East African states Refine, Develop legal frameworks to avoid ‘Curse’ for the budding oil Industry

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Diana France and Michael Burgess of Holman Fenwick Willan and Isaac Kabuye of the Ugandan Directorate of Petroleum assess recent reforms to the legal framework for oil and gas exploration and production within Kenya, Uganda and Tanzania, aimed at encouraging foreign direct investment, and modernising sectoral regulation.

At the time of the oil price drop in late 2014, the governments of Kenya, Uganda and Tanzania were in the process of revising the legal frameworks for oil and gas exploration and production. The resulting changes, although not all welcomed by the industry, reflect a thoughtful set of initiatives, aimed at encouraging greater foreign investment.

East African states have been developing and refining legislation and regulations to govern the budding upstream oil and gas sector in their jurisdictions over the last few years.  The collapse in the oil price in the second half of 2014 came at a particularly bad time for these governments, but such market movements will have encouraged them to continue to think hard about the extent to which a favourable regime should be adopted, in order to encourage international oil and gas companies (IOCs) to invest in their countries.

They will also be mindful, though, of the need to steward natural resources for present and future generations in a region in which, after all, a great deal of poverty still exists. The involvement of the IOCs in developing the sector is critical to optimising the region’s natural resources and alleviating this poverty. The IOCs offer both technical expertise and funds to invest in exploration, allowing governments to prioritise social and other projects.

Central to these efforts by the three governments is their study of the legislation and regulations across the international oil and gas industry and their focus on the elements of these which should be adopted in their countries.

Fiscal regime for oil and gas

As far as the fiscal terms applicable to the upstream industry are concerned, the governments have to undertake a balancing act when considering how far to apply what is done elsewhere, as no two countries have the same oil and gas industry. Furthermore, the same legal and fiscal terms can play out very differently across the range of upstream projects in any one country.

As a paper by management consultants, Deloitte, on Kenya’s petroleum fiscal regime (published in October 2014) noted: “An overly generous fiscal regime weakens government returns and can sow seeds of an adverse political backlash for the country yet again a very tough one can stifle the incentives for oil companies to invest in the sector hence reduced [foreign direct investment].”

Production sharing Contracts (PSCs)

All three countries use the PSC model, together with the country’s taxation regime (sometimes modified), to allocate the risks and rewards involved in upstream operations.

The PSC is entered into between the governments, on the one hand, and the IOC or IOCs on the other, which have been awarded the right to explore, develop and produce oil and gas in a designated area or ‘block’ in their countries. The IOCs work together in a consortium, which may also include the national oil company of the host government state or another government entity. There are specific provisions in the legislation and PSCs of each of Kenya, Uganda and Tanzania setting out how, when and to what extent a government entity may elect to join the consortium.

The PSC, together with relevant legislation and regulations applicable to oil and gas exploration and production, sets out the financial and governance arrangements to be observed in the conduct of petroleum operations, as well as other related matters.

PSCs are used in many jurisdictions across the international oil and gas industry.  They provide for a consortium to undertake exploration work at its own risk and expense and, once a discovery is made, determine how commerciality of that discovery is established. If the discovery is commercial, the PSC provides for the consortium to be entitled to a portion of the hydrocarbons produced and requires the consortium to account to the government for the remainder.

Models for Sharing production 

The consortium’s share of petroleum comprises ‘cost’ and ‘profit’ petroleum, the ‘cost’ element constituting a portion of the production which is valued and available to reimburse the consortium for qualifying expenditure on exploration, development and production. The remainder is designated ‘profit’ petroleum and split between the government and consortium in a fixed proportion set out in the PSC or according to a mechanism given there.

This mechanism may involve a number of thresholds by reference to the daily production of barrels of oil equivalent achieved by the project, with the portion of profit petroleum attributable to the government increasing as daily production increases.

An alternative is to have thresholds by reference to the consortium’s rate of return, or R-factor. The R-factor mechanism links the division of profit petroleum to the consortium’s net-of-cost income, increasing the profit share to be allocated to the government as the net-of-cost income rises. This creates a progressive mechanism for rewarding the consortium, resulting in the government’s revenue from the project increasing as the project’s profitability increases.

Whether daily production rates, rate of return, or R-factor apply, the thresholds may well have been one of the criteria bid by the consortium in a tender for the block or blocks covered by the PSC.

In the World Bank‘s working paper Fiscal Systems for Hydrocarbons: Design Issues by Silvana Tordo (2007), the various mechanisms of sharing profit oil are considered and the author notes that: “the use of [rate of return]and R-factor triggers is likely to be more efficient at sharing the project’s upsides and downsides between the contractor and the host government. Furthermore, because of their flexibility, R-factor and the [rate of return]-based models generally have a lower break-even price …, which makes them more attractive to the [consortium]and less risky candidates for project financing.”

Kenya and Uganda move the R-Factor

The new Kenyan Model Petroleum Agreement set out in the first schedule to the Petroleum (Exploration, Development and Production) Bill 2015 contains a significant change therefore, in moving away from a production share based on a daily rate of production to the ‘R-factor’.

The “R-factor” has also been adopted in the new Ugandan PSC, as in Kenya, in a move away from daily production which was the reference point for the sharing of profit petroleum in the previous model. These changes will be welcome to IOCs, but should also benefit both countries, by encouraging investment. The Tanzanian PSC retains a production split based on daily production.

Tanzania’s New Laws

Although apparently behind its neighbors in relation to the production sharing mechanism, the Tanzanian government has enacted new legislation with a view to bringing its oil and gas industry up-to-date.  These new laws are contained within the Petroleum Act, the Tanzania Extractive Industry (Transparency and Accountability) Act and the Oil and Gas Revenues Management Act, all of 2015.

The Petroleum Act seeks to modernize the regulatory framework of the petroleum industry in the country and creates the Tanzanian Petroleum Upstream Regulatory Authority and the Oil and Gas Bureau.  It is hoped that both organisations will be staffed by oil and gas industry professionals who will use their expertise to guide the government in its negotiations with the IOCs it contracts with and in its regulatory functions.

Less attractive to the oil and gas industry is the ring-fencing provision included as section 117 of the Petroleum Act, which limits the right of a consortium to recover expenses incurred in a contract area to the revenue derived from that contract area, so that if there is no discovery and no ‘cost oil’ from that area, such sums cannot be recovered at all. This is also the position in Uganda, where both the existing and the new PSCs provide for ring-fencing.

Extractive Industries Transparency Initiative (EITI) 

A further positive aspect of the new Tanzanian laws is the implementation of Tanzania’s commitment to the EITI, which is to be applauded.  It is hoped that the details of this legislation will prove effective in tackling this difficult area, in spite of some domestic criticism that the ‘secret’ PSC clauses go against the aim of transparency: PSC commercial terms are seen to be confidential in most countries which adopt the PSC model and there are few documents in the public domain revealing full details of fiscal terms which are currently applicable.

Kenya has recently pledged to join the EITI and Uganda has also recently repeated the commitment of its government to participating in the initiative, which is also welcomed.

Further Developments in Uganda

In addition to this progress on economic terms and transparency, the East African governments have given thought to improvements in the tax regime applicable to the upstream sector.  The Ugandan government had the current low oil price and the need to attract foreign direct investment as priorities when including provisions favourable to the industry in the Value Added Tax (Amendment) Act and the Income Tax (Amendment) Act of 2015.

This article was first published by African Law Business