The costs of cost recovery

The costs of cost recovery
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First Published: Thu, Feb 14 2008. 11 27 PM IST

Updated: Thu, Feb 14 2008. 11 27 PM IST
Reliance Industries’ new gas find announced on Wednesday affirms that the prospects of discoveries in some areas are quite bright, such as in and north of the Krishna-Godavari basin (KG basin) on the east coast. Great for the country and something we’ve known for a few years. Lower project risks in such areas should get the government thinking. It need not allow contractors here to recover capital costs before sharing the profits, since there is an inherent incentive for the latter to pad their capital costs.
Consider this. As reported by The Economic Times on Thursday, RIL wants the government to approve its capital costs for producing oil and gas from a new well — in the KG basin D6 block. This is in addition to the significant volumes set to flow from D6 by end-2008.
The issue is about RIL proposing to buy a floating unit worth $750 million for bringing the finds to shore, while it could just as well lease it at a lower cost, or opt for a pipeline worth $150 million.
The government would prefer a cheaper option, and has to take a call — its production contracts allow the contractor to recover costs out of sales revenues of the oil/gas, before profits are shared between the government and the contractor. The company which bids the best terms of profit share gets the contract, and this is thus pre-fixed. But, whenever there’s a new find within that block, the contractor has to get the costs approved.
The cost recovery model allows contractors room for inefficiency, even manipulation. They can be lax on cost controls or even inflate capital costs on paper. That’s possible since the assets in question are bought not through competitive tenders, but on mutually negotiated deals. There is only an indirect incentive for cost control—since profit on the book, and hence profit share, is calculated after the costs have been recovered, higher costs shown mean lower share. This hurts the government directly, but the contractor only indirectly if it were to book inflated costs.
A costlier floating asset may make sense for a developer of a well with a shorter life span — in its declining phase, the asset could be moved to process another find. By a transfer of assets within the group, the services may be again billed to the exchequer. A cheaper, fixed pipeline might not be so attractive.
It’s time government revisits policy — for areas where the risk is low due to better prospects for oil/gas finds. Recall that policy in the power sector was reformed in the early 2000s when risks for private generation declined. Projects then had to be competitively bid—the government no longer evaluates costs.
It would now do well to revise the hydrocarbon production sharing terms for regions with lower risks to ensure more efficiency.
Should the government refine its oil and gas contracts? Write to us at views@livemint.com
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First Published: Thu, Feb 14 2008. 11 27 PM IST
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