Energy Economics 42 (2014) 395–402

Contents lists available at ScienceDirect

Energy Economics
journal homepage: www.elsevier.com/locate/eneco

On oil investment and production: A comparison of production sharing

contracts and buyback contracts
Zhuo Feng, Shui-Bo Zhang ⁎, Ying Gao
College of Management and Economics, Tianjin University, Tianjin 300072, China

a r t i c l e i n f o a b s t r a c t

Article history: Production sharing contracts (PSCs) and buyback contracts are two important contract modes in the upstream oil
Received 4 June 2013 industry. In this paper, we build a theoretical model to compare investment and production levels under these
Received in revised form 10 December 2013 two contracts. Our model results show that PSCs lead to higher investment levels than buyback contracts. More-
Accepted 28 January 2014
over, investment level increases with international oil companies’ (IOCs') share under buyback contracts. The
Available online 12 February 2014
comparison of optimal oil production depends on IOCs' share under PSCs and the host government's marginal op-
JEL classification:
erating costs from oil production under buyback contracts. When IOCs' share of gross revenues or the host
C72 government's marginal operating costs are low, optimal oil production is higher under buyback contracts; other-
D82 wise, optimal oil production is higher under PSCs. Based on such a comparison, we investigate the host
D86 government's best decisions on revenue division under these two contract types. We demonstrate that optimal
Q38 share ratios exist for the host government to obtain maximum oil revenues under both contract types. We also
Q41 find that under both contracts the discount factor and oil price positively affect optimal investment and produc-
Q48 tion levels, respectively. Our results can provide policy implications for the host government when selecting up-
stream oil contracts in international oil cooperation.
Keywords:
Upstream oil investment
© 2014 Elsevier B.V. All rights reserved.
Oil production
Oil contracts

1. Introduction
Over the period 2011–2035, oil is predicted by the IEA to remain the
principal fuel in demand among primary energy sources (IEA, 2011). To
meet projected oil demand through to 2035, $10 trillion of investment,
in 2010 dollars, is required (IEA, 2011) and most of this investment will
flow to upstream activities as displayed in Fig. 1. The developing MENA1
region, whose economies rely heavily on the oil industry, will play a
dominant role in meeting global demand, requiring over $100 billion
annually to supply the bulk of the growth in oil output to 2035 (IEA,
2011). Many other oil-dependent economies are facing a similar chal-
lenge. The investment constraint makes it a must for most of these
countries to seek international partners.
Oil revenues are important for oil-dependent countries. Oil revenues
are a main source of government income and thus serve as the central
source of government expenditures in these countries (Farzanegan,
2011; Hamdi and Sbia, 2013). For instance, in Nigeria about 95% of ex-
port earnings and 85% of government revenues have come from the pe-
troleum sector during the past three decades (Isehunwa and Uzoalor,
⁎ Corresponding author. Tel./fax: +86 22 27401083.
E-mail addresses: fengzhuo@tju.edu.cn (Z. Feng), zhangshuibo@tju.edu.cn
(S.-B. Zhang), ygao@tju.edu.cn (Y. Gao).
1
The MENA region refers to the Middle East and North Africa.
2011). Thus, from an economic point of view, maximizing oil revenues
of the host government is of great significance for these countries during
international oil cooperation.
Contract type and contractual arrangements play important roles in
international oil cooperation. They affect IOCs' preparedness to invest
and, subsequently, oil production capacity (Toft and Duero, 2011) and
rate (Zhao et al., 2012) as well as the economic development rate of
oil fields (Mahmud and Russell, 2002), all of which affect oil revenues
the host government can receive. Consequently, the manner in which
upstream activities are financed has become a major concern for coun-
tries attempting to continue to grow their petroleum sectors and their
economies (Blake and Roberts, 2006; Isehunwa and Uzoalor, 2011).
According to Johnston (2003), petroleum fiscal regimes can be
divided into two types based on oil ownership allocation: royalty/tax
systems (concession) and contractual-based systems. The latter is
subdivided into service contracts and production sharing contracts
(PSCs). Further, upstream service contracts consist of pure service
contracts2 and risk service contracts in terms of risk allocation between
the host government and IOCs. Unlike pure service contracts in which
IOCs only obtain a flat fee, IOCs' earnings depend on oil revenues
under risk service contracts. Buyback is a particular kind of risk service
2
Pure service contracts are also known as non-risk service contracts or technical assis-
tance contracts.

0140-9883/$ – see front matter © 2014 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.eneco.2014.01.010
396 Z. Feng et al. / Energy Economics 42 (2014) 395–402
Fig. 1. Investment in oil supply infrastructures and distribution, 2011–2035 (IEA, 2011).
contract under which IOCs are paid back by being allocated a proportion
of oil for services provided (Shiravi and Ebrahimi, 2006). In what
follows, we focus on the comparison of PSCs and buyback contracts.
IOCs participate in different processes of the upstream oil industry
under PSCs and buyback contracts. PSCs allow IOCs to be involved in
all processes of oil exploration and production. Under buyback con-
tracts, however, IOCs are obliged to hand over oil fields to the host gov-
ernment when production starts. From this perspective, the selection
between PSCs and buyback contracts is equivalent to the problem
whether the host government should contract out the entire process
or just part of it.
Hart (2003) provides an insightful analysis on this issue. According
to Hart (2003), if standards of operational performance are relatively
easily specified in the initial contract but the quality of the construction
is not, then the government should bundle construction and operation
tasks when contracting both out; otherwise, if the quality of construc-
tion can be well formulated when contracting but the standards of
operational performance cannot, the government should outsource
construction and operation separately. In this model, if contractors are
only responsible for construction task, they receive a fixed repayment
from the state's financial revenue and, hence, they do not have incen-
tives to take into account subsequent operating costs. Unlike the as-
sumptions in Hart's (2003) model, however, IOCs' profits depend
heavily on operational performance under both PSCs and buyback
contracts. As a result, it does not matter whether they undertake the
production task or not, IOCs need to take into account the resulting op-
erating costs when deciding on the investment level.
Studies of buyback indicate that such a mode has limited ability to
access foreign investment (Azadi and Yarmohammad, 2011). Moreover,
compared with other upstream oil contracts, buyback contracts are
unable to promote oil production (Ghandi and Lin, 2012). Therefore,
buyback contracts cannot bring higher oil revenues for the host govern-
ment. In this paper, we focus on a comparison of buyback contracts and
PSCs to identify under what conditions those problems may emerge.
Specifically, this paper seeks to answer the following questions:
• Which of these two upstream oil contract types leads to a higher
investment level?
• Which of these two upstream oil contract types leads to a higher oil
production level?
• How can the host government obtain higher oil revenues by control-
ling the contract parameters?
Some policy implications can be derived from our analysis. First, our
analysis implies that operatorship matters. The allocation of operatorship
has a great effect on investment and production levels. Second, our re-
sults identify different factors that affect investment and production
levels under PSCs and buyback contracts. Third, our results also suggest
how the host government should decide on contract parameters to max-
imize her oil revenues from international oil cooperation.
The remainder of this paper is structured as follows. Section 2 pre-
sents a literature review of the evolution of PSCs and buyback contracts
and examines the risks borne by IOCs under these two contract modes.
Section 3 describes and compares the fiscal regimes of these two up-
stream oil contract modes. Section 4 builds a model and analyzes its
results. Finally, Section 5 concludes and suggests further research.
2. Literature review
2.1. The evolution of PSCs and buyback contracts
PSCs stemmed from sharecropping contracts in agriculture (Cotula,
2010), and were introduced into the oil industry in Indonesia in the
1960s. Since then, they have been employed by most oil-producing
regions with the exception of North America and Western Europe
(Bindemann, 2000). According to Johnston et al. (2008), over 50% of
oil-producing countries are using PSCs. OPEC has been an important
player in the world energy market (Sari and Soytas, 2009), controlling
about 78% of the world's oil reserves (Horn, 2004). Half of its member
countries adopt PSCs as their primary mode of upstream investment
regulation. These observations indicate the predominance of PSCs in
the upstream oil industry, but PSCs also introduce problems, particular-
ly the possibility that excessive profits might accrue to IOCs when oil
prices rise. Bindemann (2000) analyzes PSCs' evolution to respond to
oil price movements and indicates that PSCs, in their present form,
offer more flexibility and add more negotiable variables, such as royal-
ties, signature bonus and taxes, leaving less profit room for IOCs.
Risk service contracts are recognized worldwide due to their suc-
cessful implementation in Brazil in 1976 (Gao, 1994). The buyback is,
essentially, a particular type of risk service contract now mainly used
in Iran. Shiravi and Ebrahimi (2006) provide a comprehensive analysis
of Iranian-style buyback contracts, including their history, main features
and status in the Iranian oil industry. Following Iran's exercise, short-
term Iranian-style buyback contracts were introduced in Iraq in order
to attract foreign investment and technology to restore its oil produc-
tion capacity during the transition period (Marcel and Mitchell, 2003).
The application of the buyback approach also results in many problems.
Although Iranian-style buyback contracts have been modified (Shiravi
and Ebrahimi, 2006) to satisfy IOCs' demand for benefits to match the
risks undertaken, the buyback share of investment in the Iranian up-
stream petroleum industry has declined dramatically from 37.7% in
2005 to 16.6% in 2007 with a slight improvement in total investment
(MRC, 2008). Moreover, according to Azadi and Yarmohammad
(2011) and Fard (2011), the role of buyback contracts in Iran to attract
international investment is fading. Ghandi and Lin (2012) indicate,
using empirical data on annual average daily production, the failure of
buyback contracts to lead to optimal production in the cases of Soroosh
and Nowrooz in Iran.
2.2. Risks undertaken by IOCs
Based on the analysis of cash flow of IOCs, Ghandi and Lin (2013)
provide comprehensive risk factors under buyback contracts. These
risk factors include capital cost overrun, the time profile for capital
expenditures, operating and maintenance cost, delay in construction,
oil price fluctuations, deviations from the contractual production level,
London Interbank Offered Rate (LIBOR) reduction, and the remunera-
tion not being realized. According to them, capital cost is the most
important risk factor for IOCs. This means that IOCs cannot be compen-
sated for necessary expenditures above the amounts agreed upon in
contracts (Van Groenendaal and Mazraati, 2006). Risks borne by IOCs
under buyback are summarized in Table 1.
There are no systematic studies of risk allocation for PSCs. How-
ever, it is acknowledged that, as discussed above, with more terms
favoring the host government being introduced, IOCs will bear
more risks compared with the initial version used in Indonesia.
 Z. Feng et al. / Energy Economics 42 (2014) 395–402
Table 1
Risks undertaken by IOCs under buyback contracts.
Risk Risk factors
The overrun of non-capital Underestimation of the investment required
and operating costs
Capital expenditure above Unpredictable changes in market conditions, technical issues,
the agreed amount the time profile for capital expenditures, etc.
Changes in the original More information and data available as a result of development IOCs need to obtain the host government's approval
development plan operations
Revenue insufficiency Overestimation of production; inability to achieve contract
objectives; oil price fluctuations; deviations from the
contractual production level
Delay of the project Changes in the main development plan; delays in obtaining
governmental clearance; delays in obtaining approval from
the government; delays in handing over the contract area to
IOCs; delay in construction
According to Bindemann (2000), as a response to price rises in
1973/74 and 1989/90, terms such as royalties and tax payments
are becoming common in contracts, leaving less room for IOCs to
cushion the risks they face.
3. A comparison of fiscal regimes
As the framework to manage, regulate and share oil revenues, the
fiscal regimes are of paramount importance for the host government
and IOCs (Isehunwa and Uzoalor, 2011). They specify the distribution
of oil revenues. In this section, we provide a quantitative description
of the fiscal regimes of both PSCs and buyback contracts to prepare for
the model in the next section.
3.1. Outline of PSCs3
If commercial reserves are found in the acreage, IOCs are granted the
right to enter into the development stage under PSCs. A typical PSC con-
tains four tiers to allow IOCs to recover costs and to attain profit.
Firstly, the royalty is extracted by the host government in proportion
to gross revenues. We denote this percentage with notation α and then
the royalty is R = αPQ, where P is the current oil price and Q represents
oil output.
Secondly, capital expenditures are recovered from oil revenues in
the term of cost oil. Most production sharing contracts set a limit, σ,
on oil revenues for capital recovery4. The balance is carried forward
and is recovered later if the limit is exceeded. Therefore, the oil revenues
IOCs can achieve from cost oil are C = σ(1 − α)PQ.
Thirdly, the profit oil – the remaining oil after the deduction of roy-
alties and cost oil – is divided between the host government and IOCs at
an agreed ratio δ. Therefore, the revenues IOCs can receive from profit
oil are PO = δ(1 − σ)(1 − α)PQ.
Finally, the host government taxes the profit oil received by IOCs in
the tax rate μ. Then the tax is TAX = μδ(1 − σ)(1 − α)PQ.
The above four terms – royalty, cost oil, profit oil and tax – generalize
the main characteristics of a typical PSC. If IOCs' operating and
3
For a comprehensive discussion on the fiscal regimes of PSCs, see Johnston (2003).
4
The host government may specify cost recovery ceiling based on gross revenues or net
revenues. These stipulations are essentially the same and do not influence our analysis.
397
Results Sources
The excess decreases the share to recover capital Ghandi and Lin (2013)
costs and remuneration fee Shiravi and Ebrahimi (2006)
Van Groenendaal and Mazraati
(2006)
The excess cannot be withdrawn Ghandi and Lin (2013)
Shiravi and Ebrahimi (2006)
Van Groenendaal and Mazraati
(2006)
Azadi and Yarmohammad
(2011)
Shiravi and Ebrahimi (2006)
and to bear the resulting costs exceeding the capital
ceiling
The outstanding amounts of recovery will be carried Azadi and Yarmohammad
forward (2011)
Ghandi and Lin (2013)
Shiravi and Ebrahimi (2006)
Van Groenendaal and Mazraati
(2006)
Cost recovery and the payment of a remuneration fee Ghandi and Lin (2013)
will be postponed Shiravi and Ebrahimi (2006)
Van Groenendaal and Mazraati
(2006)
maintenance cost is denoted by OM1, the net oil revenues that IOCs
can receive in the production stage under PSCs will be
CR1 ¼ C þ PO−TAX−OM1 ¼ ð1−α Þ½δð1−σ Þð1−μ Þ þ σ PQ−OM1 :
For simplicity, we replace (1 − α)[δ(1 − σ)(1 − μ) + σ] with a sin-
gle notation τ, defined as the share ratio under PSCs. Then IOCs' net oil
revenues in the production stage can be rewritten as
CR1 ¼ τPQ −OM 1 : ð1Þ
3.2. Outline of a buyback contract
Under the buyback mode, IOCs are obliged to transfer operatorship
together with surface infrastructure to the host government when oil
production begins. The investment is then repaid by oil revenues.
Van Groenendaal and Mazraati (2006) describe the cost recovery mech-
anism under buyback contracts. They indicate that Iranian buyback
contracts contain four main elements: capital expenditure and the
repayment of the investment, payment on bank charges based on the
LIBOR plus a premium, remuneration for IOCs' efforts and an agreed
upon internal rate of return for IOCs. All repayments follow the sequen-
tial deduction of operating and maintenance costs OM2 and the host
government's share φ of gross oil revenues. Therefore, IOCs' revenues
are no bigger than (1 − φ)(PQ − OM2) under the buyback contracts.
To simplify, we assume that the repayments distributed to IOCs are
the highest they can achieve, that is, CR2 = (1 − φ)(PQ − OM2).
In this paper, we adapt the notations used by Van Groenendaal and
Mazraati (2006). We also replace (1 − φ) with a single symbol λ,
defined as the share ratio under the buyback contract. Then, the oil rev-
enues of IOCs under buyback contracts can be rewritten as
CR2 ¼ λðPQ−OM2 Þ: ð2Þ
The share ratios under both contract types determine distribution of
oil revenues as well as the distribution of risk taking. Under buyback
contracts, the host government operates oil fields and the IOCs attain
the share of oil revenues after operating costs have been deducted.
Moreover, IOCs can only be compensated within the capital ceiling.
These are two main risks that the IOCs undertake. From the expression
of CR2, the IOCs' revenues are represented by the product of the share
398 Z. Feng et al. / Energy Economics 42 (2014) 395–402
Fig. 2. Allocation process of oil revenues under PSCs. (Source: adapted from Central Bank
of Russia (2011)).
ratio and net oil revenues. This means that revenue allocation happens
after the deduction of operating costs. Moreover, the capital ceiling is in-
herently incorporated into the share ratio λ. Therefore, the risks that
IOCs undertake are accordingly introduced into the revenue function.
PSCs have incorporated more terms such as royalties and tax payments,
which leave less profit room for the IOCs. Moreover, the IOCs also have
to be subject to the capital ceiling. Under PSCs, the share ratio is defined
based on royalty, capital ceiling, profit oil allocation and tax rate and
thus incorporates risk allocation.
Figs. 2 and 3 illustrate the allocation process of oil revenues under
PSCs and buyback contracts, respectively.
4. Model
Both PSCs and buyback contracts can be classified as public–private
partnership (PPP) approaches, innovative ways of financing for the
government to procure facilities and infrastructure. Compared with
the traditional transaction approach, the main feature of PPP is bundling
construction and operation tasks when contracting both out. This com-
parison has been widely studied (see Hart, 2003; Martimort and Pouyet,
2008; Roehrich and Caldwell, 2012). Our model idea partially comes
from Hart's (2003) analysis. However, unlike Hart's model in which
the investor's income is fixed, which is from the state's financial re-
sources, IOCs' profits depend on oil revenues and cannot be compensat-
ed by the government budget under both contract types. Consequently,
IOCs have to take into account the resulting operating costs when they
make investment decisions.
The three stages of an oil venture are exploration, development and
production (Kaiser, 2007), which is represented in Fig. 4. The respective
objectives of these three stages are to estimate reserves for the prepara-
tion of well pattern design, to construct the surface infrastructure and
drill the wells, and to maintain and improve the oil production level.
The host government and IOCs contract at Date 0; the oil field is
Fig. 3. Allocation process of oil revenues under buyback contracts. (Source: adapted from
Central Bank of Russia (2011)).
explored between Dates 0 and 1 and is developed between Dates 1
and 2. Oil production starts at Date 2 and IOCs are in charge thereafter
under PSCs. However, the host government is responsible for produc-
tion during this period under buyback contracts.
4.1. Model assumptions
Consider a new oil project that is implemented and financed by IOCs.
The IOCs make decisions on two investment types between Dates 0 and
2, i and e, under both contract types. The first investment type, i, can re-
duce the fixed operating costs by improving project quality, which is
similar to Hart's assumption. The second investment type,5 e, is for bet-
ter oil recovery which can make oil more easily extracted by maintain-
ing reservoir pressure. This is achieved by better equipment and
technology. These two investment types are capital expenditures of
IOCs. Oil production between 2 and 3, Q, is determined by IOCs under
PSCs and the host government under buyback. We use k = 1, 2 to differ-
entiate operators of IOCs and the host government, respectively and,
to simplify, suppose that the operating cost function is OMk = OM0 −
βk(i) + γk(e, Q), where OM0 is the fixed operating costs, βk(i) is the
cost saving function resulting from quality improvement by investment
i and γk(e, Q) is the cost function resulting from oil production. For PPP
projects, the private developer is inclined to invest more to elevate pro-
ject quality during the construction phase in order to reduce operating
costs incurred in the subsequent operation stage (Hoppe et al., 2013).
Hence, a higher investment level leads to lower operating costs. Howev-
er, its marginal effect is diminishing, known as the law of diminishing
marginal returns. Hence, we can assume that βk′(i) N 0, β″k(i) b 0 and
γke(e, Q) b 0, γke2 ðe; Q ÞN0, where γke(e, Q) and γke2 ðe; Q Þ mean taking
the first and second derivatives of γk(e, Q) with respect to e, respective-
ly. Moreover, absolute values of β′(0) and γke(0, Q) are sufficiently large.
Also, it is reasonable to assume that γk(0, Q) approaches infinity when
no money is invested for oil production.
We assume that operating costs increase with Q, i.e. γkQ(e, Q) N 0,
where γkQ(e, Q) means taking the derivative of γk(e, Q) with respect
to Q. Further, we assume that the second derivative of γk(e, Q) with
5
We thank one anonymous reviewer for suggesting this investment type.
 Z. Feng et al. / Energy Economics 42 (2014) 395–402 399

and
 
′
 1 1
β2 i2 ¼ N : ð10Þ
Fig. 4. Timeline of oil exploration, development and production. rλ r
   
Suppose that β′2 i2 ¼ 1r , i2 Ni2  , and then β′1 ði1  Þ−β′2 i2 ¼ 0. Ac-
respect to Q is also positive, i.e., γkQ 2 ðe; Q ÞN0 (k = 1, 2), which high-
cording to the assumption β1 ′ ðiÞ−β2 ′ ðiÞN0, we can get that i1  Ni2 Ni2  .
lights increasing marginal costs when reserves are depleted

Similarly, we can achieve that γ 2e e2 ; Q ¼ − rλ 1
and e1⁎ N e2⁎. Hence,
(Chakravorty et al., 1997; Rigobon, 2008).
Management by the government suffers from bureaucratic ineffi- PSCs lead to higher investment levels compared with buyback contracts.
ciency due to its huge organization and various incentive and infor-
mation problems (Qiu and Wang, 2011). Therefore, it is reasonable 4.2.2. Production comparison
to assume that the reduction of fixed operating costs resulting from We then compare optimal oil production under these two upstream
investment under IOCs' operatorship is larger than the reduction oil contracts. Under PSCs, IOCs control operatorship and determine the
under the host government's operatorship, i.e. β1(i) N β2(i). Similar- production level to maximize the profit. The first-order condition of
ly, the operating costs incurred by oil production under IOCs' (3) with respect to Q is
operatorship are smaller than the costs under the host government's

τP−γ1Q e; Q 1 ¼ 0; ð11Þ
operatorship, i.e. γ1(e, Q) b γ2(e, Q). In consideration of IOCs' experi-
ence and expertise, they can use investment and operate oil fields
where Q1⁎ is IOCs' optimal production level under PSCs.
more efficiently compared with the host government. Thus, we fur-
Under buyback contracts, the host government controls operatorship
ther assume that IOCs obtain more marginal benefits from oil invest-
and determines oil production to maximize her oil revenues. Subtracting
ment and incur lower marginal costs from oil production i.e.
IOCs' oil revenues under buyback contracts, the oil revenues that the host
β1 ′ ðiÞNβ2 ′ ðiÞ , γ2e (e, Q) b γ1e (e, Q) and γ2Q (e, Q) N γ 1Q (e, Q). The
government can achieve is r(1 − λ)(PQ − OM2) = r(1 − λ)(PQ − OM0 +
above assumptions are displayed in Figs. 5, 6 and 7.
β2(i) − γ2(e, Q)).
Solve
4.2. Modeling
max r ð1−λÞðPQ−OM0 þ β2 ðiÞ−γ2 ðe; Q ÞÞ:
Q
4.2.1. Investment comparison
Based on the above discussion, IOCs' net present revenue function
under PSCs is The first-order condition with respect to Q is


P−γ2Q e; Q 2 ¼ 0: ð12Þ
−i−e þ r ðτPQ−OM1 Þ ¼ −i−e þ r ðτPQ−OM0 þ β1 ðiÞ−γ 1 ðe; Q ÞÞ; ð3Þ
where Q 2  represents the optimal production level for the host
where r represents IOCs' discount factor.6 Whereas under buyback con- government.
tracts, IOCs' net present revenue function is From Eqs. (11) and (12), we can derive that


−i−e þ rλðPQ−OM2 Þ ¼ −i−e þ rλðPQ −OM 0 þ β2 ðiÞ−γ2 ðe; Q ÞÞ: ð4Þ γ1Q e; Q 1 ¼ τP; ð13Þ

and
The first-order conditions of (3) with respect to i and e are


γ2Q e; Q 2 ¼ P: ð14Þ
′

−1 þ rβ1 i1 ¼ 0; ð5Þ
We cannot determine which is bigger for Q 1  and Q 2  under above
assumptions. To carry out a further analysis, we examine a special

  case in which the host government's marginal operating costs resulting
−1−rγ 1e e1 ; Q ¼ 0; ð6Þ
from oil production are proportional to those of IOCs, that is γ2Q(e, Q) =
ργ1Q(e, Q), where ρ ≥ 1. Then, we have
where i1 and e1⁎ are optimal investment levels for IOCs under PSCs.



The first-order conditions of (4) with respect to i and e are ργ1Q e; Q 2 ¼ P: ð15Þ

′

−1 þ rλβ 2 i2 ¼ 0; ð7Þ From Eqs. (13) and (15), we can get that
8  
< Q1 b Q2 ; if ρτ b 1
 

 Q1 ¼ Q2 ; if ρτ ¼ 1 : ð16Þ

−1−rλγ2e e2 ; Q ¼ 0; ð8Þ :  
Q 1 NQ 2 ; if ρτ N1

where i2  and e2⁎ are optimal investment levels for IOCs under buyback. Therefore, the comparison between optimal production levels under
From Eqs. (5) and (7), we can immediately get PSCs and buyback depends on the host government's marginal operat-
ing costs and the IOCs' share under PSCs.
′
 1
β1 i1 ¼ ; ð9Þ 4.2.3. The host government's best response7
r
Oil revenues are important for the host government in international
oil cooperation. In this section, we will discuss how the host

6
The discount factor has a negative correlation with the discount rate. If the discount
7
rate is ε, then the discount factor can be represented as r = 1/(1 + ε). We thank one anonymous reviewer for suggesting this section.
400 Z. Feng et al. / Energy Economics 42 (2014) 395–402

β (i) γ (e,Q)
γ2 (e,Q)
γ1 (e,Q)
β1 (i)

β (i)
2

Fig. 5. Assumptions of β1(i) and β2(i).

government controls parameters of τ and λ to obtain highest net oil rev-

enues. The net present revenue that the host government achieves
Q
under PSCs is RP = r(1 − τ)PQ1⁎. Under buyback contracts the host gov-
Fig. 7. Assumptions of γ1(e, Q) and γ2(e, Q) on Q when e is fixed.
ernment will obtain RB = r(1 − λ)(PQ2⁎ − OM2⁎), where OM2⁎ = OM0 −
β2(i2⁎) + γ2(e2⁎, Q2⁎). From Eq. (13) we can see that Q1⁎ is the function
dQ 1 obtain that
of τ and ¼γ P
. Therefore, the first-order condition of RP with
dτ
1Q 2 ðe;Q 1 Þ
" #
¼ −rPQ 1 þ r ð1−τ  ÞP γ
P
respect to τ is dR P
¼ 0, which can be sim-

dτ
1Q 2 ðe;Q 1 Þ  1 1
−r PQ 2 −OM2 −ð1−λÞ
 −
 ¼ 0: ð18Þ
plified as rλ3 β″2 i2 rλ3 γ 2e2 e2 ; Q

 γ1Q 2 ðe; Q 1 ÞQ 1 We will show that there is λ* ∈ (0, 1) such that Eq. (18) holds. Let f
τ ¼ 1− : ð17Þ
P 


ðλÞ ¼ −r PQ 2 −OM2 −ð1−λÞ rλ3 β1″ i − rλ3 γ 1 e ;Q and then we
2ð 2Þ 2e2 ð 2 Þ
γ 2 ðe;Q  ÞQ 
We now demonstrate that τ* ∈ (0, 1). Let g ðτ Þ ¼ τ−1 þ 1Q P 1 1 , have f(1) b 0. According to Eq. (10), β ði2 Þ and γ2e(e2⁎, Q2⁎) will go to
′ 
2
then g(1) N 0. From Eq. (13), Q1⁎ approaches zero when τ approaches infinity if λ approaches zero. Based on our assumptions, this means
zero and thus g(0) b 0. Note that g(τ) is continuous, therefore, τ* that i2  and e2⁎ will approach zero. Therefore, − r(PQ2⁎ − OM2⁎) is posi-
∈ (0, 1) exists to make g(τ*) = 0. tive when λ → 0. Note that the second term of f(λ) is positively infinite
We now calculate the optimal λ* for the host government when λ → 0, therefore f(λ → 0) N 0. Because f(λ) is continuous, we can
under buyback. From Eq. (10) we can see that i 2⁎ is dependent on immediately obtain that λ* ∈ (0, 1) exists to make Eq. (18) hold.
di2 de2
λ and ¼ − rλ2 β1″ . Similarly, ¼ rλ2 γ
. Therefore, the first- 1
dλ 2 ði2 Þ ðe2 ;Q Þ dλ
2e2

 4.3. Model results and discussion
¼ −r PQ 2 −OM2 þ
B
order condition of R B with respect to λ is dR dλ
h
 
 de i
 1
 In this section, some propositions are derived from our model re-
r ð1−λÞ β′2 i2 dλ2 −γ 2e e2 ; Q dλ2 ¼ 0. Pluggingβ′2 i2 ¼ rλ
di
,γ2e e2 ; Q ¼
sults. Also, some policy implications for the host government are noted.
di2 de2
− rλ
1
, ¼ − rλ2 β1″ , and ¼ rλ2 γ 1
into the equation, we can
dλ 2 ði2 Þ dλ
2e2 ðe2 ;Q Þ Proposition 1. PSCs lead to higher investment levels of i and e than
buyback contracts, independent of the share ratios. Moreover, optimal
investment level increases with IOCs' share under buyback contracts.
γ (e,Q)
γ (e,Q) This proposition means that IOCs place more investment into the
2
early stages under PSCs to reduce subsequent operating costs regardless
of the share ratio. In fact, once an oil contract has been signed, the share
ratio is determined. Hence, IOCs pay less attention to it when making in-
vestment decisions, which subsequently affects operating costs and
profit. More importantly, because IOCs are responsible for the operation
task under PSCs, all of the benefits from the increase of investment be-
tween Dates 0 and 2 are enjoyed by themselves. However, revenue allo-
cation happens after the deduction of the host government's operating
costs under buyback contracts. Therefore, this allocation mechanism
leads to only partial benefits from the increase of investment being
attained by IOCs, which reduces their tendency to invest more. This
also explains the optimal investment level increases with IOCs' share
γ1 (e,Q) under buyback contacts.
e Another possible explanation of the relatively low investment level
under buyback contracts lies in the ownership allocation. The main rea-
Fig. 6. Assumptions of γ1(e, Q) and γ2(e, Q) on e when Q is fixed. son why Iran adopts buyback is to protect national oil reserves. As a
 Z. Feng et al. / Energy Economics 42 (2014) 395–402
result, an IOC involved in buyback contracts adds no oil to its portfolio
and acts as a service company to supply the required capital and tech-
nology (Azadi and Yarmohammad, 2011). Under PSCs, however, IOCs
are granted rights on percentages of oil produced and operatorship
rights on the developed oil field (Ghandi and Lin, 2012), which can be
shown as assets on their books. Hence, on the strength of such booked
assets, they are able to access cheap finance, which leaves more oil
revenues for capital recovery and, accordingly, results in a higher invest-
ment level.
Ghandi and Lin's (2013) empirical research also implies the failure of
buyback contracts to promote investment levels. They study the effects
of changes in capital cost levels on IOCs' rates of return under buyback
contracts. Their results support our results by showing that capital
cost reduction increases rates of return and results in a larger variation
compared with the same percentage of increase. Consequently, if IOCs
attempt to increase their rates of return, they will cut their investment
in capital cost under buyback contracts.
As mentioned above, buyback contracts are not an ideal system to
promote investments in comparison with PSCs. This explains, from an
economic perspective, why they are mainly used in oil fields that
enjoy favorable geological conditions and require less surface infra-
structure (Al-Attar and Alomair, 2005).
Proposition 2. Under both contracts, a smaller discount factor leads
to lower investment levels, while it has little effect on optimal oil pro-
duction.
Note that the discount factor has a negative correlation with the dis-
count rate. Therefore, a smaller discount factor means a higher discount
rate, which represents less importance placed by operators on future
yields. Consequently, IOCs decrease their investment or even divert to
other businesses if their investment will be recovered in the long run.
When production starts, however, IOCs' main concern is to optimize
oil output in order to recoup their outlays as soon as possible, leaving
less emphasis on the discount factor. Ghandi and Lin's (2012) empirical
research supports our result on the optimal daily production of Iran's
Soroosh and Nowrooz fields under buyback contracts when profit is
maximized. According to them, optimal cumulative oil production is
approximately equal under different discount rates in various year/
perspective versions of their model.
Proposition 3. If γ2Q(e, Q) = ργ1Q(e, Q) and ρτ b 1, buyback contracts
lead to higher oil production; otherwise, if ρτ ≥ 1, PSCs lead to higher
oil production.
Proposition 3 means that if the host government attempts to in-
crease oil production under buyback contracts, she has to decrease her
marginal operating costs to make ρτ b 1. However, to make PSCs out-
weigh buyback contracts in oil production, the oil share that IOCs can
achieve should be enlarged to realize ρτ ≥ 1.
It is claimed that, in addition to pursuing revenue maximization, Iran
also intends to elevate its oil production level (Ghandi and Lin, 2012).
Owing to a lack of expertise and technology, however, the government




of Iran operates oil fields inefficiently and incurs higher marginal oper-
ating costs under buyback contracts, which hardly satisfy the condition
of ρτ b 1. As a consequence, the oil production level is lower under buy-
back contracts than that under PSCs.
Ghandi and Lin's (2012) empirical research also attributes the low
level of oil production under buyback contracts to the government's inef-
ficient operation. Hence, to continue to use buyback contracts in the up-
stream oil sector, the Iranian government should learn more technology,
master better management skills and gather more experience. To this
end, a number of clauses are specified in buyback contracts. Iranian buy-
back contracts specify provisions on technology transfer requirements
for IOCs, including clauses for the employment and training of nationals
as well as clauses to promote local industries and services. The Iranian
401
government should explicitly define the contents of technology transfer
and formulate regulation procedures to evaluate IOCs' performances in
this regard. Aside from these, a new amendment has recently been pro-
posed for future buyback contracts that IOCs are required to have Iranian
personnel present in the operation, so that these personnel might be
trained more effectively to handle the operation afterwards (Ghandi
and Lin, 2012).
In addition, if IOCs' share in the PSCs is small enough to make ρτ b 1,
they do not have enough incentives to produce.
In light of the discussions above, we find that, attention should be
paid to different parameters to increase oil production under PSCs and
buyback contracts. If PSCs are used in the upstream oil sector, the
share ratio between the host government and IOCs is of paramount im-
portance. Hence, differing from previous research mainly emphasizing
the cost recovery limit (Johnston, 2003), this study suggests that all fac-
tors affecting the share ratio – the royalty, the cost oil ceiling and the
profit oil allocation – affect oil production. Whereas if buyback contracts
are used, the reduction of the host government's or her representative's
marginal operating costs is beneficial for all parties involved, even if
their goals are divergent.
When ρ = 1, a corollary of Proposition 3 can be achieved.
Corollary 1. If γ2Q(e, Q) = γ1Q(e, Q), that is, marginal operating costs
increase equally under both contracts when oil production is Q, buyback
contracts lead to higher oil production.
Proposition 4. Optimal oil production increases with IOCs' share in
PSCs; however, IOCs' share in buyback contracts does not affect optimal
oil production.
Under buyback contracts, the host government operates oil fields
whose operating costs will get fully compensated before allocation.
Therefore, the profit of the host government is in proportion to net oil
revenues. This means that oil production can be determined based on
net oil revenues regardless of share ratio under buyback. However,
under PSCs when more oil is produced, only part of it is obtained by
IOCs while the operating costs are being all borne by IOCs themselves.
Therefore, optimal oil production is enhanced if a bigger part of oil rev-
enues is allocated to IOCs. Thus, the share ratio in PSCs is a critical factor
for the host government to encourage IOCs to enlarge the collective eco-
nomic pie.
Proposition 5. Higher oil price leads to higher oil production levels
under both contract types.
The logic behind Proposition 5 is intuitive. When oil price rises, IOCs
under PSCs increase oil production to seize more oil revenues. Similarly,
to respond to high oil prices, the host government under buyback con-
tracts enhances production level to generate more government revenues.
Proposition 6. The optimal share ratio for the host government under
γ 2 ðe ;Q  ÞQ 
PSCs is τ ¼ 1− 1Q 1P 1 1 ; the optimal share ratio under buyback is
λ*, where λ* solves −r PQ 2 − OM 0 −β2 i2 þ γ 2 e2 ; Q 2 − 1−λ
rλ3

1
β″2 ði2 Þ
− γ 1e ;Q ¼ 0.
2e2 ð 2 Þ
We cannot derive the explicit forms of τ* and λ* without further as-
sumptions, but we have demonstrated that both τ* and λ* exist. From
the expression of τ*, the optimal share ratio is determined under PSCs
regardless of IOCs' investment level for quality improvement. In fact,
from our model, this investment type does not affect IOCs' decision on
oil production under PSCs. Moreover, the host government gets her rev-
enues before deduction of operating and maintenance costs; thus i does
not appear in the host government's oil revenue function under PSCs.
Therefore, i does not affect the host government's decision on τ*.
402 Z. Feng et al. / Energy Economics 42 (2014) 395–402
However, the host government determines λ* under buyback based on
both investment levels and her decision on oil production. This is essen-
tially because revenue allocation happens after deduction of operating
and maintenance costs. λ affects IOCs' investment level for quality im-
provement and thus the host government's subsequent operating and
maintenance costs. Therefore, the host government needs to take all
of the variables into account when determining λ.
5. Conclusions and further research
In the next two decades, oil will remain the leading fuel among
primary energy sources. Global upstream oil sectors have witnessed a
huge increase in oil exploration and production costs. Moreover, the de-
sire for exploring and operating oil fields more efficiently has increased
the need for technology and management skills in major oil-producing
countries. These challenges largely drive the main oil-producing coun-
tries to delegate exploration and production tasks to IOCs.
PSCs and buyback contracts are two business models of partnerships
between the host government and IOCs. Previous studies indicate that
under current circumstances, IOCs favor PSCs over buyback contracts
in that the potential risks under the latter far exceed those under the
former. This, however, does not suggest the invalidity of the buyback
mechanism because the benefits allocated to IOCs can be negotiated
and adjusted to match the risks shared by them. Differing from previous
research, our analysis is operatorship-based. We find that buyback con-
tracts per se, in comparison with PSCs, are less conducive to improving
investment levels, which explains why risk service contracts are used
more commonly in oil-rich countries in which exploration and produc-
tion costs are relatively low.
Buyback contracts and PSCs have different effective domains to pro-
mote oil production. We identify two critical factors affecting oil pro-
duction under these two contract modes: IOCs' share under PSCs and
the host government's marginal operating costs under buyback con-
tracts. Therefore, to enhance oil production under PSCs, it is necessary
to ensure that IOCs maintain a higher share, whereas under buyback
contracts, reducing the host government's marginal operating costs
should be the main way to promote oil production. As additional results,
we also find that under both contracts, the discount factor positively af-
fects optimal investment levels and oil price positively affects optimal
oil production level.
We also investigate how the host government controls contract type
and parameters to obtain maximum oil revenues. Even though the
explicit forms of optimal share ratios are not given without further as-
sumptions, we have demonstrated that such share ratios exist. By com-
paring oil revenues under these two optimal share ratios, the host
government can choose the contract to attain higher oil revenues.
This paper compares only two upstream oil contracts based on the
assumption that share ratios are constant. Further studies could cover
the scenarios where share ratios can be adjusted according to oil pro-
duction level. Moreover, during the comparison of inherent incentives
of PSCs and buyback contracts to improve investment and production
levels, we assume that the host government acts as the revenue-
maximizer. However, the host government may have other objectives,
such as maintaining oil price stability, improving employment rate
and increasing political voice on the world stage, which will inevitably
affect her decisions on choice of contract type and share ratios. Further
work could make a more thorough comparison by incorporating these
multiple objectives of the host government into analysis so that we
can have a deep understanding of different performance of PSCs and
buyback contracts in practice.
Acknowledgments
We thank two anonymous reviewers for their highly insightful sug-
gestions. This research is financially supported by grants from the
National Natural Science Foundation of China (71172149 and
71231006). The authors would also like to thank Richard Fellows,
Zhan Li and Yao Li for the English proofreading. Any mistakes or faulty
interpretations are completely our own.
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