Transaction costs and choice of petroleum contract

Abstract

Petroleum contracts are very complicated in their share structure. This makes it difficult to generalize explanations on choice of petroleum contract. Current contracts are classified into four major types: concession, production-sharing, joint-venture, and service contracts. Two existing explanations on choice of contract--fisical regime and risk sharing--explain in terms of physical risk. They are inadequate for the purpose because the industry is also inherent with behavioral risk as shown by the existence of various mitigating terms in every type of contract. Behavioral risk here refers to the opportunity of the contracting parties to deviate from the original promise. This study proposes that a contract is selected not only to moderate physical risk but also to minimize ex-post opportunism. The theories of agency and self-enforcing contract are used in constructing a contractual choice model. It shows that types of contracts are distinguished by incentive payment terms, which are designed to minimize opportunism. When the country has little information on petroleum reserve, a high incentive payment contract will be selected, and vice versa. Also, if the circumstance changes ex post, new terms or a new type of contract are adopted to maximize the contracting parties' mutual benefits. The available evidence supports this hypothesis. The high incentive contract--concession contract--is always granted in newly oil exploration countries. Other three lower incentive contracts are drawn in countries which have high commercial quantity of petroleum reserve. A one-way analysis of variance test shows that means of oil-field size among the three groups of countries that adopted different types of contracts at a particular time differ significantly at the level of 90%. The Less Significant Difference (LSD) test confirms that means for the group of countries employing the production-sharing or the joint-venture differs significantly from the group of countries that employs the service contract. When oil prices change, new terms or a new type of contract are adopted without interventions from the third party. In conclusion, empirical evidence is consistence with the model for choice of petroleum contract developed in this study. The model can be more vigorously tested if additional data and information are available.