09 September 2011

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Complete CAG Report – Reliance Petroleum and Natural Gas for a special audit of PSC Part One

Complete CAG Report – Reliance Petroleum and Natural Gas for a special audit of PSC Part One

Complete CAG Report – Reliance Petroleum and Natural Gas for a special audit of PSC Part One

Government of India formulated the new exploration licensing policy that is NELP in 1997 and notified this policy in 1999.

In order to ensure balanced and effective partnerships with global E&P Companies, the Production Sharing Contracts (PSCs) between the Government and the private players were revised. These contracts were structured in such a fashion that the exploration risk viz. the cost incurred in searching for oil and natural gas, without certainty of discovery, was to be borne by the private contractors. The private contractors incur capital expenditure towards discoveries, irrespective of the fact whether oil or gas is discovered or not. It is only when hydrocarbons are discovered and assessed to be commercially viable, that the contractor has the first rights on the revenue streams accruing from sales of oil and gas till his costs are recovered.

The balance revenue, termed as "Profit Petroleum", is shared between the Government and the contractors, with the contractors generally getting a higher share in the initial stages since he has to recover contract costs.

The Government share of revenues becomes significant only when the production reaches substantial levels and the contractor has recovered his accumulated capital cost. Further, under NELP, Government companies and private players are treated at par.
The principle underlying the PSC model, under the NELP, as it currently stands, involves a scale for profit sharing between the Government of India and the contractor, based on a critical parameter—the Investment Multiple (IM).

This is essentially an index of the accumulated net cash flow to the contractor relative to the accumulated expenditure on exploration and development activities.

The objective underlying the PSC is that ideally the operator would attempt to maximize simultaneously both the government revenues and his own profit by minimizing contract costs for any level of production.

In order to ensure that the expenditure proposed to be incurred as well as actually incurred by the operator does not adversely affect the Government's revenue interests, the PSC contemplates the Management Committee (MC), chaired by a Gol representative, as responsible for approving field development plans as well as annual work programmes and budgets for development and production operations. However, operational control of E&P activities would vest with the Operating Committee, consisting of representatives of the contractors.

This audit was conducted in response to a request from the Ministry of Petroleum and Natural Gas for a special audit of PSCs in the context of large Government stake in the form of profit petroleum and concerns about the capital expenditure being incurred by some contractors in development of blocks awarded under NELP.
We scrutinized records of the Ministry of Petroleum and Natural Gas and the Directorate General of Hydrocarbons (DGH) in respect of a sample of 20 PSCs covering the period from 2003¬04 to 2007-08. In addition we also conducted supplementary scrutiny of records of operators of 4 blocks/ fields (KG-DWN-98/3, RJ-ON-90/1, Panna-Mukta and Mid & South Tapti), covering the two year period 2006-07 and 2007-08. Our audit was interrupted due to difficulties in obtaining access to the records of operators for supplementary scrutiny, which were later resolved with assistance and cooperation of Ministry of Petroleum and Natural Gas.

This report of the Comptroller & Auditor General of India for the year ended March 2011 containing the results of Performance Audit of Hydrocarbons Production Sharing Contracts has been prepared for submission to the President of India under Article 151 of the Constitution of India.

Private sector participation in hydrocarbon Exploration and Production (E&P) in India dates back to the Government of India (Gol) decision of 1991 to invite foreign and domestic private sector companies to participate in the development of oil and gas fields already discovered or partly developed by the National Oil Companies such as ONGC.

The basis for the contractual relationship between the Gol and the private contractors is the Production Sharing Contract (PSC). The PSC lays out the roles and responsibilities of all parties, stipulates the detailed procedures to be followed at different stages of exploration, development and production, and also indicates the fiscal regime (cost recovery, profit sharing etc.).

In November 2007, the Secretary, Ministry of Petroleum and Natural Gas (MoPNG) requested the CAG to conduct a special audit of PSCs for eight blocks for which regular audit had already been carried upto 2003-04/ 2004-05. MoPNG's request was made in the context of large stakes of the Government in the form of royalty and profit petroleum, and concerns voiced in some quarters about the capital expenditure being incurred by some contractors in the development projects awarded under NELP.

We agreed to the MoPNG's request for audit, indicating that we would be covering, in the first instance, five blocks — Panna-Mukta, Tapti, KG-DWN-98/3, Hazira, and PY-3 - out of the eight blocks for which special audit was requested by MoPNG.

We also subsumed a Performance Audit of Hydrocarbon PSCs, covering a sample of discovered/ pre-NELP Production Sharing Contracts and NELP PSCs.

The main objectives of the performance audit of hydrocarbon PSCs were to verify whether:
• The systems and procedures of MoPNG and Directorate General of Hydrocarbons (DGH) to monitor and ensure compliance by the operators and contractors of the blocks with the terms of the PSCs were adequate and effective; and

• The revenue interests of the Government (including royalty and Gol share of profit
netrnleum) were nrnneriv nrnterted and adenuate and effective mprhanicmc were in
position for this purpose.

Our audit scope covered a twin approach:
• Scrutiny of records at MoPNG and DGH in respect of a sample of 20 PSCs so selected as to provide a balanced coverage of (a) onshore and offshore (shallow and deepwater) blocks

(b) a cross section of operators (c) fields with oil discoveries and gas discoveries (d) pre-NELP and NELP and (e) blocks at different stages of E&P — under exploration, relinquished, discovery, production etc.; this covered the period
from 2003-04 to 2007-08.

• Supplementary scrutiny of records of operators of four blocks/ fields (KG-DWN-98/3,
Panna-Mukta, Mid & South Tapti and RJ-ON-90/1) covering the two year
period 2006-07 and 2007-08.

Our audit was, however, interrupted due to difficulties in obtaining access to the records of operators for supplementary scrutiny, which were later resolved

Despite our repeated efforts, the Panna Mukta Tapti Joint Venture (PMT JV — joint operators BGEPIL, RIL, and ONGC) did not provide important and relevant records on the ground that scrutiny of these records did not fall within our audit scope, which was limited to accounting records in terms of the PSC provisions.

The PMTJV also did not respond to the majority of our preliminary observation memoranda, on the ground that the issues raised therein were outside the scope of audit rights envisaged in the PSC.

We do not agree with the views expressed by the PMTJV. In our opinion, the records sought by our audit teams (in particular the procurement-related records) were fully covered by the PSC, and access to such records was essential for the purpose of our scrutiny. Consequently, our scrutiny of records of the Panna-Mukta and Tapti fields was incomplete, as also the findings arising therefrom. After the issue was raised yet again in June and July 2011, the PMT JV furnished part of the relevant records in July 2011, and assured that they would furnish the relevant records shortly.

The records furnished recently by them as well as the records, in respect of which assurances have been received, will be covered subsequently, and findings arising therefrom included in subsequent audit reports.

Comments on Audit Scope by Operator

The operator of KG-DWN-98/3 block challenged the scope, extent and coverage of our audit at various points of time, indicating that the CAG had conducted a "performance audit", which was not permitted under the PSCs. It was stated that nothing in the PSC permitted an audit of the operational, commercial and technical decisions of the operator. Further, an exercise, whereby the auditor would step into the shoes of the operator and attempt to evaluate whether the decisions by the operator—taken within his authorized area of operation—were in accordance with some undefined norms or the processes adhered to by bureaucratized decision making processes and that too without having the advantage of access to technical expertise or having the accountability for implementing such projects, was clearly beyond the provisions of the PSC.

We do not agree with the operator's views. In our opinion, our scrutiny was entirely consistent with the provisions of the PSC. Further, verification of charges and credits relating to the contractor's activities and other documents considered necessary to audit and verify the charges and credits, is not merely limited to an arithmetical totaling of charges and credits or tracing of charges/ expenses from the accounting statements to the contracts/ expense vouchers.

Such an exercise would extend to verifying whether the costs being depicted in the PSC accounts by the contractor, which would critically affect the determination of profit petroleum and Gol's share therein, are correctly determined, and in particular, costs incurred for procurement of goods and services are determined through a competitive process, so as to minimize costs (and ultimately maximize the Gol share of profit petroleum).

Such verification does NOT amount to the auditor stepping into the shoes of the operator and evaluating such decisions in accordance with "bureaucratized" decision making processes as stated by RIL.

Our objective remains restricted to verifying whether Gol's revenue interests (including impact on current/future Gol share of profit petroleum) are properly protected.

As stated earlier, we did not intend to, nor have we conducted a performance audit of the activities of the operators. Audit also wishes to firmly emphasise that all our enquiries and findings emerge from, and are limited to the PSC.

We do not profess to go into any procedure or policy related aspects leading to the conclusion of the PSC. Taking the PSC as given, we have merely examined the contractual obligations of the signatories to the contract, viz., the Government and the private contractors. Our findings are totally guided by the "written word" of the contract.

In its response, MoPNG (July 2011) has agreed that the scope of audit conducted by the
CAG is within the common audit parameters, and that financial/accounting audit also
envisages review of activities and resources contributing to financial events and the
controls thereon.

Main Findin s

KG-DWN-98/3 (Operator: RIL)
The KG-DWN-98/3 block, which is operated by RIL, was awarded in the first NELP round in the year 2000. It has India's largest gas discoveries (Dhirubai-1 and Dhirubai-3 gas fields) and also has a large oilfield discovery (MA oilfield). Our main findings and recommendations relating to the KG-DWN-98/3 block are as follows:

Non-relinquishment of area and declaration of entire contract area as discovery area
We found that the contractor was allowed to enter the second and third exploration phases without relinquishing 25 per cent each of the total contract area at the end of Phase-I and Phase-II as against Articles 4.1 & 4.2 of PSC. Subsequently, in February 2009, Gol also conveyed approval to treat the entire contract area of 7645 sq.km. as 'Discovery Area', thus enabling the operator to completely avoid relinquishment of area.
'Discovery Area' is defined in Article 1.39 of the PSC as "that part of the contract area about which, based on discovery' and results obtained from a well or wells drilled in such part, the contractor is of the opinion that petroleum exists and is likely to be produced in commercial quantities". The delineation of 'discovery area' is inextricably linked to results obtained from wells drilled and finding of petroleum deposits recoverable at the surface (which can be discovered only through drilling of successful wells). At the end of the Exploration Phased, the operator had drilled all wells - in the north-west part of the block only.

The sequence of events between April 2004 and February 2009 clearly demonstrates that: • Originally DGH did not agree (May 2004) to RIL's proposal (while preparing to proceed from Exploratory Phase-I to Phase-II) for not relinquishing any part of the contract area (at the end of Exploration Phase-I) and reiterated the PSC contractual provisions for relinquishment of 25 per cent at the end of Phase-I (even identifying "least priority" areas 'Discovery' is defined in Article 1.38 as 'the finding, during petroleum operations, of a deposit of petroleum not previously known to have existed, which can be recovered at the surface in a flow measurable by conventional petroleum industry testing methods'. for consideration for relinquishment). DGH, further, stated that none of the existing discoveries extended beyond 'priority area-I', and no well had been drilled in 'priority area-II', and hence it was not possible to consider the total block area as the discovery area.

• However, by April/ May 2005, DGH capitulated. While noting that there were "no two
different interpretations possible as far as the definition of discovery provided in the PSC",

DGH felt it would be "prudent to acquire and interpret the 3D seismic data in the remaining part of the block on a fast track basis". Subsequently, "the relinquishment area could also be worked out in a proper manner". In the meanwhile, RIL had already moved from Phase-I to Phase-II without any area relinquishment, and was notifying its intent to move from Phase-II to Phase-Ill, again without any relinquishment.

In August 2006, DGH informed MoPNG that the Management Committee (MC) (chaired by DGH representative) had, in July 2006, permitted the contractor to enter the next phase without relinquishing any area, since data showed "continuity of discovery" in the block area (on the basis of RIL's presentation based on the results of seismic data acquired).

• Thereafter, there was extensive correspondence between MoPNG and DGH from August 2006. MoPNG raised pertinent questions as to whether the coverage of wells was over the entire block for DGH to reach the conclusion of discovery extension, but failed to pursue this aspect further.

• By April 2007, MoPNG felt that the proposal might be considered on getting a certification from DGH that the whole area had been covered by a reasonable number of wells/ 3D seismic to substantiate continuity of channels and the extent of discovery area. DGH gave a certificate in May 2007 to MoPNG.

• Even in May 2007, internal notes of MoPNG indicated their awareness that the whole of the block had been provided as a discovery area on the basis of 3D seismic and not on drilling of wells, which were mainly confined to the NW part of the block. However, MoPNG now proposed that on the basis of the proposed discovery area, the operator should be asked to appraise the area as per appraisal-related PSC provisions.

After concerns expressed by the then Minister, PNG as to whether the decision sought to be ratified was consistent with the PSC provisions, the case was referred to a committee under the chairmanship of Additional Secretary, MoPNG. The Committee accepted the contractor's claim (February 2008) and decided (April 2008) that the timeline for appraisal of discoveries would commence from 11 July 2006 (viz. MC's acceptance of the contractor's claim).

This was finally approved by the Minister in July 2008, but communicated to DGH only in February 2009. RIL's views at different points of time (that the contractor was "of the opinion that petroleum was likely to exist", "the contract area was having hydrocarbon potential", "ultimately additional exploratory wells needed to be drilled to establish the additional hydrocarbon potential in the deeper water area of the block for which they were making efforts to hire ultra-deepwater rigs" clearly attempted to confuse potential/ prospectivity with actual discovery of hydrocarbons. Their difficulties in hiring ultra-deepwater rigs for the deep water area of the block (essentially the SW part, where no discoveries had been made) had no linkage with the contractual provisions for discovery area and relinquishment.

Thus, RIL's proposal of April 2004 to not relinquish any area and retain the whole contract area as 'discovery area' was submerged in a sea of correspondence between RIL and DGH, without relinquishment action being taken in terms of the PSC provisions, while RIL was allowed to proceed from phase to phase. By April/ May 2005, DGH had "waived" its earlier objections, and now advised/ directed the operator to complete 3D seismic data. By July 2006, DGH completed its about-turn and agreed (through the MC) to the contractor's proposal. MoPNG was aware of the flaws in the MC's decision for retention of the entire area, but, instead of reversing the same (in line with PSC provisions), it chose to accept DGH's certification for such retention.
MoPNG gave a detailed reply (July 2011) regarding acceptance of operator's opinion by DGH and MoPNG. We, however, do not agree with the reply as allowing the contractor to retain entire block area as discovery area was not in compliance with PSC provisions. The reply of MoPNG and our rebuttal thereof are given in detail in Chapter 4.

We recommend that MoPNG should review the determination of the entire contract area
as 'discovery area' strictly in terms of the PSC provisions. Further, it should delineate the
stipulated 25 per cent relinquishment area at the time of the conclusion of the 1'` and 2nd
exploratory phases, and then correctly delineate the 'discovery area' strictly based on the
PSC definition, linked to well or wells drilled in that part, without considering any
subsequent discoveries (which would be invalid on account of non-compliance with PSC

Discovery related issue

In violation of PSC provisions, in the case of 13 out of 19 discoveries between October 2002 and July 2008, the operator had, without first furnishing the initial particulars of the discoveries in writing to the MC and Government, directly given written notifications regarding potential commerciality of the discoveries.

MoPNG replied (July 2011) that in the beginning, systems and processes were not fully
established, however, over a period of time, the procedures had now been strengthened, and were being strictly followed for subsequent discoveries as per PSC requirement.

D1-D3 gas discovery

The operator submitted an "Initial" Development Plan (IDP) in May 2004 (with estimated
capital expenditure (capex) of US$ 2.4 billion). The IDP was followed up with an Addendum to the IDP (AIDP) in October 2006 (estimated capex of US$ 5.2 billion for Phase-I and US$ 3.6 billion for Phase-II).

We found that:

• Most procurement activities were undertaken late in line with the schedules of the IDP of May 2004. By contrast, activities in respect of items in the AIDP were initiated even before the submission/approval of the AIDP. Clearly, the development activities of the operator were guided by AIDP, rather than IDP.

• As indicated by the operator, advance action was taken to tie up vendors for timely
development of D1/D3 fields in anticipation of the MC approval of the AIDP. While a view could, perhaps, be taken that such pre-approval action is at the risk and cost of the
contractor, in reality, this increases the probability of such approvals becoming a fait
accompli. Since approval of estimates does not constitute acceptance of the cost projections of the operator, validating the cost incurred by him can be done only after audit of the actual cost through proper norms. Part of the expenditure in respect of individual items under AIDP incurred during 2006-07 and 2007-08 has been audited. Remaining expenditure incurred from 2008-09 onwards will be covered in future audits.

Procurement-related activities
We found that payments during 2006-07 and 2007-08 revealed instances of huge procurement contracts where we could not derive assurance as to the reasonableness of costs incurred, primarily due to lack of adequate competition — award on single financial bids; major revisions in scope/ quantities/ specifications; post-price bid opening; substantial variation orders - with consequential adverse implications for cost recovery and Gol's financial take.

In particular, regarding the MA oilfield, we found that well before submission, let alone
approval, of the Field Development Plan (FDP) and Mining Lease (ML) application, the operator had placed orders for various critical items required for development activities/ production facilities from 2006 itself. We also found serious deficiencies in the award, on a single financial bid, of a 10 year hiring contract for US$ 1.1 billion for a Floating Production, Storage and Offloading (FPSO) vessel from Aker Floating Production (AFP).

During our scrutiny of the operator's records, we have come across instances, where multiple vendors were pre-qualified. However, when technical bids were received, all vendors (except one) were rejected, and the contract was finally awarded on a single financial bid. In our opinion, such disqualification of vendors on technical grounds, after a pre-qualification process and bidders' meetings for technical clarifications, limits the competitiveness which is not in accordance with the spirit of the procurement procedure given in the PSC. In many cases, it resulted in no competing financial bids, and the contract was awarded on the basis of a single financial bid. In such a situation, the letter and spirit of the MC's role at the pre-qualification stage is vitiated. Consequently, in our opinion, in cases of procurement (under procedure 'C' — high value contracts), where pre-qualified bidders are subsequently disqualified/ declared non-responsive on various technical and other grounds and there is only one financial bid being considered, the Operator should either go back to the pre-qualification process, and ensure
that more vendors/ parties are pre-qualified. Alternatively, if the operator wishes
consideration of only a single financial bid, the matter has to be necessarily referred back to the MC (including Gol representatives)/ Gol for ex ante relaxation from PSC stipulated
procurement procedures. Post facto approval of the MC may be provided for in emergent
cases, with adequate justification.

Likewise, extension of contracts (beyond the extension periods already stipulated in the
contract) is not in consonance with PSC provisions. If the operator wishes to extend such
contracts, the matter has to be necessarily referred back to the MC for necessary relaxation.

We, therefore, recommend that in the case of the KG-DWN-98/3, MoPNG carefully review in depth the award of 10 specific contracts (of which 8 were awarded to Aker Group companies) on the basis of a single financial bid. In this recommendation we are not even remotely suggesting that the operator should follow government procurement
procedures, yet any commercially prudent private acquisition would also attempt to
generate competition and thereby obtain the most competitive price. Such concern for a
cost effective acquisition is not perceptible in the aforementioned process.

Reality views by sm –
Friday, September 09, 2011

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