June 26, 2011

LAST week we had dealt with the broad issues in the KG Basin Gas scam, in which the CAG’s findings are only one element. In this article, we will focus on what the CAG has noted in its draft report about the KG-6 block and the production sharing contract (PSC) between the government of India and the Reliance consortium. In this consortium, Reliance held 90 per cent shares and Niko 10 per cent, with Reliance being the operator.

The key findings of CAG (Comptroller and Auditor General of India) are as below.

1) Even though the PSC envisaged a phase wise vacation of the contract area for exploration under the New Exploration License (NELP), finally confining the operator to retain only the area from where commercial production takes place, the Directorate General of Hydrocarbons (DGH) and Ministry of Petroleum allowed the Reliance to retain the entire exploration area as “discovery area” in gross violation of the contract.

2) The Reliance never submitted a comprehensive field development plan, as called for in the contract. Instead, it submitted an initial development plan (IDP) with an outlay of 2.2 billion dollars in 2004 and issued an addendum to the IDP (AIDP) worth an additional 6.6 billion dollars.

3) The Reliance started procurement action even before the Addendum was submitted or passed, indicating clearly that they took the government’s approval for granted.

4) Reliance added 746 million dollars to its cost, which it had not incurred, as “estimated liabilities,” in violation of specific provisions of the contract and of all accounting norms.

5) Various sweetheart deals with its suppliers, the most flagrant one being that for a floating production vessel for 1.1 billion dollars. It appears that this was a 26 million dollar vessel, converted to a floating production vessel taken by the Reliance on a 10-year lease.

The CAG has stated that it would like to go into each of the sub-contractor’s prices and audit them further. Prima facie, a number of these contracts seem to be completely ad hoc, based on single party offers, change of terms and scope during the course of the contract, etc.

If we look at the provisions of the PSC, there are two major classes of violation. One is the Reliance keeping the total area given to it for exploration as discovery area, when the area of the major developed gas and oil fields there is less than five per cent of the total. The other is jacking up the capital cost.

The Reliance benefited in two ways – it recovered the inflated cost right in the beginning as “cost” petroleum, the second because of the nature of the profit sharing deal in PSC, it got a much higher share of the profit petroleum, then it would have otherwise. Though the CAG has not computed the total amount of scam as it wants to examine in more detail the inflation of costs, our rough estimate indicates the scam to be of the order of 10-12 billion dollars. Added to this, the additional area that the Reliance has grabbed from keeping the entire exploration area for itself and therefore any future discoveries here would go to the Reliance. As such, the scam is indeed comparable to the 2G scam, if not bigger.

As per the draft report, the total exploration area for KG Block 6 was 7,645 km. This was an offshore deep-water block and was awarded to Reliance in 2000 under NELP 1. Under the contract, Reliance was required to retain only 75 per cent and 50 per cent of the exploration area after Phase 1 and Phase 2 of the contract respectively. After Phase 3, it was supposed to retain only the area here it had made discoveries or developed gas or oil fields. Phase 1 was supposed to finish in June 2004 and Phase 2 by June 2005. Not only did Reliance not release any area, as it was supposed to do under the contract, it claimed that the entire area should be considered discovery area as various 2D and 3D surveys showed that there were hydrocarbon deposits in the entire block. The ministry of petroleum and DGH accepted this claim and in February 2009 agreed that Reliance could keep the entire block as discovery area.

1) Discovery in the contract was clearly based only on exploratory wells drilled and finding of petroleum at the surface, and not 2D and 3D seismic surveys.

2) The wells sunk by Reliance, as visible from the map of wells drilled by 2010, showed that it covered only the north west part of the block and therefore had not drilled any exploratory wells in other areas.

3) Even the seismic surveys carried out – the 2D and 3D surveys – covered only a part of the block.

4) Till the end of Phase 2, only 4.5 per cent of the area had been designated as discovery area and therefore Reliance had no basis to claim that the entire area was “discovery area.”

5) During Phase 2 of the contract period, DGH was on record asking the Reliance to relinquish 25 per cent of the area as per contract. It suddenly did a volte face later and decided that the entire exploration area could now be considered as discovery area.

Why is this issue important? This takes us to the NELP and why production sharing contracts have been devised. It has been argued that national oil companies or the public sector does not have resources to explore the country’s oil basins and therefore the case for inducting private capital. The entire argument for inducting private capital is for quick development of India’s hydrocarbon resources. If any company takes a particular area for exploration, it must finish the exploration within a certain time period or release it back to the government for awarding it to others. It cannot sit on top of an exploration area and hoard it for the future. That is why the clause of progressive release of exploration areas back to the government. After Phase 3, the only area that the private party is to keep are those where it had already discovered oil or gas by drilling actual wells or had started commercial production. Everything else had to be given back.

Normally, when gas or oil is struck in an area, its nearby areas are also likely to have hydrocarbon deposits. The value of such areas would therefore go up for any subsequent auction. Hoarding such areas means that though the party considered has not spent the money it was required for exploration, it is still allowed to retain this area and explore it at leisure.

The CAG has commented that, clearly, the contractor never intended to relinquish any part of the exploration area and this was facilitated by the DGH and the ministry of petroleum by “irregularly and incorrectly terming the entire contract area as ‘discovery area,’ when drilling of wells, which is the primary requirement for ‘discovery’ and ‘discovery area’ had not taken place in the major portion of the contract area.”

The CAG has also pointed out that RIL has similarly been granted another contract area as discovery area on the basis of discoveries when discoveries had not taken in a major part of the contract area. As per the CAG, this would open the floodgates for other private operators to follow suit and strike at the very heart of the PSC, “which mandates a time bound exploration process with relinquishment of undiscovered areas so that these can be re-auctioned for exploration and development by other willing parties.”

Phases and Dates	Area to be Relinquished
Phase 1 end date June, 2004	25 per cent of exploration area to be released
Phase 2 end date June 2005	Another 25 per cent or total of 50 per cent to be released
Phase 3 original end date June 2007 but was extended to July 2008 by MoPNG	95 per cent should have been released as only 5 per cent of the area had discoveries
February 2009	The ministry allows entire exploration area to be considered discovery area even though Reliance had not drilled wells in the rest 95 per cent of the area as called for in the PSC.

For all discoveries, the PSC calls for a detailed appraisal program and a appraisal report which identifies the boundaries of the hydrocarbon bearing block, the recoverable petroleum or gas. It is only after this that the contractor can move for claiming a commercial discovery and development of the field. In the case of KG-6 block, the Reliance skipped the appraisal part and went straight way to commercial discovery. As the appraisal report is the basis of the capital expenditure, this meant that all the capital expenditure being incurred had very little basis. The major cost escalation claimed for the D1-D3 area thus had no appraisal report. All the cost escalations and plans for expansion of production from 40 MMSCD to 80 MMSCD was done without a detailed appraisal of the discovery.

This was not the only issue. In the case of 2 other discoveries – D5 and D 18 – no proposal for appraisal have been received even after 7 and 6 years respectively. The PSC requires that if the contractor does not submit an appraisal programme for three years, the contractor would relinquish its right to develop such discovery and this area would be excluded from the contract area. Again, in spite of such blatant violation of the contract, no action has been taken by the government and Reliance continues to hold all the original exploration area and the development rights.

Why is the Reliance not exploring the contract area as it had proposed and why does it want to hold on to this entire area? Oil and gas exploration is costly business. If you strike oil or gas, as Reliance did, it would like to put its money in development of the field and getting its money out as quickly as possible. Moreover, if oil or gas has been struck, raising money in the capital market is easy, particularly given the nature of the one-sided production sharing contract that the government of India has awarded. For Reliance, the game was simple --- use the D1-D3 discovery, and the oil discovery in D6-MA-1 to bring in capital and focus on their development. Given the sweetheart deals and the cooking of the contracts as we shall detail later, this was creating capital out of market borrowings and then siphoning this from the top by inflating capital costs. Reliance did not have to spend any of their own money in this game, only cook the books.

While Reliance was looking for easy capital to finance its oil and gas field development, it did not want to relinquish the exploration area. It did not even want to put in money for the other 16 discoveries apart from D1-D3 and D6-MA-1. However, it is hot property in the oil market, and therefore Reliance wanted to retain the entire area of the D6 block for future exploration and not relinquish it to the government for auctioning again, as called for in the contract and envisaged under NELP.

The CAG’s draft report provides enough details to show how the DGH as well as the ministry of petroleum conspired with the Reliance to keep the entire exploration area. The CAG has indicted V K Sibal by name in the report and has also called for holding other concerned officials accountable for this. As we had noted in our previous article, Sibal has been under the CBI scanner for two years without any concrete steps being taken against him. However, the scale of this manipulation of the contract is not possible without the support of the ministry concerned, not simply DGH and Sibal.

The proximity of Murli Deora, the former petroleum minister and now minister of corporate affairs to the Ambanis is well-known. The petroleum ministry’s role in this manipulation is clear. A thorough probe in the role of the ministry and the minister is necessary, pending which Murli Deora should resign from the cabinet.

The other important issue is: How much did the government lose by the entire contract area having been designated as discovery area? The CAG’s draft report states that this is a huge loss as the government could have re-auctioned this area and it would have fetched a very high price because of its proximity to known hydrocarbon bearing areas. That is why blocks near Bombay High had fetched a high value in earlier auctioning of blocks. More important, blocks have been awarded to private parties in order to speed up gas and oil discoveries.

The question is: What will the government do about this? The response of Jaipal Reddy, the current minister of petroleum, makes it clear that the UPA is in a stone-walling mode, reminiscent of its 2G defence. However, irrespective of who is guilty of favouring the Reliance, what prevents the UPA government of making a simple statement – that if the PSC has been violated, the government will ensure that Reliance will not be able to gain from such violations? Why does the government not simply say we are exploring means of taking back the extra area beyond ‘discovered’ and ‘development’ areas from Reliance? That way, it would at least do some damage control.

This, however, is almost impossible for the Manmohan Singh government to do. Unlike Brazil and Venezuela, who have used their hydrocarbon and other natural resources to bank-roll pro-poor and anti-poverty measures, the trajectory of this government has been to use all natural resources such as spectrum, oil and gas, coal, iron ore, etc to bank-roll the capitalist class. This is the core of economic policies of the Congress-led UPA government. This is neo-liberalism at its ugliest.

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