Oil, Gas and Uganda’s Scramble for Foreign Direct Investment: How attractive is the licensing regime for upstream petroleum activities?

Introduction 

Uganda’s is presently touted as Africa’s next oil and gas frontier following the discovery of commercially viable quantities of oil and gas deposits in the Albertine Graben in 2006. Current estimates put the country’s oil potential at around 6.5 billion barrels, of which only 1 billion barrels are recoverable under the prevailing conditions.

The country concurrently developing an in-country refinery with capacity of up to 60,000 barrels per day and an East African crude oil pipeline with capacity of up to 180,000 barrels per day, hoping to receive first oil by 2022/2023.

Developing and commissioning this infrastructure to harness these resources is projected to cost several billions of dollars. To reap substantive benefits from its natural resources, a country needs to have a considered and proactive policy on exploration & production licensing. This can be based on rounds of competitive bidding by potential investors, both local and foreign.

The unprecedented scale of investment required is significantly beyond the reach of many domestic investors to play a leading role in the sector. Government also understandably allocates most of the limited resources towards social services delivery as well as recurrent expenditure on wages and salaries which impedes its ability to invest upfront in the sector. The only avenue left to raise the enormous capital required is foreign direct investment not only vied for by Uganda, but also other countries within the region such as Kenya, Tanzania and Mozambique which have also discovered hydrocarbons.

Inquiries by potential foreign investors about the preparedness of Uganda to facilitate the progression of the industry to the next level have constantly been emerging. In particular, there are concerns that Uganda’s licensing regime is not yet aligned to the customary practices of the global oil and gas industry .This publication attempts to find answers to some of these queries by specifically examining whether Uganda’s petroleum licensing regime is well suited to attract foreign direct investment to the oil and gas sector.

An Oil Rig on the banks of Lake Albert, Western Uganda.

Petroleum licensing framework

Following the discovery of oil and gas in Uganda , the government has been making countless efforts aimed at putting in place a robust legal framework to govern licensing and contracting of foreign oil companies to come and undertake exploration, development and production activities in Uganda’s oil and gas sector. These efforts have taken the form of the National Oil & Gas Policy of 2008, as well as the Petroleum (Exploration Development & Production) Act 2013. The Act goes on to provide for the development of a model production sharing agreement which would guide any agreements and negotiations between the government and any oil companies that wish to undertake exploration, development and production activities in Uganda’s oil and gas sector.

It was on this basis that the current model production sharing agreement was developed, approved and finally came into force in 2016.

How attractive is Uganda’s licensing regime?

Potential investors usually undertake a ground survey in any country they could potentially invest in, on which they base to assess how favorable it will be for them to invest and also the volume of returns they are likely to receive from investing in the country’s oil and gas sector. Below are some of the key aspects investors keep a keen eye on before making any investment decision.

Oil and Gas Economic Misfit

Investment protection under the Model Production Sharing Agreement

Prior to undertaking investment in developing countries, international oil companies seek assurance that the risk of unilateral and arbitrary changes in the law and investment agreements which can dilute the value of their project can be satisfactorily managed. Once the investment has been sunk, host governments more frequently renege on their earlier commitments and toughen the framework for petroleum operations by revising some licensing terms under the production sharing agreements, sometimes to the detriment of the oil companies.

This makes investors in the petroleum sector keen to include in their investment agreements stabilization clauses. The sole objective of the stabilization clause is to preclude the application to an agreement of any subsequent legislative or administrative act issued by the government or the administration that modifies the legal situation of the investor. Stabilization clauses may extend to any law that affects the economic conditions of the contract.

Economic equilibrium clauses are a commonly used form of stabilization clause. An economic equilibrium clause seeks to maintain the economic equilibrium of the project. Thus, where government enacts a new law, the investor would comply with the law. However, the investor would receive compensation from the government to defray the cost of complying with the law in order to maintain the economic equilibrium of the contract. In other words, the cost of complying with the change in the law is borne by the host state.

Another form of stabilization clause is the prohibition on unilateral changes. They are commonly dubbed intangibility clauses. The terms of the production sharing agreement may not be modified or abrogated except with the contracting parties’ mutual consent.

Some of the stabilization clauses in Uganda’s model production sharing agreement include economic equilibrium clauses and intangibility clauses. The agreement provides that if there is a change in the laws of Uganda which substantially and adversely alters the economic benefits accruing to the licensee, the licensee may within thirty six calendar months from the date on which any such change takes legal effect, notify government accordingly and thereafter the parties shall negotiate to agree upon the effect of the changes in law and the necessary adjustments to the agreement in order to maintain the economic benefit of the licensee which existed at the effective date of the agreement provided that the licensee complies with the requirement of the law at all times. This is an economic equilibrium clause. Furthermore, the model production sharing agreement is carefully crafted to bar any amendment, modification, variation or supplementation to the terms of the agreement between Uganda and international oil companies except by an instrument in writing signed by licensee and the government which shall state the date upon which the amendment or modification shall become effective. This is an intangibility clause.

From this, one can argue that Uganda’s licensing regime seems carefully crafted to take into account investors’ concerns in relation to investment protection. To this end, it can be concluded a suitable environment in so far as investment protection to attract foreign direct investment into the sector is created.

Uganda Oil and Gas Economic Misfit

Farm down of Petroleum interests

Farm down is the assignment of all or part of oil, natural gas or mineral interest to a third party for development. The third party called the ‘’farmee’’ pays the ‘’farmor’’ a sum of money upfront for the interest and also commits to spending money to perform a specific activity related to the interest. Given the high risk of failure in oil and gas activities, oil companies diversify interests as much as possible. Holding insignificant interests in several production sharing agreements rather than a significant interest in one production sharing agreement is prudent for oil companies. Diversification of these interests takes the form of assignments. Assignments provide the opportunity for big international oil companies to collaborate with smaller oil companies that could have already played a key role in de-risking the acreage in place but are constrained by resources and expertise to go it alone that the bigger players possess. Assignment of petroleum interests is done through farm-down agreements. Countries that place onerous requirements on assignment of petroleum interests can potentially discourage foreign direct investment in the sector.

Uganda’s Petroleum (Exploration, Development & Production) Act 2013 provides that the minister shall not unreasonably withhold consent to an application to transfer a license unless he or she has reason to believe that the public interest or safety is likely to be prejudiced by the transfer. The model production sharing agreement merely describes the procedures to be taken during assignment of interests.

It does not provide for any exemption from the application of transfer taxes on the assignment of interests. Gains arising on the direct and indirect disposal or assignment of petroleum interests are subject to income tax.

Previously, taxation of assignments brought about backlash from oil companies such as Heritage Oil, which believed that paying capital gains tax of over 400 million dollars on a farm down transaction was unfair. Even some of the issues that led to the meltdown of relations between Tullow Oil and the government of Uganda in 2019 were related to taxation of assignments. Government’s position was that Tullow Oil had to pay capitalist l gains tax of US $167 million on its divesture of stake to Total and China National Offshore Oil Company but the oil company was against this.

Industry pundits opined that taxing assignments is inconsistent with Uganda’s aspiration of attracting investment for oil and gas development. It has the potential to derail assignments, a key feature of attracting of foreign direct investment.

Royalty payments under the Model Production Sharing Agreement

Royalties represent a charge that is levied by the resource owner on the extraction of the natural resources. Royalties are favored by the government because they are easy to administer, collect and also provide a first tranche of payment as soon as production commences. Royalties are however unpopular with international oil companies and are criticized as insensitive to costs, front end loaded, not being related to the project profitability and with the potential to cause production to become uneconomic prematurely. International oil companies find royalties palatable only if they are designed in a manner that links them to profitability of the project.

Uganda’s model production sharing agreement sets out different royalty rates for the hydrocarbons produced. Royalties under Uganda’s model production sharing agreement are payable on the entire production not just on the incremental production. The highest royalties payable begin from 15% of gross total daily production where the production is higher than 40,000 barrels per day. Royalty rates in practice tend to range from zero to 20% but anything above 15% is considered as getting to excessive.

Uganda’s present royalty structure is not linked to project profitability which is the preferred position for oil companies but rather the entire production as a whole. It can potentially affect project economics which can deter foreign direct investment.

Cost recovery under the Model Production Sharing Agreement

Exploration and development expenses are typically borne by the oil company which forfeits the right to be reimbursed in the event discovery and development never occur.The international oil company pays a royalty on gross production if applicable. After the royalty is deducted, the company is entitled to a predetermined share of production for their costs known as cost oil. The remainder of the production dubbed profit oil is then shared between government and international oil company at a pre specified share.

Cost recovery is an ancient concept based on the principle of ‘‘the one who put up the capital should at least get their investment back.’’ Not all costs incurred by the international oil company are cost recoverable and in some instances the cost oil can be taxable. The commonest cost recoverable costs include unrecovered costs from previous years.

Countries typically place a limit on the amount of oil that can be taken as cost oil in an accounting year. This allows the government a guaranteed share of profit oil because a certain percentage of production will always come through in the profit oil split. However, the more generous the cost recovery limit is the longer time span for the government to realize its take .

Uganda’s model production sharing agreement sets out costs that a contractor can recover in respect of their petroleum operations consistent with the foregoing discussion and also prescribes indicative cost recovery limit. There is an annual cost recovery cap of 65% of each of the available crude oil and the available natural gas.

The cost recovery structure in Uganda seems to be consistent with what investors in the upstream oil and gas industry would expect to find on a comparative basis.

Allocation of profit oil under the model Production Sharing Agreement

Oil remaining after deducting royalties and cost recovery is referred to as profit oil or profit gas. Profit oil or gas is split between the contractor and the government, according to the terms of the production sharing agreements. While evaluating the attractiveness of the profit oil split, international oil companies will review the geological potential of the country and how it balances with the licensing terms and cost of doing business. For this reason, governments may not be entirely responsible for determining the appropriate division of profits and contract terms since oil and gas companies define what the market can bear. The split of profit oil in most countries ranges from just under 15% to 55% for the contractor.

The split of profit oil can be constant or based on a scale linked to cumulative or daily production rates. Some countries have progressive split systems linked to project profitability defined by rate of return or R- factors. Conventional production sharing agreements are criticized for their inflexibility in the context of changing costs and prices. They are ordinarily aimed at sharing production and not profit.

One way of introducing flexibility in the profit oil is through the use of rate of return and r- factors the effect of which is that effective government share increases as the project rate of return rises. R-factors connect the split of the profit oil to the investment payback ratio and this is defined as the ratio of the contractor’s cumulative receipts over the cumulative costs including the upfront investment.

Uganda’s model production sharing agreement provides that a party’s share of profit petroleum in any calendar year shall be calculated on the basis of the r-factor actually achieved by the licensee at the end of the preceding calendar year for the contract area.

To this end, Uganda is paying attention to the investors’ concerns for flexibility in the allocation of profit oil. Uganda has a cumulative split for profit oil or gas which increases with production. It can be argued that Uganda’s model production sharing agreement endeavored to address investors’ interests in the quest for foreign direct investment in the first licensing round.

Bonus payments under the Model Production Sharing Agreement

Bonuses also extract rent from the petroleum industry. Bonuses are paid to the government at various stages in the petroleum cycle. Signature and discovery bonuses are received prior to project development, whereas production bonuses are paid when production commences or reaches certain prescribed levels.

Uganda’s model production sharing agreement provides that when cumulative production in first reaches volumes of 50,000,000 barrels, the licensee shall pay to the government US $ 5 million as production bonus and thereafter on each additional 25,000,000 barrels, the licensee shall pay to the government a sum of US $3 million.

Bonuses are front end loaded. They are also not linked to project profitability. Whilst they provide the government with upfront revenues that are easily collected, they can discourage investment if excessive especially in marginal fields. Uganda’s bonus payments do not appear excessive to deter inflow of foreign direct investment at the moment.

Government participation

There are strong sentiments in resource rich countries that resource exploitation activities should not be left entirely in the hands of foreigners. For this reason, governments usually co-invest alongside the private investors as a means of asserting greater operational control and direction in the exploitation of petroleum. Excessive government participation is however not popular with international oil companies for a variety of reasons including the potential of reducing entitlement and the unwarranted government sway in technical and working committee meetings.

 

Government participation, however, carries risks. If the government bodies are not efficiently staffed as well as robustly supervised, there is the possible likelihood of slowing project development, decreasing the revenue accruing to the state as well as aggravating corruption.

Uganda’s Petroleum (Exploration Production & Development) Act 2013 envisages the option of the government participation through its state company the Uganda National Oil Company electing to take up a stake in the petroleum operations jointly with a licensee. The model production sharing agreement specifically provides that government or its nominee may elect to enter into a joint venture agreement with a licensee thereby allowing for state participation for no more than 20% and government shall inform the licensee of its decision in writing within 120 days of the receipt of the application for a petroleum production license. Uganda’s government participation whose rate does not exceed 20% does not appear excessive from the perspective of the international oil companies. This seems to be in line withwhat investors expect to find on a comparative basis. From this, one can conclude that a suitable environment in so far as government participation in the oil and gas sector is concerned is created.

Oil and Gas Uganda Economic Misfit

Local content in the Model Production Sharing Agreement

Very tough and restrictive local content requirements in the oil and gas industry can deter foreign direct investment. Local content is the value added brought to a host nation including its regional and local areas through the activities of the petroleum industry.

Strategies devised by most countries to secure local content include simple contractual requirements that favor the use of local goods and services, impose training obligations, preferential regulation and taxation for local industries over foreign companies. Contractual or legal provisions may prescribe that potential for technology is included in the bidding parameters and criteria for the acquisition of petroleum rights. Incentives may similarly be provided to foreign investors who invest their profits domestically as a strategy of anchoring local content.

Uganda’s local content requirements presently derive from contractual arrangements set out in the model production sharing agreement. Licensees are required to train and employ suitably qualified Ugandan citizens. These requirements are what international oil companies usually expect to find in any country framework for regulation of oil and gas activities.

From the above assessment, it is safe to say that Uganda’s local content requirements are not very restrictive to deter foreign direct investment.

Conclusion

Uganda’s Petroleum licensing regime treads the intricate and complex path of converging government objectives with those of the international oil companies. Oil and gas discoveries heighten population expectations of immediate economic prosperity which usually is not the case. Because of this pressure, government can be tempted to take an exceedingly short term view of maximizing revenue collection from natural resource projects.

The licensing regime adopted by Uganda is mindful of the global competition for foreign direct investment in the petroleum sector and largely reflect incentives and conditions that are aimed at attracting more investment to the sector. To the greatest extent the petroleum licensing regime of Uganda is favorable for foreign direct investment. The only strong drawbacks which have the potential to derail the inflow of foreign direct investment are; the unclear tax policy position on farm down transactions as well the royalty structure that is charged on production as a whole and not project profitability.

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