Oil and gas transactions in Myanmar: key issues in negotiating production sharing contracts

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

Summary and implications

A Production Sharing Contract ("PSC") (sometimes known as a Production Sharing Agreement) is a common type of contractual arrangement used for the exploration and development of oil and gas.

Usually, the terms of a PSC essentially provide for the state (as owner of the oil and gas resources) in this case usually represented by the Myanmar Oil and Gas Enterprise (collectively, the “Government”) to engage an independent oil company ("IOC") to provide technical and financial services for exploration and development operations. The IOC enjoys exclusive rights to explore and produce, while the overall management control remains with the Government.

The IOC recovers a portion of its costs of exploration from a pre-specified percentage of the oil produced (often referred to as "Cost Oil") while the remainder of the oil produced (often referred to as "Profit Oil") is split between the Government and the IOC at an agreed rate. The Profit Oil represents the main reward to the IOC for the risk taken and services rendered. The Government usually has the option to participate (and also to increase its share of participation) in the process.

The models of PSCs used in Myanmar are relatively conventional variations of the original Indonesian models: drafted in English in short, basic form.

We seek to examine and discuss a number of key terms and issues.

Contract periods and relinquishment

Typically, the exploration period for onshore and offshore shallow water blocks is three years, and it is generally possible to obtain two extensions of one year each, though a first extension of two years followed by a second one-year extension is not uncommon. In relation to offshore deep water blocks, an initial technical evaluation period of two years is generally granted, followed by a three year exploration period. Again, it is usual to obtain two extensions of one year each.

The production period for both onshore and offshore blocks is generally the longer of twenty years from commercial discovery or the duration of the relevant petroleum sales contracts.

A PSC will typically contain relinquishment provisions - i.e. provisions which provide for the surrender of a portion of the contract area after a certain time period (e.g. the first exploration period). Relinquishment provisions are intended to promote expedient and efficient exploration of the contract area. Essentially, they put a time pressure on the IOC to complete the exploration exercise otherwise they risk losing the prospect of discovery and development to a competitor following relinquishment.

Relinquishment provisions vary depending on how the contract is negotiated. We have seen agreements providing for 25% of all areas to be relinquished at the end of the exploration period and 25% at the end of the first extension of the exploration period. Other examples we have seen provide for no relinquishment until the end of the first extension of the exploration period. At the end of that period, unless a second extension is entered into, all of the contract area must be relinquished except for the discovery areas and the development and production areas. If a second extension is entered into, then 75% (instead of 100%) of all areas must be relinquished (excluding the development and production areas) so that exploration remains only on 25% of the area for the second extension period.

Work commitments

The PSC provides for a work programme which outlines the IOC's commitments with regard to various activities. These minimum work commitments are usually set out as specific milestones to be achieved by the IOC during the exploration period.

In particular, the work commitments for onshore and offshore shallow water blocks normally require completion of the geological, geophysical and seismic surveys by the end of the first year, drilling of the first well by the end of the second year and drilling of the second well by the end of the third year. The requirement for drilling the wells can, however, be negotiated and made more flexible. The work commitments for offshore deep water blocks are slightly different: the surveys must be completed during the two-year technical evaluation period, while the drilling of the wells is to be completed by the end of the three-year exploration period.

The IOC is also subject to a minimum expenditure commitment, for the execution of the above-described work commitments. Often, the IOC is entitled to pay the amount of any deficiency (sometimes referred to as “buy down amounts”) in full satisfaction of a failure to make such minimum expenditure commitments. Particular care should however be taken in drafting (and negotiating) this provision in clear, unambiguous terms, in order to avoid any potential dispute on this issue (particularly relating to limiting the IOC’s liability for any such breach).

Cost recovery

The definition of Cost Oil is essential for the feasibility of any oil and gas project by the IOC – this is the oil out of which the IOC may recover the costs and expenses of exploration and production operations up to a certain cost recovery limit.

In order to be covered as Cost Oil, costs must qualify as "costs recoverable", and the applicable accounting procedure will be essential in determining the specifics. Generally, costs recoverable includes all costs and expenses of exploration operations as well as all costs and expenses of development and production operations within the agreed areas. This definition should be reviewed carefully in order to include all intended costs that may be sustained in the exploration and production process. For example, unless costs sustained outside of the production area or costs attributable to logistics, administration and design are expressly included in the definition, they would not normally be covered.

Another provision sometimes neglected but having profound implications is the agreed accounting procedure. Among other things, the accounting procedure will determine what is, or is not, cost recoverable. The IOC should ensure that the accounting procedure reflects the manner in which the operations will be staffed, equipped and funded.

The accounting procedure is a key negotiating point and should, ideally, mirror the preferred accounting procedure included by the IOC in its draft Joint Operating Agreement (that was submitted by the IOC to the Government at the bidding stage).

From the IOC’s perspective, the agreement should provide for costs not recovered in an accounting period to be carried forward and recovered in the succeeding accounting period, and each further succeeding period, until fully recovered.

Cost recovery is also often subject to a “cap” (otherwise known as the cost recovery limit). Typically, the cost recovery limit in Myanmar will vary from 50% to 70% of costs, depending on whether the contract relates to onshore or offshore blocks, and in case of offshore blocks depending on water depth (i.e. allowed cost recovery will increase with any increase in water depth).

Royalties, Profit Oil and other amounts

The Government will also require the payment of a royalty. Based on precedent data, this is generally approximately 12.5% of "available petroleum" (i.e. petroleum produced and saved and not used in petroleum operations). If the royalty is paid in cash, the calculation is based on the fair market value of the oil. Alternatively, the Government may also elect to take the royalty “in kind” (i.e. actual physical oil produced). In such cases, it will be required to give notice to the IOC, and to take its royalty in kind for at least one year. The royalty paid to the Government is not recoverable from Cost Oil and is often subject to intense negotiation between the parties.

Petroleum that is not taken as royalty “in kind" or Cost Oil is defined as Profit Oil, and it is the oil that will be split between the IOC and the Government. The typical split of Profit Oil between the IOC and the Government ranges from 40%/60% to 10%/90%. The IOC’s share of Profit Oil is generally higher for deep water blocks (in order to take into account the higher risks and costs associated) as compared to onshore or shallow water blocks. The Government’s share of Profit Oil normally increases with increases in production whilst the IOC’s share of Profit Oil decreases with any increase in production.

The Government will also require some other amounts to be paid by the IOC.

A signature bonus paid by the IOC to the Government is generally required, the amount of which is typically based on the quantity and quality of the data made available by the Government to the IOC. This amount ranges between USD 1 million and 15 million. The signature bonus is not considered as a cost recoverable and not credited to the minimum work commitment, but it is tax deductible.

The IOC is also typically required to set aside funds for employment and training. Amounts range from USD 25,000 per year during the exploration period and USD 50,000 per year during the development and production period. Carry forwards of excess expenditures are normally allowed and these funds are considered cost recoverable. Research and development funds are also typically required, in amounts of approximately 0.5% of Profit Oil, to be established by the IOC and spent in consultation with the Government.

Production bonuses are also generally sought by the Government and payable first upon approval of the development plan and then in increasing amounts as production reaches certain defined thresholds.

All of these additional amounts and fees are usually subject to negotiation between the parties. It is likely however that the Government will be less flexible with fees that have been payable in precedent transactions.

Government participation

The concept of a government participation option is quite common in the international oil and gas industry and often takes the form of a state-owned entity being awarded a percentage stake in the project. In Myanmar, typical PSCs will provide for the triggering of an option for Government participation at first discovery of commercial petroleum. The option is valid and exercisable for a period of three months from such discovery. If the option is exercised, the Government will essentially participate in the project as a joint venture partner to the IOC and the IOC will be required to send a proposed form of Joint Operating Agreement to the Government.

In Mynanmar, the option for Government participation is typically in the range of a 15%-25% interest for onshore blocks and up to 20% for offshore blocks (or 25% if more than 5 trillion cubic feet of product are discovered). In consideration for the exercise of the option, the Government will reimburse (pro rata to its share of participation) the petroleum costs previously incurred by the IOC and a proportionate share of the signature bonus, either through immediate payment or payment from its share of Profit Oil.

Domestic supply and procurement

The PSC will typically include domestic supply requirements and domestic procurement requirements.

Following the start of commercial production, the IOC is obliged to supply a certain amount of product to the domestic market. The amount of such supply will be in the proportion that the IOC’s entitlement to the product (i.e. Cost Oil plus Profit Oil) bears to all petroleum or natural gas, as the case may be, produced in Myanmar at that time. For example, if the IOC’s share of petroleum is equal to 40% of all petroleum produced in Myanmar, the IOC will be obliged to supply 40% of its share to the domestic market.

As far as domestic procurement requirements are concerned, the IOC shall give preference to goods and services available from Myanmar nationals approved by the Government, provided that they are of comparable quality, price and availability in the required quantities. More specifically, the IOC shall use 25% of the approved annual budget each year to procure goods and services available in Myanmar, unless otherwise agreed with the Government.

Other typical provisions

As is typical for other contracts entered into with a government entity, PSCs may contain provisions pertaining to the risk of expropriation. In this regard, it is worth mentioning that there has been no expropriation in Myanmar since 1988. The Foreign Investment Law contains specific language preventing expropriations, and depending on the country of incorporation of the IOC, additional mitigation can be provided by any Bilateral Investment Treaty in force between Myanmar and the country of incorporation of the IOC (this should be taken into account when planning the investment).

As far as contract stabilization is concerned, the standard stabilization provision in the Myanmar PSCs is often less than ideal when compared to international standards. It is obviously in the IOC’s interest to negotiate a sufficiently robust stabilization provision. This can be done in the PSC or in a separate side letter.

We have noted also that the risk allocation in the standard force majeure provisions can be improved (in favour of the IOC) and should be negotiated to address specific concerns, such as rig availability and political force majeure issues.

Remittance of profits and investments

The remittance of profits outside of the country is a key concern for all foreign investors in Myanmar, and the investors in the oil and gas sector are no exception.

As part of the reform process that has been undertaken in Myanmar since 2010, the Foreign Exchange Management Law replaced the strict Central Bank approval requirements under the 1947 Foreign Exchange Regulations Act for each and every foreign currency payment out of the country.

The Foreign Exchange Management Law is intended, among other things, to liberalize transfer payments relating to "current account transactions", which include: (i) remittances for trading, services fees, settlement of short term bank loans; (ii) remittances for payment of interest on loans and net income from investments; (iii) instalment loan payments or depreciation on direct investments; and (iv) inbound or outbound remittances for family living costs.

Pursuant to Section 25 of the Foreign Exchange Management Law, current account transactions "shall not be restricted directly or indirectly for settlement or remittance out of the country". Pursuant to Section 38, these payments must be arranged through any bank with a foreign exchange "authorized dealer licence" issued by the Central Bank of Myanmar.

The Foreign Exchange Management Law also regulates remittances and payments relating to "capital account transactions", which are defined as "capital account remittances other than current account remittances". Such capital account transactions will include payment of dividends and return of equity capital. Pursuant to Sections 26 and 27 of the Foreign Exchange Management Law, such capital account transactions are subject to the right of the Central Bank to enquire as to whether the investment capital was actually "brought-in" to Myanmar as foreign investment in accordance with applicable laws, and to reject any request for permission to remit such payments if the investor fails to produce the required evidence of the original investment funds being brought-in in accordance with applicable laws.

Unfortunately, until the publication by the Central Bank of the implementing notifications relating to the Foreign Exchange Management Law, there is not much evidence or understanding as to how this relatively new regime of remittances will work in practice. As in many other sectors in Myanmar, much will depend on the evolution of the laws and practices.