By Fatma Babayeva

This article discusses the main concepts of Azerbaijan’s Production Sharing Agreements (PSAs), which regulate the legal, commercial, and fiscal relationships between the government of Azerbaijan and International Oil Companies (IOCs). It explores the reasons behind Azerbaijan’s preference of this type of contractual arrangement, the historical setup for PSA contracts within the country, and their economic peculiarities and anomalies from a legal perspective. It also touches on some dark Azerbaijani PSAs and implications that appear during the implementation of PSA contracts and points out problem areas needing reform.

After the collapse of the Soviet Union in 1991, a new set of oil- and gas-producing countries emerged in the Caspian basin, including Azerbaijan. Hydrocarbon resources of Caspian countries have become a key force for attracting huge amounts of foreign investment and a leading mechanism for their political and economic development. The dominant contractual form for exploiting and developing oil and gas fields in these countries, including Azerbaijan, has been Production Sharing Agreements (PSAs).

During the 1990s, newly established littoral states in the Caspian Sea region lacked not only the capital, but also the necessary technical expertise and skilled labor, to efficiently exploit their natural resources. Their economies were weak; transition from a centrally planned economy to capitalism and economic crises after the dissolution of the Soviet Union made it hard to afford the modern infrastructure necessary for the realization of new oil and gas projects. All these factors made them unable to apply types of production contracts other than PSAs that could be more beneficial to them as host countries.

An involvement of foreign capital and expertise is only necessary in the exploration and exploitation stages (once production starts, foreign companies become more expendable). In the meantime, IOCs also need to recoup their costs and ensure profit from the projects in which they make investments. PSA contracts are typically structured to reflect this time inconsistency issue. Most energy PSAs cover long-life projects and if any amendments to a contract are suggested by a host country, they will be challenged under arbitration and risk the loss of future investments. Host countries also need to prove their reliability if they are looking for further foreign investment or future loans from international financial organizations and banks.

As for Azerbaijan, despite many worries about the possible shift of leverage and the global economic recession, windfall revenues from high oil prices in the 2000s did not lead to an imbalance between the host country and international oil companies. Azerbaijan has never attempted to revise or change its oil policies or nationalized/quasi-nationalized oil assets (mainly because of its strong economic and political interests in maintaining the presence of Western oil companies in the country). Only recently, the country proposed to renew a contract on Azeri-Chirag-Guneshli offshore oil fields, with consent of foreign partners. Before discussing specific issues about the Azerbaijani PSAs and their nature, let us have a closer look at the major deals that Azerbaijan concluded and compare them to other types of contractual arrangements used for exploration and development of oil and gas fields.

History of Azerbaijan’s Oil and Gas Contracts

In the early 1900s, Azerbaijan was the center of the world oil industry, producing half of the world’s output. However, in the second half of the twentieth century, the situation changed and oil production in Baku stagnated as Soviet oil investment focused on Siberia.

Liberalization and perestroika in the 1980s USSR created certain opportunities for foreign investment, especially in the natural resources of the Soviet Union. This attracted the attention of transnational oil companies. After a break of 70 years, representatives of foreign firms began visiting oil-rich regions of the Soviet Union, including Azerbaijan.

In Azerbaijan, the Chirag and Azeri deposits, discovered in 1985-87, and the existence of already-developed oil-industry infrastructure caught the interest of foreign companies. In January 1991, the Soviet government announced a tender on Azerbaijani deposits, as a great amount of investment and new technologies were needed to explore fields located in the depths of the Caspian Sea. An American company, Amoco, won this tender, but the Azerbaijani government decided to bring other companies in line as well (Unocal, BP/Statoil, McDermott and Ramco) and to create a consortium that would carry out technical feasibility studies and prepare draft contracts.

After Azerbaijan gained independence, the new government continued negotiations with foreign companies on the joint exploration of oil fields, but power changes that in May 1992 and June 1993 delayed the negotiation process. Finally, on September 20, 1994, Azerbaijan signed its long-awaited “Contract of the Century” with a consortium of foreign oil companies, creating the Azerbaijan International Operation Company (AIOC). The consortium was focused on the joint development of the deepwater portion of the merged Azeri, Chirag and Guneshli (ACG) deposits. The consortium of foreign oil companies, which consisted of BP, Amoco, McDermott, Pennzoil, Exxon, Statoil, Ramco, TPAO, and Lukoil, committed to invest $7.4 billion in these three major offshore oil fields over thirty years. Upon ratification, the Azerbaijani Parliament received a $150 million payment, with a further $500 million signing bonus to be paid on ratification and agreement of a pipeline route. The National Oil Strategy was articulated with the following components: technology provided by foreign oil companies, multiple transport routes, accumulation of managerial expertise, and investment in sustainable development.

Figure 1: Interest share of companies upon conclusion of the Contract of the Century Source: Bagirov S. 2007

Nevertheless, new shareholders replaced some of the initial participants of the project over time. Currently, shares of the ACG project participants are as follows: BP – 35.8 percent; SOCAR – 11.6 percent; Chevron – 11.3 percent; INPEX – 11 percent; Statoil – 8.6 percent; ExxonMobil – 8 percent; TPAO – 6.8; percent, Itochu – 4.3 percent; and ONGC – 2.7 percent.

Although the negotiations for developing the given fields were started long before contracts were signed, only the current government of Azerbaijan was able to bring them to fruition and reap the revenues.

Despite Russian objections, political instability within the country, and the conflict with neighboring Armenia over the Nagorno-Karabakh, the signing of oil and gas contracts continued.

In the 2000s, huge investments were made by foreign firms to develop new Azerbaijani gas fields: SOCAR and BP signed a gas PSA in July 2010 for the development of the Shafag and Asiman fields. SOCAR, Total and Gaz de France signed a PSA in 2009 for the development of Absheron field, and a PSA for the Shah Deniz field, the largest gas field in Azerbaijan and the 9^th largest in the world (with reserves of about 1.2 tcm), was signed by a consortium of companies, composed of lead operator BP, Statoil, SOCAR, Lukoil, Total, NICO, and TPAO.

The creation of huge pipeline projects westward, that avoided Russia as a transit country (such as the Baku-Tbilisi-Ceyhan Pipeline and South Caucasus Pipeline), enabled Azerbaijan to decrease its traditional dependence on its powerful northern neighbor and to reinforce its independence, further promoting its geopolitical interests by converting its energy resources into a diplomatic tool.

How Do PSAs Differ from Other Types of Oil and Gas Contracts?

There are four basic types of contractual arrangements commonly used for oil and gas exploration and development: concessions, production sharing agreements, service contracts, and joint ventures. The difference between them lies in the level of control given to foreign contractors over operations and production, the level of government involvement, and the share of the revenue between foreign contractors and the government.

Concessions were the first type of oil contracts put in use and have different names depending on a country’s legislation; such as “permission,” “license,” or “rent”. In concessions, the company extracting hydrocarbon reserves in the territory of the host country owns the extracted resources.

In comparison, PSAs give more power to the host government over controlling the extraction of hydrocarbon reserves. However, how the host government chooses to exploit its energy resources (public and private ownership, state control, or lack of control) is also a crucial determinant. Even the same type of agreements may differ from contract to contract, depending on the contractual terms agreed between host state and foreign firms. Taxonomy provided by some researchers shows that the outcome in Russia (licenses with domestic private ownership) and in Uzbekistan and Turkmenistan (PSAs with state ownership and control) is superior to that in Azerbaijan (PSAs with state ownership and foreign operational control), and Kazakhstan (PSAs with foreign private ownership) is worst of all.

The first PSAs were introduced in Indonesia in 1966 and then spread globally to all oil-producing regions, with the exception of the Western Europe. PSAs are distinguished from other types of contracts in two ways: first, the foreign firm or contractor provides all technical and financial services for exploration and development operations and bears the entire exploration risk. If no oil is found, the firm receives no compensation. Second, the host government owns both the resource and installations provided by foreign company and bears no risk. It shares potential profit without having to make a direct investment. PSAs have changed over time and taken different forms in different host countries.

PSAs usually have the following properties:

• The foreign contractor pays a royalty on gross production to the government
• After the royalty is deducted, the contractor takes pre-specified share of production for cost recovery
• The remainder of the production, referred to as “profit oil” is shared between the host government and the contractor at a stipulated rate
• The contractor has to pay taxes on its share

Cost recovery is the most attractive component of the PSAs since concessions do not offer recovery for sunk costs.

Nevertheless, PSA contracts contain some drawbacks as well. There is an asymmetric information issue during the negotiations process in which the operating firms have a better idea ok the magnitude of the upfront costs and may overstate these in negotiations so that they recoup more money before the state starts to take a larger share of the revenues. Moreover, if the state fails to specify environmental and work safety obligations or other responsibilities related to the negative externalities in the contract, then the contracting party may not be obliged to spend money on these issues. Sometimes, the state negotiators may even be aware of such discrepancies in the contract, but may turn a blind eye and sign off on the contract for a bribe.

Disagreements over contracts often lead to demands for renegotiation, resulting from the increase in profitability of the natural resource, issues related to the taxation of the foreign firm, or issues related to the cost recovery and split of revenues between firm and host government. This is especially true when oil prices are high. In practice, however, the actions of the state are severely constrained for renegotiation by contractual terms and the risk of losing future FDI. It is better to establish contract provisions in order to determine when or in which cases terms on cost recovery can be renegotiated.

In addition, the profit splits between foreign firms and nations depend on the involvement of domestic companies; if domestic companies are part of the exploiting consortium, then more revenues accrue domestically.

Another type of contractual arrangement for oil and gas exploration and development is the joint venture (JV), which originated in the United States – a model proposed by the American Association of Petroleum Landmen. In JVs, an operator takes sole control of the exploration and exploitation operations supervised by an Operating Committee that is composed of co-venturers who have votes in proportion to their stakes. Under JVs, the host government and foreign operating company have direct ownership of the project (including equipment and facilities) for oil and gas production. During the 1990s, the Azerbaijani government replaced JVs with PSAs due to the economic crises, a lack of modern infrastructure, and considerable need for foreign funding to exploit its hydrocarbon reserves.

Specific Features of Azerbaijani PSAs

Azerbaijan is represented by the State Oil Company of Azerbaijan Republic (SOCAR) in domestic PSA contracts. Initially, SOCAR had a minority stake in all operational Azerbaijani PSAs, but since the signing of the “Contract of the Century,” SOCAR signed more than 30 PSAs with AIOC. Now, let us look at specifics of PSA contracts signed by Azerbaijan.

Except for the Contract of the Century, all Azerbaijani PSAs on deposits in the Caspian Sea agree on three terms: the period of exploration (about three years), the additional period of exploration (ranges from one to three years), and the period of development and extraction (is 25 years for most contracts). Only three contracts have different extraction periods: Azeri-Chirag-Guneshli and Shah Daniz deposits – 30 years, and Nakhchivan deposit – 35 years. However, the parties can extend the term of the contract if they are interested or new reserves are discovered in the contractual area. During the exploration period, the contractor makes annual per-acre payments to the Azerbaijani government.

In accordance to the PSAs, Azerbaijan owns all the resources and installations, but, unlike PSAs in other countries, the foreign contractor does not pay royalties to Azerbaijan, but does pay tax on profits between 25 and 32 percent. Azerbaijani PSAs have the following features: “(1) Operator recovers its costs at a pre-specified percentage of gross production; (2) after cost recovery, profits are distributed between the contract partners as per the PSA; (3) most PSAs also involve substantial bonus payments; (4) with regard to new capital, a PSA is a flexible agreement whereby if the Azerbaijani and international partners mutually agree, a new participant can enter the PSA; (5) the PSA provides investors with protection against changes in legislation”.

The fiscal system of Azerbaijani PSAs is structurally based on the principle of profitability responsive to costs and recovery of investments, oil price changes, production profile, timing of payments, and contractual stability.

Cost recovery in Azerbaijani PSAs includes operational (current expenses for purchase of materials, fixed, and other operational expenses) and capital expenses (drilling expenses, expenses for equipment, platforms purchased, and pipeline). The cost oil (a portion of produced oil taken on an annual basis by the operator to recoup its exploitation expenses) available to cover operating costs is 100 percent. Additionally, it is necessary to know the price of oil to calculate what percentage of oil will go to cover those expenses. Capital costs must be recovered from no more than 50 percent of the remaining total production after operational expenses are taken. After operational and capital expenses are deducted from gross production, the remaining part of the so called profit oil is then divided between SOCAR (state share) and the foreign contractor. Profit oil is calculated according to the Real rate of return (adjustments resulting from inflation and other external factors) and the R-factor (ratio of the revenue to the expenses) in Azerbaijan. All calculations are made on a quarterly basis.

In Azerbaijani PSAs, the extracted oil is divided amongst partners before it is placed on the market in territory of Azerbaijan (i.e. the extracted oil is split at the points of delivery shown on the contracts). A standard PSA grants the contractor the right to freely sell or market the produced oil and gas.

In recent years, SOCAR’s share of revenues from PSAs has been increasing compared to the times when contracts were signed, as most of the cost recovery payments have already been made to investors.

In addition, bonuses have been another source of revenue for the state. PSAs usually contain signing bonuses (paid when the contract is signed), production bonuses (paid upon attaining a certain level of production), and discovery bonuses (paid on initial discovery).

All Azerbaijani PSAs include broad stabilization clauses that couple freezing with economic balancing. The Azerbaijani government bars the application of an adverse change in laws to investment contracts. In case of amendments to laws cause deterioration of the conditions for investment, the laws that existed when the investment was made continue to be applied for 10 years.

In all standard PSAs, Azerbaijan offers innovative mechanisms for the decommissioning of oil and gas installations and other fixed assets (like platforms, pipelines, wells, gathering facilities, jackets, etc.) through jointly opened escrow accounts at an internationally reputable bank – the so called “Abandonment Fund.” It envisages the transfer of the fixed and movable petroleum assets to SOCAR following the contractor’s recovery of cost or termination of the contract, whichever is earlier.

The indemnification clauses in Azerbaijani PSAs – meant for the case of expropriation of the contractor’s rights, interests, or property by the government – are also more broad than international standards. This is why future PSAs needs to reflect more reasonable compensation standards under international law, as well as forego underdeveloped reserves where a contractor has made no investment.

Regarding taxation, each PSA has its own separate tax regime. The contractor has to pay only the taxes outlined by the contract. Foreign oil and gas companies pay taxes via SOCAR. In other words, they do not have any direct contact with state tax authorities. Tax revenues are transferred to the Ministry of Taxes of Azerbaijan by SOCAR. The tax rate depends on the share of the foreign companies in the contract: 32 percent income tax for a share greater than 30 percent. If profits are reinvested, they are exempted from taxes. However, unlike those of most petroleum-producing countries, the PSA regime of Azerbaijan does not envisage a withholding tax on dividends or repatriation of profits sourced from Azerbaijan, and it disincentivizes IOCs to reinvest their profits. Introduction of such a tax in future PSAs may induce reinvestment of IOCs’ profits and boost a more efficient fiscal regime for contracts.

Yet the advantages of Azerbaijani PSA agreements are not limited by the above-mentioned ones. All Azerbaijani PSAs have import and export duty exemptions, no custom duty is applied, and there is a zero VAT system.

In accordance with Azerbaijani PSAs, contractors are required to submit annual work programs, together with relevant budgets, for the approval of the Steering Committee before the beginning of each calendar year. In case of failure of the work obligations, PSAs contemplate a series of legal implications. If a contractor fails to implement exploration and development programs during the scheduled timeframe, SOCAR has the right to unilaterally terminate the PSA agreement, excluding force majeure cases. In such an event, any costs incurred during the exploration and any bonuses are not recoverable.

Legal Status of Azerbaijani PSAs

Each PSA contract becomes a law of the Azerbaijani state, including contractors’ rights and interests. However, the contracts pass through different processes before coming into force. First, a PSA is negotiated between SOCAR and AIOC and then is passed on to the various government departments, which may suggest amendments. The contract then has to be ratified by the parliament before finally being signed by the president. Although it seems a rather cumbersome procedure, it has not been a deterrent for potential foreign investors.

According to Sabit Bagirov, former president of SOCAR, ratification of PSA contracts by the parliament (Milli Majlis) was due to the lack of an oil law in the country when the contracts were signed.

Azerbaijan currently lacks legislation specifically governing the oil and gas sector. The legal framework for the regulation of oil and gas contracts in Azerbaijan is supposed to be based on two acts: the Subsoil Act (February 1998) and the Energy Act (November 1998). Despite the fact that both provide a general framework for exploiting energy resources, their provisions clash with each other in many instances. It is also not clear if the Energy Act is superior to the Subsoil Act. Moreover, most existing PSAs do not meet the provisions of these acts. Although a draft law of oil and gas was submitted to the parliament, it was not adopted. Even if adopted, it was going to be applied to future PSAs, not to the ones that already existed. This law was meant to outline a procedure for concluding PSAs without the need for parliamentary ratification. “Perhaps, the government’s success in attracting foreign investment into the oil and gas sector has made it reluctant to adopt oil and gas laws that might have changed the existing PSA process polished over the years.”

The president of Azerbaijan signed a decree founding the Ministry of Industry and Energy (MIE) in 2001, in order to improve the preparation and implementation of state policy. SOCAR is charged with conducting commercial functions while MIE is assigned to non-commercial functions, such as preparing, negotiating, and implementing PSAs and other types of contracts on behalf of the government. However, in reality, MIE has been accorded only nominal responsibility for concluding PSAs. SOCAR is a contractor and has its own share in contracts. At the same time, it represents the government in these contracts. The company is interested in increasing its shares, which in its own turn might reduce the revenues of the Azerbaijani government. This situation exists because of a lack of law regulating the sector and SOCAR continues to have considerable power and influence. Furthermore, Azerbaijan also lacks a modern and independent agency that could set basic rules and procedures on oil and gas operations, pipeline and environmental regulations, and the establishment of tariffs.

Subsequently, PSA contracts in the country lack the control of atmospheric emissions. Existing PSA agreements were drafted with the development and production of crude oil in mind and treated natural gas as a byproduct. In order to regulate petroleum pollution, gas flaring, and venting, Azerbaijan needs to consider investment incentives coupled with environmental taxation measures, such as carbon taxes, emission trading, and capping in future PSAs.

When it comes to the status of PSAs within the Azerbaijani legal system, there are unresolved legal anomalies, as they have been drafted in the form of contracts between private partners but have been passed into law by the parliament. Nevertheless, one of the requirements of Azerbaijan’s constitution of 1995, regarding the enforceability of a law, is that a law must be officially published and has to be available to the citizens of the country, which is not the case. Only the contracts of two deposits (ACG and Shah Deniz) are available on the website of the AIOC. To date, no PSA’s text has ever been officially published, and this could mean that PSAs have technically never entered into force. According to Alum Bati, a legal advisor, these PSAs are in fact not laws but remain as contracts, which are given the force of law. It is possible the reason for the PSAs not being published is that they contain “state secrets,” but this is also not grounded, since, according to the Law on Normative Legal Acts of 1994, hydrocarbon reserves do not fall under the category of state secrets.

Alternatively, some experts view Azerbaijani PSAs not as laws, but rather international treaties. This approach would explain their ratification. Nevertheless, a question arises about how it is possible to have an international treaty between a number of private enterprises and one or more state oil companies (SOCAR, Statoil, etc.). Under the Law on the Conclusion, Execution, and Denunciation (LOCEDIT), adopted in 1995 by the Azerbaijan Republic, international treaties may only be made with foreign states and international organizations.

The legal nature of Azerbaijani PSAs is also characterized by some as a service contract whereby a contractor (IOC) provides E&P services to SOCAR in oil and gas fields in return for remuneration from a share of produced oil or gas as consideration for its services.

Thus, the current legal petroleum regime in Azerbaijan can be evaluated as a discretionary system scattered through a number of laws (on subsoil, energy, foreign investment, taxes, land, and the environment, just to name a few), where the terms of each PSA is subject to negotiation and agreement between SOCAR and IOCs.

On the other hand, it seems like the hybrid nature of Azerbaijani PSAs does not bother foreign contractor parties. Either SOCAR misrepresented that contracts are in compliance with the constitution, legal formalities, and procedures of the Azerbaijan Republic, or contractor parties have been willing to overlook the fulfillment of certain formalities since the treatment of PSAs as law provide them with certain protection that an ordinary contract would not.

Azerbaijan Renewing the Contract of the Century

Not long ago, SOCAR decided to renew the Contract of the Century after 22 years since its signing. In May 2016, the company submitted final proposals to its foreign co-venturers on a new contract for the development of Azeri-Chirag-Guneshli (ACG) offshore oil fields’ block, and is currently waiting for their answer. The ball is now in the court of the IOCs.

The signing of the new PSA agreement is expected to take place in September 2016, which will annul the previous contract signed for a period of 30 years before reaching maturity and extend joint development and production works in the given fields for the next 25 or 30 years, on the basis of mutual consent amongst partners. The new contract will go through ratification process in the parliament and be signed by head of state as well.

The act should be considered the continuation of the previous PSA, with new terms rather than amendments. In accordance with the new PSA, Azerbaijan’s share in oil profits will continue from 80 percent, not to start over again from 30 percent, as the country will make investments itself this time. In return, foreign partners will take responsibility for the application of cutting-edge technologies and systems for constructing new platforms, achieving more effective extraction of reserves located in the contractual area, and more precise measurement of geological layers.

With this new contract, Azerbaijan creates an environment for foreign companies to invest in its oil fields, which are getting old. On the other hand, prolonging the already existing contract before it matures is also in IOCs’ best interests, as they are sure about the existence of real reserves in the contractual area and there is almost no risk involved for them. Every energy company desires to have stable production in the region, with which it is already familiar.

Dark Azerbaijani PSAs

Usually in rentier states, politically connected business interests benefit tremendously from their control of lucrative fields, especially in the oil and gas sector. Three PSA contracts ratified by the Azerbaijani parliament in 2009 were shrouded in mystery and neither SOCAR nor MIE informed the public about these PS’s and the involved oil companies. It was the first time that PSA contracts were signed in secrecy and without the usual pomp in Azerbaijan.

Some argue that information in these PSA agreements and participating new oil companies is intentionally kept undisclosed from the public and such an argument bolsters speculation among the general public that these oil companies, which were registered overseas, are indirectly owned or related to ruling elites.

These little-known new oil companies never seem to provide information on their activities or production interests. An oil expert’s research found that the mentioned PSAs were actually signed on the SOCAR premises on February 3, 2009 and that the public did not know about them for 104 days – until the contracts were submitted to the parliament. Two of these PSAs were concluded with a little-known oil company represented by a Russian citizen. Under the contract, SOCAR had only a 20 percent share, while the contracting company’s share was to be an 80 percent stake. This offshore oil company, Global Energy Azerbaijan Ltd., was registered in British Virgin Islands, has been kept secret to the public and the media, and continues to exploit 17 oil fields in Azerbaijan.

Main Policy Takeaways on Azerbaijani PSA contracts

Azerbaijan has established a stable and attractive environment for foreign investors. After the collapse of the Soviet Union, the government adopted strategies to ensure the legal protection and profitability of foreign investments. Foreign companies in the oil industry prefer countries that can offer political stability and predictable legal and regulatory frameworks. In the mid-1990s, the investment environment and fiscal regime created by Azerbaijan for PSAs offered more attractive terms than similar contracts in other Caspian Basin countries. Under these contracts, foreign contractors are exempt from paying royalties, value added taxes, excise duties, excess profit taxes, export duties, property taxes, and land taxes. Besides, the elimination of banking restrictions (including no restrictions on foreign bank accounts, payroll currency, and dollar withdrawals), the implementation of the international accounting system, the elimination of various government audits, and the application of international practices on labor laws, making Azerbaijani PSAs more attractive to potential foreign investors.

Most likely, PSA agreements will continue to be the main type of petroleum contract for Azerbaijan in the future. However, the governments needs to renegotiate its oil contracts to ensure more favorable terms for the country and increase revenue from its hydrocarbon reserves.

Fatma Babayeva

Fatma Babayeva is an MA candidate in the ENERPO program at the European University at Saint Petersburg. Fatma has a Bachelor’s degree in Translation/Interpretation and Linguistics (with honors) from the Azerbaijan University of Languages.

She can be reached at: fatma.akif@yahoo.com