09 September 2011

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Last Part Complete CAG Report – Reliance, Cairn Energy Petroleum and Natural Gas for a special audit of PSC

Last Part Complete CAG Report – Reliance, Cairn Energy Petroleum and Natural Gas for a special audit of PSC

Conclusions and General Recommendations –

Private sector participation in hydrocarbon exploration and production in India is now
robustly established, with major crude oil and natural gas discoveries in different basins
nutting India firmly on the global FM) man The Prnthirtinn Sharing Cnntrart IPSC1 — the basis of the contract between the Gol and the (private) contractors — has undergone several mutations from those in respect of discovered fields to "pre-NELP" exploration blocks to the blocks under different rounds of the New Exploration Licensing Policy (NELP). However, our audit indicated that there is considerable scope for improvement in the management of hydrocarbon E&P with private sector participation in the light of experience gained by governmental agencies over the years.

Structure of PSC

The PSC, as it currently stands, is based on a scaled formula for profit sharing between the Gol and the private contractors. This is based on a critical parameter — Investment Multiple (IM) — which is essentially an index of the capital-intensive nature of the E&P project i.e. the amount of "capex" on exploration and development activities relative to income. The slabs for profit sharing are so designed that more the capital intensive the project (i.e. lower IM), the lower the Gol share of "profit petroleum" (which could be as low as 5 to 10 per cent). Contrarily, the higher the IM (i.e less capital intensive vis-a-vis income), the higher the Gol share of "profit petroleum" (which could be as high as 85 per cent).

In practice, however, the private contractors seem to have inadequate incentives to reduce
capital expenditure and substantial incentive to increase capital expenditure or "front-end" capital expenditure, so as to retain the IM in the lower slabs or to delay movement to the higher slabs.

The structure of the IM-based profit sharing formula (especially when there is a huge jump in Gol's profit share from 28 per cent to 85 per cent on an IM slab of 2.5 or more) is such that in certain scenarios, an increase in capital expenditure, upto a point, could conceivably result in an increase in the contractor's share of profit petroleum, despite a reduction in the total profit petroleum as well as Gol's share of profit petroleum. Further, "front-ending" of capital expenditure (i.e. skewed towards the initial phases) decreases the IM, and postpones the movement to higher IM slabs; this results in a reduction in Gol share on a discounted cash flow basis, since the slabs involving higher Gol share come later, rather than earlier. Operational control of E&P operations is largely with the private operators, and the Gol's oversight role is restricted essentially to its representation (through MoPNG and/ or DGH) in the Management Committee for the block, especially in approval of Annual Work Programmes and Budgets and Field Development Plans, as well as a few approval functions delineated in the PSC.

Ashok Chawla Committee Report

We are given to understand that the report of the Ashok Chawla Committee on allocation of natural resources also draws similar conclusions regarding the IM-based profit-sharing
formula. This committee had, inter alia, representatives from MoPNG and the Ministry of
Finance, so it can safely be presumed that its conclusions were well considered. However, the report is not currently available in the public domain.

According to media reports, the Committee has stated that the system "gives incentive (to
an operator) to increase his investment, or front-end his work plan in order to see that the
threshold where Government's profit take rises rapidly is not reached".

Citing the example of KG-DWN-98/3, the Committee has stated that "the relationship
between the pre-tax IM and the share of contractor profit petroleum changes dramatically
once the pre-tax IM crosses 2.5, with the government's share increasing from 28 per cent
to 85 per cent. It is useful to remember that this schedule is bid by the operator, and not
determined by the Government."

Further, according to the Committee, "a high share of some pre-tax IM will help to win the bid, depending on the financial mode of evaluation used, but it does raise concerns that such a radical change would provide very strong incentives for any operator to adopt all investment and strategies possible to ensure that the pre-tax IM stays within the 2.5

The report clearly points out the risks associated with the IM-based formula for sharing of profit petroleum, especially with a steep jump in profit sharing from one slab to another.

In our view, even the linearity introduced in the sliding scale for IM slabs from NELP-VII onwards does not fully address these risks.

The oversight/ control of Gol representatives on high value procurement decisions is also
very limited in scope (largely restricted to prior intimation of the list of pre-qualified
bidders). In fact, a comparison of the procurement procedure under PSCs in Bangladesh and India reveals that the clauses are similar, except that the Bangladesh PSCs require approval by the Management Committee for high value procurements (typically greater than US$ 500,000). This clause is, however, missing from the Indian PSCs in almost all its versions.

Our audit review also revealed that, by and large, the DGH and the Ministry through the
Management Committee were ill equipped to pay adequate attentiion to protecting - at
every stage of E&P, be it exploration, development or production - Gol's financial interests.

Adequate attention was not paid as to how every proposal/ decision would potentially
affect Gol's share of profit petroleum. In addition to their other inadequacies, the
constraints of adequately skilled resources with MoPNG/ DGH for monitoring several
hundred PSCs simultaneously cannot also be ignored. By contrast, it is inconceivable that
the private contractor would fail to protect his financial interests, and assess ever
investment/ operational proposal to see whether it would result in incremental revenues for it both in terms of cost recovery and contractor's share of profit petroleum.
Given the similar conclusions that two independent agencies viz. the Chawla Committee
and Audit have reached as regards the adverse impact of the profit sharing mechanism in
protecting Gol's share (linked to the IM), designed in the late 1990s, there does seem to be enough ground to revisit the formula. The PSC as drawn up then, was with the limited
expertise available with the Gol at that point of time. In view of the fact that, we have
now gained the knowledge , there is need to conclusively address this issue in respect of
future PSCs

MoPNG stated (July 2011) that they were prepared to look at alternative formulas with an
open mind and would consider the suggestion of the CAG and the Ashok Chawla Committee with an open mind and take a final view on merits.

Recommendations for Future PSCs

The stated strength of the profit sharing mechanism is the sharing of risks between the
contractor and the Government — if the profits are low or non-existent, both parties suffer equally.

For future PSCs, we recommend that the IM-linkage with the profit sharing formula (even with the linear sliding scale introduced from NELP-VII onwards) be removed by the Gol.

Instead, the biddable profit-sharing percentage should be a single percentage. This will
reduce the incentive for skewed volume and timing of capital expenditure resulting in very low Gol share of PP. Further, in order to ensure a modicum of control, very high value procurement decisions above a specified limit should be subject to approval by the MC, more specifically the approval of the Gol representatives. Such a mechanism already exists in PSCs operating in Bangladesh.

Bid Evaluation Criteria
The bid evaluation criteria currently give weightage to technical/ financial ability and two
biddable parameters - committed exploratory work and fiscal package (royalty + Gol share
of profit petroleum). As regards fiscal package, the current evaluation model generally
involves multiple scenarios of oil reserves and oil prices (typically high, medium and low) as
well as a projected profile.
The assumptions based on which calculations of fiscal packages of different bidders are
made are completely hypothetical. In the absence of high quality seismic data, let alone
drilling and discovery findings, estimates of oil/ gas reserves and production profiles, as also
projected capital and operating expenses and even crude oil and natural gas prices, is
completely speculative. Admittedly, the evaluation model is applied consistently across all bidders. However, when the current system allows multiple bidding points (viz. different Gol

Consequently, we recommend that the bidders should be allowed to only make a single
point bid, which can be compared straightaway without resorting to hypothetical

As regards the biddable exploratory work programme, we are generally in agreement with the bid evaluation process, except for the system of awarding points for well depth. As pointed out in Chapter 4 (relating to KG-DWN-98/3), it is unrealistic and impractical, without having accurate and reliable seismic data, to bid upfront how deep the well should be drilled, and then expect that, notwithstanding geological objectives, the well will be drilled to the committed depth even if it means a waste of money.

Consequently, in future, while considering the bid evaluation criteria, we recommend that
either no weightage be allocated for well depth, or alternatively, well depth commitments
be categorised into two groups — wells above and below a specified depth, e.g., 1500 or
2000 metres and points be awarded accordingly.

Management of existing PSCs

The vast majority of blocks with high prospects for hydrocarbon discovery have already
been awarded through various pre-NELP/ NELP rounds, and Gol has no option but to work within the constraints of the existing PSC structure and clauses to the fullest extent possible.

Development Plans and Annual Work Programmes and Budgets
It is inconceivable that a private operator/ contractor will make investments in absolute as
well as incremental terms, in petroleum operations under the PSC without assessing
whether such investments would result in increased revenues for him in terms of cost
recovery and contractor's share of profit petroleum. It is necessary for MoPNG and DGH to function in a similar manner, with regard to Gol's financial interests. Consequently we
recommend the following:

• Review and approval of development plans should be considered not just from a
"technical perspective" viz. how best can oil and gas be extracted from the reservoirs,
but also from a financial perspective — not only overall (i.e. what is the project NPV, Rate of Return etc.), but specifically from Gol's point of view viz. what are the projections of royalty and Gol share of profit petroleum? What are the risks to these revenues? How will increases/ decreases in capital expenditure, reserves, reservoir productivity, prices etc. affect Gol's financial take?

• While reviewing and approving development plans, Gol representatives on the MC as
well as DGH and MoPNG should ensure that detailed and appropriately validated
estimates of Gol take and contractor take are included as an integral part of these plans

at the approval stage. A suitable range for Gol take, say ± 15, 20 or 25 per cent, as
considered appropriate by MoPNG, could be stipulated.

• Approval by MoPNG of such development plans should be on the clear stipulation that
any changes in capital and operating expenditure, expenditure commitments,
production quantities and other tactors, which have the impact of reducing the
Investment Multiple and Gol share of profit petroleum beyond the stipulated range
must be submitted for prior approval by Gol representatives on the MC, with detailed

• Annual Work Programmes and Budgets should be strictly in line with the approved
development plans. Any deviations or changes vis-à-vis the development plan which
have the impact of reducing the IM and Gol share of profit petroleum beyond the
stipulated range must be submitted for prior approval of the MC. Similarly, any
significant variations from the approved Work Programme and Budgets with similar
impact beyond the stipulated range must also be subject to prior approval.

• Incurring of any costs which vary from the Development Plans and Annual Work
Programmes & Budgets on an overall basis, as well as in terms of significant line items
with significant adverse impact on IM and Gol share of profit petroleum — beyond the
stipulated range - without prior approval of Gol representatives on MC should
automatically be ineligible for cost recovery.

While some of these recommendations could be misconstrued as hampering operational
flexibility in petroleum operations by the contractor, the importance of the overall
objective of protecting Gol's revenue interests cannot be ignored under any circumstances.

Procurement Activities

The provisions relating to procurement procedures in the PSCs do not provide for adequate oversight / control by Gol representatives on procurement processes. However, given the existing provisions, we recommend the following measures for protecting Gol's financial interest.

• The objective of effective procurement is to ensure optimum, not necessarily lowest,
prices through effective competition. As long as adequate number of 'responsive'
financial bids, typically three or more, from reputed vendors, who are pre-qualified after
following due process, are received and duly considered (i.e., not withdrawn,
disqualified on technical or other grounds, deviations/ non-responsiveness or otherwise
not considered), generate adequate competitive tension, the probability of effective
procurement at optimum costs remains high.

• However, when high value contracts are awarded on the basis of single 'responsive'
financial bids, in our opinion, these are awarded without competition, effectively on
nomination basis. In all such cases, prior approval of the MC should be necessary for
such awards. Post facto approval, with appropriate justification, for emergent
procurement decisions may also be considered. Similar provisions would also apply to all
procurement decisions involving post-priced bid opening changes to scope, quantities,
work, prices, conditions etc.

• Also, the practice of repeated extensions, subsequent substantial variations in scope etc.
of existing contracts is also not in line with the existing PSC procurement provisions,
which incidentally makes no mention of extensions. Extensions or scope variations for
high value contracts, beyond the contractually stipulated extensions, should also be
subject to prior MC approval, with provisions for post facto approval in emergent cases.

Relinquishment of area, and delineation of discovery and development
areas As pointed out in earlier chapters, the entire PSC process is designed to ensure that the private contractors fully explore the contract area within designated timelines, relinquish areas where hydrocarbon prospects appear poor in a phased manner, and retain only those areas where hydrocarbon discoveries are made, relinquishing the remaining area for re-allocation - through a competitive bidding process - to other potential bidders, whose hopes/ views in terms of hydrocarbon prospectivity differ (either on account of technical and other capabilities or in terms of their risk appetite) from the contract holders who have relinquished such area. We, therefore, recommend the following:

The stipulated timelines and processes in the PSC for relinquishment of contract area
should, under no circumstances, be relaxed, and compliance with these provisions should
be invariably ensured.

Further, the discovery and development areas should be rigorously delineated, keeping
strictly to the discoveries made through exploratory and appraisal well drilling and proper
delineation of reservoir boundaries. Attempts by contractors for delineation of excessively wide discovery/ development areas through elastic (and incorrect) interpretation of hydrocarbon discovery should be strongly rebutted.

Compliance with other PSC provisions

The PSC is a contractual document, and compliance with every contractual clause is of
utmost importance. It would be inappropriate to distinguish between "major" and "minor"
clauses, and neglect monitoring of compliance with so-called "minor" PSC clauses.
We recommend that DGH, and where necessary, MoPNG should put into place adequate
and effective measures to ensure that compliance with all provisions of the PSC are fully
monitored on a timely basis and appropriately documented, and action taken against
operators on a timely and consistent basis, for non-compliance with PSC provisions. For such purposes, strengthening of the resource basis of DGH in terms of adequate quantity of skilled resources may be necessary.

I did not cover chapter 3 to chapter 7
Chapter –III - Audit Approach
Chapter –IV - Findings relating to - KG-DWN-98/3 block
Chapter -V Findings relating to RJ-ON-90/1 block
Chapter -VI Findings in respect of Panna-Mukta and Mid & South Tapti Fields
Chapter -VII Compliance and Control Issues

Reality views by sm –
Friday, September 09, 2011

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