Risk and benefit sharing schemes in oil exploration

and production

Semyon Fedorov1, Maria Lavrutich1, Verena Hagspiel1, and Thomas Lerdahl2

Abstract
The volatile environment of oil exploration and production sets new challenges to
market players prompting them to explore new business models. In this paper, we
analyze a novel type of partnering in oil and gas operations, i.e. the risk and benefit
sharing schemes, that enable a field operator to bring third parties into the field
development process. We develop a valuation method to assess the feasibility of the
risk and benefit sharing schemes based on the real options approach and identify the
optimal contract policy from the perspective of both the oil company and the contractor.
We analyze two application cases where an oil company collaborates with a drilling
contractor and a FPSO leasing company to share risks and benefits resulting from the
oil field development. We incorporate an “exit” clause in the contract as an instrument
to provide flexibility for the parties to withdraw from the partnership as uncertainty
unfolds.
Our results show that the risk and benefit sharing schemes with embedded flexibility
have a potential to become an alternative form of contracting in oil and gas industry.

One of the main drivers of uncertainty for the investment in petroleum activities is the
maturation of the main exploration and production (E&P) areas in the world. New
discoveries in mature production regions are characterized by smaller sizes and
challenging technical conditions for development. Following another serious oil price
downturn in 2020 amid the COVID-19 pandemic, a wide range of oil companies
announced a reduction in their investment in new E&P projects. Many production
licenses that were awaiting a final investment decision were put on hold.
Petroleum activities are expected to be exposed to even more risks in the future, which
stem from, among other things, public pressure considering the environmental impact,
increasing emissions taxes and peak in global demand for fossil fuels. As Tidd &
Bessant (2020) argue, a volatile environment creates new challenges, which must be
identified and understood as opportunities. In particular they state that in such
conditions, decision makers can benefit from strategic flexibility, which includes
“modification capability, options-keeping capability and the ability to innovate a
business model”.
Among the solutions that can help oil companies and especially smaller ones to ensure
profitability of the hydrocarbon production in the future might be various novel
engineering, economic and contractual solutions. In this paper, we will focus on the
contracts that allow oil companies to share risks and benefits with their contractors.
Among these contractors are financial institutions, service and drilling companies,
license partners and other oil companies and suppliers. Through the risk and benefit
sharing schemes, they can get involved in the field development process with a
possibility to share costs, operational risks and future revenues with the operator.
Within a risk and benefit sharing agreement that we propose in this paper, the oil
company is responsible for a portion of capital costs only, while the rest is covered by
a contract partner. In return, the partner receives an incentive in the form of share in
future profit associated with oil production being sold in the market. We introduce a
method that allows to design a risk and benefit sharing scheme between an oil field
operator and its contractors. We analyze two different cases involving the risk and
benefit sharing scheme between different actors: 1) an oil company (field operator) and
a drilling contractor 2) an oil company (field operator) and a FPSO leasing contractor.
In both cases, we identify if there exists a fair (i.e. transparent and balanced) contract
that would be attractive for both the oil company and the contractor. We also consider
the regulator/government as the third party that must ensure that establishing the risk
and benefit sharing scheme does not lead to the reduction of tax revenues. We
introduce an “exit” clause in the risk and benefit sharing agreement that allows both
the operator and the contractor to withdraw from a partnership. This clause introduces
flexibility in the contract, that can be used to avoid sub-optimal outcomes. We use an
algorithm based on the real options approach that allows to optimize the contract
policies for both the operator and the contractor in order to ensure a fair risk distribution
and proper incentives to participate in the contract. We assess quantitatively the impact
of various parameters (costs, the hydrocarbon reservoir and the oil price) on the project
value (and value of the contract) and calculate the exact value of incentives that are
necessary to balance the contractual risks.
The real world applications of risk and benefit sharing contracts vary from large
infrastructure projects (Alonso-Conde et al. 2007) to movie rental studios (Cachon &
Lariviere 2005). In these cases, using the risk and benefit sharing schemes allows to
distribute project risks connected with uncertain demand and provide certain
guarantees for participants against unexpected variations (Alonso-Conde et al. 2007).
Cachon & Lariviere (2005) and Yao et al. (2008) also demonstrate that such contracts
might improve supply chain performance by increasing the total profit of the
participants. In oil and gas industry, however, such contractual forms are not widely
used due to several reasons.
Firstly, the market has been dominated by large oil companies, who have well
diversified portfolios, rich experience and extensive personnel and tend to encapsulate
most of the operations within a company, contracting out a relatively small range of
tasks in order to reduce costs. They have not had incentives to share risks by attracting
third parties to the field development process as they can cover losses in unsuccessful
projects by cash flow generated by profitable assets and access to cheap debt
(Osmundsen et al. 2010). The state of the art in the petroleum industry has been that
oil companies (principals) hire contractors (agents) fully covering costs to perform a
well defined and limited sort of tasks under relatively short-term agreements. Such
contractors as drilling and service companies, rig providers have been responsible for
the respective tasks with very limited involvement in overall operations of E&P projects.
Smaller companies that are emerging in the market, typically focus on assets, that
major companies refer as marginal fields (OG21 2021). Such players normally have
much less abilities to preserve their activities in case of an unfavourable outcome of
uncertain conditions. Scarce portfolios, smaller balance sheets, lower reserves, higher
cost of capital and lower debt capacity makes the small oil companies more exposed
to the market and technical risks. Cooperation with partners to develop a field can
become beneficial for such companies due the lack of technical knowledge in
operations that involve advanced technologies (Osmundsen et al. 2010). Involving
other parties would be, therefore, motivated not only by costs reduction incentives, but
rather by a potential to have access to external resources and expertise and ability to
share risks. In this study, we show that risk and benefit sharing has a potential to
become an important instrument in oil and gas industry to handle additional risks amid
changing market conditions, where new incentives and opportunities to increase
efficiency emerge. We demonstrate that the novel form of cooperation has a potential
to decrease the cost of capital for smaller oil companies in the presence of capital
market imperfections. These imperfections arise from the inability of financial
institutions to adequately assess risks related to field development, which in turn may
result in high interest rates on loans that are offered for small companies (Magri (2009)
and Czarnitzki & Hottenrott (2011)). In addition, we show that risk and benefit sharing
can be attractive for those contractors that are ready to take and manage additional
unsystematic risk and are interested in diversification of their core businesses.
Secondly, the risk and benefit sharing scheme would require much more commitment
both from field operators and contractors and more extensive information sharing from
the principal. Oil companies often treat such data as reservoir properties and fluid
characteristics as confidential information. Osmundsen et al. (2010), who analyze
incentive schemes for drilling operations, argue that oil companies remain reluctant to
disclose comprehensive data on the reservoir due to the fact that the number of
contractors that exists in the industry is scarce and most of them work with several oil
companies. This leads to the fact that contractors often have to work under conditions
of information asymmetry, knowing only the piece of information that is directly
connected with their part of work. This asymmetry might cause an agency problem
(Norrman 2008) leading to superior efficiency of the operations in question. In order to
introduce more flexibilities and incentives for contractors within risk and benefit sharing
contracts, which would require the contractor’s involvement in the whole process of the
field development in cooperation with an oil company, both parties must be ready to
share the information that has been traditionally considered as sensitive. In this paper,
we demonstrate that adopting risk and benefit sharing can contribute to the
establishment of long-term relationship between field operators and their contractors
due to the contractor’s involvement into the oil production phase. Intuitively, smaller oil
companies that typically do not have a mind-set of oil giants and are more open for
collaboration can become early adopters of the risk and benefit sharing agreements.
Thirdly, Osmundsen (2011) argues that for many contractors, accepting the reservoir
and oil price risk is too costly as their strategy is to be industrial enterprises, not oil
companies. In order to realistically assess the potential of the risk and benefit sharing
schemes, contractors must significantly improve their competence in reservoir
engineering and risk management as well as have opportunities for follow-up and
control during the production phase. In this work, we demonstrate how this issue can
be resolved by building a flexible agreement, where risk and benefits are distributed
fairly. Our results allow to estimate the range of uncertainty and value at risk for all
parties involved, making the agreement transparent.
Lastly, the legal base for risk and benefit sharing has not been developed yet. This is
why we put a particular emphasis of the role of regulator in establishing the framework
for such a cooperation in the oil and gas industry. We demonstrate how the risk and
benefit sharing contract terms can be designed such that the collaboration ensures at
least the same level of tax revenues for the regulator as the state of the art business
models.

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