International Oil and Gas Industry Disputes
Editor’s note: Hereby we publish the second part of the article by Doran Doeh, an internationally renown arbitrator who has pursued a successful legal career of over 40 years in the UK and Russia and was Senior Counsel in Dentons’ Moscow office. The first part of the article published in the May issue covered i.a. border disputes between States over continental shelf, PSAs (Production Share Agreements) and Investor-State Dispute Settlement mechanisms.
Disputes relating to Joint Ventures
Although there are some international oil and gas companies that prefer to develop projects on their own, much of the industry does so in combination with others through joint ventures. An important part of the motivation for this is to spread risks and combine expertise. In some countries, national policy encourages this by welcoming international investors but also requiring them to work closely with locals. There also many infrastructure projects – pipelines, treatment and transhipment terminals for example – where each country has its own customary approach. In some countries such infrastructure may be developed by governments, in others by specialist private utilities and in others by joint activities of producers.
Incorporated and unincorporated joint ventures
In Russia, virtually all joint ventures take corporate form – the parties usually set up a company and take shareholdings if it is a joint stock company or participation percentages if it is a limited liability company. Some very sophisticated forms of agreement have been developed for Russian incorporated joint ventures, such as the Shareholders and Operating Agreement which is often used.
In much of the rest of the world, the international industry prefers unincorporated joint ventures because of the greater flexibility they provide to tailor them to the exact needs – and compromises – of the participants.
In the case of corporate joint ventures, the disputes are much like those arising under the legislation governing companies more generally, with which Russian practitioners will be generally familiar, and therefore I will focus on unincorporated joint ventures.
Because the contractual documentation for an unincorporated joint venture of the duration expected in the upstream oil and gas industry (often more than 20 years) must provide comprehensively for the governance of the venture, the industry has developed its own forms for this. Whilst there are standard forms (most notably those of the AIPN) for the most common types of agreement – joint operating agreements, for example – each agreement is tailored to the exact needs and situation of the consortium concerned, often in long and sometimes difficult negotiations. There are often materially different views on what the terms should be – the position adopted by a huge multinational with long term presence in the industry may be very different from that of a small or medium size player and a company which is primarily an investment vehicle. Hard negotiations do not always produce good results, particularly where wrestling over language produces ambiguous wording which mean different things to the different parties involved. It is hardly surprising that such situations give rise to disputes afterwards.
Amongst the most common areas of dispute are pre-emption provisions. Virtually all joint venture agreements in the international petroleum industry have pre-emption provisions of some kind. The ventures are often very long term in expected duration, a great deal of money is usually involved, and parties want – at the minimum - some control over who may take the place of one of the other parties. In many cases they also want to have the option to increase their stake if another party wants to leave. Some, often the more entrepreneurial or speculative players, look for a high level of flexibility because they anticipate wanting to sell out (wholly or partly) if the venture is successful. Others, often industry stalwarts, take a much more long-term view but nonetheless recognize that they may at some stage need some flexibility themselves, for example in a corporate reorganization. One of the most difficult problems in drafting pre-emption clauses arises from the need of virtually all parties to avoid a pre-emption clause inadvertently acting as a “poison pill” in a take-over situation. For example, if a public bid is made for the parent company of a party which the parent wishes to accept, it will not want to be in a position where the successful bid triggers pre-emption on interests of a subsidiary which results in the subsidiary losing an asset of great importance to the parent. It is very difficult to draft a clause that wholly avoids this problem and is nonetheless enforceable without question in other circumstances.
Another problem for pre-emption clauses is to provide for the multi-asset deal, where the asset subject to the joint venture is bundled up with other assets in which the other parties to the venture are uninvolved. There are also situations where non-financial consideration is involved, and it is difficult to quantify it in financial terms. Often the compromise is to require the party offering the assets to assign values to each including the one subject to the joint venture agreement – but it is very difficult to prevent the party concerned attributing an artificially high value in the hope of avoiding pre-emption by making it too expensive for the others. An alternative is to go for expert determination but that may involve delay that is unwelcome in a take-over situation.
The art of resolving these issues often lies in working out a solution that, while not perfect, provides enough impediment to the unwanted behaviour so as to give each of the other joint venture participants the comfort that it will have a basis for fighting its respective corner if the need arises. Unsurprisingly, when a pre-emption situation arises, the parties scramble to look at the clause in the agreement and the circumstances may give rise to a dispute.
Another area of inherent tension is the relationship between the operator and the non-operators.
It is logical and common to a consortium of petroleum industry players to appoint one of their members to manage the activities and operations of the joint venture. Particularly where one or more of them are well-experienced at doing so and have the resources necessary, issues then arise. How is the operator to be paid and how much? How is it to be controlled? What standard of liability should apply? In what circumstances and how can the operator be replaced?
It is often felt by the non-operators that the position of operator gives its holder advantages. Even where there is strong provision for supervision and control by the non-operators, the operator is much closer to operations, has better access to information and has much greater ability to shape and control the direction of the project. The non-operators are therefore reluctant to pay more than the basic costs of the operator and it is common to see some kind of “no gain, no loss” principle written into the agreements. This begs questions about control of costs, and the industry has developed its own elaborate systems for programmes and budgets, authorities for expenditures, recovery of overheads and accounting procedures – but again these must be negotiated. In return, the standard of liability of the operator is usually not very stringent – the operator being liable only for gross negligence or wilful default – again, although there are standard definitions, there are variations which require negotiation.
The operator conversely often feels that it is making available superior resources and risking its reputation if anything goes wrong and therefore needs a degree of freedom to operate as it sees fit. In each case there are negotiations and it is not always easy to attain an acceptable balance, and this can give rise to disputes.
The long-term nature of petroleum industry joint ventures sometimes results in disputes arising long after operations have been completed. There was a recent dispute in the UK over liability for the pension provision of employees that were engaged by the operator many years earlier.
Default procedures can also be problematic. What happens if a party fails to pay its share of a cash call? The simple and common solution is forfeiture of interest, but some parties may feel this is too draconian a consequence and lawyers may have doubts about its enforceability, leading to elaborate “withering interest” provisions. Indeed, the issue of enforceability of such default clauses has come up time and again in the course of this author’s career even though the issue has been laid to rest more than once in the past based on then current court judgments only for doubts to re-emerge later in a different context.
Although for most of the life of a joint venture, parties will be focusing on development and operational issues, at the end of the field life there is usually some legislative or other legal requirement to remove the production facilities and restore the site. Industry joint venture agreements often provide for how this is to be funded in advance of the decommissioning liability arising, but, again, given the long term nature of the agreements and the difficulty of foreseeing all circumstances that may pertain the time the liability arises (including changes in legislation), disputes can arise as to how the provisions of the agreement are to be implemented.
Sole risk, non-consent and withdrawal
There can also be issues over non-participation in a particular operation or withdrawal from the joint venture altogether – if a party decides that it does not wish to proceed, can it withdraw and, if so, on what terms, given that the others may have been counting on its participation to spread cost and risk. Conversely, there are sometimes provisions which enable a member of the consortium to be able to carry out operations on its own if it is willing to take the risk and others are not.
Unitisation and other matters requiring references to experts
Certain kinds of joint venture agreements specifically provide for certain matters to be referred to an expert if the parties cannot agree. Among the most common are unitisation agreements. In Russia, licences tend to be granted to encompass a whole field and an extension or additional licence is granted relatively readily if it is found that a field extends over the boundary. Other countries take a different approach and it often happens that a field is found which extends over the boundary between licenced areas which have been granted to two (occasionally three) different groups. The legislation of such jurisdictions usually contains provisions whereby the different groups involved can be compelled to agree on unitisation, i.e. developing and operating the field as a single unit. In practice, it is very rare that the authorities actually impose unitisation as the parties will eventually agree it (it can take a long time, however) as being in their own interests. Nonetheless, it is common in such situations to recognize that as the field is developed the information that become available about it will greatly increase and the allocation of interests as between the parties may need to be adjusted, with compensation being made between the groups for past production and past costs which have with hindsight also have been misallocated. In some unitisations there may be an expectation that “redetermination of equities” (as it is often called) may need to take place more than once. There is usually a provision for reference to an expert to take place in such circumstances and the reference is often handled in the same way as a dispute, with each side preparing a formal case and presenting it in a hearing.
Disputes relating to M&A/A&D
Russian practitioners will be well familiar with oil and gas M&A transactions relating to shareholdings in companies, which are seen in the context of the preceding section of this article as incorporated joint ventures. They will also be familiar with kinds of disputes that arise in relation to them.
They will be less familiar with similar transactions relating to unincorporated joint ventures, which, to distinguish them from transactions concerning incorporated joint ventures, are often referred to in the industry as “acquisition and disposal” transactions (A&D).
As with the difference between incorporated and unincorporated joint ventures, the documentation for the transaction – mainly the Sale and Purchase Agreement (SPA) although there may be other documents as well – needs to take a more comprehensive approach by either describing conceptually the assets to be transferred (e.g. by referring to the production licence for an interest in a field to be transferred and then referring generically to all other assets that relate to the licence or which are used for the purposes of production of petroleum under it) or by cataloguing the assets (or both). Often the assets will consist of a complex of agreements that establish the unincorporated joint venture, but there may well be others that are entered into pursuant to the main JV agreements. If there is an operator for the field, as is usually the case so that the physical and contractual assets used to produce the field are held by the operator as agent or trustee for the other parties, then it may only be necessary to refer to the contractual arrangements which connect the seller and the operator rather than describing or cataloguing the full panoply of assets. There would then be in the SPA an extensive set of representations, warranties and undertakings as for a corporate M&A deal but relating to assets. This can give rise to disputes in the same way that they do under M&A agreements, with added complications if the description of the assets is not adequate or effective.
The oil and gas industry also had its own specialised kinds of M&A deals. One of the most characteristic is the “farm-in”, usually on an exploration prospect (i.e. where no oil has been discovered or what has been discovered is insufficient to give a full picture of the prospectivity of the relevant formation). The agreement may specify that a final depth must be reached in the well (or wells if more than one is to be drilled). There can be disputes as to whether that depth has been reached and, depending on the terms of the farm-in, whether there are any relieving circumstances (e.g. force majeure). Usually also a farm-in agreement also provides for the party coming to reimburse the established party’s back costs, and there can sometimes be disputes over these.
Where the field has been proved but there is a lot of expenditure to be incurred before it is produced, the parties may enter into a “carry” agreement under which one party pays the other party’s costs until production comes on stream, following which the funding party is repaid the carried costs out of production. In a complex deal there can be issues arising from unclear drafting as to what costs were incurred, how they are to be repaid and the valuation of production.
Oil or Gas Pricing Disputes
In the 1970s and 1980s, when there were great concerned over security of supply of oil it was much more common to enter into long term supply agreements. Such agreements in relation to oil are now mainly used for financing in order to establish a flow of receivables by a producer from a reputable and creditworthy off-taker whose credit is acceptable to a bank that will provide a loan facility secured on the cash flow under the agreement.
Long term supply agreements continue to be common in the gas industry either to finance gas field production and any attendant pipeline or LNG liquefaction plant (plus dedicated tankers if necessary). In the North Sea, for many years before there was adequate infrastructure in place and a hub gas market accessible, in order to provide the financial security needed to produce gas it was necessary to enter into life-of-field depletion contracts. These are no longer needed in the same way in the North Sea but may be required in other parts of the world. For other gas field production or pipeline projects it may be more appropriate to have long term supply agreements (on a “take-or-pay” basis or, in the case of a pipeline “send-or-pay” for very long periods of time, say 20 or 30 years). These may be necessary in other parts of the world – such as the Far East – where similar conditions (lack of pipeline infrastructure and gas hubs) still apply. LNG projects – whether for liquefaction or regasification – also tend to require such arrangements although the increasing commodification of LNG with acceptance of hub-based pricing may make this less common in the future (again, currently the Far East continues to have this situation).
A long-term agreement of this kind will include pricing provisions based, usually, on a complex and heavily negotiated formula which refers to other products which have pricing referable to regularly published sources. Because of the very long duration of the contract, it usually includes a process for review from time to time and an opportunity for one party or the other to require the pricing mechanism to be reopened. There are usually two stages to this. The first concerns establishing that circumstances have arisen – e.g. the market has changed sufficiently – justifying a price review. The second concerns the price review itself, which may include intensive scrutiny of an algebraic price formula. The agreement sets out the criteria for both stages. Both stages may – and often are – disputed, almost always through arbitration as the parties are normally very reluctant for the information involved in the process or, indeed, that there is even a process of this kind taking place, to be made public.
Disputes Relating to Infrastructure
The international petroleum industry engages in some of the largest infrastructure projects in the world, often in remote locations or extreme climatic conditions and involving cutting edge technology. However well prepared initially, plans are often changed or adapted as a project moves forward. Unexpected circumstances arise. The industry and its activities are subject to rigorous regulation of a great variety of kinds and sources and can sometimes be required to satisfy simultaneously the authorities and regimes of different countries in relation to the same project. In addition, the industry is constantly subject to public scrutiny and pressures from a wide range of political interests and lobbying groups. If not effectively controlled, petroleum can be extremely dangerous.
Unsurprisingly in such circumstances, disputes arise. Many of these are contractual, such as breach of warranty, indemnity claims, termination, price revision, force majeure and the many more general forms of breach of contract. There are disputes with regulators and other governmental authorities. Tortious claims may arise if an accident occurs.
As mentioned above, decommissioning at the end of the field life may throw up unexpected situations concerning infrastructure which may lead to disputes.
Trading and Shipping Disputes
Petroleum, in its many varieties and forms, is among the most frequently traded commodities. Although, as indicated above, much transportation takes place by pipeline, vast amounts are also shipped in vessels ranging from the largest super-tankers to relatively small vessels, and including highly specialised LNG carriers, ice-breakers and FPSOs (Floating Production Storage and Offloading vessels).
Quantity and quality claims are common as are shipping claims of all kinds including demurrage, deviation, extra port charges and bunkering costs. Whilst many of these are relatively small and are often settled between the parties, but claims can be substantial and go to dispute resolution.
Human Rights and Environmental Disputes
Mentioned in passing above in the section on ISDS (see Arbitration.ru, №5 (9) May 2019, pp. 52-53) human rights and environmental disputes can be a major challenge for petroleum industry players. It is not within the scope of this article to review these in detail, but it would be remiss of the author not to mention them.
Damages in Oil and Gas Disputes
Again, it is not within the remit of this article to go into detail on how damages are assessed in oil and gas disputes, as much of it falls within the usual practice of lawyers specializing in the many kinds of dispute mentioned above. However, it is worth mentioning a few factors which, while not unique to the petroleum industry, are particularly relevant.
One is the high volatility of prices. For many years before 1973, when OPEC first exercised its pricing power, crude oil prices were constant at US$3 per barrel. Since then, there have been times when there seemed be no limit to the increase in oil prices, and it was hard to keep the old maxim that “trees don’t grow to the sky” in mind. At others, prices were in precipitous decline and the industry seemed headed towards financial disaster. The volatility of prices makes it very difficult to assess damages and the factors and methodology to be used can be hotly disputed, with experts heavily involved in presenting contrasting alternatives.
Determination of the time value of money can also be a significant factor in dispute. If a volume of oil is not produced on a particular day, the physical oil that should have been produced is not lost because it remains in the ground – indeed the molecules which should have been produced that day are very likely to be the ones produced the next day if production resumes then, and the total volume of oil produced from the field over time may be the same. However, the date of production of that total volume will, unless the production rate is increased, be put back by a day so that, in effect, the volume of production not produced on the day the field was down will not be recovered until the end of the field life. On most methods of calculating time value of money and net present value, the physical volume concerned might as well have been lost. There are, no doubt, other industries where lack of production on a day cannot be made up, but it explains the high importance in the industry of achieving production targets and maintaining production even in very difficult circumstances. I mention this, in conclusion, because it reflects the nature of the industry.
36 Stone, Arbitrator, London