Leicester City have won the English Premier League, against all the odds and with an eighth of the budget of the pre-season favourites, Manchester City. I link this 'tale of the unexpected' to one of the strongest emerging trends in petroleum fiscal policy today: reducing cost recovery. Governments are telling the oil companies that they need to 'do a Leicester'. That is, maintain (or even improve on) their best performance – investment, production – but at a fraction of the cost.
This follows a decade of severe cost inflation that has created an atmosphere of mistrust in many countries. Companies argue that cost increases are a result of simple supply/demand economics and need to be recovered first from revenue. Governments believe the companies, in cahoots with suppliers, simply increase costs to absorb any price windfall and minimise government revenues.
As a result, governments have been increasing their scrutiny of budget proposals and audits of expenditure claims. This occurs most often in production sharing contracts (PSCs) and service contracts, where governments normally have to approve budgets prior to expenditure. The increased scrutiny creates tension and frustration and results in delays to investment. A 'lose-lose' situation, in other words.
So, the issue of cost recovery is firmly under the fiscal policy spotlight. From exploration to decommissioning, governments want companies to deliver at a lower cost. And companies want governments to stop interfering and let them get on with business. The solution beginning to gain popularity is relatively simple: remove cost recovery from the equation.
India recently introduced a new fiscal policy for the future award of marginal field licences. For many years, India has employed a traditional PSC, with production first allocated to cost recovery then remaining production ('profit oil') is shared between the company and government. Under its new revenue sharing mechanism (RSM), companies will bid for a simple share of revenue. How much profit companies can generate from that revenue while fulfilling their contractual work commitments is up to them. This model is also an option in Indonesia for coal bed methane investments.
When compared with the traditional net revenue sharing mechanism, these gross revenue sharing schemes protect the government from any cost overruns in the project. And as the government is no longer picking up the tab for higher costs, it does not need to scrutinise the budgets.