CHAPTER 9 TYPICAL WORLD PETROLEUM ARRANGEMENTS1

• Jurisdiction: United States

International Resources Law: A Blueprint for Mineral Development
(Feb 1991)
CHAPTER 9
TYPICAL WORLD PETROLEUM ARRANGEMENTS¹
Professor Ernest E. Smith ²
The University of Texas At Austin School of Law
Austin, Texas

I. INTRODUCTION

The public and private arrangements under which oil production is authorized have gone through a variety of phases since the emergence of petroleum as an internationally traded commodity in the middle decades of the last century. Historically, rights in oil were granted by means of "concessions" which authorized a company to explore, develop and market petroleum for a specified time period. The earliest grants, such as those made by various sovereigns in the Middle East, might purport to cover an entire country and last several decades. In exchange for an initial payment and a right to some fraction of the value of any oil produced, the country or its ruler transferred all managerial and decision-making rights over oil exploration and production to the company or consortium of companies that received the grant, leaving it entirely to the discretion of the company when, or even whether, to explore and drill for oil. Alternatively, a company might acquire what it deemed to be the equivalent of fee simple ownership in much of a country's oil reserves, as Standard Oil argued was the case in Mexico.

Not surprisingly, such sweeping grants of power over what might be a country's single most valuable asset rarely endured unscathed for the originally stated duration. In an effort to regain control over their mineral resources, some countries, such as Mexico and Iran, resorted to a single dramatic act of expropriation; others turned to less drastic means of altering the original agreements. In Venezuela, for example, expropriation of oil company assets occurred through a relatively gradual process lasting several years. In Saudi Arabia and several other Middle Eastern countries the original concessions were modified by on-going renegotiations that

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resulted in significantly different arrangements. The formation and growing power of the Organization of Petroleum Exporting Countries (OPEC), which represented the interests of several similarly-situated countries, helped significantly to expedite the process.

This historical development does not mean that concessions are no longer in use. They are, although today they are more likely to be called "licenses" or "leases." Virtually all publicly and privately owned oil reserves in the United States and Canada are developed under oil and gas leases which are first cousins to traditional concessions. Other countries, especially Western European nations with significant North Sea reserves, use similar arrangements; but their duration is typically far shorter than those of the early concessions and impose development schemes upon the licensee. Other types of agreements provide for a significant degree of participation in decision making by the host government or its state-owned oil company. Alternatively, a country wishing to have its resources developed but lacking the capital or technical expertise to carry out the program itself and unwilling to grant extensive rights over its minerals to foreign corporations, may enter into a service contract with a foreign company. The company agrees to explore a specific area and, if productive, develop it in exchange for a payment based upon production. The foreign company bears the financial risk of the operation, but receives no "property right" in the host country's territory or its minerals.

This paper will examine the evolution of the types of arrangements used to authorize petroleum development, briefly trace the historical events which led to the changes, and attempt to describe the basic format of the variety of arrangements which are in use today.

II. The Early Petroleum Arrangements

For most of this century the oil industry has been characterized by the concentration of control in a relatively few companies or entities. In the earliest period Standard Oil of New Jersey exerted near monopoly control on oil supply and price. Although "trust busting" legislation, such as the Sherman Act, and the U. S. Supreme Court decision in Standard Oil Co. of New Jersey v. United States, 211 U.S. 1 (1911) led to the eventual break-up of Standard Oil, control over the market merely shifted to a group of large, vertically integrated oil companies, known collectively as the "Seven Sisters" or simply "the Majors."³ Not surprisingly, during

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this period the typical arrangement for authorizing petroleum development was between the owner of the minerals in place (usually the government or its ruler) and one of the principal private multinational oil companies.

A. The "Classic" Concession

The most common form of agreement entered into between a government (or its ruler) and an oil company was the concession. Four characteristics of these early grants are especially noteworthy.

First, many of the Middle Eastern concessions were apparently granted directly by the ruler of the sheikdom or sultanate, or else by a minister acting directly on his behalf. In many instances the process seems to have been little different than that engaged in by an American landowner negotiating with a company over an oil and gas lease.

The recipients of the concessions were almost invariably consortia with partially overlapping membership. This interrelationship of the major oil companies in almost all of the concessions resulted in joint offtake agreements which limited the total amount of production from the major concessions.⁴ Because these agreements essentially limited each company to a set amount of oil which it could market, the incentive to drill new wells into an established and proven reservoir might be relatively slight. Nothing in the early concessions or the oil companies' agreements with the sovereigns prohibited such conduct.

Second, the scope of rights granted was enormous. Geographically, concessions generally covered immense areas. For example, the concession which William D'Arcy obtained from the Shah of Persia in 1901 covered 500,000 square miles;⁵ concessions granted by the rulers of Abu Dhabi⁶ and Kuwait⁷

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covered their entire countries. The government of Mexico gave S. Pearson & Son, predecessor of the British controlled Mexican Eagle Oil Company, a concession embracing almost all federally owned lands along the Gulf of Mexico.

The grants were similarly sweeping in terms of the operational rights transferred to the companies. The companies receiving them were free to drill or not to drill on any of the lands granted. Production of any oil discovered was left to the option of the grantee, which was under no obligation to release unexplored and undeveloped territory.⁸ The host countries retained no right to participate in managerial decisions,⁹ including decisions on drilling and development, even though — once than the initial consideration had been paid — virtually the only financial benefit received by the countries or their rulers was the right to royalty.

Third, the concessions were intended to last for a quite long time. Generally they were for fixed time periods which were rarely less than 60 years. The 1933 concession which the King of Saudi Arabia granted to Standard Oil of California for 50,000 pounds of gold was for a 66 year term and ultimately covered as much territory as the D'Arcy grant.¹⁰ The Abu Dhabi¹¹ and Kuwaiti¹² concessions were both for 75 years. There were always some exceptions, of course. The concessions granted in the period following the 1911 Mexican revolution were for a period that could not exceed 30 years and contained cancellation clauses in the event the company failed to comply with its obligations.¹³

Fourth, viewed from the vantage point of the last decade of the Twentieth century, the "government take" under the old

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concessions was extremely small. The host country, or ruler, normally received an initial consideration, roughly analogous to the modern oil lease bonus, and some form of royalty. Under some concessions the royalty was a specified fraction of production. The original D'Arcy concession in Persia provided for a 16% royalty.¹⁴ Few others were that generous to the host country. The concessions which the Mexican government granted over its own publicly-owned territory prior to the Revolution generally set the royalty at 10%.¹⁵ The Mexican royalty, however, was apparently computed on a net profits rather than a gross production basis, and was divided between the federal government, which received 7%, and the government of the producing state—commonly Veracruz—which received the remaining 3%.¹⁶ Other arrangements provided for a royalty calculated as a flat rate per ton rather than as a percentage of production or the value of the sale price of production. Thus, both the Ruler of Abu Dhabi and the Sultan of Muscat and Oman received three rupees per ton of oil produced from their respective concessions¹⁷ ; the Arabian concession set the royalty at 21 gold shillings per ton.¹⁸

Today, when even the least sophisticated U.S. landowner is likely to end up with a royalty no smaller than 16.667% (1/6th) of gross production, the minimal nature of government take under the old concessions is startling. It is made even more so when other aspects of the concessions are considered. The 1901 Mexican petroleum law which authorized the granting concessions on public land gave the companies liberal tax exemptions, the right to import machinery, equipment and material duty-free, and other special privileges, including the right to "expropriate" land necessary for their oil operations.¹⁹ Some of the Middle East concessions freed the

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companies from all tax obligations which were not specifically set out in the agreement.²⁰

Perhaps the following comment provides the best perspective on the concession system...