Economic Efficiency and Optimal Contractual Design of Oil Service Contracts

In recent years, some oil and natural gas producing countries have shown more interest in adapting variations of service-type contracts rather than the traditional production sharing contracts in their oil and natural gas development and exploration projects. A service contract is a long-term contractual framework that governs the relation between a host government and international oil companies (IOCs) in which IOCs develop or explore oil or natural gas fields on behalf of the host government in return for pre-determined fees without handing over the control of the extracted or subsoil or sub-surface resources to the IOCs in most cases. Even though service contracts could help the host governments' sovereign control on their oil and natural gas resources, this framework might result in economically inefficient outcomes from a profit maximizing perspective. If we also assume that the IOCs, in general, do not consider the service-type contract as their first choice in their business models, it is possible to make a strong argument for the host governments to consider increasing the efficiency of their operation by either improving the contractual design of their service contracts or adopting other contractual frameworks. In this study, after reviewing the countries with service contracts, I describe our two models of dynamically optimal oil production for two oil fields in Iran and Iraq in order to investigate the economic efficiency of oil service-type contracts in these two countries. In both cases, I find that the structure of the service contract could contribute to the overall economic inefficiency in each country. In both cases, I also show that improving the contracts towards more economic efficient outcomes is possible. Showing the existence of economic inefficient outcomes paves the way for additional discussion on implementing some contractual and policy reforms in either of the two countries or any other country with similar contractual and regulatory frameworks.