COMPLEXITIES OF REGULATORY FRAMEWORK ALTERNATIVES
By Gamal Shaban
Investments in Egypt’s oil and gas sector have remained fairly weak over the last few years. This reality emerged not only because of the nation’s high political risk and unstable economic situation, but also because some legal aspects within Egypt’s oil and gas regulatory framework failed to grant both the international oil companies (IOCs) and the privately-owned oil and gas companies the rights that they were seeking.
Egypt has been struggling with maintaining a reputable relationship with its foreign oil and gas investors in the recent years, amidst its increasing domestic energy demand. Even though the Ministry of Petroleum and Mineral Resources has been continuously boosting the nation’s energy output and offering various attractive onshore and offshore international concession bid rounds, IOCs have been having their doubts before entering in any of these concession agreements with the Egyptian government.
The Egyptian government has adapted a new legal framework already in 1973. It decided to give up the tax/royalty system in regulating the concession agreements and follow Production Sharing Agreements (PSAs) instead. The production sharing agreements that are widely known as equal sharing agreements were concluded between one of the three official entities – the Egyptian General Petroleum Corporation (EGPC), the Egyptian Gas Holding Company (EGAS), and Ganoub El Wadi Petroleum Holding Company (GANOPE). The government proclaimed that PSAs have thus reduced the pressure on the state budget and promised better outcomes for the foreign investors. Simply, the PSAs were perceived as a win-win scenario.
Yet, almost 50 years later, the international oil and gas firms operating within the Egyptian market are struggling under the PSAs provisions. They are unable to collect their payments, acquire better rates of return, earn their production shares, and expand within the sector. International exploration and production (E&P) companies and energy firms may perceive the existing legal system in Egypt as inefficient as it fails to secure their payments.
In light of the current unfavorable development in the market, ongoing debates in the industry advocate for modifications of various aspects within the contemporary oil and gas legal system. Such a move would help Egypt entice the private-owned and international oil and gas companies to expand their investments in the country, hence, enhance Egypt’s domestic productivity, generate more revenues, and balance the country’s economic situation.
PSAs Grant Government Control
The PSAs are to bring in foreign firms to explore and exploit the reserves, which would balance out countries’ lack of relevant expertise or technology needed to execute such operations. All of the current concession agreements in Egypt are issued under the PSA contract scheme.
The PSAs enable the government to have better control over the strategic industry and the state gets to continuously supervise the operations and approve the accounts, thus better regulate the market. Previously, under the tax royalty system, the government had no upper hand over the operations, as it enabled the contractor to work as a private business and only pay taxes over the volumes produced. Representatives from the Egyptian government along with some officials from the privately-owned oil and gas companies believed that the PSA system is a lucrative alternative to the former tax royalty system. In 2015, the Deputy Assistant CEO for Agreements at EGPC, Nasser Wali, told Egypt Oil&Gas that “PSAs are the best model agreement for countries like Egypt, as according to the country’s mineral resources law, all the country’s mineral resources belong to the state.” Yet, the situation might have changed since last year, as Samir Abdelmoaty, the then-Country Manager of Beach Petroleum, the company that was recently sold to RockHopper, told in an exclusive interview with Egypt Oil&Gas. In his words, while “production sharing agreements is a good working model for deepwater (offshore) projects, tax royalty payments offer a good alternative as well, and so does technical service agreement.”
It has become clear that the PSA system poses certain limitations and constraints and may need to be reviewed. Most important aspect of PSAs is that they necessarily place all the financial risk on the investors’ shoulders in regards to exploration and production operations, according to Nagy Iskander, an independent oil & gas consultant. Instead, and especially during the period of depressed market, the financial risk should be shared on an equal basis with the state, as he suggested in an article published by Daily News Egypt in April 2016. Therefore, Iskander proposes to shift from Production Sharing to Tax/Royalty regulatory framework, in particular in the gas sector.
Other alternatives, as Abdelmoaty further explained, should also be taken into consideration as “these will mitigate cost recovery mechanism problems and speed the approvals.”
Time-Consuming Cost Recovery
Egypt’s legal system has not successfully secured the foreign investors with their rightful cost recovery. Under the concession agreements as defined by the PSAs system, the contractor is entitled to gradually recover all the costs and expenses that are attributed with the operational activities at the concession area, in terms of earning around 30-40% of the produced oil and gas, Ahmed Haggag and RehamEissa wrote in The Oil and Gas Law Review, published by Gideon Roberton, the law company.
On the subject related to gas agreements, expert Nagy Iskander further mentioned that “since extraction of deep-water gas under high pressure and high temperatures is capital intensive, accounting for billions of dollars, it is expected that the cost recovery share would be high in the early years of production, reaching 70-80%, in order for the foreign investor to generate an acceptable rate of return.” However, he further argued, the percentages offered under Egypt’s current legal system are insufficient for the foreign investors.
In addition, the process of earning the cost recovery approval is hectic and time-consuming. Upon entering any agreements “the foreign partner already estimates that 10-15% of the amounts disbursed will not be recovered” as Iskander stated.
In an exclusive interview with Egypt Oil&Gas, Partner at Sharkawy&Sarhan Law Firm and an oil and gas legal expert, Ahmed Haggag, affirmed that earning the cost recovery approval is definitely a lengthy process in Egypt. He noted that “this [cost recovery] is one of the main areas that I have seen oil and gas companies struggling in. Usually the EGPC becomes very conservative when it comes to approving the costs incurred by contractors.”
He further explained that the EGPC views some entries or some expenditure that is incurred by the IOCs within the price quota as unnecessary activities, which are not required for production. Based on his own experience, he said: “I have seen lots of disputed entries whereby EGPC states that this entry or this expenditure was not necessary and they [the foreign parties] have already done it – thinking they will recover the cost anyways.”
Therefore, EGPC is reluctant to issue cost recovery approvals. In response, the IOCs then tend to apply for a competence hearing with the EGPC in order to discuss how expenses, incurred in the statements, were necessary for either exploring or producing. This type of disputes usually lasts for a longtime beyond the agreed upon timeframe.
In principle, Ahmed Haggag added that he has never witnessed “a smooth cost recovery process in Egypt.” He believes that it is more of an accounting related problem. He believes that this requires further efforts from the officials to make it a well-ordered process instead.
Another risk that various IOCs have faced in Egypt is collecting their rightful dues from the government on time. Even though the PSAs in Egypt are considered virtues of law, therefore payments and re-payments are protected and upheld by national law, the arrears to IOCs are not being secured.
In mid 2014, for instance, the total dues that the Egyptian state owed to IOCs reached an all-time high of over $8 billion. They were later reduced to $3.4 billion in the first quarter of this year and in August 2016, the Egyptian Gas Association (EGA) reported that Egypt’s oil and gas sector’s foreign debt stood at $3.2 billion in total. The attempts by the government to straighten out the bills with IOCs appear critical, as some companies already announced to have paused their operations, over the repayments gaps.
The Germany-based RWE company has frozen its operations and development plans at its respective concession areas until the firm receives back its rightful shares of money and volumes of production in full. The move came in July 2016, when a total balance of late dues to be paid to the company reached $400 million. Furthermore, other companies, like the Norway-based Scatec Solar, have announced their plans to completely withdraw from the Egyptian market.
Limiting Market Growth
This implies a whole new risk for IOCs that is forcing IOCs to reconsider entering the Egyptian market. Legal expert Ahmed Haggag, who previously consulted major energy companies like RWE, Shell, KUFPEC, Merlon International, and IPR Group of Companies, said: “The main hot topic that all the oil and gas companies are worrying about, especially nowadays, that all the companies are aware that Egypt is having a general problem with the USD liquidity, is how to secure their payments. Most of the advice I provide now is on how to secure payments and how to negotiate a better payment mechanism with EGPC.”
While the main reason behind not paying the foreign investors is of economic nature, the failure to sooth the case in its entirety is an indicator of a weak risk management strategy within the existing PSAs system.
Therefore, the Ministry of Petroleum has been proactively working on insuring that all the agreements, contracts, and legal provisions are met and insulated from disruption to lessen the weight of risks attributed with investments in the Egyptian energy sector. Nonetheless, further measures and more efforts are to be directed towards introducing alternatives within the legal framework that would preserve the foreign investor’s payments rights, even in the absence of foreign currency in the country.
In a general analysis, these prerequisites of Egypt’s legal system seem to be limiting the country’s potential.
The above outlined legal and economic deficits suggest that new investors are hesitant about entering the Egyptian energy market. The competition and the expansion opportunities within the Egyptian oil and gas market are restrained. As it appears, only the existing exploration and production (E&P) companies, that have former experience from Egypt and maintain relationships with the three governmental bodies, become active players.
Alternatives at Hand
In order to overcome the lack of incentives over the agreement framework, Nagy Iskander, propose that the tax/royalty system may be revisited to potentially replace the PSAs scheme. “If the tax/royalty system is introduced [again], many large- and mid-sized E&P companies will work hard to penetrate the Egyptian market, given their knowledge and experience with this system worldwide. This will result in more competition in the Egyptian market, and will reduce investment risks, which could be balanced against projected revenues,” he argued. This is, however, only one of possible solutions.
In attempt to design another alternative, some legal experts reflect on deficiencies that cut across different segments. Ahmed Haggag believes that one of “main challenges that we are having here is bureaucracy; the EGPC, being a governmental authority, sometimes tends to be a bit bureaucratic, one obvious example is with the cost recovery process, and also with handling the operations with the contractor under the joint ventures, and this can create deadlocks.” Therefore, minimizing the level of bureaucracy may enhance government’s negotiations with IOcs. It will lead to faster decisions and thus grant the IOCs with more flexibility and speeded results.
Other argue that the PSA might be the right system for the government to follow after all, as it gives it more control over its concession areas. Nonetheless, the system would require further modifications from the government’s side to minimize the levels of risk that foreign investors consider ahead of entering any new market.
The Egyptian government has been insistently trying to come up with new oil and gas market regulations that appear more enticing in the eyes of the foreign investors thus may help attract further investments. However, the change has not yet materialized even though the feverish discussion in the industry is bursting. As Samir Abdelmoaty noted, “we talked about the pending amendments [to agreement structure] on different occasions, such as at the last roundtable at the Egypt Oil&Gas annual convention. But the change would have to come from the government’s side.”
To date, there still remain crucial aspects to urgently address with regard to the legal framework. Egypt’s lawmakers and government official may, therefore, seek to swiftly amend the rules and regulations regarding the exploration and production sharing costs, the cost recovery processes, and energy market competition. This would need to come in line with economic growth that would minimize foreign currency fluctuations and thus guarantee country’s capability to pay off its foreign debts. There is no other way for Egypt to be able to overcome its energy and general economy crises, to regain its previous achievements, and to become an energy exporter once again