review of development prospects for the cambodian oil and gas sectors.pdf

Insights for ActionReview of Development Prospectsfor the Cambodian Oil and Gas Sectors

Cambodia

Discussion Paper No. 2

2006

Cambodia

United Nations Development ProgrammeNo. 53, Street Pasteur, Boeung Keng Kang,P.O. Box 877 Phnom Penh, CambodiaTel: (855) 23 216167 or 214371Fax: (855) 23 216257 or 721042E-mail: [email protected]

http://www.un.org.kh/undp/

UNDP CambodiaInsights for Action Initiative

Background: UNDP’s Insights for Action (IFA) initiative was developed and launched inMay 2004 in the follow-up to a meeting between H.E. Prime Minister Hun Sen andDr. Hafiz Pasha, the Regional Bureau Director of UNDP. The Prime Minister emphasizedthat “Cambodia needs UNDP much more for its ideas than its money”.

The IFA initiative was created to undertake policy research and to facilitate policydialogue among the Cambodian Government, Cambodian society and Cambodia’sdevelopment partners.

Purpose: The IFA initiative is aimed at generating innovative ideas and practicalknowledge for the effective implementation of the Government’s RectangularStrategy. Special focus is given to those aspects of the Rectangular Strategy withgreatest scope for rapidly advancing progress towards Cambodia’s MillenniumDevelopment Goals (CMDGs). In addition to a Knowledge Generation component,there is also a Knowledge Sharing component aimed at helping catalyze and developsupport for needed decisions and actions.

New Knowledge Generated: Valuable new knowledge and insights in several criticalareas have already been generated through well targeted research in collaborationwith the Supreme National Economic Council (SNEC), a cross-ministerial advisorycouncil that reports directly to the Prime Minister.

Knowledge Sharing: The Insights for Action initiative has also been developing arange of knowledge sharing activities and modalities including the CambodiaEconomic Forum (CEF), successfully launched in January 2006, media conferences,website development, and the beginning of a series of Insights for Action publications.

© 2006, UNDP CambodiaReview of Development Prospects and Options For the Cambodian Oil and Gas SectorUnited Nations Development Programme Cambodia

DISCLAIMERThe responsibility for opinions in this publication rests solely with the authors.Publication does not constitute an endorsement by the United Nations DevelopmentProgramme or the institutions of the United Nations system.

Review of Development Prospects and Options For the Cambodian Oiland Gas Sector

A UNDP Funded Discussion PaperIn Cooperation with

The Cambodian National Petroleum AuthorityHarvard’s John F. Kennedy School of Government

and Stanford University’s School of Law

Foreword

The discovery in late 2004 of potentially significant reserves of oil and gas off the coastof Cambodia presents potentially major opportunities for the country’s socio-economic development, but also some potentially major challenges.

Judging from experiences in a number of other low income developing countries overthe past forty years, the sudden surge of petroleum related revenues can have majorimplications for a country’s development path and the well-being of its people.

Unfortunately, more low income developing countries than not have been impactednegatively following a sudden surge of revenues from petroleum and other such non-renewable natural resource extraction. Reflecting these negative experiences, a newdevelopment term has emerged called “resource curse”.

Therefore, this second Insights for Action Discussion Paper attempts to facilitate abetter understanding of the possibilities in Cambodia by outlining the findings of aninitial scoping of the oil and gas sector in the country. The purpose of such a scopingis to motivate and facilitate advance planning in case future petroleum revenuesprove to be significant.

The paper also outlines some key principles to ensure that the oil and gas sectordevelops with efficiency and with maximum net revenues accruing to Cambodiathrough the negotiation of effective Production Sharing Contracts.

Most important, the paper provides an initial analysis of some of the basic safeguardsneeded to better ensure that Cambodia avoids the serious mistakes made bygovernments in some oil exporting developing countries, and Cambodian peopleavoid a resource curse and enjoy a resource blessing.

The research for this paper was carried out in the summer of 2005 with the assistanceof the Harvard University’s John F. Kennedy School of Government and Professor BrianQuinn from Stanford University’s School of Law, in collaboration with researchers fromthe Cambodia National Petroleum Authority (CNPA). The main findings of this researchwere presented at the Cambodia Economic Forum (CEF) in January 2006 organized bythe Supreme National Economic Council in collaboration with CNPA and UNDP.Participants included His Excellency Prime Minister Hun Sen, Senior Ministers andother policy officials, local universities, the international development community,NGOs, and other stakeholders.

Given the potentially major socio-economic implications for Cambodian people,UNDP’s Insights for Action initiative plans further applied research in this importantsubject area as the possibilities evolve.

Insights for ActionUNDP CambodiaJanuary 2006

iUNDP Discussion Paper No. 2

Review of Development Prospects and Options for the Cambodian Oil and Gas Sector

Table of Contents

Introduction 1

Upstream Issues 2

Upstream Development Principle 2 Maximizing Revenue from Upstream Activities 2

Box 1: A High Level OCA/JDA Strategy 6

Downstream Issues 7

Downstream Development Principles 7Maintaining Open Markets 7Minimize Direct Investments by the Government 8Ensure Market Risks Remain with the Private Sector 8Avoid Cross-Subsidization 8

Downstream Development of Oil 9Box 2: Smuggling and Downstream Development 11

Downstream Development of Natural Gas 11Box 3: Development Opportunities for LPG 13

Management of Petroleum Revenues 14

Domestic Fiscal Responsibility 15Transparency and Accountability 16Independence 17Investment Rather than Consumption 18Balancing Long-Term and Current Needs 18Professional Management of Fund 20

Development of CNPA 21

Focus on Core Competencies 21Invest in Human Resource Development 22Stewardship 23

Conclusion 24

Appendix I: Analysis of Model PSC 25

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ABBREVIATIONS AND ACRONYMS

CNPA Cambodian National Petroleum Authority

GDP Gross Domestic Product

IMF International Monetary Fund

JDA Joint Development Area

KWH Kilowatt hour

LPG Liquefied Petroleum Gas

MW Mega Watt

NGO Non-governmental organisation

OCA Overlapping Concession Area

ODA Official Development Assistance

PSC Production-Sharing Contract

UNDP United Nations Development Programme

VAT Value Added Tax

WTO World Trade Organization

1UNDP Discussion Paper No. 2


INTRODUCTION

Recent discoveries in offshore Block A and expectations of possible discoveries in theoverlapping concession area (OCA) between Thailand and Cambodia are generatingnew interest in the oil sector. It is still too early in the process to say with any certaintyhow much, if any, of the discoveries will ultimately be commercially viable. However,it is not too early in the process to begin to plan and to think about how Cambodiacan prepare itself in the event that there are significant oil and/or gas resources incommercial quantities.

The United Nations Development Programme (UNDP) does not have a direct interestin the oil and gas sector, however, experience in developing countries which havefound significant hydrocarbon resources suggests that the UNDP and internationaldonors can play a role in assisting host country governments to prepare to efficientlymanage the sector as it develops. There are many examples of resource rich countriesin the developing world where poor management of the sector becomes a roadblockto the country's ability to meet its own development goals, presenting bothmacroeconomic and political challenges. With proper planning and adequatemanagement, however, there is no reason why Cambodia should fall into the pile ofunsuccessful resource-rich economies.

This paper is not intended to provide a complete overview of all policy andmanagement issues in the oil and gas sector. It is, rather, intended to raise importantissues and in order to stimulate further discussion within the Cambodian NationalPetroleum Authority (CNPA) and between CNPA and UNDP. This first section of thispaper provides analysis of some of the most important issues relating to explorationand production of hydrocarbons (Upstream), including analysis of the modelproduction-sharing contract (Model PSC) in use in Cambodia. In the Upstream sector,Cambodia's focus should be on maximizing the revenues associated with explorationand production of crude oil and natural gas. The second section of this paper dealswith issues facing CNPA relating to potential development of petroleum refining andlocal marketing of refined petroleum products (Downstream). In the Downstreamsector, Cambodia should ensure that consumers and end-users have access to refinedpetroleum products and natural gas at world prices. The third section of this paperprovides options for managing revenue that might be expected from Cambodia'supstream activities. The emphasis regarding management of oil and gas revenuesshould be on the most efficient utilization of the resources to promote achievingCambodia's long-term development goals. The final section of this paper focuses onmanagement and development challenges facing CNPA itself, including legislativeand regulatory challenges.

UPSTREAM ISSUES

Upstream Development Principle

Negotiations with international exploration and production companies should bestructured and carried out so as to maximize revenue from production sharingcontracts (PSC) and the joint development area (JDA) with Thailand.

Maximizing Revenue from Upstream Activities

To a degree, the Model PSC is a product of the period when it was first developed inthe late 1990s when oil prices were low and there was little international interest inCambodia's oil sector. At the time, CNPA also had very little experience in negotiatingrevenue contracts. Three years later, prospects in Block A, the OCA, as well as in theother internal blocks, have improved and have attracted the interest of internationalplayers. Given the shift in negotiating leverage, the CNPA should regularly revisit itsModel PSC and its approach to negotiating future PSCs in order to maximize, to thegreatest extent possible, revenue and benefit for the Cambodian economy. Evenmodest improvements in the Model PSC can result in large marginal gains for theCambodian side given the length of the contracts and the amount of revenueinvolved.

Though the Model PSC does not offer an explicit opportunity for renegotiation, in thecontext of an ongoing contract there are always opportunities to begin arenegotiation. For example, the annual approvals of work programs required as partof the Model PSC each present an opportunity for parties to renegotiate the termsupon which the relationship moves forward. Renegotiations can be quite contentious,so CNPA should be very judicious in determining the circumstances and the termsupon which it might seek a renegotiation with any parties that have already signedthe Model PSC.

In general, the terms of the current Model PSC are generous in favor of the Contractor.The Contractor may receive up to 90 percent of the post-royalty production in orderto recover costs. The remaining ten percent of production will be split between theContractor and the CNPA on a sliding scale. At lower levels of production, the marginalsplit of "profit oil" is 58-42 in favor of the Contractor. The marginal split moves in favorof the CNPA (58-42) at production levels in excess of 50,000 barrels per day. Themarginal profit oil split in the Model PSC is the lowest of all profit oil splits whencompared to terms of PSCs from other countries in the region. Additionally, the ModelPSC is the most generous in the region in allowing contractors to recover costs fromoil revenue. The 90 percent allowance for cost recovery limits the amount of possiblecash flow that will become available to Cambodia in the early stages of production.


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Even modestimprovements in the ModelPSC can resultin largemarginalgains for theCambodian side given thelength of thecontracts and the amounts of revenueinvolved.

The chart below estimates the average percentage of revenue per barrel that therelevant host country might expect to receive given the contract terms above atvarious prices per barrel of crude oil. At lower prices, CNPA's estimated revenue perbarrel can be expected to be less than that of any of its neighbors. When the ModelPSC was first negotiated in the late 1990s, long-term oil price targets were in the rangeof only about $20 per barrel. At these prices, CNPA would have only expected revenueon the order of ten percent of revenues, the lowest expected revenue in the region.Over the past five years, industry analysts have adjusted their long-term target pricesto the $40 range. At these higher prices and assuming costs of production remainrelatively low (assumed $10 per barrel), CNPA can expect revenues on par with thoseof other countries in the region. From the chart below, it appears that there may beroom to negotiate improvements in future iterations of the Model PSC so as to limitthe downside risk (of a decline in crude prices). CNPA might also want to considerlowering maximum cost recovery available to the Contractor so that it is more in linewith other countries in the region so as to increase the guaranteed cash flow availableto CNPA as profit oil.

UNDP Discussion Paper No. 2


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$25.00 $35.00 $45.00 $55.00 $65.00Cambodia 45% 53% 57% 60% 62%Malaysia 45% 53% 57% 60% 62%Indonesia 56% 67% 73% 76% 79%Vietnam 41% 49% 53% 56% 58%Myanmar 43% 50% 54% 57% 59%Philippines 39% 46% 50% 52% 54%

Royalty Cost Recovery Profit Oil Split

Cambodia 12.5% 90% 58%-42%Vietnam 0.0% 40% 68%-32%Indonesia 20.0% 85% 85%-15%Philippines 7.5% 70% 60%-40%Myanmar 10.0% 50% 65%-35%Malaysia# 10.0% 45% 50%-50%MTJA* 10.0% 50%

Royalty Cost Recovery Profit TaxThai (III) 5-15% Amortized over 5-10 years 50%

Summary of Regional Revenue Splits

# Malaysian shallow water PSC terms.* Malaysia-Thailand Joint Area.

Estimated Percentage of Revenue per Barrel Allocated to Host Countryat Various Prices*#

* Assuming a fixed cost of $10.00 per barrel and profit oil splits equal to the highest marginal splits in favor of the government. Different actual costs may have significant impacts on the amount of revenue available.

# Includes revenue from corporate taxes.



On the natural gas side, the 65-35 allocation of profit gas in the Model PSC is favorableto the Contractor. Unlike the allocation of profit oil, the profit gas allocation under theModel PSC does not employ a sliding-scale which would improve the allocation infavor of the CNPA as average production per day increased. Using a static allocation ofprofit gas, rather than a sliding-scale, does not appear to have a basis. Given the natureof the reservoirs offshore Cambodia there may be limited economies of scaleassociated with increasing production, however the fact that the Contractor will beable to recover its costs through the cost allocation formula, the lack of economies ofscale is not a sufficient argument against employing a sliding scale to favor CNPA athigh levels of production.

The Model PSC guarantees the Contractor a 16 percent real rate of return on anyinvestments made in order to develop production for Cambodia's downstreamdomestic market for natural gas. As the guarantee of a 16 percent real return will bepaid for by adjusting CNPA’s natural gas allocation downward, a guarantee such as thishas significant implications with regard to the size of revenues that Cambodia mightexpect to receive from natural gas development. The guaranteed rate of return makesit more likely that the Contractor will pursue larger than necessary developmentsbefore local market demand has developed to sufficiently to support suchdevelopment. Depending on the the absolute amount of the guarantee and the priceof natural gas, CNPA’s revenues from natural gas could be significantly reduced as aresult of pursuing development of downstream natural gas opportunities beforethere is sufficient market demand to support that development.

For a more detailed analysis of relevant contractual terms in the Model PSC seeAppendix I.

Pending discussions with Thailand regarding the JDA present an opportunity for theCNPA to improve the revenue position of Cambodia relative to contractors. It will belikely that the JDA will adopt a single approach to granting development rights andthat the terms will be an improvement of the current Model PSC. Of course, if the JDAdevelops a Thai-styled concession approach rather than a production sharingapproach, CNPA may have to go through an additional learning process beforebecoming proficient with its terms. Nevertheless, once the JDA's model petroleumagreement is in place, CNPA can use it to improve its position relative to allsubsequent contractors both in and out of the OCA. It will, of course, be critical thatCNPA is well represented and negotiates the terms of the JDA’s model PSC when it isnegotiated.

Legal Counsel and Use of Outside Legal Counsel

Over the next decade, CNPA will be required to negotiate many production sharingcontracts and petroleum agreements. The current Model PSC, with some adjustments,is a good starting point for negotiations, but CNPA will need to structure negotiationsin order to maximize its position in the process of negotiating a production sharingcontract.

Building a strong legal department within CNPA must remain a key part of CNPA'sdevelopment strategy (see Section 4); however, the negotiation of PSCs is a complexspecialty that will take some time to learn. Negotiation of these contracts is also ahigh-risk endeavor – where learning by doing will be too expensive to risk, especiallyfor a country like Cambodia.

International exploration companies rely on large legal teams and outside counselwhen negotiating PSCs. CNPA should not be afraid to do the same. Relying onexperienced outside legal counsel in order to negotiate on behalf of CNPA could havevery positive benefits with respect to revenue accruing to CNPA in connection withPSCs.

Hiring competent legal counsel to represent CNPA for the negotiation of a PSC assistmight cost as much as $750,000. Though this might appear at first glance to be a largefee, relative to the potential benefit that might accrue from competent and effectivelegal counsel, it is not. For example, if outside legal counsel can improve the revenueallocation one percent in the direction of CNPA over the Model PSC, which couldimprove CNPA annual revenue by almost $1 million (assuming 75,000 barrels per day,at $50 per barrel). Competent legal counsel can help build additional flexibility intothe PSC in favor of Cambodia that might assist in the development of a localpetroleum services sector.

Most legal advisors will charge their clients in one of three ways: hourly rate, set fee orhourly rate on a contingency basis. Each of these arrangements has its ownadvantages and disadvantages. Hourly rates encourage legal advisors to spend agreat deal of time on issues large and small. While this usually assures thoroughanalysis of all issues, it can become quite expensive. Set fees for particular projectsensure certainty of price. Legal advisors will have the incentive to minimize theamount of work they do under these arrangements in order to maximize their profitmargin. As a result, legal advisors have an incentive to skimp on analysis of issues.Finally, contingency arrangements appear, at first glance, to be a convenientarrangement, but contingency payments can create incentives for legal advisors toensure that a deal is signed, sometimes to the detriment of the client’s rights. CNPAshould avoid contingency and set-fee arrangements. Though more expensive, hourlyrates will ensure that CNPA's legal advisors are working mostly for the benefit of theCNPA.



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Internationalexplorationcompaniesrely on largelegal teams and outsidecounsel whennegotiatingPSCs. CNPAshould not beafraid to dothe same.

Previously, CNPA has used international legal counsel as resource persons. Underthese arrangements CNPA consulted in preparation for negotiations with potentialcontractors. Using legal advisors in this manner is relatively inexpensive, but CNPAshould reconsider this approach. CNPA should consider allowing legal counsel to bethe primary negotiator of the PSC on behalf of CNPA. The presence of a third party(legal counsel) as primary negotiator creates additional negotiating room for CNPA.CNPA can use that negotiating room to push for better terms and, if necessary, forcompromise. While there may be sensitivities about a heated negotiation, competentcounsel will not feel embarrassed about asking for a lot, pushing the other side anddemanding the best deal for CNPA. The "good-cop, bad-cop" negotiating strategy iswell known, but yet still quite effective. Using outside legal counsel createsopportunities to improve CNPA's position in negotiations without injuringrelationships between the principals.

One area where more aggressive use of outside counsel will be helpful will be in theresolution of negotiations with Thailand over the OCA and the JDA. Given Thailand'sgrowing need for new hydrocarbon resources to meet demand by 2010, the Thai sidewill likely be under increasing internal pressure to reach agreements with bothCambodia and contractors. This pressure may create negotiating leverage that outsidecounsel and CNPA can use to improve Cambodia's relative position in negotiations.



The current state of parallel negotiations with Thailand over the ODA and JDA has the potential toget stuck. Though there is increasing pressure for the Thai side to come to an agreement soonerrather than later, their past insistence on low-level technical solutions to demarcation anddelineation issues makes it unlikely to expect a drastic change in stance. In addition to the lack ofdocumentary evidence needed to conclude the question of the land border at the coast, thereremain larger questions of approach to delineating the sea borders. The solutions to both of theseissues will, in the end, be largely political and will require decisions at the highest levels on bothsides. In order to change the current negotiating dynamic and reach a satisfactory conclusionrapidly, it might well be in the best interests of both sides to reach out to a neutral third party toassist in reaching a consensus outcome and resolution of outstanding border issues.

A former head of state of a country with good relations with both Thailand and Cambodia mightbe in the best position to play the role of good faith intermediary. By escalating the negotiationsaway from the technical level and dealing with players at the highest levels, parties will be able tochange the dynamic that has stalled the negotiations for the past few years. A high-levelintervention strategy can help to rapidly bring the outstanding issues to conclusion in a mannerdeemed fair by both sides.

Former international heads of state or other international persons of stature have been known tooffer their services to assist in these types of matters. CNPA could approach some potentialintermediaries through UNDP or the consultant. The consortium of OCA contractors would likelybe willing to underwrite the expense of bringing in this type of high-level assistance.

Box 1: A High Level OCA/JDA Strategy

DOWNSTREAM ISSUES

Downstream Development Principles

Policymakers are presently discussing development of certain downstream industriesin Cambodia. Given the large amounts of capital investment required by this sector,CNPA should rely on a number of basic principles in guiding their decision-makingregarding whether and how to develop certain downstream activities. Theseprinciples include the following:

1) Maintain open markets for imports of refined petroleum products to ensurethe lowest possible price for consumers;

2) Minimize direct investment in downstream entities by the government orgovernment-controlled entities;

3) Ensure that market risks for private investments in the downstream sectorremain with the private sector; and

4) Avoid cross-subsidization between the upstream and downstream sectors.

Maintaining Open Markets

In markets where demand is small, most downstream investments will require someform of market protection in order to earn a positive financial return. While marketprotection regimes, either in the form of quantitative restrictions on imports ordiscriminatory import tax, can help a small, inefficient downstream facility make afinancial return for its investors, they will result in higher-than-necessary prices forcommodities, like fertilizer or refined gasoline. These increased prices will act as a taxon Cambodia's poorest consumers and farmers and often benefit only foreigninvestors or groups of local elites who have invested in these projects.

As a member of WTO, Cambodia allows for quota-free importation of refinedpetroleum products. Refined petroleum products are subject to a relatively high taxregime (100 percent +), including import tariffs, special excise taxes and VAT.Cambodia should continue to allow private companies involved in downstreamdistribution to elect to import refined petroleum and fertilizer for so long as it isfinancially profitable for them to do so. Allowing competition with imported productswill force downstream industries to be efficient and will ensure that prices faced byconsumers will be no higher than world prices for comparable commodities.



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Minimize Direct Investments by the Government

Downstream activities, including pipelines, oil refineries, fertilizer plants and powerplants are all commercial activities. Government investment, be it direct or throughthe use of ODA or guarantees for foreign loans, should be minimized. Rather thanguiding decisions by social or other concerns, CNPA should treat all investments in thissector as commercial decisions to be managed by the private sector. Leaving theinvestments and the investment decisions to the private sector will ensure thatdevelopment of the downstream sector will be efficient and responsive to marketdemand. Government investments in low return projects like fertilizer plants and oilrefineries will act as a tax on Cambodia's farmers and consumers.

Ensure Market Risks Remain with the Private Sector

Market risks associated with private investments in downstream industries shouldremain with the private sector. By reducing risk associated with certain downstreamprojects, private sector investors might be induced to undertake investments thatthey would otherwise not pursue. Subsidies need not always take the form of cashpayments to investors. There are many potential forms of subsidies, including marketshare guarantees, restrictions on imports, loan guarantees, and access to ODA loansamong others. Government guarantees and implicit subsidies to private investors inthe downstream sector can result in large contingent liabilities for the governmentthat could prove to be a drag on economic growth and potentially reduce the CNPA'saccess to crude oil revenues. In order to ensure that downstream developments donot prevent Cambodia from reaching many of its development goals, the privatesector should be allowed to evaluate and make investment decisions in thedownstream sector without the presence of economic distortions.

Avoid Cross-Subsidization

Upstream and downstream projects each need to stand independently on their ownfeet. The CNPA should avoid selling crude oil or natural gas to domestic downstreamprojects at less than export prices. Selling crude oil and natural gas at the highest pricepossible, avoiding cross-subsidization, will maximize revenue and ensure thatCambodia's energy resources are used in the most efficient manner possible.Providing crude oil and natural gas to downstream projects at less than export pricesis a hidden subsidy that could cause gross distortions and inefficiencies. If there aresocial needs or concerns that policymakers wish to address through downstreamprojects, a more transparent subsidy program might be better suited to meetingthose goals.



Market risks associatedwith privateinvestments in downstreamindustriesshould remainwith theprivate sector.

Downstream Development of Oil

Oil producing countries throughout the world often develop oil refineries in order tomeet domestic demand and to supply refined product for export. However, oilrefineries – even small, strategic ones – can present significant risks to economic growthand development. Indeed, a back of the envelope analysis suggests that even a small,strategic refinery could significantly reduce CNPA's revenue from oil production.

For the purposes of this analysis, assume the following:

• Daily average oil production of 50,000+ BBL/day;• Oil refinery with 40,000 BBL/day capacity, operating at 100 percent capacity;• CNPA's allocation 13,181 BBL/day;• Contractor's domestic market obligation: 26,819 BBL/day supplied at world

price to refiner;• Price differential per barrel between local refinery and international refineries:

15 percent; and• Import market for refined petroleum products remains open.

Small, strategic oil refineries require less investment (on the order of $300 million fora 40,000 barrel per day plant) than larger, export-oriented plants, but the lowerinvestment is not without a cost in efficiency. Because oil refining is an industry that ismarked by significant economies of scale, smaller plants are less efficient than largerones. Assuming the price per barrel of refined petroleum for a small refinery is 15percent higher than the price per barrel of refined petroleum from a more efficientrefinery, refined products supplied by the small refinery will be more expensive thantheir imported substitutes (excluding transportation costs of approximately $12/tonfrom Bangkok to Sihanoukville).

In order for the small refinery to be commercially viable it will require subsidies orquantitative restrictions on imports. Cambodia's open market and the prevalence ofsmuggling make quantitative restrictions or additional tariff protection less likely tobe effective. Given the ineffectiveness of traditional mechanisms the most obviousavenue for subsidy will be through underpricing of CNPA's allocation of crudesupplied to a strategic refinery.

The terms of the Model PSC require that if the Contractor is required to serve thedomestic market under the Domestic Market Obligation provision that it will do soonly at export prices. In order to cover the 15 percent differential in price betweenimported refined product and refined product produced locally, CNPA would have todeliver approximately 46 percent of its daily allocation to the refinery at no cost as a



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hidden subsidy to the refiner. Assuming a $50 per barrel price for crude oil, this hiddensubsidy could cost Cambodia approximately $100 million per year. The simple analysisabove assumes 100 percent utilization of a local refinery and does not take intoaccount the fact that the particular product mix of heavy and light fuels produced bya local refinery may not precisely match local demand, leaving open the possibilitythat additional imports of particular product types might still be required.

Because of the requirements of the Model PSC for sales of the Contractor's crude toany local refinery at world prices, Cambodia should not expect that significant pricereductions will result from a small refinery coming online. Indeed, if the investmentcost for a small refinery is financed with a foreign currency loan (including a soft loan),net foreign exchange savings may also be minimal, if not negative depending on thenature of the financing. As a result, the $100 million hidden subsidy for a local refinerywould be insurance against supply disruption only.

The question that policymakers should ask is whether $100 million per year is tooexpensive for insurance and whether or not there are more cost effective ways toreach the same supply security goal. While potential supply disruption is a legitimatepolicy issue, it must be looked at in context. For the most part, international tradingmarkets for oil are deep and buyers and sellers are anonymous. Internationalcommercial players have little motivation to stop supply to any particular customer.Refining capacity in the region may, for the time being, be tight, but that does not inany way signal that significant supply disruptions are on the way. Given the currentstructure of international oil markets, the risk of supply disruption is limited. It isunlikely that if a major supplier, like Vietnam, unilaterally decided to stop supplyingrefined product to Cambodia that alternative supplies wouldn't be available fromelsewhere in the region. Indeed, Cambodia's present competitive retail distributionmarket is a de facto energy security policy. Multiple importers sourcing product froma variety of sources and countries assures that Cambodia has a diversified source forits energy needs and that the risk of unilateral disruptions of refined products fromany particular source will not have extreme negative consequences on theCambodian economy. One player in the downstream retail business described thediversification strategy as “breathing through both the nose and the mouth.”

The analysis above is not a strict argument against development of oil refineries inCambodia. At some point, it may become financially attractive for the private sector toinvest its own resources in the development of a refinery in Cambodia. Indeed, ifreserves prove to be large enough, there may well be a commercial argument forprivate sector investments to develop large-scale refineries to serve both thedomestic and export markets. When that point comes, guided by the principles setforth above, Cambodia should feel confident in licensing private investors to developsuch oil refineries.



Downstream Development of Natural Gas

Given the experience of Thailand and Vietnam, early expectations were thatCambodia might have relatively significant sources of natural gas. To date, theavailability of natural gas is still in question. However, the Model PSC provides anumber of constraints that, together with the downstream development principlesabove, limit the realistic choices for downstream development of natural gas inCambodia.

First, the minimum rate of return provision in the Model PSC guarantees theContractor a minimum real rate of return in the event that it makes investments todevelop natural gas for the domestic market. Second, proximity to Thailand and itsoffshore natural gas infrastructures makes exports of natural gas economicallyfeasible. This is aided by the fact that Chevron recently completed its acquisition ofUnocal. Unocal owns most of the offshore pipeline capacity on the Thai side of theGulf. As a result, connecting Cambodian resources to the Thai side and exportingnatural gas to the ready market in Thailand is a viable and, likely, cost effective option.Third, there is no domestic market allocation obligation under the Model PSC and,finally, under the terms of the Model PSC, the Contractor reserves unto itself the rightto export any and all of its allocation.



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The experience with smuggling of refined petroleum products into Cambodia can informdecisions regarding investment in a small-scale oil refinery for Cambodia. Estimates from variousplayers in the industry are that as much as 40 percent of the market for refined petroleum products issmuggled. The incentive for smuggling can, in part, be attributed to the tax regime which causeslarge price differentials between the price per liter in Cambodia and in its neighboring countries.

Refined Petroleum Tax RegimeImport Tariff 35%Special Excise Tax 100%VAT 10%

Even small price differentials between the local market and regional markets now create incentivesfor smuggling. Though the government has attempted to curtail it, the potential profits involvedmake smuggling lucrative.

In the event that a small capacity oil refinery is built, it will require protection in order to befinancially viable (through tariffs or quantitative restrictions). It is likely that direct competitionwith imports and smuggling will make any attempts to indirectly subsidize a small refinery projectunsuccessful. So long as Cambodia's borders remain open, providing indirect subsidies to a lowreturn oil refinery will prove exceptionally difficult.

Box 2: Smuggling and Downstream Development

With those conditions, the medium term potential for the development of natural gaswill likely be limited to supplying natural gas for power generation.

Currently almost all of Cambodia's 270 Mega Watts (MW) of installed electricgeneration capacity is made up of diesel-fired generators. Peak demand in 2004 wasonly 120 MW. As a result of the low load factors and reliance on diesel generation tomeet baseload demand, the retail price of power is very high. In Phnom Penh theaverage retail price ranges from $0.16-0.25/kilowatt hour (kwh). Cambodia still doesnot have a national grid with only 17 percent of the population having access to anypower. The Phnom Penh market makes up 85 percent of all electricity consumption inthe country. Rural areas are served by rural electric cooperatives and small networkswith retail prices ranging from $0.30-0.60/kwh. The rest of the population relies onkerosene lamps or batteries for power. By 2008, approximately 40 percent of PhnomPenh's power requirements will be imported from Vietnam at prices between $0.03-0.85 per kwh depending on time of day and season.

Depending on the costs of building a pipeline and the export price of natural gas toThailand, there may be opportunities for investments in natural gas generation ofelectric power. However, given the small size of the current market for power inCambodia, it may not be commercially feasible to install a small capacity combinedcycle plant in addition to making the necessary investments in pipelines and offshoreinfrastructure required to bring gas onshore. Current discussions envision installing a180 MW combined cycle plant. Given current demand and the installed base, 180 MWmight be too large initially.

Additionally, most of Cambodia’s current generating capacity is private, selling powerto Electricity of Cambodia through power purchase agreements. These agreementscould be relatively expensive to renegotiate or cancel. As a result, the issue ofdeveloping natural gas-fired generating capacity needs to be carefully studied.Discussions relating to installing a large combined cycle generating station to servethe Cambodian market with the surplus power made available for export to Vietnamor Thailand are still premature. Nevertheless, it is likely that the first investments indownstream natural gas will, and should, be in the power sector. As in downstreamdevelopment of oil, CNPA should evaluate development of downstream gas applyingthe same general principles illustrated above.

Fertilizer plants relying on natural gas as a fuel stock appear to be a low priority itemin the natural gas development agenda. This low priority is well placed. In manycountries, there is a wish by planners and policymakers to develop fertilizer plants inorder to ensure local farmers have cheap access to fertilizer. Foreign investors are notgenerally interested in investing in fertilizer plants, particularly small capacity plantswith relatively high costs.



Currently almost all of Cambodia's 270 MW ofinstalled electricgenerationcapacity is made up of diesel-firedgenerators.

Fertilizer plants, like oil refineries, are characterized by significant economies of scale.Low cost fertilizer plants have a capacity to produce between 500,000 and 1,000,000tons per year. According to the Ministry of Agriculture, total domestic demand forfertilizer in 2004 was 20,000 tons. Unless Cambodia is considering entering thefertilizer export market, any fertilizer plant that is built in Cambodia will likely be arelatively high cost one, requiring subsidies in order to be competitive with worldprices. Discussions regarding fertilizer plants are best put off for future years. Otherinvestments to assist agriculture might result in higher returns – upgrading irrigationsystems, for instance.



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Liguefied petroleum gas (LPG) is one area where modest support from the government andinternational donors might have positive economic benefits. Ninety percent of households inCambodia rely on firewood for household fuels. There are obvious negative environmental effectsof such heavy reliance on firewood and other biomasses for fuel. Heavy reliance puts pressure onforest resources and the environment. Additionally, less obvious negative effects include acuterespiratory illnesses, lung cancer and problems with pregnancy in women who are most directlyexposed to household smoke from the burning of solid fuels in the household. Young childrenwho are exposed to household smoke for long periods are also at increased risk to suffer fromcoughs, acute respiratory illnesses and lung cancer.

With all of the positive economic benefits associated with the use of LPG rather than firewood, thechallenge is how to promote the market for LPG and increase current usage from the present lowrate of approximately 1,000 tons per month. The largest obstacle, of course, is price. The pricingproblem is two-fold. Though the import tariff on LPG is zero, the price of LPG is linked to theinternational price of oil. Because of this , the local price for LPG is relatively high. Additionally, LPGhas high "start up costs". LPG is sold at $15-20 per cylinder (including deposit). For manyconsumers, particularly in rural areas, $15-20 for a single cylinder of LPG is a large outlay.Compared to 500 riel ($0.25) for a bundle of wood, an LPG cylinder, which might last a few weeks,can appear expensive.

Cambodia is not the only country to be faced with this pricing problem. In the early 1970sThailand created the Oil Fund, financed with revenue from import tariffs on refined petroleumproducts, to subsidize the price of LPG. By reducing consumer prices for LPG, Thailand was able topromote the use of the fuel throughout the country. Today, LPG is the most common fuel inhouseholds in Thailand.

CNPA, together with downstream players, should consider approaching international donors,including the Global Environmental Facility, to seek technical assistance to investigate what set ofpolicies might assist the private sector in Cambodia to promote broader use of LPG byhouseholds.

Box 3: Development Opportunities for LPG

MANAGEMENT OF PETROLEUM REVENUES

The list of countries which have successfully used large revenues from naturalresources wisely is not long. Unfortunately, for many countries in the developingworld, discoveries of large reserves of natural resource wealth have not promotedeconomic or social growth. In countries like Nigeria and Venezuela, populations areworse off after thirty years of oil revenue rather than better. In other countries,corruption and poor management have led to the siphoning off of national wealth forpersonal interests. In Kazakhstan, it was recently revealed that at least $1 billion fromthat nation's oil revenues was diverted to secret Swiss accounts controlled by thePresident.

The problems associated with natural resource bounties are both economic andpolitical. The economic problems include first and foremost, the possibility that largeinflows of foreign currencies could lead to appreciation of the exchange rate.Additional spending from petroleum revenues (whether through governmentspending or increased credit in the banking system) can lead to increases in domesticprices, wages and costs. This "Dutch Disease" phenomenon puts pressure on domesticmanufacturing and agriculture making them less competitive with imports. Over timethere is a shift away from tradable goods to non-tradable services like construction.Structural changes such as the ones described above can have the effect of slowinggrowth and increasing inequality between urban and rural populations as farmersfind themselves under increasing pricing pressure.

On the political side, increased access to unrestricted cash from petroleum revenuescreates opportunities for rent-seeking behavior and increased corruption. Indemocratic political systems, politicians must constantly seek to build coalitions withgroups large and small in order to create the kinds of consensus required to raise taxesto finance government operations. When a substantial portion of a government'soperations can be financed out of oil revenues, less motivation for consensus buildingexists. Rather than seek political coalitions or bargains, oil wealth can result inpoliticians attempting to increase their access to the cash resources as a means ofincreasing political control, thereby threatening the development of democraticinstitutions.

These problems, while frequent in countries with petroleum wealth, are notinevitable.

While it is still too early to put serious numbers to Cambodia's potential petroleumresources, the small size of Cambodia's economy makes it likely that any commercialproduction of oil and gas in Block A and the OCA will have a significant impact on theeconomy. A recent report by the International Monetary Fund (IMF) suggests thatthere might be 500 million barrels of recoverable reserves in Block A. For illustrative



purposes, suppose this is true. That suggests (assuming oil prices at $55 per barrel andan average revenue split of 60 percent over 25 years) an annual revenue ofapproximately $660 million per year, roughly equivalent to Cambodia’s total budgetexpenditures in 2003. If, ultimately, there are additional resources found in Cambodia’sother blocks as well as in the JDA, annual revenues from oil and gas could be multiplesof Cambodia’s present annual budget.

Effective management of these potentially large inflows could provide resources forneeded investments to help Cambodia reach its development goals, as well as providea national endowment that might be used to support Cambodian development forgenerations to come. Ineffective management could bring on macroeconomicproblems and promote corruption. Given the large amounts presently beingenvisioned, it is hard to imagine that, if poorly managed, the macroeconomicproblems would not be enormous. All of this suggests that prudent planning forpotential petroleum revenues is called for. Discussions on this subject should startwell in advance of production and at multiple levels as there may be significantlegislative hurdles to get over in order to ultimately resolve the question ofmanagement of petroleum revenues.

When entering into discussions and assessing revenue management options, CNPAand the government should consider the following principles:

1) Government should adopt and maintain sustainable fiscal policies in itsnational budgeting;

2) Revenue from oil and gas production should be managed in a petroleum fundin a manner that is transparent and accountable to the people of Cambodia;

3) A petroleum fund should be independent of politics and the national budgetingstructure;

4) Expenditures from a petroleum fund should be investments in human and physicalcapital, rather than consumption, so as to help achieve long-term developmentgoals;

5) Decisions must be made as to how to balance long-term and current needs andthe rate of spending from a petroleum fund; and

6) Funds invested by such a petroleum fund should be conservatively andprofessionally managed offshore.

Domestic Fiscal Responsibility

A key component to any sustainable strategy for revenue management must be fiscalresponsibility on the part of the national government. Because money is basicallyfungible, a well conceived petroleum fund could be sunk by an irresponsible fiscalregime. Excessive government borrowing to finance consumption or low returninvestments can undo the good effects of the wise management of a petroleum fund.



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Currently, Cambodia's fiscal health is poor. Approximately one-third of the nationalbudget is financed by external sources – official development assistance (ODA), non-government organizations (NGOs), etc. It will be extremely important to put the fiscalhouse in order and ensure sensible fiscal rules and guides. The existence of potentialoil revenues is not, and should not be, interpreted as a signal to policymakers thatdomestic tax revenues are no longer important. Existence of potential oil revenuesshould not also be misinterpreted as a signal that Cambodia will no longer need beconcerned with controlling its government spending. On both the revenue andspending side of the budgeting equation, the government should continue to plan asif there are no revenues available from oil production.

Transparency and Accountability

In order to develop long term public support for a petroleum fund and in order toreduce opportunities for corruption, there must be a high level of public disclosurerelating to its operations. In addition to raising confidence in the administration of apetroleum fund, adequate public disclosure also limits potential downside losses frompoor investments, sloppy management or corruption.

Public Reporting of Revenues Received on a Quarterly Basis:

A petroleum fund should be published on the Internet and a detailed quarterlystatement of revenues received by it from contractors. Given the offshore naturethat will characterize oil and gas production in Cambodia, making this informationpublic creates public confidence that the nation is being fairly compensated for theuse of its natural resources.

Public Reporting of Investment Income:

Quarterly publication on the Internet of a petroleum fund's investment income(loss) provides the public security that, once earned, the financial benefitassociated with oil and gas production is being appropriately conserved anddeveloped for future generations. In the event that there are poor returns, publicinformation regarding fund performance can appropriately guide national debateand discussion regarding fund management and appropriate levels of risk.



The existenceof potential oilrevenues is not,and should not be, interpretedas a signal topolicymakersthat domestictax revenuesare no longerimportant.

Public Reporting of Investments in Cambodia:

Quarterly publication of all investments undertaken by a petroleum fund inCambodia builds public confidence that revenues from oil and gas production willhave a positive tangible benefit for Cambodia's population and will help Cambodiaachieve its development goals. To the degree there are invested projects that donot meet the basic development goals of the country, regular disclosure willpromote discussion and policy debate.

All public reporting of a petroleum fund should be subject to regular auditing andreview by an independent international auditor.

Independence

Careful consideration of the management structure should be a high priority in thedesign of any petroleum fund.

The structure designated to manage both investments of a petroleum fund as well asapproving expenditures in Cambodia should be independent, to the maximumdegree possible, of short term politics. Politicization of the management entity couldeasily result in poor allocation of investment funds as well as poor expendituredecisions. A petroleum fund should be staffed by career professionals subject to amanagement board (setting direction and approving budgets) that has theparticipation of multiple stakeholders. Such a management board should includeothers outside the day-to-day political process.

Chad provides one potential governance model for a fund. In Chad, ExxonMobil, theChadian government and the World Bank agreed to a structure according to whichChad’s oil revenues are paid directly into an offshore account. This account is subjectto strict accounting and transparency regulations. In order to spend funds from thisaccount, the government must submit projects to the Revenue Oversight Committee,only half of whose members come from the Government. This Committee is taskedwith evaluating projects and has the right to reject ones which it deems to unwise.

A similar fund now being proposed for Timor-Leste establishes a Board of EminentPersons – non-political well-respected individuals from Timor and abroad – who willplay a management oversight role in the operation of a petroleum fund set up tomanage the revenues from the Timor Gap.



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Politicization of themanagemententity couldeasily result inpoor allocationof investmentfunds as well as poor expenditure decisions.

In addition to an independent board, a petroleum fund should keep its activities outof the national budgeting structure. This will help to address the fungibility issue andencourage continued improvement of the domestic fiscal regime. At the same time,financing on a project-by-project basis helps to ensure that the expenditures by thefund are investments in human and physical capital rather than consumption.

Investment Rather than Consumption

Rather than replace existing government expenditures in salaries and current costs,revenues from a petroleum fund should be viewed as natural resources to beconserved and developed. With that perspective, funds from a petroleum fund shouldnot be expended, but rather should be invested in projects that will have positivelong-term financial and economic returns thereby helping Cambodia to achieve itslong-term economic development goals.

While spending priorities will need to be set by the management board, obviouspriorities might include primary and secondary education (including scholarshipsabroad), healthcare, irrigation and rural infrastructure projects and the promotion ofnon-farm livelihoods. These priorities areas should be funded according to theireconomic benefits as evaluated by skilled professionals.

The government should avoid treating a petroleum fund as a "stabilization fund" as isdone in some other countries (e.g., Venezuela). A stabilization fund is essentially aconsumption smoothing fund that sets asides funds when prices are high and usesthose funds to support budgetary shortfalls when resource prices are low. Astabilization fund can help mitigate budget shortfalls, but its focus is on consumptionrather than investment. Where fiscal regimes are weak, this approach will supportpoor budgeting habits rather than the development of a stronger and more sustainablefiscal system.

Balancing Long-Term and Current Needs

The resources available to a petroleum fund could be potentially quite large especiallywhen compared to the current size of Cambodia's economy. How much of Cambodia'spetroleum revenues should be spent immediately, if any, and how much should besaved for future generations is an important policy discussion and one that must behad. It is an important question of balancing current investment needs, absorptivecapacity and the responsibility to ensure resources for future generations ofCambodians.



In considering how to create a petroleum fund, the question of design of the fund iscritical. There are multiple models. Below are just a few possible models thatCambodia might consider:

Permanent Income Fund:

In this model, all revenues from oil and gas are invested and only the incomereceived from the investments is made available. By converting oil and gas in theground to cash in the bank, this approach attempts to monetize natural resourcesfor the permanent benefit of the people of Cambodia. The permanent annualincome associated with this approach is smaller than one might expect from otherapproaches, especially in early stages. As a result, it requires strong political will toresist pressures to spend more of the fund immediately.

Percentage of Revenue Fund:

In this model, a designated percentage of revenue from oil and gas sales isdistributed on an annual basis. This approach can be highly volatile and is notrecommended because of the negative impact on planning and budgeting thatthe "boom and bust" cycle associated with swings in oil prices can have. The USstate of Alaska employs this type of fund. Alaska got around the potential problemof budgeting operations attempting to rely on uncertain revenues by distributingoil revenues directly to Alaskan residents.

Constant Revenue Fund:

In this model, a designated percentage of gross domestic product (GDP) isdistributed from the petroleum fund on an annual basis. While this approach canensure a predictable stream of revenue over time, in the early stages, accumulationof savings will be slow and in later stages, the fund will be depleted as GDP grows.This approach does not guarantee a permanent revenue stream from the exploitedoil and gas.

Fiscal Deficit Fund:

In this model fund (the Norwegian model), revenues are accumulated in the fundand are only paid out to cover fiscal budget deficits. This approach requires strongfiscal discipline. In the context of continuing structural deficits and fiscal laxity, thisapproach might rapidly deplete resources with little or no long-term benefit.



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Professional Management of Fund

A petroleum fund will require professional management. The government ofCambodia reportedly has some experience using special accounts to manage fundsreceived from privatization of state assets, etc. A petroleum revenue fund, however,has the potential to be a quantum larger than any of the funds in Cambodia's previousexperience. As a result, decision makers should avoid relying on previous approachesand should hire experienced professional management. If competent investmentprofessionals are not available in Cambodia, the government should not hesitate tohire international professional firms to assist it in managing the petroleum fundportfolio.

Investment decisions of a petroleum fund portfolio should be left to professionals andshould be guided by objective investment criteria. In general, the objectiveinvestment criteria should be conservative in nature with the goal of preserving thevalue of the oil revenues. As a result of the investment criteria, most if not all of theinvestments will be made offshore. Risky investments and investments of the fundportfolio within Cambodia should be avoided. Too many portfolio investments inCambodia could raise a number of problems, including corruption and rent-seekingactivity. Though there may be great interest in supporting local banking institutionsby placing petroleum fund portfolio investments with them, this should be avoidedunless such investments meet objective investment criteria set by the professionalfund managers. Current indications from the IMF are that the Cambodian bankingsystem is weak and does not have the capacity to assess risk. As a result, it is not likelythat any of the funds from a professionally managed fund will be invested in theCambodian banking system.



DEVELOPMENT OF CNPA

Established in 1998, the government has designated CNPA to be the key regulatorybody for the oil and gas sector. CNPA is still small, but as the oil and gas industry inCambodia grows, CNPA will undoubtedly grow in size, skill and responsibility. As CNPAdevelops it should consider the following principles:

1) CNPA should focus on its core competencies2) CNPA should invest in human resources3) CNPA should see itself as a steward of Cambodian resources for development

Focus on Core Competencies

Rapid growth is difficult for any organization. Rapid growth for an organization isparticularly difficult in the Cambodian context. The potential importance of the oiland gas sector means that as it grows CNPA must be very good at what it does:regulatory management of upstream activities including bidding, conservation andexploitation of Cambodia's petroleum resources.

In order to meet goals of excellence in management, CNPA must clearly define its role,its mission and then focus on its core competencies. There will be many activities inthe oil and gas sector. It will be best for CNPA to understand that it cannot and shouldnot manage all of these activities. Rather, it should focus on only the most critical andmost important aspects of its mission.

The role of CNPA is regulatory. In terms of its regulatory function, clearly the mostimportant function that CNPA serves is the regulation of the upstream sector. This iswhere CNPA is presently focusing most of its efforts. Its focus should remain there.

As it grows, CNPA’s leadership should be reluctant to take on activities that resemblethose of a company. CNPA will not, and should not, directly develop infrastructure forthe downstream sector, including pipelines, power plants or refineries. At timesresisting the urge to expand might be difficult, but it will be essential in ensuring thatupstream development of Cambodia's oil and gas reserves is done efficiently with thelargest possible benefit for the people of Cambodia.

There are other less critical regulatory areas where it appears that CNPA might beconsidering carving out a role for itself. It should resist that temptation. The draft sub-decree on sharing of government responsibilities grants certain licensing andregulatory powers that take CNPA's focus away from its core mission and do notappear to serve the development of the oil and gas sector. For example, the draftdecree provides CNPA authority to license crude oil traders. It is not clear what



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purpose such a licensing regime should serve. Crude oil trading is a type ofcommodity trading done on the international market. If a Cambodian financialservices company, or a Cambodian trading company, or an international oil companywith offices in Cambodia should want to purchase and sell crude oil on the markets inSingapore, it is not clear why they should be required to seek a license from CNPA.

The draft decree also grants CNPA the power to license importers of refined petroleumproducts. Again, it is hard to know what purpose such a licensing authority will serve.

CamControl will check the quality of imported products. Environmental regulation ofimporters is rightly the province of the Ministry of Environment. Also, quantitativerestrictions on imports are not allowed under the World Trade Organization (WTO)rules. Granting CNPA authority to grant licenses for imports of refined products couldwell come back to haunt CNPA in the event an uneconomic local refinery is developedand such a refinery requires protection from competitive imports.

CNPA should guard against trying to do too much. For each activity it adds, thereshould be a clear and persuasive rationale how it fits in CNPA's core mission and whysome other entity should not be responsible for the particular activity.

Invest in Human Resource Development

Human resource development for the oil and gas sector should be an importantmedium term issue for CNPA. The sector is in need of highly competent professionalsin almost all aspects: geologists, petroleum engineers, managers and lawyers. It is notclear that local universities and institutions will be able to meet the needs of CNPA.

For example, the local universities do not graduate petroleum engineers. The lastgeology under-graduates graduated from Phnom Penh universities in 2000. Thegeology department was then disbanded. This lack of human resources will present aconstraint to the development of CNPA as well as to the industry. Unless CNPA actsquickly, it could face a rapid depletion of its best cadres as contractors begin to hirethem away for critical assignments. Without competent personnel in place, CNPA willbe unable to complete its core function. The scale of the human resource deficiency inthis area is not overly large. A healthy Cambodian oil sector will require hundreds, notthousands, of geologists and petroleum engineers. While the scale is small, it willnevertheless require investments.



This lack of humanresources will present a constraint to thedevelopmentof CNPA aswell as to the industry.

There are a number of options for managing this medium-term resource problem.These options include: additional on-the-job training with contractors for CNPApersonnel; supporting the re-establishment of the geology department; and sendingundergraduate and graduate students overseas for degree programs in geology,petroleum engineering, etc. Scholarship programs and support for re-opening of localuniversity departments might be funded out of the Model PSC's training budget. Thecurrent level of training funds is low, but with improved prospects of commerciality,CNPA should be able to negotiate significant increases in Contractors' budgets foreducation and training.

Stewardship

The concept of stewardship is perhaps as important, if not more important, than anyother of the guiding principles in this paper. As regulator of upstream development inthe oil and gas sector, CNPA should be guided by the principle of stewardship. Assteward of Cambodia's natural resource wealth, CNPA's decisions and regulatoryactions should be made with the goal of conserving and developing the value of thenatural resource for the people of Cambodia. Oil and gas are exhaustible resources sounnecessary wasting of those assets cannot be tolerated. By ensuring the wisedevelopment of Cambodia's natural wealth, CNPA will be playing a critical and vitalrole in Cambodia's long-term economic development.



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CONCLUSION

This paper has provided some high level principles intended to guide the decision-making process in a number of areas related to the development of the oil and gassector in Cambodia. Development of the sector is still in its early stages. There arechallenges in upstream and downstream areas as well as in the efficient use of anypetroleum revenues. Cambodia can ensure that any wealth that is generated by theoil and gas sector is used wisely in order to promote economic growth anddevelopment. However, ensuring that the oil and gas sector plays a positive role ineconomic development will require that the government begin to engage indiscussions and policy debates on a number of fronts. These discussions and theaccompanying decisions are best done before resources are produced in anysignificant quantities.



APPENDIX I: ANALYSIS OF MODEL PSC

The following provides comments on certain provisions of the Model PSC. Whereappropriate, the following analysis suggests alternate contractual language orapproaches that might be more appropriate to use in future iterations of the ModelPSC.

1. Definitions

This section sets out definitions for terms used in the contract (identified with capitalletters). This section is often treated as "boilerplate", but this is an incorrect approach.Definitions for terms can have significant impacts on the interpretation as well as theimplementation of contracts.

Note: One example where close reading of contract definitions results in a differentinterpretation is in the definition of Minimum Rate of Return in the Model PSC. TheMinimum Rate of Return is defined as an "internal real rate of return" and not(( internal nominal rate of return.)) While there is only one word difference betweenthe two potential definitions, there are real (i.e., cash) implications of choosingbetween one and the other.

4. Exploration Period

This section sets out the term of the various stages of the exploration period,including conditions under which extensions to the various stages will be granted.

Note: At the end of Stage 3, if the Contractor has not been able to establish adomestic market for natural gas, then Stage 3 of the exploration period will beautomatically extended for an additional one year period. Because it is possiblethat both oil and gas exist in the contract area, this clause is ambiguous. Thisextension is unrelated to the existence of potential oil, but it provides the Contractorwith a unilateral option to delay production for one year. While such an extensionmight be appropriate where there is only a possibility of oil, where both natural gasand oil are possible, CNPA might not want to provide the Contractor with anadditional opportunity to delay production.

8. Production Permit and Development Operations

This section sets out requirements for the Contractor to apply for, and the CNPA togrant, production permits for areas that the Contractor has determined are eithercurrently commercial or potentially commercial.



Note: It appears that under clause 8.4(d) the Contractor has the ability to delaydevelopment of natural gas (and oil) by seeking automatic renewals of its productionpermit until there is an economically viable market for gas. The Model PSC isambiguous as to whether this ability to delay is specific to gas or if it can also berelied on where the Contractor has discovered oil and gas. This ambiguous provisioncan easily be read as an option in favor of the Contractor. The option remains withthe Contractor until 15 years into what should be the production period at whichpoint, CNPA will have discretion whether or not to issue a production permit. IfCNPA does not issue a production permit, then the Contractor must relinquish thearea.

9. Production Operations

This section sets out a basic description of the approval process of work programs aswell as specifying the 30 year term of the production period. The term provisionincludes a clause regarding extension of the Model PSC.

Note: This provision appears to provide the Contractor a unilateral option toextend the life of the contract almost indefinitely after the end of the 30 yearproduction period. This is unusual and precludes the possibility that 37 years afterthe Model PSC has been signed that CNPA might wish not to extend the contractwith the Contractor. CNPA should not include an automatic extension in futureiterations of the Model PSC.

Note: The process for approval of work programs provides an opportunity toattempt to renegotiate certain terms of the contract. For example, the annualrequirement for education spending is a minimum of $150,000 per the terms of theModel PSC. The approval process for the Work Program provides an opportunity topressure the Contractor to increase its spending for CNPA training, including theprovision of educational scholarships abroad.

10. Associated Gas

This section sets out the terms on which CNPA may take any associated gas during theproduction period.

Note: The Model PSC provides that CNPA may take non-commercial associatedgas without charge. Typically, non-commercial associated gas is flared as it has littleor no economic value. This term is not unusual.

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The Model PSC requires that the Contractor re-inject any non-commercialassociated gas. The Contractor will be able to lift this gas at a later point when thereis a commercial market for it. Re-injection, rather than flaring, of unused associatedgas is a good thing, however, since the costs associated with re-injection will betreated as a recoverable cost. CNPA should carefully assess the marginal costsassociated with re-injection before requiring the Contractor to do so.

11. Allocation of Production

This section sets out the allocation of production between the Contractor and CNPA.There are four general components to the allocation. First is the royalty payment.Before any production can be put towards payment of costs or profit, CNPA will take12.5 percent of total production as a royalty. The Contractor may take up to 90 percentof the remaining production to cover the costs of exploration and production. Theremaining production will be split between the Contractor and CNPA on a slidingscale. The provision also lays out the split of natural gas, net of costs.

Note: The allocation of production in the Model PSC appears more generous infavor of the Contractor than PSCs from other countries in the region. See sectionone on upstream issues.

In general, however, the right of the Contractor to keep up to 90 percent of post-royalty production in order to recover costs allows the Contractor to recover costsquickly, but it reduces the incentive of the Contractor to manage its cost structureaggressively and reduces the amount of cash flow that the CNPA can expect toreceive in the early years of production.

The split of net oil between the Contractor and CNPA is more generous in favor ofthe Contractor than it need be. Given early success with discoveries, future iterationsof the Model PSC should use a net oil split more in line with splits in the region.

The net gas allocation in the Model PSC is a static 65-35 split in favor of the Contractor.This allocation is unusual in two respects: first, the split is generous to the Contractor;second, typically the allocation should shift in favor of the CNPA as the amount ofproduction increases. However, in this case the allocation between the Contractorand CNPA does not change as production of natural gas increases. This is highlyunusual and future iterations of the Model PSC should include a sliding scale for theallocation of natural gas that increases in favor of CNPA as the amount of productionincreases.



12. Rate of Return

This section sets out a minimum real rate of return for the development of natural gasto supply the domestic market.

Note: Guaranteeing a minimum inflation-adjusted rate of return of 16 percentfor the production of supply of natural gas is not a standard approach inproduction-sharing contracts as it removes any aspect of market risk from theContractor. This provision is highly unusual and should be removed from futureiterations of the Model PSC.

According to the Model PSC, the subsidy to the Contractor in order to guarantee aminimum return will be paid by reducing the amount of CNPA's gas allocation infavor of the Contractor until the Contractor has achieved the guaranteed minimumrate of return. This structure encourages the Contractor to lift natural gas to supplyto the domestic market even when there may not be sufficient market demand tojustify the development. If the Contractor supplies natural gas to the domesticmarket before it is commercially viable to do so, then the CNPA may find itself withreduced revenues from upstream activities and potential calls for direct andindirect subsidies from downstream activities.

Clause 12.6(b) is ambiguous and contains undefined terms. It is unclear what aSubsidized Project is and this should be clarified, or dropped, in future iterations ofthe Model PSC.

13. Marketing and Sale of Production

This provision sets out the terms and obligations of the Contractor and CNPA in themarketing and sale of crude oil and natural gas.

Note: The Contractor's obligation to supply some portion of its entitlement to servethe domestic market is subject to the Contractor's existing sales commitments andis limited to only its pro-rata share of the unmet domestic demand. As a result,CNPA will have a second priority to the Contractor's other sales commitments. Anyoil made available for the domestic market under this provision will be sold atprices equivalent to export prices. As a result, this provision can secure access tocrude oil, but not limit the price, which may be an issue in periods of nationalemergency. Also, this type of provision is of limited value until Cambodia hasdeveloped local refinery capacity to turn crude oil into refined product for the localmarket.

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The domestic supply obligation does not apply to natural gas. The Contractormaintains the right to export its share of natural gas and is under no obligation tomake any of its allocation of natural gas available for the domestic market. This isunusual as one might imagine Cambodia might at some point in the future requirequantities in addition to its allocation of natural gas to supply the power sector aswell as any other downstream investments that come online.

The marketing provision in the Model PSC allows CNPA to piggy-back its marketingefforts on top of the Contractor's efforts. Especially in the early stages before CNPAor a national oil company have much experience in crude oil trading, having accessto the Contractor's expertise in crude oil trading will be extremely valuable.

16. Petroleum Costs

This provision sets out which costs associated with production of petroleum will besubject to cost recovery and which will be excluded from cost recovery.

Note: Typically, this provision refers to an accounting annex which sets out theprinciples for determining which costs are subject to cost recovery and which arenot.

17. Income Tax

This provision specifies that the Contractor will pay corporate income tax equal to 25percent of its profit oil allocation.

Note: The corporate income tax rate of 25 percent is not unusually high. In light ofthe inconsistencies between national tax law and the Model PSC, CNPA shouldconsider using tax rates consistent with the national tax law in future iterations ofthe Model PSC.

18. Surface Rental Fees and Charges

This provision sets out the amount of rental fees to be paid for surface area in thecontract area as well as other fees and charges that will be payable during the contractperiod. This provision also provides for certain tax exemptions for the Contractor andits employees.



Note: The Model PSC calls for the establishment of a Social Development ProjectsFund. Contributions by the Contractor to this fund will be considered recoverablecosts under the terms of the Model PSC. CNPA should carefully consider whetherand how to administer such a fund.

Note: The Model PSC provides that the Contractor will be "exempt" from the ValueAdded Tax (VAT), among other taxes. Exemption from VAT is a technical term andresults in the Contractor not being eligible for a refund under the tax laws. CNPAshould consider using language that will ensure that Contractors are eligible forrefunds on all VAT paid.

Note: The Model PSC provides that the Contractor shall receive exemptions fromincome tax collection for up to ten Nominated Employees. CNPA should reconsiderproviding exemptions from the personal income tax laws of foreign nationalsworking in Cambodia. European nationals are not typically taxed by their homecountries unless they are resident there. U.S. citizens are taxed on global income,but enjoy an initial exemption on approximately the first $80,000 of income. Also,investment decisions of large multinational enterprises are rarely made on thebasis of incremental benefits to certain individuals within the organization.

20. Obligations of Contractor in Respect of Petroleum Operations

This section sets forth the obligations of the Contractor under the terms of the ModelPSC with respect to day-to-day operations. This includes obligations and undertakingsrelating to environmental protection, safety, protection of petroleum resources, etc.

Note: The Contractor commits only to endeavor (try) to comply with Good PetroleumIndustry Practices with regard to the protection of petroleum resources. This is nota very high standard of compliance.

Note: The Contractor is only liable for environmental damage caused due to itsnegligence, recklessness or willful misconduct. This is inconsistent with the principlesof Cambodian environmental law which employ a strict liability for environmentaldamage.

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21. Obligations of Government

This section sets forth the obligations of the CNPA under the terms of the Model PSCwith respect to day-to-day operations.

Note: The Model PSC includes a change in laws clause that essentially freezes inplace the legislative and regulatory regime faced by the Contractor for the entireperiod of the PSC. If there are any changes to the legal regime which result in amaterial increase in the financial burden on the Contractor, CNPA is required toamend the agreement in favor of the Contractor to account for the changes. Giventhe long length of the contract, this provision might be costly for the CNPA. Forexample, if 15 or 20 years from the date of the PSC, Cambodia were to adopt stricterenvironmental controls with regard to the oil industry, this provision provides theContractor with an opportunity to either extract additional allocations of oil andgas or seek exemptions from the new laws. CNPA should consider removing thisclause from the Model PSC.

Note: The Model PSC contains a sanctity of fundamental provisions provision.While this re-states the basic principle that one party may not unilaterally changeany provision of the contract, this does not prevent unilateral waivers of rights,amendments or other changes, including a renegotiation, by both parties.

29. Administration Fee

This provision sets forth certain administrative fees payable to CNPA over the courseof the Model PSC.

Note: The Model PSC provides for an annual administration fee of $272,000,included as a recoverable cost, to cover, among other things, costs of consultants,potentially including legal consultants. If these funds are not used for the purposesstipulated, they will belong to CNPA and be available to use at CNPA's discretion.

30. Personnel and Training

This provision sets forth the Contractor's obligation to fund training opportunities forCambodian nationals not employed by the Contractor. This provision also providesthat Contractor may employ foreign nationals in its operations.



Note: The Model PSC provides that the Contractor will spend a minimum of$150,000 for training of Cambodian staff of CNPA. This figure is a minimum and issubject to annual negotiation as part of the Work Program. CNPA should consideraggressively trying to raise the specified training amount in future Work Programsso as to be able to fund increased training and educational opportunities for itsstaff and students who might enter the industry at some point in the near future.

Note: There is no cap on foreign employees. While it will no doubt be in theContractor's interest to hire as many Cambodian nationals as possible, by setting acap (at some point in the future) on the number of foreign employees, the ModelPSC can create additional hard incentives to increase attention to development ofCambodian employees and staff.

36. Transfer of Rights and Obligations

Note: The Model PSC contains an assignment provision that stipulates that CNPAmay review any proposed assignment, but that prior written approval of anassignment may not be unreasonably withheld. An assignment is a serious corporateevent. Given the long term nature of the commitment, it would be in CNPA's interestto approve any proposed assignments at its own discretion. The Model PSC isentered into between CNPA and a particular contractor, but before a new contractorsteps into the shoes of the original contractor, CNPA should have the ability, at itsdiscretion, to terminate the contract and negotiate a new agreement. An acquisitionof the Contractor by another company should also be deemed to be an assignment.

The Model PSC also contains a clause that presumes approval of an assignment inthe event CNPA does not object within a 60-day period. This is a highly unusualprovision and CNPA should consider removing it in future iterations of the ModelPSC.

Additional Provisions

CNPA should consider adding the following provisions to future iterations of theModel PSC:

Participating Interest Provision:

A participating interest provision will allow a Cambodian oil production companyto participate in production at their option at some point during the productionperiod. Costs associated with such production operations would be subject torecovery on a pro-rata basis along with the costs of the Contractor. By includingsuch a provision, CNPA can create future flexibility to assist the development oflocal oil services and a production industry. In conjunction with this provision,CNPA may wish to consider adding a newly formed Cambodian oil productioncompany as an additional party to future Model PSCs.

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Insights for ActionReview of Development Prospectsfor the Cambodian Oil and Gas Sectors

Cambodia

Discussion Paper No. 2

2006

Cambodia

United Nations Development ProgrammeNo. 53, Street Pasteur, Boeung Keng Kang,P.O. Box 877 Phnom Penh, CambodiaTel: (855) 23 216167 or 214371Fax: (855) 23 216257 or 721042E-mail: [email protected]

http://www.un.org.kh/undp/

review of development prospects for the cambodian oil and gas sectors.pdf

Documents

stanford universitys school

undp discussion paper

refined petroleum products

crude oil trading

positive economic benefits

natural resource wealth

natural gas generation

national tax law