Oil deal heavily in favour of the Russians

If the Texas-based Dynamic Global Advisory Company had its way the former Tillman Thomas-led National Democratic Congress (NDC) administration would have had to renegotiate with a group of Russian oil investors a 2008 Production Sharing Agreement (PSA) agreement that was signed with former Energy Minister, Gregory Bowen of the New National Party (NNP).

A report that was presented by Dynamic Global to Congress concluded that the Russian outfit, Global Petroleum Group (GPG) was at such an advantage in the agreement that the royalty that it was called upon to pay to Grenada for any oil discovery was “incredibly low” and not in keeping with standard oil deals.

The American oil consultancy stopped short of calling it a “sweet heart” deal between the former Energy Minister and the Russian group that is headed by Eduard Vasilev.

Dynamic Global made specific reference to the agreement which allowed the Russians to freely export its share of Petroleum that was found in Grenadian waters “free of all taxes”.

The agreement was described as “highly” questionable and not in Grenada’s best interest.

Since the return to office of the NNP following the February 19 general elections, the Russians are back and in active pursuit of their desire to find oil and gas resources in Grenadian waters.

This week the NEW TODAY brings for public attention Part III of the report that was done at the behest of the Congress government by Dynamic Global to review the controversial agreement.

 

The most important provisions of the typical international production sharing contract are contained in Article 12 on Royalty, Cost Recovery and Production Sharing. The amount of royalty to be paid by GPG is set in Article 12.1(1) at 6%, which is incredibly low and one-half to one-third of the standard royalty rate in the industry.

In addition, the royalty paid to the Treasury of the GOG was to be cost recoverable, which is also unprecedented in our experience. The payment of royalties traditionally occurs first, that is, prior to the calculation of the production splits and, consequently, they are not cost recoverable.

Crude Oil Production Sharing is described in Article 12.2(1), and, inexplicably, it provides that the Production Sharing mechanism would only begin to apply “as of the first fiscal year in which the Company obtains positive Gross Profits.

In all other production sharing contracts with which we are familiar, the production sharing concept is based on the occurrence of first production, at which time the government and the contractor begin to split the amount of production based on the percentage splits agreed in the contract.

This kind of structure is totally lacking in the PSA, and represents another instance in which the GOG must not have been aware of, or chose to ignore, the industry’s conventional structure.

Article 12.2(3) sets out the initial and subsequent splits of Gross Profits for Crude Oil, which are unusually high in favor of GPG, i.e., 75% for GPG and 25% for the GOG/Treasury for the first 5 years. After the first 5 years and every 5 years thereafter, the split for the GOG/Treasury would be increased by 5%, which is extremely low.

As a general rule, production sharing splits in international production sharing contracts are divided into the two categories of cost recovery oil and profit oil, both of which are established based on a scale that is linked to either the level of production or the internal rate of return of the project.

This provision is so unusual that it reveals the probability that GPG intended to abuse its superior negotiating position vis-à-vis the GOG.

Article 12.3(c) contains another unprecedented provision in which the GOG is given the option to trade the cash payments it would otherwise be entitled to in sub-paragraphs (a) on “royalties and production sharing” and (b) on “petroleum exchange” for shares in GPG.

This is simply unheard of in international production sharing contracts, and raises some questions about potential conflicts of interest and other improprieties.

Article 12.5 sets out the split of Gross Profits for non-associated Natural Gas, which are similar to the split for Crude Oil in Article 12.2(1), except that GPG would receive 70% and the GOG 30%. The same problems exist with this provision as is described above.

Valuation of Crude Oil excludes the following types of sales from the definition of Third Party Sales: sales of any seller to any affiliate, crude oil exchanges, barter deals or distress transactions and transactions that are not motivated by the usual economic incentives.

These are not standard exclusions, and they could lead to an abuse of the valuation process, such as transfer pricing that can occur when sales are made to affiliates.

Article 14 on Taxation provides that no taxes, duties or fees would apply to GPG with respect to the income derived by GPG from Petroleum Operations. Although the levels of taxation vary from one international production sharing contract to another, no taxation at all is extremely unusual in the modern era of such contracts.

Ordinarily, there is at least a separate petroleum tax that would apply to a contractor’s profits. Since GPG is a company organised and existing in Grenada, it would most likely be subject to the applicable income tax laws in existence in Grenada in the event GPG eventually realized a profit through its Petroleum Operations under the PSA, unless, of course, the income tax laws specifically provided that the GOG’s contractual obligations serve as an exception to the applicability of such laws to Grenadian companies.

(Please note that we are not providing tax advice in this evaluation report, and our sole purpose in raising this issue is to make the GOG aware of it.)

What was viewed as the “pure” production sharing contract form in the 1970s, 1980s, and 1990s provided that the host government would pay the applicable income taxes on behalf of the contractor, but that type of arrangement is rarely used these days.

Article 17.1 on the Ownership and Use of Assets does not reflect the normal method of determining the ownership of assets. The standard approach is for the government to acquire title to the assets either immediately after purchase and importation into the host country, or at the time when the contractor has fully recovered its costs under the cost recovery methodology that is part of the production sharing concept. In either event, the contractor retains the right to use the assets until the end of the term of the contract.

The Abandonment of assets provisions under Article 17.2 would require the GOG at the end of the term of the PSA to reimburse GPG at an agreed price for the assets that are needed for continued production.

This would lead to “double dipping” on GPG’s part because it would most likely have recovered its costs for such assets by that time. As written, the concept is not clear, inadequate, and would have been detrimental to the GOG.

Article 20 on Insurance does not adequately cover the basic requirements even though it refers to Section 27 of the Petroleum Act as the authority for the provision. The clause refers to insurance or a bond with one or more sureties, either of which is to be approved by the Minister.

 

The Advisory Committee Minutes reveal that it was agreed that GPG only needed to obtain insurance in the amount of US$50,000 for each category of loss based on Mr. Vasiliev’s claim that no major risks would be involved during the first two years of the Initial Exploration Period since marine seismic acquisition and interpretation would be the only activities undertaken.

 

This was a mistake on the part of the GOG representatives because there are substantial risks associated with offshore seismic operations in which personal injuries and loss of equipment and property are fairly common.

 

Consistent with the provisions of Article 14, Article 23.2 on Petroleum Export gave GPG the right to freely export its share of petroleum “free of all Taxes.” It is unusual under production sharing contracts worldwide for a contractor like GPG to be able to export petroleum free of export taxes.

 




Article 27 on Early Termination for Breach of Contract contains an interesting clause in Article 27.1(a), which provides for a termination scenario that the GOG could argue has already occurred.

 

Therein, it is stated, “This Agreement shall continue in full force and effect for such period as the Company continues to carry out its obligations to which this Agreement relates and shall be deemed to have terminated, if for any reason the Company ceases to carry out such obligations.”

 

The clause goes on to list the types of obligations that apply, which includes “Non fulfillment of the minimum work expenditure or programme,” which obviously is applicable with respect to GPG. In connection with deeming the PSA to have terminated, there is no associated requirement for the GOG to give notice in writing, whereas in Article 27.1(b) notice in writing is required in the event of termination if GPG was liquidated.

 

Therefore, it appears that the GOG could argue that the PSA was terminated two years ago due to GPG’s failure to perform its work program and expenditure obligations. However, GPG might counter that argument by claiming it was prevented from carrying out its obligations by the GOG.

 

Article 30 on Applicable Law and Arbitration is incomplete as written because it leaves out some common industry concepts. For instance, a clause on the procedure for appointing an independent expert and the expert’s authority should have been included since the use of an independent expert is contemplated elsewhere in the PSA, such as in Article 5, which is discussed in paragraph A4 above.

 

The arbitration clause in Article 30.3 is insufficient because it covers less than one fourth of the issues that should be addressed in order to initiate an arbitration proceeding.

 

According to the Table of Contents, Annex 1 to the PSA is supposed to contain a copy of the Exploration License, but a map of the Exploration Licensed Area has been inserted instead. The map itself is inadequate. Cartographic conventions such as the map’s projection, spheroid, coordinate system, and units of measurement are absent or undefined. Four west-to-east rows of mostly rectangular blocks are drawn on the map and 11 of these blocks are emphasized by hand-drawn diagonal lines.

 

A group of three parallel lines lies along the southern and southeastern margins of the map. These lines are also undefined. Annex 2 “Description of Licenced Area” is an unsatisfactory and inadequate attempt to describe the 11 blocks with a Letter-Number system (B6, for example), Block coordinates, and their Sea Depth.

 

The Block coordinate system is undefined and confusing. Inclusion of Sea Depths serves no purpose in clarifying the description of each block. The industry norm of detailed descriptions of the boundaries and surface areas of each block are absent.

 

Annex 2 ends with the sentence “All the blocks are disposed on the shelf of Grenada to the south and south-east from it”, whereas the 11 blocks highlighted in Annex 1 lie to the east, south and southwest of Grenada.

 

The definition of the term “Exploration Licensed Area” in the PSA is the area “to which the Exploration License of the Company relates and which is described in Annex 1 and shown on the map contained in Annex 2.”

 

Nowhere in the PSA is it stated that the PSA covers 11 blocks, and there is no differentiation among the blocks in terms of either GPG’s work program obligations or the cost recovery procedure among the blocks.

 

This is unusual because the customary approach by host countries to granting of rights to one company for multiple blocks is to (1) require that each block be covered by a separate production sharing contract, and (2) utilize the so-called “ring-fencing” approach that prohibits costs from being recovered across the borders of the blocks and requires that the accounting for production sharing, tax, and all other purposes be carried out separately for each block, i.e., consolidation is not permitted for any accounting purposes.

 

A block is ring-fenced when all costs associated with one block must be recovered from production revenues from that one block. Some countries even go so far as to require that each production sharing contract for each block be administered by a separate company.

 

In the GPG case, the GOG would have suffered a significant loss of revenue if GPG had made a petroleum discovery in, for example, 1 of the 11 blocks and then been able to recover its costs incurred in the other 10 blocks against the production from the 1 block in which a discovery and subsequent development project was achieved.

 

Annex 3 to the PSA sets out the so-called Grenada Exploration Work Program, but it does not refer to Article 6.2 of the PSA on Work Obligations during the Initial Exploration Period, nor does Article 6.2 have a reference to Annex 3.

 

The listing of activities in Annex 3 is not outlined according to the various time frames in the Exploration Period of the PSA. The same text of Annex 3 is also contained in the Exploration License as Schedule II. Paragraph (a) of the Exploration License refers directly to Schedule II, stating, “During the said period the Company shall execute such work programme which is contained and exhibited in Schedule II of this Licence”.

 

Annex 4, the Accounting Procedure and Profit Sharing Mechanism, is insufficient in many ways, such as the Gross Profits determination in Section 2 of the Annex that is mentioned in paragraph A8 above.

 

The standard accounting procedure that is attached to an international production sharing contract emphasizes the determination of cost recoverable and non-cost recoverable expenditures and accounting issues and does not deal with a concept like gross profits.

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