Sharing the spoils of petroleum

Under the Public Trust Doctrine, natural resources in India are held in the trusteeship of the government for the use and benefit of the general public. The benefits don't just accrue due to the consumption of natural resources, but also from the revenues that the government collects from the sector (therefore generating public expenditure). In the case of petroleum, in 2013-14 the total revenues to the government from the oil and gas sector were Rs 2.7 lakh crores. Of course, this includes refined products such as petrol and diesel too. Crude oil and natural gas alone contributed Rs. 65,000 crores to the exchequer.

In an attempt to enhance revenues from the sector, the government announced a new policy regime on the 2nd of September. Under this new policy, companies that extract petroleum will have to share revenues from day 1 of oil and gas sales. This is a shift from the previous policy of first letting the companies secure enough revenue to cover the costs of production, and only then share profits with the government. For the moment, this new policy applies to only the auction of a few "marginal" fields which ONGC and OIL have not produced from.

Oil catches breath near 6-1/2-year lows after falls

The most popularly cited argument (such as by the CAG) is that the old profit sharing policy led to the gold plating of costs. That is, companies either made no effort to improve efficiency of production, or outright cheated by artificially inflating costs. This implied that governments had to keep close tabs on the production and the account books of companies. The argument is that under the new revenue sharing policy, there would be no need to constantly audit companies as it wouldn't matter what the costs are. The government would be assured of its share.

The reality, as is often the case, is far more complicated. Oil exploration and production is a highly risky activity with no certainty of finding resources to pump out. In several regions of the world, 9 out of 10 exploration efforts result in losses. Even when petroleum is found and proven to be viable for production, estimates of the reserves are often not accurate.

Regardless of the policy regime in place, companies have an incentive to under-report reserve estimates to account for this uncertainty. Forecasts by the government too are regularly proven wrong: for instance, the production of natural gas in India was 15% lower than ministry estimates between 2007 and 2012.

As a result of such uncertainty, there is a risk of abandonment of fields under revenue-sharing arrangements: if - say - the government take in a field is 70%, the oil production company will not have an incentive to produce if the costs approach 30% of revenue. In such cases, companies either abandon fields or attempt to renegotiate contracts.

Further, while gold plating of costs may occur under the profit-sharing system, there is no reason why costs won't be overestimated under the revenue-sharing system, as the government revenue share is arrived at after estimating costs of production. The fact is that regardless of the system in place, companies and individuals have incentive to over-invoice and falsely claim deductions. Therefore, the need to constantly audit the accounts and processes remains regardless of the policy regime in place. Additionally, cost overruns characterize the industry, which increase the possibility of companies being exposed in an audit if they indulge in deliberate overspending.

Globally, more countries deploy profit sharing agreements than any other type of contract. However, countries with the largest reserves, including those in the OPEC, deploy revenue-sharing agreements. These countries have large conventional reserves where costs of production are generally lower, which provides adequate incentives for exploration and production activities under any policy regime. The same may not true for countries where petroleum is harder and costlier to extract.

As the recent policy change in India for the time being only applies on 69 "marginal" fields, it could prove to be an interesting experiment to gauge the interest of investing companies (especially in light of the current low oil prices); and later if production commences, it could provide insights into whether the revenue-sharing regime leads to greater government revenues and transparency. Until such results become apparent, it would be wise to not uncritically cheer this policy change.