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Managing Contractual Risks in Production Sharing Contracts: Key obligations and implications



Introduction

Production Sharing Contracts (PSCs) have become the cornerstone of Nigeria’s upstream petroleum sector, particularly following the enactment of the Petroleum Industry Act (PIA) 2021. The PIA establishes PSCs as contractual arrangements under which the financial risk-bearing party, typically an international oil company (IOC) or an indigenous contractor, undertakes exploration, development, and production activities. Under this model, the contractor recovers its capital and operating costs from a designated portion of production, known as “cost oil.” The balance of production, after royalties, constitutes “profit oil,” which is shared between the contractor and the Nigerian National Petroleum Company Limited (NNPCL), acting on behalf of the Federation.

This contractual framework marks a deliberate departure from the historical joint venture (JV) system, under which the Federal Government was required to meet significant financial obligations but often defaulted on cash calls. By contrast, the PSC system guarantees the Government a share of petroleum profits without upfront capital outlay, while retaining substantial control over natural resources. For contractors, however, the arrangement entails bearing the entire exploration and development risk, with recovery of investment and profit contingent upon the discovery of petroleum in commercial quantities.

In line with this approach, the PIA vests NNPCL as the concessionaire of all Production Sharing Contracts, Profit Sharing Contracts, and Risk Service Contracts on behalf of the Federation. This role consolidates NNPCL’s position as the national oil company, ensuring that it acts as custodian of the Federation’s petroleum interests while leveraging the technical and financial expertise of contractors.

This guidance note highlights the key risks, regulatory obligations, and practical strategies for investors and contractors navigating PSC arrangements in Nigeria.

Structure and Attributes of PSCs

PSCs under the PIA 2021 are structured to clearly allocate risks, costs, and entitlements between Nigeria, represented by NNPCL, and contractors (usually international oil companies or indigenous operators). The design of PSCs ensures that the financial risk of petroleum operations rests with the contractor, while Nigeria secures guaranteed participation and revenue without bearing exploration costs. Beyond this fundamental structure, PSCs also exhibit distinct attributes that define their operation, governance, and economic implications, as outlined below.

• Parties to a PSC

A PSC typically involves two or three categories of parties. First, the Government, acting through NNPCL, which is vested under Section 64(b) of the PIA as the concessionaire of all PSCs on behalf of the Federation. Second, the Contractor, who undertakes exploration and production at its sole cost and risk, with the right to recover costs and share in profits if petroleum is found in commercial quantities. In some cases, indigenous partners are included in the arrangement to satisfy local content requirements and promote capacity development within Nigeria.

• Cost Recovery Mechanism

The central attribute of a PSC is the cost recovery system. The contractor bears all exploration and development costs upfront. If oil is discovered and produced, the contractor is entitled to recover its costs from an agreed portion of production, referred to as “Cost Oil.” This mechanism incentivises contractors to invest in exploration while ensuring they can only recoup their expenses from actual production, thereby shielding the State from financial exposure.

• Profit Oil Allocation

Once the cost oil has been allocated for cost recovery, the balance of production becomes “Profit Oil.” Profit oil is shared between the Government (through NNPCL) and the contractor in accordance with the fiscal terms of the PSC. The exact split is negotiated within the contract, often linked to production levels, water depth, or prevailing market conditions. This arrangement guarantees the State a steady share of production while still rewarding the contractor for its risk-taking and operational efficiency.

• Royalty and Tax Obligations

In addition to cost oil and profit oil, contractors operating under PSCs remain liable for royalties and taxes as prescribed under the PIA and associated fiscal regulations. Royalties are typically production-based charges that accrue to the Federation regardless of profitability, while taxes are assessed on the contractor’s income. These fiscal obligations ensure that the Government’s revenue stream from petroleum operations is diversified and not solely dependent on profit oil allocations.

• Regulatory Oversight and Cost Audits

Unlike joint venture arrangements that rely on joint management committees, PSCs are governed by a framework of regulatory oversight provided by the Nigerian Upstream Petroleum Regulatory Commission (NUPRC). The NUPRC approves annual work programmes and budgets, monitors petroleum operations, and conducts cost audits to verify the legitimacy of expenses claimed for recovery. This oversight function is critical to ensuring transparency, protecting government revenue, and maintaining the integrity of cost recovery claims made by contractors.

• Risk Allocation

A defining attribute of PSCs is their clear allocation of risks. The contractor assumes the full financial and operational risk of exploration, development, and production. If no commercial discovery is made, the contractor cannot recover its investment. Conversely, the Government is insulated from such losses yet retains ownership of the resource and secures a guaranteed share of production in the event of success. This asymmetry is the cornerstone of the PSC system and underpins its adoption in Nigeria’s upstream sector.

Key Contractual Risks in PSCs

• Exploration and Commercial Risk

The most immediate risk in a PSC lies in the uncertainty of exploration outcomes. Contractors bear the entire financial burden of seismic surveys, drilling, and field development, but recovery is only possible if oil is found in commercially viable quantities. A dry well means the contractor absorbs the loss without recourse to the Government. Even when discoveries are made, fluctuating global oil prices can undermine commerciality, delaying cost recovery and dampening expected returns. This risk is particularly acute in deep offshore blocks, where exploration costs are high and timelines for development are extended.

• Cost Recovery and Audit Risk

Although PSCs grant contractors the right to recover costs from “cost oil,” this entitlement is subject to strict regulatory scrutiny. The NUPRC audits contractor claims to ensure only legitimate, necessary, and contractually allowable expenses are recovered. Disputes frequently arise where contractors classify expenditures as recoverable, but the regulator disallows them, leading to revenue losses for the contractor. This risk underscores the importance of meticulous cost management, transparent record-keeping, and alignment with contract terms.

• Profit Oil Sharing and Fiscal Risk

The sharing of “profit oil” is a central feature of PSCs, but it is also a source of fiscal risk. Profit-sharing ratios are often sensitive to production levels, cost recovery limits, and negotiated fiscal terms. Contractors face the risk of adverse shifts in fiscal regimes, as governments may amend laws or renegotiate contracts to capture greater revenue, especially in periods of high oil prices.

• Regulatory and Compliance Risk

PSC contractors operate in a heavily regulated environment. Under the PIA, compliance with licensing conditions, environmental standards, and reporting obligations is mandatory. Failure to meet these obligations can result in penalties, delays in approvals, or, in extreme cases, termination of the PSC. Regulatory risk is heightened by potential changes in policy or enforcement practices, which can create uncertainty and affect the predictability of operations. Contractors must therefore build robust compliance systems to mitigate this exposure.

For instance, under the PIA, renewed and renegotiated PSCs originally executed under the Petroleum Act are required to be concluded within one year of the Act’s commencement, after which any pending contracts automatically conform with the provisions of the PIA. This transition introduces regulatory uncertainty for contractors, as existing fiscal terms such as cost oil limits, profit oil sharing, and investment tax credits are subject to realignment under the new regime, potentially altering project economics and compliance obligations.

• Operational and Technical Risk

The execution of petroleum operations under PSCs, particularly in Nigeria’s offshore and deepwater terrain, carries significant operational and technical challenges. Risks such as equipment failure, drilling hazards, environmental incidents, and security threats in offshore locations can lead to cost overruns and production delays. Given that contractors cannot recover costs until production commences, any operational setback directly affects the timing of cost recovery and profit oil entitlement, compounding financial risk.

• Dispute and Stability Risk

Given the long-term nature of PSCs, disputes between the Government (through NNPCL) and contractors are almost inevitable. These may arise over cost recovery, fiscal terms, or interpretations of contract provisions. The risk is compounded by political and economic pressures that can lead to calls for contract renegotiation. Stability clauses are often negotiated into PSCs to provide some protection against adverse changes, but the effectiveness of such clauses depends on the Government’s willingness to honour them.

Practical Guidance for Contractors

For Contractors considering entry into or renegotiation of PSCs in Nigeria, practical foresight is essential. The following points provide a strategic roadmap:

• Negotiate with a Long-Term Risk Lens

PSCs typically run for decades, covering exploration through to full-field production. Contractors should approach negotiations with a holistic view of potential long-term risks, including oil price volatility, technological shifts, and regulatory reforms. Fiscal models should incorporate downside scenarios to stress-test profitability and ensure that cost recovery provisions remain viable under adverse market conditions.

• Ensure Contractual Clarity

Ambiguity is a recurring source of disputes in PSCs, particularly around cost recovery and profit oil sharing. Contractors should push for clear definitions of recoverable costs, production benchmarks, and the treatment of capital-intensive items such as decommissioning expenses. Similarly, dispute resolution clauses should specify arbitration venues, governing law, and enforcement mechanisms to avoid uncertainty when disagreements arise.

• Deploy Stabilisation and Adaptability Mechanisms

While stabilisation clauses are important to guard against sudden fiscal or regulatory changes, Contractors should also consider adaptive mechanisms such as price-linked profit oil splits or renegotiation triggers. These hybrid approaches provide protection while recognising the Government’s policy interest in maximising national benefit from hydrocarbons.

• Engage Proactively with Stakeholders

Nigeria’s petroleum sector is influenced not only by regulators and the Government but also by host communities and local content institutions. Building transparent and proactive engagement strategies can pre-empt disruptions, strengthen social licence to operate, and align operations with national development goals. Contractors should treat these relationships as strategic assets rather than compliance obligations.

Conclusion

PSCs remain the backbone of Nigeria’s upstream petroleum sector under the PIA. They offer the Government a model that preserves ownership of resources and secures guaranteed revenues without exposing it to exploration risk. For contractors, PSCs provide opportunities to access prolific reserves, but only through the assumption of significant financial and operational risks.

For Contractors, success in Nigeria’s PSC regime will depend on combining robust contractual protections with a willingness to adapt to evolving circumstances. Careful attention to cost recovery mechanisms, fiscal stability, regulatory compliance, and stakeholder engagement will be critical. Ultimately, PSCs should be approached not just as legal instruments, but as long-term partnerships with the Nigerian State, where alignment of commercial objectives with national policy will determine sustainability and profitability.

Ozioma Agu is a Partner at Stren & Blan Partners and supervises the Firm’s Energy, Finance and Infrastructure Sector. David Olajide and Onyinye Isikaku are both Associates in the Firm’s Energy, Finance and Infrastructure Sector.

Stren & Blan Partners is a full-service commercial Law Firm that provides legal services to diverse local and international Clientele. The Business Counsel is a weekly column by Stren & Blan Partners that provides thought leadership insight on business and legal matters.

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