Review Of Development Prospects For The Cambodian Oil And Gas Sectors.Pdf


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Review Of Development Prospects For The Cambodian Oil And Gas Sectors.Pdf

  1. 1. Insights for Action Review of Development Prospects for the Cambodian Oil and Gas Sectors Cambodia Discussion Paper No. 2 2006
  2. 2. UNDP Cambodia Insights for Action Initiative Background: UNDP’s Insights for Action (IFA) initiative was developed and launched in May 2004 in the follow-up to a meeting between H.E. Prime Minister Hun Sen and Dr. Hafiz Pasha, the Regional Bureau Director of UNDP. The Prime Minister emphasized that “Cambodia needs UNDP much more for its ideas than its money”. The IFA initiative was created to undertake policy research and to facilitate policy dialogue among the Cambodian Government, Cambodian society and Cambodia’s development partners. Purpose: The IFA initiative is aimed at generating innovative ideas and practical knowledge for the effective implementation of the Government’s Rectangular Strategy. Special focus is given to those aspects of the Rectangular Strategy with greatest scope for rapidly advancing progress towards Cambodia’s Millennium Development Goals (CMDGs). In addition to a Knowledge Generation component, there is also a Knowledge Sharing component aimed at helping catalyze and develop support for needed decisions and actions. New Knowledge Generated: Valuable new knowledge and insights in several critical areas have already been generated through well targeted research in collaboration with the Supreme National Economic Council (SNEC), a cross-ministerial advisory council that reports directly to the Prime Minister. Knowledge Sharing: The Insights for Action initiative has also been developing a range of knowledge sharing activities and modalities including the Cambodia Economic Forum (CEF), successfully launched in January 2006, media conferences, website development, and the beginning of a series of Insights for Action publications. © 2006, UNDP Cambodia Review of Development Prospects and Options For the Cambodian Oil and Gas Sector United Nations Development Programme Cambodia DISCLAIMER The responsibility for opinions in this publication rests solely with the authors. Publication does not constitute an endorsement by the United Nations Development Programme or the institutions of the United Nations system.
  3. 3. Review of Development Prospects and Options For the Cambodian Oil and Gas Sector A UNDP Funded Discussion Paper In Cooperation with The Cambodian National Petroleum Authority Harvard’s John F. Kennedy School of Government and Stanford University’s School of Law
  4. 4. Foreword The discovery in late 2004 of potentially significant reserves of oil and gas off the coast of Cambodia presents potentially major opportunities for the country’s socio- economic development, but also some potentially major challenges. Judging from experiences in a number of other low income developing countries over the past forty years, the sudden surge of petroleum related revenues can have major implications for a country’s development path and the well-being of its people. Unfortunately, more low income developing countries than not have been impacted negatively following a sudden surge of revenues from petroleum and other such non- renewable natural resource extraction. Reflecting these negative experiences, a new development term has emerged called “resource curse”. Therefore, this second Insights for Action Discussion Paper attempts to facilitate a better understanding of the possibilities in Cambodia by outlining the findings of an initial scoping of the oil and gas sector in the country. The purpose of such a scoping is to motivate and facilitate advance planning in case future petroleum revenues prove to be significant. The paper also outlines some key principles to ensure that the oil and gas sector develops with efficiency and with maximum net revenues accruing to Cambodia through the negotiation of effective Production Sharing Contracts. Most important, the paper provides an initial analysis of some of the basic safeguards needed to better ensure that Cambodia avoids the serious mistakes made by governments in some oil exporting developing countries, and Cambodian people avoid a resource curse and enjoy a resource blessing. The research for this paper was carried out in the summer of 2005 with the assistance of the Harvard University’s John F. Kennedy School of Government and Professor Brian Quinn from Stanford University’s School of Law, in collaboration with researchers from the Cambodia National Petroleum Authority (CNPA). The main findings of this research were presented at the Cambodia Economic Forum (CEF) in January 2006 organized by the Supreme National Economic Council in collaboration with CNPA and UNDP. Participants included His Excellency Prime Minister Hun Sen, Senior Ministers and other policy officials, local universities, the international development community, NGOs, and other stakeholders. Given the potentially major socio-economic implications for Cambodian people, UNDP’s Insights for Action initiative plans further applied research in this important subject area as the possibilities evolve. Insights for Action UNDP Cambodia January 2006
  5. 5. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector Table of Contents Introduction 1 Upstream Issues 2 Upstream Development Principle 2 Maximizing Revenue from Upstream Activities 2 Box 1: A High Level OCA/JDA Strategy 6 Downstream Issues 7 Downstream Development Principles 7 Maintaining Open Markets 7 Minimize Direct Investments by the Government 8 Ensure Market Risks Remain with the Private Sector 8 Avoid Cross-Subsidization 8 Downstream Development of Oil 9 Box 2: Smuggling and Downstream Development 11 Downstream Development of Natural Gas 11 Box 3: Development Opportunities for LPG 13 Management of Petroleum Revenues 14 Domestic Fiscal Responsibility 15 Transparency and Accountability 16 Independence 17 Investment Rather than Consumption 18 Balancing Long-Term and Current Needs 18 Professional Management of Fund 20 Development of CNPA 21 Focus on Core Competencies 21 Invest in Human Resource Development 22 Stewardship 23 Conclusion 24 Appendix I: Analysis of Model PSC 25 UNDP Discussion Paper No. 2 i
  6. 6. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector ABBREVIATIONS AND ACRONYMS CNPA Cambodian National Petroleum Authority GDP Gross Domestic Product IMF International Monetary Fund JDA Joint Development Area KWH Kilowatt hour LPG Liquefied Petroleum Gas MW Mega Watt NGO Non-governmental organisation OCA Overlapping Concession Area ODA Official Development Assistance PSC Production-Sharing Contract UNDP United Nations Development Programme VAT Value Added Tax WTO World Trade Organization UNDP Discussion Paper No. 2 iii
  7. 7. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector INTRODUCTION Recent discoveries in offshore Block A and expectations of possible discoveries in the overlapping concession area (OCA) between Thailand and Cambodia are generating new interest in the oil sector. It is still too early in the process to say with any certainty how much, if any, of the discoveries will ultimately be commercially viable. However, it is not too early in the process to begin to plan and to think about how Cambodia can prepare itself in the event that there are significant oil and/or gas resources in commercial quantities. The United Nations Development Programme (UNDP) does not have a direct interest in the oil and gas sector, however, experience in developing countries which have found significant hydrocarbon resources suggests that the UNDP and international donors can play a role in assisting host country governments to prepare to efficiently manage the sector as it develops. There are many examples of resource rich countries in the developing world where poor management of the sector becomes a roadblock to the country's ability to meet its own development goals, presenting both macroeconomic and political challenges. With proper planning and adequate management, however, there is no reason why Cambodia should fall into the pile of unsuccessful resource-rich economies. This paper is not intended to provide a complete overview of all policy and management issues in the oil and gas sector. It is, rather, intended to raise important issues and in order to stimulate further discussion within the Cambodian National Petroleum Authority (CNPA) and between CNPA and UNDP. This first section of this paper provides analysis of some of the most important issues relating to exploration and production of hydrocarbons (Upstream), including analysis of the model production-sharing contract (Model PSC) in use in Cambodia. In the Upstream sector, Cambodia's focus should be on maximizing the revenues associated with exploration and production of crude oil and natural gas. The second section of this paper deals with issues facing CNPA relating to potential development of petroleum refining and local marketing of refined petroleum products (Downstream). In the Downstream sector, Cambodia should ensure that consumers and end-users have access to refined petroleum products and natural gas at world prices. The third section of this paper provides options for managing revenue that might be expected from Cambodia's upstream activities. The emphasis regarding management of oil and gas revenues should be on the most efficient utilization of the resources to promote achieving Cambodia's long-term development goals. The final section of this paper focuses on management and development challenges facing CNPA itself, including legislative and regulatory challenges. UNDP Discussion Paper No. 2 1
  8. 8. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector Even modest improvements in the Model PSC can result in large UPSTREAM ISSUES marginal Upstream Development Principle gains for the Cambodian Negotiations with international exploration and production companies should be side given the structured and carried out so as to maximize revenue from production sharing length of the contracts (PSC) and the joint development area (JDA) with Thailand. contracts and the amounts Maximizing Revenue from Upstream Activities of revenue To a degree, the Model PSC is a product of the period when it was first developed in involved. the late 1990s when oil prices were low and there was little international interest in Cambodia's oil sector. At the time, CNPA also had very little experience in negotiating revenue contracts. Three years later, prospects in Block A, the OCA, as well as in the other internal blocks, have improved and have attracted the interest of international players. Given the shift in negotiating leverage, the CNPA should regularly revisit its Model PSC and its approach to negotiating future PSCs in order to maximize, to the greatest extent possible, revenue and benefit for the Cambodian economy. Even modest improvements in the Model PSC can result in large marginal gains for the Cambodian side given the length of the contracts and the amount of revenue involved. Though the Model PSC does not offer an explicit opportunity for renegotiation, in the context of an ongoing contract there are always opportunities to begin a renegotiation. For example, the annual approvals of work programs required as part of the Model PSC each present an opportunity for parties to renegotiate the terms upon which the relationship moves forward. Renegotiations can be quite contentious, so CNPA should be very judicious in determining the circumstances and the terms upon which it might seek a renegotiation with any parties that have already signed the Model PSC. In general, the terms of the current Model PSC are generous in favor of the Contractor. The Contractor may receive up to 90 percent of the post-royalty production in order to recover costs. The remaining ten percent of production will be split between the Contractor and the CNPA on a sliding scale. At lower levels of production, the marginal split of "profit oil" is 58-42 in favor of the Contractor. The marginal split moves in favor of the CNPA (58-42) at production levels in excess of 50,000 barrels per day. The marginal profit oil split in the Model PSC is the lowest of all profit oil splits when compared to terms of PSCs from other countries in the region. Additionally, the Model PSC is the most generous in the region in allowing contractors to recover costs from oil revenue. The 90 percent allowance for cost recovery limits the amount of possible cash flow that will become available to Cambodia in the early stages of production. 2 UNDP Discussion Paper No. 2
  9. 9. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector Summary of Regional Revenue Splits Royalty Cost Recovery Profit Oil Split Cambodia 12.5% 90% 58%-42% Vietnam 0.0% 40% 68%-32% Indonesia 20.0% 85% 85%-15% Philippines 7.5% 70% 60%-40% Myanmar 10.0% 50% 65%-35% Malaysia# 10.0% 45% 50%-50% MTJA* 10.0% 50% Royalty Cost Recovery Profit Tax Thai (III) 5-15% Amortized over 5-10 years 50% # Malaysian shallow water PSC terms. * Malaysia-Thailand Joint Area. The chart below estimates the average percentage of revenue per barrel that the relevant host country might expect to receive given the contract terms above at various prices per barrel of crude oil. At lower prices, CNPA's estimated revenue per barrel can be expected to be less than that of any of its neighbors. When the Model PSC was first negotiated in the late 1990s, long-term oil price targets were in the range of only about $20 per barrel. At these prices, CNPA would have only expected revenue on the order of ten percent of revenues, the lowest expected revenue in the region. Over the past five years, industry analysts have adjusted their long-term target prices to the $40 range. At these higher prices and assuming costs of production remain relatively low (assumed $10 per barrel), CNPA can expect revenues on par with those of other countries in the region. From the chart below, it appears that there may be room to negotiate improvements in future iterations of the Model PSC so as to limit the downside risk (of a decline in crude prices). CNPA might also want to consider lowering maximum cost recovery available to the Contractor so that it is more in line with other countries in the region so as to increase the guaranteed cash flow available to CNPA as profit oil. Estimated Percentage of Revenue per Barrel Allocated to Host Country at Various Prices*# $25.00 $35.00 $45.00 $55.00 $65.00 Cambodia 45% 53% 57% 60% 62% Malaysia 45% 53% 57% 60% 62% Indonesia 56% 67% 73% 76% 79% Vietnam 41% 49% 53% 56% 58% Myanmar 43% 50% 54% 57% 59% Philippines 39% 46% 50% 52% 54% * Assuming a fixed cost of $10.00 per barrel and profit oil splits equal to the highest marginal splits in favor of the government. Different actual costs may have significant impacts on the amount of revenue available. # Includes revenue from corporate taxes. UNDP Discussion Paper No. 2 3
  10. 10. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector On the natural gas side, the 65-35 allocation of profit gas in the Model PSC is favorable to the Contractor. Unlike the allocation of profit oil, the profit gas allocation under the Model PSC does not employ a sliding-scale which would improve the allocation in favor of the CNPA as average production per day increased. Using a static allocation of profit gas, rather than a sliding-scale, does not appear to have a basis. Given the nature of the reservoirs offshore Cambodia there may be limited economies of scale associated with increasing production, however the fact that the Contractor will be able to recover its costs through the cost allocation formula, the lack of economies of scale is not a sufficient argument against employing a sliding scale to favor CNPA at high levels of production. The Model PSC guarantees the Contractor a 16 percent real rate of return on any investments made in order to develop production for Cambodia's downstream domestic market for natural gas. As the guarantee of a 16 percent real return will be paid for by adjusting CNPA’s natural gas allocation downward, a guarantee such as this has significant implications with regard to the size of revenues that Cambodia might expect to receive from natural gas development. The guaranteed rate of return makes it more likely that the Contractor will pursue larger than necessary developments before local market demand has developed to sufficiently to support such development. Depending on the the absolute amount of the guarantee and the price of natural gas, CNPA’s revenues from natural gas could be significantly reduced as a result of pursuing development of downstream natural gas opportunities before there is sufficient market demand to support that development. For a more detailed analysis of relevant contractual terms in the Model PSC see Appendix I. Pending discussions with Thailand regarding the JDA present an opportunity for the CNPA to improve the revenue position of Cambodia relative to contractors. It will be likely that the JDA will adopt a single approach to granting development rights and that the terms will be an improvement of the current Model PSC. Of course, if the JDA develops a Thai-styled concession approach rather than a production sharing approach, CNPA may have to go through an additional learning process before becoming proficient with its terms. Nevertheless, once the JDA's model petroleum agreement is in place, CNPA can use it to improve its position relative to all subsequent contractors both in and out of the OCA. It will, of course, be critical that CNPA is well represented and negotiates the terms of the JDA’s model PSC when it is negotiated. 4 UNDP Discussion Paper No. 2
  11. 11. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector International exploration companies Legal Counsel and Use of Outside Legal Counsel rely on large legal teams Over the next decade, CNPA will be required to negotiate many production sharing and outside contracts and petroleum agreements. The current Model PSC, with some adjustments, counsel when is a good starting point for negotiations, but CNPA will need to structure negotiations negotiating in order to maximize its position in the process of negotiating a production sharing PSCs. CNPA contract. should not be afraid to do Building a strong legal department within CNPA must remain a key part of CNPA's development strategy (see Section 4); however, the negotiation of PSCs is a complex the same. specialty that will take some time to learn. Negotiation of these contracts is also a high-risk endeavor – where learning by doing will be too expensive to risk, especially for a country like Cambodia. International exploration companies rely on large legal teams and outside counsel when negotiating PSCs. CNPA should not be afraid to do the same. Relying on experienced outside legal counsel in order to negotiate on behalf of CNPA could have very positive benefits with respect to revenue accruing to CNPA in connection with PSCs. Hiring competent legal counsel to represent CNPA for the negotiation of a PSC assist might cost as much as $750,000. Though this might appear at first glance to be a large fee, relative to the potential benefit that might accrue from competent and effective legal counsel, it is not. For example, if outside legal counsel can improve the revenue allocation one percent in the direction of CNPA over the Model PSC, which could improve CNPA annual revenue by almost $1 million (assuming 75,000 barrels per day, at $50 per barrel). Competent legal counsel can help build additional flexibility into the PSC in favor of Cambodia that might assist in the development of a local petroleum services sector. Most legal advisors will charge their clients in one of three ways: hourly rate, set fee or hourly rate on a contingency basis. Each of these arrangements has its own advantages and disadvantages. Hourly rates encourage legal advisors to spend a great deal of time on issues large and small. While this usually assures thorough analysis of all issues, it can become quite expensive. Set fees for particular projects ensure certainty of price. Legal advisors will have the incentive to minimize the amount of work they do under these arrangements in order to maximize their profit margin. As a result, legal advisors have an incentive to skimp on analysis of issues. Finally, contingency arrangements appear, at first glance, to be a convenient arrangement, but contingency payments can create incentives for legal advisors to ensure that a deal is signed, sometimes to the detriment of the client’s rights. CNPA should avoid contingency and set-fee arrangements. Though more expensive, hourly rates will ensure that CNPA's legal advisors are working mostly for the benefit of the CNPA. UNDP Discussion Paper No. 2 5
  12. 12. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector Previously, CNPA has used international legal counsel as resource persons. Under these arrangements CNPA consulted in preparation for negotiations with potential contractors. Using legal advisors in this manner is relatively inexpensive, but CNPA should reconsider this approach. CNPA should consider allowing legal counsel to be the primary negotiator of the PSC on behalf of CNPA. The presence of a third party (legal counsel) as primary negotiator creates additional negotiating room for CNPA. CNPA can use that negotiating room to push for better terms and, if necessary, for compromise. While there may be sensitivities about a heated negotiation, competent counsel will not feel embarrassed about asking for a lot, pushing the other side and demanding the best deal for CNPA. The "good-cop, bad-cop" negotiating strategy is well known, but yet still quite effective. Using outside legal counsel creates opportunities to improve CNPA's position in negotiations without injuring relationships between the principals. One area where more aggressive use of outside counsel will be helpful will be in the resolution of negotiations with Thailand over the OCA and the JDA. Given Thailand's growing need for new hydrocarbon resources to meet demand by 2010, the Thai side will likely be under increasing internal pressure to reach agreements with both Cambodia and contractors. This pressure may create negotiating leverage that outside counsel and CNPA can use to improve Cambodia's relative position in negotiations. Box 1: A High Level OCA/JDA Strategy The current state of parallel negotiations with Thailand over the ODA and JDA has the potential to get stuck. Though there is increasing pressure for the Thai side to come to an agreement sooner rather than later, their past insistence on low-level technical solutions to demarcation and delineation issues makes it unlikely to expect a drastic change in stance. In addition to the lack of documentary evidence needed to conclude the question of the land border at the coast, there remain larger questions of approach to delineating the sea borders. The solutions to both of these issues will, in the end, be largely political and will require decisions at the highest levels on both sides. In order to change the current negotiating dynamic and reach a satisfactory conclusion rapidly, it might well be in the best interests of both sides to reach out to a neutral third party to assist in reaching a consensus outcome and resolution of outstanding border issues. A former head of state of a country with good relations with both Thailand and Cambodia might be in the best position to play the role of good faith intermediary. By escalating the negotiations away from the technical level and dealing with players at the highest levels, parties will be able to change the dynamic that has stalled the negotiations for the past few years. A high-level intervention strategy can help to rapidly bring the outstanding issues to conclusion in a manner deemed fair by both sides. Former international heads of state or other international persons of stature have been known to offer their services to assist in these types of matters. CNPA could approach some potential intermediaries through UNDP or the consultant. The consortium of OCA contractors would likely be willing to underwrite the expense of bringing in this type of high-level assistance. 6 UNDP Discussion Paper No. 2
  13. 13. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector DOWNSTREAM ISSUES Downstream Development Principles Policymakers are presently discussing development of certain downstream industries in Cambodia. Given the large amounts of capital investment required by this sector, CNPA should rely on a number of basic principles in guiding their decision-making regarding whether and how to develop certain downstream activities. These principles include the following: 1) Maintain open markets for imports of refined petroleum products to ensure the lowest possible price for consumers; 2) Minimize direct investment in downstream entities by the government or government-controlled entities; 3) Ensure that market risks for private investments in the downstream sector remain with the private sector; and 4) Avoid cross-subsidization between the upstream and downstream sectors. Maintaining Open Markets In markets where demand is small, most downstream investments will require some form of market protection in order to earn a positive financial return. While market protection regimes, either in the form of quantitative restrictions on imports or discriminatory import tax, can help a small, inefficient downstream facility make a financial return for its investors, they will result in higher-than-necessary prices for commodities, like fertilizer or refined gasoline. These increased prices will act as a tax on Cambodia's poorest consumers and farmers and often benefit only foreign investors or groups of local elites who have invested in these projects. As a member of WTO, Cambodia allows for quota-free importation of refined petroleum products. Refined petroleum products are subject to a relatively high tax regime (100 percent +), including import tariffs, special excise taxes and VAT. Cambodia should continue to allow private companies involved in downstream distribution to elect to import refined petroleum and fertilizer for so long as it is financially profitable for them to do so. Allowing competition with imported products will force downstream industries to be efficient and will ensure that prices faced by consumers will be no higher than world prices for comparable commodities. UNDP Discussion Paper No. 2 7
  14. 14. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector Market risks associated with private investments in Minimize Direct Investments by the Government downstream industries Downstream activities, including pipelines, oil refineries, fertilizer plants and power should remain plants are all commercial activities. Government investment, be it direct or through with the the use of ODA or guarantees for foreign loans, should be minimized. Rather than private sector. guiding decisions by social or other concerns, CNPA should treat all investments in this sector as commercial decisions to be managed by the private sector. Leaving the investments and the investment decisions to the private sector will ensure that development of the downstream sector will be efficient and responsive to market demand. Government investments in low return projects like fertilizer plants and oil refineries will act as a tax on Cambodia's farmers and consumers. Ensure Market Risks Remain with the Private Sector Market risks associated with private investments in downstream industries should remain with the private sector. By reducing risk associated with certain downstream projects, private sector investors might be induced to undertake investments that they would otherwise not pursue. Subsidies need not always take the form of cash payments to investors. There are many potential forms of subsidies, including market share guarantees, restrictions on imports, loan guarantees, and access to ODA loans among others. Government guarantees and implicit subsidies to private investors in the downstream sector can result in large contingent liabilities for the government that could prove to be a drag on economic growth and potentially reduce the CNPA's access to crude oil revenues. In order to ensure that downstream developments do not prevent Cambodia from reaching many of its development goals, the private sector should be allowed to evaluate and make investment decisions in the downstream sector without the presence of economic distortions. Avoid Cross-Subsidization Upstream and downstream projects each need to stand independently on their own feet. The CNPA should avoid selling crude oil or natural gas to domestic downstream projects at less than export prices. Selling crude oil and natural gas at the highest price possible, avoiding cross-subsidization, will maximize revenue and ensure that Cambodia's energy resources are used in the most efficient manner possible. Providing crude oil and natural gas to downstream projects at less than export prices is a hidden subsidy that could cause gross distortions and inefficiencies. If there are social needs or concerns that policymakers wish to address through downstream projects, a more transparent subsidy program might be better suited to meeting those goals. 8 UNDP Discussion Paper No. 2
  15. 15. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector Downstream Development of Oil Oil producing countries throughout the world often develop oil refineries in order to meet domestic demand and to supply refined product for export. However, oil refineries – even small, strategic ones – can present significant risks to economic growth and development. Indeed, a back of the envelope analysis suggests that even a small, strategic refinery could significantly reduce CNPA's revenue from oil production. For the purposes of this analysis, assume the following: • Daily average oil production of 50,000+ BBL/day; • Oil refinery with 40,000 BBL/day capacity, operating at 100 percent capacity; • CNPA's allocation 13,181 BBL/day; • Contractor's domestic market obligation: 26,819 BBL/day supplied at world price to refiner; • Price differential per barrel between local refinery and international refineries: 15 percent; and • Import market for refined petroleum products remains open. Small, strategic oil refineries require less investment (on the order of $300 million for a 40,000 barrel per day plant) than larger, export-oriented plants, but the lower investment is not without a cost in efficiency. Because oil refining is an industry that is marked by significant economies of scale, smaller plants are less efficient than larger ones. Assuming the price per barrel of refined petroleum for a small refinery is 15 percent higher than the price per barrel of refined petroleum from a more efficient refinery, refined products supplied by the small refinery will be more expensive than their imported substitutes (excluding transportation costs of approximately $12/ton from Bangkok to Sihanoukville). In order for the small refinery to be commercially viable it will require subsidies or quantitative restrictions on imports. Cambodia's open market and the prevalence of smuggling make quantitative restrictions or additional tariff protection less likely to be effective. Given the ineffectiveness of traditional mechanisms the most obvious avenue for subsidy will be through underpricing of CNPA's allocation of crude supplied to a strategic refinery. The terms of the Model PSC require that if the Contractor is required to serve the domestic market under the Domestic Market Obligation provision that it will do so only at export prices. In order to cover the 15 percent differential in price between imported refined product and refined product produced locally, CNPA would have to deliver approximately 46 percent of its daily allocation to the refinery at no cost as a UNDP Discussion Paper No. 2 9
  16. 16. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector hidden subsidy to the refiner. Assuming a $50 per barrel price for crude oil, this hidden subsidy could cost Cambodia approximately $100 million per year. The simple analysis above assumes 100 percent utilization of a local refinery and does not take into account the fact that the particular product mix of heavy and light fuels produced by a local refinery may not precisely match local demand, leaving open the possibility that additional imports of particular product types might still be required. Because of the requirements of the Model PSC for sales of the Contractor's crude to any local refinery at world prices, Cambodia should not expect that significant price reductions will result from a small refinery coming online. Indeed, if the investment cost for a small refinery is financed with a foreign currency loan (including a soft loan), net foreign exchange savings may also be minimal, if not negative depending on the nature of the financing. As a result, the $100 million hidden subsidy for a local refinery would be insurance against supply disruption only. The question that policymakers should ask is whether $100 million per year is too expensive for insurance and whether or not there are more cost effective ways to reach the same supply security goal. While potential supply disruption is a legitimate policy issue, it must be looked at in context. For the most part, international trading markets for oil are deep and buyers and sellers are anonymous. International commercial players have little motivation to stop supply to any particular customer. Refining capacity in the region may, for the time being, be tight, but that does not in any way signal that significant supply disruptions are on the way. Given the current structure of international oil markets, the risk of supply disruption is limited. It is unlikely that if a major supplier, like Vietnam, unilaterally decided to stop supplying refined product to Cambodia that alternative supplies wouldn't be available from elsewhere in the region. Indeed, Cambodia's present competitive retail distribution market is a de facto energy security policy. Multiple importers sourcing product from a variety of sources and countries assures that Cambodia has a diversified source for its energy needs and that the risk of unilateral disruptions of refined products from any particular source will not have extreme negative consequences on the Cambodian economy. One player in the downstream retail business described the diversification strategy as “breathing through both the nose and the mouth.” The analysis above is not a strict argument against development of oil refineries in Cambodia. At some point, it may become financially attractive for the private sector to invest its own resources in the development of a refinery in Cambodia. Indeed, if reserves prove to be large enough, there may well be a commercial argument for private sector investments to develop large-scale refineries to serve both the domestic and export markets. When that point comes, guided by the principles set forth above, Cambodia should feel confident in licensing private investors to develop such oil refineries. 10 UNDP Discussion Paper No. 2
  17. 17. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector Box 2: Smuggling and Downstream Development The experience with smuggling of refined petroleum products into Cambodia can inform decisions regarding investment in a small-scale oil refinery for Cambodia. Estimates from various players in the industry are that as much as 40 percent of the market for refined petroleum products is smuggled. The incentive for smuggling can, in part, be attributed to the tax regime which causes large price differentials between the price per liter in Cambodia and in its neighboring countries. Refined Petroleum Tax Regime Import Tariff 35% Special Excise Tax 100% VAT 10% Even small price differentials between the local market and regional markets now create incentives for smuggling. Though the government has attempted to curtail it, the potential profits involved make smuggling lucrative. In the event that a small capacity oil refinery is built, it will require protection in order to be financially viable (through tariffs or quantitative restrictions). It is likely that direct competition with imports and smuggling will make any attempts to indirectly subsidize a small refinery project unsuccessful. So long as Cambodia's borders remain open, providing indirect subsidies to a low return oil refinery will prove exceptionally difficult. Downstream Development of Natural Gas Given the experience of Thailand and Vietnam, early expectations were that Cambodia might have relatively significant sources of natural gas. To date, the availability of natural gas is still in question. However, the Model PSC provides a number of constraints that, together with the downstream development principles above, limit the realistic choices for downstream development of natural gas in Cambodia. First, the minimum rate of return provision in the Model PSC guarantees the Contractor a minimum real rate of return in the event that it makes investments to develop natural gas for the domestic market. Second, proximity to Thailand and its offshore natural gas infrastructures makes exports of natural gas economically feasible. This is aided by the fact that Chevron recently completed its acquisition of Unocal. Unocal owns most of the offshore pipeline capacity on the Thai side of the Gulf. As a result, connecting Cambodian resources to the Thai side and exporting natural gas to the ready market in Thailand is a viable and, likely, cost effective option. Third, there is no domestic market allocation obligation under the Model PSC and, finally, under the terms of the Model PSC, the Contractor reserves unto itself the right to export any and all of its allocation. UNDP Discussion Paper No. 2 11
  18. 18. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector Currently almost all of Cambodia's 270 MW of installed electric With those conditions, the medium term potential for the development of natural gas generation will likely be limited to supplying natural gas for power generation. capacity is made up of diesel-fired Currently almost all of Cambodia's 270 Mega Watts (MW) of installed electric generators. generation capacity is made up of diesel-fired generators. Peak demand in 2004 was only 120 MW. As a result of the low load factors and reliance on diesel generation to meet baseload demand, the retail price of power is very high. In Phnom Penh the average retail price ranges from $0.16-0.25/kilowatt hour (kwh). Cambodia still does not have a national grid with only 17 percent of the population having access to any power. The Phnom Penh market makes up 85 percent of all electricity consumption in the country. Rural areas are served by rural electric cooperatives and small networks with retail prices ranging from $0.30-0.60/kwh. The rest of the population relies on kerosene lamps or batteries for power. By 2008, approximately 40 percent of Phnom Penh's power requirements will be imported from Vietnam at prices between $0.03- 0.85 per kwh depending on time of day and season. Depending on the costs of building a pipeline and the export price of natural gas to Thailand, there may be opportunities for investments in natural gas generation of electric power. However, given the small size of the current market for power in Cambodia, it may not be commercially feasible to install a small capacity combined cycle plant in addition to making the necessary investments in pipelines and offshore infrastructure required to bring gas onshore. Current discussions envision installing a 180 MW combined cycle plant. Given current demand and the installed base, 180 MW might be too large initially. Additionally, most of Cambodia’s current generating capacity is private, selling power to Electricity of Cambodia through power purchase agreements. These agreements could be relatively expensive to renegotiate or cancel. As a result, the issue of developing natural gas-fired generating capacity needs to be carefully studied. Discussions relating to installing a large combined cycle generating station to serve the Cambodian market with the surplus power made available for export to Vietnam or Thailand are still premature. Nevertheless, it is likely that the first investments in downstream natural gas will, and should, be in the power sector. As in downstream development of oil, CNPA should evaluate development of downstream gas applying the same general principles illustrated above. Fertilizer plants relying on natural gas as a fuel stock appear to be a low priority item in the natural gas development agenda. This low priority is well placed. In many countries, there is a wish by planners and policymakers to develop fertilizer plants in order to ensure local farmers have cheap access to fertilizer. Foreign investors are not generally interested in investing in fertilizer plants, particularly small capacity plants with relatively high costs. 12 UNDP Discussion Paper No. 2
  19. 19. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector Fertilizer plants, like oil refineries, are characterized by significant economies of scale. Low cost fertilizer plants have a capacity to produce between 500,000 and 1,000,000 tons per year. According to the Ministry of Agriculture, total domestic demand for fertilizer in 2004 was 20,000 tons. Unless Cambodia is considering entering the fertilizer export market, any fertilizer plant that is built in Cambodia will likely be a relatively high cost one, requiring subsidies in order to be competitive with world prices. Discussions regarding fertilizer plants are best put off for future years. Other investments to assist agriculture might result in higher returns – upgrading irrigation systems, for instance. Box 3: Development Opportunities for LPG Liguefied petroleum gas (LPG) is one area where modest support from the government and international donors might have positive economic benefits. Ninety percent of households in Cambodia rely on firewood for household fuels. There are obvious negative environmental effects of such heavy reliance on firewood and other biomasses for fuel. Heavy reliance puts pressure on forest resources and the environment. Additionally, less obvious negative effects include acute respiratory illnesses, lung cancer and problems with pregnancy in women who are most directly exposed to household smoke from the burning of solid fuels in the household. Young children who are exposed to household smoke for long periods are also at increased risk to suffer from coughs, acute respiratory illnesses and lung cancer. With all of the positive economic benefits associated with the use of LPG rather than firewood, the challenge is how to promote the market for LPG and increase current usage from the present low rate of approximately 1,000 tons per month. The largest obstacle, of course, is price. The pricing problem is two-fold. Though the import tariff on LPG is zero, the price of LPG is linked to the international price of oil. Because of this , the local price for LPG is relatively high. Additionally, LPG has high "start up costs". LPG is sold at $15-20 per cylinder (including deposit). For many consumers, particularly in rural areas, $15-20 for a single cylinder of LPG is a large outlay. Compared to 500 riel ($0.25) for a bundle of wood, an LPG cylinder, which might last a few weeks, can appear expensive. Cambodia is not the only country to be faced with this pricing problem. In the early 1970s Thailand created the Oil Fund, financed with revenue from import tariffs on refined petroleum products, to subsidize the price of LPG. By reducing consumer prices for LPG, Thailand was able to promote the use of the fuel throughout the country. Today, LPG is the most common fuel in households in Thailand. CNPA, together with downstream players, should consider approaching international donors, including the Global Environmental Facility, to seek technical assistance to investigate what set of policies might assist the private sector in Cambodia to promote broader use of LPG by households. UNDP Discussion Paper No. 2 13
  20. 20. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector MANAGEMENT OF PETROLEUM REVENUES The list of countries which have successfully used large revenues from natural resources wisely is not long. Unfortunately, for many countries in the developing world, discoveries of large reserves of natural resource wealth have not promoted economic or social growth. In countries like Nigeria and Venezuela, populations are worse off after thirty years of oil revenue rather than better. In other countries, corruption and poor management have led to the siphoning off of national wealth for personal interests. In Kazakhstan, it was recently revealed that at least $1 billion from that nation's oil revenues was diverted to secret Swiss accounts controlled by the President. The problems associated with natural resource bounties are both economic and political. The economic problems include first and foremost, the possibility that large inflows of foreign currencies could lead to appreciation of the exchange rate. Additional spending from petroleum revenues (whether through government spending or increased credit in the banking system) can lead to increases in domestic prices, wages and costs. This "Dutch Disease" phenomenon puts pressure on domestic manufacturing and agriculture making them less competitive with imports. Over time there is a shift away from tradable goods to non-tradable services like construction. Structural changes such as the ones described above can have the effect of slowing growth and increasing inequality between urban and rural populations as farmers find themselves under increasing pricing pressure. On the political side, increased access to unrestricted cash from petroleum revenues creates opportunities for rent-seeking behavior and increased corruption. In democratic political systems, politicians must constantly seek to build coalitions with groups large and small in order to create the kinds of consensus required to raise taxes to finance government operations. When a substantial portion of a government's operations can be financed out of oil revenues, less motivation for consensus building exists. Rather than seek political coalitions or bargains, oil wealth can result in politicians attempting to increase their access to the cash resources as a means of increasing political control, thereby threatening the development of democratic institutions. These problems, while frequent in countries with petroleum wealth, are not inevitable. While it is still too early to put serious numbers to Cambodia's potential petroleum resources, the small size of Cambodia's economy makes it likely that any commercial production of oil and gas in Block A and the OCA will have a significant impact on the economy. A recent report by the International Monetary Fund (IMF) suggests that there might be 500 million barrels of recoverable reserves in Block A. For illustrative 14 UNDP Discussion Paper No. 2
  21. 21. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector purposes, suppose this is true. That suggests (assuming oil prices at $55 per barrel and an average revenue split of 60 percent over 25 years) an annual revenue of approximately $660 million per year, roughly equivalent to Cambodia’s total budget expenditures in 2003. If, ultimately, there are additional resources found in Cambodia’s other blocks as well as in the JDA, annual revenues from oil and gas could be multiples of Cambodia’s present annual budget. Effective management of these potentially large inflows could provide resources for needed investments to help Cambodia reach its development goals, as well as provide a national endowment that might be used to support Cambodian development for generations to come. Ineffective management could bring on macroeconomic problems and promote corruption. Given the large amounts presently being envisioned, it is hard to imagine that, if poorly managed, the macroeconomic problems would not be enormous. All of this suggests that prudent planning for potential petroleum revenues is called for. Discussions on this subject should start well in advance of production and at multiple levels as there may be significant legislative hurdles to get over in order to ultimately resolve the question of management of petroleum revenues. When entering into discussions and assessing revenue management options, CNPA and the government should consider the following principles: 1) Government should adopt and maintain sustainable fiscal policies in its national budgeting; 2) Revenue from oil and gas production should be managed in a petroleum fund in a manner that is transparent and accountable to the people of Cambodia; 3) A petroleum fund should be independent of politics and the national budgeting structure; 4) Expenditures from a petroleum fund should be investments in human and physical capital, rather than consumption, so as to help achieve long-term development goals; 5) Decisions must be made as to how to balance long-term and current needs and the rate of spending from a petroleum fund; and 6) Funds invested by such a petroleum fund should be conservatively and professionally managed offshore. Domestic Fiscal Responsibility A key component to any sustainable strategy for revenue management must be fiscal responsibility on the part of the national government. Because money is basically fungible, a well conceived petroleum fund could be sunk by an irresponsible fiscal regime. Excessive government borrowing to finance consumption or low return investments can undo the good effects of the wise management of a petroleum fund. UNDP Discussion Paper No. 2 15
  22. 22. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector The existence of potential oil revenues is not, and should not Currently, Cambodia's fiscal health is poor. Approximately one-third of the national be, interpreted budget is financed by external sources – official development assistance (ODA), non- as a signal to government organizations (NGOs), etc. It will be extremely important to put the fiscal policymakers house in order and ensure sensible fiscal rules and guides. The existence of potential that domestic oil revenues is not, and should not be, interpreted as a signal to policymakers that tax revenues domestic tax revenues are no longer important. Existence of potential oil revenues should not also be misinterpreted as a signal that Cambodia will no longer need be are no longer concerned with controlling its government spending. On both the revenue and important. spending side of the budgeting equation, the government should continue to plan as if there are no revenues available from oil production. Transparency and Accountability In order to develop long term public support for a petroleum fund and in order to reduce opportunities for corruption, there must be a high level of public disclosure relating to its operations. In addition to raising confidence in the administration of a petroleum fund, adequate public disclosure also limits potential downside losses from poor investments, sloppy management or corruption. Public Reporting of Revenues Received on a Quarterly Basis: A petroleum fund should be published on the Internet and a detailed quarterly statement of revenues received by it from contractors. Given the offshore nature that will characterize oil and gas production in Cambodia, making this information public creates public confidence that the nation is being fairly compensated for the use of its natural resources. Public Reporting of Investment Income: Quarterly publication on the Internet of a petroleum fund's investment income (loss) provides the public security that, once earned, the financial benefit associated with oil and gas production is being appropriately conserved and developed for future generations. In the event that there are poor returns, public information regarding fund performance can appropriately guide national debate and discussion regarding fund management and appropriate levels of risk. 16 UNDP Discussion Paper No. 2
  23. 23. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector Politicization of the management Public Reporting of Investments in Cambodia: entity could easily result in Quarterly publication of all investments undertaken by a petroleum fund in poor allocation Cambodia builds public confidence that revenues from oil and gas production will of investment have a positive tangible benefit for Cambodia's population and will help Cambodia funds as well as achieve its development goals. To the degree there are invested projects that do poor expenditure not meet the basic development goals of the country, regular disclosure will promote discussion and policy debate. decisions. All public reporting of a petroleum fund should be subject to regular auditing and review by an independent international auditor. Independence Careful consideration of the management structure should be a high priority in the design of any petroleum fund. The structure designated to manage both investments of a petroleum fund as well as approving expenditures in Cambodia should be independent, to the maximum degree possible, of short term politics. Politicization of the management entity could easily result in poor allocation of investment funds as well as poor expenditure decisions. A petroleum fund should be staffed by career professionals subject to a management board (setting direction and approving budgets) that has the participation of multiple stakeholders. Such a management board should include others outside the day-to-day political process. Chad provides one potential governance model for a fund. In Chad, ExxonMobil, the Chadian government and the World Bank agreed to a structure according to which Chad’s oil revenues are paid directly into an offshore account. This account is subject to strict accounting and transparency regulations. In order to spend funds from this account, the government must submit projects to the Revenue Oversight Committee, only half of whose members come from the Government. This Committee is tasked with evaluating projects and has the right to reject ones which it deems to unwise. A similar fund now being proposed for Timor-Leste establishes a Board of Eminent Persons – non-political well-respected individuals from Timor and abroad – who will play a management oversight role in the operation of a petroleum fund set up to manage the revenues from the Timor Gap. UNDP Discussion Paper No. 2 17
  24. 24. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector In addition to an independent board, a petroleum fund should keep its activities out of the national budgeting structure. This will help to address the fungibility issue and encourage continued improvement of the domestic fiscal regime. At the same time, financing on a project-by-project basis helps to ensure that the expenditures by the fund are investments in human and physical capital rather than consumption. Investment Rather than Consumption Rather than replace existing government expenditures in salaries and current costs, revenues from a petroleum fund should be viewed as natural resources to be conserved and developed. With that perspective, funds from a petroleum fund should not be expended, but rather should be invested in projects that will have positive long-term financial and economic returns thereby helping Cambodia to achieve its long-term economic development goals. While spending priorities will need to be set by the management board, obvious priorities might include primary and secondary education (including scholarships abroad), healthcare, irrigation and rural infrastructure projects and the promotion of non-farm livelihoods. These priorities areas should be funded according to their economic benefits as evaluated by skilled professionals. The government should avoid treating a petroleum fund as a "stabilization fund" as is done in some other countries (e.g., Venezuela). A stabilization fund is essentially a consumption smoothing fund that sets asides funds when prices are high and uses those funds to support budgetary shortfalls when resource prices are low. A stabilization fund can help mitigate budget shortfalls, but its focus is on consumption rather than investment. Where fiscal regimes are weak, this approach will support poor budgeting habits rather than the development of a stronger and more sustainable fiscal system. Balancing Long-Term and Current Needs The resources available to a petroleum fund could be potentially quite large especially when compared to the current size of Cambodia's economy. How much of Cambodia's petroleum revenues should be spent immediately, if any, and how much should be saved for future generations is an important policy discussion and one that must be had. It is an important question of balancing current investment needs, absorptive capacity and the responsibility to ensure resources for future generations of Cambodians. 18 UNDP Discussion Paper No. 2
  25. 25. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector In considering how to create a petroleum fund, the question of design of the fund is critical. There are multiple models. Below are just a few possible models that Cambodia might consider: Permanent Income Fund: In this model, all revenues from oil and gas are invested and only the income received from the investments is made available. By converting oil and gas in the ground to cash in the bank, this approach attempts to monetize natural resources for the permanent benefit of the people of Cambodia. The permanent annual income associated with this approach is smaller than one might expect from other approaches, especially in early stages. As a result, it requires strong political will to resist pressures to spend more of the fund immediately. Percentage of Revenue Fund: In this model, a designated percentage of revenue from oil and gas sales is distributed on an annual basis. This approach can be highly volatile and is not recommended because of the negative impact on planning and budgeting that the "boom and bust" cycle associated with swings in oil prices can have. The US state of Alaska employs this type of fund. Alaska got around the potential problem of budgeting operations attempting to rely on uncertain revenues by distributing oil revenues directly to Alaskan residents. Constant Revenue Fund: In this model, a designated percentage of gross domestic product (GDP) is distributed from the petroleum fund on an annual basis. While this approach can ensure a predictable stream of revenue over time, in the early stages, accumulation of savings will be slow and in later stages, the fund will be depleted as GDP grows. This approach does not guarantee a permanent revenue stream from the exploited oil and gas. Fiscal Deficit Fund: In this model fund (the Norwegian model), revenues are accumulated in the fund and are only paid out to cover fiscal budget deficits. This approach requires strong fiscal discipline. In the context of continuing structural deficits and fiscal laxity, this approach might rapidly deplete resources with little or no long-term benefit. UNDP Discussion Paper No. 2 19
  26. 26. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector Professional Management of Fund A petroleum fund will require professional management. The government of Cambodia reportedly has some experience using special accounts to manage funds received from privatization of state assets, etc. A petroleum revenue fund, however, has the potential to be a quantum larger than any of the funds in Cambodia's previous experience. As a result, decision makers should avoid relying on previous approaches and should hire experienced professional management. If competent investment professionals are not available in Cambodia, the government should not hesitate to hire international professional firms to assist it in managing the petroleum fund portfolio. Investment decisions of a petroleum fund portfolio should be left to professionals and should be guided by objective investment criteria. In general, the objective investment criteria should be conservative in nature with the goal of preserving the value of the oil revenues. As a result of the investment criteria, most if not all of the investments will be made offshore. Risky investments and investments of the fund portfolio within Cambodia should be avoided. Too many portfolio investments in Cambodia could raise a number of problems, including corruption and rent-seeking activity. Though there may be great interest in supporting local banking institutions by placing petroleum fund portfolio investments with them, this should be avoided unless such investments meet objective investment criteria set by the professional fund managers. Current indications from the IMF are that the Cambodian banking system is weak and does not have the capacity to assess risk. As a result, it is not likely that any of the funds from a professionally managed fund will be invested in the Cambodian banking system. 20 UNDP Discussion Paper No. 2
  27. 27. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector DEVELOPMENT OF CNPA Established in 1998, the government has designated CNPA to be the key regulatory body for the oil and gas sector. CNPA is still small, but as the oil and gas industry in Cambodia grows, CNPA will undoubtedly grow in size, skill and responsibility. As CNPA develops it should consider the following principles: 1) CNPA should focus on its core competencies 2) CNPA should invest in human resources 3) CNPA should see itself as a steward of Cambodian resources for development Focus on Core Competencies Rapid growth is difficult for any organization. Rapid growth for an organization is particularly difficult in the Cambodian context. The potential importance of the oil and gas sector means that as it grows CNPA must be very good at what it does: regulatory management of upstream activities including bidding, conservation and exploitation of Cambodia's petroleum resources. In order to meet goals of excellence in management, CNPA must clearly define its role, its mission and then focus on its core competencies. There will be many activities in the oil and gas sector. It will be best for CNPA to understand that it cannot and should not manage all of these activities. Rather, it should focus on only the most critical and most important aspects of its mission. The role of CNPA is regulatory. In terms of its regulatory function, clearly the most important function that CNPA serves is the regulation of the upstream sector. This is where CNPA is presently focusing most of its efforts. Its focus should remain there. As it grows, CNPA’s leadership should be reluctant to take on activities that resemble those of a company. CNPA will not, and should not, directly develop infrastructure for the downstream sector, including pipelines, power plants or refineries. At times resisting the urge to expand might be difficult, but it will be essential in ensuring that upstream development of Cambodia's oil and gas reserves is done efficiently with the largest possible benefit for the people of Cambodia. There are other less critical regulatory areas where it appears that CNPA might be considering carving out a role for itself. It should resist that temptation. The draft sub- decree on sharing of government responsibilities grants certain licensing and regulatory powers that take CNPA's focus away from its core mission and do not appear to serve the development of the oil and gas sector. For example, the draft decree provides CNPA authority to license crude oil traders. It is not clear what UNDP Discussion Paper No. 2 21
  28. 28. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector This lack of human resources will present purpose such a licensing regime should serve. Crude oil trading is a type of a constraint commodity trading done on the international market. If a Cambodian financial to the services company, or a Cambodian trading company, or an international oil company development with offices in Cambodia should want to purchase and sell crude oil on the markets in of CNPA as Singapore, it is not clear why they should be required to seek a license from CNPA. well as to The draft decree also grants CNPA the power to license importers of refined petroleum the industry. products. Again, it is hard to know what purpose such a licensing authority will serve. CamControl will check the quality of imported products. Environmental regulation of importers is rightly the province of the Ministry of Environment. Also, quantitative restrictions on imports are not allowed under the World Trade Organization (WTO) rules. Granting CNPA authority to grant licenses for imports of refined products could well come back to haunt CNPA in the event an uneconomic local refinery is developed and such a refinery requires protection from competitive imports. CNPA should guard against trying to do too much. For each activity it adds, there should be a clear and persuasive rationale how it fits in CNPA's core mission and why some other entity should not be responsible for the particular activity. Invest in Human Resource Development Human resource development for the oil and gas sector should be an important medium term issue for CNPA. The sector is in need of highly competent professionals in almost all aspects: geologists, petroleum engineers, managers and lawyers. It is not clear that local universities and institutions will be able to meet the needs of CNPA. For example, the local universities do not graduate petroleum engineers. The last geology under-graduates graduated from Phnom Penh universities in 2000. The geology department was then disbanded. This lack of human resources will present a constraint to the development of CNPA as well as to the industry. Unless CNPA acts quickly, it could face a rapid depletion of its best cadres as contractors begin to hire them away for critical assignments. Without competent personnel in place, CNPA will be unable to complete its core function. The scale of the human resource deficiency in this area is not overly large. A healthy Cambodian oil sector will require hundreds, not thousands, of geologists and petroleum engineers. While the scale is small, it will nevertheless require investments. 22 UNDP Discussion Paper No. 2
  29. 29. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector There are a number of options for managing this medium-term resource problem. These options include: additional on-the-job training with contractors for CNPA personnel; supporting the re-establishment of the geology department; and sending undergraduate and graduate students overseas for degree programs in geology, petroleum engineering, etc. Scholarship programs and support for re-opening of local university departments might be funded out of the Model PSC's training budget. The current level of training funds is low, but with improved prospects of commerciality, CNPA should be able to negotiate significant increases in Contractors' budgets for education and training. Stewardship The concept of stewardship is perhaps as important, if not more important, than any other of the guiding principles in this paper. As regulator of upstream development in the oil and gas sector, CNPA should be guided by the principle of stewardship. As steward of Cambodia's natural resource wealth, CNPA's decisions and regulatory actions should be made with the goal of conserving and developing the value of the natural resource for the people of Cambodia. Oil and gas are exhaustible resources so unnecessary wasting of those assets cannot be tolerated. By ensuring the wise development of Cambodia's natural wealth, CNPA will be playing a critical and vital role in Cambodia's long-term economic development. UNDP Discussion Paper No. 2 23
  30. 30. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector CONCLUSION This paper has provided some high level principles intended to guide the decision- making process in a number of areas related to the development of the oil and gas sector in Cambodia. Development of the sector is still in its early stages. There are challenges in upstream and downstream areas as well as in the efficient use of any petroleum revenues. Cambodia can ensure that any wealth that is generated by the oil and gas sector is used wisely in order to promote economic growth and development. However, ensuring that the oil and gas sector plays a positive role in economic development will require that the government begin to engage in discussions and policy debates on a number of fronts. These discussions and the accompanying decisions are best done before resources are produced in any significant quantities. 24 UNDP Discussion Paper No. 2
  31. 31. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector APPENDIX I: ANALYSIS OF MODEL PSC The following provides comments on certain provisions of the Model PSC. Where appropriate, the following analysis suggests alternate contractual language or approaches that might be more appropriate to use in future iterations of the Model PSC. 1. Definitions This section sets out definitions for terms used in the contract (identified with capital letters). This section is often treated as "boilerplate", but this is an incorrect approach. Definitions for terms can have significant impacts on the interpretation as well as the implementation of contracts. Note: One example where close reading of contract definitions results in a different interpretation is in the definition of Minimum Rate of Return in the Model PSC. The Minimum Rate of Return is defined as an "internal real rate of return" and not (( internal nominal rate of return.)) While there is only one word difference between the two potential definitions, there are real (i.e., cash) implications of choosing between one and the other. 4. Exploration Period This section sets out the term of the various stages of the exploration period, including conditions under which extensions to the various stages will be granted. Note: At the end of Stage 3, if the Contractor has not been able to establish a domestic market for natural gas, then Stage 3 of the exploration period will be automatically extended for an additional one year period. Because it is possible that both oil and gas exist in the contract area, this clause is ambiguous. This extension is unrelated to the existence of potential oil, but it provides the Contractor with a unilateral option to delay production for one year. While such an extension might be appropriate where there is only a possibility of oil, where both natural gas and oil are possible, CNPA might not want to provide the Contractor with an additional opportunity to delay production. 8. Production Permit and Development Operations This section sets out requirements for the Contractor to apply for, and the CNPA to grant, production permits for areas that the Contractor has determined are either currently commercial or potentially commercial. UNDP Discussion Paper No. 2 25
  32. 32. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector Note: It appears that under clause 8.4(d) the Contractor has the ability to delay development of natural gas (and oil) by seeking automatic renewals of its production permit until there is an economically viable market for gas. The Model PSC is ambiguous as to whether this ability to delay is specific to gas or if it can also be relied on where the Contractor has discovered oil and gas. This ambiguous provision can easily be read as an option in favor of the Contractor. The option remains with the Contractor until 15 years into what should be the production period at which point, CNPA will have discretion whether or not to issue a production permit. If CNPA does not issue a production permit, then the Contractor must relinquish the area. 9. Production Operations This section sets out a basic description of the approval process of work programs as well as specifying the 30 year term of the production period. The term provision includes a clause regarding extension of the Model PSC. Note: This provision appears to provide the Contractor a unilateral option to extend the life of the contract almost indefinitely after the end of the 30 year production period. This is unusual and precludes the possibility that 37 years after the Model PSC has been signed that CNPA might wish not to extend the contract with the Contractor. CNPA should not include an automatic extension in future iterations of the Model PSC. Note: The process for approval of work programs provides an opportunity to attempt to renegotiate certain terms of the contract. For example, the annual requirement for education spending is a minimum of $150,000 per the terms of the Model PSC. The approval process for the Work Program provides an opportunity to pressure the Contractor to increase its spending for CNPA training, including the provision of educational scholarships abroad. 10. Associated Gas This section sets out the terms on which CNPA may take any associated gas during the production period. Note: The Model PSC provides that CNPA may take non-commercial associated gas without charge. Typically, non-commercial associated gas is flared as it has little or no economic value. This term is not unusual. 26 UNDP Discussion Paper No. 2
  33. 33. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector The Model PSC requires that the Contractor re-inject any non-commercial associated gas. The Contractor will be able to lift this gas at a later point when there is a commercial market for it. Re-injection, rather than flaring, of unused associated gas is a good thing, however, since the costs associated with re-injection will be treated as a recoverable cost. CNPA should carefully assess the marginal costs associated with re-injection before requiring the Contractor to do so. 11. Allocation of Production This section sets out the allocation of production between the Contractor and CNPA. There are four general components to the allocation. First is the royalty payment. Before any production can be put towards payment of costs or profit, CNPA will take 12.5 percent of total production as a royalty. The Contractor may take up to 90 percent of the remaining production to cover the costs of exploration and production. The remaining production will be split between the Contractor and CNPA on a sliding scale. The provision also lays out the split of natural gas, net of costs. Note: The allocation of production in the Model PSC appears more generous in favor of the Contractor than PSCs from other countries in the region. See section one on upstream issues. In general, however, the right of the Contractor to keep up to 90 percent of post- royalty production in order to recover costs allows the Contractor to recover costs quickly, but it reduces the incentive of the Contractor to manage its cost structure aggressively and reduces the amount of cash flow that the CNPA can expect to receive in the early years of production. The split of net oil between the Contractor and CNPA is more generous in favor of the Contractor than it need be. Given early success with discoveries, future iterations of the Model PSC should use a net oil split more in line with splits in the region. The net gas allocation in the Model PSC is a static 65-35 split in favor of the Contractor. This allocation is unusual in two respects: first, the split is generous to the Contractor; second, typically the allocation should shift in favor of the CNPA as the amount of production increases. However, in this case the allocation between the Contractor and CNPA does not change as production of natural gas increases. This is highly unusual and future iterations of the Model PSC should include a sliding scale for the allocation of natural gas that increases in favor of CNPA as the amount of production increases. UNDP Discussion Paper No. 2 27
  34. 34. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector 12. Rate of Return This section sets out a minimum real rate of return for the development of natural gas to supply the domestic market. Note: Guaranteeing a minimum inflation-adjusted rate of return of 16 percent for the production of supply of natural gas is not a standard approach in production-sharing contracts as it removes any aspect of market risk from the Contractor. This provision is highly unusual and should be removed from future iterations of the Model PSC. According to the Model PSC, the subsidy to the Contractor in order to guarantee a minimum return will be paid by reducing the amount of CNPA's gas allocation in favor of the Contractor until the Contractor has achieved the guaranteed minimum rate of return. This structure encourages the Contractor to lift natural gas to supply to the domestic market even when there may not be sufficient market demand to justify the development. If the Contractor supplies natural gas to the domestic market before it is commercially viable to do so, then the CNPA may find itself with reduced revenues from upstream activities and potential calls for direct and indirect subsidies from downstream activities. Clause 12.6(b) is ambiguous and contains undefined terms. It is unclear what a Subsidized Project is and this should be clarified, or dropped, in future iterations of the Model PSC. 13. Marketing and Sale of Production This provision sets out the terms and obligations of the Contractor and CNPA in the marketing and sale of crude oil and natural gas. Note: The Contractor's obligation to supply some portion of its entitlement to serve the domestic market is subject to the Contractor's existing sales commitments and is limited to only its pro-rata share of the unmet domestic demand. As a result, CNPA will have a second priority to the Contractor's other sales commitments. Any oil made available for the domestic market under this provision will be sold at prices equivalent to export prices. As a result, this provision can secure access to crude oil, but not limit the price, which may be an issue in periods of national emergency. Also, this type of provision is of limited value until Cambodia has developed local refinery capacity to turn crude oil into refined product for the local market. 28 UNDP Discussion Paper No. 2
  35. 35. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector The domestic supply obligation does not apply to natural gas. The Contractor maintains the right to export its share of natural gas and is under no obligation to make any of its allocation of natural gas available for the domestic market. This is unusual as one might imagine Cambodia might at some point in the future require quantities in addition to its allocation of natural gas to supply the power sector as well as any other downstream investments that come online. The marketing provision in the Model PSC allows CNPA to piggy-back its marketing efforts on top of the Contractor's efforts. Especially in the early stages before CNPA or a national oil company have much experience in crude oil trading, having access to the Contractor's expertise in crude oil trading will be extremely valuable. 16. Petroleum Costs This provision sets out which costs associated with production of petroleum will be subject to cost recovery and which will be excluded from cost recovery. Note: Typically, this provision refers to an accounting annex which sets out the principles for determining which costs are subject to cost recovery and which are not. 17. Income Tax This provision specifies that the Contractor will pay corporate income tax equal to 25 percent of its profit oil allocation. Note: The corporate income tax rate of 25 percent is not unusually high. In light of the inconsistencies between national tax law and the Model PSC, CNPA should consider using tax rates consistent with the national tax law in future iterations of the Model PSC. 18. Surface Rental Fees and Charges This provision sets out the amount of rental fees to be paid for surface area in the contract area as well as other fees and charges that will be payable during the contract period. This provision also provides for certain tax exemptions for the Contractor and its employees. UNDP Discussion Paper No. 2 29
  36. 36. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector Note: The Model PSC calls for the establishment of a Social Development Projects Fund. Contributions by the Contractor to this fund will be considered recoverable costs under the terms of the Model PSC. CNPA should carefully consider whether and how to administer such a fund. Note: The Model PSC provides that the Contractor will be "exempt" from the Value Added Tax (VAT), among other taxes. Exemption from VAT is a technical term and results in the Contractor not being eligible for a refund under the tax laws. CNPA should consider using language that will ensure that Contractors are eligible for refunds on all VAT paid. Note: The Model PSC provides that the Contractor shall receive exemptions from income tax collection for up to ten Nominated Employees. CNPA should reconsider providing exemptions from the personal income tax laws of foreign nationals working in Cambodia. European nationals are not typically taxed by their home countries unless they are resident there. U.S. citizens are taxed on global income, but enjoy an initial exemption on approximately the first $80,000 of income. Also, investment decisions of large multinational enterprises are rarely made on the basis of incremental benefits to certain individuals within the organization. 20. Obligations of Contractor in Respect of Petroleum Operations This section sets forth the obligations of the Contractor under the terms of the Model PSC with respect to day-to-day operations. This includes obligations and undertakings relating to environmental protection, safety, protection of petroleum resources, etc. Note: The Contractor commits only to endeavor (try) to comply with Good Petroleum Industry Practices with regard to the protection of petroleum resources. This is not a very high standard of compliance. Note: The Contractor is only liable for environmental damage caused due to its negligence, recklessness or willful misconduct. This is inconsistent with the principles of Cambodian environmental law which employ a strict liability for environmental damage. 30 UNDP Discussion Paper No. 2
  37. 37. Review of Development Prospects and Options for the Cambodian Oil and Gas Sector 21. Obligations of Government This section sets forth the obligations of the CNPA under the terms of the Model PSC with respect to day-to-day operations. Note: The Model PSC includes a change in laws clause that essentially freezes in place the legislative and regulatory regime faced by the Contractor for the entire period of the PSC. If there are any changes to the legal regime which result in a material increase in the financial burden on the Contractor, CNPA is required to amend the agreement in favor of the Contractor to account for the changes. Given the long length of the contract, this provision might be costly for the CNPA. For example, if 15 or 20 years from the date of the PSC, Cambodia were to adopt stricter environmental controls with regard to the oil industry, this provision provides the Contractor with an opportunity to either extract additional allocations of oil and gas or seek exemptions from the new laws. CNPA should consider removing this clause from the Model PSC. Note: The Model PSC contains a sanctity of fundamental provisions provision. While this re-states the basic principle that one party may not unilaterally change any provision of the contract, this does not prevent unilateral waivers of rights, amendments or other changes, including a renegotiation, by both parties. 29. Administration Fee This provision sets forth certain administrative fees payable to CNPA over the course of the Model PSC. Note: The Model PSC provides for an annual administration fee of $272,000, included as a recoverable cost, to cover, among other things, costs of consultants, potentially including legal consultants. If these funds are not used for the purposes stipulated, they will belong to CNPA and be available to use at CNPA's discretion. 30. Personnel and Training This provision sets forth the Contractor's obligation to fund training opportunities for Cambodian nationals not employed by the Contractor. This provision also provides that Contractor may employ foreign nationals in its operations. UNDP Discussion Paper No. 2 31