Risk Mitigation Using Joint Venture Agreement in the Upstream Petroleum Industry

The concept of risk and Joint venture in the petroleum industry is a common phenomenon and has evolved over the years basically because of the peculiarity of the industry and the environment in which it operates. Risks extend to geological circumstances like the size of the discovery, topography of the proposed oil fields and the location of the field (onshore or offshore).

Recent innovations have made possible for oil and natural gas extraction in deep waters which before time had been quite difficult. The risk involved is quite enormous and can only be matched by a viable prospect or a field with great potential, sufficient enough to generate positive economic rents.

Others include oil and gas prices, regulatory and legislative changes, fiscal (tax) policy changes including the increased cost of compliance, depletion of new discoveries or replacement reserves, operational hazards like injuries, spills and blow outs, inaccurate reserve estimates, extreme weather conditions, environment restrictions and regulations, reduction in demand for oil and natural gas, competition from alternative sources of energy, increased operating cost, inadequate or unavailable insurance coverage, inadequate liquidity or access to capital, shortage of rigs, equipment and personnel, uncertain energy policy, worsening and supply and demand shocks etc. Joint venture businesses and agreements are more inclined towards resources, cost and reward sharing and its introduction into the petroleum industry has been adopted by both International oil companies (IOC) and National oil companies (NOC) as a negotiation tool to implement exploration and production

. 1. 2MOTIVATION – CONCEPTUAL FRAMEWORK In the light of the fundamental and background issues above, specifically the potential impact of the risks and uncertainties in executing activities in the oil and gas industry cannot be ignored.

Taking a close look at the industry, it is easier to assume that International oil companies (IOC) and national oil companies (NOC) are not faced with the risk and as such the industry is seen to be thriving. However in an effort to diversify the risks identified, over the years oil companies have adopted methods to manage risks and maximise their gains by integrating and disintegrating activities along the supply chain line, having full knowledge of the prospects of an oil field before embarking on investments, initiating contractual relationships with national oil companies aimed at either sharing risks or obtaining incentives relative to unprofitable investments etc.

Some IOCs have signed contractual agreements indicating a form of partnership with explicit details of level of participation in potential oil field developments. The idea is simple, funds and resources are pooled together and combined interests are initiated in the investments such that anticipated cash flows, profits and incentives as well as risks, losses, fines and penalties are shared based on predetermined agreement. Thus the conceptual framework here is the extent to which these agreements can influence decision making relative to the existing risk and uncertainties on one hand and the participating firms’ ultimate goal of maximising its benefits to investors. 1. 3RESEARCH QUESTIONS

Throughout the study, the fundamental questions sought to be answered will include; * Why do Joint venture agreements exist? * Why are most joint ventures unincorporated rather than incorporated? * For potential new joint ventures, what are the incentives that encourage their start-up and how is the welfare optimization of all partners factored into agreements to avoid conflict of interest? * For existing joint ventures, how receptive should partners be to modifications in existing agreements by way of fiscal, political and economic changes? * What are the reasons for unsuccessful joint ventures and the possibilities of avoiding the failures? 1. 4SIGNIFICANCE OF STUDY

The research addresses itself to: Scholars – that they may gain valuable insight and improved knowledge of the risk profile of oil and gas fields and appreciate a modelling approach of how certain variables contribute to viability of the field; Investors – to assist toward building a diversified portfolio with investments in an optimal mix of oil and gas fields while trying as much as possible to reduce potential losses from investments; Independent oil and gas companies – to provide differing and alternative options for embarking on development and production projects in the wake of limited capital and resources, and to have a background knowledge of the important elements (e. g. choice of venture partner) of a potential joint venture agreement; Policy makers and regulators – to identify reasons for joint venture failures and proffer potential solutions and recommendation on a case basis; Energy analyst – to appreciate a modelling approach of how elements of risks, investment, portfolio management and contractual agreements interplay to give an understanding of upstream development. 1.

5SCOPE AND LIMITATION The study will lay much emphasis on risk and joint venture agreements in the upstream sector of the oil industries as it affects project development. In order to streamline our valuation indices, revenue streams from crude oil (excluding gas) alone will be used. The implication is that the appraisal of the field development will be limited to income streams from the sale of crude oil. There will be two (2) case study reviews to illustrate risk and joint venture activities at the exploration and development phase. The purpose is to expand on the theoretical dynamics of risks and joint venture agreements using real life case analysis.

To demonstrate upstream project appraisal of joint venture projects, this study will adopt hypothetical indices relative to the oil prices, tax and fiscal system, capital and operating expenditures, reserves, field life and weighted average cost of capital. The rationale behind the estimates, the underlying assumptions as well as their limitations will be discussed in CHAPTER 3. A royalty plus a corporate tax system will be used as a tool to determine governments take from each oil field. This will help to demonstrate in our model, the impact of unanticipated fiscal adjustments and also ensure that government take is directed at the output. The model will involve the development of 8 hypothetical oil fields, equally divided into onshore and offshore.

From these fields the following (3) scenarios will be modelled separately and each result compared and discussed in line with the research questions and aim of the dissertation: Scenario1: Interest in the 8 fields is shared between a single IOC and the host country’s NOC (i. e. 2 Joint venture partners) and the IOC have the entire investments in its portfolio. The investment appraisal will measure the viability of the entire project from the point of the IOC. Scenario 2:There are multiple Joint Venture Partners (i. e. NOC and several IOC interests). The appraisal will be from the standpoint of an IOC with differing interest in each field while the aggregate position of the IOC across the 8 fields will be measured and discussed. Scenario 3:An improvement on Scenario 2 indicating capital budget allocation.

The proposed IOC above has joint venture investment options across the 8 fields and certain budgeted capital expenditure to which to maximise the company’s wealth. 1. 6OUTLINE OF DISSERTATION Chapter 2: This will begin with understanding the risk and investment issues in the upstream petroleum industry and an introduction into joint venture agreements, a review of the types of agreement and the reasons behind venture relationships. A critical review and assessment of two real case studies – a successful and unsuccessful joint venture will be discussed with an aim of highlighting the risks discussed earlier and the impact of joint venture activities at identifying and managing the risks.

Chapter 3: The data and methodology required to develop the model from which to demonstrate joint venture agreements and operations on the upstream development projects will be specified. The relevant parameters and assumptions to help validate the model will also be specified. Results of each of the 3 case scenarios by way of charts and diagrams will be included in the chapter. This will also include results of the sensitivity analysis. Chapter 4: The result from chapter 3 will be discussed extensively in this chapter and the three scenarios will be compared in line with the aim of the dissertation. The limitations of the parameters used for model will also be discussed.

Chapter 5: The dissertation will be concluded in this chapter by bringing together all the information gathered from the study. It discussed the implication of the case studies in line with the models. We revisit the risk issues in the upstream with the intention of identifying future risk diversification strategies like real options etc. CHAPTER 2LITERATURE REVIEW & CASE STUDY 2. 1BACKGROUND Knowledge will be drawn from existing literature on Joint venture and the oil and gas industry with emphasis on risk profile, investment decision-making and investment appraisal in the upstream sector. The literature review is structured to focus on explaining theoretically, the research questions clearly stated in chapter 1. 2. 2JOINT VENTURE – AN INTRODUCTION

In the upstream industry, it is extremely rare for a single company to execute an exploration and production activity by itself. The general norm is via Joint venture and partnerships. Venture alliances have received increased attention since the 1990s and have seen oil companies on a search for new ways of doing business in order to increase performance. The hostile and difficult economic environment has further ensured companies are not far from this objective. Furthermore, joint ventures have opened up opportunities in many countries especially where exploitation has been restricted to national companies (Jenkins 2000). The concept involves two or more companies operating together by pooling their asset or properties for a limited purpose or time (Hardy 2002).

Burrows (2011) citing the case between United Dominion Corporation Ltd v Brian (1985) defined it as “…an association of persons for the purposes of particular trading, commercial, mining or financial undertaking or endeavour with a view to mutual profit, with each participant usually (but not necessarily) contributing money, property or skill”. 2. 3TYPES OF JOINT VENTURE There are several forms of joint venture but the legal classification falls into three (3) (Abduljaami 2011): * Contractual Joint Venture * Corporate Joint Venture * Unincorporated Venture Contractual joint ventures are good choices for one-off and short term business agreements.

Usually set to terminate within a short term future date, it requires no form of legal registration or formal dissolution procedure to terminate and is applicable when very few assets are involved. Corporate joint venture requires that a new corporation be set-up which will be separate and independent from the businesses of the participating companies. The new company will be used as a tool for driving the business and does this by itself (Hardy 2002, Abduljaami 2011). Unincorporated joint venture is quite similar to the corporate joint venture because it also requires the establishment of an entity. It however differs based on the type of entity as unincorporated joint venture exists in the form of “limited liability Company”.

Burrows (2011) describes it as “an association of participants” lacking form and equity capital. This is common in upstream oil and gas development and the reason will be discussed below. 2. 4CHOICE OF JOINT VENTURE Hardy (2002) distinguished between the two latter types of joint venture and the rationale for each. The incorporated JV oversees its activities via the appointees on the board of directors and the new company levies its partners for expenses and projects cost while their percentage interest are reflected in their shareholdings. Upon completion, the assets are distributed or sold to the Joint Venturers. The fact that unincorporated JV does not use a separate entity translates to them operating as partners.

In fact both forms of JV are assumed to be disguised partnership since the law provides that any form of relationship that subsists between persons carrying a business in common with a view to making profit is a partnership (UK Partnership Act 1890 c39. ). The purpose of this is to make the parties liable for each other’s action. As a limited liability partner or limited liability company the extent of the liability of a venture partner is limited to the amount invested in the business by the unincorporated venturer. Corporate JV who have legal issues have each co-venturer fully liable to the JV creditors (Abduljaami 2011). This has been seen to be a major reason why most oil company joint ventures are unincorporated. 2. 5JOINT VENTURE RELATIONSHIPS IN THE OIL INDUSTRY

Traditionally, most joint ventures exist in the upstream industry (Hardy 2002) and were usually between two major international companies focused on exploration and production in particular geographic areas (Jenkins 2000). Examples of these existed between shell and Exxon in Northwest Europe, Chevron and Texaco in Southeast Asia and BP and shell in Africa (Jenkins 2000: Yergin & Stanislaw 1993). The previous belief about JV is that partners refuse to cooperate and thus behave as an independent entity. Usually there is an operator in the JV while others work independently, though keeping checks on activities of the operator to ensure their shareholders interest are protected. This is because the shareholders are divergent in their separate interest.

However in recent times, the new style of working is that a joint team drawn from staff from all venture partners are integrated into a supporting role (Jenkins 2000). An exploration and production venture between contemporary oil companies includes pooling of acreage holdings and contracts to take part in specific license rounds in individual countries. The basis for this according to Jenkins (2000) is to “enhance financial capability and risk sharing”. Another benefit includes gaining synergy from harnessing individual partner skills and complimenting each other’s capability. At some time, a strategic venture between BP and Statoil specifically defined the countries to jointly participate in seeking exploration ventures.

The venture sought to ensure risks are shared between the partners and also to benefit from partners expertise and political influence; a number of successful projects were traceable to this arrangement. Other joint venture agreements that has successfully been executed and still exist include; Chevron-Schlumberger venture in the California Lost Hills field in 1990, Lasmo-Schlumberger venture in the Dacion field in Venezuela, Andrew Well Venture in the North sea which included, BP, Schlumberger, Baker Hughes, Transocean and Santa Fe. The Hibernia venture in Canada had Mobil, Chevron, Petro-Canada, Norsk Hydro and Murphy led to HMDC (Hibernia Management Development Company Ltd) (Cameron et al 2000).

The success of the upstream joint venture is usually a function of the relationship between partners aimed at arriving at a “win-win” situation for all partners. On a field basis, this will include benefits from reduced field development costs, enhanced well production, improved resource optimization, lower learning cost and reduced cycle time (Cameron et al 2000). This study is focused more on how JV can be used as a tool for risk mitigation in the upstream industry; therefore discussion about the relationship between partners is excluded. However the extent of cooperation between the partners cannot be discounted at achieving a successful venture. 2.

6RISK ANALYSIS OF THE UPSTREAM INDUSTRY Anderson et al (1981) defines risk and uncertainty as “… a situation in which one has no knowledge about which of several states of nature has occurred or will occur…” while Humphreys and Berkley (1985) further breaks down the components of uncertainty as the lack of ability to affirm with confidence an act or event sequence, a future preference or action, or an ability to influence future e events. In a brief explanation of risk, Lathrop and Watson (1982) described it as a potential for adverse consequences. Exploration and production of oil and natural gas require huge capital expenditure and involves numerous risks.

It is subject to natural hazards and other uncertainties some of which are related to the physical characteristics of oil or natural gas fields. Exploration activities involve numerous risks including the risk of dry holes or failure to find commercial quantities of hydrocarbons (Van Vactor 2010). In a high profile, capital intensive, resource driven project like the upstream industry, there is little tolerance for the potential impact of not thoroughly accessing the risk and uncertainties of an exploration and development project. In very realistic settings, risks and uncertainty constitute a key impediment to successful capital investment and decision-making (Simpson et al. , 2000 and 1999; Lamb et al.

, 1999; Ball and Savage, 1999; Watson; 1998; Murtha, 1997; Newendorp, 1996; McCaskey 1986; Corbin, 1980). Smith (1997) in his report on future opportunities and challenges of the upstream oil and gas industry in the 21st century agrees emphatically that the upstream oil and gas industry is founded on uncertainty and risk. He related most of the risks to declining reserves, environmental challenges and competition from alternative sources of energy, oil prices and technology and geographical frontiers amidst various reasons. Kemp (1988) highlighted the risks at the development stage as development cost risk, oil price risk, political risks and reservoir risks. 2. 6.

1OIL PRICE RISK: Economists argue that prices are generally determined by the forces of demand and supply, but a deeper analysis of current trend as depicted by Vactor (2010) reflects high fluctuation and unpredictability in oil prices beyond the impact of demand and supply. This has been complimented by unstable political events in the Middle East and Caspian region, changing economic growth in Asian countries like china, revised resource assessment and consumer reactions all of which are quite difficult to forecast. The attention brought about by volatile oil prices has increased in recent years, even Hamilton (2009) suggested that price was a contributing factor to the recession between 2007 and 2009. Characterising the relationship between investment and prices has been difficult with no precise consensus emerging.

Skjerpen, Ringlund and Rosendahl (2004) tried to explain the relationship by reviewing why supply has not responded strongly to higher prices in recent times and this led to observing seven (7) important regional differences in supply elasticities. Cathsassus, Collin_Dufresne and Routledge (2005) paper which was mostly concerned with modelling of oil price behaviour revealed empirical findings which supported the notion of “lumpiness and non-linearity in oil investment” relating it to the impact of fixed adjustment cost. By modelling oil prices as a regime-switching process, the model was able to confirm significant features of oil prices (e. g. backwardation).

Furthermore, the impact of oil prices is very important in investment appraisal since majority of the income streams is determined by the prevailing oil prices over the life of the project, thus the need to adopt a forecasting approach for future prices. The IDB 2010 confirmed that the oil price volatility in the last 4 years to 2008 was a credible reason for sluggish investment activities by oil producers despite some periods having persistent high prices. Once an investment has been made, the price risk becomes a constant unavoidable companion. 2. 6. 2POLITICAL/REGULATORY RISK: These are adverse circumstances suffered by IOCs and can be linked to decisions made by the host government. This occurs by way of expropriation, state intervention, lack of legal clarity, and unanticipated alteration to existing regulations and agreements (Daniel et al, Kindle Edition, and Marsh (n. d. )).

The ideal purpose of regulations amongst other things is to manage the way the natural resources are extracted and produced and this differs by location or countries. It is normal for IOCs to prefer counties with stable political and legislative system and also generous long term lease agreements; however some investors still invest wherever the oil and gas is despite the location not matching their preference. This may lead to sudden nationalisation or frequent regulatory changes by the government especially when the capital has been invested. Furthermore countries characterised by political restlessness and upheaval poses security issues to staff and operations of the companies, thus there is an important need to consider the political situation prior to operation by any IOC.

Kemp’s (1989) manuscript on “Development of National Policies towards Oil and Gas Exploration in the UK and their Effects” sited three conditions under which these political risks materialises; * When certain discontinuities exist in the business environment * When the discontinuities above are difficult to anticipate * When the discontinuities result from a political change Taking the UK for example, oil price increases in the late 1970s from $14 to $39 was followed by rising adjustment in the UKs petroleum and fiscal regime when the SPD (Supplementary Petroleum Duty) was introduced in 1981. This is an example of a discontinuity brought about by unstable oil price.

Some countries with recent political upheaval include Liberia, Nigeria, Libya and Egypt on the African continent. 2. 6. 3GEOLOGICAL/RESERVOIR RISK: Oygard (2005) describes this as an evaluation of geological factors critical to discovering and recovery of commercial quantities of hydrocarbon by relating probability of discovery to the probability of reservoir, a trap mechanism, a hydrocarbon charge and retention of hydrocarbon after accumulation. The easy to get reserves have either been fully extracted or still being extracted and thus exploration and production activities have now been focused on less friendly environments usually by way of a platform in the center of a surging ocean (Beattie 2012).

The totality of geological risk is not limited to the difficulty and challenges of extraction but also includes the possibility that recoverable reserves in a field may not be commercial or perhaps a well may be a dry hole. 2. 6. 4ACCESS TO AVAILABLE RESOURCES: An interesting characteristic of oil distribution is that the biggest deposits are far from population centers Vactor (2010). Once located, it is usually a distance from the market. The BP statistical review 2012 shows that the current world proven reserves is distributed as follows; Middle East – 48. 1% , South and central America – 19. 7%, North America – 13. 2%, Europe and Asia – 8. 5%, Africa – 8% and the Asian Pacific – 2. 5%.

Recent estimation confirms that 75% of global proven reserves are in the control of national oil companies thus making them gatekeepers of world’s oil supplies (Jessen 2008). The implication is that both the NOCs and the IOCs now compete for reserves and this constitutes a threat to the latter. 2. 6. 5ENVIRONMENTAL RISKS: The importance of tackling environmental risks is becoming a more central issue for oil industries and regulators. The process of petroleum extraction carries adverse environmental impact on a regional and global scale. These includes, oil spills, volatile organic compounds, air pollution and soil surface and ground water toxicity (Kharaka & Dorsay 2005).

In a bid to regulate these activities, governments have factored in certain environmental standards into the contractual agreements with investors. International environmental community is always alert to wade into potential issues that come up from exploration and production activities (see case study). 2. 6. 6COST RELATED RISK: All other risks are assumed to fit into the cost implication of any project. Both operational and capital costs greatly influence the potential development of oil fields. The upstream capital cost index measuring cost inflation in oil projects has increased by 79% since 2000 (Vactor 2010). Inability to manage and control costs will undermine the competitiveness of oil companies. Burdensome regulations and difficulties with drilling make projects more expensive.

Oil companies still struggle with shortage of qualified manpower required during boom times and are sometimes required to pay more to retain existing workers (Beattie 2012). All these costs have made the industry capital intensive thereby reducing the number of players. Other risks include, demand and supply shocks, inflation, exchange rate, climate concerns, uncertain energy policies and competition from renewable energy sources. (Jessen 2008). 2. 7RISK DIVERSIFICATION – SYSTEMATIC & UNSYSTEMATIC RISK Brealy & Myers (2007) recommended diversification as a means to reduce the risk profile of a portfolio. Introducing it as a strategy designed to reduce risk by distributing the portfolio across a wide range of investments. The risks were divided into “systematic” and “unsystematic” risk. Ross et al (2005)

sums up the total risk of any investment as the addition of its systematic and unsystematic risk and further defined systematic risk as “…any risk that affects a large chunk of assets, each to a greater or lesser degree…” Also referred to as a market risk brought about by economy wide (macroeconomic) sources and affects the overall industry. The unsystematic risk known as the unique risk is usually related to specific investment or project and has peculiarities attributable to the investment alone (Brealy & Myers 2007). The fundamental aim of diversification is to eliminate the unique risks or unsystematic risks some of which are listed as exploration risks, reserves, recovery, production, drilling and operations (Kemp 2012). Chart 2. 1: Chart distribution of systematic & Unsystematic risk: Adapted from Kemp (2012) Chart 2. 1: Chart distribution of systematic & Unsystematic risk: Adapted from Kemp (2012)

The market risks are brought about by macroeconomic indices like inflation, crude oil prices, foreign exchange, material and resource costs etc. , and cannot be diversified. Figure (2. 1) shows that the level of the systematic risk remains constant for every combination of portfolio (i. e. any accumulation of investments in oil fields) while the unsystematic risk reduces up to the point where it is entirely eliminated and the investment has only the systematic risk to deal with. 2. 8UPSTREAM RISK AND PROJECT EVALUATION Sequel to identifying the risk factors and understanding how to diversify them, the viability of a potential joint venture development project is important otherwise the purpose of the venture will be defeated.

Appraisal techniques commonly used at the development stage include the use of NPV and IRR which are discounting methods. The advantage they proffer is that they acknowledge the time value of money and consider all cash flows throughout the life of the project. The fundamental issue at this point is the choice of discount rate. The Weighted average cost of capital (WACC) usually an aggregate reflection of the forms of capital employed by organisations is usually adopted. But having justified the existence of certain risk factors, it is normal for investors to require a level of compensation for these risks (Newendorp 1996). Therefore oil risk preferences are usually

incorporated into the choice of discount rates such that the discounting is an addition of the opportunity cost of capital and a certain risk premium to compensate investors. The credibility of NPV as decision tool has been questioned severally. Michel (2001) criticised the assumption of forecasted cash flows adding that unanticipated variations are not accounted for by NPV. The choice of discount rate has been questioned as well. While some literatures recommend discount rates of similar projects having same risk profile (ACCA 2008, Kruger et al 2011), others lay emphasis on the capital structure or the average risk profile of the entire company portfolio (Brealy & Myers 2008).

However the latter does not consider potential changes to investors’ future capital structure and the fact that project with greater risk will be discounted by a lower discount factor. They have totally neglected the effect of diversification. In oil production terms when we assume an existing portfolio of oil fields with specific risks and an additional field project in a different country, having a political risk (e. g. Society upheaval) or economic risk (inflation or exchange rate), it is unprofessional to ascribe the existing risk profile of the portfolio to the new field since its own risk structure is different and investors might require a higher return on the investment.

Without a specific discount rate that portrays both the risk profile of the project and the capital structure over the life of the investment, the NPV is vulnerable to manipulations and thus, the viability of the project (Michel 2001). In recent times, sensitivity analysis has been used, where the NPV is examined after several simulations of a distribution of discount rate. 2. 9MITIGATING RISK THROUGH VENTURE AGREEMENTS Jenkins (2000) highlighted 4 potential forms of agreements and their peculiarities in managing risks. The first is in the form of technological ventures where partners set up joint industry projects (JIPs). Example is the alliance between Mobil, BP, Texaco and Chevron which was given the acronym “MoBPTeCh”.

The idea behind MoBPTeCh stems from the notion that the nature of technology in the upstream industry leads to rapid technology transfer and the competitive advantage is in being an early user. Furthermore a review of IOCs research and development programs shows that there is considerable duplication of work done. The implication is that more cost is being incurred and technological joint venture is a way to harness the individual efforts and thus accelerate the pace of innovation while utilising resources efficiently. The second venture exists solely for project development. We discussed the capital intensive nature of the upstream industry and its associated risk.

Stating that a key component of the venture agreement was the financial contribution of partners, Jenkins (2000) added that the implication is that partners enter a risk-reward sharing agreement that is structured to ensure alignment with objectives of performance. The third form of joint venture exists between oil companies and service companies. While the oil companies want an improved rate of recovery and production at a lower cost, the servicing company’s objective is to increase its p