Don’t kill the goose…

The extended gestation period is finally over and the Government of India has taken a decision on allowing the transfer of its stake in Cairn India by Cairn Energy to Vedanta. What is disquieting about the decision is the manner in which the issues relating to royalty and cess are sought to be dealt with. As far as royalty payments are concerned, the approval has been made contingent on royalty being cost recoverable from the revenues from the producing oilfield. This was a condition that ONGC, in particular, had been insisting on before it would consent to the transfer of holding interest from Cairn Energy to Vedanta. The other condition laid down is that Cairn India would withdraw arbitration proceedings in respect of cess payable on production from the fields in the Rajasthan block.
Press reports on the issues relating to payment of royalty by the contractor repeatedly refer to a “historical policy anomaly” in the decision to exclude royalty payment from the fiscal regime of upstream petroleum contracts of that time. Since this does not bring out the true picture as to why private investors were exempted from royalty payments under contracts signed in the Fourth Round of bidding (under which the Rajasthan block was awarded), certain clarifications are in order. Royalty was a component payable by the national oil companies, ONGC and OIL, under the administered pricing mechanism in existence for the public sector oil producing companies. Right from the mid-1980s, when the Third Round of bidding for exploration was launched, policy makers recognised that private foreign investment would be attracted only if the risk-reward package was such as to offset the rather lukewarm perception regarding the prospectivity of exploration acreages in India. The Fourth Round continued this policy of government extracting revenue from production only after the private contractor had recovered a major portion of its investment in exploration activities and development of petroleum discoveries. Consequently, royalty was excluded from the fiscal terms to which companies were subject. It was hoped that early recovery of costs by the private bidder would serve as an inducement to attract private companies (both Indian and foreign) to invest in exploration activities in India. Given the balance of payments position in 1991 and the desperate need to accelerate oil and gas exploration efforts and augment oil and gas production at that time, the decision to exclude royalty as a component of the fiscal package was an appropriate decision if private investment, especially foreign investment, in this sector was to be realised. It is unfortunate that we tend to forget the critical foreign exchange position at that time and the energy crunch that required bold measures to increase oil and gas production through private investment.
There remains the issue of ONGC being asked to foot the entire royalty payment on production from the Barmer block, although it is, firstly, only a 30% stakeholder in the block and, secondly, as a constituent of the contractor, is not liable for any royalty payment. As this is an onshore block, royalty would accrue to the Government of Rajasthan and there is no likelihood that the State Government would forego an important source of revenue. The issue then really boils down to whether the Government of India would work out an arrangement to compensate ONGC for the royalty paid by it on behalf of the contractor to the State Government. Under the Fourth Round, the Government of India would share in the profits from production after recovery of costs by the contractor. At average oil prices of US$ 80 per barrel, the Government of India stands to make about at least US$ 25 per barrel over the life of the oilfield. Royalty at 12.5% (US$10 per barrel) would still leave a considerable surplus with the Government of India after compensating ONGC for payment of royalty. It is, therefore, eminently feasible for the Government of India to reimburse ONGC for the royalty paid by it and still make a handsome return from the block. The option being reported in the press of royalty payments by ONGC being made recoverable from the contract costs is inappropriate, both from the viewpoint of the economics of the venture and the implications for investor confidence. Any alteration in the fiscal terms will affect the returns to the private investor. There is no reason why the private investor should forego returns promised to it under the PSC. There is also the issue of such a change in the PSC being introduced at the stage of production. Any such move would seriously undermine investor confidence in the sanctity of contracts entered into with the government.
It appears that Cairn India has gone into arbitration over the issue of payment of cess on oil produced from the block. Since we are not privy to the signed PSC, it is not possible to comment on this issue, save to say that the provisions of the PSC would definitely have a bearing on the outcome of the arbitral proceedings. However, to make the withdrawal of arbitration claims a precondition for approving transfer of ownership in Cairn India smacks, to say the least, of an element of compulsion – not the best way to continue to attract private investment in this sector.
When India embarked on the upstream petroleum exploration rounds post-1991, one of the major concerns of foreign investors was the slow pace of and inconsistent decision making in the Indian government. Twenty years later, if the same concerns continue to dog investors, the impact on private investment would be adverse. Recent NELP rounds reveal a rather lukewarm response and if investor apprehensions are not addressed, we may see a further slide in investor response in future rounds. In fact, such an approach of the government in one infrastructure sector could well have an impact on investment in other sectors as well. If we want the goose to continue laying golden eggs, we must ensure that we do not kill the goose.

2 responses to this post.

  1. well said sir and only people who were involved with attracting independents such as Cairn can appreciate. given that our track record to attract private participation from integrated oil companies is average, this will send out the right signal. best wishes


  2. Posted by Gokul Chaudhri on August 12, 2011 at 9:00 am

    I endorse the view being expressed. In addition to the policy and contractual terms being undermined, the decision of the Government reflect how it is in a postion of conflict as a regulator for the sector and a financial stakeholder of the royalties. Effectively the prosecution and the judge! In additon, the PSC allows for dispute resolution mechanism and there is a functioning judiciary, and this too has been undermined. The claims of ONGC needed to be addressed correctly thru these dispute resolution and judicial mechanisms.


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