Oil and gas concessions, production sharing and service contracts

A government that owns the oil under its soil still needs someone to find it, drill it and carry the cost of failure. The contract that hands over that job decides who pays, who owns the oil at the wellhead, and how the profit is split. Four model families cover most of the world, and real contracts blend them. Knowing the model tells you which questions to ask before you look at any number.

The licence or concession

Under a concession, the state grants the company the right to explore for and produce hydrocarbons in a defined area for a set term. The company pays for everything, owns the oil it produces and sells it. The state takes its share through taxes: a royalty on production or revenue, income tax on profits, and sometimes bonuses on signing or on reaching production milestones. The fiscal system is usually set by the petroleum law and the tax code, so the contract itself can be short.

The main risk for the investor is change in law. Because the terms sit in legislation, a later government can alter them. Investors manage that risk through stability clauses and international arbitration provisions, and through investment treaties where they apply.

Production sharing contracts

In a production sharing contract, or PSC, the state keeps title to the resource and the company acts as a contractor. The company funds exploration and bears the loss if it finds nothing. If it finds oil, production is divided in a sequence. First comes a royalty where one applies. Then a portion of production, usually called cost oil, is set aside to let the contractor recover its approved costs. What is left is profit oil, and the contract splits it between the state and the contractor, often on a scale that rises with production or with the contractor's rate of return.

The contractor's share is often taxed as well, or the tax is paid on its behalf out of the state's share. Either way, the key terms to find are the cost recovery ceiling, the list of costs that qualify for recovery, the profit oil split and how it changes, and any state participation through the national oil company.

Service contracts

In a service contract the company is paid a fee for its work and does not receive production as such. A pure service contract pays a fee per barrel produced, and the state takes all the oil. A risk service contract has the company bear exploration risk and be repaid, with a return, only if oil is found. The company's economics depend on the fee schedule and on how the state treats cost recovery, rather than on the oil price directly. That reduces upside and reduces some downside, and many companies accept it only for fields where the geology is well understood.

Participation contracts, and the Ecuadorian example

Ecuador uses the term participation contract, a model in which the contractor carries the investment and receives a share of the production. Ecuador's Hydrocarbons Law also provides for service contracts in which the contractor is paid a per-barrel fee. The law was reformed in 2010 to push the sector toward service contracts, and provisions on the contract modalities have been the subject of amendments and Constitutional Court rulings since. Because of that history, anyone studying an Ecuadorian opportunity should work from the current consolidated text in the Registro Oficial and from the specific contract, not from a summary.

That is a lesson that applies beyond Ecuador. Contract families are labels. What counts is the signed contract, the law that sits behind it, and the date.

The fiscal terms to read first

Whatever the model, a handful of terms decide the economics.

• Royalty. A share of production or revenue paid to the state before costs. It is paid even when the project loses money, so a high royalty hurts marginal fields most.
• Cost recovery. How much of the early production may be set aside for costs, and which costs qualify. A low ceiling slows payback.
• Profit split. How the remaining production or profit is shared, and whether the split depends on production, price or rate of return.
• Income tax. Whether it is separate from the contract share, and its rate.
• State participation. A carried or paid-up interest for the national oil company, which changes how much of the project the investor actually owns.
• Term. The length of the exploration period and the production period, and the conditions for extension.
• Stability and dispute resolution. How the contract protects the terms and where disputes are decided.

A government can reach about the same take through any of these systems. The IMF's work on fiscal regimes for extractive industries makes the point that a well-designed regime should meet a country's revenue needs while still offering investors an attractive return. It also notes that extractive industries account for over half of government revenues in many petroleum-rich countries, which explains why states defend their terms and revise them when prices rise.

How companies get the contract

Most states award exploration and production rights through a licensing round: the ministry announces blocks, publishes the model contract and the bidding rules, and invites bids. The bid variable is set in advance and may be a work programme, a signature bonus, a profit share or a combination. Pre-qualification asks for technical and financial capacity, and some states require a local partner or a minimum stake for the national company.

Other awards are negotiated directly, which gives more room for bespoke terms and less visibility. The EITI Standard asks implementing countries to disclose contracts and licences and to say which exploration contracts are published (Requirement 2.4), so a country's EITI report is a good first place to learn which contracts are public. The Standard also encourages disclosure of beneficial ownership at a threshold of ten percent or lower, and requires disclosure of politically exposed persons who hold an interest, which helps an incoming investor to check who they would be partnering with.

What to do before you bid

Obtain the model contract and the petroleum law, and read them together. Build a simple cash flow for a field with plausible volumes and check how the take splits at three oil prices. Look at how past contracts in the same country were amended, and whether the state has renegotiated terms after a price rise. Hire local counsel for the parts that depend on constitutional or administrative law. And check whether the ministry's published terms match what recent awards actually signed, since the gap between a model and a final contract tells you how much room for negotiation exists.

Guides explain how things generally work. They are not legal, tax or investment advice for a specific project or country. See our editorial policy.