The Indian upstream petroleum sector — a case for effective regulation

My last blog (30 November) detailed the fiscal regime in the upstream petroleum (exploration and production) sector. The intention was to show why the Government of India went in for a progressive resource rent taxation regime related to the profitability of a specific oil/gas field in the New Exploration Licensing Policy (NELP) bidding rounds. It would, however, be necessary to also point out the dangers inherent in any profit-based taxation scheme and the need for effective regulatory mechanisms to monitor pricing, production and costs in an oil/gas production venture to ensure that governments are not deprived of their rightful shares of revenue.
Let us start with the concept of ‘gold plating’ of costs. As the name suggests, this is nothing more than companies attempting to inflate costs of projects to show reduced profits, thereby reducing the tax they pay the government. In production sharing contract (PSC) systems, which (in the Indian context) should be more rightly termed ‘profit-sharing contract’ systems, since it is the profits from the project that are split between the government and the contractor, the contractor has (if not properly regulated) the incentive to show inflated estimates of the costs incurred by it on exploration, development and production operations. Since, under the NELP, cost recovery is the first charge (after royalty payment) on field revenues, higher costs translate into a lower volume of revenues available for profit sharing; as the previous blog shows, this also leads to the project showing a lower level of profitability (in terms of the pre-tax Investment Multiple {IM}) and placing the government-contractor sharing in the lower tranches of the IM. Government is then placed in a situation where it gets a lesser percentage of an already depleted profit petroleum.
Companies could conceivably attempt to restrict the share of profit petroleum flowing to the government by bidding absurdly high shares of profit petroleum for the government at relatively low IM tranches. Since lower tranches are reached relatively early in the life of field production, this distorts the net present value of the project at the time of bid evaluation in favour of such a bidder and ensures that it is successful in its bid. Subsequently, during the operation of the PSC, as long as the project does not enter the tranche where government draws a high share of the profits (or where low absolute profit petroleum gives only a meagre share of the overall field revenue to government), the contractor stands to garner a lion’s share of the field revenues. This situation can be brought about by the contractor in one or more of three ways:
(i) The contractor can enter into arrangements with sub-contractors to charge exorbitant prices for services rendered or goods provided in exploration, development and/or production operations. Of course, the contractor itself benefits financially from such an arrangement only if the sub-contractor is an affiliate or works out some system with the contractor to share the economic rent derived from overcharging for services. The contractor may also enhance production (or operational) costs by charging high overheads;
(ii) Cutting back on annual production enables the contractor to reduce the annual flow of revenue and thereby curtail profitability for a given level of cost recovery. This will push the profit-sharing numbers into a lower tranche, with a lesser percentage accruing to the government apart from also reducing the absolute amount of profit petroleum available in a particular year for division between the government and the contractor. There is also then a possibility that lower levels of annual production can be sustained over a greater number of years at lower levels of profitability, cutting into the government take;
(iii) Pricing of the final product – oil and/or gas – can influence the overall profitability of the venture. Sale of the oil/gas to a subsidiary or affiliate of the contractor or to a company with which the contractor has some undisclosed arrangement at prices lower than what would have obtained in a free market transaction will diminish the gross revenue as well as the profit petroleum.
It is in this context that strong and effective regulatory systems need to be in place to ensure that the contractor is carrying out petroleum operations in accordance with best industry practices. The experience of the Indian upstream petroleum sector in this regard has been discouraging, to say the least. Either the upstream regulator, the Directorate General of Hydrocarbons (DGH), has not performed the role assigned to it or the government has not empowered it in a manner enabling it to carry out its responsibilities effectively. So what are the attributes that make for a good regulator and how has the DGH fared in that regard? On two important criteria for a strong, effective regulator, the DGH comes out with a less than satisfactory report card:
(i) Autonomy: The selection of the person to head the regulatory body must be through an impartial, rigorous process. Right from 1993, the Government of India has kept the powers to appoint the DGH. Not only that, the DGH and the staff under him are drawn from the two national oil companies, Oil and Natural Gas Corporation and Oil India Ltd. In such a setting, with their future careers dependent on their respective government-owned corporations, there is every likelihood that any decision of the DGH would be seen as being weighted in favour of the government and the national oil companies, even if such is actually not the case. The temporary nature of their sojourn in the DGH also tends to make the DGH operatives naturally conservative and risk-averse – add to that the general tendency in the Indian system to view every decision with suspicion and you have a perfect recipe for a “pass the buck” syndrome to develop in the DGH. Not surprisingly, decision-making on PSC issues is almost totally Ministry-based, leading to interminable delays. As a party to the PSC, the Petroleum Ministry should not be the adjudicator in PSC issues where government and company interests and interpretations could (and often do) diverge. Recent history has thrown up instances where the Government of India has intervened in matters which ought to have been determined by the provisions of the PSC. The approval of the interest transfer in Cairn India to Vedanta only after the latter agreed to payment of royalty in the Rajasthan discovery (in contravention of the agreed PSC provisions) and the continuing imbroglio over the price payable for gas produced from the D-6 field in the Krishna-Godavari basin are but two instances where a straightforward interpretation of the PSC provisions has not been adhered to by the Government of India. Recently, we read of Cabinet approval being required for Cairn India undertaking exploration activity in its discovered field in the Barmer basin with the aim of augmenting oil reserves, when the matter related to essentially a technical decision that should have fallen within the jurisdiction of the DGH.
(ii) Competence: It is not my intention (nor within my abilities) to comment on the technical capabilities of the DGH personnel. Suffice it to say that deputing personnel for a certain tenure to the DGH is certainly not the best way to develop PSC and oil/gas field management competencies in the DGH. Three recent examples show how the DGH has not played the role that would have been expected of a strong regulator. Curiously, all three cases relate to the D-6 block where the Reliance-BP-Niko consortium is producing gas from an early NELP contract award. The first concerns the excessive expenditure allegedly incurred by the contractor in developing and producing gas from the field. An effective regulator would have analysed the expenditures in relation to the oil/gas production and taken a view on whether to allow the costs for cost recovery purposes. If the regulator was confident of its assessment, it would have been ready to face the challenge of determining the appropriateness of the costs incurred by the contractor through an arbitration process. In the D-6 case, at least from the newspaper articles, one only understands that approval to the development plan was withheld and subsequently granted. When challenged by the contractor to go in for arbitration, the government appears to have backtracked on its earlier stand. Such a knee-jerk approach shows neither the Petroleum Ministry nor the DGH in a favourable light. A second issue relates to the falling gas production from the field, far below the estimates originally projected by the contractor. While there have been all sorts of wild speculation on the reasons for the same, there has been no indication (or any clarification from the side of the DGH) as to why the production has fallen off so sharply. If the DGH was of the view that the contractor had wilfully reduced production, it should have taken necessary steps to compel the contractor to increase production by invoking the relevant provisions of the PSC. By failing to do so, the DGH created doubt in the public mind about the reasons for the fall in production, putting the government’s credibility at stake. Thirdly, there has been unseemly controversy over the pricing of the gas sold from the D-6 field. The PSC provides for the basis for valuation of the gas sold: it is not clear why there has been so much debate on what is essentially a commercial decision and why no effort has been made by the DGH (or the government, for that matter) to clarify the policy in this regard.
It is pointless blaming the DGH for the current state of affairs. The DGH is a creation of the government and it was (and is) the duty of the Government of India to create a strong and effective DGH which can safeguard the interests of the country while also providing a conducive environment for efficient oil and gas field operations. Unless the Government of India takes steps to strengthen the DGH and provide it with autonomy as well as managerial and technical competence, there is every likelihood that the interests of government (and of the country) will be compromised. Not only that, the trend of reduced investor interest in exploration ventures in India will be intensified, with long-term implications for the country’s energy security.

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