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Service Contracts

Discuss the financial, commercial and contractual activities used in management worldwide oil and gas industry.

The current assignment reflects the strategy adopted by the major oil and gas producing nations. They have either adopted variations in service contract or they have showed the interest in the current study as a substitute to “Production Sharing Contracts” over the period of 2015. Service contract can be defined as a contract, which examines the variations of service contracts from each of the countries (Alemán-Nava et al. 2014). Service contracts in long term is usually considered as long run contractual parameters which is preferred by a number of the “host governments” to obtain the “International Oil Companies” (IOC) expertise along with  capital without the need to pass on the “Field and Production” ownerships rights to them.   

It is understood that some of the “Oil and Natural Gas” manufacturing nations have expressed their growing curiosity in undertaking numerous types of “Service Contracts” rather than obtaining “Production Sharing Contracts” (PSC) or concessions in their oil and natural gas growth and exploration venture. The systematic dimensions of service contracts govern the relations between the host government and “International Oil Companies” (IOC).  IOC on the other hand explores oil and natural gas on behalf of host government in contrast to pre-determined fees.

Under the framework of services contract, which is similar to “Production Sharing Agreements”, regarded as closest legal framework, IOC brings the technology and employs their capital investment (Alemán-Nava et al. 2014). On the other hand, under the service contracts the IOC has contracted to prearranged return in lieu of giving out profit oil. The International Oil Companies have adopted the technique of reimbursement under “Service Contracts and Production Sharing Contracts” which differs in four other classes such as “Field Ownership Rights”, “Crude Oil Ownership Rights” and the level of risk that each of the side shoulders (Dale et al. 2014).

One of the sole reasons behind every nation adopting the variations in service is their concern for upholding the dominion over financial resources. Under the service contract policy, several nations uphold their field ownerships and in majority circumstances, produce crude oil ownership rights which they do not assign to foreign nations (Ghandi and Lin 2012). Several nations have expressed their interest in adopting service contract as service contracts enables those nations to relinquish less control over the oil fields and over the produced crude oil organizations but they still use their expertise of International Oil Companies (IOC)

Production Sharing Contracts (PSC)

With the help of “Production Sharing Contracts” sovereignty concerns arises due to the decision-making authority of IOC in shouldering the development and exploration functions. Production sharing contracts also enables the foreign nations to share the ownership of produced crude under the assistance of foreign nations (Yusuf et al.  2014). When foreign nations surrender their sovereignty on natural resources, there is a low probability for adequate oversight from the host nation’s government. The international oil company employs several regulatory measures to supervise the operational role owned by state-level oil companies. An additional root for sovereignty concerns that arises from “Production Sharing Contracts” (PSC) is the “tax code or institutional deficiencies” which could act as a barrier for the host nation governments to collect rents from the international oil companies efficiently. Oil producing companies have illustrated their interest to attenuate few of the concerns arising from sovereignty concerns arising from “Production Sharing Contract” (PSC) due to the shortage of political institutional problems.

A service contracts has the ability to address the sovereignty concerns as the conceptual framework of IOC is prone to huge profit or loss. The objectives of state owned oil companies are to diversify the objectives into dynamic profit maximization environment. These factors causes the service contracts to be economically insufficient. Undertaking dynamic policy of profit maximization leads to increase in efficiency of the service contract for both Iran and Iraq   to buy back their own technical service contract. Study reveals that the conceptual framework of service contract is exposed to the risk of profit or loss depending upon the dynamic policy of profit maximization adopted by the government of host nation. According to (Groenendaal and Mazraati 2012) undertaking dynamic profit maximization policy act as opposing factors to undiscounted revenues even though increasing cumulative production could yield more improved outcomes.

Environment of uncertainty prevails due to the concept of dynamic profit maximization decision. Such decision requires the operator to update its decision based on the optimal production quantity along with the forecast obtained through forecasted price of oil market. Nevertheless, remuneration is predetermined in association with the production profile for life time term of contract. It is to be noted that the current contract service lacks the required tools for undertaking vibrant profit maximization objectives by the oil companies owned by the state government (Tordo et al. 2013). Particularly in terms of buyback of Iran service contract, IOC remuneration was entitled to specified amount of time based on the pre-arranged contractual profile. Under such requirements, shift in the degree of contractual level of production might be hard for the operator to discover. As stated in the case of Iraq, IOC remuneration level per barrel is close to reaching the targeted plateau of production without putting any instrument in place to decide upon the optimum degree of production in each period.   

Sovereignty Concerns

Under the production sharing contract it is very much likely that IOC in collaboration with the oil companies owned by the state level government must follow dynamic approach of profit maximization. It is due to the fact under production sharing IOC are given the authority of process of making decision and ownership rights on the produced crude oil (Ross 2012). International Oil Companies (IOC) is more likely to form collaboration with the state-owned oil companies for dynamic profit maximization objectives. It is noted that IOC and state owned oil companies form collaboration, which are more likely to produce economic efficiency under the conceptual framework of service contract. According to Shuen et al. (2014) it is evident that a clear description has been established among the service contract and the production sharing contract and it is understood that majority of nations prefer to move towards service contracts. By adopting service contracts, the ability of host nation government is exposed to attract the investment from international oil companies.

The cost of capital and decision for interaction amid International Oil Companies and the national oil companies is based on the allocation of ownerships rights for produced crude oil. Allocation of ownership rights helps in sharing the risk between the IOC and NOC.

In relation to IOC cost of capital of Iran is different from other countries. Service contract is of IOC is different from cost of ceiling if once the contract is assigned signature to it. Most of buy back contract of service cost have the option of changing the degree of cost after signing the contract and such prevalent disadvantage could limit have the limitation of increasing the risk of IOC contracts (Ngoasong 2014).

Concession and licensing agreements have considerably evolved ever since their introduction as one sided contract. There were several nations or colonies with high resources were dependent on the other states or resource rich empires. Numerous organizations complete the bidding process after putting their assent for the license to such ownership rights. However, with the advent of modernization of oil and gas sector several oil companies has opted out of the concessional rates and adopted PSC/PSA contracts due to lack of concession in seismic exploration (Ngoasong 2014). Oil companies are left with no choice but to take calculated risk regarding the strategy of making bid for a license. The oil companies are more cautious towards the price of bid as there is no guarantee regarding the concession which will cover the cost of company’s and generate profit. The host government on the other hand will not maximize the potential return from the auction systems.

Dynamic Profit Maximization Policy

Further reasons which states the reasons of host government moving away from concession and replacing with the PSA or PSC is due to the fact the being a signatory to any specific contract, the host government like to seek more profit in most of the energy deals. The host government is currently in the awkward situation as they are under the obligation of regulating itself. Another reason for shifting away is the corruption that is present in the high investment cost. Several Companies potential bid for lucrative deals to make illegal payments by disguising the government officials.

IOC being the largest producers of Oil and natural gas has responded to the dramatic change in the production and exploration process by strong market incentives. It has also devoted a large number of shares to the soaring profits and cash flow for the exploration of new fields (Shuen et al. 2014). IOC has not been able to replace the amount of their reserves asserts in recent years in contrast to the small scale U.S companies. It is also to be noted that IOC have not responded according to the market challenges in contrast to their strong IOC’s exploration expenditure which resulted in large increase in non-OPEC productions. The exploration expenditure from the five largest IOC’s has been flat to lower in the aftermath of OPEC so that it can sustain the constraints in the market supply. Instead of favoring exploration in exploration and production activities in resource rich nations such as Saudi Arabia, Iraq, Iran, Kuwait and U.A.E 56% of IOC increased operating cash flow on share was repurchased. IOC has also increased their spending on develop resources to sustain these assets quickly when the prices of oil are high.

As rightly put forward by Kavousi and Ansari (2014), the Venezuela intended to introduce an intricate contractual advance in the three different stages of auctions of operating service agreements on 34 different areas. In the two initial rounds of the operational service contracts, the recovery of IOC comprised of the initial investment in addition to the interest as well as supplementary per barrel fee for production in order to cover the operational cost. However, the payments made to the IOC were essentially in the denomination of the US dollar that helped to protect t against the foreign exchange fluctuation risks (Mitchell et al. 2012). However, Kuwait also expressed interest and pursued three different variations of the service level agreements. The government of Kuwait declared a new variation of the service level agreements also popularly called as the operating service contract that could restrict the level of control over the possession rights as per the constitutional provisions.

Moving towards Service Contracts

Again, a new edition of the service agreement of Kuwait was also signed that in turn improved the overall technical service contract with the intention of development of a field for natural gas (Feng et al. 2014). However, Kuwait parliament conducted a probe investigation over the enhanced technical service contract and decided the restrain the process of giving identical agreements to different intercontinental corporations.

As rightly indicated by Liu (2014), the capital cost decision interface of IOC or else IOC, Iran is different from the service type agreements of the two other nations owing to the restricted alternatives relating to the capital cost ceiling. This is primarily because IOCs essentially do not have the choice to alter the level of cost capital after signing the contract almost in all of the buy-back service agreements of Iran. The restriction of choice as regards the level of the cost of capital can also escalate the degree of risk in this type of service level contracts (Mills 2013).

However, the capital cost decision interaction can be considered as a serious matter of concern in case of Iraq as the Iraqi government might possibly find it expensive to attain the production plateau. Therefore, the Iraqi government can restrain the capital expenditure of IOC (Mitchell et al. 2012). Nevertheless, in accomplishing the task of holding back the capital expenditure, the government of Iraq might perhaps raises the level of economic efficiency of the agreements.

As rightly pointed out by Ross (2012), the IOCs are essentially entitled to a specific fraction of the overall crude production as per the third round of the service level agreement in Venezuela. This is a crucial feature of the third round contract of the service agreement as the other service agreements preserves and retains the ownership of the state-owned oil corporations of the produced crude (Mills 2013). However, as regards the operatorship right of the developed area Iran preserves the authority for its own nationalized subsidiary. Generally, the IOC runs the fields as prescribed under different service agreements. Iran’s Soroosh and Nowrooz buy-back service level agreements declare the fact that the operatorship rights can also be a foundation of economic effectiveness (Mitchell et al.  2012).

In accordance with the service level agreements, the IOCs do not share the profit oil and remuneration is considered as the lone source of the earned profit for the specific investment. However, the remunerations are enumerated with reference to constant rate of return for the IOCs in the particular project as per the buy-back service agreements of Iran (Mitchell et al.  2012). Again, the remuneration is solely founded on each barrel production according to the first two initial rounds of the service agreements in both Iraq as well as Venezuela. However, in the third round, Venezuela experiences a descending technique for the remuneration structure of IOC that is primarily founded on the rate of return of the project.

Cost of Capital

In conclusion, it can be said that not all service agreements are identical to the risk exposure of IOC. The service agreements are at variance with the risk shared between the IOC as well as the NOC. Furthermore, the flooded capital cost can be considered as the primary source of the risk for the IOC as per the buy-back service agreements in Iran whereas the case might not be same for other cases. The above mentioned study helps us in gaining deep understanding regarding the stratagem as well as different fiscal systems related to the oil and natural gas along with energy of major oil producing nations that have adopted a variation of a service agreement. In particular, the study also suggests that the service level agreements might perhaps be elucidated by way of heightened concerns regarding sovereignty as well as political scenario on one side and requirement for the oil capital of different intercontinental corporations on the other hand. The above study also helps in investigating the drawbacks of different service level agreements counting the prospective for economically unproductive results. Furthermore, the above study also gives deep insight regarding the probable solutions for enhancing the economic efficacy of different service level agreements.

Reference List:

Alemán-Nava, G.S., Casiano-Flores, V.H., Cárdenas-Chávez, D.L., Díaz-Chavez, R., Scarlat, N., Mahlknecht, J., Dallemand, J.F. and Parra, R., 2014. Renewable energy research progress in Mexico: A review. Renewable and Sustainable Energy Reviews, 32, pp.140-153.

Feng, Z., Zhang, S.B. and Gao, Y., 2014. On oil investment and production: A comparison of production sharing contracts and buyback contracts.Energy Economics, 42, pp.395-402.

Ghandi, A. and Lin, C.Y.C., 2012. Do Iran’s buy-back service contracts lead to optimal production? The case of Soroosh and Nowrooz. Energy Policy,42, pp.181-190.

Ghandi, A. and Lin, C.Y.C., 2014. Oil and gas service contracts around the world: a review. Energy Strategy Reviews, 3, pp.63-71.

Mills, R.M., 2013. Northern Iraq's Oil Chessboard: Energy, Politics and Power. Insight Turkey, 15(1), p.51.

Ngoasong, M.Z., 2014. How international oil and gas companies respond to local content policies in petroleum-producing developing countries: A narrative enquiry. Energy Policy, 73, pp.471-479.

Ross, M., 2012. The oil curse: how petroleum wealth shapes the development of nations. Princeton University Press.

Shuen, A., Feiler, P.F. and Teece, D.J., 2014. Dynamic capabilities in the upstream oil and gas sector: Managing next generation competition. Energy Strategy Reviews, 3, pp.5-13.

Tordo, S., Warner, M., Manzano, O. and Anouti, Y., 2013. Local content policies in the oil and gas sector. World Bank Publications.

Yusuf, Y.Y., Gunasekaran, A., Musa, A., Dauda, M., El-Berishy, N.M. and Cang, S., 2014. A relational study of supply chain agility, competitiveness and business performance in the oil and gas industry. International Journal of Production Economics, 147, pp.531-543.

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