#Agenda2014 No more license raj in upstream oil and gas sector

“The Licence Raj was a result of India’s decision to have a planned economy where all aspects of the economy are controlled by the state and licenses are given to a select few. Up to 80 government agencies had to be satisfied before private companies could produce something and, if granted, the government would regulate production” Source Wiki

Though Licence raj is a rarity now, it has assumed various forms in certain industries. Oil and Gas, both upstream and downstream, is an example of an industry which has continued to be at mercy of government.

“If you are an entrepreneur, would you like to get in to a business where Government(Worst it is not even government it is the regulator) appoints two nominees to a management committee (highest decision making body) where one member will be chairman of the committee and other will be deputy chairman?”

Yes! Above business condition is the norm of the day. Oil and Gas sector is yet to see light which can free them from government intervention in day to day business affairs. For the benefit of other readers who don’t know intricacies of Oil and Gas Upstream sector, here is the snapshot of how this business operates all over the world.

Oil and Gas Upstream business background

Exploration of Oil and Gas is considered to be the high risk and high return business; traditionally there has always been a scarcity of the resources and the investments due to the risk involved. Joint Ventures between different corporates are formed to share risks, resources and investments.

Sometimes one of the partners takes the responsibility for the day-to-day running of the joint venture. This partner is referred to as the “Operator”. The operator is responsible not only for the efficient running of the joint venture but also for the accounting for the venture and reporting the profit or loss to the other partners.Partners who do not operate the venture are sometimes referred to as “Non-Operating” partners. Although most Oil and Gas upstream players carry out their business operations using joint ventures, only in early 1990s Joint Ventures came in to use in Indian Upstream industry. Let’s quickly look into the brief history of Oil and Gas Upstream industry.

Indian Upstream Industry history

Indian Oil and Gas was dominated by Government corporations who are often called as ‘National Oil Company’ (NOC). ONGC and Oil India Ltd (OIL) had dominated Indian Upstream sector till 1991. ONGC started as a commission linked to Ministry of Petroleum and Natural Gas and became a Public Sector Corporation in 1994. In 1959 Oil India Pvt Ltd was formed with an equal partnership with Burmah Oil Company (UK) and Government of India. For two decades OIL remained as a Joint Venture company and in 1981 OIL India was nationalised. Till 1990 there was no bidding for exploration of blocks, government of India nominated exploration blocks to ONGC or OIL.

Post 1990 Government of India auctioned off some of the blocks under production sharing agreement. Directorate General of Hydrocarbon (DGH) was set up in 1993. Most of the employees of DGH were/are from ONGC or OIL. DGH was/is supposed to be an upstream regulator, but it has never become a truly independent regulator.

In 1997 New Exploration Licencing policy or NELP was announced. Intention of NELP was to invite international players in domestic market and bring best practice in Indian Oil and Gas sector. NELP regime is based on production sharing contract. India adopted PSC model in order to invite both foreign and Indian companies and to attract investment and latest technology in upstream sector.

Adopting PSC model Government of India thought “PSC model was more progressive than nomination regime as Management committee constituted under it offered suitable forum for regular interaction between government and contractors” Whatever may be good intention behind policy/law, till the time India is not free from cowboy capitalism and phony socialism, all those good policy remains on paper only.

Production sharing Contract existing model and issues associated with it

Existing PSC model has a number of issues associated with it, one being fiscal model that it has adopted to share the profit with the government. Contractor (Operator) was supposed to share the profit with the government once it recovers all the cost from the revenue earned from the sales of Oil and Gas. Ratio of sharing profit was based on an investment multiple. An investment multiple was the ratio of the net cash income earned over the cost incurred. Even though Profit petroleum was the profit share of the government, the essence of this ‘profit sharing’ is the tax on profit.

It is important to draw attention of the reader that it took more than 30 to 40 years with annual revision (tweaking) of Income tax law to come to this stage, where litigation between assessor (Tax department) and assesse has reduced to a large extent. Since Profit Petroleum to be received from operator was in the form of income tax, it was natural to have a disagreement about the cost incurred by the operators/contractors. Operator/Contractors have more reasons to inflate cost to show less profit than to pay profit petroleum share with government.

Policy makers were too optimistic or disconnected with the ground realities thinking that contractors/operators will share profit with government without resorting to gold plated cost to reduce profit.

Role of Regulator

Directorate of hydrocarbon is clearly unequipped and an inefficient regulator to deal with the accounting issues coming out of the calculations of government profit share. Two critical components of profit share were a) Calculation of the ‘Profit Petroleum’ and b) The ‘Cost Petroleum’. Cost recoveries, inherent for the calculation of profit petroleum, makes it necessary for the DGH to actively monitor the expenditure on a regular basis.

A wise man has said “The only thing that saves us from the bureaucracy is its inefficiency”. In order to have a wider say in the decision making, control cost and increase profits, in addition to the role of a regulator, DGH also assumed the role of managing Oil and Gas Upstream Business in India. All production sharing contract signed under NELP regime had more or less following provisions with respect to constituents of the management committee.

• Annual work programme and budget for the exploration phase
• Annual work progress and cost for the same, “offshoot cost monitoring has resulted lot of disagreement between the operating committee and the management committee over procurement procedures.”
• Proposal to surrender or relinquishment of any part of contract area
• Proposal to declare discovery as the commercial discovery.

Last two points has been major point of contention between DGH and Operators/contractors. This is where allegation of cowboy capitalism is often raised against the Operators/Contractors.

Constraints and challenges faced by Regulator

DGH has been staffed with personnel on deputation basis from PSU such as ONGC and OIL India. It has never been able to strengthen its capacity or expertise. This has resulted in administrative burden on the sector as a whole. Considering babu culture in government department in general and DGH in particular, manual system of managing cost approval (Authorization for expenditure, commonly known as AFE), scheduling management of committee meetings, and preparing minute of meetings manually caused delays and it has become increasingly difficult to manage.

To the defense of ‘Management Committee’ headed by DGH, Operator along with the other partner forms ‘Operating Committee’. ‘Management committee’ can only take up subjects and decision points which have been put before it by ‘Operating Committee’. ‘Operating Committee’ cannot take decisions which fall within jurisdiction of management committee. Isn’t it exciting? If not exciting, it certainly creates a lot of deadlock situations. Most of the delays in the projects of the upstream industry are the result of bureaucratic tussles between the operating committee and the management committee.

Relinquishment and Surrender of allotted area

Commercial discovery declaration is within the jurisdiction of the Management committee. No Contractor can delicate their discovery as a commercial discovery and go ahead with the development plan till the time management committee approves. As per PSC terms, the contractors are required to surrender or relinquish contract area allocated to the contractors which are not identified as the part of discovery area.

Surrender or relinquishment of the allocated contract area has been the major source of controversy, it has been alleged that a few contractors (read Reliance) don’t surrender the contract area which are not part of the development plan or the part of discovery area.

Allotment of land for exploration and provision PSC are entangled with complications due to the nature of role DGH plays seating the Management committee. There is no doubt that many of the contractors/Operators didn’t surrender their contract areas which are not part of the discovery, but at the same time, it is important to note that bureaucratic hurdle started long back with the PSC.

Management committee didn’t provide consideration for the deep water exploration and delay caused by lack of technical knowledge with domestic explorer. KG basin has been our (India) first real deep water exploration. Reliance and GSPC both have struggled due to lack of technical know how to complete exploration in deep water.

E and P Industry players has been complaining about long delays in starting of actual work due to approval from different ministries such as Defense, Environment and forest and other state government ministries. Needless to say, delay in getting approval from various government agencies has downstream impact on meeting timeline committed by E and P companies to the management committee. It has been no surprise when some of the foreign players, who relinquished their blocks without going ahead with exploration, found difficult to get around Indian licence raj.

Coming back to the controversy on relinquishment and surrender of allotted blocks, blame cannot be placed solely on the contractors/operators but on various factors such as delay in adoption of Open Acreage Licencing policy (OLAP), resolution of gas pricing issue, removing ministerial level and bureaucratic hurdle posed by different ministries and government agencies.

Gas pricing mechanism and Controversy

Oil/Gas/Mining industry has been governed, since independence with assumption that government is the owner of hydrocarbon/mining products extracted out of mother earth. (This has been challenged recently in the Supreme Court). But in case of RIL vs. RNRL, Supreme Court held that Gas is the property of the nation. We will see the litigation due to these conflicting Supreme Court judgement. Gas pricing mechanism is much linked with how ownership of the mineral rights is conferred. In RIL vs. RNRL supreme court felt “the EGOM decisions, regarding the utilization of the natural gas and the price formula/basis etc. do not suffer from any legal or constitutional infirmities”. This gave legal mandate to EGOM to decide over the Gas Pricing.

There has been a lot of scrutiny over Government of India’s decision to increase gas price from present $4.2 mmbtu to $ $8.4 mmbtu from April 2014. However till March 2014, gas price will be around $6.8. From Oil and Gas ‘Upstream’ companies’ perspective, this policy announcement has put them in the same basket as any other ‘NELP producing Operators’. It is a different matter that most of the opinion makers have concluded that this move by government of India will directly benefit RIL.

Before this policy announcement, there are broadly three pricing regimes for gas in India, One for gas priced under Administered pricing mechanism (APM) and other for the non APM or free market gas.

 Almost all upstream players operating in India prefer to have arm’s length based gas price, may be some decision makers in planning commission/petroleum ministry would be happy to oblige as well. However main hindrance for this policy adoption has been Gas Utilisation policy and objectives set by government of India. Gas consumption is primarily concentrated in Power, fertiliser and LPG sectors.

In principle, Indian Upstream sector incentivise investment so that production reaches optimum levels and all exploitable reserves put to production expeditiously.Well in real world,Reliance Industry is accused of not producing enough to meet India rising demand, because it is not getting right price for production.

For an Upstream company in India, if they are producing Oil/Crude, they can get market price. But if they produce Gas, they have to follow gas price discovery mechanism dictated by government of India.

Mr Anil Jain and Ms Anupama Sen in their paper “Natural Gas in India: An Analysis of Policy” highlighted following conflicting provisions regarding price determination of Natural Gas

Article 19 of production sharing contract prescribe how price of will be calculated. Contract applies to both Oil and Gas; however terms applicable to gas are less flexible than those of oil. The terms of Oil does not include administered allocation policy. NELP assures oil producer of international prices. The only restriction is that Oil must be sold in India. Article 21.3 states that contractor would have freedom to market the gas and sells its entitlement within India.

The government, however, appeared to want to retain some form of control through a gas utilisation policy, as gas continued to have competing demands on its use by state-owned enterprises in power and fertilisers. In order to reconcile these conflicting aims, the government included a general reference to a gas utilisation policy in the NELP Model Production Sharing Contract, but did not issue any formal statement on its right to prioritise allocation. In the absence of a formal clarification, there were differences in perception between the government and private companies on the extent of ‘freedom’ guaranteed under NELP. Eventually, in 2007, faced with calls for clarity, in the seventh round of NELP the government clarified its authority to prioritise the allocation of gas through an amendment to Article 21 in the Model Production Sharing Contract for NELP VII.

The NELP Production Sharing Contract from the seventh round onwards therefore has two conflicting objectives; (1) the assurance of marketing freedom to contractors for the exploration and production of domestic gas, and (2) the prioritised allocation of gas to be carried out through the government’s gas utilisation policy.

Key component of Gas pricing and related controversy is 1) price of the Gas 2) Gas allocation Policy

Report of the committee on production sharing contract mechanism in Petroleum industry has discussed various methods to arrive at the gas price and has also recommended combination two methods 1) Netback price of Indian LNG import at well head of exporting countries 2) Arriving competitive price in India based on prices prevailing at various hubs 3) Average price of this two methods should be adopted as Gas price which will be applicable for all sectors uniformly.

It is important to note that gas production quantity under NELP (Pvt Joint ventures) under 12^th Plan is no more than one third of the total gas production, yet this very one third production quantity is driving Gas pricing policy of India.

To summarise, till the time our policy makers don’t bring parity between Oil and Gas price produced in the country, controversy on the Gas pricing will keep popping up every now and then.

Gas Utilisation Policy

Gas Utilisation Policy refers to the system of prioritised allocation which has long influence planning and operations in the main gas consuming sectors, particularly power and fertilisers. In the decade of 1990 the Gas allocation was under bureaucratic control of ‘Gas Linkage committee’. The sector wise allocation and to the region wise allocation was norm of the day. There was no clear allocation policy, decision made by ‘Gas Linkage committee’ were on an ad-hoc basis.

At this time most of the gas was produced by the Public sector undertaking, and sold to public sector undertaking producing fertiliser and power. In 1999 with NELP rounds, Gas Linkage committee lost its relevance to certain extent; they had little control over private producers under NELP.

Even though initial NELP contracts didn’t have restrictions on the administered allocation and price for gas products, NELP VII brought conflicting provisions from the marketing of gas products perspective (conflicting provisions are listed in section Gas price).

NELP D-6 (Operated by RIL) gave rebirth to Gas Linkage Committee in the form of ‘Empowered Group Ministers (EGoM). Difference is earlier it used to be bureaucrats who use to control ad-hoc allocation, now it is controlled by Ministers.

EGoM wants to keep control in their hand on allocation policy and Gas price, but every now and then we hear that marketing of Gas products will be given parity with Oil. Oil does not have administered allocation policy and selling price of Oil is directly linked with international crude price.

Fertiliser sector has been made as one of the most important priority sector however there was little done to make sure Gas actually reach these consumers within fertiliser industry.

Conclusion

Every five year plan had a mandatory section to put emphasis on energy security and how new policy statement will reform the sector. However there is no visible progress made in Oil and Gas Upstream industry. In fact Industry is marred with controversy specifically on Gas pricing issue/Gas allocation. Other ailments such as incompetent regulator and lack of technology available with the current Oil and Gas Upstream players are hardly discussion among policy wonks. I hope new government post 2014 will be able to provide the much needed independence to Oil and Gas Upstream industry and free industry from clutches of Licence raj.

References

1. BHP gives up India oil & gas blocks over delays
2. Ownership of mineral vests
3. Report of the committee on production sharing contract mechanism in Petroleum industry
4. Report of the committee on production sharing contract mechanism in Petroleum industry
5. Natural Gas in India: Analysis of Policy by Anil Jain and Anupama Sen