Have contracts used in the oil and gas sector enabled companies like Reliance Industries to siphon off more than their fair share?

In February 1997, faced with a critical shortage of energy, India’s policy makers put together a new exploration licensing policy (NELP) that aimed to boost private investment in the oil and gas sector.

Since 1999, when the policy came into effect, both private and public-sector oil and gas companies have participated in eight rounds of bidding for exploration and production licences auctioned by the Ministry of Petroleum and Natural Gas. The 235 exploration blocks that have been auctioned have led to the investment of US$15.88 billion in the sector.

The Indian and international companies that were awarded the licences have been bound by production-sharing contracts put in place to ensure a balanced and effective partnership between the government of India, which owns the oil and gas resources, and the companies that undertake exploration and production.

But a report published in September by the Comptroller and Auditor General of India (CAG), following performance audits of the production-sharing contracts, has turned the spotlight on how the contracts have been implemented.

Contract structure

First used in the 1960s in Indonesia, production-sharing contracts are structured so that costs incurred by an exploration company are recovered from the initial revenue obtained. The government does not contribute to the cost of exploration and development, and its entitlement to the profits begins only after the private companies recover their investment.

Venkatesh Raman Prasad, a Gurgaon-based partner at J Sagar Associates, notes that production-sharing contracts are also different from other contracts with the Indian government in that “no signature bonuses have to be paid to the government at the time of bidding”.

Venkatesh Raman Prasad Partner J Sagar Associates

At the heart of each production-sharing contract in India is a sliding scale by which profits are shared. This depends on the capital intensity of the project and also on whether a contractor chooses to recover its investment upfront or spread it out, a choice it makes at the bidding stage.

These two factors decide the “investment multiple” of the contract – the higher the investment multiple, the smaller the contractor’s share of the profits.

Unlike auctions where the prize goes to the highest bidder, the bids for exploration blocks auctioned under the NELP have been evaluated based on a bidder’s technical and financial ability, and its proposed work programme and fiscal package. This includes how profits are to be shared between the bidder and the government.

Reliance Industries, which the CAG report mentions often, has 23 oil and gas production-sharing contracts. The company’s blocks include the famous KG-D6 field in the Krishna-Godavari basin in the Bay of Bengal where in 2002 the country’s biggest gas discovery was made.

According to Reliance, “KG-D6 was the single largest source of domestic gas in the country in FY-2011 and accounted for almost 35% of the total gas consumption in India”.

Missing gas

In anticipation of a reliable supply of gas, various fertilizer, power and other industrial ventures have sprung up near the network of pipelines laid by Reliance. But while the company’s initial projection was to produce 60 million standard cubic metres per day (mscmd) by 2011 – which was to go up to 80 mscmd by 2012 – it now produces only around 40 mscmd.

As a result, the new industrial ventures have had to run below their capacities and meet some of their needs by importing expensive liquefied petroleum gas.

This has raised doubts about Reliance’s ability to make reliable projections. But more importantly the company has been caught up in investigations carried out since March 2008, after the Ministry of Petroleum and Natural Gas requested a special audit of production-sharing contracts awarded from 2003 to 2008 in eight blocks, including those in the Krishna-Godavari basin.

The CAG report says the “request was made in the context of large stakes of the government in the form of royalty and profit petroleum, and concerns voiced in some quarters about the capital expenditure being incurred by some contractors in the development projects awarded under New Exploration Licensing Policy”.

In the line of fire

According to Tapan Sen, a member of parliament who is on a parliamentary standing committee on petroleum and natural gas, a field development plan (FDP) initially put together by Reliance mentioned production of 40 mscmd of gas at a cost of US$2.47 billion.

However this was later amended, in line with the provisions of the contract. The production target was doubled to 80 mscmd per day and the new planned expenditure was set at US$8.84 billion, which is 3.6 times the earlier estimate.

Hinting at financial irregularities behind the increased expenditure, Sen told The Hindu, “the whole FDP was approved by the director-general of hydrocarbons, VK Sibal – who is facing CBI [Central Bureau of Investigation] investigations now – in 33 days flat”.

The CAG report raises fundamental questions about the production-sharing contracts. It says that the structure of the contracts encourages contractors to increase capital expenditure, which in turn reduces the government’s share of oil and gas revenue. The report states that private contractors have “inadequate incentives to reduce capital expenditure and substantial incentive to increase it”.

The report also says: “it is unrealistic and impractical, without having accurate and reliable seismic data, to bid upfront how deep the well should be drilled, and then expect that, not withstanding geological objectives, the well will be drilled to the committed depth even if it means a waste of money”.

Commenting on the CAG report, Alok Deshpande, a research analyst at Elara Capital, says it suggests that rules were not followed and not that laws were broken.

Jagannadham Thunuguntla, head of research at SMC Global Securities, points to allegations that the regulator has not penalized Reliance despite its underperformance.

Recent reports in Mint say that the CAG is currently examining Reliance’s books to look for losses caused to the public exchequer in operations at the KG-D6 block between 2008 and 2010.

Reliance however refutes all allegations. In a statement issued on 8 September the company said that in KG-D6, it “has set a global benchmark for effective, efficient project completion and capital cost competitiveness under the most trying circumstances and we are proud of our achievements”.

It added: “We reiterate that as a contractor, we remain committed to complying with the production-sharing contract provisions and procedures, including adopting good international petroleum industry practices in our operations.”

Technical complexities

Given the many unknowns that contractors have to grapple with while searching for and developing offshore oil and gas, preparing a field development plan can be tricky. As a result some observers are willing to give the contractors the benefit of any doubt.

Sunjoy Joshi, a former joint secretary in the Ministry of Petroleum and Natural Gas, argues that “in large deep-sea fields it makes sense to create excess capacity right in the beginning, as adopting a modular approach would not be economically viable for the development of small and marginal fields that are discovered in the future”.

Joshi is currently director of the Observer Research Foundation in New Delhi, but he was at the ministry when the government signed the KG-D6 contract with Reliance. He points out that the operations involve huge costs and some, like those for seismic surveys, which are “purely indicative”, may not yield much results. Joshi also notes that the risk are high as a company may drill many wells without striking any oil or gas.

In addition, increasing production without jeopardizing the potential of the field is a constant challenge. Thunuguntla suggests this is what prompted Reliance to bring in BP as its technical partner. In February this year BP announced a US$7.2 billion deal to buy a 30% stake in Reliance’s 23 oil and gas fields including those at KG-D6.

Sen told The Hindu that while Reliance has already realized its costs for KG-D6, the Indian government will get its share of the profits only after 10 years, after the capital invested by private companies has been recovered.

Good for government?

However, Joshi who argues that private companies did not get an unfair advantage says: “the government has not lost anything because it did not invest anything at all in the first place”. He believes that the nation has gained as it has got access to gas, which “otherwise would never have happened”.

Sunjoy Joshi Director Observer Research Foundation

Furthermore, Joshi says that the government already gets revenue from gas sales as the production-sharing contracts allow for payment of royalties. “No matter whether the contractor makes or does not make money, he would still have to pay royalty, which is 5% of the wellhead price for first seven years of natural gas and 10% for oil”.

Defending the sharp rises in the development costs of the fields, Joshi says a contractor can only be accused of adopting unfair practices if it fudges its accounts, funnels the money to an affiliated company or takes kickbacks. Hiking capital expenditure increases a contractor’s costs, not its profits.

Partha Bardhan, a New Delhi-based energy specialist and partner at management consulting firm Anemotis, does not share this view. He believes that Indian companies often inflate project costs and that this may be true for Reliance.

Bardhan says that even in international contracts, a vendor and purchaser could make a deal to adjust prices for products from different fields, depending on whether a production-sharing contract is involved.

However, Bardhan concedes that as Reliance is known to have strong connections within the government machinery, “even if it does something right, people would doubt it”.

Partha Bardhan Partner Anemotis

Template contracts

The production-sharing contracts are not negotiated by the parties in the usual way. According to Joshi, model template contracts were drafted by Indian and international experts, including some from the Commonwealth Secretariat in London, and included in the bid documents.

Joshi says this means that companies that signed these contracts – Reliance, Oil and Natural Gas Corporation (ONGC), Cairn Energy, Gujarat State Petroleum Corporation, and a Canadian company, Niko Resources – had little say in what was in them.

The contracts are subject to rule 5(2) of the Petroleum and Natural Gas Rules, 1959, which empowers the government of India to include such “additional terms, covenants and conditions as may be provided in the agreement between the Central Government and the licensee or the lessee”.

These rules in turn were drawn up under sections 5 and 6 of the Oilfields (Regulation and Development) Act, 1948, which regulates the grant of exploration licences and mining leases in respect of petroleum and natural gas.

Thunuguntla points out that the substance of the contracts has evolved over time. Those signed in the initial years “left ample room for interpretation, which has led to many disputes on the issue of royalty payment or pricing of the oil and gas produced”.

Jagannadham Thunuguntla Head of Research SMC Global Securities

The trouble between ONGC and the exploration company Cairn India over sharing of royalty on oil blocks in Rajasthan is a recent example of disputes that resulted from the early contracts. It delayed the closing of Cairn’s US$9.6 billion deal with the UK’s Vedanta Resources for more than a year.

Thunuguntla says that contracts signed after 2007 are much clearer, although they are seen as too stringent by the private sector. International energy companies skipped bidding for the 19 offshore and 13 onshore blocks awarded in the eighth round of auctions under the NELP in 2009.

In the bidding for the ninth round, which took place in March, bids were received for 33 more blocks, but none have been awarded as yet. The UK’s BG Group and BHP Billiton were notable international bidders.

A step backwards?

The recommendations in the CAG report would tighten the regulatory aspects of production-sharing contracts and Joshi warns that this will not be good for the oil and gas sector: “If the future contracts are rewritten as recommended by the CAG then the exploration in Indian oil and gas sector will be pushed back by 10 to 20 years, as the private investment in the sector will diminish.”

Deshpande, at Elara Capital, is also of the view that unless the government gives private companies some leeway in what they spend on exploration, companies will be circumspect about going into exploration efforts.

The CAG report recognizes this when it says: “some of these recommendations could be misconstrued as hampering operational flexibility in petroleum operations by the contractor”. However, it adds that “the importance of the overall objective of protecting Government of India’s revenue interests cannot be ignored under any circumstances”.

As a result Hemant Sahai, managing partner at HSA Advocates, says: “we anticipate greater scrutiny for all future contracts”. At the same time he emphasizes that, “the state cannot rescind the agreements or breach [their] terms in exercise of its sovereign powers, since the same would be setting a disconcerting precedent for the sector”.

Hemant Sahai Managing Partner HSA Advocates

To balance the situation, Sahai recommends a structure that would ensure the independent scrutiny of the players involved. He also suggests that general financial rules should be formulated to be used in drafting the development costs stipulated in the contract.

Bardhan at Anemotis believes that by remedying the contracts, “the government can avoid huge losses to the public exchequer in the future”. While he is confident that private investors will continue to be interested no matter how contracts are revised, he is concerned that investment would stall if the changes in the contracts lead to delays in the government’s decision making process.

Early days

However, whether any of this will happen and the production-sharing contracts will be revised is yet to be decided. The CAG report is now being looked into by the parliament’s public accounts committee, which is currently headed by the leader of the opposition, Murli Manohar Joshi. The Ministry of Petroleum and Natural Gas is yet to formally respond to criticism levelled against it in the CAG report.

Clearly, these are early days and as Sahai as HSA Advocates says, “the final word … has not been spoken”.