THOUGH not a common term outside of accounting, ring-fencing is an important aspect of production contracts and activities and plays a role in how exploration and development costs are recuperated or recovered by oil companies.

Production Sharing Agreements allow oil companies to recoup the costs they incur from drilling the wells and building the infrastructure needed to extract resources. Depending on the terms of the production sharing agreement, the oil company recoups a portion of these costs from the initial production volumes (cost oil) prior to revenue splitting between the company and the government (profit oil). This basic cost recovery is a part of standard contracts.

The challenge comes with finding the right balance for how much of these costs are recovered from the initial production volumes and how. Specific cost recovery terms reflect the nature of the amount of risk in the exploration and development work the oil company is undertaking, as well as the projected pace of production and other complex factors.
A government negotiating a contract with companies normally has several competing priorities. Naturally, they want to maximize the amount of total revenue that the country receives. But they must also ensure that the contract creates incentives for companies to keep exploring and drilling wells. This balancing act makes cost recovery provisions one of the most delicate parts of a contract.

Depending on the country and contract, a company is allowed to get back the costs of developing a well through a share of production or by tax allowances. Some countries allow cost recovery to be extended to developing nearby wells under the same contract (called block wide ring fencing), which are technically separate projects but are being undertaken by the same company in an area. In effect, this allows greater capital flexibility and coordination in development.

In this way, countries can encourage companies to explore larger areas and develop more wells, which ultimately leads to more revenue and more production. A country may lose some initial revenue that it otherwise would have gained through taxes or production sharing, but the trade-off is increased exploration activity, production potential and higher government revenues in the long-run.

Some countries put restrictions on this accounting practice. These restrictions are called field level ring-fencing because they draw a metaphorical fence around a field and only allow companies to recoup expenses from development within that geographic ring. Any costs incurred on wells inside of the ring can be deducted from production at future wells inside the ring-fence if the wells are successful, but the costs can’t be deducted from any other existing or future production outside of the ring-fence.

Field level ring-fencing can slow down the overall pace of development because companies need to take higher risk that the cost of the exploration well won’t be recuperated, provide more money up front to keep developing wells and wait years longer for that investment to pay off, if that investment pays off at all. This increases risk and can discourage any exploration or development work beyond the specific requirements of the contract for that area.

As the Natural Resource Governance Institute (NRGI), an international nonprofit dedicated to responsible management of resources, explained in a report about Ghana’s challenges with ring-fencing, “Despite widespread use, ring-fencing must be approached with caution. It has the potential to speed up the payment of corporate income tax, yet it may also deter further exploration and development, limiting the future tax base.”

As Guyana explores creating provisions related to ring-fencing to future oil and gas contracts, it’s important to consider the “double edged sword” aspect of ring-fencing that the NRGI is talking about. We naturally want to get as much revenue as possible. But getting more in the short term might not be worth sacrificing long term revenues and the overall pace of development.

It will be up to the government to listen to experts and find a balance that serves Guyana’s interests both now and in the future.