Production sharing contracts

How do production sharing contracts work?

The state, often through a national oil company, grants a contractor, or a group of contractors, the right to explore an area. The contractor bears all exploration and development costs. If oil is found and produced, the contractor recovers its costs from a share of production, cost oil, usually limited to a set percentage of output each period, with unrecovered costs carried forward. What remains, profit oil, is split between the state and the contractor in agreed proportions, often on a sliding scale that gives the state more as production or returns rise. Many contracts also have royalties, bonuses and an income tax.

Production sharing contracts: cost oil and profit oil at two prices

A field produces 1,000,000 barrels in a year. The contractor has US$ 21 million of recoverable costs, cost oil is capped at 40% of production, and profit oil is split 40% to the contractor and 60% to the state.

At the higher price, fewer barrels are needed to recover the same costs, so the contractor's entitlement falls by 40,000 barrels, although its revenue rises. This inverse effect also applies to reserves: a contractor's entitlement reserves fall when price assumptions rise.

How does the contractor recognise revenue?

On the barrels it is entitled to and sells to customers, under IFRS 15, when control passes. Barrels belonging to the state, whether cost oil already used up or the state's profit oil, are not the contractor's revenue, even if the contractor physically lifts and sells them on the state's behalf. Where the contractor lifts more or less than its entitlement in a period, the difference is an imbalance settled in later liftings, recorded as a liability or asset rather than revenue. See overlift and underlift and joint operating agreements.

What if the state pays the contractor's income tax?

Some contracts say the contractor's income tax is paid by the state or national oil company out of the state's profit oil. If the contractor is the legal taxpayer, receives tax receipts and the tax is based on taxable profit, it is the contractor's income tax under IAS 12. The contractor then grosses up: it recognises revenue for the barrels used to pay the tax and an equal income tax expense. If the payment is in substance just part of the state's share of production, no gross-up is appropriate. Royalties based on volumes or revenue are not income taxes; a royalty taken in barrels simply reduces the contractor's entitlement. See royalties and petroleum taxes and IAS 12 income taxes.

How are signature and production bonuses treated?

A signature bonus paid to obtain the contract is a cost of acquiring the exploration right, capitalised as an exploration and evaluation asset or intangible asset. Production bonuses, payable when output reaches agreed levels, are usually capitalised as additional acquisition cost when they become payable, although some companies expense them; the policy should be consistent and disclosed. See IFRS 6 exploration and evaluation.

How are the contractor's assets and depletion measured?

The contractor capitalises its exploration and development spending as its own assets, even though title to facilities often passes to the state as they are installed, because the contractor controls their use and benefits through cost oil. It depletes them over its entitlement reserves, using its entitlement production, so the numerator and denominator are consistent. Unrecovered costs carried forward are not a separate receivable: they are recovered only from future production. See depletion and units of production.

What about service contracts?

Under a risk service contract, the contractor develops the field for a fee per barrel, paid in cash or in kind, and never owns the oil in the ground. Its income is revenue from a service under IFRS 15, and its costs may be a receivable from the state rather than oil and gas assets. Whether the contractor can report reserves depends on reserve reporting rules, not on IFRS. See oil and gas accounting.

This guide is general information. It is not tax or legal advice for your situation.