For years, oil and gas companies primarily utilized production sharing contracts when partnering with governments or other firms to research and develop natural resources. Lately, however, there has been increasing use of service level agreements to govern these relationships. This type of agreement has various advantages, as well as one particular disadvantage that can be rather significant. Despite their limitations, they are continuing to become the agreement of choice among companies in the oil and gas sector. Here are two reasons these agreements are so popular now, as well as the major drawback to them, and some things that firms must consider before agreeing to this kind of arrangement.
Capital Without Control
Countries rich in natural resources obviously want to exploit those resources to their advantage. Unfortunately, this can be incredibly costly and time-consuming. And, in many cases, countries may not have the expertise or technological know-how to even attempt this. For this reason, governments lured foreign companies to help with exploration and development with the promise of sharing the proceeds, the terms of which were outlined in those production sharing contracts. Although these arrangements still exist and have their own benefits, countries are often concerned that they will lose control over the resource and production processes.
It is because of this fear that service level agreements have become more mainstream, as foreign companies with the requisite capital can get the projects off the ground without the government relinquishing as much control. In most service agreements, the firm with the capital will engage in the exploration and development of the host nation’s natural resources in exchange for fixed fees or other payments. From a contract management perspective, this seems like it will make matters slightly less complicated as the end goal is to simply provide a service. However, it can also make things slightly tricky because the firm may not have complete say in how it will deliver that service given that the government asking for such an arrangement is likely seeking to retain ultimate control.
Expertise Without Interference
Of course, in addition to firms offering capital that a government might not otherwise have readily available, they also bring along the all important expertise and technological tools needed. The benefit to the service agreement is that the outside firm is expected to deliver a service, and as with any service-oriented enterprise, the goal should be to ensure customer satisfaction.
Since the service agreement determines the firm’s compensation, there can be more focus on doing the job to the host country’s satisfaction and less focus on the firm’s own enrichment. The firms that enter into a service agreement must simply provide their expertise to earn their fees and refrain from interfering with the manner in which the host country’s leaders intend to handle and utilize those resources. The contract management team, in particular, must ensure compliance with any government mandates as well as timely performance to ensure a positive outcome.
Beware of Lost Profits
The mere mention of lost profits clearly raises a gigantic red flag. Most companies do not want to enter into a contract that promises any such outcome. The thing about lost profits in this case is that it does not entirely impact the service-bound firm because it should have negotiated for pay that is not associated with output. Now, from the host country’s standpoint, this may signal that a firm will not have the incentive to work hard if they earn the same amount regardless of what they manage to extract, and in some instances there may be firms guilty of such laziness. But, as with any service agreement, an unhappy client will inevitably result in a contract cancellation or non-renewal.
Thus, although the country rich in resources may not earn as much as it could, profit maximization may not be the driving force for its exploration and development, at least not at the outset. In many cases, countries with newly discovered natural resources must first determine what exists, examine whether it can be used internally, and then assess whether exportation is possible.
Ultimately, managing a service level agreement is not all that different from managing any other type of service contract, primarily requiring diligent oversight and punctual performance.