“adverse selection” in field development contracts

To begin, it is useful to briefly review the concept of adverse selection in economic enterprises, so that we can later explore its dimensions within the National Iranian Oil Company (NIOC). 

– In contracts theory, the concept of information asymmetry means that one party to a contract possesses more or better information than the other. This situation is highly probable in NIOC’s field development contracts with its contractors. Contrary to common perception, the imbalance does not always tilt in favor of NIOC. In fact, there are cases where contractors possess more precise and higher-quality data than NIOC, the reservoir owner, or have access to advanced technology, cutting-edge analytical tools, and top-tier consultants who provide more accurate reservoir models. Conversely, NIOC may hold data that, due to organizational culture, departmental data ownership, or confidentiality considerations, intensifies information asymmetry. Although confidentiality agreements are meant to address such concerns, in practice these issues persist. 

– This information asymmetry casts a shadow over other contractual obligations, leading to improper risk allocation and ultimately to imbalance in contractual commitments between the parties. One of the consequences of information asymmetry is adverse selection. 

– George Akerlof, Nobel Prize laureate in economics, famously explained adverse selection in his article “The Market for Lemons.” Using the example of the used car market, he showed how information asymmetry leads to adverse selection in economic enterprises. In his example, “lemons” refer to poor-quality used cars. Sellers know the defects of their cars, but buyers do not. If buyers had access to this information, they would offer lower prices to owners of poor-quality cars. Since they do not, buyers face adverse selection. 

– In line with this, in the 2016 Cabinet resolution on the general conditions, structure, and model of Iran’s upstream oil and gas contracts (IPC), and subsequent amendments, one element that can create the ground for adverse selection is the method of determining the depletion baseline. 

– The depletion baseline is a key element in this contractual model. According to Clause “B” of Article 6 of the resolution, contractor remuneration is based on incremental production above the depletion baseline. Repayment of direct costs (DCC), indirect costs (IDC), operating expenses (OPEX), cost of money (COM), fee and other ancillary costs to the foreign party are made from revenues generated by up to 50% of incremental production above the depletion baseline. 

– The Supreme Council of Oil and Gas Reservoir Engineering, established by Cabinet resolution No. 86453/T53521H, is responsible for approving depletion baselines. Article 2 of the resolution specifies the composition of the Council: 

1. Minister of Petroleum
2. Deputy Minister for Hydrocarbon Resource Supervision
3. Deputy Minister for Engineering, Research, and Technology
4. CEO of NIOC
5. Director of Exploration at NIOC
6. Relevant hydrocarbon resource official at NIOC headquarters, appointed by the CEO
7. Four industry experts in reservoirs, geology, and earth sciences in the oil sector
8. Three Iranian academic and research faculty members specializing in reservoirs, geology, and earth sciences in the oil sector

– Conclusion: Establishing an accurate depletion baseline is of critical importance for evaluating the annual production profile of the foreign party and for repayment of costs. Any deviation in its determination can result in adverse selection for either party. 

Sometimes the depletion baseline may be set so low that with minimal effort the contractor quickly reaches FTP (Full Term Production), leaving NIOC exposed to adverse selection. Conversely, it may be set so high that the project’s economics become unviable, creating difficulties for the contractor in recovering and amortizing its investment.