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Crude oil and its extraction

The much sought after and depleting hydrocarbon resources, crude oil and natural, are nothing more than an ‘anomaly’ for the geologist who finds it. For, it is the anomaly in the seismic data of the earth’s surface, which is a signpost—dig there and you find it. The chase for oil and gas properties across the world has never been so furious. At the forefront of the rush are the Chinese companies, which are scrambling to secure energy supplies from every conceivable corner of the Earth. ONGC Videsh Ltd (OVL), the overseas investment arm of the state-owned ONGC, is well entrenched in this game, where geopolitics sometime override economic considerations. How does this business work? For a citizen wondering what the commercial underpinnings of this oft-repeated mantra of energy security is all about, here’s a primer. FE takes a Closer Look at the issue:

 

How are the various kinds of oil and gas properties bought and sold in the market?

 

There are three kinds of oil properties. Undeveloped exploration blocks are the first kind, where only seismic data is available — data which leave a lot to interpretation on the location of oil and gas, its quantity. For instance, the 5A block in Sudan, which OVL bagged sometime back in an undeveloped block. The second category relates to discovered, though undeveloped blocks. Here, oil/gas has been found, though investments to evacuate the hydrocarbon have not been made. The third category is the producing block, as in the case of the Greater Nile property in Sudan, where OVL picked up a stake.

 

How are the properties valued?

 

In the case of undeveloped properties, the sponsor works with limited data on hydrocarbon reserves. The risk associated with this business is the highest. The uncertainty plagues the ability to forecast development costs, reserves, etc. More often than not, the estimates are way off the actuals. In the case of discovered, though undeveloped blocks, the risk is definitely lower, though the cost variations on setting up infrastructure to evacuate, the production schedule estimates, as well as the reserve estimates, can vary. The classic example is that of OVL’s investment in Sakhalin, Russia. Here, OVL initially pegged the internal rate of return at 14%. However, this was pruned to 11%, following the slippage in production schedules and review of reserves. In the case of producing blocks, the returns are the lowest, in line with the lower risk. OVL’s attempt to take a pie of the Russian oil major, Yuganskneftgas, is an example.

 

How does geopolitics impact the returns from oil fields?

 

One man’s poison is another nectar. A few years before, when OVL got into Sudan, the country risk was very high, since there was civil unrest and it was seen to be a refuge for terrorists. So, when an American company decided to pull out, it could not extract the premium, since the political risk borne by it was higher than that borne by India. To put in perspective, OVL’s bid for the Russian property, if successful, will not earn as much returns as the Sudan property.

 

How does OVL bid for a property?

 

Here’s the tough part. So tough that OVL’s owner, the government, has stated in internal meetings that a more transparent mechanism needs to be adopted to determine bid prices. In the case of the Sakhalin property, investments have overshot 25%. However, there are good stories like Sudan. Simply put, OVL takes the weighted average long-term price of oil, taking that as the year-1 price. It builds a 3% escalation on the price and arrives at the bid level, which also takes into account the fiscal regime in the country bearing the asset. The return on a net present value basis of this bid is called the hurdle rate. This has, more or less, been the international model! Though, of late, owing to the sustained firm global price of crude, OVL has expressed its apprehension to the government that the pricing model requires refinement.

 

In a consortium, why is there is a clamour for operatorship of the hydrocarbon block by the various stakeholders?

 

The operator decides the way to extract the hydrocarbon resource, in a manner that returns are maximised. It is the operator who will invest equipment and other resources to commercialise the hydrocarbon property, Since there is no one way to do it, each corporate entity brings its own methodologies. In a consortium, operatorship technically does not provide any financial advantage in terms of share of hydrocarbon extracted. On the flip side, there is always the fear that the operator will gold-plate the project, hence earn more than the other stakeholders. This is a fear that is entertained by the government, too, since it also gets a share of the oil or gas in cash or kind, which is arrived at after knocking off the costs involved in extracting the hydrocarbon.