Production Sharing Contract (PSC)

A Production Sharing Contract (PSC) is a contractual framework commonly used in the petroleum and natural gas industry, under which the government, as the owner of natural resources, allows a private or foreign contractor to explore, develop, and produce hydrocarbons in a specified area. In return, the contractor shares the production with the government according to agreed terms. This arrangement enables the government to attract investment, technology, and expertise while retaining ownership and control over its natural resources.

Background and Concept

The Production Sharing Contract system originated in the 1960s as an alternative to concession agreements traditionally used by oil-producing countries. It was first introduced by Indonesia to ensure greater state participation and revenue control. Over time, many resource-rich developing nations adopted the PSC model to balance risk-sharing and revenue generation.
In India, the PSC framework was introduced in 1991 as part of economic liberalisation and energy sector reforms. The government shifted from the earlier nomination regime, where exploration was confined to public sector enterprises such as ONGC and OIL, to a more open and competitive exploration regime involving private and foreign participation.
The New Exploration Licensing Policy (NELP), launched in 1997–98, formalised PSCs as the contractual basis for oil and gas exploration and production. The policy sought to attract private investment, enhance domestic production, and reduce import dependency.

Structure and Key Features of PSC

A Production Sharing Contract defines the rights and obligations of both the government (licensor/owner) and the contractor (licensee/operator). Its essential components include:

1. Exploration and Development Rights:The contractor receives the right to explore and produce hydrocarbons within a designated block or contract area. Ownership of the resource remains with the government.
2. Cost Recovery (Cost Oil/Gas):The contractor can recover its exploration, development, and operational costs from a portion of the production. This recovered portion is known as “Cost Oil” or “Cost Gas.”
3. Profit Sharing (Profit Oil/Gas):After deducting cost recovery, the remaining production — called “Profit Oil” — is shared between the government and the contractor according to a pre-agreed formula.
4. Work Programme and Expenditure Commitment:The contractor must undertake a minimum exploration work programme, including seismic surveys and drilling, within specified timelines.
5. Royalty and Taxes:The contractor pays royalties and applicable taxes in addition to the profit share due to the government.
6. Duration:PSCs are long-term contracts, usually lasting 20 to 25 years, covering exploration, development, and production phases.
7. Risk and Reward Sharing:
   • The contractor bears the exploration risk — if no commercial discovery is made, the government bears no financial loss.
   • If hydrocarbons are discovered, both parties share the rewards as per the agreed formula.

Stages of a PSC

A typical Production Sharing Contract involves three major stages:

1. Exploration Phase:
   • Geological surveys, seismic studies, and exploratory drilling are undertaken.
   • If no commercial discovery is made, the contract may lapse.
2. Development Phase:
   • If a discovery is declared commercial, the contractor develops infrastructure for production (wells, pipelines, processing facilities).
3. Production Phase:
   • Extraction and sale of oil and gas occur.
   • Production is divided into cost recovery and profit sharing segments.

Mechanism of Cost and Profit Sharing

The division of production under a PSC generally follows this sequence:

1. Gross Production:The total volume of oil or gas produced from the field.
2. Royalty:A fixed percentage of gross production paid to the government as a royalty.
3. Cost Recovery:The contractor deducts costs incurred in exploration, development, and operations. This portion is limited by a maximum ceiling (known as the cost recovery limit).
4. Profit Oil/Gas:The balance production after cost recovery is shared between the government and contractor according to a sliding scale linked to production levels or pre-tax internal rate of return (IRR).
5. Taxes:Both parties are liable to pay taxes as applicable under the Income Tax Act and Petroleum Taxation Rules.

For example:If a PSC specifies a cost recovery ceiling of 70%, and total production is 100 barrels:

• 70 barrels may be allocated as cost oil to recover expenses.
• The remaining 30 barrels constitute profit oil, shared between the government and contractor (e.g., 60:40 ratio).

Advantages of the PSC Model

• Risk Mitigation for Government: Exploration and financial risks are borne by private contractors.
• Incentive for Investment: Contractors can recover costs and earn profits if successful, attracting global companies.
• Technology Transfer: Encourages introduction of modern exploration and production technologies.
• Revenue for the State: The government earns through royalties, profit shares, and taxes.
• Production Accountability: Contractors must declare production volumes transparently, ensuring monitoring.

Criticisms and Challenges

Despite its benefits, the PSC framework has faced criticism and operational challenges in India:

1. Cost Recovery Disputes:
   • The system allowed contractors to inflate costs, thereby reducing the share of Profit Oil due to the government.
   • The high-profile KG-D6 gas field dispute involving Reliance Industries Ltd. and the government highlighted this issue.
2. Complex Monitoring:
   • Verifying actual costs and production levels requires strong regulatory oversight, often lacking in practice.
3. Delays in Approvals:
   • Bureaucratic delays in clearances and audits often hinder timely project execution.
4. Revenue Uncertainty:
   • Government revenues fluctuate based on cost recovery patterns and production performance.
5. Risk of Under-Reporting:
   • The structure may encourage under-reporting of production to manipulate profit-sharing outcomes.

Reforms and Policy Shifts

In response to the shortcomings of the PSC model, the Government of India has gradually transitioned to alternative contractual frameworks to improve efficiency and transparency.

1. Revenue Sharing Model (RSM):Introduced under the Hydrocarbon Exploration and Licensing Policy (HELP) in 2016, this model replaces the cost recovery mechanism with a revenue-sharing approach. Under RSM:
   • The government and contractor share gross revenue (instead of profit).
   • Cost recovery disputes are eliminated.
   • Simplified audit and oversight processes reduce administrative complexity.
2. Open Acreage Licensing Policy (OALP):Also introduced under HELP, it allows investors to select exploration blocks of their choice throughout the year and submit bids.
3. Uniform Licensing Policy:Enables contractors to explore and produce all forms of hydrocarbons (oil, gas, shale, coal-bed methane) under a single license.

These reforms aim to create a more investor-friendly environment while ensuring fair government revenues.

PSC in the Indian Context

Major PSCs in India were signed under the NELP regime between 1997 and 2016. Notable examples include:

• KG-D6 Block (Reliance Industries – Niko Resources) in the Krishna-Godavari Basin.
• Ravva Field (Cairn Energy – ONGC) in the Bay of Bengal.
• Panna-Mukta-Tapti Fields (ONGC, Reliance, BG Group) in the Arabian Sea.

The Comptroller and Auditor General (CAG) of India has repeatedly emphasised the need for improved cost audits, transparent production reporting, and greater government oversight in PSC operations.

Global Experience

Globally, PSCs are widely used in countries such as:

• Indonesia, Malaysia, and Vietnam in Asia.
• Nigeria, Angola, and Libya in Africa.
• Russia and Kazakhstan in Eurasia.
• Colombia and Peru in Latin America.

Each country customises its PSC framework to balance investor incentives with national interests.

Comparative Overview: PSC vs Revenue Sharing Model (RSM)

Significance

The Production Sharing Contract model played a vital role in India’s energy sector liberalisation by:

• Attracting foreign direct investment (FDI) in oil and gas exploration.
• Enhancing domestic hydrocarbon reserves and production capacity.
• Laying the groundwork for regulatory evolution in upstream petroleum management.