crude oil production contracts: a simple overview

Financial commentators have been pointing out recently that neither the large international integrated oil companies’ profits nor their stock prices are rising in line with the upwardly spiking price of oil.  This has to do with the changing nature of production-sharing agreements in the development of sovereign oil deposits.

There’s a ton of jargon in the oil business used to describe the often complex process of deciding how revenues and costs from a project are split up among the parties involved.  This is a highly simplified outline (but still good enough, I think, for a stock market investor) of how it works:

Generally speaking, an oil company (or group of companies) leases oil and gas rights to a specified block of acreage owned by a government through a competitive auction (in the past, colonial-style political or military coercion could easily have been the real key, however) .  In some cases, the winner will pay a large up-front fee.  In all cases, he is obliged to pay for and drill a specified number of exploratory wells over a specified time period, or else forfeit the lease.

If economically viable quantities of hydrocarbons are found, the oil firm must begin commercial development, again within a certain period of time.  The company “carries” the government, that is, it pays all development expenses.  Typically it can gradually recover these costs once production begins by being allocated an extra share of output until it has been recompensed.

Sometimes, the oil company takes physical possession of some or all of the oil and can do what it wants with it, sometimes not.  This can be a big deal in times of shortage.  For companies designated as “national champions” in nations like China or Japan, and asked to find supplies that can be sent back home in a pinch, it’s always a big deal.

three frameworks

I’ve seen three major contract frameworks, one following after the other, since I began watching the international oil industry in 1978:

1.  When I became an oil analyst, the typical arrangement called for the ol company to pay a fixed fee, say, $.50 or $1 a barrel, to the government that leased the mineral rights to a major international oil firm.  The oil company owned the oil, and might resell the crude immediately or refine and market it.  Such a firm made a good profit even when oil sold for under $2 a barrel.  But when prices rose in the early Seventies and again later in that decade, reaching as high as $35, the oil companies enjoyed the entire windfall.

This was a mixed blessing.  The contracts were seen as so unfair and one-sided that many oil-producing countries nationalized their oilfields and threw the majors out.

2.  In the 1980s, new contracts retained the general form of their predecessors but were renames production sharing agreements.  They called for a sharing of production revenues in specified percentages, say 70/30, with the oil company receiving the smaller portion.  That worked for a while.  But as prices rose from $12-$15 a barrel to $25-$30, and the majors began to make huge profits relative to their invested capital once more, the same problem of perceived onesidedness arose again.  Producing nations reacted in a somewhat similar vein as earlier, but either levying new taxes or simply unilaterally mandating more favorable terms to contracts.

3.  During the past decade or so, a new type of contract has emerged.  Again, the general form of the original contract has been retained.  But the production sharing arrangements call now for the oil producing country to receive an escalating percentage of revenues as the oil price rises.  While the contract terms tend to be expressed in this manner, the intention, I think, is to cap the returns to the oil major from a given project at, say, 25%-30% yearly.  The producing country basically retains everything above that.

Are the oil companies okay with this latest development?  Well, they continue to drill.  Of course, a lot depends on the riskiness of a specific project, but I think the oil company investment conclusion is that getting a 25% annual return for the life of a twenty- or thirty-year project is better than getting a 100% return for two years and then losing the project entirely.

stock market implications

For individual stock market investors, though, it’s important to realize that professional portfolio managers, or at least the oil analysts who work for them, understand the rules of the new order.  So they won’t chase after the stocks of companies that they know have large proportions of newer contracts.