Doing Business in Uganda: A Review of Uganda’s Oil Sector in light of the recent Tullow Oil - Heritage Oil deal

Written by Atipo Ambrose Peter Jr., Partner and Head, Energy, Mining and Infrastructure, Kiiza & Kwanza Advocates & Legal Consultants

Uganda is one of the new oil states that are currently attracting a great deal of global attention for the right reasons – its huge oil potential! It is against this background that an informative piece has been put together for The Oil Council’s Members to provide a legal, regulatory and fiscal overview, as well as an analysis of recent developments in the country’s oil sector.

Uganda is bordered by Eastern DRC in the West and Southern Sudan in the North. These countries offer a massive market, and are likely to join the East African Common Market soon, making the East African region one of the world’s illustrious mineral rich regions. Uganda has had a relatively stable political environment since 1986 when the current ruling party took over power, and has successively maintained power through democratic process of universal adult suffrage since 1996. The rest of East Africa has also had a relatively stable political environment save for the DRC that was plagued by wars in the not so distant past.

The government has three organs namely the Executive, The Legislature and the Judiciary. These organs are headed by the President, Speaker of Parliament and the Chief Justice respectively enhancing a democratic system of checks and balances.

With a current GDP of $36,745bn and a GDP per Capita of US $1,146, the country has realised massive economic progress, and with the prevailing fiscal and economic stability, the future of this small nation of 236,040 square kilometres is looking very bright especially amidst the recent discoveries of massive quantities of commercial oil and gas reserves, which so far stand at a minimum 2bn barrels which still represents less than 30% of the explored areas.

Exploration Areas and Current Operators

The country is divided into various blocks and currently the number of licensed blocks stands at eight –covering a total area of approximately 18,000 square kilometres, with four of the eight blocks being major blocks that have proven successful. There are four major operating companies namely Tullow Oil, Heritage Oil, Dominion Petroleum and Tower Resources, all being independents.

However, with their recent successes in commercial discoveries and the recent farm out of Heritage from the Tullow-Heritage Joint Development, majors such as Eni International, Exxon Mobil (NYSE:XOM), CNOOC (NYSE:XOM) and Total (NYSE:TOT) have increasingly expressed interest in participating in the development of the Ugandan Oil sector, with most of them desiring farm ins or farm downs into already existing explored and proven blocks – particularly the blocks where Tullow is involved, in the oil rich Albertine Grabben.

This has presented Tullow Oil Plc (LON:TLW) with an array of suitors to choose from for joint development and is mainly a matter of strategy for Tullow, when it decides to chose who to work with however; infrastructure capabilities are considered the main strength Tullow will require from its new partners.

Exploration Gains

In just 10 years from the year 2000, approximately 40 E & A wells have been drilled in the major oil basin, the Albertine basin, which covers an area of 20,000sqkm, recording an impressive success rate of approximately 92%. The Albertine basin has had a total of 39 E & A wells drilled with two wells coming out P & A dry.

Oil Blocks and Fields

1. Buffalo-Giraffe in Block 1 discovered in 2008 with reserve estimates in the region of 400mmbbls, which was under the operation of Heritage and under a 50:50 joint development with Tullow, before the farm out and is now under Tullow

2. Ngassa Well in Block 2 discovered in 2009 and potentially the biggest oil field in the Albertine basin with reserves estimated at close to 2billion barrels and is under the operation of Tullow previously under a 50:50 JD with Heritage and

3. Kingfisher well in Block 3A discovered in 2006 with reserves in the region of 400mmbbls too and is under the operation of Tullow but used to be under a 50:50 JD with Heritage before the farm out.

The Kingfisher oil field has however been withdrawn by the government because of the failure of the operator to apply for a production licence in time. Tullow should have picked this up in its due diligence and moved swiftly to have it rectified either before the farm out (if time allowed) or should have gotten assurances from the government before buying Heritage’s stake in it. This well was expected to be the first of all wells to produce oil under the early production scheme late this year or early next year. There is however still an option to apply for the licence, however it will be competitive since the law also allows other interested parties to apply.

Policy and Laws - Recent Developments

These successful discoveries have necessitated the government to fast track all necessary measures to ensure organised and optimum production and development hence the new oil bill which is supposed to operationalise the National Oil and Gas Policy.

There is an official moratorium on awarding any oil blocks till the new law is in place, with negotiations ongoing through the official Ministry of Energy channels. Currently, Uganda uses an old oil law, The Petroleum (Exploration and Production) Act – Cap 150 (Laws of Uganda) of 1985. However, a new more robust and modern law, The Petroleum (Exploration, Development, Production & Value Addition) Act [2010] is in the pipeline and the bill is currently heading back to Parliament for review. The timeline given for enactment of this bill into law is by December 2010.

Legal Regime Overview

The Ministry of Energy & Mineral Development is the main point of contact for petroleum licensing, with their Petroleum Exploration and Production Department directly mandated to handle such activities. With the enactment of the new law, this department is going to be broken up to create (i) the Petroleum Ministry to provide general policy formulation, guidance and oversight, (ii) a National Oil Company for the commercial participation of the state in development of the petroleum industry and (iii) the National Petroleum Authority to carry out the industry regulatory functions.

PSA

Uganda operates under the PSA licensing regime with a 2006 model PSA offering the current major guideline into Uganda’s petroleum licensing terms and conditions. The PSA is characterised by negotiable Signature Bonuses that present an opportunity for explorers to negotiate on a rate as opposed to a fixed one. This is coupled with a royalty based system on a sliding payment scale linked to production with rates varying from between 5% to 13%. Since the size of the Signature Bonus is generally based on the exploration licence’s presumed recovery potential (and value), as well as, the market’s interest in the rights, the Bonus is expected to increase in the next bid round because of higher competition for the exploration licences.

State Participation

In regard to state participation, up to the current day, there is no state participation mainly due to a lack of an NOC. However in the next licensing round, state participation is expected at a limited but increasing rate considering the limited capacities in terms of human and technical resource. Despite this, the PSA provides for compulsory state participation in all E, P & D programs and from the different PSAs signed so far, indications of the figure for compulsory state participation is in the region of 20% which is expected to remain this low for some time as the state builds its capacity.

Fiscal Regime Overview

The fiscal regime allows for ring fencing within the contract area for purposes of cost recovery and profit sharing purposes and under cost recovery, indications from the cost recovery provisions in the current PSAs signed so far put cost recovery in the region of 50%-60%.

Tax

The Income Tax Act Cap 340 and the VAT Act Cap 349 constitute Uganda’s tax code and provide for a 30% Corporate Income Tax rate – chargeable on corporate income within a financial year for operations within the country for any corporate entity. There is also a 30% Capital Gains Tax on capital gains within Uganda and is usually payable on value gained on business assets. This is the subject of dispute between Heritage and the Ugandan Government. These several taxes and charges are typical for the petroleum industry.

It is expected that the tax provisions for minerals and petroleum are going to be revised and separate tax provisions that take into account industry specific issues will be created by the end of 2011 and before the next bidding round so as to avoid disputes related to retrogressive application of the law.

Local Content

Local content provisions require utilisation and employment of local human and technical resources where necessary and applicable, however, with the proposed law, the local content provision do not provide for the percentage. Since a specific law that exclusively deals with local content is to be enacted, the details will be included therein. The current provisions in the bill are therefore not exhaustive.

National Oil & Gas Policy and Proposed Oil Law

There is a new proposed law as mentioned earlier, and it proposes to combine the upstream and downstream operations in the same piece of legislation. However, there has been widespread commentary against such a proposal, and it is expected that downstream will be handled under its own separate law.

The main concerns of the government are that if downstream and upstream are handled under different laws, it will create a loophole through which the government will lose money to companies engaged in both upstream and downstream operations as the two activities are governed by different tax provisions. The proposed oil law attempts to be robust, taking into account modern petroleum industry practices. It however also attempts to deal with many issues at the same time hence being too crowded and to some extent disjoined and contradictory. Provision for the institutions and some other aspects should be given in the act and the relevant detail detailed in subsequent regulations.

Value Addition, Refinery and Pipeline

The government under the National Oil & Gas Policy is 100% behind the development of a refinery and as such, the proposed law allows government to insist on production of a stream of oil that is sufficient to operate a refinery, and that would be able to meet the domestic needs of the EA Common Market as described earlier.

Tullow is under pressure from the government to deliver on this aspect and as such has chosen CNOOC and Total for the farm down so as to benefit from their deep pockets and infrastructure expertise in building the refinery, pipeline and other relevant infrastructure.

Environment

On the environment, the proposed law prohibits earthen storage of oil and gas, and also prohibits flaring except in circumstances where it is necessary for safe operations. There is need to set the parameters of safe operations so as to make this provision definite, otherwise it is likely to cause confusion and conflict between the government and the operators. Safe operations within certain defined industry safety standards would be more appropriate so as to create definiteness in this.

It also provides for compulsory decommissioning in accordance with modern industry practice and further provides for the setting up of a decommissioning fund which will be capitalised regularly up to an agreed amount either when production has reached 50% of aggregate estimated recoverable reserves, or 5 years before the expiry of the production license. This is a good step in the right direction because it takes into account industry best practice principles by providing for decommissioning and the decommissioning fund.

However, it does not state whether the environment provisions of the petroleum law are the principle or subject to the general environment law. This can be taken care of in the general contract; however there is a need to come out with provisions specific to the petroleum industry because of the different nature of the industry, therefore all environmental provisions related to the petroleum industry should be put in the petroleum law.

The challenge firms have found so far in regard to the environmental laws is that the laws are not exhaustive and as such present problems for the government in trying to enforce certain provisions which might not necessarily be in line with industry environmental practice thus causing confusion. Otherwise, they leave the operators in a position where they cannot comfortably make a decision that might have environmental consequences.

Stabilisation Clause

On stabilisation clauses, the proposed law is silent and as such, it is expected that the international principles on stabilisation of petroleum contracts will apply. The practice has been to have this aspect taken care of in the PSA or any other licensing contract since it is a contractual term and would be well taken care of during PSA negotiations.

Next Steps

Once this law is in place, Uganda will go on to announce a major bidding round within the first Quarter of 2011, under a more organised system, as it is expected that all the institutions namely the National Oil Company, The Oil Ministry and The National Petroleum Authority among others will all be in place. This bidding round is expected to attract a great deal of international interest from even the majors.

The Revenue Management Bill, 2010 which is to provide for the management of petroleum revenues, is currently before cabinet. It is however expected to come into force before the next bidding round in the first quarter of next year if all goes according to plan.

Recent Developments – Dispute

The Heritage Oil (LON:HOIL) - Tullow Oil Plc (LON:TLW) deal will go down as the first major transaction in Uganda’s oil industry to date, and also reveals a taste of the kind of money characteristic to the oil industry. The bill paid out by Tullow for Heritage’s 50% stake in the JD being $1.5bn, a windfall profit indeed considering that they had only invested $150m so far. This didn’t however go down smoothly as the Uganda tax authority levied a $404m tax bill on Heritage for capital gains which money Heritage wasn’t ready to pay apparently based on the advice of their advisors.

Unfortunately for Tullow, in its quest to meet a deadline in which to exercise its pre-emption rights under the JD, so as to prevent what seemed like an already sealed sale transaction between Heritage and Eni International, it went on to seal a deal with Heritage and paid out the full sum of $1.45bn with another $150m agreed to be paid at a later date.

After Heritage’s farm out, Tullow retained the residual interest in the Tullow Heritage JD and is in the process of farming down Total and CNOOC, mainly because of a need to meet its commercial obligations while also meeting the government’s desires and objectives vide the National Oil and Gas Policy, which emphasises the need for value addition for maximum economic gain, and thus requires the construction of a refinery to refine the locally produced crude and a pipeline to distribute the finished product to the regional and international markets. CNOOC recently built a similar refinery in China that utilises the same grade of crude as Uganda’s and coupled with the deep pockets it has as well as its willingness to obtain rights at almost any price, it is Tullow’s first choice and seemingly the best candidate for the farm down.

Total is a major that has also expressed interest in a joint development with Tullow and as such is going to be involved with the two on an shared interest basis of one third of the entire area for each of the players.

Recent Developments – Is Tullow pulling out?

It is noteworthy that, Tullow who are increasingly tending towards production are likely to go the whole nine yards and take part in production and development despite expectations that they are pulling out soon. The farm down with CNOOC and Total into Tullow’s entire Ugandan interest, has introduced into the market two majors with deep pockets, experience and capabilities and as such, Tullow has reduced its production and development burden by two thirds which indicates that they are seriously considering taking part in the more expensive Production and Development stages.

Yet again, it could also be a strategy by Tullow to increase the value of its position through the association with majors who are hungry to fully take advantage of the Ugandan oil finds, and in the process, make a killing when it decides to sell off its stake but only after the government is comfortable and satisfied that the JD partners are meeting or will have met and complied with the national development objectives as per the PSA including building a refinery and pipeline among others.

Yet from another angle, it would beat conventional wisdom for Tullow to sell at the brink of production of the first oil yet it has the option of selling later in the course of production. The intentions of Tullow are not known, however, Tullow continues to emphasise that it is not going anywhere, and indications of Tullow’s behaviour so far are not contradictory to that position.

Recent Developments – Why has Tullow lost Kingfisher?

This question can be answered by considering the history of the events that culminated into this rather absurd and careless situation for Tullow.

Firstly, Uganda Government was increasingly growing impatient with Tullow for failure to start the early production scheme early enough before 2010 and also coupled with subsequent failures by Tullow to meet its deadlines. All this, amid indications that Tullow, as a wildcatter would not be interested in going the whole nine yards (and as such would later sale off its interest to another oil company before production) did not help matters in terms of its relationship with government.

Heritage later expressed interest in selling its entire Ugandan stake, and went shopping around for a potential buyer, without starting at home first. It found a very interested party in the oil major, Eni International, a subsidiary of Eni Spa one of the most highly capitalised companies in the world. Eni convinced the government that it would do over and beyond what was required of Heritage in its PSA viz; build a refinery, sustain production at a level that will optimally serve the refinery, build a pipeline to the coast and most of all, start production immediately, since the reserves had been proven among others.

The government was smitten by the potential of what Eni would do, and thus threw its full weight behind it, despite the legal limitations in the Tullow-Heritage JDA which required a JD Partner interested in selling its stake in the JD, to give first priority to the remaining JD Partner.

Whether this was a tactic by Heritage to get the most in terms of dollars from Tullow, we cannot tell, but it worked. If one were to consider that, had Heritage tried to sell to Tullow in the first instance, Tullow could have offered probably less than a billion dollars or at most 1 billion dollars for Heritage’s stake.

So, Heritage well aware of the existing and legally enforceable pre-emption right of the surviving JD Partner went on and shopped for Eni and actually concluded a sale and purchase agreement with it in total disregard of the contractual provisions of its JD Agreement, in what everyone considered a done deal, a deal with the full blessing of the government. All for what?

To get the most from its stake before its official exit from Uganda and it was successful in attracting a whopping $1.5bn from Tullow who decided, against government’s hopes and desires, to use its pre-emption right, thus slamming the first door on Eni to the chagrin and disappointment of the government.

What seemed like a simple legal battle on issues of pre-emption rights in Joint Development Programs and the right of the host state to sanction certain contractual transactions among and between developers in the oil sector has turned into a more serious battle with the government using all means to reassert its position as the sovereign, and Tullow is now paying the price for its ambition on one hand and its negligence in failing to apply for a production licence on time on the other. If the government unduly retained permission to grant the development license, otherwise, Tullow shall be considered negligent and if I were to be asked, I would say that Tullow is in this opposition because of its own ambition and most of all trying to fight a host state that has gained an increased bargaining position.

Considering that the government was highly in favour of Eni taking up the Heritage stake, it put government on a collision course with Tullow. It is suspect that the new twists witnessed recently stem from Tullow’s role in the frustration of the Heritage-Eni deal and also Tullow’s rush payment to Heritage before the government would have a chance to sanction the transaction, hence leading to Heritage leaving the country without settling its tax obligations, this decision has come back to haunt Tullow.

It is widely believed that the government’s withdrawal of Kingfisher from Tullow, is to create a situation where the government will ultimately hand it over to Eni through competitive bidding with the best development plan taking the day, or even still, arm twist Tullow through behind the scenes actions to accept a farm in by Eni who have been seriously lobbying since their failed Heritage stake takeover bid. Eni has much more potential than Tullow to develop the Kingfisher well, in terms of finance, skill, expertise and experience and considering that they are in the (very) good books of the government currently, they are considered the top contenders for the development of the Kingfisher oil field.

Recent Developments – Tax Dispute and Arbitration

The withdrawal of Kingfisher from Tullow is the latest twist in this Uganda oil industry drama and sends signals which indicate the government’s attempt to impress its sovereign position as having the ultimate power in all these industry transactions, and a stern signal to the oil companies that they would go against the government position at their own peril especially in instances where government cooperation is required.

Recent Developments – Improved Bargaining Position

Would government have acted like this earlier? Of course not, however with the changing fortunes, government has attained a higher bargaining advantage in that, with the commercial discoveries, government is sought after by, more than it seeks after, oil companies because the oil companies are now attracted to the big finds.

What Uganda is experiencing are the effects of operating without a proper and well defined legal and fiscal framework, as well as, the effects of lack of skilled personnel in the petroleum industry and a major shift in the bargaining power of the government and the industry players with the government having attained a better bargaining position than it had previously. However, with the ongoing reforms and fast tracking of the new law, some problems and issues of the nature as discussed here above might not arise and all the money spent in investing in the Uganda oil sector will be money well spent. It is business as usual for petroleum industry players.

About Atipo Ambrose Peter Jr: The Author is a Lawyer and an International Independent Oil & Gas consultant. He is with the Law Firm Kiiza & Kwanza Advocates & Legal Consultants, where he heads the Firm’s Energy, Natural Resources and Infrastructure Group. (www.kkattorneys.com) and also consults under Lead Energy Consult, an Integrated East African based Energy & Natural Resources Consulting Firm. He heads the firm’s Energy, Mining and Infrastructure Practice. He is also a member of the Association of International Petroleum Negotiators (AIPN), Energy Institute UK, SPE, Aberdeen Chapter. You can contact him directly at: atipoap@kkattorneys.com

Information on the Ugandan oil sector can be found at www.ugandaenergyportal.com