contractor legal entitlement = (35 + 18.75)
15.00% Contractor take
(Contractor after-tax share ÷ Total share oil)
* See Table 4-2
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Table 4-2
Classification of Reserves
Contractor
Gross 50% Working
Recoverable Interest Contractor Contractor
Reserves Share Entitlement Liftings*
100 MMBBLS 50 MMBBLS 22.375 MMBBLS 22.375 MMBBLS
Half of Half of
100 MMBBLS 44.75 MMBBLS
from above
*Ultimately should equal actual entitlements. In any given accounting or

reporting period may be more or less than actual entitlement.
There are other aspects of the Indonesian system that

affect the contractor take. These are ignored when the 85%/15%
split is mentioned because from the perspective of exploration
and development economics, they are not material. They are
explained in detail later in this chapter.
RESERVE CLASSIFICATION AND REPORTING

In the previous example, gross production is 100 MMBBLS.
Assume that a company holds a 50% working interest in this
field. The company’s reserve position is summarized in Table 4–2.
The gross reserve figures are used when discussing field size
thresholds for exploration and development. When discussing the
value of reserves in the ground, the gross reserves, or working-
interest reserves are used. However, the contractor entitlement is
the basis for crude liftings and financial reporting. The entitle-
ment figure is based in part on cost recovery, which depends on
oil prices. Therefore, with each reporting period and changing
prices, the entitlement reserve figure will change. For example, if
oil prices are expected to be lower than those assumed in the pre-
vious calculation, the entitlement would be greater. With lower
oil prices, the contractor cost oil requirement increases.
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In any given accounting or reporting period, the contractor

liftings can be different than the actual entitlement because of
under- or overliftings due to price changes and various other fac-
tors. Because of these differences in reserve classification, it can
sometimes be confusing when someone is discussing reserves.
Which classification are they talking about?
Most of the discussion in this book centers on the microeco-
nomics of exploration and development of working-interest
reserves. Financial reporting, on the other hand, uses reserves
associated with contractor entitlement. This number is even more
elusive than ordinary reserves estimates. As mentioned previous-
ly, entitlement is a function of oil prices. A perfect example of the
impact is found in the reserves disclosure segment of the Maxus
Energy Corporation 1991 Annual Report [page 47, footnote (b)]:
(b) The 1990 and 1991 changes reflect the impact of the
change in the price of crude oil on the barrels to which
the Company is entitled under the Indonesian produc-
tion sharing contracts. The 1990 change due to the
impact of increasing prices was a reduction of 20.7 mil-
lion barrels. Decreasing prices in 1991 resulted in an
increase of 25.6 million barrels.
The ownership relationship under a production sharing con-

tract has forced Maxus to report entitlement reserves. Footnote
(c) is another matter.
(c) Subsequent to year-end 1991, Maxus signed a letter

of understanding to become operator of Block 16 in
Ecuador and to increase its ownership interest from
15% to 35%. This will add 36.7 million barrels of new
reserves.
Ecuador uses a service contract. Maxus does not have title

to these reserves. Maxus could easily be entitled to a share of
47
#CHAP 4 4/30/04 3:40 PM Page 48
revenues for cost recovery and a share of profits, but not a

share of production. Yet somehow an attempt was made to
communicate to shareholders the magnitude of reserves
involved. Presumably the 36.7 MMBBLS relate to an equivalent
of entitlement to profits and not to working-interest barrels.
The virtue of working-interest barrels is that they are subject
primarily to engineering principles and will not change drastically
with oil price changes. Working-interest reserves provide com-
mon ground for nearly all parties concerned. Financial reporting
starts with a cash flow projection of gross or working-interest
reserves. Contractor entitlement depends on the level of costs and
oil prices. Entitlement reserves often amount to around 50% of
working-interest reserves. Therefore, the value per barrel from oil
company annual and 10-K reports is about double the value of
working-interest reserves.
Sample PSC Cash Flow

Projection
The cash flow projection in Table 4–3 outlines elements of a
simple PSC with a detailed explanation of the calculations involved
in arriving at year-by-year cash flow. The PSC consists of:
Royalty = 0%
Cost recovery limit = 60%
DD&A = 5-year straight-line decline (SLD)
Profit oil split = 35% for the contractor
Taxes = 40%
The development costs are all capitalized, and depreciation
starts when production begins. The last column (N) is the undis-
counted contractor net after-tax cash flow.
The development scenario outlined in this projection is for a
40-MMBBL field with a projected 11-year life. Total capital costs
are $60 million, and estimated operating costs during the life of
the field are $117 million. Costs represent 22% of gross revenues.
48
#CHAP 4 4/30/04 3:40 PM Page 49
Calculation of Government/Contractor Take

Total costs –176,993
Total profit 622,871
Government profit oil –404,865 ($622,870 – $218,005)

Government taxes – 89,002 (includes $3,000 bonuses)
Contractor take $129,003 ($218,005 – $89,002)
Contractor take 21% ($129,003/$622,871)

Government take 79%
Contractor financial
entitlement 305,996 ($129,003 + $176,993)
38% ($305,996/$799,864)
Note: There are some minor rounding differences.
BASIC ELEMENTS
The basic elements of a production sharing system are catego-
rized in Table 4–4. These elements are also found in concessionary
systems with the exception of the cost recovery limit and production
sharing. Each of the economic elements listed in the table are dis-
cussed separately. Noncommercial aspects are covered in Chapter 8.
As this table shows, many aspects of the government/con-
tractor relationship may be negotiated but some are normally
determined by legislation. Those elements that are not legislated
must be negotiated. Usually, the more aspects that are subject to
negotiation, the better. This is true for the government agency
responsible for negotiations as well as for the oil companies.
Flexibility is required to offset differences between basins,
regions, and license areas within a country.
49
#CHAP 4
50
Table 4-3
4/30/04
Sample Production Sharing Contract Cash Flow Projection

Contractor Total Contractor 40.0% Net
OIL OIL Gross Intangible Tangible Operating Cost Profit Profit Tax Loss Income Cash
3:40 PM
Production Price Revenues Cap Ex Cap Ex Expense Bonus DD&A Oil Oil Oil C/F Tax Flow
Year (MBBLS) ($/bbl) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M)
(A) (B) (C) (D) (E) (F) (G) (H) (I) (J) (K) (L) (M) (N)
1994 0 $20.00 0 0 10,000 0 2,000 0 0 0 0 0 0 (12,000)

Page 50
1995 0 20.00 0 0 8,000 0 0 0 0 0 0 2,000 0 (8,000)

1996 0 20.00 0 0 15,000 0 0 0 0 0 0 2,000 0 (15,000)
1997 4,500 20.00 90,000 15,000 10,000 11,500 1,000 8,600 35,100 54,900 19,215 2,000 6,486 10,329
1998 7,000 20.00 140,000 2,000 0 14,000 0 8,600 24,600 115,400 40,390 0 16,156 32,834
1999 5,600 20.00 112,000 0 0 12,600 0 8,600 21,200 90,800 31,780 0 12,712 27,668
2000 4,760 20.00 95,200 0 0 11,760 0 8,600 20,360 74,840 26,194 0 10,478 24,316
2001 4,046 20.00 80,920 0 0 11,046 0 8,600 19,646 61,274 21,446 0 8,578 21,468
2002 3,439 20.00 68,782 0 0 10,439 0 0 10,439 58,343 20,420 0 8,168 12,252
2003 2,923 20.00 58,465 0 0 9,923 0 0 9,923 48,541 16,990 0 6,796 10,194
2004 2,485 20.00 49,695 0 0 9,485 0 0 9,485 40,210 14,074 0 5,629 8,444
2005 2,087 20.00 41,744 0 0 9,087 0 0 9,087 32,657 11,430 0 4,572 6,858
2006 1,732 20.00 34,647 0 0 8,732 0 0 8,732 25,915 9,070 0 3,628 5,442
2007 1,427 20.00 28,411 0 0 8,421 0 0 8,421 19,990 6,997 0 2,799 4,198
2008 0 20.00 0 0 0 0 0 0 0 0 0 0 0 0
40,000 799,864 17,000 43,000 116,993 3,000 43,000 176,993 622,870 218,005 86,002 129,003
(A) Production Profile (H) Depreciation of Tangible Capital Costs: 5-Year Straight Line Decline
(B) Crude Price (I) Contractor Cost Oil = (D) + (F) + (H) if (C) is greater than zero: Up to a
(C) Gross Revenues = (A) x (B) maximum of 60% of (C)
(D) Intangible Capital Costs (Expensed) [However, (J) Total Profit Oil = (C) – (J)
Preproduction costs are often capitalized] (K) Contractor Profit Oil = (J) x 35%
(E) Tangible Capital Costs [Capitalized - see Column (H)] (L) Tax Loss Carry Forward (See Column G)
(F) Operating Expenses (Expensed) (M] Income Tax (40%) = ( (K) – (L) ) x 40% If (K) – (G) – (L) > (zero) then
(G) Bonuses are typically not “cost recoverable” but are tax deductible. ((K) – (G) – (L)) x 40% otherwise (zero)
In this example the tax loss is carried forward until production begins. (N) Contractor After-tax Net Cash Flow = (C) – (D) – (E) – (F) – (G) – (J) + (K) – (M)
#CHAP 4 4/30/04 3:40 PM Page 51
Table 4-4
Production Sharing
Fiscal/Contractual Structure
National Contract
Legislation Negotiation
Operational • Gvt. participation • Work commitment

Aspects • Ownership transfer • Relinquishment
• Arbitration • Commerciality
• Insurance
Revenue or • Royalties* • Bonus payments

Production • Taxation* • Cost recovery limits
Sharing • Depreciation rates • Production sharing*
Elements • Investment credits
• Domestic obligation
• Ringfencing
*Those features most commonly associated with contractor take.
The legislative body ordinarily has more authority than the

national oil company or oil ministry empowered to negotiate con-
tracts. Therefore, some items are simply not subject to negotiation.
If a national oil company has authority to negotiate the profit oil
split, then the tax rate is not such an issue. While fiscal elements
such as taxes are normally legislated, others are subject to negoti-
ation and are defined in the PSC. Only a contract can set forth
such elements as contract area coordinates, work commitment,
and duration of phases of the contract. Governments that use the
PSC often allow more latitude in negotiations.
WORK COMMITMENT
Work commitments are generally measured in kilometers of
seismic data and number of wells. There are some instances
where the work commitment may consist only of seismic data
acquisition with an option to drill. These are referred to as seismic
options. Other contracts have hard, aggressive drilling obligations.
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#CHAP 4 4/30/04 3:40 PM Page 52
The terms of the work commitment outline penalties for nonper-

formance.
The work commitment is a critical aspect of international
exploration. It embodies most of the risk of petroleum explo-
ration. With most exploration efforts, taxes are never experienced
because so many wildcats are dry. There is perhaps only a
10%–15% chance of ever getting beyond the work commitment.
Negotiators focus a lot of attention on the work commitment.
This is explained in greater detail in Chapter 8.
The main variables that are involved in fiscal design are
shown in Illustration 4–1. The designers standing at the fiscal
control panel are contemplating a classic production sharing sys-
tem. To create a concessionary system as far as the arithmetic
goes, they would simply turn the cost recovery limit and the con-
tractor profit oil split up to 100%. That would leave a simple roy-
alty/tax system. Not a huge difference.
BONUS PAYMENTS
Cash bonuses are sometimes paid upon finalization of negoti-
ations and contract signing, hence the term signature bonus.
Although cash payments are most common, the bonus may con-
sist of equipment or technology. Not all PSCs have bonus require-
ments. Among contracts that have bonus provisions, there are
many variations.
Production bonuses are paid when production from a given
contract area or field reaches a specified level—usually some mul-
tiple of 1,000 BOPD. For example, a contract may require a U.S.
$2 million bonus payment to the government when production
reaches 20,000 BOPD and another U.S. $2 million bonus if pro-
duction exceeds 40,000 BOPD. There will be a specified time
period such as a month or quarter during which the average pro-
duction rate must exceed the benchmark level that triggers the
bonus payment. Sometimes the production bonuses are paid at
startup of production or upon reaching a milestone in cumulative
production.
52
#CHAP 4 4/30/04 3:40 PM Page 53
Illustration 4-1 Fiscal design
ROYALTIES
Royalties are a fundamental concept, and the treatment is
similar under almost all fiscal systems. While there are some exot-
ic variations on the royalty theme, they are rare. Royalties are
taken right off the top of gross revenues. Some systems will allow
a netback of transportation costs. This occurs when there is a dif-
ference between the point of valuation for royalty calculation
purposes and the point of sale. Transportation costs from the
point of valuation to the point of sale are deducted (netted back).
The concept of a royalty should be foreign to a PSC. This is
because of the ownership issue. Many PSCs do not have a royalty.
The ones that do range as high as 15%. A PSC royalty is treated
just as it would be under a concessionary system. It is the first
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#CHAP 4 4/30/04 3:40 PM Page 54
calculation made. Payment of a royalty implies ownership on the

part of the royalty payer. But in a PSC, the contractor has no
ownership at this stage. The primary reason that this terminology
is used is because of the hierarchy of the arithmetic associated
with royalties.
In the Philippines, given sufficient level of Filipino ownership
(30% onshore or 15% in deepwater), the government pays the
contractor group 7.5% of gross revenues—right off the top. This
part of the contractor fee is equivalent to or may be viewed as a
negative royalty. It is discussed in more detail in Chapter 5.
In New Zealand a hybrid royalty scheme has been proposed.
Either a 20% Accounting Profits Royalty (APR) is levied or a 5%
Ad Valorem Royalty (AVR), whichever is higher. The AVR is simi-
lar to the basic industry royalty levied on gross revenues. The
APR, as the first part of the name implies, allows virtually all ordi-
nary accounting deductions in computing the royalty. The APR
therefore is not a typical royalty. It behaves more like tax on
income.
A specific rate royalty is a fixed amount charged per barrel or
per ton. This kind of royalty is relatively rare, but it may also go
by another name, such as “export tariff,” like that found in the
former Soviet Union (FSU). Another type of specific rate royalty
is the $1.00/bbl (900 peso) War Tax levy in Colombia. This addi-
tional levy was enacted in 1990 and is intended to cover the first
six years of production. These are even more regressive than an
ordinary royalty.
Another aspect of royalties that contributes to their lack of
popularity with industry is that they can cause production to
become uneconomic prematurely. This works to the disadvantage
of both industry and government.
The royalty scale in Illustration 4–1 ranges from zero to 20%.
Anything above 15% is getting excessive. It is inefficient and
counterproductive to have royalties too high. A 20% royalty on
$18.00 oil is $3.60/bbl. This makes a huge difference with small
54
#CHAP 4 4/30/04 3:40 PM Page 55
field developments and marginal production. A marginal field, for

example, may require up to 50% of gross revenues over the life
of the field for recovery of capital and operating costs. A 20% roy-
alty in that situation would represent 40% of profits. That is way
too much. One remedy that has become popular is to scale royal-
ties and other fiscal elements to accommodate marginal situa-
tions.
Sliding Scales
A feature found in many petroleum fiscal systems is the slid-
ing scale used for royalties, taxes, and various other items. The
most common approach is an incremental sliding scale based on
average daily production. The following example shows a sliding
scale royalty that steps up from 5% to 15% on 10,000 BOPD
tranches of production. If average daily production is 15,000
BOPD, the aggregate effective royalty paid by the contractor is
6.667% (10,000 BOPD at 5% + 5,000 BOPD at 10%).
SAMPLE SLIDING SCALE ROYALTY
Average Daily Production Royalty
First Tranche Up to 10,000 BOPD 5%

Second Tranche 10,001–20,000 BOPD 10%
Third Tranche Above–20,000 BOPD 15%
Sometimes misconceptions arise when it is assumed that once

production exceeds a particular threshold all production is subject
to the higher royalty rate. Sliding scales do not work that way
unless specified in the contract and that is very rare.
Production levels in sliding scale systems must be chosen care-
fully. If rates are too high, then the system effectively does not
have a flexible sliding scale. In some situations tranches of 50,000
BOPD can be too high, or conversely 10,000 BOPD tranches may
55
#CHAP 4 4/30/04 3:40 PM Page 56
be too low. The choice is dictated by the anticipated size of discov-

eries. For a point of reference, most fields worth developing in the
international arena will produce from 15%–25% of their reserves
in a peak year of production. Generally, the larger the field, the
lower the peak percentage rate. Therefore, a 100-MMBBL field
might be expected to produce perhaps around 15% of its reserves
or 15 MMBBLS in the peak year of production. This is an average
daily rate of 41,000 BOPD. If a region is not capable of yielding
100-MMBBL fields, then sliding scale tranches of 50,000 BOPD
are useless. There are many variations on the sliding scale theme.
Other aspects of the approach are discussed in Chapter 5.
The sequence of calculations that follows the royalty calcula-
tion always leads to the recovery of costs. Under the concession-
ary system these are called deductions. Contractual systems use a
more descriptive term called cost recovery.
COST RECOVERY
Cost recovery is the means by which the contractor recoups
costs of exploration, development, and operations out of gross
revenues. Most PSCs have a limit to the amount of revenues the
contractor may claim for cost recovery but will allow unrecovered
costs to be carried forward and recovered in succeeding years.
Cost recovery limits or cost recovery ceilings, as they are also
known, if they exist, typically range from 30%–60%.
Cost recovery is an ancient concept. Even communists are
comfortable with it. The ones who put up the capital should at
least get their investment back. Beyond that, there is wide dis-
agreement. The cost recovery mechanism is one of the most com-
mon features of a PSC. It is only slightly different than the cost
recovery techniques used in most concessionary systems.
Sometimes the hierarchy of cost recovery can make a differ-
ence in cash flow calculations. This is particularly the case if cer-
tain cost recovery items are taxable. Cost recovery or cost oil nor-
mally includes the following items listed in this order:
56
#CHAP 4 4/30/04 3:40 PM Page 57
1. Unrecovered costs carried over from previous years

2. Operating costs
3. Expensed capital costs
4. Current year DD&A
5. Interest on financing (usually with limitations)
6. Investment credit (uplift)
7. Abandonment cost recovery fund
Once the original exploration and development costs are

recovered, operating costs comprise the majority of recovered
costs. At this stage, cost recovery may range from 15%–30% of
revenues.
In most respects, cost recovery is similar to deductions in cal-
culating taxable income under a concessionary system. The profit
oil share taken by the government could be viewed as a first layer
of taxation. However, the terminology is specific and harkens
back to the ownership issue. A contractor under a PSC does not
own the production, and therefore at the point of cost recovery
has no taxable revenues against which to apply deductions. The
government reimburses the contractor for costs through the cost
recovery mechanism and then shares a portion of the remaining
production or revenues with the contractor. It is only at that point
then that taxation becomes an issue.
Exceptions
While the cost recovery treatment is common in the universe
of PSCs and service agreements, there are exceptions to every
rule. Some contracts have no limit on cost recovery. The second
generation Indonesian PSC had no such limit. From a mechanical
point of view, it was not a PSC. And there are other PSCs that
have no limit on cost recovery. Some PSCs have no cost recovery!
The 1971 and 1978 Peruvian model contracts made no
allowance for cost recovery prior to the profit oil split. The gov-
ernment simply granted the contractor a share of production
57
#CHAP 4 4/30/04 3:40 PM Page 58
which ranged from 44%–50%, depending upon the contract area.

The contractor also paid a tax on net income. This type of sharing
arrangement was also found in the 1975 Trinidadian offshore
contract with Mobil. There was no provision for cost recovery;
production was simply divided 60%/40% in favor of the govern-
ment up to 50,000 BOPD and 65%/35% from 50,000 to 100,000
BOPD. This unusual feature is viewed by some as a royalty. The
government took its share right off the top, regardless of deduc-
tions or cost recovery requirements.
Another exception is where excess cost oil goes directly to the
government. Although this feature is quite rare it is noteworthy.
This provision was proposed by Egypt during the Nile Delta licens-
ing round in 1989. It is also found in the Syrian PSC, which has a
25% cost recovery ceiling. Figure 4–2 illustrates this variation on
the cost recovery theme. The cost recovery ceiling in this example
is 40%, but the contractor recovered eligible costs out of 21% of
gross revenues in this example. The remaining 19% then went
directly to the government. It was not subject to the profit oil split.
Tangible vs. Intangible Capital Costs

Sometimes a distinction is made between depreciation of fixed
capital assets and amortization of intangible capital costs. Under
some concession agreements, intangible exploration and develop-
ment costs are not amortized. They are expensed in the year they
are incurred and treated as ordinary operating expenses. Those
rare cases where intangible capital costs are written off immedi-
ately can be an important financial incentive. Most systems will
force intangible costs to be amortized. Therefore, recovery of
these costs takes longer, with more revenues subject to taxation
in the early stages of production.
Many accounting conventions around the world make little or
no distinction between intangible capital costs and operating costs
that are expensed. The exception is with intangible exploration
and development costs prior to production. These preproduction
58
#CHAP 4 4/30/04 3:40 PM Page 59
* It is possible that this excess cost oil could be subject to a separate split
rather than going directly to the government.
Figure 4–2 Egyptian-type production sharing flow diagram
59
#CHAP 4 4/30/04 3:40 PM Page 60
costs under most systems are amortized beginning with produc-

tion startup. Depreciation rates are the other primary limitation to
the rate of recovery of capital costs. This is true for all fiscal sys-
tems that require capitalization of costs.
Interest Cost Recovery

Sometimes interest expense is allowed as a deduction. This
can include interest during construction or a rate based on cumu-
lative unrecovered capital. Under a PSC this is referred to as inter-
est cost recovery. Some systems limit the amount of interest
expense by using a theoretical capitalization structure such as a
maximum 70% debt. In Papua New Guinea, the government lim-
its the interest deduction with a capitalization restriction based on a
2/1 debt/equity ratio. Some systems will limit the interest rate
itself, regardless of the actual rate of interest incurred.
China allows recovery of a 9% annual deemed interest rate on
development costs. This rate is compounded annually and recov-
erable through cost recovery along with development costs.
This concept can take on added dimension and begin to look
like a rate-of-return feature that is being found in more and more
fiscal systems. It is discussed further in Chapter 5, which deals
with ROR contracts. It is covered further later in this chapter in
the discussion of the Indonesian PSC.
General & Administrative Costs (G&A)

Many systems allow the contractor to recover some home office
administrative and overhead expenses. Nonoperators are normally
not allowed to recover such costs. Contractors in Indonesia are lim-
ited to 2% of gross revenues for G&A cost recovery.
The 1989 Myanmar model contract had a sliding scale
allowance for G&A based on total petroleum costs each year:
For the first U.S. $5 million: 4%
For the next U.S. $3 million: 2%
For the next U.S. $4 million: 1%
Over U.S. $12 million: 0.5%
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In China an annual overhead charge is allowed for offshore

exploration at a rate of 5% on the first $5 million per year, drop-
ping down to 1% for costs above $25 million. Development over-
head charges are allowed at a rate of 2.5% on the first $5 million,
dropping down to 0.25% on costs exceeding $25 million.
Overhead for operating costs was allowed at a flat rate of 1.8%.
UNRECOVERED COSTS CARRIED FORWARD

Most unrecovered costs are carried forward and are available
for recovery in subsequent periods. The same is true of unused
deductions. The term sunk cost is applied to past costs that have
not been recovered. There are four classes of sunk cost:
• Tax Loss Carry Forward (TLCF)
• Unrecovered Depreciation Balance
• Unrecovered Amortization Balance
• Cost Recovery Carry Forward
These items are typically held in abeyance prior to the begin-

ning of production. Many PSCs do not allow preproduction costs
to begin depreciation or amortization prior to the beginning of
production, so there is no TLCF. Bonus payments, though, may
create a TLCF.
Exploration sunk costs can have a significant impact on field
development economics, and they can strongly affect the devel-
opment decision. The importance of sunk costs and development
feasibility centers on an important concept called commerciality.
This issue is discussed in detail later in this chapter.
The financial impact of a sunk cost position on the develop-
ment decision can be easily determined with discounted cash flow
analysis. The field development cash flow projection should be
run once with sunk costs and once without. The difference in
present value between the two cash flow projections is the pre-
sent value of the sunk cost position. For example, if a company
has $20 million in sunk costs and is contemplating the develop-
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Table 4-5
COST RECOVERY SPECTRUM

RANGE OF COST RECOVERY LIMITS
20% 40% 60% 80% 100%
Cruel & Low End Upper End More Rare

1 2 3 4
Unusual Typical Rare
1
No examples in this author’s experience.
2
Cost recovery limits of 40%–60% probably encompass over 75% of the fis-
cal systems that have a limit.
3
Indonesia had no limit on cost recovery for many years and now with the 20%
“First Tranche Petroleum” has the equivalent of an 80% cost recovery limit.
4
Concessionary systems usually have no limit on cost recovery.
ment of a discovery, the present value of the sunk costs could be

on the order of $10–$15 million. This would depend on whether
or not the costs could be expensed or if they must be capitalized.
It also depends on restrictions on cost recovery—primarily the
cost recovery limit.
Table 4-5 shows the range of cost recovery limits found in the
universe of PSCs.
With marginal field development a low cost recovery limit has a
big impact. For example, a cost recovery limit of 50% or less in a
marginal situation can have effectively the same impact on project
NPV and IRR as a 5–10 percentage point reduction in contractor
take. However, with large profitable fields, even the lower levels of
cost recovery are much less an issue. The problem for fiscal design
and negotiations lies in estimating the range of field sizes likely to
be found and structuring provisions that can handle them.
Abandonment Costs
The issue of ownership adds an interesting flavor to the con-
cept of abandonment liability. Under most PSCs the contractor
cedes ownership rights to the government for equipment, plat-
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forms, pipelines, and facilities upon commissioning or startup.

The government as owner is theoretically responsible for the cost
of abandonment. In fact, governments are responsible, and they
do pay for abandonment costs, but they do it indirectly. The gov-
ernment ultimately pays for abandonment just as it paid for
drilling and development. Abandonment costs are recovered
through cost recovery just as the costs of exploration, develop-
ment, and operations are. Anticipated cost of abandonment is
accumulated through a sinking fund that matures at the time of
abandonment. The costs are recovered prior to abandonment so
that funds are available when needed.
Profit Oil Split and Taxation

Profit oil is split between the contractor and the government,
according to the terms of the PSC. Sometimes it is negotiable. The
contractor’s share of profit oil is usually subject to taxation.
Published government or contractor take figures refer to the after-
tax split.
Explorers focus on geopotential and how that potential balances
with fiscal terms and the cost of doing business. When evaluating
fiscal terms the focus is on division of profits—the government/
contractor take. Figure 4–3 illustrates the effective tradeoff.
Geopotential, costs, infrastructure, political stability, and other key
factors that influence business decisions are weighed against con-
tractor take. The split in most countries ranges from just under
15% to over 55% for the contractor. Beyond these extremes are
the exceptions that are becoming more and more rare.
Governments are not totally responsible for determining the
appropriate division of profits and contract terms. Oil companies
help define what the market can bear—as shown in Illustration
4–2. This situation happens all the time.
COMMERCIALITY
An important aspect of international exploration is the issue
of commerciality. It deals with who determines whether or not a
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Figure 4–3 Creating a level playing field
discovery is economically feasible and should be developed. It is a

sensitive issue. This is because there are often situations where
accumulated exploration expenditures are so substantial that by
the time a discovery is made, these sunk costs have a huge eco-
nomic impact on the development decision. From the perspective
of the contractor, these sunk costs upon development will flow
through cost recovery (or will be used as deductions), and they
can represent considerable value. But they represent a liability, or
a cost, as far as the government is concerned. If cost recovery is
too great, then the government may end up with only a small
percentage of the gross production, depending upon the contrac-
tual/fiscal structure.
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Illustration 4–2 Realities of the marketplace
Some regimes will simply allow the contractor to decide

whether or not to commence development operations. Other sys-
tems have a commerciality requirement. This requirement essentially
places the burden of proof on the contractor as to whether or not
development of a discovery is economically beneficial for both the
contractor and the government. The benchmark for obtaining com-
mercial status for a discovery is usually a predetermined percentage
of gross take for the government. Under many commerciality claus-
es, a discovery cannot be developed unless it is granted commercial
status by the host government. The grant of commercial status
marks the end of the exploration phase and the beginning of the
development phase of a contract.
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In Colombia the commerciality issue is complicated by the

government’s, 50%-carry through the exploration and delin-
eation phase. Government participation effectively begins at the
point that commercial status is granted. If the government does
not agree that the discovery can justify development, the contrac-
tor may still go forward. In that case, the government back-in
does not take effect until the contractor recoups 200% of the
investment. Then the government backs in. Up to that point, the
government receives a 20% royalty.
The issue is particularly critical with progressive regimes
where government take is based more on profitability than gross
revenues. If a marginal field is developed under a progressive
regime then the government share of revenues could be both
small and substantially delayed. This creates an important con-
sideration that is critical in fiscal design. There is a trade-off. The
systems with significant limits on the contractor’s access to gross
revenues have little need for a commerciality requirement. But
the countries that have no cost recovery limits and low royalties
often protect themselves with a commerciality clause. The dis-
cussion of commerciality under the Indonesian PSC later in this
chapter illustrates the trade-off.
GOVERNMENT PARTICIPATION
Many systems provide an option for the national oil company
to participate in development projects. Under most government
participation arrangements, the contractor bears the cost and risk
of exploration. If there is a discovery, the government backs-in for
a percentage. In other words, the government is carried through
exploration. This is fairly common and automatically assumed
whenever some percentage of government participation is quoted.
Both the Indonesian and Malaysian PSCs have government
participation clauses, but Indonesia rarely exercises its option to
participate.
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The key aspects of government participation are:

• What percentage participation?
(Most range from 10%–51%.)
• When does the government back in?
(Usually once a discovery has been made.)
• How much participation in management?
(Large range of degree of participation.)
• What costs will the government bear?
(Usually only their prorated share of development costs.)
• How does government fund its portion of costs?
(Often out of production.)
The financial effect of a government partner is similar to that of

any working-interest partner with a few large exceptions. First, the
government is usually carried through the exploration phase and
may or may not reimburse the contractor for past exploration costs.
Second, the government’s contribution to capital and operating
costs is normally paid out of production. Finally, the government is
seldom a silent partner.
In Colombia the government has the right to take up to 50%
working interest and will reimburse the contractor up to 50% of
any successful exploratory wells. In China the government partici-
pation is 51%. This usually defines the upper limit of direct gov-
ernment involvement.
Contractors prefer no government participation. This is not
totally selfish, but stems from a desire for efficiency as well as
economy. Joint operations of any sort, especially between diverse
cultures, can have a negative impact on operational efficiency.
This is particularly true when the interests of government and an
oil company can be so polarized.
INVESTMENT CREDITS AND UPLIFTS

Some systems have incentives, such as investment credits or
uplifts. Uplifts and investment credits are two names for the same
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basic concept. An uplift allows the contractor to recover an addition-

al percentage of capital costs through cost recovery. It works the
same way in a concessionary system. For example, an uplift of 20%
on capital expenditures of $100 million would allow the contractor
to recover $120 million. Uplifts can create incentives for the indus-
try, and there are a number of different designs. Uplifts are a key
aspect of rate-of-return contracts which are discussed in Chapter 5.
DOMESTIC OBLIGATION
Many contracts have provisions that address the domestic
crude oil or natural gas requirements of the host nation. These
provisions are often referred to as the domestic supply require-
ment or domestic market obligation (DMO). Usually they specify
that a certain percentage of the contractor’s profit oil be sold to
the government. The sales price to the government is usually at a
discount to world prices. The government may also pay for the
domestic crude in local currency at a predetermined exchange
rate. Revenues from sale of domestic crude are normally taxable.
RINGFENCING
The issue of recovery or deductibility of costs is further
defined by the revenue base from which costs can be deducted.
Ordinarily all costs associated with a given block or license must
be recovered from revenues generated within that block. The
block is ringfenced. This element of a system can have a huge
impact on the recovery of costs of exploration and development.
Indonesia requires each contract to be administered by a separate
new company. This restricts consolidation and effectively erects a
ringfence around each license area.
Some countries will allow certain classes of costs associated
with a given field or license to be recovered from revenues from
another field or license. India allows exploration costs from one
area to be recovered out of revenues from another, but develop-
ment costs must be recovered from the license in which those
costs were incurred.
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From the government perspective, any consolidation or

allowance for costs to cross a ringfence means that the govern-
ment may in effect subsidize unsuccessful operations. This is not a
popular direction for governments because of the risky nature of
exploration. However, allowing exploration costs to cross the fence
can be a strong financial incentive for the industry.
The importance of risk dollars has already been demonstrated.
If a country with an effective tax burden of 50% allowed explo-
ration costs to be deducted across license boundaries, then the
industry could be drilling with 50¢ dollars. It would cut the risk in
half. From the perspective of the development engineer, this cut
would have little meaning unless development and operating
costs are also allowed to cross. Dropping or loosening the
ringfence can provide strong incentives, especially to companies
that have existing production and are paying taxes.
In the late 1980s and early 1990s, exploration in the U.K. sector
of the North Sea reached record levels. This is because the govern-
ment allowed exploration costs to cross the ringfence as deductions
against the 75% PRT tax on older fields. This created a huge explo-
ration incentive for any company paying PRT taxes. And explo-
ration drilling shot up. Companies were purchasing what came to
be known as Forties Units. These were .25% working-interest shares
in the British Petroleum-operated Forties field, which during 1992
produced more than 160,000 BOPD. Some of the larger companies
had substantial unused tax cover, and smaller companies did not
have enough. They could buy a couple of Forties Units and take
advantage of the exploration relief provided by the hole in the
ringfence. The dynamics of ringfencing can be spectacular. In 1994
the U.K. government abandoned the cross-fence PRT deduction,
and exploration dropped off dramatically.
REINVESTMENT OBLIGATIONS
Some contracts require the contractor to set aside a specified
percentage of income for further exploratory work within a license.
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In France the level of taxation was effectively reduced when

the company reinvested a certain portion of income. This
approach is not as harsh as a firm obligation. The objective, of
course, is to get companies to spend more in-country and repatri-
ate less of their profits. Reinvestment obligations or reinvestment
incentives are fairly rare.
TAX AND ROYALTY HOLIDAYS

Governments can enact legislation or issue decrees that are
designed to attract additional investment. Tax or royalty holidays
are often used for this purpose. These specify that for a given holi-
day period, royalty or taxes are not payable.
Myanmar built into their PSC for the 1989–90 licensing round
a three-year holiday on their 30% income tax. The start of the
holiday begins with the start of production. Therefore, the first
three years of production from licenses issued at that time will
not be burdened with corporate income tax.
When reviewing fiscal terms that have time limitations, the
starting point is as important as the time period. In some
instances the holiday begins on the effective date of the contract,
or on a specific calendar date. In other cases the holiday may
begin with production startup.
Holidays can make quick-look analysis a bit difficult. However,
there are some basic rules. A tax holiday has no impact if no dis-
covery is made or if there is no production. If there is production,
the effect of a holiday is twofold. A reduction in levies, taxes, or
royalties will always be beneficial to the petroleum industry, and
the holiday almost always comes at the early stage of production
when it does the most good in terms of present value.
A production profile is shown in Table 4–6. For convenience,
a 100-MMBBL field is used—the annual production, therefore, in
millions of barrels (MMBBLS) also represents the percentage of
production per year. In the first year, 16.5 MMBBLS are produced
(16.5% of the production), and production declines exponentially
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at a rate of 15% per year thereafter.

In this example, by the end of the fourth year, over 50% of
the reserves have been produced. However, in terms of present
value discounted at 15%, over 70% of the reserves have been
produced. A simple three-year holiday would cover over 60% of
the reserves in terms of present value. This production profile is
relatively conservative. Many Southeast Asia fields have produced
at much faster rates, with many producing as much as 25% of
their ultimate recoverable reserves in the first year.
THE INDONESIAN PSC

Understanding the current Indonesian PSC and how it evolved
leads to good general understanding of PSCs and the foundation of
all contractual systems. There are a number of reasons for this, the
most obvious one being that the first PSCs ever were signed there in
1966. Since then Indonesia has been one of the most active coun-
tries in Southeast Asia with nearly half of all contractors/licenses in
the region. There were over 50 operating companies in Indonesia,
and over 100 PSCs had been signed there by 1994. Because so many
companies have participated in Indonesia, it is one of the best-
known systems in the world. Most negotiators have worked their
way through more than one vintage of the Indonesian PSC. It will
continue to function as a model for all others.
The sharing of production is the heart and soul of a PSC. The
best way to evaluate a PSC is to begin with how the production is
shared. The contractor’s share is often referred to as the contractor
entitlement. The contractor entitlement in Indonesia is calculated
as follows:
Contractor
Entitlement = Cost recovery
+ Investment credit
+ Contractor equity share (profit oil)
– Domestic market requirement (adjustment)
– Government tax entitlement
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Table 4-6
Present Value Profile of

Oil Production
Mid-Year - - - - - - - Discounted - - - - - - -
Production Cumulative Discount Production Percentage
Profile Percentage Factor Profile
Year (MMBBLS) Produced 15% (MMBBLS) Annual Cumulative
1 16.5 16.5% .933 15.4 26.4% 26.4%

2 14.0 30.5 .811 11.4 19.5 45.9
3 11.9 42.4 .705 8.4 14.4 60.3
4 10.1 52.5 .613 6.2 10.6 70.9
5 8.6 61.1 .533 4.6 7.9 78.8
6 7.3 68.4 .464 3.4 5.8 84.6
7 6.2 74.6 .403 2.5 4.3 88.9
8 5.3 79.9 .351 1.9 3.2 92.1
9 4.5 84.4 .305 1.4 2.3 94.4
10 3.8 88.2 .265 1.0 1.7 96.2
11–15 11.8 100.0 .188 * 2.2 3.9 100.0
100.0 58.4 100.0%
*Aggregate discount rate for last five years of production
The basic features common to most PSCs are cost recovery,

profit oil, and taxes. The other features of the Indonesian system
are specific to Indonesia and are explained later in this chapter.
Each aspect of the Indonesian PSC is described in detail, starting
with the one aspect that is characteristic because of its absence.
Indonesia has no royalty.
NO ROYALTY
The Indonesian PSCs are characterized in part by the lack of a
royalty. However, some people refer to the first tranche petroleum
(FTP) as the equivalent of a royalty. Others view it as more of a
cost recovery limit. Both aspects of the FTP are discussed later.
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COST RECOVERY
Cost recovery limits (which to a large extent comprise the
only mechanical difference between concessionary systems and
PSCs) have changed dramatically through the years in Indonesia.
The first generation contracts of the 1960s had a 40% limit. The
second generation contracts after 1976 did away with the cost
recovery limit.
Elements that make up cost recovery are normally recovered
on a first-in, first-out basis. Any costs carried forward from prior
years are recovered first. The order is as follows:
1. Amortization of noncapital carryforward
2. Depreciation of capital carryforward
3. Unrecovered prior year costs
4. Current year noncapital costs (operating costs)
5. Current year depreciation of capital costs
6. Investment credit
FIRST TRANCHE PETROLEUM

With the fourth-generation contracts outlined in the 1988–89
incentive packages, a new contract feature was introduced. It is
called first tranche petroleum (FTP). The first tranche petroleum ele-
ment requires that 20% of production be shared
71.1538%/28.8462% in favor of the government before cost
recovery. The contractor’s share is taxed.
The FTP is viewed by some as a 14.23% royalty because that
is the government before-tax share of the 20% first tranche.
However, the contractor share of first tranche petroleum is taxed
at the effective rate of 48%. The result is that 3% of gross produc-
tion goes to the contractor and 17% goes to the government. The
remaining 80% of production is available for cost recovery. Hence
the FTP works exactly like a cost recovery limit. The strongest
argument in favor of viewing the FTP as a cost recovery limit
instead of a royalty is that it is not regressive like a royalty.
In older Indonesian PSCs, the contractors had to demonstrate
that the Indonesian government would ultimately receive a mini-
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mum of 49% of the total revenue over the life of a field in order
to be granted the commercial status required for field development.
With the arrival of the 1988–89 Indonesian contracts, this feature
of the Indonesian PSC was being simplified, and in some cases it
was eliminated altogether. Contracts signed after August 1988
included FTP which eliminated the minimum total revenue
requirement for commerciality.
INVESTMENT CREDITS AND UPLIFTS

The Indonesian contracts have allowances for investment
credits (ICs) and uplifts. The difference between the two is that
the uplift applies to all capital costs, and the IC does not. The IC
and the uplift are otherwise similar. The IC applies only to facili-
ties such as platforms, pipelines, and processing equipment. This
excludes drilling costs and completion costs.
In Indonesia the investment credit is immediately recoverable
and need not be depreciated like the costs which justified the
credit. It can also be carried forward.
Investment credits reduce the ultimate profit oil split for both
the contractor and the host government. The investment credit
benefits are also taxable. The economic impact of the 17%–20%
investment credits in Indonesia are almost negligible from the
explorationist point of view. But in the joint operating agree-
ments administered by joint operating bodies (JOA/JOB), the
uplift is 110% and can have quite an impact.
Because investment credits are taxable, the order of cost recov-
ery can be important. In Indonesia the ICs could be carried for-
ward two years, but they were last in the priority of cost recovery.
A provision was allowed to put the IC first if it appeared that its
carry-forward eligibility would expire. Furthermore, the ICs in
Indonesia had other stipulations. They were available only for oil
operations, not gas. The credits were also contingent upon
Indonesia ultimately getting a 49% share of the production from
a field.
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The investment credits and uplifts are cost recoverable but not
deductible for calculation of income tax. The opposite is true for
bonuses, which are not cost recoverable, but they are tax
deductible.
INDONESIAN DMO ADJUSTMENT

The Indonesian DMO requires the contractor to sell 25% of
the contractor’s share oil to Pertamina. The computation for the
share oil is based upon the contractor pretax profit oil share of
28.8462%. After 60 months of production from a given field, the
price the contractor receives for the DMO crude is 10% of the
realized price.
In Indonesia the DMO requirement is based upon total lift-
ings:
Total lifting × 28.8462% = Contractor share oil
Total lifting × 28.8462% × 25% = DMO (post-1984 contracts)
The obligation is referred to as the DMO adjustment. The

adjustment is based upon the quantity of DMO crude oil and the
difference between the DMO price and actual realized prices.
The DMO adjustment is based upon share oil as previously
defined where contractor profit oil is based on the government/
contractor equity split following cost recovery. Therefore, the
DMO adjustment could theoretically exceed the contractor’s share
of profit oil. However, the DMO adjustment is defined as the less-
er of the contractor profit oil or the DMO adjustment. A sample
calculation follows. Assume that during a one-year period, the
contractor produced 1 MMBBLS at $20.00/bbl in a given field
after 60 months of production:
SAMPLE INDONESIAN DMO ADJUSTMENT CALCULATION
DMO Adjust = Gross Production × Price Differential × DMO % × Share Oil %

DMO Adjust = 1 MMBLS × ($20.00 – $2.00) × 25% × 28.8462%
= $1,298,079 or 64,904 bbl
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NEW OIL VS. OLD OIL

In Indonesia, when discussing the domestic market obligation
(DMO), the terms new oil and old oil are used. The first 60 months
of production from a field is new production, and the contractor
receives market price for the DMO crude. After that the produc-
tion is referred to as old oil, and the DMO crude sells to the gov-
ernment for 10% of market price. Older contracts pegged the
DMO price at 20¢/bbl.
Some of the early PSCs in Indonesia are either expiring or
being renegotiated. With renegotiation of these earlier contracts,
some of the old fields are still receiving and will continue to
receive only 20¢/bbl for old DMO crude. But new fields discov-
ered after a certain date (depending on the contract) will receive
10% of the market price for DMO crude after 60 months of pro-
duction. Therefore, some production streams from these old con-
tract areas will consist of three classes of crude oil, each receiving
a different price:
New Old Old

Oil Oil Oil
Old Fields New Fields
DMO Crude price = Market price 20¢/bbl 10% of

Market price
Consider the 5-year holiday for the Indonesian DMO. In the

sample field profile in Table 4–6, nearly 80% of the reserves are
produced in terms of present value by the time the low-price
phase of the DMO kicks in. This is an important consideration.
The DMO can sound quite harsh, but with a 5-year holiday, it
has little meaning as far as exploration economics are con-
cerned.
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INDONESIAN CRUDE PRICES

Production is shared in kind (barrels), and it is necessary to
determine a price to convert oil to dollars in order to calculate
cost recovery, taxes, and internal transfers. Terminology and
methodology have changed over the years, but the current
method uses the Indonesian Crude Price (ICP), which has been in
effect since April 1989. The ICP is determined by the government
monthly, based on a moving average spot price of a basket of five
internationally traded crudes:
• Indonesian (Minas)
• Malaysian (Tapis)
• Australian (Gippsland)
• UAE (Dubai)
• Oman
Under the ICP formula, the price of Cinta crude for April
delivery, for example, is set at the average of the basket of crudes
during the last 15 days of March and the first 15 days of April,
plus or minus the difference between the rolling average price of
Cinta crude and the basket of crudes during the past 52 weeks.
For instance, assume that the average spot price for the basket of
crudes for the last 15 days of May and first 15 days of June is
$15/bbl. Assume too that Cinta crude during the past 52 weeks
has sold at an average price of $1.25/bbl less than the basket of
crudes. The ICP price of Cinta crude for June delivery would be
calculated as:
Basket average spot price $15.00

Average 52-week adjustment for Cinta crude –1.25
Cinta ICP for June delivery $13.75
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Tax calculations are based on ICP, and cash flow is based upon
actual realized prices. For most economic modeling, particularly
for full-cycle economics and exploration risk analysis, there is no
distinction made between estimated market prices and ICP. In the
long run, ICP and realized prices will average out any differences.
BONUSES
Bonuses are negotiated for each contract and consist of signa-
ture or signing bonuses as well as production bonuses. In the past
the Indonesian bonuses payments have been relatively modest.
Bonuses are not recoverable through cost recovery, but they are
deductible against income and withholding taxes.
EVOLUTION OF THE INDONESIAN CONTRACT

The Mining Law of 1960, Law No. 44 Concerning Oil and Gas
Mining, clarified the status of foreign oil companies as contractors.
This was founded on the 1945 Constitution Article 33, which
placed the nation’s natural wealth within the jurisdiction of the
state. This set the stage for development of the Indonesian PSC in
all its variations. Because of the importance of the Indonesian
contract its evolution is outlined here.
CONTRACTS OF WORK
The predecessors of the PSC are the early contracts of work, a
fairly outmoded term that is nearly synonymous with PSC. The
early contracts in Indonesia were referred to as such but had vir-
tually all the elements of a PSC or a risk service agreement. The
modern PSC in Indonesia is much more complex, but this is
where it began.
The cash flow projection in Table 4–7 outlines the basic ele-
ments of a fourth generation Indonesian PSC with a detailed
explanation of the calculations involved in arriving at year-by-
year cash flow.
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INDONESIAN CONTRACT EVOLUTION

1954 Original model of future contracts signed with Stanvac
1963 Contracts of work signed by Stanvac, Shell, and CalTex

• 60%/40% Split after Cost Recovery
1966 First Generation PSC—Basic PSC Signed with IIAPCO

• 40% Cost recovery limit
• 65%/35% Split inclusive of taxes in favor of government
67.5%/32.5% Above 75,000 BOPD
• 25% Domestic Market Obligation (DMO) full price for first 5
years of production, 20¢/bbl thereafter.
1976 Second Generation PSC

• 100% Cost recovery (no limit)
• 10-year amortization of noncapital costs (SLD)
• 14-year depreciation of capital costs (DDB)
• 85%/15% Split inclusive of taxes in favor of government
• 20% Investment credit
• 25% DMO 20¢/bbl after 60 months
1978 Changes: Decree 267

• Taxes became payable: Effective 56% tax
• 45% Tax on net income
• 20% Tax on distributable income after-tax (withholding)
• 85%/15% Split (Oil) determined on after-tax basis
Oil 65.9091%/34.0909% in favor of the government
• 70%/30% Split (Gas) determined on after-tax basis
Gas 31.8181%/68.1818% in favor of the contractor
1984 Third Generation PSC—New Tax Laws—Decree 458

• 17% Investment Credit
• Effective 48% tax
• 35% Tax on net income
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• 20% Tax on distributable income after-tax (withholding)

• Depreciation: Oil 7-year DDB (switching to SLD in year 5)
Gas 14-yr DDB (switching to SLD)
• 85%/15% Equity split (Oil)
Oil 71.1538%/28.8462% in favor of the government
• 70%/30%–65%/35% Equity split (Gas)
Gas 57.6923%–67.3077% Contractor pretax share
1988–1989 Changes—Fourth Generation PSC—Incentive

Packages
• First Tranche Petroleum 20%
• Depreciation: Oil, 5-year DB; Gas, 8-year DB
• Commerciality requirement excluded
• 17% Investment credit
• DMO priced at 10% of export price
• Equity split in frontier areas 80%/20% up to 50,000 BOPD
also for marginal fields with less than 10,000 BOPD
• Deepwater investment uplift 110% for Oil, 55% for Gas
1994 Eastern Frontier Incentive Package

• Equity split in Eastern Indonesia 65%/35%
JOINT OPERATING AGREEMENTS/JOINT OPERATING

BODY (JOA/JOB)
In the 1970s Pertamina introduced a joint venture arrange-
ment where the contractor participates as a 50%/50% partner
with the government in areas previously under Pertamina’s con-
trol. The first such contract was signed in 1977, and many have
been signed since then. Typically the contractor matches previous
expenditures for the area or funds 100% of future operations for
a given period such as two to three years, whichever is greater.
After that, the contractor and Pertamina split exploration, devel-
opment, and operating costs 50%/50%. Oil production is also
shared on a 50%/50% basis. The contractor’s 50% share of the
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Table 4–7
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production then is subject to the standard PSC terms, i.e., the

85%/15% split, and the FTP, DMO, ICs, etc. Some people view
this as an effective 92.5%/7.5% split, but this is a rather extreme
view that ignores the government sharing of costs.
Pertamina has the option of paying its share of costs or having
the contractor pay on Pertamina’s behalf. If Pertamina elects to
have the contractor pay its share of costs, these costs are subject
to a 50% uplift that flows to the contractor through cost recovery.
The JOA type of joint venture is administered by a Joint
Operating Body (JOB) comprised of three representatives each
from the contractor and Pertamina.
SENSITIVITY ANALYSIS OF THE

INDONESIAN PSC
The complexity of the Indonesian PSC provides a good exam-
ple for evaluating the economic sensitivity of various contract ele-
ments. Cash flow analysis was performed on a 50-MMBBL field
development scenario. The basic assumptions are outlined in
Table 4–8.
In order to gauge the effect of the DMO and the investment
credit, hypothetical scenarios were developed. Three cash flow
projections excluded the DMO and the IC. These scenarios yield-
ed pure splits between the government and the contractor of
84%/16%, 85%/15%, and 87%/13% respectively. The resulting
present values from the cash flow projections provided the basis
of comparison. This is shown in Table 4–9.
The project present value of the standard Indonesian contract
terms (which included the DMO and the IC) fell about halfway
between the results of the pure 85%/15% split and the 87%/13%
split. The present value of the standard contract terms discounted
at 15% is $26.9 million. The pure 85%/15% split had a present
value of $30.2 million. The effect of the DMO alone pulled the
effective split down to an equivalent 86.4%/13.6% split. This is
shown in Figure 4–4.
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Figure 4-4 Indonesian contract sensitivity analysis
The DMO is nearly invisible from the exploration perspective.

Because of the present value effect the DMO also has little influ-
ence on development feasibility economics. However, after five
years of production, the DMO exerts a stronger influence. Under
similar analysis on old oil, the effective split comes closer to an
89%/11% split in favor of the government. This highlights the
different perspectives of development feasibility and production
economics.
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Table 4-8
Indonesian PSC Sensitivity Analysis

Model Input Parameters
INPUT
Field size 50/MMBBLS
Peak production rate 19,000 BOPD

Lambda 14%
(% of reserves produced in peak year)
Decline rate 12%
Field life 15+ Years
Initial oil price $18.00/bbl

4% Escalation
Development capital costs $108 MM *

$2.15/bbl
Operating costs
Fixed $6 million/year
Variable $1/bbl
Total First year $1.85/bbl
RESULTS based upon standard contract terms
Net present value (15% DCF) $27 million

$0.52/bbl
Internal rate of return 28%
Return on investment 152%
Payout 5 Years
*50% of capital costs are assumed to be eligible for the 17% investment
credit.
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Table 4-9
Indonesian PSC Sensitivity

Analysis Results
Equivalent
Contractor
NPV After-tax
15% Take
($M) (%)
Pure 84/16 Split 33,543 16.0% Pure Split

Contractor 30.7692%*
No DMO
No investment credit
Investment Credit Only 32,900 15.3% Effective

17% investment credit
No DMO

No DMO
STANDARD CONTRACT 26,996 14.0% Effective

DMO = 10% of wellhead price
17% investment credit
DMO Only 25,492 13.6% Effective

10% of wellhead price

Nonstandard terms
Contractor 25.00%*
No DMO
Indonesian effective tax rate of 48% assumed in all cases.

* Contractor pre-tax profit oil share
85
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#CHAP 5 4/30/04 3:52 PM Page 87
RISK SERVICE CONTRACTS
5
RISK SERVICE
CONTRACTS
S ervice contracts are based on a simple formula: The

contractor provides all capital associated with exploration and
development of petroleum resources. In return, if exploration
efforts are successful, the government allows the contractor to
recover those costs through sale of the oil or gas and pays the
contractor a fee based on a percentage of the remaining revenues.
This fee is often subject to taxes. All production belongs to the
government. The net importing countries are the ones most likely
to use this approach. They need the crude. By 1994 service agree-
ments were being used in Argentina, Brazil, Chile, Ecuador, Peru,
Venezuela, and the Philippines. In Peru either the service contract
or a concession could be used.
When the term service contract is used it is normally understood
to be a risk service contract. The term risk contract is also used. The
term risk service is widely accepted but rather inappropriate. The oil
service industry would hardly recognize the service contracts found
in the upstream end of the business. To refer to an exploration
agreement where the oil company puts up all the capital and risks
87
#CHAP 5 4/30/04 3:52 PM Page 88
loosing it all as a service agreement is an obvious misnomer. But

this is what it is called. The added term risk is clearly an improve-
ment. Because the contractor does not get a share of production,
such terms as production sharing and profit oil are not appropriate
even though the arithmetic will often carve out a share of revenues
in the same fashion that a PSC shares production.
The distinction between PSCs and risk service contracts is
minute. The nature of the payment for the contractor’s services is
the point of distinction. Other than that, the arithmetic and ter-
minology are quite similar. This is why many service agreements
are commonly referred to as PSCs. The Philippine risk service
contract is a perfect example. It is often referred to as a PSC even
by the government. There is, however, a feature found in the
Philippine system that makes it unique. The service contracts of
the Philippines and Ecuador are examined here.
PHILIPPINE RISK
SERVICE CONTRACT
The language of the Philippine contract is identical to that of
most PSCs with the exception of the Filipino Participation Incentive
Allowance (FPIA). The FPIA is part of the service fee, and it is based
on gross revenues just like a royalty except that it goes to the con-
tractor group. The FPIA, based on a sliding scale, can get as high as
7.5% if Filipino participation is 30% or more onshore. Offshore,
15% Filipino participation will qualify for the FPIA.
Filipino Participation (%) FPIA, %
Up to 15% 0
15–17.5 1.5
17.5–20 2.5
20–22.5 3.5
22.5–25 4.5
25–27.5 5.5
27.5–30 6.5
30 or more 7.5
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The Philippine contract has a 70% cost recovery limit, and

profit sharing is 60%/40% in favor of the government. The con-
tractor 40% share of profits is not subject to taxation. The con-
tractor’s taxes are paid out of the government share of profit oil.
Calculation of the contractor entitlement under the Philippine
contract is based on the following assumptions:
Gross revenues = $100 million

Assume Contractor Group eligible for full 7.5% FPIA
Costs eligible for cost recovery =
$50 million – high cost case
$20 million – low cost case
CONTRACTOR ENTITLEMENT
Low Cost High Cost
Case Case
$100.0 MM $100.0 MM Gross revenues
–7.5 –7.5 FPIA service fee
92.5 92.5 Net revenues1
–20.0 –50.0 Costs recovery
72.5 42.5 Revenues available for sharing
–43.5 –25.5 Government 60% share
29.0 17.0 Contractor 40% share
+7.5 +7.5 FPIA
$36.5 $24.5 Total contractor service fee
+20.0 +50.0 Costs recovery
$56.5 MM $74.5 MM Total contractor entitlement
45.6% 49.0% Contractor take 2
1
The term net revenues is used loosely here.
2
Total Contractor Service Fee ÷ (Gross Revenues – Cost Recovery)
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The government entitlement in the low cost case came to only

$43.5 million, or 43.5% of revenues. The contractor’s share of
gross revenues was $56.5 million. The revenues available for
sharing (including the FPIA) came to $80 million ($100 MM –
$20 MM cost recovery). Of this, the contractor share came to
$36.5 million. The contractor take, therefore, is 45.6% ($36.5
MM/$80 MM).
The contractor take increased from 45.6% to 49% with the
higher cost case. There are few systems that behave like this.
Because of the way the service fee is calculated, the system is one
of the most progressive in the world. This is because the FPIA is
based on gross revenues—it behaves like a negative royalty.
ECUADOR RISK
SERVICE CONTRACT
Ecuador uses an R factor calculation for its service contract.
The contractor’s entitlement is based on costs recovery and a ser-
vice fee that is taxed at a rate of 40%. Part of the fee calculation is
based on a formula consisting of a sliding scale R factor. An
unusual aspect of the Ecuador service fee is that it is calculated
before the normal cost recovery arithmetic found in most PSCs
and service agreements. It is not as progressive as the Philippine
FPIA, but it is a step in the same direction. The formula for the
service fee is as follows:
SERVICE FEE FORMULA:

TS = PR(INA) + R(P – C)Q
where:
TS = Annual Service Fee payment in U.S. dollars.
PR = Average Prime Rate (decimal fraction)
INA = Development and Production Costs less reimbursements
P = Average International Crude Price ($/bbl)
C = Production Costs ($/bbl)
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Q = Annual Production (MMBBLS)

For R Factor Calculation (BOPD)
R = Average Profit Factor (decimal fraction)
= (R1(Q1) + R2(Q2))/(Q1+Q2), etc.
R is based upon the following incremental sliding scale:
Example
Production Rate (Q) R Factor
Up to – 10,000 BOPD .30 R1 *

10,001 – 30,000 BOPD .25 R2
30,000 – 50,000 BOPD .23 R3
50,000 – 70,000 BOPD .20 R4
70,000 + .18 R5
* The R factor for the first tranche of production ranges from

.25–.35 and steps down in increments of .02–.05 depending on
the contract.
A sample calculation of contractor entitlement is shown next.

It starts with the contractor service fee calculation. The assump-
tions are outlined as follows:
TS = PR(INA) + R(P – C)Q
where:
PR = 10% (.10)
INA = $25 million (assumed)
Q = 6 MMBBLS (assumed) = average 16,438 BOPD
R = (.30 × 10,000 + .25 × 6,438)/16,438 = .2804
P = $16.00/bbl (assumed)
C = $10 MM (assumed) = $1.67/bbl
TS = .10 × $25 MM + .2804($16.00 – $1.667) × 6MM

= $2.5 MM + $24.114 MM
= $26.61 MM
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The contractor entitlement is based upon the after-tax service

fee and cost recovery. The step-by-step calculation of the entitle-
ment is shown as follows:
CONTRACTOR ENTITLEMENT
$26.61 MM Service fee

–2.50 Incentive deduction (PR × INA)
$24.11 MM Taxable income

-9.64 Income tax (40%)
+2.50 (PR × INA)
$16.97 MM Service fee after-tax

+20.00 Assumed cost recovery
$36.97 MM Total contractor entitlement
Gross revenues, by the way, were $96 million. The revenues

available for sharing came to $76 million ($96 MM – $20 MM cost
recovery). Of this, the contractor’s share came to $16.97 million,
and contractor take therefore is 22.3% ($16.97 MM/$76 MM).
Because of the way the service fee is calculated, the system is
fairly progressive. Had the capital costs been higher, the contractor
take would also have been higher. This is because of the hierarchy of
the calculation and the nontaxable element of the service fee based
upon PR × INA. The sliding scale R factor is modestly progressive, but
the way the service fee is calculated, the government share flexes
upward and downward to accommodate variations in profitability.
RATE OF RETURN CONTRACTS

Contracts with flexible terms are becoming standard. There are
many advantages for both the host government and the contrac-
tor with contracts that encompass a range of economic conditions.
This is the acid test.
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Table 5-1
Flexible Contract Terms and Conditions

Contract Terms Factors and Conditions
Subject to Sliding Scales That Trigger Sliding Scales
■ Profit Oil Split ■ Production Rates

■ Royalty ▲ Water Depth
■ Bonuses ▲ Cumulative Production
▲ Cost Recovery Limits ▲ Oil Prices
▲ Tax Rates ▲ Age or Depth of Reservoirs
◆ Uplifts ▲ Onshore vs. Offshore
▲ R Factors*
▲ Remote Locations
◆ Oil vs. Gas
◆ Crude Quality (Gravity)
◆ Time Period (History)
◆ Distance from shore
◆ Rate of Return*
■ Most Common *Rate of Return Contracts

▲ Less Common
◆ Rare
The most common method used for creating a flexible system

is with sliding scale terms. Most sliding-scale systems trigger on pro-
duction rates. As production rates increase, government take, in
one fashion or another, increases. This theoretically allows equi-
table terms for development of both large and small fields.
Contracts may subject a number of terms to sliding scales.
Some contracts will provide flexibility through a progressive
tax rate. Others will tie more than one variable to a sliding scale
such as cost recovery, profit oil split, and royalty. Table 5–1 shows
the diversity of contract elements that are subject to sliding scales
and the factors that trigger a change.
There are many sliding scales. One of the more unusual is the
Guatemala contract of the late 1980s with a sliding scale royalty
based on variations in crude quality. The royalty rate increases or
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Figure 5–1 Government take vs project profitability
decreases one percentage point every degree above or below 30º

API crude gravity.
The objective with sliding-scale systems is to create an envi-
ronment where the government take flexes upward with
increased profitability. The result of most fiscal structures though
is that project profitability is a function of government take. As a
rule, it is better for both parties when government take is a func-
tion of profitability. Figure 5–1 illustrates this aspect of flexibility,
showing how government take increases as project profitability
increases with a flexible rate of return (ROR) system. This is the
objective of sliding scales as well as ROR systems. Inflexible sys-
tems with high royalty rates can work in just the opposite way. A
stiff nonnegotiable royalty is the antithesis of flexibility. Even a
progressive sliding-scale royalty scheme can be regressive. Just
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Government Allowed 22,5%

Riskfree Carry
-
-
-
U.S. AAA Bond + 5%
Contractor Share After Tax
* The BPT is creditable against U.S. income tax. APT is not creditable but is deductible.
Figure 5–2 Papua New Guinea regime
because the royalty rate becomes progressively larger with some

pseudomeasure of profitability, such as production rates, royalties
are so strongly regressive that with most marginal discoveries,
government take is invariably higher. There are many systems
that exhibit this characteristic of reverse flexibility.
Some countries have developed progressive taxes or sharing
arrangements based on project rate of return (ROR). The effective
95
#CHAP 5
96
Table 5-2
4/30/04
Sample Rate of Return Contract Cash Flow Projection

Basic Net Amount Amount Resource Net
3:52 PM
OIL OIL Gross Tangible Operating Taxable Income Cash Brought Carried Additional Rent Cash
Production Price Revenues Cap Ex Expense DD&A Deductions Income Tax Receipts Forward Forward Profits Tax Flow
Year (MBBLS) ($/bbl) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M) ($M)
(A) (B) (C) (D) (E) (F) (G) (H) (I) (J) (K) (L) (M) (N) (O)
1994 0 $20.00 0 20,000 0 0 0 0 0 (20,000) (20,000) 0 0 (20,000)

Page 96
1995 0 20.00 0 8,000 0 0 0 0 0 (8,000) (26,000) (34,000) 0 0 (8,000)

1996 0 20.00 0 50,000 0 0 0 0 0 (50,000) (44,000) (94,200) 0 0 (50,000)
1997 4,500 20.00 90,000 25,000 11,500 20,600 32,100 57,900 20,265 33,235 (122,460) (89,225) 0 0 33,235
1998 7,000 20.00 140,000 0 14,000 20,600 34,600 105,400 36,890 89,110 (115,992) (26,882) 0 0 89,110
1999 5,600 20.00 112,000 0 12,600 20,600 33,200 78,800 27,580 71,820 (34,947) 0 36,873 18,436 53,384
2000 4,760 20.00 95,200 0 11,760 20,600 32,360 62,840 21,994 61,446 0 0 61,446 30,723 30,723
2001 4,046 20.00 80,920 0 11,046 20,600 31,646 49,274 17,246 52,628 0 0 52,628 26,314 26,314
2002 3,439 20.00 68,782 0 10,439 0 10,439 58,343 20,420 37,923 0 0 37,923 18,961 18,961
2003 2,923 20.00 58,465 0 9,923 0 9,923 48,541 16,990 31,552 0 0 31,552 15,776 15,776
2004 2,485 20.00 49,695 0 9,485 0 9,485 40,210 14,074 26,137 0 0 26,137 13,068 13,068
2005 2,087 20.00 41,744 0 9,087 0 9,087 32,657 11,430 21,227 0 0 21,227 10,613 10,613
2006 1,732 20.00 34,647 0 8,732 0 8,732 25,915 9,070 16,845 0 0 16,845 8,422 8,422
2007 1,427 20.00 28,411 0 8,421 0 8,421 19,990 6,997 12,994 0 0 12,994 6,497 6,497
2008 0 20.00 0 0 0 0 0 0 0 0 0 0 0 0 0
40,000 799,864 103,000 116,993 103,000 219,993 579,870 202,955 376,916 297,624 148,812 228,104
(A) Production Profile (I) Basic Income Tax = 35%

(B) Crude Price (J) Net Cash Receipts = (C) – (D) – (E) – (I)
(C) Gross Revenues = (A) x (B) (No royalty in this example) (K) Amount Brought Forward = (L from previous year) x 1.3 [Amount Carried Forward
(D) Tangible Capital Costs [Capitalized — see Column (F)] uplifted by 30%—This is the ROR aspect]
(E) Operating Expenses (Expensed) (L) Amount Carried Forward = (J) + (K) if the balance is still negative
(F) Depreciation of Tangible Capital Costs: 5-Year Straight Line Decline (M) Additional Profits = (J) + (K) if the balance is positive
(G) Deductions = (E) + (F): Up to maximum of Net Revenue (N) Resource Rent Tax = (M) x .5
(However, this example assumes no royalty) (O) Contractor After-tax Net Cash Flow = (C) – (D) – (E) – (I) – (N)
(H) Taxable Income for Basic Income Tax = (C) – (G)
#CHAP 5 4/30/04 3:52 PM Page 97
government take increases as the project ROR increases. In order

to be truly progressive, the sliding-scale taxes and other attempts
at flexibility should be based on profitability, not production rates.
Most contracts have progressive elements, but they are usually
based on levels of production instead of a direct measure of prof-
itability. Production levels are a proxy for profitability, but that is
all. There are many other factors that influence project profitabili-
ty, which is why ROR contracts are structured the way they are.
ROR systems take into account product prices, costs, timing, and
production rates. All of these factors influence project profitability.
The ROR approach is characterized by a modest royalty and
tax. The state receives no other funds until the oil company has
recovered the initial financial investment plus a predetermined
threshold rate of return. Theoretically, this rate of return would
represent a minimum rate to encourage investment. The govern-
ment share is calculated by accumulating the negative net cash
flows and compounding them at the threshold rate until the
cumulative value becomes positive. When that happens, addition-
al taxes are levied, but the contractor still receives some of the
profits in excess of the threshold rate of return. These additional
taxes are often referred to as resource rent taxes (RRT).
THE PAPUA NEW GUINEA ROR SYSTEM

The PNG system is typical of the classic ROR formula. Under
this system the government receives a 1.25% royalty and a
22.5% carried interest (carried through exploration). A basic
petroleum tax (BPT) of 50% is levied only if the contractor’s
income meets or exceeds 25% of the initial investment.
There is an additional tax levied if the contractor’s rate of
return exceeds 27%. This is done by compounding the negative
net cash flows at a rate of 27%. Once the cumulative net uplifted
cash flow becomes positive the additional 50% resource rent tax
kicks in. It is called the Additional Profits Tax (APT). This is the
hallmark of a ROR system. It is also called a trigger tax. Reaching a
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minimum rate of return triggers the tax. The basic structure of the
PNG contract is illustrated in Figure 5–2.
Calculation of cash flow from a simple ROR contract is shown
in Table 5–2. It outlines the basic ROR system elements with a
detailed explanation of the calculations involved in arriving at
year-by-year cash flow. In this example, there is no royalty, and
the basic income tax is 35%. A 30% uplift is applied on the accu-
mulated negative net cash flows. Once the cumulative balance of
net cash flow becomes positive, an additional 50% resource rent
tax is imposed.
Critics of the ROR concept complain that these contracts are
too restrictive, that the uplift (rate-of-return) places an unreason-
ably low ceiling on upside potential.
The resource rent tax concept was first employed in Papua
New Guinea (PNG). Other countries that use this kind of tax are
Australia, Liberia, Equatorial Guinea, and Tanzania.
The treatment of interest cost recovery is close to the ROR
concept. Interest cost recovery features found in some PSCs or
concessionary systems normally apply a compound interest rate
to unrecovered capital costs. In many ways this builds in an ele-
ment of guaranteed return on invested capital. The similarity ends
there because there is not an additional tax once the uplifted cost
pool has been recovered.
TUNISIAN CONTRACT WITH R FACTOR

Some contracts use what is called an R factor. The most com-
mon use of such a factor is found in the Tunisian and Peruvian
contracts. In these contracts the definitions are virtually identical:
R factor = Accrued Net Earnings/Accrued Total Expenditures. In
Tunisia oil and gas royalties, taxes, and government participation
are all based upon the R factor.
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TUNISIAN R FACTOR
X
R = –––––
Y
where:
X= Cumulative net revenue actually received by the
contractor equals turnover (gross revenues)
for all tax years less taxes paid
Y= Total cumulative expenditure, exploration, and appraisal

expenses and operating costs actually incurred by
contractor from date contract is signed
Example: Tunisian R Factor/Sliding Scale Taxation
Income Tax
R Factor Rate, %
< 1.5 50%

1.5–2.0 55
2.0–2.5 60
2.5–3.0 65
3.0–3.5 70
3.5 + 75
In this contract the R factor is based on a return on invest-

ment (ROI). Once the contractor has received his costs plus 50%,
or a ROI of 150%, the tax rate increases from 50% to 55%. In
some respects it is similar to a rate-of-return contract. The typical
rate of return contracts trigger on internal rate of return (IRR).
These concepts are discussed later.
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COLOMBIAN R FACTOR
In 1994 the Colombian government introduced yet another
variation on the R factor theme. The formula started out relative-
ly similar to other such factors with one twist. The definition of
the Colombian R is as follows:
COLOMBIAN R FACTOR
X
R = ––––––––––––––––––––––––––
(ID + A – B + (α × C) + GO)
where:
X = Accumulated earnings of the contractor
(ID + A – B + (α × C) + GO) = Accumulated Investment

+ Accumulated Costs of the contractor
ID = 50% of cumulative gross development costs
A = Cumulative gross successful exploration costs
B = Cumulative successful exploration costs

reimbursed by ECOPETROL (50% partner)
C = Cumulative gross unsuccessful exploration costs
α = Proportion of dry-hole costs reimbursed by

ECOPETROL—a bid item, maximum 50%
GO = Contractor cumulative net operating costs

including War Tax payments and duties on imports
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Figure 5–3 R factor system sensitivity analysis
Colombian Sliding Scale R Factor

Contractor
Percentage
R Factor Participation
< 1.0 50%

1.0–2.0 50/R
2.0 + 25
The contractor share is 50% after royalties until payout is

achieved. If R = 1.5, the contractor share equals 33.33% and
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continues to step down until it reaches 25%, when two times

payout is achieved.
Figure 5–3 illustrates the effect an R factor can have on project
economics. The results on contractor project IRR are shown as
costs and oil prices vary. Costs and prices are the most sensitive
factors in project economics. They have the largest impact, and
with an R factor, both are accounted for simultaneously. The R
factor deals with all variables that affect project economics. The
sensitivity is shown by the slope of the lines. The R factor has a
dampening effect. Contractor potential upside from price increas-
es is diminished, but the downside is also protected. It is the same
with costs. If costs are relatively higher, the R factor mitigates the
negative impact. If costs are lower both the contractor and gov-
ernment benefit.
Some governments have devised unique and complex fiscal
elements as seen in some of these sample risk service agreements
and Illustration 5–1.
JOINT VENTURES
Joint ventures are common in the international oil industry.
Most companies are willing to take on partners for large-scale or
high-risk ventures in order to diversify—this is good risk manage-
ment. These joint operations between industry partners differ from
the government-contractor relationships that are also joint ven-
tures but are normally referred to as government participation.
Some of the proposed Russian joint ventures are characterized
by a 100% carry for the production association partner through
development including operating costs. This is an extreme exam-
ple of government participation. However, most of the Russian
JVs deal with proved, well-delineated reservoirs. The exploration
risk aspect is greatly diminished.
The opening up of the former Soviet Union and other countries
dominated by centrally planned economies has added dimension to
the joint-venture concept. These countries, particularly republics of
the former Soviet Union and Eastern Europe, prefer joint ventures
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Illustration 5–1 fiscal creativity
because they have personnel and organizations in place that need

to be integrated into future operations. Many areas with petroleum
potential in these countries already have petroleum operations
with equipment, infrastructure, and personnel.
Figure 5–4 illustrates the general nature of a contractor/gov-
ernment joint venture. Here the government (through the nation-
al oil company) is a 30% working-interest partner. The proceeds in
this example are subject to the terms of a PSC with a 60%/40%
profit oil split in favor of the contractor group. However, the con-
tractor group includes the government as partner. Both partners
receive their prorated share of cost oil. Profit oil is split according
to the working interest shares. This example shows the profit oil
split according to the PSC and the additional split dictated by the
joint venture arrangement. This is why many people treat govern-
ment participation as though it were an added layer of taxation.
However, when the government backs in after discovery, it is
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Government
Foreign Oil National
Company Oil Company
Exploration
Capital and License
Technology Area
70% of 30% of
Development Development
Capital Capital
70%/30%
Joint Venture
Company
Gross Revenues
– Royalty
– Cost Recovery Prorated
Profit Oil
Split According 40%
to the PSC
60%
Remaining
Profit Oil 30%
According to WI%
70%
– Taxes
Contractor Net
Profit Oil After Tax
Figure 5–4 Joint venture, PSC
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effectively cashing in on the value added at that point. That ele-

ment of government take occurs long before production begins.
In a pure joint venture, the host government and the contrac-
tor share equally in costs and risks. This would have little practical
application. However, there is a broad range from pure joint ven-
tures to some of the least pure joint enterprises found in the former
Soviet Union. The key ingredient is the amount of carry.
Under most oil company/government joint ventures the oil
company bears the costs and risks of exploration. In other words,
the government is carried through exploration. This is fairly nor-
mal and is automatically assumed whenever some percentage of
government participation is quoted.
JOINT VENTURE/GOVERNMENT PARTICIPATION SPECTRUM
–– Pure Joint Venture

Light All costs/risks shared
Very rare
–– Mauritania Type Participation
Government carried through exploration
Contractor recovers exploration costs
plus 50% uplift on government share
–– Typical Joint Venture
BURDEN
Most common
Contractor can recover exploration costs
–– Colombian Type Joint Venture
and delineation
–– Full Carry
and development
Not common
Heavy –– Russian Type of Joint Venture
Government carried through rehabilitation
and development, until it has cash flow
from operations
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National Government
Foreign Oil Represented by
Company or Local Production
Consortium Association
Capital & Proved &

Technology Probable
50%/50% Reserves,
Joint Venture Equipment,
Company and
Personnel
Gross Revenues
– Direct Taxes and Costs

(a) Export Tariff ($30–$40/ton)
(b) Royalty (8%)
(c) Replacement of Minerals Payment (10%)
(d) Pipeline Tariffs ($10–$20/ton)
(e) Value Added Taxes
(f) Road Use Tax (0.4%)
(g) Excise Tax (18%)
(h) Mandatory (Currency) Conversion
(i) Local Taxes
(j) Social Obligations
= Net Proceeds from Export
– Operating Expenses and G&A
= Taxable Income
– Capital Expenditure Deduction (DD&A)
(Limited to 50% of taxable income—Russia only)
= Profits Tax Base
– 32% Profits Tax (20%–40% in various republics)
= Net Income
Net Income 10%–30% BPO

50% APO
70%–90% BPO BPO = Before payout

50% APO APO = After payout
+ Capital Expenditure Deduction

= Contractor After-tax Cash Flow
Figure 5–5 “Typical” joint venture in Russia
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Where the government actually pays its share of costs, the

government share of profits is not the same as a tax on income.
When government is carried through exploration and backs in
after discovery, the impact of government participation behaves
like a capital gains tax. In extreme cases (like Russia) where the
contractor pays all rehabilitation, development, and operating
costs, the government share of joint-venture profits behaves like
an added layer of taxation. At any rate, all forms of government
participation reduce the potential rewards of exploration. This
must be factored into the risk equation.
Direct reimbursement vs. cost recovery is a present value
issue. The contractor invariably recovers costs of exploration and
development either through cost recovery, deductions, or direct
reimbursement. The difference is timing.
Figure 5–5 outlines a sample Russian joint venture, if there is
such a thing. With the proliferation of negotiated deals, it is
extremely hard to characterize them all with one example.
However, this particular structure has many of the basic elements.
A 50%/50% joint venture has strong appeal to the Russians.
Figure 5–5 outlines a fairly harsh fiscal system. It is probably too
harsh to survive, but this is the often-proposed basis for initial
negotiations. Many elements are based on gross revenues and act
like royalties regardless of what they are called. Net income is
divided between JV partners 90%/10% to 70%/30% in favor of
the foreign oil company before payout (BPO) and 50%/50% after
payout (APO). Often profits are reinvested BPO. The government
share is viewed by many as just another layer of taxation, and a
large one at that. The contractor take ranges from 10%–20%.
TECHNICAL ASSISTANCE
CONTRACTS (TACS)
TACs are often referred to as rehabilitation, redevelopment,
or enhanced oil recovery projects. They are associated with
existing fields of production and sometimes, but to a lesser
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extent, abandoned fields. The contractor takes over operations

including equipment and personnel if applicable. The assistance
that includes capital provided by the contractor is principally
based on special technical know-how such as steam or water
flood expertise.
Many smaller companies are finding their niche by targeting
these projects. They provide lower-risk situations with opportuni-
ties for a company to leverage technical expertise. Despite the
reduced risks, EOR projects require careful screening. Some coun-
tries have fields and basins that are nearly as depleted as those
found in the United States. Few rehabilitation/EOR projects
beyond the primary recovery stage will be viable. Added potential
such as infill drilling or undrilled deeper horizons often provides
the primary financial incentive. Cost and timing estimates are
critical, and fiscal terms are critical.
Indonesia has special terms for marginal fields (those with pro-
duction of less than 10,000 BOPD of production). A 10,000-BOPD
field could have 15–25 MMBBLS of oil.
Many countries try to tighten the fiscal terms on EOR projects
because of the reduced risk. This can be seen in the various con-
tracts offered in Myanmar (Appendix A), where the proposed
profit oil split for exploration blocks is 65%/35% in favor of the
government, while the proposed split is 70%/30% for improved
oil recovery (IOR/EOR) blocks. Unfortunately, most companies do
not agree that EOR projects can sustain tougher fiscal terms.
If fiscal terms are out of balance, no amount of technical
expertise will salvage a project. As a rule, it takes a minimum of
10–30 MMBBLS of recoverable reserves to justify the costs of an
international development project—usually more for EOR. And,
if the project is an EOR project that requires substantial pressure
makeup, then the fiscal terms need to be flexible.
Development threshold field size for EOR is generally about
twice what it would be for primary production. An EOR project in
Western Siberia may well require 150 MMBBLS or more of
recoverable reserves to create sufficient economy of scale.
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If there is existing production, then a decline rate, or production

profile, is negotiated. The production defined by the negotiated
decline rate is exempt from the sharing arrangement. This produc-
tion goes directly to the government. Production above the negotiat-
ed rate is incremental production, which theoretically is the result of
the technical assistance provided by the contractor. The concept is
illustrated in Figure 5–6. This incremental production is normally
subject to a production sharing arrangement, although TACs can be
found under a variety of systems.
Key elements of these arrangements:
• Government need for technology and capital
• Associated personnel
• Existing proved reserves
• Existing infrastructure, and equipment
• Joint management
Rehabilitation projects are often structured in three phases that
follow a logical sequence. Each phase carries a specific work program,
and the contractor has the option to proceed into each subsequent
phase. The decision to go forward is based on the technical results of
each previous phase. A three-phase TAC is outlined as follows:
THREE-PHASE TECHNICAL ASSISTANCE

CONTRACT OUTLINE
PHASE ONE: FEASIBILITY STUDY

• Bonus
• Minimum work commitment
• 6 months to 1 year
At end of the feasibility study, the contractor has the option of

surrendering the acreage and dropping out if the work commit-
ment has been fulfilled. Or the contractor may choose to go for-
ward into Phase Two. The government is given the results of the
feasibility study and presented with a work program outline and a
budget for the next phase.
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Figure 5–6 Technical Assistance/EOR Contracts
PHASE TWO: PILOT PROGRAM

• Bonus
• Minimum work program
• 2–3 years
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The pilot program will consist of a small-scale water or steam

injection test to determine if the reservoir will take injected fluids at
sufficient rates. During the injection the contractor will monitor the
reservoir response. At the conclusion of the pilot program, if the
work program is fulfilled, the contractor has the option of relin-
quishing all rights or entering Phase Three, the commercial develop-
ment phase. The government is given the results of the second
phase pilot program and presented with budget for the next phase.
PHASE THREE: COMMERCIAL DEVELOPMENT

• Bonus
• Workovers
• Drilling
• Implement full-scale EOR
If the contractor enters into the commercial development

stage of the contract, production will be shared through a PSC
governed by a royalty/tax system or divided according to a specif-
ic joint-venture arrangement.
HALLWOOD CASPIAN
In April 1994, Hallwood Energy Partners announced by news
release it had entered an EOR joint-venture agreement with the
State Oil Company of the Azerbaijan Republic (SOCAR) for the
Marshall Field located in the Caspian Sea. Discovered in 1954, the
field had already produced over 50 MMBBLS of oil. Production at
the time the contract was signed was 1,750 BOPD. The terms of
the deal disclosed by Hallwood indicated that Hallwood and
SOCAR would recover their costs proportionally from 70% of net
revenues from production above 2,700 BOPD. During the first
phase of the joint venture, profit would be divided 60% to
Hallwood and 40% to SOCAR. The joint-venture term was for 25
years with an initial term of three years, which called for
Hallwood to spend a maximum of $65 million and a minimum of
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$5 million in a three-phase development plan for the field. There

are aspects found here that are characteristic of some of the
rehabilitation deals found in the former Soviet Union.
Cost Recovery
In many proposed joint ventures in the FSU republics, the
government partner also wants to recover costs. From the perspec-
tive of the industry partner, the government cost recovery can act
like an added layer of taxation. If SOCAR is also putting up money,
then it would not be viewed that way. However, it is unlikely that
SOCAR has any money to provide for the project. The amount of
government cost recovery for past costs is a point of debate/negoti-
ation. The government cost recovery would likely be funded out of
incremental production.
Cost recovery is also limited to 70% of net revenues, which
unsurprisingly implies a royalty. Hallwood, therefore, would be
able to recover costs out of something less than 70% of gross
revenues.
Incremental Production
The incremental production starts at 2,700 BOPD, not at the
current rate of production that was announced as 1,750.
Therefore, 950 BOPD of production must be made up before cost
recovery or profit sharing may begin. Many negotiations for these
deals can get sticky over a beginning like this. The extra 950 BOPD
would be viewed by some as an additional royalty.
Net Revenues
The release indicated that sharing would be 60%/40% during the
first phase of the joint venture. This implies that after payout the
sharing arrangement will change in favor of the government.
Furthermore, the Hallwood share of profit will likely be subject to
taxes.
There is not sufficient information to determine if it is a good
deal or not. The exploration rights may be of value. Perhaps there
is life left in the field.
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THRESHOLD FIELD SIZE ANALYSIS
6
THRESHOLD
FIELD SIZE
ANALYSIS
T hreshold field size analysis is an important exercise in
the international business. It focuses exploration efforts and pro-
vides insight into fiscal systems. It also helps define boundary
conditions for explorers and development engineers. Too often,
time is spent evaluating the prospects in a country that is domi-
nated by a fiscal system that simply will not justify exploration
efforts.
The subject of success probability centers on the difference
between technical success and commercial success. The differ-
ence, as mentioned earlier in this book, is development threshold
field size. As the threshold field size approaches zero, as it has in
the United States for all practical purposes, the difference begins
to disappear. It has not disappeared in the international sector.
This is one reason why flexible contracts have been created.
Development thresholds depend on costs, lead times, reservoir
characteristics, and the host country fiscal system. The main rea-
son for threshold analysis is to decide whether or not to even
attempt exploration efforts.
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Risk capital is a critical factor, and it depends on the nature of

the work commitment. Companies must keep exploration costs
down in order to compete. But it is hardly an issue in develop-
ment economics.
EXPLORATION VS.
DEVELOPMENT THRESHOLDS
The huge risks force oil companies to search for giant fields. It
is a basic formula for the industry. But once a discovery has been
made, the amount of risk associated with finding it has little
meaning. The decision to develop a discovery is determined by
the technical and economic feasibility from that point forward.
Development geologists and engineers can develop many fields
that would not have been considered large enough to justify risking
exploration capital. Threshold field size, from an explorationist’s
point of view, is on the order of 100–300 MMBBLS or more, but
development thresholds are an order-of-magnitude smaller.
The key variables used in exploration threshold field size
analysis are:
• Risk capital estimate
(Work commitment, G&G, seismic, dry-hole costs, etc.)
• Probability of finding hydrocarbons
• Estimated development costs
• Oil prices estimates
• Expected field size distribution
• Estimated production profiles
• Fiscal terms
The key variables used in development threshold field size

analysis are:
• Estimated development costs
• Oil prices estimates
• Estimated reserves and production profiles
• Fiscal terms
• Sunk costs
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Oil prices and costs are some of the most sensitive factors. Per-
well deliverability is also one of the key factors because it has
such a strong influence on capital and operating cost require-
ments. Costs are also strongly affected by water depth and
remoteness.
Discounted cash flow analysis is the workhorse of threshold
field size analysis. The deepwater and remote frontier regions pro-
vide good examples for demonstrating methods of determining
threshold field size. From a geographical perspective, 600 ft of
water, as a rule, marks the limit of the continental shelf and the
beginning of the continental slope. Indonesia and Malaysia offer
special deepwater incentives for projects in water deeper than 600
and 650 ft, respectively. In the international sector, even 400 ft of
water can seem awfully deep.
This industry is characterized by high capital costs and diverse
technical boundaries. Yet technical feasibility is becoming less of
an issue. Field-proven off-the-shelf technology provides a wide
array of building blocks for frontier field development under a
variety of conditions. The most important challenge at the
moment is to reduce the high capital and operating costs associat-
ed with frontier regions.
In many regions offshore seismic costs for data acquisition,
processing, and interpretation can range from $1,000 to
$1,500/km. In the remote jungles of Southeast Asia, the acquisi-
tion costs alone can exceed $20,000/km, and in the highlands of
Papua New Guinea, the costs are even higher. Imagine 100 km of
seismic data costing over $2 million!
Drilling costs depend on many factors, but they are magnified
in the international business. Many wells in the Timor Gap were
budgeted at around $9 million each for the relatively moderate
water depths. In the Philippines many of the deepwater wells cost
over $25 million.
Mobilizing a rig and services into a remote onshore location
can easily put well costs for a modest depth well with no harsh
drilling conditions into the $5 million range. Building a drilling
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MAXIMUM CAPITAL COSTS PER BARREL

THAT CAN BE SPENT FOR
FIELD DEVELOPMENT
$/bbl
$6.00
$5.50
$5.00 U.S.A.
PHILIPPINES
$4.50
MYANMAR
$4.00
VIETNAM
$3.50 INDONESIA
MALAYSIA
$3.00
10% 15% 20% 25% 30% 35% 40% 45% 50%
Contractor Take
Based on $18.00/bbl wellhead price
Figure 6–1 Comparing fiscal terms: Capital cost limits
location and a road to the wellsite alone can rival the costs of
some U.S. wells. The Llanos of eastern Colombia is characterized
by deep, tough drilling conditions. A 17,000-ft well can easily cost
$20 million and stands a strong chance of not reaching its objec-
tive due to steeply dipping beds and hard, deep drilling.
OPERATING COSTS
VS.
CAPITAL COSTS
The tradeoff between operating costs and capital costs is domi-
nated by the timing of these costs. Operating costs are spread over
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such a much longer time period and follow most of the capital
cost expenditure. Therefore, in terms of present value, capital
costs are twice as critical as operating costs.
Some analysts use a technical cost factor that combines capital
and operating costs in terms of dollars per barrel. The formula for
the technical cost factor is:
Technical cost factor = Unit capital cost

+ Unit operating cost ÷ 2
For example, if $100 million is required to develop a 50-

MMBBL field, the capital cost is $2.00/bbl. If during the expected
15-year life of the field, projected operating costs average $10
million per year, the unit operating cost then would be $3.00/bbl
[(15 years × $10 MM/year)/50 MMBBLS]. The technical cost
index then would be $3.50/bbl [$2.00 + ($3.00/2)].
Figure 6–1 shows how the contractor take correlates with cap-
ital cost limits for field developments. For example, in Indonesia,
as capital costs approach $3.50/bbl project economics quickly
become subeconomic at an $18.00/bbl wellhead price.
TECHNICAL
VS.
COMMERCIAL
SUCCESS RATIOS
Consider an area where technical success ratios are on the
order of 20% or more, like much of the Gulf of Mexico and many
areas in Southeast Asia. Success ratios are enhanced these days
with high-quality seismic data, especially offshore, but the differ-
ence between technical success and commercial success can be
substantial. This is particularly the case in deepwater and frontier
regions. This is illustrated in Figure 6–2. In this example, a gas
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discovery is not considered viable, and unfortunately this is often

the case. Gas development thresholds are discussed later.
For many areas worldwide, the frontier environments will
require a bare minimum of 50 MMBBLS of recoverable oil to jus-
tify development. To consider anything less than a 50-MMBBL
field as noncommercial can have a strong influence on the com-
mercial success ratio. If the probability of finding hydrocarbons is
on the order of 20%, then it would not be unrealistic to expect
the probability of finding something greater than 50 MMBBLS to
drop down to 10% or less. In the Gulf of Mexico deepwater, the
probability of finding a field larger than 50 MMBBLS of oil or oil
equivalent (BOE) is 5%–8%. Commercial success ratios are fur-
ther limited in frontier areas, because gas discoveries must be
huge to be economic.
From the viewpoint of the explorationist, the question is,
“How large must the target be?” High deepwater and frontier
costs require huge targets. Furthermore, tight fiscal terms demand
even larger targets to justify spending risk dollars.
The Expected Monetary Value (EMV) approach introduced in
Chapter 2 is used in a slightly different way to quantify the
explorer’s position. The relationship between risk dollars and the
anticipated probability of success is outlined with the EMV equa-
tion.
Threshold field size (reward) is estimated by making assump-
tions about the probability of success from exploration drilling
and the value of the reserves that may result from successful
exploration efforts. Assuming that discovered undeveloped
reserves are worth around 50¢/bbl, and exploration costs are U.S.
$15 million, the relationship between an assumed success ratio of
8% and required target size can be calculated. The EMV at
breakeven is zero. This identifies the threshold or minimum target
size for exploration efforts under the assumption outlined above.
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Chance of finding liquid hydrocarbons.
Chance of finding a field large enough to develop.
Figure 6–2 Technical vs. Commercial success probability
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EXPECTED MONETARY VALUE BREAKEVEN ANALYSIS
where:
EMV = Expected Monetary Value

= 0 at breakeven
Risk capital = $15 million
SP = Probability of success = 8%
Reward = Minimum target size (in this case)
0 = (Reward × .08) - [$15 MM × (1 – .08)]
(Reward × .08) = [$15 MM × (1 – .08)]
$15 MM × .92
Reward =
.08
Reward = $172.5 million

= Breakeven results
= Threshold value
= 345 MMBBLS (at 50¢/bbl)
Figure 6–3 shows the relationship between risk dollars and

success ratio. If $15 million are placed at risk with only 8%
chance of success, then the potential reward must be worth at
least $172.5 million. Figure 6–4 describes what this means in
terms of exploration threshold field size for deepwater in
Southeast Asia and the Gulf of Mexico. These target sizes are con-
sistent with a technical success ratio of perhaps up to 20% and
development thresholds of over 50 MMBBLS.
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Figure 6–3 Expected value graph
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Based on the costs of deepwater development, fiscal terms,

commercial success probability at around 8%, and an assumed
exploration expenditure (risk capital) of U.S. $15 million,
the explorationist must look for 200-500 MMBBLS of
recoverable oil.
Based on $18.00/bbl crude.
Figure 6–4 Detail: Breakeven/Threshold exploration target
Table 6–1
Wave Height Comparison, feet

100-year 50-year Average
Wave Wave Winter Summer
North Sea 90 85 8 5.5

Gulf of Mexico 60 50 5 4
Java Sea 30 25 2.6 2.3
GULF OF MEXICO VS. SOUTHEAST ASIA

COMPARISON
Much of the international business is offshore. Over 50% of
the activity in Southeast Asia (excluding China) in terms of pro-
duction and drilling is offshore. The Gulf of Mexico is a good
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Based on $18.00/bbl wellhead price
Figure 6–5 Minimum Recoverable Reserves for Development
source of comparison for much of that region. Generally, the cli-

mates are similar. By contrast, the North Sea is quite harsh in
terms of temperature, water depth, and wave height. Table 6–1
compares wave height characteristics.
The kind of exploration thresholds found in the region are
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illustrated in Figure 6–4. Figure 6–5 shows development thresh-

olds. The systems that have little or no flexibility have limited
expression along the X axis. Some systems are quite flexible, and
contractor take can have quite a broad range. Other systems are
fairly rigid—like Malaysia and Indonesia. Indonesia developed a
new set of terms for the Eastern frontier in 1994. In that region
the split is 65%/35% in favor of the government.
Reservoir quality and per-well deliverability are nearly as
important as total reserves. Project economics in the deepwater
and frontier regions require prolific production rates.
Special deepwater and frontier terms are critical because of the
risks and costs of deepwater exploration and development. The
incentives currently in place in some countries are not sufficient.
GAS PROJECTS
In international exploration, oil and gas are quite different.
Gas discoveries are often noncommercial unless they are quite
rich in liquids, close to an existing market, or very large. There
are many giant gas fields that are still waiting on pipe.
Threshold field size for gas is substantially greater on a Btu
basis for both exploration and development thresholds. For
example, in some areas the threshold field size for development
of an oil discovery may be on the order of 20–30 MMBBLS. This
situation is shown in Figure 6–5. In the same region, gas develop-
ment threshold field sizes may be more on the order of 500 BCF
to over 3 TCF (100–500 MMBOE).
Contract terms for oil are clearly defined, yet the terms for a
possible gas discovery may be quite vague. In many systems
where gas terms are nailed down, they probably should not be.
Sometimes a simple gas clause is used, indicating that if gas is dis-
covered, the government and the contractor will sit down and
negotiate.
In many places there are substantial quantities of associated
gas that are simply flared every day. In the famous Russian
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Samotlov oil field, gas was flared at rates of up to 2 BCFD. At the

AMOCO-operated gas/condensate Sajaa field and liquids extrac-
tion plant in Sharjah, up to 450 MCFD were flared at one time.
When gas discoveries do get developed, it is normally quite a
long time after discovery. In the ARCO-operated Northwest Java
(NWJ) block off the coast of Java, a gas development project
exceeding $1 billion finally was launched in 1993 for associated
and nonassociated gas. Prior to that, for over 20 years, the nonas-
sociated gas was simply flared—up to 100 MMCFD at times. The
same amount of gas was being flared in the adjacent Southeast
Sumatra (SES) block.
If the gas had not been flared, the oil could not have been
produced economically. There are numerous countries that are
tightening their flaring policy, and the flaring option is becoming
rare. But shut-in gas is nearly worthless and so is shut-in oil.
When a gas discovery is made, it is customarily followed by a
well-known ritual. What can we do with all this gas? Most explo-
rationists are oil oriented. Gas is not a stranger, but gas develop-
ments in the international arena are generally large scale, and the
numbers get big quickly. What are the options? The list includes:
• Gas Sales: produce it and pipe it to market
• LPG: liquids extraction, gas plant
• Methanol
• Fertilizer: ammonia/urea
• LNG
GAS SALES
The ideal situation for a gas discovery would be a local mar-
ket for the gas at a reasonable price. The United States and
Europe are about the only places where these things are taken
for granted. Most exploration acreage is located a long distance
from the kind of markets that would make gas sales a simple
matter of laying pipe. Numerous gas discoveries have sat idle for
years awaiting development.
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By as early as 1983, ARCO knew it had at least 3 TCF of

recoverable gas in the Yacheng discovery just south of Hainan
Island, and it could at that time guarantee long-term deliverability
of at least 400 MMCFD for over 20 years. The purchase agree-
ment and development plans waited 10 years. Building a 10-year
wait into exploration economics can kill a lot of drilling decisions.
And, it will have been much longer than 10 years from the spud-
ding of the discovery well to first deliveries in Kowloon 480 mi
and U.S. $1.2 billion away. First deliveries were scheduled for
January 1996, 13 years after discovery.
LIQUIDS EXTRACTION AND LPG

Liquids extraction can range from low-volume plants that strip
out condensates to large-scale facilities that liquify LPGs. LPGs are
primarily de-ethanized propanes and butanes with some pentanes
thrown in. Condensates are made up of pentanes and some of the
heavier hydrocarbons (see Appendix I). Worldwide gas plant sizes
range from 98 to 124 MMCFD in terms of inlet capacity, and liq-
uid/gas yield averages 26 bbl per MMCF of condensate.
The international sector requires rather large-scale projects,
and if gas is rich enough, then LPG extraction may be a develop-
ment option. As a rule, the condensate yield alone must be at
least 30 bbl per MMCF, and LPGs may double that. LPG fraction-
ating plants can be big projects.
An LPG facility at the ARUN LNG complex in Indonesia cost
$400 million to construct in the late 1980s. The capacity was 1.9
million tons/year—over 55,000 B/D. In late 1993 the Gas
Authority of India announced plans to build a 140,000 metric
ton/year LPG plant (6,000–7,000 B/D) in Maharashtra (Oil & Gas
Journal, Nov. 8, 1993, p. 42). The plant was to be finished by mid-
1996—two and one-half years later at a cost of $92.6 million.
METHANOL
Methanol is the alcohol of methane: methyl alcohol CH3OH.
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Methane gas is converted into synthesis gas, which is a mixture of

carbon monoxide and hydrogen gas, and then reassembled into
methanol. It is used as a feedstock in the petrochemical industry
and can be used as an automotive fuel directly or indirectly. The
indirect use is as a feedstock for methyl tertiary butyl ether
(MTBE).
The capital cost for a world-class, 2,000-ton/day methanol
plant requiring up to 60 MMCFD inlet gas can range from $250 to
$300 million.
FERTILIZER
Natural gas is the feedstock for manufacture of ammonia,
which is the primary feedstock for fertilizer known as urea.
In early 1994 plans were announced for a world-class ammo-
nia urea complex at Gresik, East Java. Costs were estimated at
$242 million for the 1,350 metric ton/day ammonia–1,400
tons/day urea plant (Petromin Magazine, March 1994). This partic-
ular plant would probably not be considered to be a balanced
plant. Only about 800 tons/day of ammonia would be required to
manufacture 1,400 tons/day of urea. But ammonia has uses other
than as a feedstock for fertilizer. The plant example outlined in
Table 6–2 is a balanced plant requiring 80 MMCFD feed gas. The
plant is assumed to produce 1,000 tons/day of ammonia and
1,750 tons/day of urea.
LIQUIFIED NATURAL GAS (LNG)

LNG is liquified methane and ethane. The problem that faces
LNG development is primarily the huge up-front capital cost of
building a full-range LNG chain from gas field development to liq-
uefaction, transportation, and receiving terminals. The liquifying
temperature for LNG is –162ºC. As a result, the processing, stor-
age, and transportation are quite expensive.
A new LNG plant can easily cost $2 billion, with each expan-
sion train of an existing facility costing $400–$600 million and
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taking from 24 to 36 months to complete. Existing facilities have

a huge cost advantage over grassroots construction. The cost for
expansion is nearly half. In March 1994 the Badak Train-F 2.3
MMT/Y capacity LNG plant at Bontang, East Kalimantan, came
onstream. The cost was $522 million, including infrastructure
support, housing, and roads. Interest during construction added
another $177 million, and the total cost came to $699 million.
Construction on Train-G also at Bontong was due to begin in
April 1994 at an estimated cost of $580 million.
Table 6–2 summarizes vital statistics for world class gas devel-
opment options. The objective here is to give an indication of the
thresholds and boundary conditions that govern or influence
international gas projects. Every situation is different, and cost
estimates that are not site specific are notoriously inaccurate. The
difference in construction cost can vary by over 100% from one
location to another, depending on many factors. This is illustrated
to some extent by the difference between grass roots construction
and expansion with LNG facilities—a 4:1 difference. There is
another important difference. Most upstream project costs that
are quoted do not include interest during construction. Most gas
development and downstream project costs quoted in the press
do include interest during construction. There is a similar differ-
ence with operating costs. Upstream operating cost quotes do not
include DD&A. When those in the downstream end of the indus-
try quote operating costs, they ordinarily include DD&A. They
may also include feedstock costs, which can make a big differ-
ence. Regardless of these heavy qualifiers, it was felt that at least
an attempt to give ballpark cost figures would be better than
nothing. Interest during construction and DD&A are not included
in the cost estimates summarized in Table 6–2. Neither are feed-
stock costs included in operating costs.
There are additional costs that have not been included. Many
options require an export terminal, and export products require
tankers. The cost for a terminal can range from as low as $200
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Table 6–2
GAS DEVELOPMENT OPTIONS

Gas LPG Gas Fertilizer LNG
Sales Plant Cycling Methanol Ammonia/Urea Plant
Product Natural Gas LPGs and Condensate Methanol Granulated Liquified

and Condensate Gas is Hydrogen Urea Methane &
Condensate + Gas reinjected Ethane
Threshold Wide range

Field Size
(BCF) 50–200 300–400 250–400 500 600 4,000
Minimum Feed 10–20 MMCFD 60–80 MMCFD 40–75 MMCFD 60 MMCFD 80 MMCFD 600 MMCFD
Gas (MMCFD) 300/train
% Produced/Yr 7% or more 5%–10% 7%/Year 5%/Year 5%/Year 4%/Year

Project Life 5–12 Years 10–20 Years 13 Years 20 Years 20 Years 25 Years
Capacity 20 MMCFD 60 MMCFD 30 MMCFD 2,000 tons/ 1,750 tons/ 11,000 tons/day
4,000 BCPD 1,000+ BCPD day day 4.3 MM tons/year
Market Local Local & Local Export Local Export

Requirements Pipeline Export Ship Truck LNG Tanker
Plant Location No Local or Local Port City Local Port City

Plant Port City
Required $5–$10+ $50–$60 $75–$100 $250–$300 $150–$200 $2.5–$3,000

Capital Cost Grassroots
$MM
Lead Time 4–24 Months 3+ Years 2–3+ Years 4 Years 5 Years 7–10 Years
Construction 2+ Years 2+ Years 3 Years 3 Years 3+ Years
Annual $4 MM $8 MM $15 MM $30 MM $35 MM $80 MM

Op. Costs
Current (1994) 50¢–$2.50/MCF $110–$130/ton $10–$11/bbl $125–$140/ton $160–$180/ton $200/ton

Product Prices Condensate
$/MCF Equivalent 50¢–$2.50 $3.00/MCF
Threshold $1.00/MCF $160/ton $12/bbl $180+/ton $180+/ton $220/ton

product price
to build now
Economics Liquid/Gas Minimum

strongly yield needs based on 2
affected by to be above process
gas price 30–40 bbls trains
per MMCF
Long-term
minimum
take-or-pay
contracts
required to
start
1Excluding Feedstock
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million to over $500 million for deepwater port facilities capable

of handling large tankers. Also, extended distances from the field
to the plant or port facilities will increase pipeline costs. Extra
large export distances can add even more. For example, a round
trip from Mobil’s Arun LNG complex in Indonesia to Japan is
about 15 days. A typical cargo for an LNG tanker with 125,000
m3 storage is 57,000 tons, equivalent to about 2.7 BCF of liqui-
fied gas. Assuming it takes 20 cargoes per year, a tanker can
transport about 1.14 million tons per year—150 MMCFD equiva-
lent. The two-train world class LNG facility in Table 6–2 produc-
ing 4.3 million tons per year would need four tankers at well over
$100 million each. LNG is big business.
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GLOBAL MARKET FOR EXPLORATION ACREAGE
7
GLOBAL
MARKET FOR
EXPLORATION
ACREAGE
G overnments are becoming increasingly aware of their
position in the global market for exploration acreage or rehabilita-
tion projects. The market for drilling funds and technology is
supercompetitive and getting sophisticated.
Most countries developing petroleum fiscal systems are choos-
ing the PSC. It is an obvious trend that began in the 1960s. The
financial results could be the same with a concessionary agree-
ment, depending upon the aggregate level of taxation.
Philosophical and political considerations give the advantage to
the PSC.
There are still promising sedimentary basins on this planet
that are virtually unexplored. These basins are more geologically
complex, more remote than the established provinces, or they
are dominated by a harsh environment. Yet even basins with
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established drilling and production history have a long way to

go in terms of exploration and development maturity by com-
parison to the United States.
Many regions are at a stage that existed 20–40 years ago in
the United States. The total wells drilled in the United States now
exceeds 3.2 million. This is two orders of magnitude greater than
the 30,000-odd wells that have been drilled in the Asia Pacific
region (excluding China). Seismic data acquisition in the United
States is about 10 times greater. There have been roughly 6.2 mil-
lion mi of seismic data acquired in the United States compared to
650 thousand mi of data acquired in the Asia Pacific.
Four times as many wells have been drilled in the United
States as in Russia. If the industry drilled 50,000 wells per year in
Russia, it would take 40 years to catch up to where the United
States is now just in terms of the number of wells drilled.
Variations in maturity like this account for much of the shift in
focus from the United States to the international sector. Well pro-
ductivity outside the United States is nearly 20 times that of a
typical 12-B/D U.S. oil well.
Of the nearly 600,000 producing oil wells in the United States,
over two-thirds are stripper wells—producing less than 10 BOPD.
The average production rate for these 400,000-odd stripper wells
is just over 2 BOPD. There is still geological potential in areas of
the United States, but most of these areas are off-limits to the oil
industry.
One perspective on the geological scale offered overseas can
be seen in the kind of production rates found. Figure 7–1 summa-
rizes oilwell production rates of various countries and compares
them to production statistics from the United States. This figure
also illustrates the advanced maturity in the United States.
Many countries have good exploration potential, and they
know how to compete for Western capital. Fiscal terms in most of
these countries are tougher than those in the United States, but
not in relation to the fundamentals of political risk, geology, and
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* United Kingdom and Norway

Production and Well Data from Oil & Gas Journal Worldwide Production Report, Vol. 91 No. 52, 27 December 1993.
Figure 7–1 Comparison of oilwell production rates
economic potential. These governments are aware of their posi-

tion in the global market and understand fairly well what the
market can bear. They are watching closely the hyperactivity in
Eastern Europe and the former Soviet Union. The growing com-
petition for drilling funds and Western technology should benefit
companies in the international exploration business. There are a
lot of different opportunities in the international sector—some-
thing for nearly everyone. It is a slightly different game, but rocks
are rocks and taxes are taxes.
During the 1990s activity in the former Soviet Union and
Eastern Europe took on the aspect of a modern-day gold rush.
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Figure 7–2
During the first quarter of 1991 the Soviet oil output hit a 15-year
low, and the region is desperate for Western capital and technology.
Major international oil companies and companies that have never
ventured overseas are flocking to this region. Russia promises to be
a hub of activity, if it can live up to its promise. To do this it must
create a competitive investment climate and overcome the curse of
political instability and the famous Russian bureaucracy.
Everything must balance. This is shown in Figure 7–2. If the bal-
ance is too far in favor of oil companies’ interests, then perhaps in
the short term there may be a flourish of exploration activity. But in
the long run, it is unlikely that an unbalanced situation will persist.
Too often fiscal adjustments follow successful exploration efforts.
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Contract negotiations must seek the appropriate balance.

Part of negotiations is knowing the market. Obtaining terms
that are good in the global context is one thing, but nobody wants
to negotiate the worst terms in a country, even if they are rela-
tively good terms. Nearly half of the equation in negotiations is to
secure terms that will be acceptable to a potential partner.
Knowing the market and what kind of terms are realistic depends
on a region’s prospectivity.
PROSPECTIVITY
The most obvious geotechnical aspects of exploration are field
sizes and success ratios. Targets must be large, and just how large
they must be depends on costs and fiscal terms. Sometimes coun-
tries are compared on the basis of barrels of oil discovered per
wildcat. The question is, Will past statistics provide some insight?
Just how meaningful historical information is in regard to success
ratios and the size of discoveries depends on the maturity of an
area and other factors. If all the major structures have been
drilled, then the past is certainly not the key to the future.
Costs are critical. With maturity and infrastructure develop-
ment in a given province, costs often come down. This is particu-
larly true with exploration and transportation costs, which are
highest for the first field developments in an area.
Well productivity is a dominant factor in development costs.
This is particularly true with offshore developments and increas-
ing water depth. Wells that produce 500 BOPD in the United
States are rare and exciting, but in the international arena, partic-
ularly in deepwater or frontier areas, they may well be marginal
or even uneconomic.
While most fiscal systems in the international arena are
tougher than in the United States, the more favorable geological
potential usually compensates. The chance of finding over 100
MMBBLS is realistic in Latin America, Southeast Asia, and West
Africa but unlikely in most of the United States. The exceptions in
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the United States are the deep water of the Gulf of Mexico, off-
shore California, and Alaska. Political risks are also normally
greater, but again, if there is sufficient geological potential and the
fiscal terms are appropriate, there may be opportunity.
POLITICAL RISK
One of the major considerations in international operations is
the element of country risk. How can companies gauge the atten-
dant risks of doing business outside their own country? It is not
easy.
Nationalization or expropriation of assets once loomed fore-
most as the greatest risk that the industry faced overseas. It is still
the worst nightmare for many a company or negotiator, as shown
in Illustration 7–1. However, the scrutiny of the expanding global
economy and the interlocking financial markets make this kind of
action much more unlikely than in the past. The international
business and financial community can impose severe penalties on
a government that expropriates the assets of an expatriate compa-
ny, regardless of whether or not the company receives compensa-
tion. It is not a decision that is taken lightly.
Expropriation is not illegal in the eyes of international law as
long as it is done in the best interests of the country and the com-
panies involved are compensated. These are the most common
aspects of legal expropriation. But adequate compensation is sel-
dom the hallmark of these kind of government actions. However,
governments know that even a hint of nationalization, expropria-
tion, or confiscation can send ugly signals. It can take years to
reassure potential investors. While confiscation of assets is a risk,
it is often overshadowed by other factors. More realistic risks
include such things as creeping nationalization through expanding
taxes, progressive labor legislation, or price controls.
POLITICAL STABILITY
One of the more difficult aspects of conducting business in
another country is the element of never-ending rule changes.
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Illustration 7–1 A negotiators worst nightmare—expropriation
Policy shifts constitute the most prevalent and immediate risks

that confront the industry. These include changes in government
and fluctuating tax laws. In some countries the rate of change is
excessive. Democracies, for example, have a habit of making
changes that affect the business community nearly as often as
elections are held. In terms of volatility and unpredictable tax law
changes, the U.S. record is not the best. The United States has
shown an eagerness to impose excess (windfall) profits taxes, yet
the government is not nearly as responsive as other countries are
to make compromises when adverse conditions face the industry.
Contract flexibility can add an element of stability.
Theoretically governments are less likely to change the rules if fis-
cal or contract terms themselves are responsive.
Figure 7–3 shows where political risk fits into the risk analysis
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framework. The best way to evaluate or quantify aspects of politi-

cal risk or any other kind of risk is with expected value theory
(EMV theory). Expected value theory is the central theory, and
possible scenarios or outcomes are represented by their financial
impact through discounted cash flow analysis. The fiscal terms of
a country and the political stability have a huge impact on the
country’s prospectivity.
Aside from the geological dimension, almost all of the ele-
ments that affect the investment decision are or can be influenced
by the government and the nature of the business climate offered
to the industry. The investment decision is also influenced by utili-
ty theory and gambler’s ruin theory, both of which are strongly influ-
enced by the estimated probability of success and the nature of
the perceived risks.
GAMBLER’S RUIN THEORY

Gambler’s ruin occurs when a risk-taker with a limited
amount of funds goes broke through a continuous string of fail-
ures. With any kind of drilling budget there is such a risk, but it
can be reduced through diversification.
The concept of gambler’s ruin flows from the same estimates
of risk used in expected value theory. The estimate of the proba-
bility of success is used to help determine the maximum level of
capital exposure under specific confidence level criteria. The objec-
tive for management is to stay in the drilling game long enough
for the odds to work as they should.
Another way of looking at it would be to ask the question,
What would be a statistically significant sampling size (at a confi-
dence level of 95%), given the nature of the play?
The concept of gambler’s ruin is used for avoiding a successive
string of failures that would exhaust a drilling budget. For example,
at least one success must be achieved. It is a rather fancy concept
for a well-known adage: “Don’t put all your eggs in one basket!”
The gambler’s ruin algorithms are outlined as follows:
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EXPLORATION ECONOMICS—RISK ANALYSIS

DRILLING FIELD SIZE PROBABILITY
COSTS/TIMING ESTIMATES OF
ESTIMATES DELIVERABILITY SUCCESS
ESTIMATES
Technical &
Geological
Risks
POLITICAL RISK
ANALYSIS
DISCOUNTED CASH FLOW ANALYSIS
Threshold Field Size Analysis

Monte Carlo Simulation
Sensitivity Analysis
Breakeven Analysis
EXPECTED MONETARY UTILITY

VALUE (EMV) THEORY
Whether or not
to invest?
NO YES
GAMBLER’S RUIN
THEORY
How much to invest?
Figure 7–3 Risk Analysis flow diagram
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Probability Probability
of at least =1 – of all failures
one success
Assume that a confidence level of 95% is desired, and the

probability of success is estimated at 15%. How many wells must
be drilled to be 95% confident of having at least one success? At
least 18. With 18 wells there is still roughly a 5% chance of hav-
ing all dry holes. The maximum percentage of the total budget
that can be spent is 5.4%.
Two investors can participate in the same drilling venture: one
gambling and the other exercising sound investment strategy. The
difference is in the level of exposure.
GAMBLER’S RUIN ALGORITHMS
.95 = 1 – (1-sp)n
where:
.95 = Desired confidence level
sp = Probability of success
(1 – p) = Probability of failure
n = Number of trials
(exploratory wells)
Solving for n:
log (0.05)
n =
log (1 – sp)
where:
0.05 = 1 – Desired confidence level
Probability of all failures
sp = Probability of success
(1 – p) = Probability of failure
n = Number of trials
(exploratory wells)
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UTILITY THEORY
Human and corporate behaviors manage to carry on, whether
or not people know or care that there is an exotic name that
applies to their actions. Utility theory is also known as preference
theory. It describes to a large extent why people will happily stick
a quarter into a slot machine in Las Vegas even though the odds
are squarely against them. The expected value of that sort of
action is negative—always. This is called gambling. But quarters
have almost no utility. When it comes to risking a few million
dollars on an exploratory well, even expected value theory is not
enough. Expected monetary value theory explains what people
should do and what the boundary conditions are. It does not
explain behavior. If the expected value of a potential investment
opportunity is positive, then it is worthy of consideration. Just
how positive must an expected value be? The standard industry
two-outcome EMV model is used once again in Figure 7–4 to
illustrate the essence of utility theory. As before, the risk capital is
$15 million. The possible reward in this two-outcome model has a
value of just over $100 million. These points define the EMV
curve. Staying below the curve results in positive expected values.
For example, the expected value is equal to $20 million with an
estimated probability of success of 30%. If management were bid-
ding on this project, the bonus bid would have to be less than $20
million. According to the utility curve, the bid would have to be
less than $2 million.
The EMV break-even success ratio is close to 13%, but the
utility break-even success ratio is over 25%. Utility curves and
EMV curves approach each other at the end points. If manage-
ment was convinced that the $15 million well had 0% chance of
success, then it would be worth a negative $15 million. No com-
pany would drill such a well—unless someone paid the company
$15 million to do it. Drilling contractors do it all the time. On the
other hand, if management were convinced that this drilling
opportunity had a 99% or 100% chance of success, the expected
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value and utility values converge. It would be like buying produc-

tion or proved undeveloped reserves. It is in the middle ground
where the curves diverge. Companies have different risk profiles
or levels of risk aversion. Under the same set of assumptions, the
EMV curves would look the same, but the utility curves would
not. Determining a company’s utility curve with a drilling venture
like this is complicated and gets academic. It is not done often.
Sometimes the whole subject is simply marked down as gut feel
and left at that.
It was pointed out in Chapter 2 that the endpoint values rep-
resent the result of discounted cash flow analysis, discounted at
the corporate cost of capital. The margin between the utility curve
and the EMV curve is sometimes viewed as the minimum risk pre-
mium. This is one reason why negotiations get sticky on the sub-
ject of profitability. For drilling ventures like this that are success-
ful, the rewards are spectacular, but only within the narrow con-
text of the discovery well—which requires ignoring any associat-
ed dry holes. Once a discovery is made, it is hard to speak in
terms of chance of success. This is particularly true from a govern-
ment’s viewpoint because it may not be aware or may not care
that the company has drilled five dry holes before the discovery.
Utility theory and expected value theory suddenly become useless
once a discovery is made. And unfortunately, the bargaining
power of the company suffers accordingly.
BARGAINING POWER
While geological risks begin to diminish after discovery, politi-
cal and financial risks intensify. Bargaining power of the contrac-
tor begins to diminish also. The essence of bargaining is power,
and the relative strength of bargaining positions shifts during the
cycle of petroleum exploration and development. This shift is
shown in Figure 7–5.
Once a resource project becomes commercial, bargaining
power really begins to shift. The large investments for the devel-
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Figure 7–4 EMV graph with utility curve superimposed
opment phase of petroleum operations start out as a source of

strength for the contractor. By the time production commences,
capital investment is a sunk cost, and facilities installed in a for-
eign country can represent a significant source of vulnerability to
the contractor.
Payout is another milestone where the shift increases in favor
of the government. Once the contractor has reached payout, prof-
itability can appear to be excessive to some governments. The
concepts of profitability and a fair return on investment start to be
reviewed at this point. The subject of exploration economics and
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Adapted by the author from: Bosson, R., and Varon, M., The Mining Industry and the
Developing Countries, Washington, D.C.: World Bank, 1977.
Figure 7–5 Relative bargaining power
the substantial risks taken by the petroleum industry are hard to

sell. The contractor’s position has changed.
Outcomes at all stages in the life cycle of a petroleum license
are determined by bargaining power. The relative bargaining
power of the oil company is greatest in the early stages prior to
contract signing and after that, before discovery. There are natural
milestones along the evolutionary path of ultimate bargaining
power, but the trend clearly shifts power over to the state as the
cycle progresses.
OPERATIONAL RISKS
The partnership between a government and an outside oil
company, whether formal or informal, goes beyond written con-
tract terms and conditions. Good working relationships can make
a big difference.
The operational risks are some of the real, tangible risks asso-
ciated with doing business in a foreign country. If it takes a week
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to obtain a visa, then imagine what it might be like trying to

import equipment, supplies, and personnel.
LANDLOCKED COUNTRIES
One of the worst negotiating positions occurs with landlocked
countries. Dealing with one government is enough of a challenge.
Dealing with two is more than twice as difficult. The dynamics
multiply. It seems that neighboring countries never seem to see
eye to eye, especially when an oil company wants to cross one of
them with a pipeline. This dilemma can tax even the most sea-
soned and experienced negotiators.
QUANTIFYING POLITICAL RISK

One of the most frequently asked questions regarding political
risk is, How do you quantify political risk? The best way is to use the
expected monetary value theory described earlier in this book. The
following example in Table 7–1 shows the possible scenarios envi-
sioned for a hypothetical exploration venture. It is assumed that
the exploration effort could be subject to varying degrees of politi-
cal unrest, as well as possible expropriation. The table shows the
relative weighting attached to the various possible outcomes. The
project appears to be worth consideration even though there is an
acknowledged risk of expropriation as outlined in the EMV model.
In this example the expected value is $51 million, in spite of
the obvious risks. The model accounts for an 8% chance of expro-
priation in addition to a substantial risk associated with political
unrest in the country. The table is another representation of EMV
theory, but allows more than two possible outcomes. It is a tabu-
lar format for what is known as a decision tree. In many respects,
whether or not management explicitly estimates probabilities or
models the economic results of possible scenarios, the risks and
rewards are weighed and balanced. Sometimes it is called gut feel,
intuition, or experience. While this example has a positive
expected value, many managers would prefer a healthier climate.
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Table 7-1
Quantifying Political Risk

Expected
Present Monetary
Value Probability Value
Possible Outcome ($MM) (%) ($MM)
Unsuccessful Exploration –$50 70% –$35

Effort: $50 MM Work Program
Large Discovery $700 5% $35

Moderate political unrest
Large Discovery 500 5% 25

Substantial political unrest
Moderate Discovery 350 6% 21

Moderate political unrest
Moderate Discovery 250 6% 15

Substantial political unrest
Large Discovery –150 4% –6

Assets expropriated during
development work
Moderate Discovery –100 4% –4

Assets expropriated during
development work
100% $51
Risk aversion/utility values come into play. As mentioned earlier,

EMV theory is only part of the equation.
It is one thing to quantify political risk, regardless of how it is
done. It is quite another thing to protect against it. The first thing
that comes to mind is insurance. This is one way to transfer risk
as outlined below, which is one of many ways to manage risk.
INSURANCE
A small percentage of foreign investment is insured. However,
in some countries eligible for foreign assistance and insurance cov-
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erage the number of projects insured can be quite high. Many risky
countries are eligible for various types of political risk insu ance
covered through international organizations, but some are not.
Insurance coverage is available for virtually any aspect of
country/political risk. A couple of the more prominent include
the Overseas Private Investment Corporation (OPIC) and the
Multilateral Investment Guarantee Agency (MIGA). Both of these
entities require that they be notified before any commitment is
made. If a contractor desires coverage for any aspect of political
risk through these agencies, the contractor must inform them
early on. Since they are involved from the inception of an invest-
ment, they are interested in the contractor’s means of risk man-
agement.
RISK MANAGEMENT INCLUDES:

• Risk Avoidance
Forgoing an opportunity because risk of loss is too great
• Loss Prevention
Reduction of loss frequency
• Risk Retention
Not all risks are avoidable
Establishment of funded reserves to offset losses
• Risk Transfer
Similar to loss prevention: spreading risk through
farmouts and joint ventures
• Insurance
Variation of risk transfer
Of all the risks that exist, the greatest concern centers on the
specter of expropriation. In the past there have been spectacular
losses from nationalization, expropriation, and confiscation of
industry assets. The following outlines provide basic rules for
reducing risk of expropriation or at least minimizing losses.
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Reducing Expropriation Risk

• Keep a low profile
• Maintain close relationships with the government
• Avoid layoffs (particularly of nationals)
• Avoid geographical overconcentration
• Utilize local industries and national personnel
Minimizing Expropriation Losses

(in the face of impending expropriation)
• Stop new investment and shipments
• Cut back inventories and cash
• Pay down debts to home country suppliers
• Borrow heavily from local sources
OPIC is the best known agency for insuring aspects of political

risk. OPIC was created as an independent U.S. government
agency through the Foreign Assistance Act of 1969. OPIC is limit-
ed by statute to insure projects in less developed countries
(LDCs). However, the principal initiative of OPIC was to meet the
needs of U.S. investors in foreign petroleum and mining projects.
The primary kinds of coverage that OPIC provides are for:
• Inconvertibility
(inability to convert payment in local currency
received as income—does not cover devaluation)
• Expropriation
(includes confiscation and nationalization including
creeping expropriation)
• War
(includes revolution and insurrection)
OPIC insures only net unrecovered costs of projects. This is

one reason why the larger companies in particular do not use
OPIC insurance that much. The risk of substantial contract
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revisions in the early exploration stage of a contract are just not as

great as they are after a discovery is made, or after the company
has recouped most or all of its costs.
As a general rule, war risk premiums for OPIC political risk
insurance are higher than expropriation risk premiums. OPIC
insurance premiums for example would range from 0.3 to up to
1.5% of coverage per year with 90%–95% indemnification of the
amount insured. By comparison, a premium for earthquake cov-
erage might be on the order of 0.1% of coverage, depending upon
the region. OPIC coverage for war, revolution, or insurrection
requires that the disruption last for more than six months. OPIC
evaluation criteria include the nature of the project and the
arrangement with the host government, including incentives and
regulations. Some of the most important considerations are the
effect on the economy, employment, wages, local suppliers,
downstream industry, and the environment.
MIGA was established by the World Bank in 1985. It was
established to promote private investment in the member coun-
tries, including Switzerland, and the insured must be citizens of
member countries. The insurance coverage is similar to that
offered by OPIC.
The United States Export-Import Bank (Eximbank) also pro-
vides some means of political risk insurance for U.S. manufac-
tured equipment exported overseas.
Private insurance is also available, but premiums are generally
higher. There is more flexibility with private insurance and confi-
dentiality is better. Once a contract is issued with OPIC or MIGA it
becomes public information. Private organizations cover virtually
everything that OPIC or MIGA cover.
The key to success in the international industry is to be able to
evaluate and to manage the attendant unavoidable risks and
ensure that they are more than outweighed by the potential
rewards. The industry is a risk-taking industry, but avoiding
undue risks and minimizing risk is a winning strategy.
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PRODUCTION SHARING CONTRACT OUTLINE
8
PRODUCTION
SHARING
CONTRACT
OUTLINE
E xamination of a PSC, service contract, or even a con-

cessionary arrangement must consider the greater regulatory and
legal context. Nearly every country has a legal and legislative
framework within which all agreements reside. Figure 8–1 illus-
trates the legal and contractual foundation for petroleum agree-
ments. It starts with the constitution. Not all countries have the
same framework shown in Table 8–1. The foundation is the
nation’s constitution. From the constitution flows the taxing and
legislative authority that governs petroleum legislation and out-
lines the authority and boundary conditions for relationships with
foreign companies.
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LEGAL/REGULATORY/
CONTRACTUAL FRAMEWORK
The Nation’s Constitution
Tax Law
Petroleum Legislation
Production Sharing Contract
Joint Operating Agreement
Figure 8–1 Legal/Regulatory/Contractual Framework
THE CONSTITUTION
The constitution of a country is the foundation upon which all
else must stand. Petroleum legislation and individual contracts
cannot contradict constitutional law. For example, the
Venezuelan Constitution required that any contract disputes
involving the public interest be resolved exclusively in
Venezuelan courts. With that in mind, it would be difficult or
foolish to draft an arbitration clause in a petroleum contract that
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places the venue for arbitration outside of Venezuela. The consti-

tution dictates the lines of authority for the various aspects that
govern the relationship between the contractor and the state.
TAX LAW
Sometimes the taxes pertaining to the petroleum industry or
industry in general are found under a separate set of laws. The
tax liabilities that the contractor is subject to may be included in
the contract by reference to the pertinent tax law, or simply by
mention of the fact that taxes must be paid. The Indonesian PSC
does not mention the 35% income tax, nor does it mention
directly the additional 20% withholding tax. The reference is
oblique but not intended to mislead. The taxes are simply defined
by a higher authority. The Indonesian production sharing contract
clause that deals with taxes effectively falls under the Rights and
Obligations of the Contractor:
Contractor Shall:
be subject to and pay to the Government of the Republic
of Indonesia the Income Tax and the final tax on profit
after tax deduction imposed on it pursuant to the
Indonesian Tax Law and its implementing Regulations.
CONTRACTOR shall comply with the requirements of
the law in particular with respect to filing of returns,
assessment of tax and keeping and showing of books and
records.
PETROLEUM LEGISLATION
Petroleum legislation in many countries can be rather archaic
and can contain many irrelevant procedures. Pertinent legisla-
tion governed by the constitution may include specific petroleum
legislation that authorizes the national oil company or oil min-
istry to negotiate certain aspects of agreements between the state
and foreign companies. Some governments have no petroleum
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legislation, and the arrangement between the contractor and the

state may be embodied totally under the terms of a contract.
Some such contracts even dictate the taxes to be paid.
PRODUCTION SHARING CONTRACT

The PSC is the official link between the government and con-
tractor in those countries that use this system. For those countries
that do not, a concessionary agreement is used, but it will cover
most of the same aspects that are negotiated in a PSC. In either
case, if there is government participation, a joint operating agree-
ment may also be required.
ENVIRONMENTAL/CONSERVATION REGULATIONS
Environmental laws are being drafted at a furious pace, and if
there is no written law, then it is likely there soon will be.
Environmental regulations are important and becoming even
more so. Even if there is not specific contract language that
addresses this issue, many feel that the typical contract clauses
that require the contractor to exercise “prudent oilfield practices”
include the obligation to protect the environment.
Table 8–1 shows some of the diversity of legal frameworks
found in the petroleum industry.
PSC COMPONENTS
The following outline contains typical sections that are cov-
ered in production sharing contracts between host governments
and foreign oil companies. There are many variations, but the fol-
lowing descriptions are fairly standard. Furthermore, the issues
discussed here are relevant to other fiscal arrangements as well,
whether they are embodied in a PSC or petroleum law or a
license agreement.
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Table 8–1
Examples of Legal/Regulatory Frameworks

Type of Legal Petroleum Authorized
Government* Constitution* System* Legislation State Agency
Papua Westminster 9/16/1975 English Petroleum Act Department of

New Guinea Style Common Law 1977 – 4/1978 Minerals and
Parliamentary Chapter 198 Energy
Democracy Income Tax Act
1978
Chapter 110
Malaysia Constitutional 8/31/1957 English Petroleum Petronas

Monarchy Amended 1963 Common Law Developments Nat. Oil Co.
Acts 1974/5
Carigali
Exploration Arm
Nigeria Military 10/1/1979 English Petroleum Nigerian Nat.

Government Amended 2/84 Common Law Drilling & Oil Co. (NNOC)
Since 1983 Revised 1989 Islamic Law Prod. Regs.
and of 1969 as
Tribal Law Amended
Colombia Republic — 7/5/1991 Based upon Decree 2310 of Ecopetrol

Executive Spanish Law 1974 as Nat. Oil Co.
Branch regulated by
Dominates Decree 743 of
1975
Resolution
000058 (prices)
Tunisia Republic 6/1/1959 Based upon Decree Law Minister for

French Nº 85-9 14/9/85 Energy and
Civil Law Modified by Mines
and Law Nº 87-9
Islamic Law 6/2/87 and
Decree Law
Nº 90-55
18/6/90
Vietnam Communist 12/18/1990 Based upon Law of 29 Dec. Petrovietnam

State Communist 1987 on Nat. Oil Co.
Legal Theory Foreign
and Investments
French
Civil Law
Ivory Coast Republic 11/3/1960 Based upon Law of 64-249 PETROCI

ˆ
Cote Multiparty French 7/1964 amended Nat. Oil Co.
d’Ivoire Presidential Civil Law by Decree 64-96
Regime and 3&4/1965
customary Law 70-489 of
Law 3 August, 1970
Qatar Traditional Provisional Discretionary No Petroleum Qatar Petroleum

Monarchy Constitution system of law Law Producing Co.
enacted controlled by QPPC
4/2/1970 the Amir and Nat. Oil Co.
Islamic Law
*From: The World Factbook 1991, Central Intelligence Agency
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PSC OUTLINE
ARTICLE TITLE
I General Scope
II Definitions
III Purchase of Data
IV Duration, Relinquishment, and Surrender
V Work Programs and Expenditures
VI Production Areas
VII Signature and Production Bonuses
VIII Rights and Obligations of National Oil Company
IX Rights and Obligations of Contractor
X Valuation of Petroleum
XI Payments
XII Recovery of Operating Costs and
Net Sales Proceeds Allocation
XIII Employment and Training of Local Personnel
XIV Title to Equipment
XV Ownership Transfer
XVI Books and Accounts
XVII Procurement
XVIII Joint Operating Agreement
XIX Force Majeure
XX Arbitration
XXI Insurance
XXII Termination
XXIII Entire Contract and Modification
Exhibit A Description of Contract Area

Exhibit B Map of Contract Area
Exhibit C Accounting Procedure
Exhibit D Management Procedure
GENERAL SCOPE
The first section of the contract outlines who the various parties
to the contract are. This will include the foreign oil company, or
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companies if there are more than one, and the national oil compa-
ny or the agency acting on behalf of the host nation. The oil com-
panies are identified and thereafter referred to as the “contractor.”
The host government national oil company or agency is also iden-
tified and then subsequently referred to by initials or a short name.
DEFINITIONS
This is a standard contract section that defines specifically
technical and financial terms to promote a common understand-
ing and source of reference. The definitions can be fairly straight-
forward and can provide an important foundation for mutual
understanding of the contract. However, terms such as force
majeure, effective date, commercial discovery, production period, wildcat
well, exploration well, and appraisal well often seem quite simple
until there is a problem. Then the contract is hauled out, and any
differences or confusion between the definitions and any corre-
sponding language within the body of the contract will be the
focus of much discussion or perhaps arbitration.
PURCHASE OF DATA
This clause specifies that a data package consisting of geologi-
cal and geophysical information must be purchased. The purchase
price is stated, and a brief description of the data package is
included. This clause will often stipulate that the purchase price
for the data package will not be recoverable under the cost recov-
ery provisions of the contract.
Costs for data packages range from $10,000 to upwards of
$75,000 and more in some countries. Data package quality can
sometimes be fairly good.
Sometimes the data package purchase requirement precedes
the contract signature or negotiations, and it may be stipulated
that the data be acquired before beginning negotiations. The price
of the packages in those cases is not as much an indication of data
quality, perhaps, as it is a means of screening applicants.
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DURATION, RELINQUISHMENT, AND SURRENDER

Sometimes these aspects of the contract are placed under sep-
arate clauses, but they are strongly interrelated. Duration lan-
guage includes a description of the length of the exploration and
production phases of the contract and the terms under which
extensions may perhaps be granted and the duration of the
extensions.
The primary exploration phase ranges from two to more than
six years without extensions. At the end of the exploration peri-
od, the contractor is usually required to surrender/relinquish a
portion of the contract area. This obligation may sometimes be
waived if an extension of the exploration period is granted.
Contracts specify conditions under which extensions may be
granted, which may include a bonus, technical justification of
some sort, or additional work. Extensions will allow an additional
one to three years, depending upon circumstances.
This clause requires careful consideration under ordinary
circumstances. But it is particularly important under extreme
climatic conditions, such as above the 50th parallel where spring
breakup can shut down operations or where weather windows
limit the amount of time each year during which companies can
operate. Monsoons, winter conditions, spring breakup, and ice-
berg seasons are a few examples. Not only do these kinds of con-
ditions limit available time, but coordinating operations between
windows becomes critical. What may take a year to do in south
Texas may require two years or more in a rice paddy or three
years just south of permafrost.
Some contracts outline a delineation phase after discovery,
with an additional well commitment. Delineation periods are
much like exploration extensions and range from one to two
years. The importance of this phase is that the contractor’s
delineation drilling costs are sometimes not reimbursed upon
government back-in. When predevelopment phase costs are not
reimbursed, or if the government is carried through this phase,
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the importance of obtaining sufficient information or test results

is critical to prove commerciality as soon as possible.
The development phase of a contract, often referred to as the
exploitation phase, can last from 20 to 30 years or more. Anything
less than 20 years is unusual and not recommended.
Normally there is a distinction between the exploration and
development phases of a contract. A typical relinquishment clause
may stipulate that after a three-year exploration phase, the con-
tractor must relinquish or surrender 25% of the acreage. Some-
times, with inconclusive exploratory drilling, extensions may be
granted for delineation drilling and development feasibility stud-
ies. Area reduction clauses are standard, and the most common
percentages that are quoted refer to percentage of “original” area.
But, like many other aspects of this business, this is not an
absolute. The term backaway is sometimes used for the contrac-
tor’s option of total relinquishment after the exploration phase if
all work commitments have been fulfilled.
WORK PROGRAMS AND EXPENDITURES

This is one of the more important sections of the contract. The
work program is ordinarily specified in terms of kilometers of
seismic data to be acquired and the number of wells to be drilled.
Such things as shooting and processing parameters for the
seismic and minimum footage requirement for the drilling obliga-
tion may be included. Sometimes a minimum expenditure level
regardless of the number of wells is required in the work commit-
ment. For example, a contractor may agree to a work commit-
ment of at least $20 million or three wells, whichever is greater.
Contracts may also require that wells be spudded within a certain
period, such as within 12 to 24 months of contract signing.
Problems here can occur with well classification or definition.
For example, suppose an operator drilled a successful exploratory
well as the first of a two-well commitment and drilled the second
well 3 mi away to find that the accumulation encountered in the
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second well was actually an extension of that found by the first.

The government may argue that the well was a delineation well
on the first discovery, and that another exploratory well was
required to fulfill the obligation.
Another example: Suppose two wells were planned for sepa-
rate fault blocks, and the first well was dry. The operator decides
to back-up and sidetrack the first well and drill directionally to
test the second fault block. The objective of testing both fault
blocks was met, but the government asks, “When will the second
well be spudded?”
In most exploratory efforts, the relationship between contrac-
tor and government will not get beyond the work program stage
because most exploration efforts are unsuccessful. The structuring
and wording of the work program is important to both contractor
and government.
In most contracts this section also outlines the authority of the
host government to review all budget proposals on a periodic
basis. The host government’s national oil company or oil ministry
will have the right to make suggestions and to propose revisions
to any work plan and budget. However, the contractor normally
has the authority to make final decisions on matters concerning
the work program once the contract has been negotiated.
PRODUCTION AREAS
Some contracts specify that once a discovery is made, the
productive limits of the field must be identified and mapped. The
reason for this, in some cases, is that costs associated with devel-
opment of a discovery may be treated differently than costs asso-
ciated with exploration efforts. Furthermore, when the time for
relinquishment arrives, the productive areas are exempt. In Chile
the government grants a 5-km protective halo around fields as part
of the definition of production area. In other countries specific
contract terms (such as the Indonesian DMO) apply on a field-
by-field basis, so the determination of productive area is critical.
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SIGNATURE AND PRODUCTION BONUSES

The signature or signing bonus is well known and highly
unpopular with the oil industry. The signature bonus is an artifact
of competitive bidding, but can easily be part of negotiated deals.
The signature bonus is simply a payment that occurs at or as a
function of contract signing.
Some contracts will specify that added bonuses be paid at var-
ious milestones such as threshold production levels or cumulative
production landmarks. For example, the contract may stipulate in
this clause that the contractor pay the host government a $2 mil-
lion bonus when production for a certain period exceeds 10,000
BOPD. Another bonus may be required when production exceeds
20,000 BOPD. Such production bonuses stipulate a certain period
such as a month or 120 days during which average production
must exceed the specified level. Or perhaps a bonus would be
required at production startup or when the 50 millionth barrel is
produced. There are many variations on this theme. Payments are
typically due within 30 days of the end of the month in which the
obligation to make the payment occurs.
RIGHTS AND OBLIGATIONS OF NATIONAL OIL COMPANY

This section covers various issues that are not specifically cov-
ered in other sections of the contract. The rights and obligations
of the national oil company may include:
• The right of access to the data acquired by the contractor
• The right to assist and expedite the contractor’s execution of
the work program
• The right to appoint its representatives with respect to the
contract and the joint venture management team
• The right to remove at the contractor’s expense any of the
contractor’s employees if the employee is incompetent,
and/or unacceptable to the national oil company due to
political or social behavior
• Use of contractor’s equipment by the national oil company to
the extent that it does not interfere with operations
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RIGHTS AND OBLIGATIONS OF CONTRACTOR

The rights and obligations of the contractor may include:
• Fulfillment of all technical requirements
• Funds furnished for the performance of the work program
• The right to sell, assign, convey, or otherwise dispose of all or
any part of its rights and interests under the contract to an
affiliate or other parties with the prior written consent of the
national oil company. It is hoped consent would not be
unreasonably withheld. (see Ownership Transfer)
• Taxes
Some contracts will specify what the tax rates will be. This is
usually when tax rates are a negotiated item and the tax
rates may be found in the Sales Proceeds Allocation clause
(which goes by many names).
When taxes are legislated, usually from a higher authority
than the national oil company, the actual tax rate may not
be specified and the contract will simply state that the con-
tractor is responsible for all taxes.
• Submit weekly and monthly reports to the national oil compa-
ny
• Give preference to goods and services available within the
host nation
• Allow duly authorized representatives of the national oil
company access to the area covered in the contract
VALUATION OF PETROLEUM
The valuation of crude petroleum exported from the host coun-
try is often defined at the international market price, or it is based
on a predetermined “basket” of crudes. This price formula then
provides the basis for determining taxes and the basis of cost recov-
ery. This price may often be different than actual “realized” prices.
Sometimes a committee consisting of contractor and national oil
company personnel is established to monitor the international mar-
ket price and maintain a realistic value of crude for transactions
between the contractor and the national oil company.
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The valuation issue is particularly critical if the contractor is

paid in cash for services, as in a typical service agreement, or if
the contractor has a crude purchase agreement with the national
oil company.
PAYMENTS
There are often numerous obligations and corresponding pay-
ments between the host government agencies and the contractor.
This clause stipulates the currency that will be used for payments
between the contractor and the national oil company or other
agencies. Most, but not all, contracts use U.S. dollars. Sometimes
more than one currency is used, such as U.S. dollars and the local
currency. When local currency is used, artificial exchange rates
other than the floating market rate can cause problems.
RECOVERY OF OPERATING COSTS AND

NET SALES PROCEEDS ALLOCATION
This section of the contract will explain the contractor’s entitle-
ment to recover all operating costs out of gross sales proceeds
(unless the contract has a royalty). This section usually explains
that if operating costs exceed the funds available for recovery, the
remainder may be carried forward. It further outlines the allocation
of revenues remaining after cost recovery. These remaining rev-
enues are usually referred to as profit oil in the contract. Applicable
taxes levied on the contractor’s share of profit oil may be specified
here, or the applicable body of tax law that applies will be specified.
EMPLOYMENT AND TRAINING OF LOCAL PERSONNEL

This section of the contract is usually an agreement by the
contractor to employ as many qualified nationals and/or person-
nel from the national oil company staff as is possible, subject to
competitive standards. Furthermore, this section outlines the tim-
ing of recruitment and training programs for the national oil com-
pany personnel.
This clause can appear to be toothless, in some cases requiring
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simply that preference to nationals be given. However, employing

nationals is important, whether contractually required or not. In
other cases there may be quotas that must be met. Some contracts
will stipulate up to 85% employment of nationals.
TITLE TO EQUIPMENT
Most PSCs and service agreements specify that any equipment
purchased by the contractor becomes the property of the national
oil company as soon as it arrives in the country. The clause fur-
ther stipulates that the contractor has the right to the use of the
equipment in the petroleum operations. This clause will often fur-
ther indicate that the cost of the equipment is recoverable. Under
some contracts, title passes when the costs have been recovered
under the cost recovery provisions of the contract.
Equipment that is rented or leased (and not purchased) by the
contractor does not become the property of the national oil com-
pany and this clause grants contractor rights to freely import or
export such equipment from the country.
OWNERSHIP TRANSFER
In some contracts the ownership transfer rights are covered
under the Rights and Obligations of Contractor clause. Ownership
transfer, also known as transfer of rights, or assignment, is an
important aspect of contract negotiations. It deals with the con-
tractor’s ability to find partners. Assignments that involve affiliated
companies are normally a simple formality requiring notification
or an application to the government. Transfer of rights to a third
party is a different matter. Most contracts will give the contractor
right to assign “in whole or in part any rights, privileges, duties or
obligations” to any third party acceptable to the national oil com-
pany or appropriate authority. The process under which a third
party is introduced and considered for acceptance can be daunting.
The determining factors are usually the financial integrity and to a
lesser degree, technical capability, unless operatorship is being
transferred. It is hoped that the transfer would be free of charges,
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fees, or related taxes, such as a capital gains tax.

Capital gains taxes or regulations on the transfer of rights can
have a strong influence on the marketability of a concession for
sale or farmout. Some contracts will cede to the national oil com-
pany a right of first refusal—the option of taking up the interests
being transferred under the same terms offered. In China the
national oil company has this right for any nonrelated party
transactions.
The problem with this issue from the government perspective
is that most governments resent companies making their licenses
the focus of international commerce. They view the process often
as one of promotion rather than exploration. The countries with
more experience in these matters do not worry so much about
this and understand the element of partnering which is such a big
part of this industry.
The ideal wording from the contractor’s point of view goes
something like this:
Contractor shall have the right to freely assign, transfer,

or otherwise dispose of any part or all of its interests to
any affiliated company and to sell, transfer, convey, or
otherwise dispose of all or any part of its interests to
parties other than affiliated companies or other contrac-
tor participants with the prior written consent of the
Ministry, which consent shall not be unreasonably with-
held or delayed. Assignments are exempt from all taxes,
levies, and duties.
Other language that would be desirable from the point of

view of the contractor but which is less common:
Conditions for transfer must be approved by the

Government; such approval shall not be unreasonably
withheld. If within thirty (30) days after notification to
the Government of the proposed transfer, the latter has
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not made known its decision, the transfer will be

deemed accepted. Transfers of any nature will be exempt
of any taxes.
BOOKS AND ACCOUNTS

This clause stipulates who will be responsible for keeping the
books and accounts and what rights the other parties have for
auditing and inspecting the books. The accounting procedure to
be used is normally specified and outlined in an appendix—
Appendix C in this outline.
PROCUREMENT
This clause primarily deals with the government’s desire to
ensure that local participation is maximized for goods and ser-
vices. Many of the details for regulating procurement may not be
found in the PSC, though. The Malaysian contract does not speci-
fy what levels of expenditure will trigger the need for a tender or
government approval, but these details are found in the joint
operating agreement between the contractor and the national oil
company.
Most budgets are submitted to the national oil company for
approval and have set levels of expenditure for given projects or
items that will require an authorization for expenditure (AFE).
The procedures and limiting criteria for contract awards are usu-
ally specified according to whether or not they fall under explo-
ration, development, or production operations.
For large capital items, the contracts usually require a compet-
itive tender. The level of expenditure that requires tendering can
have a big influence on the efficiency of operations. Generally,
expenditures over $50,000 will be put out for bid.
For expenditures above $250,000 or so, a bid list may be
required. The Vietnamese PSC requires international tendering
for any work costing over $200,000. The government will publish
a list of companies, and only those companies will be eligible for
tendering for certain goods or services. If the contractor has a pre-
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ferred supplier for a particular item, then it is important to get

that supplier qualified for the bid list.
Between that level and, say, $1,000,000, the contractor would
tender, but may have authority to choose without government
approval. Above $1,000,000 or so, the government will usually
have approval rights. The lower these thresholds are, the less effi-
cient an operation can become.
JOINT OPERATING AGREEMENT

With government participation, an operating agreement will
also be required. These operating agreements are similar to the
JOAs used between industry working-interest partners. The PSC
itself may indicate the requirement for a JOA. Here is an example
from a recent Malaysian contract:
[The participating companies and the Malaysian

National Oil Company operating arm CARIGALI]…as
Contractors shall, as a condition precedent to the sign-
ing of this Contract, enter into an agreement between
themselves to provide for the procedures whereby they
shall exercise their rights and fulfill their obligations as
Contractors (such agreement hereinafter referred to as
the “Joint Operating Agreement”).
In the Malaysian contract, this article also stipulates the 15%

entitlement (carried working-interest share) that CARIGALI has
in the license.
FORCE MAJEURE
Force majeure is a French term meaning “an overpowering force
or coercive power.” Its application to a contract is to limit the liabili-
ty of either party, contractor or national oil company, for nonper-
formance of contract obligations due to war, political disturbances,
an act of state, riots, earthquakes, epidemics, or other major causes
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beyond human control. As mentioned previously, the term is

sometimes defined in the Definition section of the contract.
Some negotiators would like to see bureaucratic delays
included as a force majeure item, but in most cases that sort of lan-
guage will not fly.
ARBITRATION
This clause describes the methods and rules by which disputes
will be settled, should conflicts arise between the parties to the
contract. More and more countries are willing to agree to interna-
tional arbitration of disputes.
Typical arbitration clauses stipulate that contract disputes be
arbitrated in a specific language and arbitration system. Often the
arbitration clause stipulates that each side appoint an arbitrator,
and these two arbitrators choose a third to make up a tribunal.
The decision of the majority is usually final.
The inclusion of such nonjudicial dispute resolution mecha-
nisms is becoming widespread and widely accepted. It can be
done on an ad hoc basis where the arbitrators are determined by
provisions of the contract, or there are numerous agencies which
include:
• ICSID (International Center for the Settlement of Investment
Disputes)
• ICC (International Chamber of Commerce)
• UNCITRAL (United Nations Committee on International
Trade Law)
• AAA (American Arbitration Association)
In Equatorial Guinea the dispute resolution clause is an agree-

ment to submit the dispute to ICSID for conciliation and, if unre-
solved after three months, for arbitration. A key question is, Is
Equatorial Guinea a party to the ICSID convention? It may have
signed the convention but not ratified it. Or it may not have even
signed it. If the country has not signed and ratified the appropri-
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ate convention identified in the contract, then any dispute will

drop down into the local courts. Without arbitration as the means
for resolution of disputes, the local court system is usually the
only other alternative.
In addition to the choice of method or institution and rules
under which disputes will be arbitrated, the arbitration clause
should state that the decision of the arbitrator or arbitral board
shall be final and binding on both parties.
One advantage of arbitration is that it is private, unlike litiga-
tion, and often less expensive.
INSURANCE
Most contracts require that the contractor secure and main-
tain insurance with reputable international insurance companies
satisfactory to the national oil company. Furthermore, the con-
tractor is usually required to make sure that subcontractors are
adequately insured.
TERMINATION
Contracts under many circumstances may be terminated by
the contractor by giving 60–90 days written notice to the national
oil company. This condition usually does not apply during the
exploration phase of the contract if the contractor has not com-
pletely fulfilled the work obligations.
ENTIRE CONTRACT AND MODIFICATION

This clause usually states that the contract and exhibits consti-
tute the entire agreement between contractor and national oil
company, that any other representations not embodied in the
contract will not apply. All prior negotiations, representations, let-
ters of intent, or other agreements are deemed cancelled or
merged within the contract.
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EXHIBIT A: DESCRIPTION OF CONTRACT AREA

This exhibit usually outlines the exact coordinates and physi-
cal boundaries of the contract area.
EXHIBIT B: MAP OF CONTRACT AREA

A map of the contract area is usually included and considered
a standard part of the contract. Coordinates mentioned in Exhibit
A are usually shown on the contract area map.
EXHIBIT C: ACCOUNTING PROCEDURE
This exhibit usually specifies what currency will be used for
the books and records, as well as what language. English is usual-
ly preferred, as are U.S. dollars. Such things as operating costs are
defined. Items to be excluded from cost recovery are also stipulat-
ed.
EXHIBIT D: MANAGEMENT PROCEDURE

This clause will often stipulate that the contractor is responsi-
ble for the execution of the work program. It may further outline
the makeup of the management committee, format for meeting
minutes, and responsibilities and functions of the management
committee. This section may set forth subcommittees for procure-
ment and accounting.
OTHER CONTRACT TERMS AND ISSUES
ABANDONMENT
The ownership issue always seems to surface with the subject
of abandonment under a PSC. In theory, where ownership of the
assets and facilities rests with the state, as it normally does with a
PSC, there also rests the abandonment liability. This would be
particularly true if the contract expired and operations passed to
the national oil company before shut-down. The issue gets slight-
ly abstract because abandonment is a normal procedure under
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standard oilfield operating practices, but there is no revenue

stream available to recover costs of abandonment when that time
comes. However, this is usually not such a complex matter.
Abandonment costs can be estimated and amortized with the
establishment of an interest-bearing reserve fund through cost
recovery during the producing years. Properly structured, the
abandonment cost would be anticipated, and the fund would
mature at the appropriate date with sufficient funds to cover
abandonment. This could be done with a straight-line method or
a unit-of-production approach. This issue was not anticipated in
many of the early PSCs.
ECONOMIC STABILITY, EQUILIBRIUM, OR INTANGIBILITY CLAUSES

There is much discussion about developing language for pro-
tection against additional taxes and levies that are enacted after
contract signature. These clauses theoretically allow for an equal-
izing adjustment in the contract to neutralize the effect of any
additional taxes that may be imposed. This would be an antidote
for creeping expropriation. If the parliament increased income
taxes, such a clause might require the national oil company to
adjust the profit oil split in order to keep the contractor “econom-
ically whole.” If taxes go up, the profit oil split is adjusted to keep
the contractor take at the original contract level.
This would essentially give the national oil company more
power than the taxing authority and would emasculate the taxing
authority, as far as the petroleum industry was concerned. It is
hard to imagine that a government body such as a parliament or a
congress would effectively cede its authority to the national oil
company.
Normally, contractors have no such economic stability guaran-
tees, and it is unlikely that such clauses will flourish. There is an
old saying: “What Parliament giveth Parliament may taketh away.”
This is an ancient and universal truth. Furthermore, why should
petroleum companies receive special exemption from raised taxes?
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This can be a dangerous political position for a company or an

industry. It may be more appropriate to try to protect against legis-
lation that discriminates against the petroleum industry.
The Ecuador Service Agreement has an equilibrium clause that
allows for adjustment in the service fee formula in the event of tax
level changes. The purpose of the adjustment is to effectively main-
tain the same economic terms that had been agreed upon in the
contract. The Vietnamese PSC also has language to this effect. It
addresses the possibility of a legal or administrative provision or
amendment that might result in a modification to the terms of the
contract. If there is an adverse effect on the contractor,
Petrovietnam will take measures to guarantee a situation that is
economically equivalent to that initially envisaged in the contract.
The Malaysian PSC also has a clause that addresses this issue.
The terms of this Contract have been negotiated and

agreed having due regard to the terms of the Petroleum
(Income Tax) Act, 1967 as amended by the Petroleum
(Income Tax) Amendment Act, 1976 and export duty in
force on the Effective Date. If, at any time or from time
to time there should be changes in the aforesaid or the
introduction of any other legislation, regulations or
order which imposes taxes and duties peculiar to the
petroleum industry and not of general application, the
effect of which would be to increase or decrease materi-
ally the liability of Contractors to pay petroleum income
tax or such other taxes and duties, then the Parties may
consult each other with a view of arriving at an equi-
table arrangement so as to take account of such changes.
The Chinese PSC has a broader clause:
If a material change occurs to the Contractor’s economic

benefits due to new laws, decrees, rules, and regulations
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or any amendment to applicable laws, decrees, and reg-

ulations made by the government, the Parties shall
make necessary revisions to the Contract to maintain
the Contractor’s normal economic benefits.
The virtue of having such clauses is that perhaps it would be

less likely that changes subsequent to contract signature would
have an adverse effect. Or a change in taxes, for example, may be
less likely. Furthermore, clauses such as these add some teeth to
claims for compensation should changes occur.
RENEGOTIATION CLAUSES
Some contracts have provisions for review and renegotiation
at various contract intervals. This kind of clause amounts to an
“agreement to agree” at a later stage in the contract life. There are
strong emotions on both sides of this issue. Many negotiators
have doubts about the value of review clauses and believe that it
is perhaps better to structure flexible terms that can respond to a
variety of economic conditions. They prefer to nail down every
contract item as precisely as possible.
Others believe that renegotiation clauses provide a means of
reaching agreement on basic issues and leaving the more uncer-
tain issues for a time when better information is available to
decide. A good example is what is sometimes referred to as the
gas clause. Some contracts will specify the sharing and tax arrange-
ment specifically for a gas discovery. But in the international sec-
tor, gas is quite different than oil in many ways. Some of these gas
clauses effectively state that in the event of a gas discovery, the
parties to the contract will agree to negotiate further.
The Ghana PSC had a renegotiation clause that provided for a
review of the contract terms at any time if significant changes
occurred in the circumstances that had prevailed at the time of entry
into the agreement. Some such clauses require periodic review.
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Illustration 8–1
The Chinese contract also has a gas clause. The thrust of

the clause is that:
Allocation of the natural gas shall be in conformity

with general principles of allocation for the crude oil
stipulated in the contract. However, the percentages of
the allocation shall be adjusted by the parties through
negotiations in light of actual conditions in the gas field
so that the contractor shall be able to obtain a reason-
able economic benefit.
It is nearly impossible to anticipate and account for everything

that may occur during the life of an agreement. Very often a
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problem appears to be an obvious blunder—hindsight is crystal

clear. This is portrayed in Illustration 8–1. Many readers may
recall that Rudolph was recruited at the last moment with little
time for negotiation.
CUSTOMS DUTIES EXEMPTIONS

Contractors are usually exempt from normal customs duties.
One reason for this is that title to the equipment is transferred to
the government anyway. Sometimes title will transfer as it clears
customs.
Many companies would like to see the customs duties exemp-
tions, as agreed in the contract, included in the nation’s petrole-
um law. There are often conflicts of authority between the host
government, the national oil company, and the customs and
immigration authority. A PSC may clearly state that no delays or
duties will be imposed at customs, but unless this is well under-
stood and respected by the customs officials, then it may not mat-
ter what the contract says.
The language often takes the following form:
Contractor and its subcontractors are entitled to import

or export, without duty and without undue delays,
equipment, materials, vehicles, spare parts, foodstuffs,
and other supplies that are necessary for operations.
EXCHANGE CONTROL
Some governments try to regulate currency exchanges and
financial transactions that involve capital coming into or going
out of the country. These exchange controls are usually adminis-
tered by the central bank or a government board of control. The
situation becomes a problem particularly where local currency is
overvalued. The difference between official exchange rate in a
country and the black market rate is often a direct measure of the
magnitude of the problem.
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GOVERNING LANGUAGE
The governing language of the contract is usually the national
language of the country. Indonesia requires the contracts to be
written in Indonesian and English, but the English text is official.
In China the contract language is both English and Chinese with
both versions having equal force. In Vietnam contracts are
required in Vietnamese and French. This, of course, conjures up
images of three translations.
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ACCOUNTING PRINCIPLES
9
ACCOUNTING
PRINCIPLES
A n understanding of basic accounting concepts

and principles helps when confronting the numerous fiscal sys-
tems in the international petroleum industry. The basic issues
that define generally accepted accounting principles (GAAP) are
straightforward and usually based on common sense. Knowing
the reasoning behind accounting conventions can provide a
good framework for understanding some of the accounting
aspects of various fiscal systems. Most fiscal systems worldwide
follow GAAP as outlined here.
Furthermore, eligibility requirements for foreign tax credits
usually revolves around whether or not the foreign tax payments
conform to GAAP, particularly in the determination of taxable
income.
The Financial Accounting Standards Board (FASB) in the
United States, an independent, self-regulating organization,
establishes standards known as GAAP for the accounting indus-
try. The FASB outlines procedures and rules that define accepted
accounting practices for financial reporting. The FASB publishes
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broad guidelines and detailed procedures for financial account-

ing practices.
ACCOUNTING CONCEPTS
Eleven basic accounting concepts provide the foundation of
accounting theory. These principles are fundamental to the
understanding of financial reporting and calculation of taxable
income. They may not be perfect. In nearly every case where
there is a weakness in a particular principle or accounting prac-
tice, it is easy to point out the problem, but not so easy to find a
better solution.
ACCOUNTING CONCEPT
1. Money measurement
2. Entity
3. Going concern
4. Dual aspect
5. Accounting period
6. Materiality
7. Conservatism
8. Consistency
* 9. Realization
* 10. Matching
* 11. Cost
* These last three concepts are of prime importance in under-

standing financial reporting in the oil industry.
1. THE MONEY MEASUREMENT CONCEPT

Financial information is expressed in monetary terms. It
would not be practical to record on the balance sheet the number
of barrels or acres a company owns. Money is the common
denominator, and quite often the U.S. dollar is the currency used
for accounting and reporting.
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2. THE ENTITY CONCEPT

Accounts are kept for business entities. The answer to any
accounting issue must address the question, How does it affect the
business? According to the entity concept, accountants are not
concerned with persons who own or operate the business, but
with the business itself.
3. THE GOING-CONCERN CONCEPT

Accounting assumes that a business will continue forever. If
there is evidence, that the entity is going to liquidate, the
accounting function might need to assess what the entity is worth
to a potential buyer.
4. THE DUAL-ASPECT CONCEPT

The resources owned by a business or entity are called assets.
The claims against these assets are called equities. The two types of
equities are (1) liabilities that represent the claims of creditors and
(2) the owner’s equity. The total claims on the assets are equal to
the assets.
Assets = Equities
Assets = Liabilities + Stockholders’ Equity
This is why both sides of the balance sheet balance. The essen-
tial concept is that for every resource available to a company,
somebody has a claim on it.
5. THE ACCOUNTING-PERIOD CONCEPT

Accounting practices are based on the need to report periodi-
cally the status of a business entity. The basic time period is the
fiscal year (12 months). Many companies use interim reports,
usually quarterly and even monthly reports.
6. THE MATERIALITY CONCEPT

Insignificant items do not require attention.
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7. THE CONSERVATISM CONCEPT

This principle dictates that given a choice, an asset will be
recorded at the lowest or most conservative value. As far as the
income statement is concerned, this principle provides that poten-
tial losses be accounted for, and yet potential gains or profits are
not registered until they are realized. The result, theoretically, is
that financial statements will provide a conservative view of the
business.
8. THE CONSISTENCY CONCEPT

The consistency concept stipulates that once an entity
embarks on an accounting methodology, it must be consistent in
its treatment of accounting issues unless it has good reason to do
otherwise. At times, companies decide to make changes in
accounting policies. These changes are explained in the footnotes.
9. THE REALIZATION CONCEPT

The realization principle dictates that revenue should be rec-
ognized only at the time a transaction is completed with a third
party, or when the value is reasonably certain. One common con-
cern centers on the applicability of the realization principle to the
petroleum industry. Some feel this principle should not be applic-
able because the major asset of an oil and gas company is its
reserves, and the value of a company’s reserves is not directly
reflected on the balance sheet.
Neither the balance sheet nor the income statement allow
appropriate recognition for important oil and gas discoveries in
the accounting period in which a discovery is made. When a com-
pany makes a major discovery, there is no mechanism for report-
ing the results from an accounting point of view. The impact on
the income statement comes when the discovery begins to pro-
duce, yet economic value was realized the moment the discovery
was made.
Another aspect of the realization concept is the accrual method
of accounting for revenue and expenses and ultimately taxes.
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Under this method, revenue is recorded as it is earned, or is said

to have accrued, and does not necessarily correspond to the actu-
al receipt of cash. This concept is important for the understanding
of the Statement of Cash Flows and the concept of cash flow. For
example, assume that a company sold 1,000 bbl of oil for $20/bbl,
but had received only $17,000 by the end of the accounting peri-
od. From an accrual accounting point of view, revenues are
recorded as $20,000.
Revenues $20,000
Beginning receivables +1,000
Cash flow potential 21,000

Ending receivables – 4,000
Realized cash flow 17,000 = Sales less increase

in receivables
The income statement would reflect $20,000 because the

accrual method of accounting realized the income at the point of
sale, not at the point of actual cash exchange. The balance sheet
would show the $17,000 increase in cash as well as an increase in
accounts receivable for the $3,000 not yet received. However, the
actual cash received is $17,000.
10. THE MATCHING CONCEPT

The matching principle provides that revenues should be
matched with the corresponding costs of producing such revenues.
A serious accounting issue in the oil and gas industry deals with the
matching principle because it is so difficult to match the costs of
finding oil and gas with the revenues from production. Under
GAAP the assets reported on the balance sheet consist of capitalized
historical costs. Earnings are recognized as reserves are produced
rather than when they are discovered or revised.
Two separate systems of accounting in the industry are based
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primarily on this issue as it pertains to the treatment of explo-

ration costs. The two systems are called Full Cost and Successful
Efforts accounting. While revenues are typically recognized when
oil or gas is sold, the fundamental difference between the FC and
SE accounting systems lies in how the corresponding costs of
finding those reserves match those revenues.
11. THE COST CONCEPT

In accounting, an asset is recorded at its original cost. This cost
is the basis for all subsequent accounting for the asset. The prima-
ry rationale behind the cost principle is that the value of an item
may change with the passage of time, and determination of value
is subjective. There is no subjectivity associated with the actual
cost of an item.
Because of the cost principle, the accounting entry on the bal-
ance sheet for oil and gas assets usually has little to do with the
actual value of the assets. For instance, if a company were to
obtain a lease and then discover 1 MMBBL of oil, the accounting
entry would not change because of the discovery. It would never
reflect anything other than the associated costs less depreciation.
Only the net tangible costs would represent all that oil.
In this example there is substantial appreciation in value that
is ignored by GAAP. However, accountants do not ignore eco-
nomic value completely. The cost principle provides that assets
should be reflected on the balance sheet at cost, unless there has
been a decline in their utility or economic value. Accountants do
not mind an asset on the books at less than its true market value,
but they are careful to keep accounting entries from exceeding
economic value.
Costs associated with oil and gas exploration and production
fall into four fundamental categories:
Lease Acquisition Costs. Costs associated with obtaining a lease

or concession and rights to explore for and produce oil and gas.
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Exploration Costs. Costs incurred in the exploration for oil and

gas such as geological and geophysical costs (G&G), exploratory
drilling, etc.
Development Costs. Costs associated with development of oil

and gas reserves, such as drilling costs, storage and treatment
facilities, etc.
Operating Costs. Costs required for lifting oil and gas to the sur-
face, processing, transporting, etc.
Treatment of these costs is fairly straightforward. The one

exception is the way that exploration costs are treated. This pro-
vides the basis for the two different accounting practices that are
used in the industry.
SUCCESSFUL EFFORTS AND

FULL COST ACCOUNTING
These two accounting methods, Full Cost (FC) and Successful
Efforts (SE), can give very different results, on earnings, return on
equity, and book value. Both systems follow as best they can the
accounting principles of matching, realization, and cost, yet there
is debate about which system is most appropriate. Primarily, the
two systems differ on how capital costs associated with explo-
ration drilling are treated. The main difference is that drilling
costs of unsuccessful exploration wells are capitalized under FC
accounting and expensed under the SE accounting system.
SUCCESSFUL EFFORTS ACCOUNTING

Before the 1950s virtually all oil companies used some form
of Successful Efforts (SE) accounting. The rationale behind SE is
that expenditures that provide no future economic benefit
should be expensed at the time incurred. The SE approach will
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expense or write-off exploratory dry-hole costs in the accounting

period in which they are incurred. This is similar to many other
businesses that write-off business failures. Proponents of SE
agree that only expenditures directly associated with the discov-
ery of hydrocarbons should be capitalized. SE companies treat
exploration expenditures like other companies would treat
research and development. If a research results in a viable prod-
uct, then capital expenditures are capitalized, otherwise the costs
are expensed.
COST CENTERS
One of the main differences between the two systems
results from the choice of size and use of cost centers. It is this
difference that makes the largest financial impact. With SE,
costs for a cost center can be held in suspense until it is deter-
mined if commercial quantities of oil or gas are present. With a
well or lease as the cost center, costs are expensed if the well is
dry and capitalized if it is a discovery. This can be quite a sub-
jective decision. Sometimes the decision to drill a well may be
held up because of the perceived impact on the financial state-
ments during a specific accounting period should the well turn
out to be unsuccessful.
FULL COST ACCOUNTING

The philosophy behind FC accounting is that costs of acquisi-
tion, exploration, and development are necessary for the produc-
tion of oil and gas. This rationale acknowledges that dry holes are
an inevitable part of the exploration effort. With FC the entire
company can be a cost center, and all costs of exploring for oil
and gas are capitalized. Companies with international operations
typically treat each country as a separate cost center. By contrast,
as mentioned earlier, successful-efforts companies may treat each
well as a cost center.
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Ceiling Test Limitation

FC accounting requires a write-down on the book value of oil
and gas assets if it exceeds the SEC value of reserves. For this rea-
son, FC companies use large cost centers. This is the ceiling test
required by the SEC for the cost of oil and gas properties on the
balance sheet. The recorded capitalized costs for producing oil and
gas properties is limited to the net present value of the reserves dis-
counted at 10%. This is the SEC value of reserves or standardized mea-
sure. If the SEC value of reserves falls below the capitalized costs on
the balance sheet, a ceiling write-down occurs. For example, if a
company had a book value for proved oil and gas properties of
$100 million, and if the SEC value of these reserves was $130 mil-
lion, there would be no write-down. The company would have a
cost ceiling cushion of $30 million. In 1986, when oil prices dropped
so dramatically, cushions disappeared, and many FC companies
experienced substantial write-downs. The most important problem
that this caused was that many companies suddenly found them-
selves in violation of covenants in their loan agreements.
Impairments and write-downs occur under SE accounting,
too. It is usually not considered as great an issue because such a
large part of exploration costs are expensed and not capitalized.
But, in consistency with the conservatism principle, the carrying
value of SE oil and gas properties is subject to write-downs if the
economic value of a property is less than the recorded value.
Periodic assessments are made to insure that the value of leases
have not been impaired due to negative results of drilling or
approaching expiration dates.
COMPARISON
With each system, lease bonus payments, related legal costs,
and intangible drilling costs (IDCs) are capitalized. Capitalized
costs within a cost center are usually amortized on the unit-of-
production method (explained later in this chapter). Basic ele-
ments of the two systems are compared in Table 9–1.
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Table 9–1
Comparison of Accounting Systems

Successful Full
Efforts Cost
Method Method
G & G costs Exp Cap

Exploratory dry hole Exp Cap
Lease acquisition costs Cap Cap

Successful exploratory well Cap Cap
Development dry hole Cap Cap
Successful development well Cap Cap
Operating costs Exp Exp
Which companies typically Major Oil Smaller

use each method Companies Independent
Companies
Size of cost center used Small Large
Single Well, Company,

Lease, Country,
or or
Field Hemisphere
Comment Favored by Approved by

FASB SEC
G & G = Geological and Geophysical

Exp = Expensed (written off in accounting period)
Cap = Capitalized (written off over a number of accounting periods)
DEPRECIATION, DEPLETION, &

AMORTIZATION (DD&A)
Depreciation is a means of accounting for the recovery of the
costs of a fixed asset by allocating the costs over the estimated
useful life of the asset. When this concept is applied to a mineral
resource such as oil and gas reserves, it is called depletion. The
concept is called amortization when the allocation of costs is
applied to intangible assets. The terms depreciation, depletion, and
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amortization (DD&A) are sometimes used interchangeably, or

more often collectively as DD&A.
The combined DD&A for many companies can be quite signif-
icant. The per-unit values that are deducted for income tax pur-
poses can range from $3 to more than $10/bbl.
The importance of DD&A is that these expenses are deducted
from income for federal and provincial tax purposes or as an
important component of cost recovery under a PSC. The deprecia-
ble life of an asset is usually determined by legislation to emulate
the useful life of that asset. GAAP usually dictate the use of
straight-line decline over the useful life of an asset. However,
some forms of accelerated depreciation are allowed as well. Four
methods of depreciation/amortization are summarized:
• Straight-line decline (SLD)
• Sum-of-the-year’s digits (SYD) *
• Declining balance (DB) *
• Double declining balance (DDB) *
• Unit of production
*Accelerated depreciation
STRAIGHT-LINE DECLINE
Under SLD depreciation the asset is amortized in equal install-
ments over its useful life. Thus if a six-year life is used, the depre-
ciation rate would be 1/6 of the original value per year. Sometimes
contract summaries identify the depreciation rate as a percentage,
such as 25%. This nomenclature indicates that the asset is depre-
ciated at a rate of 25% per year, the equivalent of a four-year
straight-line decline.
SUM-OF-THE-YEAR’S DIGITS
SYD is based upon an inverted scale which is the ratio of the
number of digits in a given year divided by the total of all years dig-
its. For example, with a five-year SYD depreciation schedule, the
five year’s digits are added (5 + 4 + 3 + 2 + 1) to get 15.
Depreciation in the first year then (because it is an inverted scale) is
equal to 5/15 of the asset value. Year 2 would be 4/15 and so on.
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SUM-OF-THE-YEAR’S DIGITS DEPRECIATION

$100,000 investment
Year Fraction Percent Depreciation Balance
1 5/15 33.333% $33,333 $66,667
2 4/15 26.667% 26,667 40,000
3 3/15 20.000% 20,000 20,000
4 2/15 13.333% 13,333 6,667
5 1/15 6.667% 6,667 0
100.000% $100,000
DECLINING BALANCE
With the DB method, depreciation is straight-line depreciation
calculated for the remaining balance of the asset for each year. For
example, a four-year DB would depreciate 25% of an asset in the
first year. The following year 25% of the remaining balance (75%)
would be depreciated (18.75%). The third year, 25% of the
remaining balance (.25 × .5625) would be depreciated and so on.
DOUBLE DECLINING BALANCE

The DDB method calculates depreciation by doubling straight-
line depreciation for the remaining balance of the asset for each
year. For example, four-year DDB would depreciate 50% of an asset
in the first year. The following year depreciation would be 50% of
the balance, or 50% of 50% = 25%. The remaining balance would
be 25%, so in the third year depreciation would be 50% of that.
FORMULA FOR UNIT-OF-PRODUCTION METHOD
P
Annual Depreciation = (C – AD – S)
R
where:
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C = Capital costs of equipment

AD = Accumulated depreciation
S = Salvage value
P = Barrels of oil produced during the year *
R = Recoverable reserves remaining at the
beginning of the tax year
* If there is both oil and gas production associated with the capital
costs being depreciated, then the gas can be converted to oil on
a thermal basis.
Table 9–2 compares four depreciation methods for an asset

with a useful life for accounting purposes of seven years.
Table 9–2
DEPRECIATION SCHEDULES
Input
Investment ($) 100
Year 7
7 Year 7 Year 7 Year 7 Year

SLD DB DDB SYD
Year Annual Cum. Annual Cum. Annual Cum. Annual Cum.
1 14.29 14.29 14.29 14.29 28.57 28.57 25.00 25.00
2 14.29 28.57 12.24 26.53 20.41 48.98 21.43 46.43
3 14.29 42.86 10.50 37.03 14.58 63.56 17.86 64.29
4 14.29 57.14 9.00 46.02 10.41 73.97 14.29 78.57
5 14.29 71.43 7.71 53.73 7.44 81.41 10.71 89.29
6 14.29 85.71 6.61 60.34 5.31 86.72 7.14 96.43
7 14.29 100.00 5.67 66.01 3.79 90.51 3.57 100.00
8 33.99 100.00 9.49 100.00
9
10
SLD = Straight-line decline

DB = Declining balance
DDB= Double declining balance
SYD = Sum-of-the-year’s digits
189
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DOUBLE TAXATION
10
DOUBLE
TAXATION
M ost companies doing business overseas must

deal with the effects of both foreign taxes and their home country
tax treatment of foreign income. Under U.S. tax law, the entire
income, regardless of the source, of a domestic corporation is sub-
ject to U.S. income taxes. In this context double taxation is a key
issue of international operations.
Double taxation occurs when countries have different defini-
tions of taxable income/or profits. It can also arise when a taxpay-
er or taxpaying entity resident (for tax purposes) in one country
generates income in another country. It generally refers to situa-
tions where the same profit is taxed more than once in more than
one country.
Because of the competitive nature of the global industry, there
is little room for double taxation. Margins are thin enough and
there are few, if any, projects or provinces with sufficient potential
to allow an added burden of taxation. Without relief from double
taxation, very little foreign exploration would be undertaken. If
there were room for added home-country taxes on foreign
191
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upstream operations, then it would only be due to inefficient rent

extraction on the part of the host country.
Relief from double taxation comes from double taxation
treaties (bilateral or multilateral) or home-country regulations
that allow relief. The most common remedy is where companies
are allowed to offset home-country corporate taxes with tax
credits from foreign-paid taxes. Since 1918 the United States has
provided unilateral relief from double taxation by allowing
foreign income taxes or taxes on profits to be used as a tax credit
against U.S. corporate income tax liabilities. The policy outlined
in Internal Revenue Code Section 901(a) allows a credit against
foreign income taxes to alleviate the double taxation that would
exist if foreign income earned were taxed both by the United
States and the host government of the country in which the
income was earned. Different forms of relief are summarized in
Table 10–1.
TAX CONSIDERATIONS
In order to be eligible for creditability against U.S. taxes, a for-
eign levy must be a tax, and its predominant character must be
that of a U.S. income tax.
A tax is a compulsory payment to foreign country pursuant to
its authority to levy taxes. Consumption taxes, penalties, and cus-
toms duties would not qualify as a tax in this sense. According to
the U.S. Internal Revenue Code Section 901, creditable foreign
taxes include “income, war profits, and excess profits taxes paid
or accrued . . . to any foreign country or any possession of the
United States.”
PREDOMINANT CHARACTER
U.S. regulations dictate that in order to qualify, the foreign tax
must be an income tax; that is, its predominant character must be
that of a U.S. income tax predominantly consistent with U.S.
income taxation principles. The purpose of the U.S. foreign tax
credit system is to alleviate double taxation on income taxes.
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DOUBLE TAXATION
Therefore, nonincome-type taxes such as property taxes and con-

sumption taxes are not creditable. There are two primary tests for
the predominant character requirement. The first is referred to as
the net gain requirement.
Under the normal circumstances under which the tax applies,
the foreign tax must be likely to reach a net gain. There are three
main requirements.
1. REALIZATION REQUIREMENT
The foreign tax law must generally conform to the realization
principle of accounting. The tax is imposed either during or
after the occurrence of a taxable event—not before. If income
or gain is recognized and taxed before when it would have
been realized and recognized under generally accepted U.S.
accounting principles, then the realization test is not met.
2. GROSS RECEIPTS REQUIREMENT

Calculation of the tax must begin with gross receipts or be
predominantly based upon gross receipts.
3. NET INCOME REQUIREMENT

The significant costs incurred in operations reaping the gross
receipts must be allowed as deductions in calculating taxable
income. The timing of the recovery of costs must allow for all
substantial costs (or more) to be recovered.
Second, if a foreign tax is contingent upon creditability of that

tax against the taxpayer’s home-country income taxes, it is
referred to as a soak-up tax, and U.S. regulations will not allow it
to be credited.
There are other limitations—for example, foreign royalties
will normally not qualify. Royalties and bonuses are considered to
be payment for specific economic benefits that are not ordinarily
available on substantially the same terms to all taxpayers in a
given country. This situation is typical for the petroleum industry
193
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where the specific benefit is usually the right to extract hydrocar-

bons. Taxpayers that receive a specific economic benefit and are
also subject to pay taxes are referred to as dual-capacity taxpayers,
because they both receive a benefit and pay taxes.
If a foreign government owns mineral resources in which the
taxpayer has an interest, a foreign tax will not be recognized as a
tax for U.S. federal income tax purposes, unless that government
also requires payment of an appropriate royalty or other considera-
tion for the payment that is commensurate with the value of the
concession or license—the specific economic benefit. The foreign
income tax must be calculated separately and independently of the
amount of the royalty and of any other taxes, payments, or charges
imposed by the foreign government. If the foreign tax does not
impose a royalty, the IRS allows dual-capacity taxpayers to separate
the levy into its separate components—creditable tax payment and
royalty payments or the equivalent. The dual-capacity taxpayer
must also prove the creditability of the tax portion or the qualifying
amount of the levy. There are two methods for separating a foreign
levy into its distinct creditable and noncreditable elements—the
facts and circumstances method, and the safe harbor method.
In the facts and circumstances method, the dual-capacity tax-
payer establishes which portion of the foreign levy is not paid for
the specific economic benefit.
The safe harbor method is based upon an IRS Code formula:
SAFE HARBOR FORMULA
Creditable portion of levy = (A – B – C) × D/1 – D
where:
A = the amount of gross receipts
B = the amount of costs and expenses
C = the total amount foreign levy paid by the dual-
capacity taxpayer
D = general tax rate
194
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DOUBLE TAXATION
For example, assume that Teton Exploration (a dual-capacity

taxpayer) is subject to a 50% income tax in Country X where the
general tax rate is 35%. The Country X tax on Teton income is a
separate tax than the Country X general income tax structure.
The safe harbor formula is used to calculate the creditable portion
of the levy and to separate the payment for the specific economic
benefit. Assume that Teton has $20 million in gross receipts and
$12 million in costs and expenses. The resulting reported net
income of $8 million is taxed at a rate of 50%.
Calculation of the eligible foreign tax credit (in millions of dol-
lars) follows:
.35
FTC = (20 – 12 – 4) ×
1 – .35
FTC = $4 × .53846
FTC = $2,153,840
The noncreditable payment for the specific economic benefit

is $1,846,160—the difference between the foreign tax credit and
the actual payment ($4 million).
$4,000,000 Actual tax paid

- 2,153,840 Creditable portion
$1,846,160 Payment for specific economic benefit,

noncreditable
The regulations in this area are quite lengthy.
195
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Taxes in Lieu of Income Taxes

Some foreign taxes that do not meet the net gain require-
ments may still qualify for creditability. A foreign tax that is
imposed “in lieu of a tax on income” may be treated as an income
tax. A foreign tax will qualify as an in-lieu-of tax if it is a tax, it is
not a soak-up tax, and if a substitution requirement is met. Under
the substitution requirement, a tax is an in-lieu-of tax if it oper-
ates as a substitute to and not in addition to an income tax. It
need not be a complete substitute.
Relief from the burden of double taxation comes in three
basic forms: exemptions, tax credits, and deductions.
EXEMPTIONS. Under the exemption system, profit is taxed in one

country and is exempt from tax in the others.
TAX CREDITS. A common system is where income taxes paid in a

source country are creditable against income taxes in the country
of residence. This system means that the effective tax is the high-
er of the two country’s tax rates.
DEDUCTION. Under this system, taxes paid in the source country

are deductible against income taxes in the country of residence.
For example, in Papua New Guinea the Basic Petroleum Tax is
creditable against U.S. income taxes but the Additional Petroleum
Tax (which is essentially the basis for classifying the PNG contract
as a ROR contract) is not creditable. However, the APT is
deductible when calculating U.S. income taxes.
The Indonesian 35% income tax is creditable against U.S.

income taxes. The Indonesian production share and the 20% with-
holding tax do not qualify. The 35% tax is consistent with the gen-
eral IRS guidelines for tax creditability under Section 901:
1. The amount of tax is calculated separately and independently of
the amount of royalty (if any) and other taxes or charges imposed.
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DOUBLE TAXATION
Table 10–1
Double Taxation Relief

System
U.S.
No Tax Tax Tax
Relief Deduction Credit Exemption
Profits in Country X $100 $100 $100 $100
Country X Income Tax (26%) 26 26 26 26
After-tax Income in Country X 74 74 74 74
Home-country Tax Basis 100 74 100 0
Home-country Tax (34%) 34 25 8 0
After-tax Income 40 49 66 74
Total Taxes Paid 60 51 34 26
Effective Total Tax Rate 60% 51% 34% 26%
2. The income tax is imposed on the receipt of income deter-

mined on the basis of arm’s length transactions and in accordance
with U.S. income taxation principles.
3. The taxpayer’s liability cannot be discharged from property
owned by the foreign government.
4. The tax liability is computed on the basis of the taxpayer’s
entire extractive operations within the country.
5. Reasonable limitations on the recovery of capital expenditures
is allowed, but the taxpayer must be able to deduct without limi-
tation the significant expenses incurred.
In some production sharing contracts, there is not a direct
royalty or tax payment by the contractor, and the language of the
197
#CHAP 10 5/3/04 9:23 AM Page 198
contract effectively states that royalties and taxes are paid by the
national oil company out of its share of profit oil. The Egyptian
PSC is a good example of this. The income tax liabilities of the
contractors in Egypt were paid by EGPC out if its share of profit
oil. The IRS allowed companies to credit the Egyptian income tax
liability against U.S. tax liabilities in spite of the arrangement.
The 1971 and 1978 Peruvian model contracts with no direct
cost recovery provisions created a problem. These contracts sim-
ply gave the contractor a share of production. This kind of
arrangement was even further removed from the general IRS
guidelines than the Egyptian contract. In order to achieve eligibil-
ity, Belco Petroleum and Occidental Petroleum negotiated with
the Peruvian government for a contract revision which would
have resulted in an option under which the companies could pay
a 40% tax on gross income or a 68.5% net income tax paid
directly to the government. The proposed agreement included a
royalty to be paid to the national oil company PetroPeru.
However, in 1980 the Peruvian government decided against the
gross income tax and passed legislation for a tax on net income.
LIMITATION ON AVAILABLE TAX CREDIT

If income from a foreign operation is taxed at a rate that is
higher than the U.S. tax rate, then the total creditable taxes could
exceed the U.S. tax on that foreign income. However, the United
States limits the amount of credit on foreign income to the
amount of U.S. tax on that income. The U.S. approach to the tax-
ation of income from foreign operations is based on the principle
that foreign operations should face a total tax rate at least equal
to the U.S. tax rate.
BRANCHES VS. SUBSIDIARIES

U.S. companies operating overseas in the past have normally
made use of a branch or a special-purpose, Delaware-incorporated
subsidiary.
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DOUBLE TAXATION
BRANCH
When a foreign operation is a branch of the home-country
parent organization, no intercompany dividend is involved, and
normally withholding taxes are not levied. For example, a compa-
ny operating as a branch in New Zealand does not pay the 15%
withholding tax, but the income tax rate is higher for a branch at
38% compared to the normal rate of 33% for domestic corpora-
tions and foreign-controlled subsidiaries. Some countries treat
payments from branches to parents as dividends for withholding
tax purposes, but this is very rare. Prior to 1984 in the United
States, the rule of thumb was, “You always drilled in branches.”
This was because losses from a branch’s operations could be offset
against other domestic income. At a later date, when the branch
began to throw off profits, it could be incorporated in the foreign
jurisdiction to allow the potential deferral of taxation on the prof-
its. Companies can no longer do this because prior branch foreign
losses have to be recaptured when a foreign branch is incorporat-
ed. Now the default option is usually to drill through a controlled
foreign corporation (CFC). If the drilling is unsuccessful, and assum-
ing the corporate structure is properly set up, the stock of the CFC
can be taken as a loss under IRC Section 165(g)(3). If the drilling
is successful, it may be possible to defer paying any current U.S.
tax on the foreign earnings—depending on the classification of
the income under Subpart F (which will be discussed later).
SUBSIDIARY CORPORATION
If the foreign operation is structured through a subsidiary
company, a controlled foreign corporation (CFC), it will pay
income taxes on profits generated in the foreign country and also
pay dividend withholding taxes when they are repatriated to the
parent company. These withholding taxes are usually 15%–20%.
The foreign tax credit availability is limited to shareholders with
10% or more of the voting stock of the CFC. To qualify as a CFC
in the United States for eligibility for tax credits, U.S. shareholders
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#CHAP 10 5/3/04 9:23 AM Page 200
must own more than 50% of the voting stock or value of the
company.
A U.S. shareholder is a U.S. person who owns 10% or more of
the voting power of the foreign corporation. Thus there is some
planning room here to allocate nonvoting shares disproportion-
ately to either create a CFC (i.e., to allow creditability of taxes) or
not do so (i.e., where the taxpayer desires to let profits build up
untaxed offshore).
Subsidiary companies are normally taxed when profits are
remitted to the parent, as opposed to branch profits, which are
taxed as they accrue.
Tax credits from international operations can come directly
through a branch where the taxes are paid directly or indirectly
through a subsidiary where the taxes are deemed to have been
paid. There are some other differences between direct and indirect
credits. Direct credits are operative in the year the taxes are paid,
whereas the indirect credit, except when Subpart F is applicable, is
triggered when income is distributed. The most common form of
indirect tax credit is when a domestic company receives a dividend
from a foreign subsidiary. The direct credit can be claimed by
either an individual or a corporation but the indirect, or deemed-
paid, credit can only be claimed by a corporation. The parent
company must own at least 10% of the voting stock of the sub-
sidiary. The amount deemed paid is based upon a proration of the
actual amount paid and the percentage interest held by the parent.
The actual computation of the deemed-paid credit can be
formidable in practice. The concept is to “gross up” the dividend
and attribute the foreign tax paid with respect to that dividend,
taking into account the foreign corporation’s earnings and profit
layers and the domestic parent’s ownership percentage.
Significantly, the code allows a deemed-paid credit for a second-
tier and third-tier subsidiary, provided the domestic parent has at
least a 5% indirect interest in these entities. Thus, if a third-tier
subsidiary produces income which generates a foreign tax credit
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DOUBLE TAXATION
and then pays a dividend which eventually goes to the domestic

parent, the domestic parent may take a deemed-paid foreign tax
credit.
Registration of a company in a foreign country usually
requires the following:
• Appointing a local agent
• Maintaining a registered office in the country
• Lodging a certified copy of the certificate of incorporation
and other documents (financials, annual reports, etc.)
verifying the company’s existence and validity with the reg-
istrar of companies or equivalent authority
• Submitting a certified list of directors
This topic would not be complete without a discussion of

Subpart F. Subpart F seeks to treat certain kinds of income earned
by CFCs as currently taxable to the U.S. shareholders in a manner
similar to, but certainly not just like, an S Corporation, regardless
of whether the profits have been repatriated to the U.S. share-
holders. In a similar vein, a foreign tax credit may be taken on a
deemed-paid basis for any income recognized by U.S. share-
holders through the application of Subpart F.
Subpart F is particularly important in the oil and gas industry,
which is given special treatment. A special limitation is imposed
on the amount of foreign taxes taken into account on the income
from Foreign Oil and Gas Extraction Income (FOGEI) and Foreign
Oil Related Income (FORI). The purpose of these rules is to
prevent allocation of FTCs out of the FOGEI category (which is
usually taxed at a high rate) to FORI, or some other classification,
which may be taxed at a lower rate, thereby enhancing the over-
all use of FTCs.
Foreign tax credit usage may be restricted under certain rules
that require the recapture of overall foreign losses from a branch’s
operations. These rules work by re-sourcing foreign income as
domestic income to the extent prior foreign losses had reduced
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domestic taxable income. Although only 50% of the otherwise

foreign source income is recharacterized in a taxable year—there-
by limiting the rule’s effect to some degree—special rules may
apply where a foreign property is disposed of that could re-source
more than 50% of the otherwise foreign source income.
Certain rules called dual consolidated loss provisions apply to
both domestic corporations and to separate units of the domestic
subsidiary (i.e., branches). These rules prevent a U.S. company
from “double dipping” by deducting losses from its worldwide
operations under the normal U.S. tax rules and again in a foreign
jurisdiction where the foreign jurisdiction allows losses to be
taken on other than a source basis.
As mentioned before, a branch’s losses must be recaptured
when the branch is incorporated in a foreign jurisdiction. The
amount recaptured is reduced by any overall foreign losses previ-
ously recaptured as described earlier. Other rules may apply
which could reduce the amount recaptured. The important point
to keep in mind is that these rules only apply if there are foreign
losses attributable to the branch being incorporated. If there are
no foreign losses, it may be possible to incorporate the branch
tax-free if it constitutes an active trade or business. Again the IRS
has devised special rules for the oil and gas industry, that apply
here to determine whether or not an oil and gas working interest
constitutes an active trade or business.
202
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COMMENTARY
11
COMMENTARY
T he international petroleum industry has entered an era

of intense global competition. More countries than ever are open
for business and are aggressively seeking capital. In 1993 there
were official licensing rounds in 40 countries. Other nations were
actively negotiating with oil companies. Republics of the former
Soviet Union dominate the scene. This has created a heightened
competitive awareness among countries all over the world. They
now actively compete with one another. It is no longer a passive
market. Countries must be proactive, and their marketing efforts
have to be consistent with their culture, geology, and fiscal terms.
Whole regions such as Southeast Asia, Latin America, and
West Africa are being evaluated on the basis of prospectivity, fiscal
terms, and general business environment. Ultimately, countries
within certain geographic regions may need to cooperate.
Individual countries may not be able to stand alone.
Petroleum fiscal designs are evolving. Clear trends have been
established. Most governments are relying on production sharing
contracts, lower royalties, and fewer signature bonuses.
203
#CHAP 11 5/3/04 9:25 AM Page 204
Exploration risks are high enough without bonuses. Competition

and enlightenment have fostered these trends.
Governments are more flexible in awarding blocks and
licenses. It is difficult for countries to design fiscal terms appropri-
ate for every geological province. Countries can let industry help
determine what the market can bear by negotiating terms.
Independent oil companies are going overseas as never
before, entering the domain of the major oil companies.
Exploration target thresholds are three to four times higher for a
major than an independent. This inefficiency has added an impor-
tant dynamic to the international business. Risk capital is too crit-
ical, and dinosaurs will not survive in the exploration business.
Fewer and fewer regions are capable of yielding the major oil
company exploration thresholds of more than 400 MMBBLS of
oil.
As the international sector expands, oil provinces in the
United States have entered a stage of supermaturity. No other
region comes close. Figure 11–1 illustrates the worldwide picture
as of January 1993. Onshore in the lower 48 states the average oil
well produces less than 10 BOPD. By international exploration
standards, the onshore United States is dead.
The future for the upstream oil industry lies outside the con-
tinental United States. In regions such as Latin America, Africa,
Asia, and the former Soviet Union, opportunities will proliferate
as these regions mature. Competition will help forge realistic and
balanced fiscal terms as well as improved business climates. It is
an exciting future with many challenges. Good luck!
– Daniel Johnston
204
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COMMENTARY
Regional Reserves Distribution
bbls
1%
2
6
7
After: Grossling, B., Nielsen, D., “In Search of Oil,” January, 1985. Updated and revised by the
author with information from Oil & Gas Journal Energy Database, the Oil & Gas Journal Worldwide
Production Report, 27 Dec. 1993, and Oil Industry Outlook, Ninth Edition 1993–97.
Figure 11–1 Regional reserves distribution
205
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#CHAP 12 5/3/04 11:53 AM Page 207
APPENDICES
12
APPENDICES
APPENDIX A
S F S
AMPLE ISCAL YSTEMS
T he following examples outline basic elements of the

fiscal systems from selected countries. The terms outlined here are
nonproprietary, public domain information gathered from a vari-
ety of sources. Where appropriate, the source has been given. In
most cases the terms are general. There may be some variation
within a given country, but the terms outlined should be repre-
sentative. It is believed that the summaries are complete in regard
to the key royalty, tax, and production-sharing elements.
However, where the information is not available or is ambiguous
regarding such things as ringfencing or exploration obligations,
the countries were nevertheless included.
207
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COUNTRY FISCAL TERM SUMMARIES

1 Abu Dhabi 22 Ivory Coast
2 Albania (Cote
ˆ d’Ivoire)
3 Algeria 23 Korea
4 Angola 24 Malaysia
5 Argentina 25 Malta
6 Bangladesh 26 Morocco
7 Bolivia 27 Myanmar
8 Brunei Myanmar Contracts
9 Cameroon (IOR, RSF, Offshore)
10 China Offshore 28 New Zealand
11 China Onshore 29 Nigeria
12 Colombia 30 Norway
13 Congo 31 Pakistan
14 Egypt 32 Papua New Guinea
15 Equatorial Guinea 33 Philippines
16 France 34 Spain
17 Gabon 35 Syria
18 Ghana 36 Thailand
19 India 37 Timor Gap
20 Indonesia 38 Tunisia
(2nd Generation Pre-1984) 39 Turkmenistan
Indonesia 40 United Kingdom
(4th Generation Post-1988–89) History
21 Ireland 41 Uzbekistan
42 Vietnam
43 Yemen (North)
208
#CHAP 12 5/3/04 11:53 AM Page 209
APPENDICES
ABU DHABI
Early Concessions
Area 1 MM + Acres
Duration
Exploration 2 years
Production 33 years
Relinquishment ?
Exploration Obligations Seismic Survey

+ 1 or more wells
aggregate depth of 30,000 ft
Royalty Sliding Scale:

Up to 100,000 BOPD 12.5%
100,001–200,000 16%
200,001 + 20%
Bonuses Commercial Discovery $5 MM

50,000 BOPD $3 MM
100,000 BOPD $6 MM
200,000 BOPD $6 MM
Cost Recovery 100% No Limit
Depreciation 5-year straight line
Taxation (Income Tax) Sliding Scale, BOPD

Up to 100,000 55%
100,001–200,000 65%
200,001 + 85%
Ringfencing Each license separate
Domestic Market Obligation Nil
State Participation Some
Later modern contracts in Abu Dhabi followed the OPEC model:

20% Royalty
85% Tax
209
#CHAP 12 5/3/04 11:53 AM Page 210
ALBANIA
Circa 1991
Area No restriction, Designated blocks
Duration
Exploration 2 + 3 + 1.5 years with discovery
Production 4-year development period + 20 years
Relinquishment 25%
or 100% of no discovery
Exploration Obligations Seismic work programs offshore

Start within 3 months
Royalty Nil
Signature Bonus Nil
Production Bonus 25,000 BOPD: $1.0 million

50,000 BOPD: $1.0 million
Cost Recovery 45% limit
Depreciation 20%/year for 5 years
Profit Oil Split

(In favor of government) Approximately 60%/40%
Profit Gas Split Negotiable
Taxation 50% income tax
State Participation Nil
210
#CHAP 12 5/3/04 11:53 AM Page 211
APPENDICES
ALGERIA
Royalty/Tax (Law N° 86-14 of Aug 19, 1986)
Partnership Contracts & PSCs (Law N° 91–21 of Dec 4, 1991)
Area
Duration
Exploration 4 years + 2-year extension
Production 12 years from date of exploration permit
Relinquishment
Exploration Obligations
Royalty Zone N 20%

Area A 16.25%
Area B 12.25%
Under certain conditions the 20% royalty may be reduced in Areas A & B
Bonuses None for exploration permits

Negotiated for existing fields
Depreciation G&G Costs and dry holes 100%

Producing Wells 25%/year
Buildings & Facilities 20%/year
Pipelines 10%/year
Taxation Income Tax Zone N 85%*

Area A 75%*
Area B 65%*
Under certain conditions the 85% tax rate may be reduced in Areas A & B.
The 1980 Amoco contract had 55% tax rate.
* Only valid with partnership contracts
Ringfencing
Domestic Market Obligation For gas, negotiated formula depends

on size of discovery
State Participation 51% at discovery to Sonatrach (NOC)

Carry through exploration
+ 2 extension wells
Other
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#CHAP 12 5/3/04 11:53 AM Page 212
ANGOLA
1989 Model PSC
Area Designated blocks
Duration
Exploration 5 years (3 + 2 one-year extensions)
Production 20 years
Relinquishment ?
Royalty Nil
Signature Bonus Yes, & production & education bonuses

Old contracts had 61% uplift for
development costs recovered over 6 years.
Profit Oil Split Cumulative Split, % Cumulative Split, %

(Two examples) Production, Gvt/ Production, Gvt/
MMBBLS Company MMBBLS Company
Up to 25 60/40 Up to 25 45/55
25–50 70/30 25–75 70/30
50–100 80/20 75–175 80/20
Over 100 90/10 Over 175 90/10
on field by field basis
Ringfencing Each license separate usually
Investment Uplift 40% of tangible capital costs
Other Old contracts had $20/bbl (1987 price cap).

Gvt took excess above price cap escalated by
U.N. factor for manufactured goods exports from
developed nations. 1992 price cap = $35/bbl
State Participation Yes, back-in option for development

up to 51%—less in deepwater
212
#CHAP 12 5/3/04 11:53 AM Page 213
APPENDICES
ARGENTINA
Royalty/Tax (1990)
Duration
Exploration 3 years with two 2-year extensions
Delineation 1 following discovery
Production 20 years
Relinquishment
Royalty 12%
5% marginal fields
Bonuses
Depreciation
Taxation (Profit Tax) 30%

1% sales tax
1% assets tax
Ringfencing
Domestic Market Obligation Yes
State Participation 15%–50% gvt option (old contracts)
213
#CHAP 12 5/3/04 11:53 AM Page 214
BANGLADESH
(1989)
Duration
Exploration 4 years + two 2-year extensions
Production 15 years from date of 1st sale
Relinquishment After: 4 years 25%

After: 6 years 50%
After: 8 years 100% with no discovery
Exploration Obligations 1 well minimum
Royalty Nil
Signature Bonus No
Production Bonus 5,000 BOPD: U.S. $0.5 million

10,000 BOPD: 1.0 million
Cost Recovery Sliding Scale, BOPD

Up to 5,000 40% Limit
5,001–10,000 35%
10,001 + 30%
Depreciation 10% year straight line
Profit Oil Split Production, BOPD Split, %

(in favor of government) Up to 5,000 70/30
5,000–10,000 75/25
10,001–25,000 80/20
25,001–50,000 85/15
50,001 + 90/10
Profit Gas Split Negotiated
Taxation Nil, profit split is effectively

after-tax split
Domestic Market Obligation Pro rata up to 25% at market price
214
#CHAP 12 5/3/04 11:53 AM Page 215
APPENDICES
BOLIVIA
Operation, Association, and Service Contracts
Area Not to exceed 1 MM hectares in traditional areas

Not to exceed 1.5 MM hectares in nontraditional areas
20,000 hectare lots
Duration Maximum Term 30 years

Exploration 4 years + 2 if gas is discovered
Production 24–26 years depending on extension
Relinquishment Exploitation area following exploration

phase may not exceed 3 lots (60,000 hectares)
Bonuses
Depreciation
Royalties 19% national tax based on gross production

11% departmental participation royalty
1% national compensatory royalty
Taxation 40% net profits tax
Ringfencing
Domestic Market Obligation
State Participation
Other
215
#CHAP 12 5/3/04 11:53 AM Page 216
BRUNEI
Royalty/Tax
From PetroAsian Business Report, March 1994
Area No limitations
Duration
Exploration 8 years onshore, 17 offshore
Production Total of 38 years onshore, 40 offshore
30-year extensions may be available
Relinquishment 75% after exploration period

if discovery is made
Exploration Obligations B$4,000/km2 seismic or

B$12 million, whichever is greater,
in the first 4 years
in the next 4 years at least B$8,000/km2
Royalty 12.5% onshore

10% for fields 3–10 nautical miles offshore
8% for fields more than 10 miles offshore
Bonuses May be required—negotiable

Rentals B$15/km2 during first 4 years
B$45/km2 thereafter
Cost Recovery Limit None
Depreciation ?
Taxation 55% petroleum income tax
Ringfencing
State Participation State has option to take up to 50%
Other
216
#CHAP 12 5/3/04 11:53 AM Page 217
APPENDICES
CAMEROON
(1990)
Duration
Exploration 4 years + three 4-year renewals
Production 25 years
Relinquishment

Up to 50,000 tons/yr (1,000 BOPD) 2%
50,001–400,000 tons/yr (7,700 BOPD) 6%
400,001–700,000 tons/yr (13,400 BOPD) 9%
700,001–1,000,000 tons/yr (19,000 BOPD) 11%
Over 1,000,001 tons/yr 12.5%
Gas less than 300 billion m3/yr (29 MMCFD) 1%

more than 300 billion m3/yr 5%
Signature Bonus
Depreciation
Profit Oil Split (In favor of government)

Cumulative Production Split %
Up to 15 MM tons (100 MMBBLS) 60/40
15–30 MM tons (200 MMBBLS) 65/35
Over 30 MM tons (200+ MMBBLS) 70/30
Taxation 57.5% for petroleum companies
Ringfencing
State Participation 50% state reimburses contractor

for exploration costs
217
#CHAP 12 5/3/04 11:53 AM Page 218
CHINA Offshore PSC

From PetroMin Magazine, Dec. 1993
Area ?
Duration 30 years
Exploration 7 years
Production 15 years + extensions with approval
Relinquishment ?
Exploration Obligations ?
Royalty Oil, BOPD Gas, MMCFD

Up to 20,000 0% Up to 195 0%
20,001–30,000 4% 195–338 1%
30,001–40,000 6% 338–484 2%
40,001–60,000 8% 484 + 3%
60,001–80,000 10%
80,001 + 12.5%
(BOPD converted from tons/year at 7:1) : (MMCFD converted from MM m3/year at 35.3:1)
Pseudoroyalty 5% consolidated industrial and

Based on Gross Revenues commercial tax
Profit Oil Split (Negotiable) Example Split, %

Production Rate, BOPD Gvt/Contractor
Up to 10,000 10/90*
10,000–20,000 20/80
20,000–40,000 30/70
40,000–60,000 40/60
60,000–100,000 50/50
Over 100,000 60/40
*Some contracts start at 95% and slide to 45%.
Bonuses ?
Cost Recovery Limit 50%–62.5%

With 9% interest cost recovery on development costs
Depreciation 6-year SLD

(15% in Hainan Province)
3% local income tax
10% surtax
Contractors must also pay vehicle and vessel usage, license tax, and individual income tax.
Ringfencing Yes, for cost recovery but not for

income tax purposes
Domestic Market Obligation No
State Participation Up to 51% upon commercial production
218
#CHAP 12 5/3/04 11:53 AM Page 219
APPENDICES
CHINA Onshore PSC

From PetroMin Magazine, Dec. 1993
Area ?
Duration 30 years maximum

Exploration 8 years (3 + 2 + 3)
Production 15 years + extensions with approval
Relinquishment ?
Exploration Obligations ?
Bonuses ?
Royalty
Oil, BOPD Gas, MMCFD
Up to 1,000 0% Up to 10 0%
1,001–2,000 1% 10–20 1%
2,001–3,000 2% 20–30 2%
3,001–4,000 3% 30–40 3%
4,001–6,000 4% 40–60 4%
6,001–10,000 6% 60–100 6%
10,001–15,000 8% 100–150 8%
15,001–20,000 10% 150–200 10%
20,001 + 12.5% 200 + 12.5%
(BOPD converted from tons/year at 7:1) (MMCFD converted from MM m3/year at 35.3:1)
Pseudoroyalty 5% CIC Tax based on gross revenues

Based on Gross Revenues Commercial Tax
Profit Oil Split (Negotiable) Example Split, %

Production Rate, BOPD Gvt/Contractor
Up to 10,000 10/90
10,000–20,000 20/80
20,000–40,000 30/70
40,000–60,000 40/60
60,000–100,000 50/50
Over 100,000 60/40
Cost Recovery 60% onshore

With 9% interest cost recovery on development costs
Taxation 30% income tax (15% in Hainan Province)

3% local income tax
10% surtax
Contractors must also pay vehicle and vessel usage, license tax, and individual income tax.
Ringfencing Yes
Domestic Market Obligation No
State Participation Up to 51% upon commercial production
219
#CHAP 12 5/3/04 11:53 AM Page 220
COLOMBIA
Mid 1980s Association Contract, pre-1994
Area Various blocks
Duration 28 years including exploration period

Up to 10 years for exploration
Relinquishment 50% at end of year 6

25% more at end of year 8
Remainder is dropped at end of year 10 except commercial field and 5 km band.
Exploration Obligations Yes, negotiated
Royalty 20%
1990 War Tax 600–900 pesos/bbl fluctuating but based on
$1.00/bbl for 1st 6 years of production
Bonuses
Cost Recovery 100% No limit

The term “cost recovery” is not used, but contractor collects all of gross revenues
except royalty (i.e., 80%) until payout.
Depreciation

25% surcharge from 1993–97
effective rate 44%
(expected reduction to 36%)
Remittance Tax 12%–15%
Ringfencing No
Domestic Market Obligation Receives FMV 75% in U.S. $
State Participation 50% carried interest

At back-in Ecopetrol reimburses 50% of
cost of successful wells
The government percentage of production increases with cumulative production
above 60 MMBBLS.
Contractor
Cumulative Share of
Production, MMBBLS Production, %
0–60 50
60–90 45
90–120 40
120–150 35
Over 150 30
220
#CHAP 12 5/3/04 11:53 AM Page 221
APPENDICES
CONGO
Royalty/Tax (1993)
Area
Duration
Exploration 10 years
Production 30 years
Relinquishment
Royalty 14.5%–19% Oil (Negotiated)

9% Gas
The old royalty calculated on 80% of FOB price ranging from 6.5% at 1,000 BOPD to
15% for 100,000 BOPD. Gas 2%–5%.
Bonuses 250 MM CFA Francs at 30,000 BOPD

625 MM CFA Francs at 75,000 BOPD
may be capitalized and deducted
Depreciation 5-year straight-line decline
Taxation 55%
Domestic Market Obligation Not to exceed 30% of contractor’s oil
Ringfencing Development area one ringfence
State Participation 50% Gvt reimburses contractor out of

75% of gvt net revenues with interest
221
#CHAP 12 5/3/04 11:53 AM Page 222
EGYPT
Early 1980s
From: Petroleum Company Operations and Agreements in Developing Countries,
Raymond F. Mikesell, 1984
Duration ?
Relinquishment After each phase 25% of original area

All except development leases after exploratory period
Exploration Obligations Bid item

For each commercial discovery, contractor must drill an additional other prospect.
Royalty 0% EGPC pays royalties and taxes

out of its share of profit oil
Signature Bonus $1– $5 MM
Production Bonus Yes
Cost Recovery 30% Limit

(In favor of government)
Up to 90,000 80/20
90,000–140,000 82.5/17.5
140,000 + 85/15
Taxation Paid by government,

therefore profit oil split
is effectively an after-tax split
State Participation 50%/50% joint venture
222
#CHAP 12 5/3/04 11:53 AM Page 223
APPENDICES
EGYPT
1986 Standard Model
Duration
Exploration 8 years maximum, 3 phases
After discovery 1-year delineation period
Production 20 years
Relinquishment After each phase 25% of original area

All except development leases after exploratory period
Exploration Obligations Bid item

For each commercial discovery contractor must drill an additional other prospect.
Royalty 0%–10% Negotiated
Signature Bonus $2–$4 MM
Production Bonus $3 MM at 30,000 BOPD

$5 MM at 50,000 BOPD
$7 MM at 100,000 BOPD
Cost Recovery 40% Limit Offshore 30% Onshore
Depreciation 20%/year expl. & dev. costs
Profit Oil Split Proposed in 1986 Split %

Production, BOPD Newer Older
Up to 20,000 70/30 80/20
20,000–40,000 75/25 83/17
40,000 + 80/20 85/15
Most contracts continue to be based on standard flat 85%/15% split.
Taxation Paid by government,

therefore profit oil split
223
#CHAP 12 5/3/04 11:53 AM Page 224
EQUATORIAL GUINEA
PSC ROR Contract
Area 125,000-acre grid blocks
Duration
Exploration 5 years, three 1-year/1-well extensions
Production 30 years from commercial discovery
50 years for gas
Relinquishment 40% at end of 3rd year

additional 20% before end of 5th year
Exploration Obligations Drilling
Royalty 10%
Bonuses Signature $1 MM
Discovery $300,000 +
First Oil Sales $1 MM
Production Bonuses $2–$5 MM at 10,000–20,000 BOPD ±
Surface Rentals $.50–$1.00 per hectare ±
Cost Recovery Limit After paying royalty, no limit
Depreciation 25% per year (all costs)
Profit Oil Split (two examples shown here)

“Net Crude Oil” after royalties and cost recovery
Contractor’s Contractor’s
Pretax Contractor Pretax Contractor
Real ROR, % Share, % Real ROR, % Share, %
up to 30 100 up to 20 100
30–40 60 20–40 80
40–50 40 40–60 50
over 50 20 over 60 10
Ringfencing
Domestic Market Obligation If requested to do so, contractor

sells to government a portion of
net crude oil at market prices.
State Participation
Other
224
#CHAP 12 5/3/04 11:53 AM Page 225
APPENDICES
FRANCE
Late 1980s
Area Minimum 175 km2

after relinquishment
Duration
Exploration 5 years +
maximum of two 5-year extensions
Production 5 years + two 5-year extensions
for fields < 2.1 MMBBLS
up to 50 years for large fields

Extension 12.5% (leaving 37.5%)
Royalty Sliding Scale: Oil, %

Up to 1,000 BOPD 0
1,001–2,000 6
2,001–6,000 9
6,001 + 12
Gas Royalty for production over 30 MMCFD = 5%
Signature Bonus
Cost Recovery Concessionary System, 100%
Depreciation

Tax deferral/depletion allowance
23.5% of gross or 50% of net income
if spent on further exploration
225
#CHAP 12 5/3/04 11:53 AM Page 226
GABON
PSC (1989)
Area 0.1–1 million-acre blocks
Duration
Production 20 years

5 years 50%
Exploration Obligations 1–3 Well minimum

Up to 10,000 BOPD 5%
10,001–20,000 10%
20,001–40,000 15%
40,001 + 20%
Signature Bonus U.S. $0.5–$2 million
Production Bonus Startup: U.S. $1.0 million

Cost Recovery 55% Limit

40% older contracts

Up to 5,000 65/35
5,000–10,000 70/30
10,001–20,000 73/27
20,001–30,000 75/25
30,001–40,000 80/20
40,000 + 85/15
Taxation 56% income tax paid by government

out of contractor share of profit
oil—therefore profit oil split
Domestic Market Obligation Up to 20% of profit oil sold at 75% of

market price, otherwise pro rata
State Participation 10% Working Interest
226
#CHAP 12 5/3/04 11:53 AM Page 227
APPENDICES
GHANA
Royalty/Tax 1986 Vintage
ROR provision came later
Area
Duration
Exploration 7 years
Production 18 years (25 years including exploration)
Relinquishment negotiated
Royalty 12.5%
Bonuses None or negotiated
Depreciation 20% per year (exploration & development)
Taxation 50% local income tax
Additional Profits Tax After-tax

[Post-1986] ROR, % Rate, %
Up to 15 50
15–25 60
over 25 70
Ringfencing
Domestic Market Obligation At world prices
State Participation GNPC carried for 10% through exploration

has option to increase participation
to majority interest during development
Other
227
#CHAP 12 5/3/04 11:53 AM Page 228
INDIA PSC
Early 1990s
Area ?
Duration
Exploration
Production
Relinquishment
Royalty None
Bonuses None
Cost Recovery 100% no limit
Depreciation 4 Years
Profit Oil Split Investment Multiple

Cumulative Net Cash Flow ÷ Contractor
Exploration & Development Costs Share, %
0–1.5 100
1.5–2.0 90
2.0–2.5 85
2.5–3.0 80
3.0–3.5 75
over 3.5 60
Taxation 50%
Ringfencing Development costs are ringfenced

by field. Exploration costs are not.
State Participation 30% Back-in
228
#CHAP 12 5/3/04 11:53 AM Page 229
APPENDICES
INDONESIA
Second Generation (Pre-1984)
Area No restriction, designated blocks
Duration
Exploration 3 years
Production 20 years
Relinquishment 25%
or 100% if no discovery
Exploration Obligations Multiwell commitments
Royalty Nil
Signature Bonus Various
Production Bonus Many variations, each contract is

different
Cost Recovery No limit
20% Investment credit applies

to facility, platform, pipeline
costs; is recoverable but taxable
Depreciation Oil 7-year double declining balance

going to straight line in year 5
Gas 7-year declining balance switching
to straight line in year 8
Profit Oil Split

(In favor of government) 65.9091% / 34.0909%
Profit Gas Split

Ringfencing Each license ringfenced
Domestic Market Obligation After 60 months production from a

field, contractor receives 20¢/bbl
for 25% of oil
State Participation Up to 50%—Option seldom exercised
229
#CHAP 12 5/3/04 11:53 AM Page 230
INDONESIA
Fourth Generation (Post 1988–89)
Duration
Exploration 3 years
Production 20 years
Relinquishment 25%
Exploration Obligations Multiwell commitments
Royalty Nil
Signature Bonus Still exist, various
Production Bonus Many variations

each contract is different
Cost Recovery 80% limit because of 1st tranche

petroleum of 20%
17% Investment credit applies
to facility, platform, pipeline
costs; is recoverable but taxable
Depreciation Oil 25% declining balance with

balance written off in year 5
Gas 10% declining balance with
balance written off in year 8
Profit Oil Split

Profit Gas Split

(In favor of contractor) 42.3077% / 57.6923%
Domestic Market Obligation After 60 months production from a

field, contractor receives 10% of
market price for 25% of oil
State Participation Up to 50% in joint operating

agreement contracts
230
#CHAP 12 5/3/04 11:53 AM Page 231
APPENDICES
IRELAND
Concession
Duration
Relinquishment
Royalty None
Bonuses
Cost Recovery Limit 100%, no limit
Depreciation 100%, all costs expensed
Taxation 25% tax on profits
Ringfencing
State Participation
Other
231
#CHAP 12 5/3/04 11:53 AM Page 232
^
IVORY COAST (Cote d’Ivoire
1988 Vintage PSC
Area
Duration
Exploration 5 years (3 periods: 2 + 1 + 2)
Production 25 years + additional period of 10 years
Relinquishment 50% after 2nd period (end of 3rd year)
Royalty None with PSCs
Bonuses Negotiated
Model contract mentions $12 MM
Cost Recovery Limit 40%
Depreciation
Profit Oil Split

Shallow Water Deepwater
< 1,000 m > 1,000 m
Contractor Contractor
Production BOPD Share, % Share, %
Up to 30,000 52 60
30,001–50,000 48 56
50,001–100,000 38 54
100,001–120,000 32 54
more than 120,000 30 54
Taxation 50% maximum tax on profits

Set at 34% in 1993
Ringfencing
Domestic Market Obligation Up to 15% or prorated share

Contractor receives 15% of FOB price
State Participation Varies between 10% and 60%. Fixed at 15%

for deepwater (NOC Petroci)
After 1993 reduced to 10% with state
option for up to 30% after discovery.
Other
232
#CHAP 12 5/3/04 11:53 AM Page 233
APPENDICES
KOREA
Concession
Area
Duration
Exploration
Production
Relinquishment
Royalty 15%
Bonuses
Cost Recovery Limit 100%, no limit
Depreciation
Taxation 50%
Ringfencing
State Participation
233
#CHAP 12 5/3/04 11:53 AM Page 234
MALAYSIA
Late 1980s, Early 1990s
Duration
Development 2 years + 2-year extension
Production 15 years for oil/20 years for gas
Relinquishment No interim relinquishment
Exploration Obligations Seismic and multiwell commitments
Royalty 10%
0.5% Research Cess
Signature Bonus None (Older contracts had bonuses)
Production Bonus None (Older contracts had bonuses)
Cost Recovery 50% limit for oil/60% for gas

Up to 10,000 50/50
10,001–20,000 60/40
20,001 + 70/30
All production in excess of 50 MMBBLS 70/30
Profit Gas Split For first 2 TCF 50/50

(In favor of contractor) After 2 TCF produced 70/30
Taxation 25% duty on profit oil exported

(with 20% export tax exemption)
45% petroleum income tax
State Participation Up to 15%
234
#CHAP 12 5/3/04 11:53 AM Page 235
APPENDICES
MALAYSIA
1994
Duration
Development 2 years + 2-year extension
Production 15 years for oil/20 years for gas
Relinquishment No interim relinquishment
Exploration Obligations Seismic and multiwell commitments
Royalty 10%
0.5% Research Cess
Signature Bonus None (Older contracts had bonuses)
Production Bonus None (Older contracts had bonuses)
Cost Recovery 50% limit for oil/60% for gas

Up to 10,000 50/50
10,001–20,000 60/40
20,001 + 70/30
All production in excess of 50 MMBBLS 70/30
Profit Gas Split For first 2 TCF 50/50

(In favor of contractor) After 2 TCF produced 70/30
Taxation 20% duty on profit oil exported

(with 50% export tax exemption)
40% Petroleum income tax

Also, gas development costs recovered from gas production, and oil development
costs recovered from oil production.
State Participation Up to 15%
235
#CHAP 12 5/3/04 11:53 AM Page 236
MALTA
PSC 1988 Vintage
Area
Duration
Exploration
Production
Relinquishment
Bonuses Negotiable at 3 levels

Production, BOPD
50,000
100,000
150,000
Royalty None
Cost Recovery Limit No Limit
Depreciation All costs 25% per year
Profit Oil Split Negotiable

(Example)
Production, BOPD Contractor’s
Share, %
Up to 50,000 75
50,000–100,000 70
over 100,000 60
Taxation 50% of contractors profit oil

Bonuses are not cost recoverable,
but they are tax deductible
Ringfencing
Domestic Market Obligation None
State Participation None
236
#CHAP 12 5/3/04 11:53 AM Page 237
APPENDICES
MOROCCO
Concession (1983 License Round)
Area at least 500 and less than 5,000 km2
Duration
Exploration 4 years + 2–3 4-year renewals
Production
Relinquishment 25% on first renewal

25% on second renewal
12.5% on third renewal
Royalty Sliding Scale Rate, %

Up to 1,000 BOPD 0
1,001–2,000 6
2,001–6,000 9
6,001–20,000 12
20,001 + 14
Total royalties may not exceed 12.5% of gross value of production
Bonuses
Rentals $2-6/1,000 acres/year initial period
$3-12/1,000 acres/year after 1st renewal
$12-25/1,000 acres/year after 2nd renewal
Taxation 48% profits tax
Special surtax after 4 years continued

production in excess of 7,500 BOPD or
1 MMCFD gas. Tax is equal to the difference
between total taxes assessed including
royalties and rentals and 50% of net profits.
Ringfencing ?
237
#CHAP 12 5/3/04 11:53 AM Page 238
MOROCCO
Royalty/Tax (1989 with 1986 incentives)
Area
Duration
Exploration
Production
Relinquishment
Royalty 12.5% of gross value of production

after first 4 MM tons (28 MMBBLS)
have been produced
Bonuses upon discovery

negotiable also production bonuses
not deductible for tax purposes
Depreciation 5-year DDB exploration capital

10-year SLD development capital
Taxation 52.8% effective tax rate
Special surtax based on profit/investment ratio
Assumed
Surtax, % Ratio
10 1.0
20 1.5
30 2.0
40 2.5
50 3.0
Ringfencing ?
State Participation 35% carried through exploration
238
#CHAP 12 5/3/04 11:53 AM Page 239
APPENDICES
MYANMAR
First License Round 1989/1990
Duration
Exploration 3 + 1 + 1 years
Production 20 years
Relinquishment 25% + 25%

Exploration Obligations Negotiable

(Initial Phase) U.S. $12–$88 million
Averaged U.S. $20 million
Royalty 10%
+ 0.5% for research & training
Signature Bonus U.S. $4.0–$7.5 million
Production Bonus Discovery: U.S. $1.0 million

10,000 BOPD 2.0 million
Depreciation 10%

Up to 50,000 70/30
50,001–100,000 80/20
100,001–150,000 85/15
150,001 + 90/10
Profit Gas Split Production, MMCFD Split, %

Up to 300 70/30
301–600 80/20
601–900 85/15
901 + 90/10

Tax holiday first 3 years under Foreign Investment Law
Domestic Market Obligation Pro rata: up to 20% of contractor’s

share of oil at U.S. $1/bbl
239
#CHAP 12 5/3/04 11:53 AM Page 240
SUMMARY OF PRODUCTION SHARING CONTRACT TERMS

MYANMAR ONSHORE OFFSHORE
1992 New EP Blocks IOR RSF <600ft >600ft
Exploration 3 years 6-month study 6-month study 3 years 3 years

Period period period
2 yrs to get 2 yrs to start
increase production
Extensions 2X1 2 X 1 year 2 X 1 year
Development 20 years 15 yrs from 20 yrs from 20 years 20 years

Period for each increase of start of for each for each
discovery production production discovery discovery
Relinquishment 25% 1st 0 or 100% 0 or 100% 25% 1st 25% 1st

extension after study after study extension extension
period period period period period
Royalty 10% 10% 10% 10% 10%
Cost Recovery 40% 40% 40% (MOGE 50% 50%

Limit recovers sunk
costs 50/50)
Production 30,000 65/35% 10,000 70/30% 10,000 70/30% 25,000 60/40% 25,000 60/40%
Sharing Oil 50,000 70/30 20,000 75/25 20,000 75/25 50,000 65/35 50,000 65/35
100,000 80/20 30,000 80/20 30,000 80/20 100,000 80/20 100,000 75/25
BOPD 150,000 85/15 30,000+ 85/15 30,000+ 85/15 150,000 85/15 150,000 80/20
Gvt./Contractor% 150,000+ 90/10 150,000+ 90/10 150,000+ 90/10
Production 180 65/35% 300 65/35% 300 60/40%

Sharing Gas 300 70/30 600 75/25 600 70/30
MMCFD 600 80/20 900 85/15 900 80/20
900 85/15 900+ 90/10 900+ 90/10
900+ 90/10
Signature $5 MM $5 MM after $5 MM after $5 MM + $5 MM

Bonus study period study period
Discovery $1 MM $500,000 data $500,000 data $1 MM $1 MM

Bonus
Production 10,000 $2 MM $200,000 $1 MM at 25,000 $2 MM 25,000 $2 MM

Bonus 30,000 3 MM commerciality commerciality 50,000 3 MM 50,000 3 MM
50,000 4 MM 100,000 4 MM 100,000 4 MM
100,000 5 MM 150,000 5 MM 150,000 5 MM
200,000 10 MM 200,00010 MM 200,000 10 MM
Income Tax 30% 30% 30% 30% 30%

3-yr holiday 3-yr holiday 3-yr holiday 3-yr holiday 3-yr holiday
Training $50,000 per yr $50,000 per yr $50,000 per yr $50,000 per yr $50,000 per yr
R&D 0.5% of profit 0.5% of profit 0.5% of profit 0.5% of profit 0.5% of profit
Domestic Oil @ 60% of world 20% of profit

Requirement price oil @ 10% price
Other 10% finders

bonus (royalty)
Most terms are negotiable. This table represents general or proposed terms outlined by MOGE.
240
#CHAP 12 5/3/04 11:53 AM Page 241
APPENDICES
NEW ZEALAND, Concessionary

Proposed 1991 Crown Minerals Act (Awaiting ratification)
Duration
Exploration 5 years with 5-year extension
Production Life of the field
Relinquishment 50% after 5 years
Royalty (Hybrid) 5% ad valorem royalty (AVR)

or 20% accounting profits royalty (APR)
whichever is greater
Previously the royalty was a flat 12.5% AVR
Signature Bonus Negotiable No
Cost Recovery No limit
Depreciation 20%
Taxation 33% income tax (resident companies)

15% withholding tax
38% income tax (nonresident companies)
State Participation Nil (Previously was 11% carry

through exploration phase.)
241
#CHAP 12 5/3/04 11:53 AM Page 242
NIGERIA
PSC 1987, Ashland Contract
Area
Duration
Exploration
Production
Relinquishment
Royalty 20%
Bonuses
Depreciation

Up to 50,000 65/35
over 50,000 70/30
1986 terms guaranteed $2/bbl profit margin on equity crude.
Taxation 85%
65% during cost recovery
“while amortizing preproduction costs”
Ringfencing
State Participation
Other Some uplifts/investment credits
242
#CHAP 12 5/3/04 11:53 AM Page 243
APPENDICES
NIGERIA
PSC New 1994 Terms
Area
Duration
Exploration
Production
Relinquishment
Exploration Obligations $24 million first 3 years

$30 million next 3 years
$60 million ten additional years
Former requirement: $176 MM over 10 years
Royalty Water Depth, m Rate, %

up to 200 16.667
200–500 12
500–800 8
800–1000 4
> 1000 0
Bonuses $2 million @ 10,000 BOPD

$2 million @ 50,000 BOPD
Cost Recovery Limit ? Under old contracts the limit was 40%
Depreciation

Up to 100,000 55/45
100,001–200,000 60/40
over 200,000 62/38
Taxation 50%
Down from 85% under older contracts, which had lower 65% rate during cost recovery
period.
Ringfencing
State Participation
Other 50% investment credit
243
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NORWAY
Concession
Area
Duration 30 Years
Exploration
Production Field Specific
Relinquishment
Royalty 0 (Post-1986)
Prior to 1986 royalty ranged from 8%–14%
Bonuses None
Depreciation 6-years SLD Beginning in a year of investment.

Prior to 1986 “when placed in service”

30% special tax
The basis of the special tax is free income, which is similar to ordinary income tax
basis but includes additional deduction for 5% uplift on development capital costs.
Ringfencing Not in upstream end
State Participation Statoil has option on up to 80%

working interest—no carry. Prior to 1986
government was carried through exploration.
Other Prior to 1986, 5% uplift on dev. cap. ex. for

6 years, abolished.
0.7% Tax capital tax = ad valorem tax on book
value of investments 15% production credit
(deduction)
244
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APPENDICES
PAKISTAN
Concession (Mid-1980s vintage)
Area Maximum 125 km2
Duration 20 yrs onshore, 25 offshore
Relinquishment 25% after 4 years + 25% after 2 more
Royalty 12.5% less annual rentals
Bonuses OXY had $1 MM at commercial production

$1.5 MM at 5,000 BOPD
$3 MM at 25,000 BOPD
$5 MM at 50,000 BOPD or BOE Equivalent (6:1)
Depreciation
Taxation 50%
55% Maximum
Ringfencing
Domestic Market Obligation Pro rata
State Participation Government had option to acquire

25% Working interest in OXY block.
40% Working interest in Badin block.
245
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PAPUA NEW GUINEA

Concession (ROR)
Area Graticular blocks

5 minutes longitude x 5 minutes latitude
9 km x 9 km graticules
Licenses may be 60–200 blocks
(approximately 1.25–4 million acres)
Duration
Exploration Under petroleum prospecting license (PPL)
6 years + 5-year extension for 50%
of area if work program complete
Production Under petroleum development license (PDL)
25 years with 20-year extension
Relinquishment Surrender 25% after first 2 years
Exploration Obligations Negotiated
Royalty 1.25%
Bonuses Negotiated
Cost Recovery Limit No limit

Company allowed to recover its investment plus agreed rate of interest U.S. AAA
Bond rate + 5%
Depreciation 8-year SLD. Some accelerated (4-year SLD)

allowed if target income is not met.
Taxation 50% Basic Petroleum (income) Tax (BPT)

Exempt if target income test is not met (25% of investment)
50% Additional Profits Tax (APT)
Resource Rent Tax based on 27% ROR threshold test.
Ringfencing
State Participation 22.5% carried through exploration

State share of Development costs paid
out of State share of production.
Other
246
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APPENDICES
PHILIPPINES
Risk Service Contract early 1990s
Duration
Seismic Option 1 year
Exploration 10 year maximum
Production 30 years
Relinquishment

Two-well option after seismic
Royalty* –7.5% (goes to contractor group)

Depends upon level of Filipino
*Filipino Participation ownership up to 30% onshore
Incentive Allowance (FPIA) up to 15% in deepwater qualifies
for full 7.5% (FPIA)
Filipino Participation, % FPIA, %

Up to 15% 0
15–17.5 1.5
17.5–20 2.5
20–22.5 3.5
22.5–25 4.5
25–27.5 5.5
27.5–30 6.5
30 or more 7.5
Signature Bonus Negotiable
Production Bonus No
Depreciation 10%
Profit Oil Split 60%/40%

(In favor of Government) Contractor’s 40% is a “service fee”
Taxation No, paid out of gvt share
Ringfencing Cost recovery allowed on two or more

deepwater blocks
Domestic Market Obligation Pro rata
State Participation Nil (FPIA)
247
#CHAP 12 5/3/04 11:53 AM Page 248
SPAIN
Royalty/Tax
Area 10,000 to 40,000 hectares

24,700 to 98,800 acres
Duration
Exploration
Production 30 with two 10-year extensions
Relinquishment
Royalty None
Bonuses Negotiable, unlikely
Depreciation Exploration and intangible costs

amortized over 4 years SLD
Most tangible costs capitalized 4 years SLD
Platforms 8 years SLD
Pipelines 5 years SLD
Ringfencing
Other 10% Investment credit on tangible capital costs

25% Depletion allowance on gross revenues if it is
reinvested in Spain, but limited to 40% of
taxable income
248
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APPENDICES
SYRIA
PSC
Area
Duration
Exploration
Production
Relinquishment
Royalty 11% 1985 Pecten Group royalty is 12.5%
Bonuses Production Bonuses

50,000 BOPD
100,000 BOPD
Not recoverable 200,000 BOPD
Cost Recovery Ceiling 35% of gross production less royalties
1985 Pecten Group Cost Recovery Ceiling 25% and unused cost oil goes directly to
government
Depreciation Exploration capital and operating

costs expensed.
Development costs: 5 years SLD
Profit Oil Split Sample Ranges

Example Example Pecten
Production, BOPD 1, % 2, % 1985, %
Up to 25,000 22.5 25 21
25,001–50,000 21.36 24 21
50,001–100,000 20 19
100,001–200,000 18 19
over 200,000 13.35 15 15
Taxation Taxes paid by government on behalf of

contractor
Ringfencing
Other
249
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THAILAND
Royalty/Tax Contract early 1990s
Duration
Relinquishment
Royalty Rate, %
up to 2,000 BOPD 5
2,000–5,000 6.25
5,000–10,000 10
10,000–20,000 12.5
over 20,000 15
Signature Bonus Yes, $2–$5 million
Production Bonus No
Depreciation 5 Years for tangibles, intangibles 10 Years

for preproduction/postproduction expenses
Taxation 50% Income tax
Supplemental Tax Special remuneratory benefit (SRB)

Progressive rate from 0%–75%
Based generally upon ratio of annual petroleum profit ÷ by cumulative depth in meters
of all wells drilled in the block plus a constant—100,000 m, for example.
$/M SRB Rate

Less than $200 0%
200–580 1% per $10/m
580–1,340 40% + 1% per $40/m
1,340–3,650 60% + 1% per $154/m
over 3,650 75%
Assuming 24 Thai Bhat per U.S. $1.00.

The more drilling, the lower the tax: this is an unusual one.
Ringfencing ?
State Participation ?
250
#CHAP 12 5/3/04 11:53 AM Page 251
APPENDICES
TIMOR GAP
Zone of Cooperation, 1991–92 License Round
PSC Jointly Administered by Indonesia & Australia
Area Main blocks in Zone of Cooperation A (ZOCA)

comprise 20–40 subblocks at 10 km2 each
Duration
Exploration 6 years with option for 4-year extension
With development contract automatically
extends to 30 years
Committed Expenditures
Exploration First year seismic only $1–$4 MM
Second year 0–2 wells $.5–$8 MM
Third year 1–3 wells $.5–$21 MM
4th–6th years 1–4 wells $6–$30 MM
Relinquishment 25% after 3 years; another 25% after 6th year
Royalty None
Bonuses
Cost Recovery Limit 90% Effective limit for 1st 5 years*

80% Effective limit thereafter*
*10% first-tranche petroleum (FTP) (similar to Indonesian FTP) after 5 years production
reverts to 20% FTP
Profit Oil Split

Contractor
Production, BOPD Share, %
Up to 50,000 50
50,001–150,000 40
150,001–200,000 30
Natural Gas 50
Taxation 48% Effective tax rate (similar to Indonesia)

Comprised of 35% income tax and 20%
withholding tax
Companies will lodge income tax returns with both countries. In each country a 50%
tax rebate will be given.
Ringfencing
Domestic Market Obligation Similar to Indonesian DMO

25% of pretax profit oil (After 60 months, 10% of market price)
Other 17% IC on eligible costs similar to Indonesian IC

127% investment credit (IC) for deepwater
251
#CHAP 12 5/3/04 11:53 AM Page 252
TUNISIA
New Hydrocarbon Laws, 18 June 1990
Concession
Area
Duration
Exploration
Production
Relinquishment
Royalty R Factor Oil, % Gas, %

< .5 2 2
.5–.8 5 4
.8–1.1 7 6
1.1–1.5 10 8
1.5–2.0 12 9
2.0–2.5 14 10
2.5–3.0 15 11
3.0–3.5 15 13
3.5 + 15 15
R factor = accrued net earnings/accrued total expenditures
Bonuses
Depreciation 30% per year (all investments)
Taxation
Income Tax
R Factor Rate, %
< 1.5 50
1.5–2.0 55
2.0–2.5 60
2.5–3.0 65
3.0–3.5 70
3.5 + 75
Ringfencing
Domestic Market Obligation Pro rata up to maximum 20%

DMO price = FOB price –10%
State Participation
Contractor recoups state share Sample
of exploration costs out of R Factor Level, %
20% of state share of revenues. < 1.5 45
1.5 + 50
252
#CHAP 12 5/3/04 11:53 AM Page 253
APPENDICES
TURKMENISTAN
“Joint Enterprise” Contracts
Summarized from Oil & Gas Journal, Vol. 91, No. 6, Feb. 8, 1993 (pp. 38–39)
Area
Duration 25 years
with optional 10-year extensions
Relinquishment
Obligations Block
II $60 MM 5 years
III $50 MM 5 years
IV $50 MM 5 years
Royalties (Sliding scale)

Blocks II & III, BOE/J Rate Block IV, BOE/J Rate
Up to 3,649 0% Up to–7,299 0%
3,656–7,299 2 7,300–21,899 2
7,300–10,949 5 21,900–36,499 5
10,950–18,249 7 36,500–51,099 7
18,250 + 15 51,100 + 15
Bonuses Amount
Block Minimum Bid Reserves Group
II $15 MM $15.25 MM 230 MMBBLS + 1.87 TCF Larmag/Noble
III $20 MM $20 MM 642 MMBBLS + 2.16 TCF Eastpac/TMN
IV $30 MM $30 MM 230 MMBBLS + .89 TCF Bridas
Depreciation ?
Production Sharing
Block
II 50% 50% split
III 10% 90% in favor of the government
IV 30% 70% in favor of the government
These quoted percentages are possibly “after-tax”?
Taxation 35% on joint venture profits

Guaranteed against increases
Ringfencing ?
Domestic Market Obligation ?
State Participation 50% JV fully carried?
Other Net operating losses (NOL) carried forward 5 years
253
#CHAP 12 5/3/04 11:53 AM Page 254
UNITED KINGDOM
Concession, Early 1990s
Duration
Exploration 18 years
Production Field specific
Relinquishment
Exploration Obligations Bid, negotiated
Royalty Nil
Bonuses None
Cost Recovery Limit 100% no limit
Depreciation 25% declining balance

75% petroleum revenue tax (PRT) on net
revenues after capital costs are recovered.
Some limits for marginal fields.
Also free oil allowance against PRT
Ringfencing Each license is ringfenced

For PRT each field is ringfenced
Other 35% uplift on some capital costs
254
#CHAP 12 5/3/04 11:53 AM Page 255
APPENDICES
UNITED KINGDOM, Fiscal

Summary of 1983–84 changes:
Before After
1985 1985
INCOME $100 $100
ROYALTY 12.5% 0%
Abolished for projects
approved after April 1992
Net Revenue 87.5 100
PRT (75%) 65.62 0

Phaseout by end of 1986
21.88 100
CORPORATE TAX 11.38 (52%) 35 (35%)
Contractor Share 10.5 65
GOVERNMENT TAKE 89.5% 35%
Current corporate tax rate in the UK is 33% which yields a “pure” 67/33% split in favor
of contractor group for fields developed since1982.
Amount of oil exempted from PRT doubled to 1 million metric tons per year ≈ 20,000
BOPD. Cumulative limit ≈ 10 million metric tons (73 MMBBLS).
In effect, on a field of 20,000 BOPD or less, only tax is corporate tax of 35%.
No APRT, PRT, or royalty.
255
#CHAP 12 5/3/04 11:53 AM Page 256
HISTORY
Petroleum Production Act of 1934 Fiscal framework vested oil
and gas ownership with the Crown.
Oil Taxation Act of 1975 Introduction of PRT (initially 45%)
based upon profits of each individual field. “Ringfencing” intro-
duced as Part II of the Act prevents oil companies from offsetting
profits with other losses within the company. However, N. Sea
losses can be set against profits from other activities in a company.
(PRT gradually increased)

1975 Government increased take to 76.9%
1981 Supplementary Petroleum Duty 20% tax, which was with-

drawn after two years. This had increased government take to
90.3%. PRT rate in 1981 was increased to 75%.
APRT ACT 1986 Between 1983 and 1986 advance payments

of PRT (APRT) were required in early stage of field, even though
no PRT may have been required at that time. The last payment of
APRT was for the chargeable period ending December 1986. Up
to then, the PRT liability had not been sufficient to absorb all the
APRT paid. The Act provided for immediate repayment of up to
£15M (15 million pounds sterling per field participant).
FINANCE ACT of 1983 Exploration and appraisal drilling
expenses were available for immediate PRT relief; oil allowance
for new fields doubled; new oil fields exempted from royalty.
FINANCE ACT of 1987 Up to 10% of development costs on
certain new fields can be set against PRT liabilities in existing
fields.
PRESENT SYSTEM
ROYALTY: 12.5% for licenses issued in 1st–4th rounds trans-
portation costs may be deducted.
256
#CHAP 12 5/3/04 11:53 AM Page 257
APPENDICES
No transportation costs may be deducted for 5th and subse-

quent licensing rounds.
No royalty for onshore or offshore fields which received
development approval after 1 April 1982.
Discretionary Royalty Relief: based upon the Petroleum and
Submarine Pipelines Act of 1975, the Secretary of State for
Energy with consent of the Treasury can refund royalties in
whole or in part to provide incentive to develop or to continue to
produce.
CORPORATE TAX (CT): 35% on net revenues after deduction

of royalty, PRT, and ringfenced expenses.
PETROLEUM REVENUE TAX (PRT): 75% of profits less vari-

ous reliefs. Also charged on tariff receipts
1. Gas pre-30 June 1975 exempt.

2. Up to 10% of costs to develop certain new fields can be set
against PRT.
3. Provisions for losses on abandoned fields.
4. Expenses allowable against PRT:
a. License Royalties
b. Capital Expenditure + 35% Uplift on certain Expl &
Dev costs prior to payback. Intended to compensate for
interest and costs of financing—not deductible for
PRT purposes.
c. Oil Allowance exempts from PRT fixed amount of oil or
gas subject to a cumulative total.
Section 8 OTA 1975 250,000 metric tons (5,000 BOPD)

Cumulative limit 5 MM tons (36 MMBBLS)
all fields, pre-1 April 1982
257
#CHAP 12 5/3/04 11:53 AM Page 258
Section 36 FA 1983 500,000 metric tons (10,000 BOPD)

Cumulative limit 5 MM tons (36 MMBBLS)
offshore outside S. Basin after 4/82
Section 138 FA 1988 125,000 metric tons (2,500 BOPD)
Cumulative limit 2.5 MM tons (18 MMBBLS)
Onshore & S. Basin fields after 4/82
Safeguard Provision: if during periods before payback and

half the periods after, the PRT charge would return on a field
before corporation tax (CT) to less than 15% of cumulative
“upliftable” expenditure (measured on historical cost), the charge
(PRT) is to be cancelled.
258
#CHAP 12 5/3/04 11:53 AM Page 259
APPENDICES
UZBEKISTAN
Joint Ventures
1st License Round 1993
Area 10 designated blocks
Duration
Exploration 7 years
Production 23 years
Relinquishment 25% after 4 years and 25% each year thereafter
Minimum Work Commitments 3 wells on 9 blocks (2 on one block)

1,000–2,000 km seismic, Average 1,600
Royalty Bid item, maximum 10% (Fixed or sliding scale)
Minimum Signature Bonus Average $1.1 million ($0–$2 MM)

Production Bonuses (bid item at 25, 50, and 100 MBOPD)
Geodata Packages $30–$60,000
Cost Recovery Limit Bid Item Maximum 60%

Before______and after______recovery of initial costs
Profit Oil/Gas Splits Bid Items Gas

Oil BOPD Split % MMM3/Day Split %
Up to 10,000 ___/___ up to 5 ___/___
10,001–25,000 ___/___ 5–10 ___/___
25,001–50,000 ___/___ 10–15 ___/___
50,001–75,000 ___/___ over 15 ___/___
75,001 + ___/___
Proposed level of contractor share to range from 20% to 30%
Taxation Income Tax 18% with 30% foreign ownership

as low as 10% with > 30% foreign ownership
as high as 35% with < 30% foreign ownership
Possible 5-year holiday starting with operations
Export Tax 10% (Repatriation of profits tax)

VAT 25% on goods & services except G&G
Property Tax 1%, 2-year exemption
The following yet to be determined by the Cabinet of Ministers
Tax on raw materials, excise charges, land tax, and
payment for use of natural resources tax
Ringfencing
259
#CHAP 12 5/3/04 11:53 AM Page 260
VIETNAM
From PetroMin Magazine, July 1991
Duration
Exploration 3 + 1 + 1 years
Production 20 years
Relinquishment 25% to 35%

Exploration Obligations Minimum U.S. $50–$60 million

(Initial Phase) or 3 exploration wells
Royalty Nil
Signature Bonus U.S. $ 0.5 million
Production Bonus Discovery: U.S. $ 2.5 million

Cost Recovery 40% limit or

16% plus entitlement to purchase
29% to 40% of oil at discounted prices
Depreciation Not clear

Up to 15,000 67/33
15,001–30,000 72/28
30,001–70,000 76/24
70,001–100,000 80/20
100,001 + Negotiable
Profit Gas Split Negotiable
Taxation Taxes paid by Petrovietnam

profit oil split is effectively
an “after-tax” split
260
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APPENDICES
VIETNAM
Fina/Shell Contract, 16 June 1988
Area Blocks 112, 114, 116
Duration
Exploration 5 years + 6-month extension for drilling
Production 25 years + 5-year extension
Relinquishment 25% at end of 3rd year

25% at end of 4th year
The whole of remaining areas relinquished after exploration period except development
areas.
Exploration First 3 years

Obligations 10,000 km seismic or at least $6.5 MM
3 wells or at least $8 MM per well
Fourth year 5,000 km seismic or at least $4 MM
2 wells or at least $8 MM per well
Fifth year 2 wells or at least $10 MM per well
The last wells in 4th and 5th years conditional upon results of first well. At least one of
first 4 wells to be at least 3,500 m deep.
Royalty Nil
Signature Bonus U.S. $ 1 million (deductible)
Production Bonus Startup: U.S. $ 1.0 million

(not deductible) 50,000 BOPD: 2.0 million
Cost Recovery 38.5% limit (60% for Gas)

Depreciation Not clear
Profit Oil Split Contractor Share

Gas Same (6:1) Before After After
Payout, Payout, Threshold,
Production, BOPD % % %
Up to 50,000 40 36 32
50,001–60,000 37.5 33.75 30
60,001–70,000 35 31.5 28
70,001–80,000 32.5 29.25 26
80,001–90,000 30 27 24
90,001–100,000 25 22.5 20
100,001 + 20 18 16
Threshold volume is based upon an a cumulative production level.
Taxation Taxes paid by Petrovietnam

Profit oil split is effectively an “after-tax” split
Domestic Market Obligation Government has option to take all

at market price
State Participation 15% ?
261
#CHAP 12 5/3/04 11:53 AM Page 262
N. YEMEN
Hunt Onshore PSC 1981
Area 12,600 km2 (3 million acres ±)
Duration
Exploration
Production 20 years
Relinquishment
Royalty None
Bonuses
Depreciation
Profit Oil Split 85%/15% in favor of the government
Taxation
Ringfencing
State Participation
Other
Some of the newer contracts have roughly 40% cost recovery limit and 70%/30%
profit oil split in favor of the government.
262
#CHAP 12 5/3/04 11:53 AM Page 263
APPENDICES
APPENDIX B
PERSPECTIVES ON
ECONOMIC RENT
Rent theory is the foundation of petroleum taxation. The fol-
lowing discussions may be helpful.
David Ricardo, The Principles of Political Economy and Taxation,
1911 (1976 edition), Chapter II On Rent, page 33:
Rent is that portion of the produce of the earth
which is paid to the landlord for the use of the
original and indestructible powers of the soil. It is
often, however, confounded with the interest and
profit of capital, and, in popular language, the term
is applied to whatever is annually paid by a farmer
to his landlord. . . .
Adam Smith sometimes speaks of rent in the
strict sense to which I am desirous of confining it, but
more often in the popular sense in which the term is
usually employed. He tells us that the demand for
timber, and its consequent high price, in the more
southern countries of Europe caused a rent to be
paid for forests in Norway which could before afford
no rent. Is it not, however, evident that the person
who paid what he thus calls rent, paid it in consider-
ation of the valuable commodity which was then
standing on the land, and that he actually repaid
himself with a profit by the sale of the timber?
263
#CHAP 12 5/3/04 11:53 AM Page 264
If indeed, after the timber was removed, any

compensation were paid to the landlord for the use
of the land, for the purpose of growing timber or
any other produce, with a view to future demand,
such compensation might justly be called rent,
because it would be paid for the productive powers
of the land; but in the case stated by Adam Smith,
the compensation was paid for the liberty of remov-
ing and selling the timber, and not for the liberty of
growing it. He speaks also of the rent of coal mines,
and of stone quarries, to which the same observa-
tion applies—that the compensation given for the
mine or quarry is paid for the value of the coal or
stone which can be removed from them, and has
no connection with the original and indestructible
powers of the land. This is a distinction of great
importance in an inquiry concerning rent and prof-
its; for it is found that the laws which regulate the
progress of rent are widely different from those
which regulate the progress of profits, and seldom
operating in the same direction….
In the future pages of this work, then, when-
ever I speak of the rent of land, I wish to be under-
stood as speaking of that compensation which is
paid to the owner of land for the use of its original
and indestructible powers.
This specific concern over profit sharing acquires
a distinctive importance from the element of eco-
nomic rent in the exploitation of natural resources.
Put simply, this rent element comprises that part of
264
#CHAP 12 5/3/04 11:53 AM Page 265
APPENDICES
the marginal gain derived from working a given

mineral deposit over its next cheapest alternative.
Ministry of Commerce (1992) Crown Minerals Act 1991:

Evaluation of Allocation and Pricing Regimes, Resources Policy,
Energy and Resources Division, Ministry of Commerce,
Wellington, New Zealand:
…the Ricardo model of rent generation relates to
plots of similar areas and implicitly assumes the
application of a common development and produc-
tion technology. This means that the concept of eco-
nomic rent has to be widened to take account of
variations in the scale of production and the form of
technology that is utilized. In this wider context eco-
nomic rent can be defined, as the “residual value
which exists after all factors of production, including
capital have returned their opportunity costs.”
Raymond F. Mikesell, Petroleum Company Operations and

Agreements in the Developing Countries, Washington, D.C., 1984.
Chapter 4, page 30:
…while the third objective (maximizing host
government’s revenue from oil lands) has to do with
the division of the economic rent between the host
government and the petroleum company or compa-
nies. By economic rent we mean the surplus of
revenue over full economic costs of producing oil.
Page 46:
Accounting profits vary widely over time and
do not constitute a proper measure of economic
265
#CHAP 12 5/3/04 11:53 AM Page 266
rent since they do not reflect full economic cost.

The only proper measure of pure economic rent is
the surplus over the net return to the investor that
yields an IRR equal to the opportunity cost of capi-
tal. Moreover, if an investment is to be made, this
IRR must be adjusted for risk.
Kamal Hossain, Law and Policy in Petroleum Development, 1979,

page 84:
…economic rent (is) the difference between
total revenues and total cost, including the costs of
management and an appropriate risk premium.
Zuhayr Mikdashi, The International Politics of Natural Resources,

Ithaca and London, Cornell University Press, 1976.
…economic rent accruing to a given mineral
deposit is equal to the difference between the cost
(including normal return on the required capital,
but not including “user cost”) of producing that
deposit and the cost of producing a marginal
deposit.
Anthony Burris and William Robson, “Evaluation of Royalty

Bid and Profit Share Bid Bidding Systems.” Published under the
auspices of the U.S. Department of Energy, Exploration and
Economics of Petroleum Industry, Volume 20, Institute of Petroleum,
1981:
According to a predetermined schedule, the
Department of the Interior (of the U.S.) offers for
sale oil and gas leases on OCS tracts. These leases
266
#CHAP 12 5/3/04 11:53 AM Page 267
APPENDICES
transfer the rights to exploit the oil and gas

resources. These rights then have an economic
value and reflect the bidder’s evaluation of the eco-
nomic rent he might gain by winning the lease.
The economic rent to the bidder is the difference
between the value of production and the resource
extraction costs and is the amount the Govern-
ment as lessor should seek to capture as societal
value of the resource. This recognizes that all long-
run costs such as returns on investment and risk
premiums have been netted out.
Paul Davidson, Laurence Falk, and Loesung Lee, “The

Relations of Economic Rents and Price Incentives to Oil and Gas
Supplies.” Studies in Energy Tax Policy, Ballinger Publishing
Company, 1975. (Brannon, G. ed.), page 119:
To the extent that each oil and gas property has
no alternative use, payments to the landowner in
the form of leasehold bonuses, royalties, and for
many foreign properties, taxes are essentially eco-
nomic rents.
Khong Cho Oon, The politics of oil in Indonesia: Foreign company-

host government relations, 1986, page 17:
This specific concern over profit sharing acquires
a distinctive importance from the element of eco-
nomic rent in the exploitation of natural resources.
Put simply, this rent element comprises that part of
the marginal gain derived from working a given
mineral deposit over its next cheapest alternative.
267
#CHAP 12 5/3/04 11:53 AM Page 268
Host governments naturally wish to secure as

much as possible of the value of the economic rent,
and this desire has led most of them to lay down
the concept of a national claim to ownership of
their minerals.
268
#CHAP 12 5/3/04 11:53 AM Page 269
APPENDICES
APPENDIX C
ABBREVIATIONS AND ACRONYMS
AAA American Arbitration Association

$/BBL Dollars per Barrel
$/BOE Dollars per Barrel of Oil Equivalent
$/BOPD Dollars per Barrel of Oil per Day
$/MCF Dollars per Thousand Cubic Feet of gas
$/MCFD Dollars per Thousand Cubic Feet of gas per day
ADB Asian Development Bank
ADV Ad Valorem Tax
AFE Authorization for Expenditure
AIG American International Group
AIGPRI American International Group Political Risk, Inc.
API American Petroleum Institute
APR Accounting Profits Royalty
ASEAN Association of Southeast Asian Nations
AVR Ad Valorem Royalty
B Billion
B/CD Barrels per Calendar Day (refinery: 365 days)
B/SD Barrels per Stream Day (usually 330 days)
BBL Barrel (crude or condensate), 42 U.S. Gallons
BCF Billion Cubic Feet of gas
BCPD Barrels of Condensate Per Day
BIT Bilateral Investment Treaty
BOE Barrels of Oil Equivalent (see COE)
BOEPD Barrels of Oil Equivalent Per Day
BOPD Barrels of Oil Per Day
BtU British Thermal Unit
BWPD Barrels of Water Per Day
CAPEX Capital Expenditures
CAPM Capital Asset Pricing Model
269
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CEO Chief Executive Officer

CFC Controlled Foreign Corporation
CIF Cost, Insurance, and Freight
CNG Compressed Natural Gas
COE Crude Oil Equivalent (also called BOE)
COO Chief Operating Officer
CPE Centrally Planned Economy
CR Cost Recovery
DCF Discounted Cash Flow
DCFM Discounted Cash Flow Method (not common)
DD&A Depreciation, Depletion, and Amortization
DDB Double Declining Balance Method
DMO Domestic Market Obligation
DO Domestic Obligation
Dwt Deadweight (as in Dwt Tonnage = long tons)
E&P Exploration & Production
EBO Equivalent Barrels of Oil (See BOE and COE)
EIA Energy Information Administration
EMV Expected Monetary Value
EOR Enhanced Oil Recovery (see IOR)
EPIC Engineering, Procurement, Construction, and
Installation
EV Expected Value (see EMV)
FASB Financial Accounting Standards Board
FC Full Cost Accounting
FCPA Foreign Corrupt Practices Act
FIFO First-In First-Out
FMV Fair Market Value
FOB Free On Board
FOGEI Foreign Oil and Gas Extraction Income
FORI Foreign Oil Related Income (downstream)
FPIA Filipino Participation Incentive Allowance
FSU Former Soviet Union
G&A General and Administrative Expenses
270
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APPENDICES
G&G Geological and Geophysical

GAAP Generally Accepted Accounting Principles
GAO General Accounting Office
GM General Manager
IC Investment Credit
ICC International Chamber of Commerce
ICJ International Court of Justice
ICSID International Centre for the
Settlement of Investment Disputes
IDC Intangible Drilling and Development Costs
IEA International Energy Association
(Associated w/ OECD)
IMF International Monetary Fund (UN)
INA Insurance Company of North America
IOR Improved Oil Recovery (same as EOR)
IRR Internal Rate of Return
ITC Investment Tax Credit
JOA Joint Operating Agreement
JOB Joint Operating Body
L/C Letter of Credit
LDC Less Developed Country
LIBOR London Interbank Offered Rate
LIFO Last-In First-Out
Lloyds Lloyds of London
LNG Liquified Natural Gas
LP Limited Partnership
LPG Liquid Petroleum Gas
Ltd Limited Liability (British Corporation)
M Thousand
MM Million
MBBLS Thousand Barrels
MBO Management Buy Out
MCFD Thousand Cubic Feet of gas per Day
MIGA Multilateral Investment Guarantee Agency
271
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MMBBLS Million Barrels

MMCF Million Cubic Feet of gas
MNC Multinational Corporation
NOC National Oil Company
NOL Net Operating Losses
NGL Natural Gas Liquids
NPV Net Present Value
NRI Net Revenue Interest
OAPEC Organization of Arab Petroleum
Exporting Countries
OECD Organization for Economic Cooperation
and Development
OIDC Oil Importing and Developing Countries
OPEC Organization of Petroleum Exporting Countries
OPEX Operating Expenses
OPIC Overseas Private Investment Corporation
ORI Overriding Royalty Interest (Same as ORRI)
ORRI Overriding Royalty Interest (Same as ORI)
PDP Proved Developed Producing (Oil & Gas Reserves)
PE Price Earnings Ratio
PLC (British) Public Limited Company
PO Purchase Order
PSA Production Sharing Agreement (same as PSC)
PSC Production Sharing Contract (same as PSA)
PUD Proved Undeveloped (Oil & Gas Reserves)
PV Present Value
PVP Present Value Profits
RI Royalty Interests
RLI Reserve Life Index
ROA Return on Assets
ROC Return on Capital
ROE Return on Equity
ROI Return on Investment
ROR Rate of Return
272
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APPENDICES
RRA Reserve Recognition Accounting

RRR Resource Rent Royalty
RRT Resource Rent Tax
RSA Risk Service Agreement
(not common—same as RSC)
RSC Risk Service Contract
(not common—same as RSA)
SE Successful Efforts Accounting
SEC Securities and Exchange Commission
Semi Semisubmersible Drilling/Production Vessel
SFAS Statement of Financial Accounting Standards
STB Stock Tank Barrel
STOIP Stock Tank Oil In Place
TAC Technical Assistance Contract
TCF Trillion Cubic Feet of Gas
TCM Technical Committee Meeting
TEA Technical Evaluation Agreement
TLCB Tax Loss Carry Back
TLCF Tax Loss Carry Forward
TNC Trans-National Corporation
UNCITRAL United Nations Committee on
International Trade Law
VAT Value-added Tax
WI Working Interest
WPT Windfall Profits Tax
273
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APPENDIX D
WORLDWIDE PRODUCTION STATISTICS (1992)
Average Average
Producing Daily per
Oil Production, Well,
Country Wells BOPD BOPD
1 Abu Dhabi 993 1,842,000 1,855
2 Algeria 1,446 1,161,159 803
3 Angola 486 545,734 1,123
4 Argentina 8,402 554,000 66
5 Australia 1,081 533,000 493
6 Austria 1,149 23,091 20
7 Bahrain 352 36,747 104
8 Bangladesh 25 1,064 42
9 Barbados 102 1,308 13
10 Benin 8 3,000 375
11 Bolivia 332 21,180 64
12 Brazil 6,249 625,670 100
13 Brunei 738 171,866 233
14 Cameroon 193 113,700 589
15 Canada 40,667 1,245,294 31
16 Chile 355 15,778 44
17 China 49,700 2,835,000 57
18 Taiwan 84 1,160 14
19 Colombia 2,905 438,000 151
20 CIS 148,990 8,949,000 60
21 Congo 396 152,841 386
22 Croatia 919 38,860 42
23 Denmark 120 156,889 1,307
24 Dubai 151 402,000 2,662
25 Ecuador 999 321,000 321
274
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APPENDICES
Average Average
Producing Daily per
Oil Production Well,
26 Egypt 1,015 873,000 860
27 France 609 58,031 95
28 Gabon 329 300,000 912
29 Germany 2,308 65,000 28
30 Ghana — 1,800 1,800
31 Greece 13 13,721 1,055
32 Guatemala 16 5,616 351
33 Hungary 1,776 37,333 21
34 India 2,681 546,970 204
35 Indonesia 8,047 1,504,558 187
36 Iran 688 3,455,000 5,022
37 Iraq 820 425,000 518
38 Israel 11 184 17
39 Italy 234 83,000 355
40 Ivory Coast 12 1,000 83
41 Japan 274 10,600 39
42 Jordan 4 58 15
43 Kuwait 295 880,000 2,983
44 Libya 1,092 1,492,000 1,366
45 Malaysia 561 661,000 1,178
46 Mexico 4,740 2,667,725 563
47 Morocco 9 214 24
48 Myanmar 450 13,000 29
49 Netherlands 200 57,580 288
50 Neutral Zone 158 341,000 2,158
51 New Zealand 52 36,815 708
52 Nigeria 1,824 1,902,000 1,043
53 Norway 386 2,176,888 5,640
54 Oman 1,243 732,158 589
55 Pakistan 115 60,681 528
275
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Average Average
Producing Daily per
Oil Production Well,
56 PNG 23 52,380 2,277
57 Peru 3,157 116,992 37
58 Philippines 4 8,942 2,236
59 Poland 2,302 3,631 1.6
60 Qatar 238 425,000 1,786
61 Ras Al Khaima 7 1,000 142
62 Saudi Arabia 1,400 8,137,000 5,812
63 Serbia 646 22,000 34
64 Sharjah 31 40,000 1,290
65 South Africa 5 4,100 820
66 Spain 45 21,607 480
67 Suriname 223 5,000 22
68 Syria 963 518,000 538
69 Thailand 314 51,431 164
70 Trinidad & Tobago3,262 135,415 42
71 Tunisia 181 106,157 587
72 Turkey 732 82,000 112
73 UK 735 1,928,731 2,624
74 USA 602,197 7,170,969 12
75 Venezuela 12,140 2,314,000 191
76 Vietnam 100 105,000 1,050
77 Yemen 179 176,000 983
78 Zaire 60 23,763 396
925,749 60,040,391 65
From: Oil & Gas Journal, Worldwide Production Report, Vol. 91, No. 52,
Dec. 1993
276
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APPENDICES
APPENDIX E
SELECTED US ENERGY STATISTICS (1992)
Stripper Oil Wells 462,823 Average Production 2.23 BOPD
(78% of total oil) Remaining Recoverable
7,500 bbls
RLI = 9 years (1/RLI = 11%)
17,500+ shut-in per year
Other Wells 149,956 Average Production 39 BOPD
Remaining Recoverable
142 MBBL/Well
Total Oil Wells 594,189 Average Production 12.1 BOPD

(94% on artificial lift)
Remaining 41.5 MBBLS/Well
Total Gas Wells 280,899 Average Production 182 MCFD

143.5 TCF
510 MMCF/Well
Total U.S. O&G Wells 875,088 1/1/93 currently producing

Cumulative U.S. Wells 3,182,606 1/1/93 producing and
abandoned
Average Daily Oil Production 6,882 MBOPD

Average Daily Gas Production 47 BCFD
Seismic Crew Count 847

Active Drilling Rigs 721
277
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Wells Drilled
New Field W/C 1,411 Average Depth 6,000 ft
Other Exploratory 1,851
Oil 7,975
Gas 6,425
Dry 6,038
Service Wells 863
Total 21,301
Success Ratio 70%
Proved U.S. Reserves

Oil 24,682 MMBBLS
Gas 167 TCF
NGL 7,464 MMBBLS
Reserve Life Index

Oil 10 Years
Gas 10 Years
From: United States Department of Energy —

Energy Information Administration
American Petroleum Institute
Independent Petroleum Association of America
Baker Hughes Rig Count
Seismic Crew Count Society of Exploration Geophysicists
278
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APPENDICES
APPENDIX F
CONVERSION FACTORS
Btu Equivalents: Oil, Gas, Coal, and Electricity
One British Thermal Unit (Btu) is equal to the heat required to raise
the temperature of one pound of water (approximately one pint)
one degree Fahrenheit at or near its point of maximum density.
One barrel (42 gallons) of crude oil

= 5,800,000 Btu of energy
= 5,614 cubic feet of natural gas
= 0.22 tons of bituminous coal
= 1,700 kw hours of electricity
One cubic foot of natural gas (dry)

= 1,032 Btu of energy
= 0.000178 barrels of oil
= 0.30 kw hours of electricity
One short ton (2,000 pounds) of bituminous coal

= 26,200,000 Btu of energy
= 25,314 cubic feet of natural gas
= 7,679 kw hours of electricity
One kilowatt (kw) hour of electricity

= 3,412 Btu of energy
= 3.306 cubic feet of natural gas
279
#CHAP 12 5/3/04 11:53 AM Page 280
One gigajoule (109J) GJ

= 947,820 BtU of energy
GJ = gigajoules (109 joules) ≈ .9 MCF gas
TJ = terajoules (1012 joules) ≈ .9 MMCF gas
PJ = petajoules (1015 joules) ≈ .9 BCF gas
One British thermal unit (Btu)

= 1,055.06 Joules
METRIC CONVERSIONS
One metric ton of crude oil

= 2,204 pounds
= 7–7.5 barrels of oil
One cubic meter of natural gas

= 35.314 cubic feet
One cubic meter of liquid

= 6.2888 barrels
One liter of liquid

= 1.057 quarts
Distance
1 foot = 0.305 meters
1 meter = 3.281 feet
1 statute mile = 1.609 kilometers = 0.868 nautical miles
1 nautical mile = 1.852 kilometers = 1.1515 statute miles
280
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APPENDICES
Area
1 square mile = 640 acres = 2.59 square kilometers = 259.0 square hectares
1 square kilometer = 0.368 miles = 100 hectares = 247.1 acres
1 acre = 43,560 square feet = 0.405 hectares
1 hectare = 2.471 acres
Volume
1 cubic foot = 0.028317 cubic meters
1 cubic meter = 35.514667 cubic feet
1 cubic meter = 6.2898 barrels
1 U.S. gallon = 3.7854 liters
1 liter = 0.2642 U.S. gallons
1 barrel = 42 gallons = 158.99 liters
Weight
1 short ton = 0.907185 metric tons = 0.892857 long tons
= 2000 pounds
1 long ton = 1.01605 metric tons = 1.120 short tons
= 2240 pounds
1 metric ton = 0.98421 long tons = 1.10231 short tons
= 2204.6 pounds
281
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APPENDIX G
METRIC U.S. CONVERSIONS
Unit Metric Equivalent U.S. Equivalent
acre 0.40468564 hectares 43,560 square feet

barrel 158.98729 liters 42 gallons
degrees Celsius water: boils 100° multiply by 1.8,
freezes 0° add 32° = Fahrenheit
fathom 1.8288 meters 6 feet
hectare 10,000 square meters 2.471 acres
kilogram 0.001 metric tons 2.2046 pounds
kilometer 1,000 meters 0.62137 miles
square kilometer 100 hectares 247.1 acres
nautical mile 1.852 kilometers 1.151 statute miles
liter 0.001 cubic meters 61.02374 cubic inches
1.0567 quarts, liquid
meter 100 centimeters 3.280839 feet
ton, long or 1,016.047 kilograms 2,240 pounds
deadweight
ton, metric 1,000 kilograms 2,204.623 pounds
ton, short 907.18474 kilograms 2,000 pounds
282
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APPENDICES
APPENDIX H
BARRELS PER METRIC TON VS. API GRAVITY
Bbl/to
Degrees
283
#CHAP 12 5/3/04 11:53 AM Page 284
APPENDIX I
RELATIVE OIL PRICE VS. API GRAVITY
19 Slope = 25¢–50¢/bbl/Degree API

= 1.5%–3%
18 change in price/Degree API
17
16
Price $/bbl
15
14
13
12
11
10
10° 15° 20° 25° 30° 35° 40° 45°

Degrees API
Depending upon market conditions and the particular region, the

slope of the curve can change dramatically.
Percent Sulfur
.5% 1% 2.5% over
Sweet Intermediate Sour
The average sulfur content for U.S. refineries is 1%.
284
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APPENDICES
APPENDIX J
NATURAL GAS PRODUCTS
HYDROCARBON SERIES TERMINOLOGY
C1 C2 C3 C4 C5+
LNG Liquified Natural Gas
CNG Compressed Natural Gas
LPG Liquified Petroleum Gas
NGL Natural Gas Liquids
COND Condensate
Methane Ethane Propanes Butanes Pentanes+
285
#CHAP 12 5/3/04 11:53 AM Page 286
APPENDIX K
H2S AND NATURAL GAS
1 ppm = .0001% Detectable by odor
10 ppm = .001% 7 hours exposure allowable
over 20 ppm Protective equipment is necessary
100 ppm = .01% Kills sense of smell in 3–15 minutes,

may burn eyes and throat
200 ppm = .02% Kills smell rapidly, burns eyes and throat
500 ppm = .05% Sense of reasoning and balance impaired

Respiratory problems within 2–15 minutes
Artificial resuscitation needed promptly
700 ppm = .07% Unconsciousness occurs quickly.

Breathing stops, and death results if not
immediately resuscitated.
1,000 ppm = .10% Immediate unconsciousness
286
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APPENDICES
APPENDIX L
PRESENT VALUE OF ONE TIME PAYMENT
1
Present Value of $1 =
(n – .5)
(1+i)
(Midyear discounting)
Period
(n) 5% 10% 15% 20% 25% 30% 35%
1 .976 .953 .933 .913 .894 .877 .861
2 .929 .867 .811 .761 .716 .765 .638
3 .885 .788 .705 .634 .572 .519 .472
4 .843 .717 .613 .528 .458 .339 .350
5 .803 .651 .533 .440 .366 .307 .259
6 .765 .592 .464 .367 .293 .236 .192

7 .728 .538 .403 .306 .234 .182 .142
8 .694 .489 .351 .255 .188 .140 .105
9 .661 .445 .305 .212 .150 .108 .078
10 .629 .404 .265 .177 .120 .083 .058
11 .599 .368 .231 .147 .096 .064 .043

12 .571 .334 .200 .123 .077 .049 .032
13 .543 .304 .174 .102 .061 .038 .023
14 .518 .276 .152 .085 .049 .029 .017
15 .493 .251 .132 .071 .039 .022 .013
16 .469 .228 .115 .059 .031 .017 .010

17 .447 .208 .100 .049 .025 .013 .007
18 .426 .189 .087 .041 .020 .010 .005
19 .406 .171 .075 .034 .016 .008 .004
20 .386 .156 .066 .029 .013 .006 .003
21 .368 .142 .057 .024 .010 .005 .002

22 .350 .129 .050 .020 .008 .004 .002
23 .334 .117 .043 .017 .007 .003 .001
24 .318 .106 .037 .014 .005 .002 .001
25 .303 .097 .033 .011 .004 .002 .001
287
#CHAP 12 5/3/04 11:53 AM Page 288
APPENDIX M
REFERENCES AND SOURCES OF INFORMATION
Barrows, G. Worldwide Concession Contracts and Petroleum Legislation.

Tulsa: PennWell Publishing Company, 1983.
Barry, R. The Management of International Oil Operations. Tulsa:

PennWell Publishing Company, 1993.
Beck, R. Oil Industry Outlook Ninth Edition 1993–1997 Projection to

2001. Tulsa: PennWell Publishing Company, 1992.
Bosson, R., and M. Varon, The Mining Industry and the Developing
Countries. Washington, D.C.: World Bank, 1977.
Boulos, A. “How a Domestic Oil Company Goes International: A

Strategy for Success.” Production Sharing Contracts
Conference Proceedings, AIC Conferences, Houston, March
1994.
Burke, F., and R. Dole, Business Aspects of Petroleum Exploration in

Non-Traditional Areas. BMC, 1991.
Darden, M. Legal Research Checklist for International Petroleum

Operations, Section on Natural Resources, Energy, and
Environmental Law. Monograph Series Number 20, American
Bar Association, 1994.
_________. “Lifting Agreements in International Petroleum

Operations.” Presentation to the Energy Law Section of the
Dallas Bar Association, 16 February 1994.
288
#CHAP 12 5/3/04 11:53 AM Page 289
APPENDICES
Derman, A. International Oil and Gas Joint Ventures: A Discussion with

Associated Form Agreements, Section on Natural Resources,
Energy, and Environmental Law. Monograph Series Number
16, The American Bar Association, 1992.
Dur, S. “Negotiating PSC Terms.” Production Sharing Contracts

1994.
Fee, D. Oil & Gas Databook for Developing Countries, 2nd Edition.
Commission of the European Communities, 1988.
Foley, M. and G. Gussis, “Tax & Fiscal Regimes: A Comparative

Analysis.” Oil & Gas Production-Sharing Contracts (PSCs),
Concessions and New Petroleum Ventures in the Asia-Pacific
Basin, Conference Proceedings, Institute for International
Research, Houston, April 1993.
Frame, S. “Risk & Reward—Assessing Upstream Potential.” Oil &

Gas Production-Sharing Contracts (PSCs), Concessions and
New Petroleum Ventures in the Asia-Pacific Basin, Conference
Proceedings, Institute for International Research, Houston,
April 1993.
Gosain, V. “How to Identify Creditable Foreign Taxes.” U.S.

Taxation of International Operations, Warren Gorham Lamont,
1992, pp. 5,471–5,495.
Hallmark, T. “Political Risk: Assessing dangers in international

exploration, development.” Offshore Magazine, (May 1991):
27–34.
Hook, F. “Sovereign Risk and the Resource Industries.” PetroMin

Magazine, (April 1992): 39–45.
289
#CHAP 12 5/3/04 11:53 AM Page 290
Hossain, K. Law and Policy in Petroleum Development London,:

Frances Pinter (Publishers) Ltd., 1979.
Johnston, D, “Current Status of Petroleum Fiscal Systems in the

World Oil & Gas Industry.” Production Sharing Contracts
1994.
Johnston, D, “International Petroleum Fiscal Systems: Production

Sharing Contracts.” Petroleum Accounting and Financial
Management Journal, Special International Issue, (Summer
1994).
Johnston, D, “The Production Sharing Concept.” PetroMin

Magazine—Singapore, (August 1992): 26–34.
Khong Cho Oon. The politics of oil in Indonesia: Foreign company-host

government relations. Cambridge: Cambridge University Press,
1986.
McPherson, C. and K. Palmer, “New Approaches to Profit Sharing

in Developing Countries.” Oil & Gas Journal, (25 June 1984):
119–128.
Mikdashi, Z. The International Politics of Natural Resources. Ithaca

and London: Cornell University Press, 1976.
Mikesell, R. Petroleum Company Operations and Agreements in the

Developing Countries. Washington, D.C.: Resources for the
Future, Inc.,1984. Distributed by Johns Hopkins University
Press.
Mustafaoglu, M. “Comparison of Major International Petroleum

Tax Systems.” Journal of Petroleum Technology, (Society of
Petroleum Engineers) (October 1981): 1835–1843.
290
#CHAP 12 5/3/04 11:53 AM Page 291
APPENDICES
Ricardo, D. The Principles of Political Economy and Taxation. London:

Dent & Sons Ltd. Printed in Great Britain by Biddles Ltd,
Guildford, Surrey, First published in 1911. Reprinted in 1976.
Smith, D., “Comparison of Fiscal Terms in the Far East, South

America, North Africa and C.I.S.” Oil & Gas Production-
Sharing Contracts (PSCs), Concessions and New Petroleum
Ventures in the Asia-Pacific Basin, Conference Proceedings,
Institute for International Research, Houston, April 1993.
Smith, D. and L. Wells, Negotiating Third-World Mineral Agreements.

Cambridge, Mass:, Ballinger Publishing Company, 1975.
Stauffer, T. and J. Gault, “Effects of Petroleum Tax Design upon

Exploration and Development.” SPE Paper 9576, from
Proceedings of the 1981 Hydrocarbon Economics and
Evaluations Symposium, pp. 199–211.
Stauffer, T. “Political Risk and Overseas Investment” SPE Paper

18514, from Proceedings of the SPE Symposium on Energy,
Finance and Taxation Policies held in Washington, D.C.,
September 1988.
Wood, D. “Appraisal of economic performance of global explo-

ration contracts.” Two-part series, Oil & Gas Journal, (October
29, 1990; November 5, 1990): 48–53, 50–53.
_________. Legal Framework for the Treatment of Foreign Investment.

Volume I, Washington, D.C.: The World Bank, 1992.
_________. Legal Framework for the Treatment of Foreign Investment.

Volume II, Washington, D.C.: The World Bank, 1992.
291
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_________. Petroleum Accounting and Financial Management Journal,

Special International Issue. Summer 1994, Denton, Texas:
Institute of Petroleum Accounting, (Johnston, D. ed., 1994)
_________. The Petroleum Report, Indonesia’s Petroleum Sector.

Jakarta, Indonesia: Embassy of the United States of America,
June 1990.
_________. Studies in Energy Tax Policy. Edited by G. Brannon.

Cambridge, Mass.: Ballinger Publishing Company, 1975.
292
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GLOSSARY
13
GLOSSARY
Abrogate. To officially abolish or repeal a treaty or contract
through legislative authority or an authoritative act.
Accelerated depreciation. Writing off an asset through depreci-

ation or amortization at a rate that is faster than normal account-
ing straight line depreciation. There are a number of methods of
accelerated depreciation but they are usually characterized by
higher rates of depreciation in the early years than the latter years
in the life of the asset. Accelerated depreciation allows for lower
tax rates in the early years.
Ad Valorem. Latin for according to value, a tax on goods or prop-

erty, based upon value rather than quantity or size.
Affiliate. Two companies are affiliated when one owns less than
a majority of the voting stock of the other or when they are both
subsidiaries of a third parent company (see Subsidiary). A sub-
sidiary is an affiliate of its parent company.
Amortization. An accounting convention designed to emulate

the cost or expense associated with reduction in value of an
intangible asset (see Depreciation) over a period of time.
Amortization is a noncash expense. Similar to depreciation of tan-
gible capital costs, there are several techniques for amortization of
intangible capital costs:
• Straight Line Decline (SLD)
• Double Declining Balance (DDB)
293
#CHAP 13 5/3/04 1:55 PM Page 294
• Declining Balance (DB)

• Sum of Year Digits (SYD)
• Unit of Production
Arbitration. A process in which parties to a dispute agree to set-

tle their differences by submitting their dispute to an independent
individual or group for settlement. Each side of the dispute choos-
es an arbitrator, and those two choose a third. The third arbitrator
acts as the chairman of the tribunal which then hears and reviews
both sides of the dispute. The tribunal then renders a decision
that is final and binding.
Book Value. (1) The value of the equity of a company. Book

value per share is equal to the equity divided by the number of
shares of common stock. Fully diluted book value is equal to the
equity less any amount that preferred shareholders are entitled to
divided by the number of shares of common stock. (2) Book
value of an asset or group of assets is equal to the initial cost less
DD&A.
Branch. An extension of a parent company, but not a separate

independent entity. Subsidiary companies are normally taxed as
profits are distributed as opposed to branch profits which are
taxed as they accrue.
Calvo Clause. A relatively obsolete contract clause once promot-

ed in Latin American countries where the contractor explicitly
renounced the protection of its home government over its opera-
tion of the contract. The objective of the Calvo Doctrine was to
direct disputes to local jurisdictions and avoid international arbi-
tration.
Capitalization. All money invested in a company including long

term debt (bonds), equity capital (common and preferred stock),
retained earnings, and other surplus funds.
294
#CHAP 13 5/3/04 1:55 PM Page 295
GLOSSARY
Capitalization Rate. The rate of interest used to convert a series

of future payments into a single present value.
Capitalize. (1) In an accounting sense, the periodic expensing

(amortization) of capital costs through depreciation or depletion.
(2) To convert an (anticipated) income stream to a present value
by dividing by an interest rate, as in the dividend discount model.
(3) To record capital outlays as additions to asset value rather
than as expenses.
Generally, expenditures that will yield benefits to future oper-
ations beyond the accounting period in which they are incurred
are capitalized—that is, they are depreciated at either a statutory
rate or a rate consistent with the useful life of the asset.
Cash Flow. (1) Net income plus depreciation, depletion, and

amortization and other noncash expenses. Usually synonymous
with cash earnings and operating cash flow. (2) An analysis of all
the changes that affect the cash account during an accounting
period.
Central Bank. The primary government-owned banking institu-

tion of a country. The central bank usually regulates all aspects of
foreign exchange in and out of the country. It actively intervenes
in the acquisition and sale of its own currency in foreign
exchange markets primarily to maintain stability in the value of
the country’s currency.
CIF. Cost insurance and freight is included in the contract price for
a commodity. The seller fulfills his obligations when he delivers the
merchandise to the shipper, pays the freight and insurance to the
point of (buyer’s) destination, and sends the buyer the bill of lad-
ing, insurance policy, invoice, and receipt for payment of freight.
The following example illustrates the difference between an FOB
Jakarta price and a CIF Yokohama price for a ton of LNG (see FOB).
295
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FOB Jakarta $170/ton also called netback price

+ 30/ton Freight charge
CIF Yokohama $200/ton
Commercial Discovery. In popular usage, the term applies to

any discovery that would be economically feasible to develop
under a given fiscal system. As a contractual term, it often applies
to the requirement on the part of the contractor to demonstrate
to the government that a discovery would be sufficiently prof-
itable to develop from both the contractor’s and government’s
points of view. A field that satisfied these conditions would then
be granted commercial status, and the contractor would then
have the right to develop the field.
Concession. An agreement between a government and a compa-

ny that grants the company the right to explore for, develop, pro-
duce, transport, and market hydrocarbons or minerals within a
fixed area for a specific amount of time. The concession and pro-
duction and sale of hydrocarbons from the concession is then
subject to rentals, royalties, bonuses, and taxes. Under a conces-
sionary agreement the company would hold title to the resources
that are produced.
Consortium. A term that applies to a group of companies operat-

ing jointly, usually in a partnership with one company as operator
in a given permit, license, contract area, block, etc.
Contractor. An oil company operating in a country under a pro-

duction sharing contract or a service contract on behalf of the
host government for which it receives either a share of produc-
tion or a fee.
Contractor After-Tax Equity Split. Same as contractor take.
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GLOSSARY
Contractor Take. The total contractor after-tax share of profits.
Cost Insurance and Freight (CIF). A transportation term that

reflects the price of a commodity at the point of sale which
includes all transportation costs including insurance, etc. (see
CIF).
Cost of Capital. The minimum rate of return on capital required

to compensate debt holders and equity investors for bearing risk.
Cost of capital is computed by weighting the after-tax cost of debt
and equity according to their relative proportions in the corporate
capital structure.
Cost Oil. A term most commonly applied to production sharing

contracts which refers to the oil (or revenues) used to reimburse
the contractor for exploration costs, development capital costs,
and operating costs.
Country Risk. The risks and uncertainties of doing business in a

foreign country, including political and commercial risks (see
Sovereign Risk).
Creeping Nationalization or Creeping Expropriation. A sub-

tle means of expropriation through expanding taxes, restrictive
labor legislation, labor strikes, withholding work permits, import
restrictions, price controls, and tariff policies. The difference
between nationalization and expropriation is that nationalization
is usually on an industry-wide level and expropriation focuses on
a particular company.
Debt Service. Cash required in a given period, usually one year,

for payments of interest and current maturities of principal on
outstanding debt. In corporate bond issues, the annual interest
plus annual sinking fund payments.
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Depletion. (1) Economic depletion is the reduction in value of a

wasting asset by the removal of minerals. (2) Depletion for tax
purposes (depletion allowance) deals with the reduction of min-
eral resources due to removal by production or mining from an
oil or gas reservoir or a mineral deposit.
Depreciation. An accounting convention designed to emulate

the cost or expense associated with reduction in value of an asset
due to wear and tear, deterioration, or obsolescence over a period
of time. Depreciation is a noncash expense. There are several
techniques for depreciation of capital costs:
• Straight Line Decline
• Double Declining Balance
• Declining Balance
• Sum of Year Digits
• Unit of Production (see Unit of Production)
Dilution Clause. In a joint operating agreement, a clause that

outlines a formula for the dilution of interest of a working-inter-
est partner if that partner defaults on a financial obligation. Also
called a withering clause.
Direct Tax. A tax that is levied on corporations or individuals—

the opposite of an indirect tax, such as a value-added tax (VAT) or
sales taxes.
Disposal. This term usually refers to transportation and sales of

crude or gas from the field.
Dividend Withholding Tax. A tax levied on dividends or repa-

triation of profits. Tax treaties normally try to reduce these taxes
whether they are so named or simply operate in the same man-
ner as a withholding tax.
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GLOSSARY
Dollars-of-the-Day. A term usually associated with cost esti-

mates that indicate the effects of anticipated inflation have been
taken into account. For example, if a well costs $5 million right
now in “today’s dollars” (the opposite of dollars-of-the-day), then
the cost of the well two years from now might be estimated at
$5.51 million in dollars-of-the-day assuming a 5% inflation fac-
tor. Also called escalated dollars.
Domestication. A form of creeping nationalization where host

government enacts legislation that forces foreign-owned enter-
prises to surrender various degrees of ownership and/or control to
nationals.
Double Taxation. (1) In economics a situation where income

flow is subjected to more than one tier of taxation under the
same domestic tax system—such as state/provincial taxes, then
federal taxes, or federal income taxes and then dividend taxes. (2)
International double taxation is where profit is taxed under the
system of more than one country. It arises when a taxpayer or
taxpaying entity resident (for tax purposes) in one country gener-
ates income in another country. It can also occur when a taxpay-
ing entity is resident for tax purposes in more than one country
(see Dual Residence).
Double Taxation Treaty. Formal agreement between countries to

reduce or eliminate double taxation. A bilateral tax treaty is a treaty
between two countries to coordinate taxation provisions which
would otherwise create double taxation. A multilateral tax treaty
involves three or more countries for the same purpose. The United
States has few treaties with oil-producing nations.
Dual Residence. When a taxpaying entity is resident for tax

purposes in more than one country. This can happen when differ-
ent countries apply the tests for determining residence and the
company passes the test in more than one country.
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Dutch Disease. The adverse results of large-scale positive shock

to a single sector of a nation’s economy, so named because of the
problems associated with large-scale development of the
Groningen Gas field in the Netherlands in the 1970s. Typically the
sector of economy that is booming causes widespread inflation
and other sectors, particularly agriculture, suffer from inability to
attract workers. The drastic increase in foreign exchange can
cause problems with local currencies and fiscal and monetary
problems can occur without proper management.
Economic Rent. The difference between the value of production

and the cost to extract it. The extraction cost consists of normal
exploration, development, and operating costs as well as a suffi-
cient share of profits for the industry. Economic rent is what the
governments try to extract as efficiently as possible.
Entitlements. The shares of production to which the operating

company, the working-interest partners, and the government or
government agencies are authorized to lift. Entitlements are
based upon royalties, cost recovery, production sharing, taxation,
working-interest percentages, etc. Generally, legal entitlement
equals Profit Oil plus Cost Oil in a PSC.
Equity Oil. Usually this term refers to oil or revenues after cost
recovery (or cost oil). It is also referred to as profit oil or share
oil—terms that are most often associated with PSCs. Generally
speaking, the analog to equity oil in a concessionary system
would be pretax cash flow. Like pretax cash flow, equity oil may
also be subject to taxation.
Eurodollar. U.S. currency that is held in foreign banks (mostly

European) that is used in settling international transactions.
Excise Tax. A tax based either on production, sale, or consump-

tion of a specific commodity such as tobacco, coffee, gasoline, or oil.
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GLOSSARY
Exclusion of Areas. see Relinquishment
Expense. (1) In a financial sense, a noncapital cost associated

most often with operations or production. (2) In accounting, costs
incurred in a given accounting period as expenses and charged
against revenues. To expense a particular cost is to charge it
against income during the accounting period in which it was
spent. The opposite would be to capitalize the cost and charge it
off through some depreciation schedule.
Exploratory Well. A well drilled in an unproved area. This can

include: (1) a well in a proved area seeking a new reservoir in a
significantly deeper horizon, (2) a well drilled substantially
beyond the limits of existing production. Exploratory wells are
defined partly by distance from proved production and by degree
of risk associated with the drilling. Wildcat wells involve a higher
degree of risk than exploratory wells.
Expropriation. Similar to the concept of nationalization or out-

right seizure or confiscation of foreign assets by a host govern-
ment. With expropriation the confiscation is directed toward a
particular company; nationalization is where a government con-
fiscates a whole industry. Expropriation is legal but theoretically
must be accompanied by prompt, adequate, and effective com-
pensation and must be in the public interest.
Fair Market Value (FMV) of Reserves. Often defined as a

specific fraction of the present value of future net cash flow dis-
counted at a specific discount rate. The most common usage
defines FMV at 2/3–3/4 of the present value of future net cash flow
discounted at the prime interest rate plus .75–1 percentage point.
Finding Cost. The amount of money spent per unit (barrel of oil
or MCF of gas) to acquire reserves. Includes discoveries, acquisi-
tions, and revisions to previous reserve estimates.
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Fiscal Marksmanship. The ability of authorities to predict with

any degree of accuracy or certainty the tax revenues that may fall
due to be paid to the government. In the petroleum industry, it is
particularly difficult to estimate accurately what revenues may be
generated for countries with little or no exploration history.
Fiscal System. Technically, the legislated taxation structure for a

country including royalty payments. In popular language, the
term includes all aspects of contractual and fiscal elements that
make up a given government-foreign oil company relationship.
FOB. Free on Board. A transportation term that means that the

invoice price includes transportation charges to a specific destina-
tion. Title is usually transferred to the buyer at the FOB point by
way of a bill of lading. For example, FOB New York means the
buyer must pay all transportation costs from New York to the
buyer’s receiving point. FOB plus transportation costs equals CIF
price (see CIF—Cost Insurance Freight).
Foreign Corrupt Practices Act. Sometimes referred to as

antibribery legislation. It is illegal for a U.S. company or individ-
ual to knowingly pay a foreign official in order to obtain or to
retain business. This includes commissions or payments to agents
or intermediaries with the knowledge that all or a part of the pay-
ments will be given to a foreign official. The FCPA also has vari-
ous record-keeping and reporting requirements.
Foreign Tax Credit. Taxes paid by a company in a foreign coun-

try may sometimes be treated as taxes paid in the company’s
home country. These are creditable against taxes and represent a
direct dollar-for-dollar reduction in tax liability. This usually
applies to foreign income taxes paid and credited against home-
country income taxes. Other taxes which may not qualify for a
tax credit may nevertheless qualify as deductions against home-
country income tax calculation.
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GLOSSARY
Franked Dividends. Dividends that have already been taxed at

the corporate level and are therefore either not subject to with-
holding tax or the taxes paid are creditable against withholding
taxes.
Gazette. To announce officially license round offering or results,

or publication of notification of acceptance of bids in official gov-
ernment publication (gazette). To gazette means to offer block, as
in “The licenses have not been gazetted yet.”
Gold Plating. When a company or contractor makes unreason-

ably large expenditures due to lack of cost-cutting incentives. This
kind of behavior could be encouraged where a contractor’s com-
pensation is based in part on the level of capital and operating
expenditure.
Government After-Tax Equity Split. Same as government

take.
Government Take. The total government share of profit oil or

revenues not associated with cost recovery. Same as government
after-tax equity split and government marginal take.
Hard Currency. Currency in which there is widespread confi-

dence and a broad market such as that for the U.S. dollar, the
British pound, Swiss francs, or Japanese yen. The opposite would
be soft currency where there is a thin market and the currency
fluctuates erratically in value. Soft currencies usually are based
upon unrealistic exchange rates that do not reflect the market
value of the currency.
Hectare. Metric unit of area equal to 10,000 m2 or 100 ares,

which also equals 2.471 acres.
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Hull Formula. Compensation for expropriation, in the language

of many bilateral and multilateral investment treaties, should be
“prompt, adequate, and effective.” This is known as the Hull
Formula. Alternate wording found in other treaties includes, “fair
and equitable,””reasonable,””market value at date of expropria-
tion,” etc.
Hurdle Rate. Term used in investment analysis or capital bud-

geting that means the required rate of return in a discounted cash
flow analysis. Projects to be considered viable must at least meet
the hurdle rate. Investment theory dictates that the hurdle rate
should be equal to or greater than the incremental cost of capital.
Hydrocarbon Series. The various components of crude oil and

natural gas composed of carbon and hydrogen atoms.
Hydrocarbon Series
C1 - Methane - CH4
C2 - Ethane - C2H6
C3 - Propanes - C3H8
C4 - Butanes - C4H10
C5 - Pentanes - C5H12
C6 - Hexanes - C6H14
C7 - Heptanes - C7H16
C8 - Octanes - C8H18
C9 - Nonanes - C9H20
C10 - Decanes - C10H22
and so forth
Incentives. Fiscal or contractual elements emplaced by host gov-

ernments that make petroleum exploration or development more
economically attractive. Includes such things as:
• Royalty holidays
• Tax holidays
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GLOSSARY
• Tax credits
• Reduced government participation
• Lower government take
• Investment credits/uplifts
• Accelerated depreciation
Inconvertibility. Inability of a foreign contractor to convert pay-

ments received in soft local currency into home country or hard
currency such as dollars, pounds, or yen.
Indirect Tax. A tax that is levied on consumption rather than

income (see Direct Tax). Examples of indirect taxes include value-
added taxes, sales taxes, or excise taxes on luxury items.
Intangible Drilling and Development Costs (IDCs).

Expenditures for wages, transportation, fuel, fungible supplies
used in drilling and equipping wells for production.
Intangibles. All intangible assets such as goodwill, patents, trade-

marks, unamortized debt discounts, and deferred charges.
Investment Credit. A fiscal incentive where the government

allows a company to recover an additional percentage of tangible
capital expenditure. For example, if a contractor spent $10 mil-
lion on expenditures eligible for a 20% investment credit, then
the contractor would actually be able to recover $12 million
through cost recovery (see Uplift). These incentives can be tax-
able. Sometimes the investment credit is mistakenly referred to as
an investment tax credit.
Joint Venture. The term applies to a number of partnership

arrangements between individual oil companies or between a
company and a host government. Typically an oil company or con-
sortium (contractor group) carries out sole risk exploration efforts
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with a right to develop any discoveries made. Development and

production costs then are prorated between the partners, which
may include the government.
Letter of Credit. An instrument or document from a bank to

another party indicating that a credit has been opened in that
party’s favor guaranteeing payment under certain contractual
conditions. The conditions are based upon a contract between the
two parties. Sometimes called a performance letter of credit which is
issued to guarantee performance under the contract.
Letter of Intent. A formal letter of agreement signed by all par-

ties to negotiations after negotiations have been completed out-
lining the basic features of the agreement, but preliminary to for-
mal contract signing.
License. An arrangement between an oil company and a host

government regarding a specific geographical area and petroleum
operations. In more precise usage, the term may apply to the
development phase of a contract after a commercial discovery has
been made (see Permit).
Lifting. The amount of crude oil an operator produces and sells,

or the amount each working-interest partner (or the govern-
ment) takes. The liftings may actually be more or less than actual
entitlements which are based on royalties, working-interest per-
centages, and a number of other factors. If an operator or partner
has taken and sold more oil than it was actually entitled to, then
it is in an overlifted position. Conversely if a partner has not taken
as much as it was entitled to it is in an underlifted position (see
Nomination and Entitlements).
Limitada. Business entity which resembles a partnership with

liability of all members limited to their contribution and no
general partner with unlimited liability. Normally treated as a
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GLOSSARY
partnership by the United States for tax purposes. Similar to a

limited liability company in the United States, although the
limitada was the forerunner.
London Interbank Offered Rate (LIBOR). The rate that the

most creditworthy international banks that deal in Eurodollars
will charge each other. Thus LIBOR is sometimes referred to as
the Eurodollar Rate. International lending is often based on LIBOR
rates. For example, a country may have a loan with interest
pegged at LIBOR plus 1.5% (see Eurodollar).
Marginal Government Take. Same as government take.
Maximum Cash Impairment. Maximum negative cash balance

in a cash flow projection.
Nationalization. Government confiscation of the assets held by

foreign companies throughout an entire industry (see
Expropriation).
Netback. Many royalty calculations are based upon gross

revenues from some point of valuation, usually the last valve off
of a production platform or at the boundary of a field or license
area. The point of sale, however, may be different than the point
of valuation. The statutory royalty calculation may allow the
transportation costs from the point of valuation to the point of
sale to be deducted. This is called a netback formula.
Nomination. Under a lifting agreement the amount of crude oil

a working-interest owner is expected to lift. Each working-inter-
est partner has a specific entitlement depending upon the level of
production, royalties, their working interest, and their relative
position (i.e., underlifted or overlifted), etc. Each working-interest
partner must notify the operator (nominate) the amount of its
307
#CHAP 13 5/3/04 1:55 PM Page 308
entitlement that it will lift. Sometimes, depending upon the lifting

agreement, the nomination may be more or less than the actual
entitlement (see Liftings and Entitlements).
OPEC. Organization of Petroleum Exporting Countries founded

in 1960 to coordinate petroleum prices of the members. Members
include:
• Iran
• Iraq
• Kuwait
• Saudi Arabia
• Venezuela
• Qatar
• Indonesia
• Libya
• Abu Dhabi (UAE)
• Algeria
• Nigeria
• Ecuador (dropped out)
• Gabon
Operating Profit (or loss). The difference between business rev-

enues and the associated costs and expenses exclusive of interest
or other financing expenses, and extraordinary items, or ancillary
activities. Synonymous with net operating profit (or loss), operat-
ing income (or loss), and net operating income (or loss).
OPIC. (Overseas Private Investment Corporation) A U.S. govern-

ment agency founded under the Foreign Assistance Act of 1969 to
administer the national investment guarantee program for invest-
ment in less developed countries (LDCs) through the issuance of
insurance for risks associated with war, expropriation, and incon-
vertibility of payments in local currency.
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GLOSSARY
Overlifting. Over/underlifting is the difference between actual

contractor lifting during an accounting period and the contractor
entitlements based upon cost recovery and profit oil, in the case
of a PSC. A lifting is the actual physical volume of crude oil taken
and sold.
Overspill. In international taxation, a situation where a taxpay-

ing company has a credit for foreign taxes that is greater than its
corporate tax liability in its home country, giving it has an unused
and/or unusable tax credit.
Permit. In a loose sense the term is used to describe any arrange-

ment between a foreign contractor and a host government
regarding a specific geographical area and petroleum operations.
In a more precise usage, the term may apply to the exploration
phase of a contract before a commercial discovery has been made
(see License).
Posted Price. The official government selling price of crude oil.

Posted prices may or may not reflect actual market values or mar-
ket prices.
Present Value. The value now of a future payment or stream of

payments based on a specified discount rate.
Prime Lending Rate. The interest rate on short-term loans that

banks charge to their most stable and creditworthy customers.
The prime rate charged by major lending institutions is closely
watched and is considered a benchmark by which other loans are
based. For example, a less well-established company may borrow
at prime plus 1%.
Production Sharing Agreement. This (PSA) is the same as a

Production Sharing Contract (PSC). While at one time this term
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#CHAP 13 5/3/04 1:55 PM Page 310
was quite common, it is used less frequently now, and the term
Production Sharing Contract is becoming more common.
Production Sharing Contract. A contractual agreement

between a contractor and a host government whereby the con-
tractor bears all exploration costs and risks and development and
production costs in return for a stipulated share of the production
resulting from this effort.
Pro Forma. Latin for as a matter of form. A financial projection

based upon assumptions and possible events that have not
occurred. For example, a financial analyst may create a consoli-
dated balance sheet of two nonrelated companies to see what the
combination would look like if the companies had merged. Often
a cash flow projection for discounted cash flow analysis is referred
to as a pro forma cash flow.
Progressive Taxation. Where tax rates increase as the basis to

which the applied tax increases. Or where tax rates decrease as
the basis decreases. The opposite of regressive taxation.
Protocol. (1) Culturally dictated forms of ceremony and etiquette

that govern business relationships, meetings, and negotiations. (2)
Formal document primarily used in republics of the former Soviet
Union signed by parties who attend meetings or negotiations indi-
cating various minor agreements or stages of agreement reached.
This document is not the same as a letter of intent, which is more
formal and usually signifies that negotiations have been concluded.
Rate of Return Contract. Sometimes referred to as a Resource

Rent Royalty. The government collects a share of cash flows in
excess of the return required to generate investment. The govern-
ment share is calculated by accumulating negative net cash flows
at a specific threshold rate of return, and once the accumulated
value becomes positive, the government takes a specified share.
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GLOSSARY
Regressive Tax. Where tax rates become lower as the basis to

which the applied tax increases. Or where tax rates increase as
the basis decreases. The opposite of progressive taxation.
Reinvestment obligations. A fiscal term that requires the con-

tractor/operator to set aside a specified percentage of profit oil or
income after-tax that must be spent on domestic projects such as
exploration.
Resource Rent Tax. Some economists refer to additional profits

taxes as a resource rent tax. Australia has a specific tax based
upon profits which is referred to as resource rent tax (RRT) (see
Rate of Return Contract). Normally the RRT is levied after the
contractor or oil company has recouped all capital costs plus a
specified return on capital that supposedly will yield a fair return
on investment.
Relinquishment A contract clause that refers to how much con-

tract or license area a contractor must surrender or give back to
the government during or after the exploration phase of a con-
tract. Licenses are usually granted on the basis of an initial term
with specific provisions for the timing and amount of relinquish-
ment prior to entering the next phase of the contract. Also
referred to as exclusion of areas.
Ringfencing. A cost center based fiscal device that forces con-

tractors or concessionaires to restrict all cost recovery and or
deductions associated with a given license (or sometimes a given
field) to that particular cost center. The cost centers may be indi-
vidual licenses or on a field-by-field basis.
For example, exploration expenses in one nonproducing
block could not be deducted against income for tax calculations in
another block. Under a PSC, ringfencing acts in the same way:
cost incurred in one ring fenced block cannot be recovered from
another block outside the ringfence.
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Royalty Holiday. A form of fiscal incentive to encourage invest-

ment and particularly marginal field development. A specified
period of time in years or months, during which royalties are not
payable to the government. After the holiday period, the standard
royalty rates are applicable (see Tax Holiday).
Seismic Option. A contractual arrangement or agreement between

a host government and a contractor that gives the contractor a peri-
od during which it has exclusive rights over a geographic area or
contract area during which the contractor will shoot additional seis-
mic data. After data acquisition, processing, and interpretation, the
contractor has the right to enter into an additional phase of the
agreement or a more formal contract with the government for the
area, which usually includes a drilling commitment.
Severance Tax. A tax on the removal of minerals or petroleum

from the ground, usually levied as a percentage of the gross value
of the minerals removed. The tax can also be levied on the basis
of so many cents per barrel or per million cubic feet of gas.
Shelf Company. An incorporated entity which has no assets and

or income but has gone through the process of registration and
licensing. Some operations in foreign countries are started with
acquisition of a shelf company because of the long delays that can
be experienced in incorporating a company.
Sinking Fund. Money accumulated on a regular basis in a sepa-

rate account for the purpose of paying off an obligation or debt.
Sliding Scales. A mechanism in a fiscal system that increases

effective taxes and/or royalties based upon profitability or some
proxy for profitability, such as increased levels of oil or gas pro-
duction. Ordinarily each tranche of production is subject to a spe-
cific rate, and the term incremental sliding scale is sometimes used
to further identify this.
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GLOSSARY
Sovereign Risk. Also called country risk or political risk—refers

to the risks of doing business in a foreign country where the
government may not honor its obligations or may default on
commitments. Encompasses a variety of possibilities including
nationalization, confiscation, expropriation, among others (see
Country Risk).
Spot Market. Commodities market where oil (or other com-

modities) are sold for cash and the buyer takes physical delivery
immediately. Futures trades for the current month are also called
spot market trades. The spot market is mostly an over-the-counter
market conducted by telephone and not on the floor of an orga-
nized commodity exchange.
Spot Price. The delivery price of a commodity traded on the spot

market. Also called the cash price.
Subsidiary. A company legally separated from but controlled by

a parent company who owns more than 50% of the voting
shares. A subsidiary is always by definition an affiliate company
(see Affiliate). Subsidiary companies are normally taxed as profits
are distributed as opposed to branch profits, which are taxed as
they accrue.
Sunk Costs. There are a number of categories of sunk costs:

• Tax Loss Carry Forward (TLCF)
• Unrecovered Depreciation Balance
• Unrecovered Amortization Balance
• Cost Recovery Carry Forward
These costs represent previously incurred costs that will ulti-
mately flow through cost recovery or will be available as deduc-
tions against various taxes (if eligible).
Surrender. (see Relinquishment). Surrender is most often used

synonymously with relinquishment in the context of area
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#CHAP 13 5/3/04 1:55 PM Page 314
reduction. However, the term also is used to describe a contrac-

tor’s option to withdraw from a license or contract at or after
various stages in a contract.
Take-or-Pay Contract. A type of contract where specific quanti-

ties of gas (usually daily or annual rates) must be paid for, even if
delivery is not taken. The purchaser may have the right in follow-
ing years to take gas that had been paid for but not taken.
Tax. A compulsory payment pursuant to the authority of a gov-

ernment. Fines, penalties, interest, and customs duties are not
taxes.
Tax Haven. A country where certain taxes are low or nonexis-

tent in order to increase commercial and financial activity.
Tax Holiday. A form of fiscal incentive to encourage investment.

A specified period of time, in years or months, during which
income taxes are not payable to the government. After the holi-
day period, the standard tax rates apply.
Tax Treaty. A treaty between two (bilateral) or more (multilater-

al) nations which lowers or abolishes withholding taxes on inter-
est and dividends, or grants creditability of income taxes to thus
avoiding double taxation.
Tranche. Usually a quantity or percentage of oil or gas production

that is subject to specific criteria. (1) The Indonesian first tranche
production (FTP) of 20% means that the first 20% of production is
subject to the profit oil split and taxation, and this tranche of pro-
duction is not available for cost recovery. (2) Sliding scale terms
typically subject different levels of production (tranches) to differ-
ent royalty rates, tax rates, or profit oil splits.
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GLOSSARY
Example:
Sliding Scale Royalty:

Tranches, BOPD Royalty, %
First Tranche Up to 10,000 5

Second Tranche 10,001–20,000 10
Third Tranche 20,001–40,000 15
Fourth Tranche 40,001 + 20
Transfer Pricing. Integrated oil companies must establish a price

at which upstream segments of the company sell crude oil pro-
duction to the downstream refining and marketing segments. This
is done for the purpose of accounting and tax purposes. Where
intrafirm (transfer) prices are different than established market
prices, governments will force companies to use a marker price or
a basket price for purposes of calculating cost oil and taxes.
Transfer pricing also refers to pricing of goods in transactions
between associated companies.
Treaty Shopping. Seeking out tax benefits and treaties of vari-

ous countries in order to structure an appropriately situated busi-
ness entity in a given country that would take advantage of bene-
fits that would not ordinarily be available.
Turnover. A financial term that means gross revenues—used

outside of the United States.
Underlifting. see Overlifting
Unit-of-Production Depreciation. Method of depreciation for

capital costs. This method attempts to match the costs with the
production those costs are associated with.
315
#CHAP 13 5/3/04 1:55 PM Page 316
Formula for Unit-of-Production Method

P
Annual Depreciation = (C – AD – S)
R
where:
C = Capital costs of equipment

AD = Accumulated depreciation
S = Salvage value
P = Barrels of oil produced during the year *
R = Recoverable reserves remaining at the
beginning of the tax year
* If there is both oil and gas production associated with the capital
costs being depreciated, then the gas can be converted to oil on a
thermal basis.
Uplift. Common terminology for a fiscal incentive whereby the

government allows the contractor to recover some additional per-
centage of tangible capital expenditure. For example, if a contrac-
tor spent $10 million on eligible expenditures and the govern-
ment allowed a 20% uplift then the contractor would be able to
recover $12 million. The uplift is similar to an investment credit.
However, the term often implies that all costs are eligible where
the investment credit applies to certain eligible costs. The term
uplift is also used at times to refer to the built-in rate of return ele-
ment in a rate of return contract.
Value-Added Tax. A tax that is levied at each stage of the pro-

duction cycle or at the point of sale. Normally associated with
consumer goods. The tax is assessed in proportion to the value
added at any given stage.
316
#CHAP 13 5/3/04 1:55 PM Page 317
GLOSSARY
Wildcat Well. An exploratory well drilled far from any proven

production. Wildcat wells involve a higher degree of risk than
exploratory or development wells.
Withering Clause. see Dilution Clause
Withholding Tax. A direct tax on a foreign corporation by a for-

eign government. The tax is levied on dividends or profits remit-
ted to the parent company or to the home country, as well as
interest paid on foreign loans.
Working Interest. The percentage interest ownership a compa-

ny (or government) has in a joint venture, partnership, or consor-
tium. The expense-bearing interests of various working-interest
owners during exploration, development, and production opera-
tions may change at certain stages of a contract or license. For
example, a partner with a 20% working interest in a concession
may be required to pay 30% of exploration costs but only a 20%
share of development costs. With government participation, the
host government usually pays no exploration expenses but pays
prorated development and operating costs and expenses.
World Bank. A bank (funded by approximately 130 countries)

that makes loans to less developed countries (LDCs). The official
name of the World Bank is the International Bank for
Reconstruction and Development.
317
#CHAP 13 5/3/04 1:55 PM Page 318
#CHAP 13 5/3/04 1:55 PM Page 319
INDEX
INDEX
Abandonment 57, 63, 170
Abu Dhabi 14, 209, 274
Accounting principles 177
Ad valorem taxes 9, 33, 34, 54
Albania 14, 210
Algeria 14, 211, 269, 274
AMOCO 24
Amortization 30, 60, 186
Angola 14, 212, 274
Arbitration 52, 152, 157, 168
Argentina 87, 133, 213, 274
Australia 13, 14, 98, 123, 251
Bangladesh 214, 274

Bargaining power 29, 142–144
Bolivia 215, 274
Bonuses 6–10, 18–21, 52–53, 62, 75, 78, 93, 161
Book value 183, 185
Branch 198
Breakeven analysis 120
British Petroleum 70
Brunei 14, 216, 274
Cameroon 14, 217, 274

Capital gains taxes 107, 164, 258
Capitalization 60
Cash flow 11, 30–35, 41–45, 49, 50, 62, 81–83, 96–98, 115, 181
Cash flow analysis 10, 20, 31, 62, 82, 115, 138, 139, 142
319
#CHAP 13 5/3/04 1:55 PM Page 320
Ceiling 57–59, 185

China 14, 61, 68, 165, 218, 219, 274
Cities Service 24
Colombia 14, 55, 66, 68, 100, 105, 116, 155, 220, 274
Commerciality 8, 52, 62, 65–67, 74, 80, 159
Commercial success ratio (See Success probability)
Concessionary systems 3–5, 21, 25, 29
Congo 14, 221, 274
Consolidation 69
Contractor marginal take 10
Contractor take 9–15, 29–31, 36, 37, 43, 45, 46, 49, 52, 63–64,
88, 92
Contractor 3, 4, 22
Cost center 184–186
Cost of capital 20, 142, 266
Cost recovery 10–13, 18–19, 41–52, 57, 60–62, 66–68, 93, 98,
104, 112
Cost recovery ceiling 57–59
Côte d'Ivoire 155, 232
Customs duties 174
Data purchase 157

Debt 60, 199
Deductions 30, 32, 33, 36, 56
Depreciation 30–34, 49, 52, 60, 73, 186–189
Discount rate 72
Discounted cash flow 20, 62, 115, 138, 139, 142
Dividend taxes 198–200
Domestic market obligation (DMO) 52, 68, 75–79, 82, 85, 160
Domestic obligation (See Domestic market obligation)
Double taxation 191
Double taxation treaties 192
Economic rent 5–9, 16–17, 192, 263
320
#CHAP 13 5/3/04 1:55 PM Page 321
INDEX
Ecopetrol 100, 155

Ecuador 48, 87, 88, 90–92
Egypt 14, 58, 59, 133, 197, 222, 223, 275
Enhanced oil recovery (EOR) 26–27, 107–108, 111
Entitlement 6, 13, 45–49, 72, 89–92, 163, 167
Equatorial Guinea 27, 98, 168, 224
Equilibrium clause (See Stability clause)
Equity split 10, 76, 80
ESSO 24
Excise taxes 106
Expected monetary value (EMV) theory 6, 19–21, 121, 138–146
Expensed costs 32, 41, 57, 62, 183–187
Expropriation 136, 137, 145, 149, 171
Fair market value 15, 220

Fertilizer 125, 127, 129
Filipino Participation Incentive Allowance (FPIA) 88–90
Financial reporting 47, 48, 177
First tranche petroleum 73–74, 80
Force majeure 157, 167
Foreign tax credit 177, 192, 195, 199–202
France 22, 70, 225, 275
Full cost accounting 182, 184
Gabon 14, 226, 275

Gamblers ruin theory 138
Gas clause 124, 173
Gas projects 124
Generally accepted accounting principals (GAAP) 177
Ghana 173, 227, 275
Government marginal take 10
Government participation 9, 26, 66–68, 98, 102–107, 154
Government take 10–12, 31, 49, 66, 93, 95, 105
Gulf of Mexico 117, 118, 120–123 136,
321
#CHAP 13 5/3/04 1:55 PM Page 322
Hallwood Energy Partners 111
Improved oil recovery (IOR) (See Enhanced oil recovery)

Inconvertibility 148
India 14, 69, 126, 228, 275
Indonesia 3, 10, 13–22, 40, 45–47, 58, 61, 67, 69, 71–86, 122,
123, 133, 275
Insurance 52, 146, 149
Intangibility clause (See Stability clause)
Interest cost recovery 60, 98, 218
Internal rate of return 31, 63, 84, 99, 101
Investment credits 11, 32, 41, 52, 57, 68, 73–75, 80–85
Investment uplift 68, 74–75, 82, 93, 97–98
Ireland 14, 231
Joint operating agreements (JOA) 26, 75, 82, 152, 166–167

Joint operating bodies (JOB) 82
Joint ventures 26, 82, 101–107, 111–112
Kerr McGee 24
Korea 14, 233
Lifting 45, 47, 75

Liquified Natural Gas (LNG) 125, 127–130
Liquified Petroleum Gas (LPG) 125, 126, 129
Malaysia 13, 14, 17, 67, 77, 115, 116, 122–124, 155, 166,
167, 172, 234, 235, 275
Malta 236
Marathon 24
Mauritania 105
Methanol 125, 127, 129
Multilateral Investment Guarantee Agency (MIGA) 147
Mineral ownership 21–25, 39, 42, 48
322
#CHAP 13 5/3/04 1:55 PM Page 323
INDEX
Mobil Oil Company 58, 130

Morocco 14, 237, 238, 275
Myanmar 14, 61, 70, 108, 116, 122, 123, 239, 240, 275
Nationalization 136, 147

Negotiation 2, 7, 16–18, 52, 63, 76, 135, 164
Net revenues 12, 30–44, 89, 99, 111–113
Netback 54,
New Zealand 14, 54, 199, 241, 264, 275
Nigeria 14, 133, 155, 242, 243, 275
North Sea 69, 70, 122, 123, 133
Norway 14, 133, 244, 275
Organization of Petroleum Exporting Countries (OPEC) 14, 209

Overseas Private Investment Corporation (OPIC) 148, 149
Ownership transfer 52, 164
Pakistan 246, 275

Papua New Guinea 14, 27, 60, 95–98, 115, 123, 196, 245
Payout 101, 106, 107, 143
Pertamina 40, 75, 82
Petroleum legislation 151–152, 155
Petronas 155
Political risk 132, 136–146
Present value 6, 8, 11, 13, 15, 20, 31, 62, 71, 72, 83–85, 107, 117
Production sharing 39
Production sharing agreement (See Production sharing contract)
Production sharing contract 39
Profit oil 40, 45, 49, 51, 52, 57–63, 68, 73, 75–76, 88, 93,
103, 108, 163, 171, 197
Profit sharing 23, 40, 45, 89, 112
R Factor 90–93, 98–102

Rate of return contract 26, 92
323
#CHAP 13 5/3/04 1:55 PM Page 324
Redevelopment 27, 107

Regressive elements 8, 9, 37, 55, 74, 94
Rehabilitation 27, 107
Relinquishment 52, 111, 158
Renegotiation clause 173
Rent (See Economic rent)
Repatriation Taxes (See Withholding taxes)
Resource rent 7
Resource rent tax 97, 99
Ricardo, David 263
Ringfence 52, 69
Risk 7,18, 19–24, 27, 52, 69, 78, 87
Risk management 147–149
Risk premium 142, 149
Risk Service Agreements 23–25, 87
Royalty 7–11, 18, 19, 29–34, 41, 44, 52, 54
Royalty holiday (See Tax and royalty holidays)
Russia 102, 105–108, 125, 132, 134
Safe Harbor formula 194–195

Severance Tax 9, 33, 34
Shell 24
Signature bonus 7, 18, 52, 161, 203 (See Bonuses)
Sliding scales 55–56, 93–94
Spain 14, 17, 247, 276
Stability clause 171
Subsidiary 198–202
Success probability 19, 20, 119
Success ratios (See Success probability)
Successful efforts accounting 182–184
Surrender 109
Syria 14, 58, 248, 276
Tariffs 9, 106
Tax credits 177, 192, 196, 199–200
324
#CHAP 13 5/3/04 1:55 PM Page 325
GLOSSARY
Tax and royalty holidays 11, 70, 77

Tax loss carry forward (TLCF) 32, 61, 62
Technical Assistance Contracts (TACs) 26, 27, 107–110
Technical cost factor 117
Technical success ratio (See Success probability)
Tennessee Gas Transmission 24
Thailand 14, 123, 249, 276
The Philippines 14, 23, 54, 87, 88, 115, 123, 129, 250, 276
Threshold field size 15, 16, 108, 113
Timor Gap 14, 115, 122, 123, 251
Transfer of rights (See Ownership transfer)
Trigger tax 97–99
Trinidad 58, 276
Tunisia 98, 99, 155, 252, 276
Turkey 276
Turkmenistan 253
Union Oil 24
Unit-of-production method 171, 185–188
United Kingdom 133, 254–258
United States 13, 14, 113, 132, 133, 177
Uplift (See Investment credit)
Urea 125, 127, 129
Utility Theory 138, 139, 141–143, 145
Uzbekistan 259
Vietnam 14, 116, 122, 123, 155, 166, 172, 175, 260–261, 276
Withholding taxes 9, 45, 78, 153, 196, 199

Work commitment 18–21, 51–52, 109, 159
Working interest 13, 15, 26, 47, 48, 67, 70, 103,
Yemen 133, 262, 276
Zaire 276
325

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#FRONT MATTER 4/30/04 3:00 PM Page 1

Marketing Manager: Julie Simmons

Director: Mary McGee

Library of Congress Cataloging-in-Publication Data

All rights reserved. No part of this book may be reproduced,

Johnston_FM.indd 4 3/5/07 10:24:10 AM

8 PRODUCTION SHARING CONTRACT OUTLINE 151

I’m particularly grateful for the help from Rich Anderson on

To my wife Jill and our children:

T he international petroleum industry involves tremen-

INTERNATIONAL PETROLEUM FISCAL SYSTEMS AND PRODUCTION SHARING CONTRACTS

fertile ground in the philosophy of petroleum taxation. It has

INTERNATIONAL PETROLEUM FISCAL SYSTEMS AND PRODUCTION SHARING CONTRACTS

means operator, contractor, contractor group, or consortium. The

PETROLEUM FISCAL SYSTEMS

T here are more petroleum fiscal systems in the world

INTERNATIONAL PETROLEUM FISCAL SYSTEMS AND PRODUCTION SHARING CONTRACTS

is divided among the laborers, owners of the capital, and

PETROLEUM FISCAL SYSTEMS

Figure 2–1 Allocations of revenues from production

INTERNATIONAL PETROLEUM FISCAL SYSTEMS AND PRODUCTION SHARING CONTRACTS

PETROLEUM FISCAL SYSTEMS

Figure 2–2 The spectrum of taxation

under the concept of commerciality in Chapter 4. Additional per-

INTERNATIONAL PETROLEUM FISCAL SYSTEMS AND PRODUCTION SHARING CONTRACTS

CONTRACTOR TAKE: SYNONYMS GOVERNMENT TAKE: SYNONYMS

Under a system such as the Indonesian production-sharing

Operating income ($) = Cumulative gross revenues minus

The best way to calculate take requires detailed economic

PETROLEUM FISCAL SYSTEMS

Calculation of Government/Contractor Take

Gross revenues $1,000

Contractor take 42% ($250/$600)

Under systems with liberal cost recovery provisions, the gov-

Estimating Contractor Take Step-by-Step

INTERNATIONAL PETROLEUM FISCAL SYSTEMS AND PRODUCTION SHARING CONTRACTS

2. Estimate the overall development and operating costs; for

STEP 1 100% Gross revenues

The fiscal terms of a number of countries are included in

PETROLEUM FISCAL SYSTEMS

participation of selected countries is summarized in Table 2–2. These

Implications of Contractor Take

Valuation Rule of Thumb

INTERNATIONAL PETROLEUM FISCAL SYSTEMS AND PRODUCTION SHARING CONTRACTS

Comparison of Terms—Selected Countries

Abu Dhabi (OPEC Terms) 9–12 100 0

PETROLEUM FISCAL SYSTEMS

U.S. NET PRESENT VALUE RANGE PER BARREL

Based on $18.00/bbl Wellhead Price

Figure 2–3 Comparing fiscal terms—FMV per barrel

otherwise stated, all references to reserve volumes or field sizes

INTERNATIONAL PETROLEUM FISCAL SYSTEMS AND PRODUCTION SHARING CONTRACTS

Changing Economic Perspectives

PETROLEUM FISCAL SYSTEMS

The result of government efforts are sometimes referred to as fis-

The design of an efficient fiscal system must take into consid-

INTERNATIONAL PETROLEUM FISCAL SYSTEMS AND PRODUCTION SHARING CONTRACTS

OIL COMPANY OBJECTIVES

PETROLEUM FISCAL SYSTEMS