Review Of Development Prospects For The Cambodian Oil And Gas Sectors.Pdf

Insights for Action
Review of Development Prospects
for the Cambodian Oil and Gas Sectors
Cambodia

Discussion Paper No. 2
2006

UNDP Cambodia
Insights for Action Initiative

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

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

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

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

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

© 2006, UNDP Cambodia
Review of Development Prospects and Options For the Cambodian Oil and Gas Sector
United Nations Development Programme Cambodia

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

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

A UNDP Funded Discussion Paper
In Cooperation with
The Cambodian National Petroleum Authority
Harvard’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 coast
of 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 over
the past forty years, the sudden surge of petroleum related revenues can have major
implications for a country’s development path and the well-being of its people.

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

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

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

Most important, the paper provides an initial analysis of some of the basic safeguards
needed to better ensure that Cambodia avoids the serious mistakes made by
governments in some oil exporting developing countries, and Cambodian people
avoid a resource curse and enjoy a resource blessing.

The research for this paper was carried out in the summer of 2005 with the assistance
of the Harvard University’s John F. Kennedy School of Government and Professor Brian
Quinn from Stanford University’s School of Law, in collaboration with researchers from
the Cambodia National Petroleum Authority (CNPA). The main findings of this research
were presented at the Cambodia Economic Forum (CEF) in January 2006 organized by
the Supreme National Economic Council in collaboration with CNPA and UNDP.
Participants included His Excellency Prime Minister Hun Sen, Senior Ministers and
other 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 important
subject area as the possibilities evolve.

Insights for Action
UNDP Cambodia
January 2006

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

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

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

Management of Petroleum Revenues 14

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

Development of CNPA 21

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

Conclusion 24

Appendix I: Analysis of Model PSC 25

UNDP Discussion Paper No. 2 i


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

UNDP Discussion Paper No. 2 iii


INTRODUCTION
Recent discoveries in offshore Block A and expectations of possible discoveries in the
overlapping concession area (OCA) between Thailand and Cambodia are generating
new interest in the oil sector. It is still too early in the process to say with any certainty
how 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 Cambodia
can prepare itself in the event that there are significant oil and/or gas resources in
commercial quantities.

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

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

UNDP Discussion Paper No. 2 1

Even modest
improvements
in the Model
PSC can result
in large
UPSTREAM ISSUES
marginal
Upstream Development Principle
gains for the
Cambodian Negotiations with international exploration and production companies should be
side given the structured and carried out so as to maximize revenue from production sharing
length of the contracts (PSC) and the joint development area (JDA) with Thailand.
contracts and
the amounts Maximizing Revenue from Upstream Activities
of revenue
To a degree, the Model PSC is a product of the period when it was first developed in
involved. the late 1990s when oil prices were low and there was little international interest in
Cambodia's oil sector. At the time, CNPA also had very little experience in negotiating
revenue contracts. Three years later, prospects in Block A, the OCA, as well as in the
other internal blocks, have improved and have attracted the interest of international
players. Given the shift in negotiating leverage, the CNPA should regularly revisit its
Model PSC and its approach to negotiating future PSCs in order to maximize, to the
greatest extent possible, revenue and benefit for the Cambodian economy. Even
modest improvements in the Model PSC can result in large marginal gains for the
Cambodian side given the length of the contracts and the amount of revenue
involved.

Though the Model PSC does not offer an explicit opportunity for renegotiation, in the
context of an ongoing contract there are always opportunities to begin a
renegotiation. For example, the annual approvals of work programs required as part
of the Model PSC each present an opportunity for parties to renegotiate the terms
upon which the relationship moves forward. Renegotiations can be quite contentious,
so CNPA should be very judicious in determining the circumstances and the terms
upon which it might seek a renegotiation with any parties that have already signed
the 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 order
to recover costs. The remaining ten percent of production will be split between the
Contractor and the CNPA on a sliding scale. At lower levels of production, the marginal
split of "profit oil" is 58-42 in favor of the Contractor. The marginal split moves in favor
of the CNPA (58-42) at production levels in excess of 50,000 barrels per day. The
marginal profit oil split in the Model PSC is the lowest of all profit oil splits when
compared to terms of PSCs from other countries in the region. Additionally, the Model
PSC is the most generous in the region in allowing contractors to recover costs from
oil revenue. The 90 percent allowance for cost recovery limits the amount of possible
cash flow that will become available to Cambodia in the early stages of production.

2 UNDP Discussion Paper No. 2


Summary of Regional Revenue Splits
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 Tax
Thai (III) 5-15% Amortized over 5-10 years 50%
# Malaysian shallow water PSC terms.
* Malaysia-Thailand Joint Area.

The chart below estimates the average percentage of revenue per barrel that the
relevant host country might expect to receive given the contract terms above at
various prices per barrel of crude oil. At lower prices, CNPA's estimated revenue per
barrel can be expected to be less than that of any of its neighbors. When the Model
PSC was first negotiated in the late 1990s, long-term oil price targets were in the range
of only about $20 per barrel. At these prices, CNPA would have only expected revenue
on 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 prices
to the $40 range. At these higher prices and assuming costs of production remain
relatively low (assumed $10 per barrel), CNPA can expect revenues on par with those
of other countries in the region. From the chart below, it appears that there may be
room to negotiate improvements in future iterations of the Model PSC so as to limit
the downside risk (of a decline in crude prices). CNPA might also want to consider
lowering maximum cost recovery available to the Contractor so that it is more in line
with other countries in the region so as to increase the guaranteed cash flow available
to CNPA as profit oil.

Estimated Percentage of Revenue per Barrel Allocated to Host Country
at Various Prices*#
$25.00 $35.00 $45.00 $55.00 $65.00
Cambodia 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%
* 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 favorable
to the Contractor. Unlike the allocation of profit oil, the profit gas allocation under the
Model PSC does not employ a sliding-scale which would improve the allocation in
favor of the CNPA as average production per day increased. Using a static allocation of
profit gas, rather than a sliding-scale, does not appear to have a basis. Given the nature
of the reservoirs offshore Cambodia there may be limited economies of scale
associated with increasing production, however the fact that the Contractor will be
able to recover its costs through the cost allocation formula, the lack of economies of
scale is not a sufficient argument against employing a sliding scale to favor CNPA at
high levels of production.

The Model PSC guarantees the Contractor a 16 percent real rate of return on any
investments made in order to develop production for Cambodia's downstream
domestic market for natural gas. As the guarantee of a 16 percent real return will be
paid for by adjusting CNPA’s natural gas allocation downward, a guarantee such as this
has significant implications with regard to the size of revenues that Cambodia might
expect to receive from natural gas development. The guaranteed rate of return makes
it more likely that the Contractor will pursue larger than necessary developments
before local market demand has developed to sufficiently to support such
development. Depending on the the absolute amount of the guarantee and the price
of natural gas, CNPA’s revenues from natural gas could be significantly reduced as a
result of pursuing development of downstream natural gas opportunities before
there is sufficient market demand to support that development.

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

Pending discussions with Thailand regarding the JDA present an opportunity for the
CNPA to improve the revenue position of Cambodia relative to contractors. It will be
likely that the JDA will adopt a single approach to granting development rights and
that the terms will be an improvement of the current Model PSC. Of course, if the JDA
develops a Thai-styled concession approach rather than a production sharing
approach, CNPA may have to go through an additional learning process before
becoming proficient with its terms. Nevertheless, once the JDA's model petroleum
agreement is in place, CNPA can use it to improve its position relative to all
subsequent contractors both in and out of the OCA. It will, of course, be critical that
CNPA is well represented and negotiates the terms of the JDA’s model PSC when it is
negotiated.


International
exploration
companies
Legal Counsel and Use of Outside Legal Counsel
rely on large
legal teams
Over the next decade, CNPA will be required to negotiate many production sharing and outside
contracts and petroleum agreements. The current Model PSC, with some adjustments, counsel when
is a good starting point for negotiations, but CNPA will need to structure negotiations negotiating
in order to maximize its position in the process of negotiating a production sharing PSCs. CNPA
contract. should not be
afraid to do
Building a strong legal department within CNPA must remain a key part of CNPA's
development strategy (see Section 4); however, the negotiation of PSCs is a complex the same.
specialty that will take some time to learn. Negotiation of these contracts is also a
high-risk endeavor – where learning by doing will be too expensive to risk, especially
for a country like Cambodia.

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

Hiring competent legal counsel to represent CNPA for the negotiation of a PSC assist
might cost as much as $750,000. Though this might appear at first glance to be a large
fee, relative to the potential benefit that might accrue from competent and effective
legal counsel, it is not. For example, if outside legal counsel can improve the revenue
allocation one percent in the direction of CNPA over the Model PSC, which could
improve 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 into
the PSC in favor of Cambodia that might assist in the development of a local
petroleum services sector.

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



Previously, CNPA has used international legal counsel as resource persons. Under
these arrangements CNPA consulted in preparation for negotiations with potential
contractors. Using legal advisors in this manner is relatively inexpensive, but CNPA
should reconsider this approach. CNPA should consider allowing legal counsel to be
the 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, for
compromise. While there may be sensitivities about a heated negotiation, competent
counsel will not feel embarrassed about asking for a lot, pushing the other side and
demanding the best deal for CNPA. The "good-cop, bad-cop" negotiating strategy is
well known, but yet still quite effective. Using outside legal counsel creates
opportunities to improve CNPA's position in negotiations without injuring
relationships between the principals.

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

Box 1: A High Level OCA/JDA Strategy

The current state of parallel negotiations with Thailand over the ODA and JDA has the potential to
get stuck. Though there is increasing pressure for the Thai side to come to an agreement sooner
rather than later, their past insistence on low-level technical solutions to demarcation and
delineation issues makes it unlikely to expect a drastic change in stance. In addition to the lack of
documentary evidence needed to conclude the question of the land border at the coast, there
remain larger questions of approach to delineating the sea borders. The solutions to both of these
issues will, in the end, be largely political and will require decisions at the highest levels on both
sides. In order to change the current negotiating dynamic and reach a satisfactory conclusion
rapidly, it might well be in the best interests of both sides to reach out to a neutral third party to
assist 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 might
be in the best position to play the role of good faith intermediary. By escalating the negotiations
away from the technical level and dealing with players at the highest levels, parties will be able to
change the dynamic that has stalled the negotiations for the past few years. A high-level
intervention strategy can help to rapidly bring the outstanding issues to conclusion in a manner
deemed fair by both sides.

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



DOWNSTREAM ISSUES

Downstream Development Principles

Policymakers are presently discussing development of certain downstream industries
in 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-making
regarding whether and how to develop certain downstream activities. These
principles include the following:

1) Maintain open markets for imports of refined petroleum products to ensure
the lowest possible price for consumers;
2) Minimize direct investment in downstream entities by the government or
government-controlled entities;
3) Ensure that market risks for private investments in the downstream sector
remain 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 some
form of market protection in order to earn a positive financial return. While market
protection regimes, either in the form of quantitative restrictions on imports or
discriminatory import tax, can help a small, inefficient downstream facility make a
financial return for its investors, they will result in higher-than-necessary prices for
commodities, like fertilizer or refined gasoline. These increased prices will act as a tax
on Cambodia's poorest consumers and farmers and often benefit only foreign
investors or groups of local elites who have invested in these projects.

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


Market risks
associated
with private
investments in
Minimize Direct Investments by the Government
downstream
industries Downstream activities, including pipelines, oil refineries, fertilizer plants and power
should remain plants are all commercial activities. Government investment, be it direct or through
with the the use of ODA or guarantees for foreign loans, should be minimized. Rather than
private sector. guiding decisions by social or other concerns, CNPA should treat all investments in this
sector as commercial decisions to be managed by the private sector. Leaving the
investments and the investment decisions to the private sector will ensure that
development of the downstream sector will be efficient and responsive to market
demand. Government investments in low return projects like fertilizer plants and oil
refineries 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 should
remain with the private sector. By reducing risk associated with certain downstream
projects, private sector investors might be induced to undertake investments that
they would otherwise not pursue. Subsidies need not always take the form of cash
payments to investors. There are many potential forms of subsidies, including market
share guarantees, restrictions on imports, loan guarantees, and access to ODA loans
among others. Government guarantees and implicit subsidies to private investors in
the downstream sector can result in large contingent liabilities for the government
that could prove to be a drag on economic growth and potentially reduce the CNPA's
access to crude oil revenues. In order to ensure that downstream developments do
not prevent Cambodia from reaching many of its development goals, the private
sector should be allowed to evaluate and make investment decisions in the
downstream sector without the presence of economic distortions.

Avoid Cross-Subsidization

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



Downstream Development of Oil

Oil producing countries throughout the world often develop oil refineries in order to
meet domestic demand and to supply refined product for export. However, oil
refineries – even small, strategic ones – can present significant risks to economic growth
and 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 for
a 40,000 barrel per day plant) than larger, export-oriented plants, but the lower
investment is not without a cost in efficiency. Because oil refining is an industry that is
marked by significant economies of scale, smaller plants are less efficient than larger
ones. Assuming the price per barrel of refined petroleum for a small refinery is 15
percent higher than the price per barrel of refined petroleum from a more efficient
refinery, refined products supplied by the small refinery will be more expensive than
their imported substitutes (excluding transportation costs of approximately $12/ton
from Bangkok to Sihanoukville).

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

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



hidden subsidy to the refiner. Assuming a $50 per barrel price for crude oil, this hidden
subsidy could cost Cambodia approximately $100 million per year. The simple analysis
above assumes 100 percent utilization of a local refinery and does not take into
account the fact that the particular product mix of heavy and light fuels produced by
a local refinery may not precisely match local demand, leaving open the possibility
that 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 to
any local refinery at world prices, Cambodia should not expect that significant price
reductions will result from a small refinery coming online. Indeed, if the investment
cost 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 the
nature of the financing. As a result, the $100 million hidden subsidy for a local refinery
would be insurance against supply disruption only.

The question that policymakers should ask is whether $100 million per year is too
expensive for insurance and whether or not there are more cost effective ways to
reach the same supply security goal. While potential supply disruption is a legitimate
policy issue, it must be looked at in context. For the most part, international trading
markets for oil are deep and buyers and sellers are anonymous. International
commercial 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 in
any way signal that significant supply disruptions are on the way. Given the current
structure of international oil markets, the risk of supply disruption is limited. It is
unlikely that if a major supplier, like Vietnam, unilaterally decided to stop supplying
refined product to Cambodia that alternative supplies wouldn't be available from
elsewhere in the region. Indeed, Cambodia's present competitive retail distribution
market is a de facto energy security policy. Multiple importers sourcing product from
a variety of sources and countries assures that Cambodia has a diversified source for
its energy needs and that the risk of unilateral disruptions of refined products from
any particular source will not have extreme negative consequences on the
Cambodian economy. One player in the downstream retail business described the
diversification strategy as “breathing through both the nose and the mouth.”

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



Box 2: Smuggling and Downstream Development

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

Refined Petroleum Tax Regime
Import Tariff 35%
Special Excise Tax 100%
VAT 10%

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

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

Downstream Development of Natural Gas

Given the experience of Thailand and Vietnam, early expectations were that
Cambodia might have relatively significant sources of natural gas. To date, the
availability of natural gas is still in question. However, the Model PSC provides a
number of constraints that, together with the downstream development principles
above, limit the realistic choices for downstream development of natural gas in
Cambodia.

First, the minimum rate of return provision in the Model PSC guarantees the
Contractor a minimum real rate of return in the event that it makes investments to
develop natural gas for the domestic market. Second, proximity to Thailand and its
offshore natural gas infrastructures makes exports of natural gas economically
feasible. This is aided by the fact that Chevron recently completed its acquisition of
Unocal. Unocal owns most of the offshore pipeline capacity on the Thai side of the
Gulf. As a result, connecting Cambodian resources to the Thai side and exporting
natural 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 right
to export any and all of its allocation.


Currently almost
all of Cambodia's
270 MW of
installed electric With those conditions, the medium term potential for the development of natural gas
generation will likely be limited to supplying natural gas for power generation.
capacity is made
up of diesel-fired Currently almost all of Cambodia's 270 Mega Watts (MW) of installed electric
generators. generation capacity is made up of diesel-fired generators. Peak demand in 2004 was
only 120 MW. As a result of the low load factors and reliance on diesel generation to
meet baseload demand, the retail price of power is very high. In Phnom Penh the
average retail price ranges from $0.16-0.25/kilowatt hour (kwh). Cambodia still does
not have a national grid with only 17 percent of the population having access to any
power. The Phnom Penh market makes up 85 percent of all electricity consumption in
the country. Rural areas are served by rural electric cooperatives and small networks
with retail prices ranging from $0.30-0.60/kwh. The rest of the population relies on
kerosene lamps or batteries for power. By 2008, approximately 40 percent of Phnom
Penh'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 to
Thailand, there may be opportunities for investments in natural gas generation of
electric power. However, given the small size of the current market for power in
Cambodia, it may not be commercially feasible to install a small capacity combined
cycle plant in addition to making the necessary investments in pipelines and offshore
infrastructure required to bring gas onshore. Current discussions envision installing a
180 MW combined cycle plant. Given current demand and the installed base, 180 MW
might be too large initially.

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

Fertilizer plants relying on natural gas as a fuel stock appear to be a low priority item
in the natural gas development agenda. This low priority is well placed. In many
countries, there is a wish by planners and policymakers to develop fertilizer plants in
order to ensure local farmers have cheap access to fertilizer. Foreign investors are not
generally interested in investing in fertilizer plants, particularly small capacity plants
with relatively high costs.



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 1,000,000
tons per year. According to the Ministry of Agriculture, total domestic demand for
fertilizer in 2004 was 20,000 tons. Unless Cambodia is considering entering the
fertilizer export market, any fertilizer plant that is built in Cambodia will likely be a
relatively high cost one, requiring subsidies in order to be competitive with world
prices. Discussions regarding fertilizer plants are best put off for future years. Other
investments to assist agriculture might result in higher returns – upgrading irrigation
systems, for instance.

Box 3: Development Opportunities for LPG

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

With all of the positive economic benefits associated with the use of LPG rather than firewood, the
challenge is how to promote the market for LPG and increase current usage from the present low
rate of approximately 1,000 tons per month. The largest obstacle, of course, is price. The pricing
problem is two-fold. Though the import tariff on LPG is zero, the price of LPG is linked to the
international price of oil. Because of this , the local price for LPG is relatively high. Additionally, LPG
has high "start up costs". LPG is sold at $15-20 per cylinder (including deposit). For many
consumers, 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 1970s
Thailand created the Oil Fund, financed with revenue from import tariffs on refined petroleum
products, to subsidize the price of LPG. By reducing consumer prices for LPG, Thailand was able to
promote the use of the fuel throughout the country. Today, LPG is the most common fuel in
households 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 of
policies might assist the private sector in Cambodia to promote broader use of LPG by
households.



MANAGEMENT OF PETROLEUM REVENUES
The list of countries which have successfully used large revenues from natural
resources wisely is not long. Unfortunately, for many countries in the developing
world, discoveries of large reserves of natural resource wealth have not promoted
economic or social growth. In countries like Nigeria and Venezuela, populations are
worse 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 for
personal interests. In Kazakhstan, it was recently revealed that at least $1 billion from
that nation's oil revenues was diverted to secret Swiss accounts controlled by the
President.

The problems associated with natural resource bounties are both economic and
political. The economic problems include first and foremost, the possibility that large
inflows of foreign currencies could lead to appreciation of the exchange rate.
Additional spending from petroleum revenues (whether through government
spending or increased credit in the banking system) can lead to increases in domestic
prices, wages and costs. This "Dutch Disease" phenomenon puts pressure on domestic
manufacturing and agriculture making them less competitive with imports. Over time
there 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 slowing
growth and increasing inequality between urban and rural populations as farmers
find themselves under increasing pricing pressure.

On the political side, increased access to unrestricted cash from petroleum revenues
creates opportunities for rent-seeking behavior and increased corruption. In
democratic political systems, politicians must constantly seek to build coalitions with
groups large and small in order to create the kinds of consensus required to raise taxes
to finance government operations. When a substantial portion of a government's
operations can be financed out of oil revenues, less motivation for consensus building
exists. Rather than seek political coalitions or bargains, oil wealth can result in
politicians attempting to increase their access to the cash resources as a means of
increasing political control, thereby threatening the development of democratic
institutions.

These problems, while frequent in countries with petroleum wealth, are not
inevitable.

While it is still too early to put serious numbers to Cambodia's potential petroleum
resources, the small size of Cambodia's economy makes it likely that any commercial
production of oil and gas in Block A and the OCA will have a significant impact on the
economy. A recent report by the International Monetary Fund (IMF) suggests that
there 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 and
an average revenue split of 60 percent over 25 years) an annual revenue of
approximately $660 million per year, roughly equivalent to Cambodia’s total budget
expenditures in 2003. If, ultimately, there are additional resources found in Cambodia’s
other blocks as well as in the JDA, annual revenues from oil and gas could be multiples
of Cambodia’s present annual budget.

Effective management of these potentially large inflows could provide resources for
needed investments to help Cambodia reach its development goals, as well as provide
a national endowment that might be used to support Cambodian development for
generations to come. Ineffective management could bring on macroeconomic
problems and promote corruption. Given the large amounts presently being
envisioned, it is hard to imagine that, if poorly managed, the macroeconomic
problems would not be enormous. All of this suggests that prudent planning for
potential petroleum revenues is called for. Discussions on this subject should start
well in advance of production and at multiple levels as there may be significant
legislative hurdles to get over in order to ultimately resolve the question of
management of petroleum revenues.

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

1) Government should adopt and maintain sustainable fiscal policies in its
national budgeting;
2) Revenue from oil and gas production should be managed in a petroleum fund
in a manner that is transparent and accountable to the people of Cambodia;
3) A petroleum fund should be independent of politics and the national budgeting
structure;
4) Expenditures from a petroleum fund should be investments in human and physical
capital, rather than consumption, so as to help achieve long-term development
goals;
5) Decisions must be made as to how to balance long-term and current needs and
the rate of spending from a petroleum fund; and
6) Funds invested by such a petroleum fund should be conservatively and
professionally managed offshore.

Domestic Fiscal Responsibility

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


The existence
of potential oil
revenues is not,
and should not Currently, Cambodia's fiscal health is poor. Approximately one-third of the national
be, interpreted budget is financed by external sources – official development assistance (ODA), non-
as a signal to government organizations (NGOs), etc. It will be extremely important to put the fiscal
policymakers house in order and ensure sensible fiscal rules and guides. The existence of potential
that domestic oil revenues is not, and should not be, interpreted as a signal to policymakers that
tax revenues domestic tax revenues are no longer important. Existence of potential oil revenues
should not also be misinterpreted as a signal that Cambodia will no longer need be
are no longer concerned with controlling its government spending. On both the revenue and
important. spending side of the budgeting equation, the government should continue to plan as
if 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 to
reduce opportunities for corruption, there must be a high level of public disclosure
relating to its operations. In addition to raising confidence in the administration of a
petroleum fund, adequate public disclosure also limits potential downside losses from
poor 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 quarterly
statement of revenues received by it from contractors. Given the offshore nature
that will characterize oil and gas production in Cambodia, making this information
public creates public confidence that the nation is being fairly compensated for the
use 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 benefit
associated with oil and gas production is being appropriately conserved and
developed for future generations. In the event that there are poor returns, public
information regarding fund performance can appropriately guide national debate
and discussion regarding fund management and appropriate levels of risk.


Politicization
of the
management
Public Reporting of Investments in Cambodia:
entity could
easily result in
Quarterly publication of all investments undertaken by a petroleum fund in poor allocation
Cambodia builds public conﬁdence that revenues from oil and gas production will of investment
have a positive tangible beneﬁt for Cambodia's population and will help Cambodia funds as well as
achieve its development goals. To the degree there are invested projects that do poor expenditure
not meet the basic development goals of the country, regular disclosure will
promote discussion and policy debate.
decisions.

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

Independence

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

The structure designated to manage both investments of a petroleum fund as well as
approving expenditures in Cambodia should be independent, to the maximum
degree possible, of short term politics. Politicization of the management entity could
easily result in poor allocation of investment funds as well as poor expenditure
decisions. A petroleum fund should be staffed by career professionals subject to a
management board (setting direction and approving budgets) that has the
participation of multiple stakeholders. Such a management board should include
others outside the day-to-day political process.

Chad provides one potential governance model for a fund. In Chad, ExxonMobil, the
Chadian government and the World Bank agreed to a structure according to which
Chad’s oil revenues are paid directly into an offshore account. This account is subject
to strict accounting and transparency regulations. In order to spend funds from this
account, the government must submit projects to the Revenue Oversight Committee,
only half of whose members come from the Government. This Committee is tasked
with 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 Eminent
Persons – non-political well-respected individuals from Timor and abroad – who will
play a management oversight role in the operation of a petroleum fund set up to
manage the revenues from the Timor Gap.



In addition to an independent board, a petroleum fund should keep its activities out
of the national budgeting structure. This will help to address the fungibility issue and
encourage 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 the
fund 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 be
conserved and developed. With that perspective, funds from a petroleum fund should
not be expended, but rather should be invested in projects that will have positive
long-term financial and economic returns thereby helping Cambodia to achieve its
long-term economic development goals.

While spending priorities will need to be set by the management board, obvious
priorities might include primary and secondary education (including scholarships
abroad), healthcare, irrigation and rural infrastructure projects and the promotion of
non-farm livelihoods. These priorities areas should be funded according to their
economic benefits as evaluated by skilled professionals.

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

Balancing Long-Term and Current Needs

The resources available to a petroleum fund could be potentially quite large especially
when compared to the current size of Cambodia's economy. How much of Cambodia's
petroleum revenues should be spent immediately, if any, and how much should be
saved for future generations is an important policy discussion and one that must be
had. It is an important question of balancing current investment needs, absorptive
capacity and the responsibility to ensure resources for future generations of
Cambodians.



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

Permanent Income Fund:

In this model, all revenues from oil and gas are invested and only the income
received from the investments is made available. By converting oil and gas in the
ground to cash in the bank, this approach attempts to monetize natural resources
for the permanent benefit of the people of Cambodia. The permanent annual
income associated with this approach is smaller than one might expect from other
approaches, especially in early stages. As a result, it requires strong political will to
resist 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 is
distributed on an annual basis. This approach can be highly volatile and is not
recommended because of the negative impact on planning and budgeting that
the "boom and bust" cycle associated with swings in oil prices can have. The US
state of Alaska employs this type of fund. Alaska got around the potential problem
of budgeting operations attempting to rely on uncertain revenues by distributing
oil revenues directly to Alaskan residents.

Constant Revenue Fund:

In this model, a designated percentage of gross domestic product (GDP) is
distributed from the petroleum fund on an annual basis. While this approach can
ensure a predictable stream of revenue over time, in the early stages, accumulation
of 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 exploited
oil and gas.

Fiscal Deficit Fund:

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



Professional Management of Fund

A petroleum fund will require professional management. The government of
Cambodia reportedly has some experience using special accounts to manage funds
received 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 previous
experience. As a result, decision makers should avoid relying on previous approaches
and should hire experienced professional management. If competent investment
professionals are not available in Cambodia, the government should not hesitate to
hire international professional firms to assist it in managing the petroleum fund
portfolio.

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



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

1) CNPA should focus on its core competencies
2) CNPA should invest in human resources
3) 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 is
particularly difficult in the Cambodian context. The potential importance of the oil
and gas sector means that as it grows CNPA must be very good at what it does:
regulatory management of upstream activities including bidding, conservation and
exploitation 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 in
the oil and gas sector. It will be best for CNPA to understand that it cannot and should
not manage all of these activities. Rather, it should focus on only the most critical and
most important aspects of its mission.

The role of CNPA is regulatory. In terms of its regulatory function, clearly the most
important function that CNPA serves is the regulation of the upstream sector. This is
where 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 resemble
those of a company. CNPA will not, and should not, directly develop infrastructure for
the downstream sector, including pipelines, power plants or refineries. At times
resisting the urge to expand might be difficult, but it will be essential in ensuring that
upstream development of Cambodia's oil and gas reserves is done efficiently with the
largest possible benefit for the people of Cambodia.

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


This lack
of human
resources
will present purpose such a licensing regime should serve. Crude oil trading is a type of
a constraint commodity trading done on the international market. If a Cambodian financial
to the services company, or a Cambodian trading company, or an international oil company
development with offices in Cambodia should want to purchase and sell crude oil on the markets in
of CNPA as Singapore, it is not clear why they should be required to seek a license from CNPA.
well as to
The draft decree also grants CNPA the power to license importers of refined petroleum
the industry. products. Again, it is hard to know what purpose such a licensing authority will serve.

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

CNPA should guard against trying to do too much. For each activity it adds, there
should be a clear and persuasive rationale how it fits in CNPA's core mission and why
some 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 important
medium term issue for CNPA. The sector is in need of highly competent professionals
in almost all aspects: geologists, petroleum engineers, managers and lawyers. It is not
clear 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 last
geology under-graduates graduated from Phnom Penh universities in 2000. The
geology department was then disbanded. This lack of human resources will present a
constraint to the development of CNPA as well as to the industry. Unless CNPA acts
quickly, it could face a rapid depletion of its best cadres as contractors begin to hire
them away for critical assignments. Without competent personnel in place, CNPA will
be unable to complete its core function. The scale of the human resource deficiency in
this area is not overly large. A healthy Cambodian oil sector will require hundreds, not
thousands, of geologists and petroleum engineers. While the scale is small, it will
nevertheless require investments.



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

Stewardship

The concept of stewardship is perhaps as important, if not more important, than any
other of the guiding principles in this paper. As regulator of upstream development in
the oil and gas sector, CNPA should be guided by the principle of stewardship. As
steward of Cambodia's natural resource wealth, CNPA's decisions and regulatory
actions should be made with the goal of conserving and developing the value of the
natural resource for the people of Cambodia. Oil and gas are exhaustible resources so
unnecessary wasting of those assets cannot be tolerated. By ensuring the wise
development of Cambodia's natural wealth, CNPA will be playing a critical and vital
role in Cambodia's long-term economic development.



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 gas
sector in Cambodia. Development of the sector is still in its early stages. There are
challenges in upstream and downstream areas as well as in the efficient use of any
petroleum revenues. Cambodia can ensure that any wealth that is generated by the
oil and gas sector is used wisely in order to promote economic growth and
development. However, ensuring that the oil and gas sector plays a positive role in
economic development will require that the government begin to engage in
discussions and policy debates on a number of fronts. These discussions and the
accompanying decisions are best done before resources are produced in any
significant quantities.



APPENDIX I: ANALYSIS OF MODEL PSC
The following provides comments on certain provisions of the Model PSC. Where
appropriate, the following analysis suggests alternate contractual language or
approaches that might be more appropriate to use in future iterations of the Model
PSC.

1. Definitions

This section sets out definitions for terms used in the contract (identified with capital
letters). 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 the
implementation of contracts.

Note: One example where close reading of contract definitions results in a different
interpretation is in the definition of Minimum Rate of Return in the Model PSC. The
Minimum 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 between
the two potential definitions, there are real (i.e., cash) implications of choosing
between 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 a
domestic market for natural gas, then Stage 3 of the exploration period will be
automatically extended for an additional one year period. Because it is possible
that both oil and gas exist in the contract area, this clause is ambiguous. This
extension is unrelated to the existence of potential oil, but it provides the Contractor
with a unilateral option to delay production for one year. While such an extension
might be appropriate where there is only a possibility of oil, where both natural gas
and oil are possible, CNPA might not want to provide the Contractor with an
additional opportunity to delay production.

8. Production Permit and Development Operations

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



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

9. Production Operations

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

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

Note: The process for approval of work programs provides an opportunity to
attempt to renegotiate certain terms of the contract. For example, the annual
requirement for education spending is a minimum of $150,000 per the terms of the
Model PSC. The approval process for the Work Program provides an opportunity to
pressure the Contractor to increase its spending for CNPA training, including the
provision of educational scholarships abroad.

10. Associated Gas

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

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



The Model PSC requires that the Contractor re-inject any non-commercial
associated gas. The Contractor will be able to lift this gas at a later point when there
is a commercial market for it. Re-injection, rather than flaring, of unused associated
gas is a good thing, however, since the costs associated with re-injection will be
treated as a recoverable cost. CNPA should carefully assess the marginal costs
associated 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 take
12.5 percent of total production as a royalty. The Contractor may take up to 90 percent
of the remaining production to cover the costs of exploration and production. The
remaining production will be split between the Contractor and CNPA on a sliding
scale. 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 in
favor of the Contractor than PSCs from other countries in the region. See section
one 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 costs
quickly, but it reduces the incentive of the Contractor to manage its cost structure
aggressively and reduces the amount of cash flow that the CNPA can expect to
receive in the early years of production.

The split of net oil between the Contractor and CNPA is more generous in favor of
the Contractor than it need be. Given early success with discoveries, future iterations
of 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 of
production increases. However, in this case the allocation between the Contractor
and CNPA does not change as production of natural gas increases. This is highly
unusual and future iterations of the Model PSC should include a sliding scale for the
allocation of natural gas that increases in favor of CNPA as the amount of production
increases.



12. Rate of Return

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

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

According to the Model PSC, the subsidy to the Contractor in order to guarantee a
minimum return will be paid by reducing the amount of CNPA's gas allocation in
favor of the Contractor until the Contractor has achieved the guaranteed minimum
rate of return. This structure encourages the Contractor to lift natural gas to supply
to the domestic market even when there may not be sufficient market demand to
justify the development. If the Contractor supplies natural gas to the domestic
market before it is commercially viable to do so, then the CNPA may find itself with
reduced revenues from upstream activities and potential calls for direct and
indirect subsidies from downstream activities.

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

13. Marketing and Sale of Production

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

Note: The Contractor's obligation to supply some portion of its entitlement to serve
the domestic market is subject to the Contractor's existing sales commitments and
is 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. Any
oil made available for the domestic market under this provision will be sold at
prices equivalent to export prices. As a result, this provision can secure access to
crude oil, but not limit the price, which may be an issue in periods of national
emergency. Also, this type of provision is of limited value until Cambodia has
developed local refinery capacity to turn crude oil into refined product for the local
market.



The domestic supply obligation does not apply to natural gas. The Contractor
maintains the right to export its share of natural gas and is under no obligation to
make any of its allocation of natural gas available for the domestic market. This is
unusual as one might imagine Cambodia might at some point in the future require
quantities in addition to its allocation of natural gas to supply the power sector as
well as any other downstream investments that come online.

The marketing provision in the Model PSC allows CNPA to piggy-back its marketing
efforts on top of the Contractor's efforts. Especially in the early stages before CNPA
or a national oil company have much experience in crude oil trading, having access
to 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 be
subject to cost recovery and which will be excluded from cost recovery.

Note: Typically, this provision refers to an accounting annex which sets out the
principles for determining which costs are subject to cost recovery and which are
not.

17. Income Tax

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

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

18. Surface Rental Fees and Charges

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



Note: The Model PSC calls for the establishment of a Social Development Projects
Fund. Contributions by the Contractor to this fund will be considered recoverable
costs under the terms of the Model PSC. CNPA should carefully consider whether
and how to administer such a fund.

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

Note: The Model PSC provides that the Contractor shall receive exemptions from
income tax collection for up to ten Nominated Employees. CNPA should reconsider
providing exemptions from the personal income tax laws of foreign nationals
working in Cambodia. European nationals are not typically taxed by their home
countries 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 the
basis 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 Model
PSC with respect to day-to-day operations. This includes obligations and undertakings
relating to environmental protection, safety, protection of petroleum resources, etc.

Note: The Contractor commits only to endeavor (try) to comply with Good Petroleum
Industry Practices with regard to the protection of petroleum resources. This is not
a very high standard of compliance.

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



21. Obligations of Government

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

Note: The Model PSC includes a change in laws clause that essentially freezes in
place the legislative and regulatory regime faced by the Contractor for the entire
period of the PSC. If there are any changes to the legal regime which result in a
material increase in the ﬁnancial burden on the Contractor, CNPA is required to
amend the agreement in favor of the Contractor to account for the changes. Given
the long length of the contract, this provision might be costly for the CNPA. For
example, if 15 or 20 years from the date of the PSC, Cambodia were to adopt stricter
environmental controls with regard to the oil industry, this provision provides the
Contractor with an opportunity to either extract additional allocations of oil and
gas or seek exemptions from the new laws. CNPA should consider removing this
clause 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 change
any 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 course
of 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 purposes
stipulated, 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 for
Cambodian nationals not employed by the Contractor. This provision also provides
that Contractor may employ foreign nationals in its operations.


Review Of Development Prospects For The Cambodian Oil And Gas Sectors.Pdf

Review Of Development Prospects For The Cambodian Oil And Gas Sectors.Pdf

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