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Dow Jones Newswires: PSAs Still Shield Oil Companies from Cost Overruns

By Matthew Allen     
Dow Jones Newswires     

LONDON Sep 27, 2006 (Dow Jones Newswires) Production-sharing agreements like those in place at Russia’s Sakhalin liquefied natural gas project offer higher levels of protection from project cost overruns than royalty and taxation mechanisms, despite hyper-inflation in the oil industry, a report by consultants Wood Mackenzie said Wednesday.

Such contracts may also mean, however, that companies are less exposed to the potential upside of oil-price increases, author Graham Kellas said.

Falling oil prices mean it may take longer for a company’s costs to be recouped, and higher commodity prices mean costs are often greater than anticipated.

Higher costs are causing hyper-inflation in the oil and gas industries and causing significant cost overruns in the development of new oil and gas fields, the report said.

The Sakhalin project saw Royal Dutch Shell PLC (RDSB.LN), which owns a 55% stake in the project, double its costs last year to $20 billion. The project is run on the basis of a PSC deal with the Russian government.

The report found that an extra dollar incurred in costs doesn’t necessarily reduce the value of the project to investors by an equal amount, due to the fact that expenses can be tax-deductible or recovered in the PSCs.

Under production-sharing contracts, or PSCs, oil and gas companies win tax breaks while the government gets a share of the oil and gas produced once the project’s costs have been covered by the company.

“Profitability-based contracts are geared towards a much higher government take only when the project’s returns have been made,” Kellas said.

“PSCs can create a government take that is very high in the early years or very low in the early years. The issue of Sakhalin is that it’s very low in the early years of production.”

He added because of the size of the investment and length of time it will take to recover costs, “it’s actually going to take quite a long time before the (Russian) government’s percentage take increases to any significant level.”

The report said the impact of cost overruns on investors’ returns can vary significantly depending on the regime and the type of contracts used.

As an example, the report cites a hypothetical 100-million-barrel oil-field development with a $200 million cost overrun which could mean a $152 million reduction in the project’s net present value in Iran and a $26 million increase in Angola. Net present value is a standard method for evaluating a long-term project’s value for investors.

The majority of countries cited in the report which have a smaller impact on net present value operate PSC contracts.

Kellas said that although a PSC is an effective way of protecting a company from the downside of capital cost overruns, they can also limit potential gains from price increases.

“It depends on what you’re concerned about, cost overruns or price increases. Companies will receive less under the PSCs than they do under concessions as the PSCs will be generating a higher percentage government take,” Kellas said. “That higher percentage government take is a good thing when you’ve got cost overruns and it’s a bad thing when you’ve got price increases.”

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