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Tinkering with the profit sharing mechanism may do more harm than good, R.K. Batra, Distinguished Fellow, The Energy and Resources Institute (TERI)

The government on May 30, 2012 announced the constitution of a committee under the chairmanship of Prime Minister's Economic Advisory Council’s (PMEAC) chairman C. Rangarajan to review the existing production sharing contracts (PSCs). In this backdrop, R.K. Batra, Distinguished Fellow, The Energy and Resources Institute (TERI) throws light on various issues which need to be taken into account while reviewing the PSCs so as to preserve investor confidence.

India currently refines 200 million tonnes of crude oil, of which the indigenous contribution is around 33 million tonnes. It is estimated that by the year 2025 India’s crude oil demand could be in excess of 400 million tonnes per annum and the import component as high as 90%. A similar situation exists for gas imports. It is therefore imperative that India increases its production of these two fuels. Unfortunately, there have been some issues over the last couple of years which have ruffled the feathers of both government and producers resulting in delays and loss in investor confidence. I write with specific regard to the tiff between the Petroleum Ministry and Reliance on the drop in production of gas from the KG Basin and the arm twisting of Cairn Energy when it wanted to exit the country. The Prime Minister had said very recently that one of his main tasks is to restore investor confidence and bring about greater transparency in decision making. He has appointed a committee headed by Mr C Rangarajan, the chairman of the PM’s Economic Advisory Council, to review various aspects of the current production sharing contracts, with regard to their management and implementation. The committee will also look into the basis for pricing domestic gas, minimizing the monitoring of the contractor and more importantly, review the profit sharing mechanism. The committee is to submit its report by the 31st August 2012. Had it not been for the Reliance issue, probably the need for this committee would not have been found necessary and to that extent its’ appointment is welcome. But there are a few issues that the committee would do well to bear in mind.

First, and most important, of all the sectors in the oil and gas industry, exploration and production are the most risky ones. For example, putting up a refinery is a pretty safe bet, with inputs and outputs pegged at market prices. Almost all Indian refineries operate at 100% capacity and the newer ones have been given financial incentives by the state and central government. Under the production sharing contracts as presently structured, the exploration company bears all the risk and has to write off its entire expenditure if no oil or gas is found. Therefore, the first call on the revenues generated, if drilling is successful, is reimbursement to the contractor of all expenses incurred. After that, there is a mechanism for sharing of either profits or production, between the contractor and the government, with the contractor’s share gradually reducing and that of the government increasing. It is therefore of the utmost importance that the government acts as a facilitator and a mentor, particularly to this segment of the industry. Any action that is seen to dampen investor confidence and the expectation of a reasonable return on its investment or the lack of a level playing field will discourage existing players and deter new players with grave consequences to our foreign exchange outgo, capacity to import deficit products and overall energy security. The committee must bear this aspect uppermost in its mind with regard to whatever recommendations it may make.

Second, in the case of Reliance, there have been long standing issues of pricing and freedom to market the gas which have been compromised by setting a very low price and dictating to whom Reliance should sell the gas. Also, the significant drop in gas production from what was originally envisaged, has come as a deep disappointment to the government, the contractor, pipeline builders and consumers. This has resulted in government wanting to deduct $1 billion from Reliance’s reimbursable costs, which has led to the company seeking arbitration on the issue. If costs have been inflated, by all means take strict action against any contractor who does so, but do not throw out the baby along with the bath water. Reliance has given reasons for the drop in production due to sand and water ingress into the wells. These are technical issues that can be examined and resolved. Such instances happen to even the best operator internationally, because of the very nature of drilling thousands of metres below the surface of the earth where the geology, despite the best scientific studies, can have unforeseen problems. The government needs to look no further than OVL’s investment in 2009 of $2.1 billion to purchase the UK based Imperial Energy in the Tomsk region of Russia’s Siberia. At that time expectations were that oil would be produced at 45,000 barrels per day by 2015 and 80,000 barrels per day at its peak. However, production is stagnant at 16,000 barrels per day and despite a further investment of around $0.5 billion, OVL has now called for a review. The reasons for the inability to meet the target have been problems with the oil reservoirs (as in the case of Reliance) apart from harsh climatic conditions etc.

Third, the operator must get the market price for its gas, which could be the weighted average of imported LNG and transnational gas by pipeline, whenever the latter happens. There is no justification for the step-motherly treatment to domestic gas when international prices prevail in the case of domestic crude oil. Compared to crude oil, gas is more difficult to store and transport and is the fuel of the future taking into account its lower impact on the environment. Let the government give subsidies directly to the fertilizer and power sectors, if it so wishes, which will be far easier to implement than (say) in the case of kerosene through the PDS system, but it must not hobble the contractor and by so doing score a self-goal. At market prices of gas the contractor will recoup his investment faster and government’s share of profit petroleum will kick in earlier, which can contribute to subsidies, though at a later stage.

Fourth, the office of the Director General of Hydrocarbons cannot wear two hats; that of being a regulator and also a wing of the government. Further, it needs to have permanent staff of its own and not have to take on deputationists from the same organizations which it is meant to regulate.

Fifth, government representatives on the managing committee for a particular production sharing contract must have a good working knowledge of the industry, to be able to take quick and informed decisions.

Sixth, tinkering with the profit sharing mechanism may do more harm than good. This has worked well in several countries and any problems that arise will have more to do with a lack of trust, poor economics and absence of a level playing field, rather than any intrinsic shortcomings.

Finally, BP has invested $7 billion to buy into the KG Basin gasfield and the faith that they have reposed in government doing what is best for the industry, should not be dented or dissipated. The underground risks that exploration companies face should be balanced by a risk free climate above ground. Investor confidence will be restored, not by promises for the future, but by specific time bound action. Otherwise the road shows that we hold every time there is a new NELP round will become ‘no shows’ and we will be left to rue at leisure.