February 2016
Below $30 - Disputes in a Low Oil Price World
Practice Group(s):
By John Gilbert and Jonathan Hoff
Oil & Gas
The news that crude prices fell below $30 per barrel - the lowest in 10 years - was not
greeted with shock but by predictions that they might continue to fall and would stay low
for some time 1. Any attempt to predict the future will almost certainly be proved wrong,
but the fact that many are preparing for a long period of lower prices will in itself give rise
to disputes as organizations look to protect their positions and redouble efforts to reduce
costs. Examples of the types of disputes that have already arisen and will continue to
arise in the oil and gas industry are described in this note.
Production Sharing Contracts and Joint Operating Agreements
The key area for dispute under both Production Sharing Contracts (“PSCs”) and Joint
Operating Agreements (“JOAs”) will be the participants' commitment to ongoing
investment in exploration, development and production of fields. Governments will want
to see levels of investment and activity maintained in order to secure levels of production
and income. However, the licensees of any block, particularly in the exploration and
development phases, will be questioning the economic viability of any expenditure or
commitment to future investment. The threat to licensees who do not fulfil their
obligations under PSCs is that the licence will be taken from them. Nevertheless, the risk
of this being carried out may be reduced as governments will be concerned about
whether they will be able to find willing replacements.
For participants in JOAs, disputes may arise in relation to:
1. the decision-making process in the approval and implementation of annual work
programs and budgets and the approval of Authorizations for Expenditure and
contract awards where different participants have different preferences or imperatives
in relation to level of investment2;
2. the mechanism for sole risk activities where not all of the participants contribute to or
share in certain activities3;
3. the payment of cash calls or invoices for a share of operating expenses where a
participant faces problems with cash flow4; and
4. the operation of pre-emption rights if participants are trying to reduce exposure by
farming out part of, or disposing of all of, their participating share or if there are
consolidations across the industry 5.
1
On 26 January 2016, the World Bank reduced its forecast for the annual price per barrel for 2016 to $37.
For example, Hyperdynamics has recently been reported to have commenced litigation and arbitration proceedings
in the United States against Tullow and Dana Petroleum in relation to a dispute over a field in Guinea, see Offshore
Energy Today, 11 January 2016
3
The English High Court decision in Ithaca Energy v North Sea Energy [2012] 1793 (QB), demonstrates the types of
dispute that may arise in relation to the operation of sole risk provisions
4
It has recently been reported that a dispute has arisen between the Nostra Terra - Independent Resources JV and
North Petroleum International Company over cash calls in relation to East Ghazalat, Egypt
http://www.iii.co.uk/stockmarketwire/290625/nostra-terra-irg-jv-serves-dispute-notice-north
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The recent Australian case of Santos Offshore Pty Ltd v Apache Oil Australia Pty Limited [2015] WASC 242 shows
how disputes can arise over the operation of pre-emption rights
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Below $30 - Disputes in a Low Oil Price World
It is fundamental to most JOAs that the participants share the risks and expenses on the
one hand and opportunities and rewards on the other, according to their participating
interest share. Where one participant is unable to meet its share of the expenses, the
ultimate sanction is that it will be declared in default and it may lose its participating
share. However, in the current environment, it may be that other participants are
reluctant to take this step because they do not wish to assume a greater proportion of the
cost and risk.
Service and construction contracts
In order to reduce cost or to defer production, operators of projects may wish to reduce
the scope of service and construction contracts or postpone them. They may also seek
to renegotiate pricing or payment terms6. Ultimately, the operator may wish to bring the
contract to an end 7. How these situations are resolved will depend upon many factors,
including the contractual terms, the relationship between the parties and the value
involved. To date, many of these situations have been resolved through negotiation, as a
drive to reduction in cost has been recognized as essential throughout the industry.
Nevertheless, as optimism for a quick price recovery fades, more disputes may emerge
as both operators and service providers try to protect value.
Long term supply agreements
With current market conditions, long term supply agreements will be, for some, valuable
assets and, for others, millstones. Long term supply agreements can be found across
the oil and gas industry for crude oil, pipeline gas, LNG and refined products. Their
impact on both buyer and seller will depend on how price is calculated and, particularly,
whether it is calculated by reference to a market for that product or some other means.
Lower oil prices will, in some instances, cause the price to become out of step with the
parties’ expectations or the market into which the product is being sold. If that is the
case, the buyer (and sometimes the seller) may look carefully at any flexibility it has in
relation to the volumes delivered under the contract and whether there is any provision
for a review of price.
Even without express provisions allowing for a price review, the party suffering as a result
of the price fall may look to renegotiate price or, ultimately, to terminate the agreement if
that is not possible. Different legal systems take different approaches in this regard - in
some civil law systems, the ability to seek relief from hardship is recognized, whereas
common law systems tend to take the view that an agreement becoming economically
less advantageous to one party is not a reason to alter, suspend or terminate
performance.
Hedging arrangements
Declining commodity prices, and the accompanying financial impact and credit
downgrades, can have significant impacts on hedging and sales contracts. These
contracts frequently impose obligations to provide increasing amounts of collateral upon
credit downgrades or as specified trigger levels of tangible net worth are crossed. In
addition, these contracts may contain an adequate assurance of performance
requirement, which allows a counterparty to demand collateral if it has reasonable
6
Steps being taken to scale back, postpone or renegotiate rates for work are described in
http://www.ft.com/cms/s/0/7b706010-5c97-11e5-9846-de406ccb37f2.html#axzz3yGXjBqQH
7
Examples of rig/drill ship contracts being terminated are numerous over the past year, for a recent example see
http://www.worldoil.com/news/2016/01/22/eni-terminates-ocean-rig-drillship-contract-on-oil-slump
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Below $30 - Disputes in a Low Oil Price World
grounds for insecurity of the other party’s ability to perform. In order to maintain sufficient
margin to support hedging activities, access to cash liquidity or letter of credit facilities is
critical. Hedging agreements that are supported by liens on assets face similar pressure.
Navigating disputes as to credit support can be tricky, as the timeline to provide credit
support under hedging and sales agreements is typically only a few days in order to
avoid default.
Throughput agreements
Long term delivery obligations under throughput agreements may also be a source of
disputes. Finance for the construction of processing facilities and pipelines is often
dependent on a level of delivery being secured from the users of the facility or pipeline
under throughput agreements. Where those users may not wish or cannot afford to
continue production at the level required by the throughput agreement, disputes may
arise. Those disputes may be between not just the producer and facility/pipeline owner
but also with the finance provider. In particular, the facility/pipeline owner may find itself
in a very difficult position as it is caught in the middle between the financier and the
users.
On the flip side, the reduction in the crude price has led to increased refining margins in
some regions and so throughput in refineries has been high. Consequently, for
companies wishing to take advantage of higher refining margins, the battle may be to
secure increased throughput during the period.
Insolvency
Relatively few insolvencies have been seen to date. Many think that there has been a
reluctance on the part of major creditors and bondholders to push for this step to be
taken, preferring instead to take greater control over the operation of the business whilst
it continues as a going concern. This will particularly be the case for licence-holders of
fields which risk losing that licence as a result of an insolvency. In these circumstances,
a pragmatic approach on all sides is required to protect value although, as those with
experience of such situations will know, threats of disputes and brinksmanship will often
be seen behind closed doors.
Although there have been few insolvencies seen in producers of oil and gas, for service
companies the picture has been less optimistic. A recent study in the UK has shown the
number of insolvencies in service companies increased in significantly 2015. 8
Conclusion
The fall in the price of crude has already and will continue to lead to disputes. Although
there will be a reluctance to divert resources towards fighting them, the need to protect
value may make that unavoidable. If faced with a dispute, it will be critical to identify
areas of difference early and to take steps to manage the dispute as soon as possible;
this will allow the best prospect of mitigating most effectively the risks that the dispute
presents.
8
See http://www.moorestephens.co.uk/news-views/january-2016/insolvencies-of-uk-oil-and-gas-service-companies-a
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Below $30 - Disputes in a Low Oil Price World
Authors:
John Gilbert
John.Gilbert@klgates.com
+44.(0)20.7360.8122
Jonathan Hoff
Jon.Hoff@klgates.com
+1.713.815.7303
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