Contract
Stability In The Petroleum Industry:
Changing The Rules And
The Consequences
By
Peter D Cameron
High
oil prices have triggered reviews of existing contracts by
host governments in many petroleum producing countries.
In some cases, notably in Venezuela, Bolivia and Ecuador, the
result has been to initiate highly publicized renegotiations
of existing contract terms with foreign contractors. As long
as prices remain high relative to the 1990s, it is very likely
that more of such reviews and renegotiations will occur.
Peter Cameron carried
out an extensive study of the strains on fiscal stability in
contracts in the international petroleum industry and their
implications 1. This article examines two of its main themes:
greater flexibility in the use of stabilization clauses and
the increasing use of arbitration to enforce petroleum agreements.
1. Changing The Rules
Amid all
the publicity surrounding the claims and counter-claims that
frequently accompanies contract renegotiations, two key,
recurring features can be identified in the international petroleum
industry. Firstly, such demands for contract review usually
come in waves followed by long periods of stability. The last
one occurred in the 1970s and early 1980s, when a quadrupling
of the oil price led to contract negotiations and in some cases,
nationalizations of assets. The resulting disputes led to key
arbitration awards, often cited by writers on this subject
as evidence of ‘the state of the law’ on expropriation.
We may call this the ‘classical’ period of contract
renegotiation. A wave begins with the actions of one or two
countries and then spreads to other regions, acquiring a global
character. Recently, it is the actions of Venezuela and Russia
that have initiated a new wave of contract renegotiations,
which has spread to other regions, including the Middle East,
North Africa and parts of Asia. Secondly, for every country
that seeks to renegotiate a petroleum agreement, there are
several that are so keen to attract foreign investment that
they will accept terms that include ‘stabilization’ clauses
imposing penalties or specific procedures on them (or their
NOC) if they elect to change the terms materially at a future
date. In other words, for every wave that puts the international
oil industry on the defensive there is an – usually unpublicized – opportunity
for the industry to obtain more reassuring conditions from
other host countries for acreage carrying perhaps a higher
degree of geological and/or political risk.
The present wave occurs in a very different context from that
of the classical period of contract negotiations. Then, awards
were made that addressed disputes arising from an international
petroleum industry that bears only a passing resemblance to
the one we have today. The producer-consumer dynamics have
changed but more importantly there are new market players both
as producers (Kazakhstan, Azerbaijan, Russia and several African
states, for example) and as consumers (China and India, for
example). The latter group appears to be willing to conclude
contract terms that differ from those offered by traditional
players in terms of incentives for host countries. The players
themselves (the IOCs) are a more concentrated group and the
current generation of IOCs is learning to live with both NOCs
in the host countries and globally operating NOCs as competitors.
Although the host governments responsible for the present
wave of unilateral amendments may not have offered stabilization
clauses in their contracts, they do affect contracting practice
in this respect. In such a climate of uncertainty stabilization
provisions appear to offer an additional security against political
risk. Both foreign investors and host governments eager to
attract petroleum investment may respectively seek and offer
provisions that they might not otherwise have sought or offered
(and which they may come to regret). Not surprisingly, the
market place for stabilization provisions in petroleum agreements
has been expanding, with a greatly increased diversity of products
attracting and perhaps even puzzling host governments and their
negotiators.
2. Contract Stability And The NOCs
Two kinds
of stabilization clause are particularly common. On the one
hand, there is the provision that has the effect
of ‘freezing’ the terms of a petroleum agreement
for the life of that accord. On the other, there is the provision
that requires an action disturbing the balance in the fiscal
arrangements to be compensated by another action or actions
that restores the effect of the original provision (‘re-balancing’).
This usually opens up a negotiation of some kind between the
parties. In practice, the diversity of provisions available
is made up of hybrids of these two approaches. The view of
contract stability as requiring a ‘freezing’ of
key contract terms over long periods of time has been in decline
for many years, not least because of the difficulties of enforcing
such a rigid approach that seems to be largely aimed at avoiding
expropriation. In practice, if the government of a sovereign
state wants to expropriate, few would now challenge its right
to do so; the legal issue would be about the amount and the
form of compensation to be paid to the investor. These days,
the more challenging legal issues would be about actions that
amount to ‘creeping expropriation’ and whether
(or how) they are protected by one of the more than 2,300 Bilateral
Investment Treaties (BITs) that are in force around the world.
A survey
of legal practice reveals a number of published awards that
are directly relevant to disputes over the first kind
of stabilization but with respect to the second, guidance is
available only from cases that are principally concerned with
related issues such as indirect expropriation. These ‘modern’ approaches
to stabilization provide that if the host government adopts
a measure subsequent to the conclusion of the agreement in
which the fiscal terms are set out, that is likely to have
damaging consequences to the economic benefits for one or both
of the parties, a re-balancing will take place; the focus is
on the result of a unilateral action rather than on whether
a host government has the right to take it. Petroleum agreements
differ in their treatment of how this balancing is to be effected:
it may be automatic or achieved in a manner set out in the
agreement such as according to a formula or model or following
a discussion of amendments by the parties. Implicitly, such
an approach recognizes that some change in core fiscal terms
over the life of the project is a distinct possibility; however,
should it happen, there has to be a corresponding adjustment
to ensure that the original terms of the deal struck in the
contract will survive any such change. Not all of the fiscal
obligations are necessarily included in the re-balancing that
the contract envisages in such an event. Some may address only
increases in taxes. As a result, the IOC is left with a significant
exposure to the imposition of other forms of fiscal obligation.
Contract
stability has also been affected – and arguably
enhanced for the IOCs – by the rapid growth of NOCs since
the 1980s. In many cases the host country’s NOC will
now play a central role in the operation of fiscal stabilization.
Sometimes the contract for exploration and production is made
between the foreign investor(s) and the NOC rather than the
state itself, and on other occasions between the NOC and the
host government. A stabilization clause may therefore be negotiated
with the NOC rather than the state. This is not in practice
a complicating factor and may make it easier to reach an agreement.
It has a bearing on situations where, in the case of PSCs,
the host government pays additional fiscal obligations on behalf
of the IOC (Azerbaijan, 1980s Qatar model PSC) or does so only
to the extent of the host government’s share of profit
oil (current PSCs in Trinidad and Tobago; current PSCs in Egypt).
This effective tax exemption is only applicable to the extent
of the NOC’s (or host government’s) share of profit
oil. In practice, the host government seems to be granting
a specific tax exemption in the event of a change in the overall
tax regime. But in cases where the NOC or host government share
of profit oil is relatively small, this mechanism will provide
only a modest ‘insurance policy’ against increased
taxes, especially where the PSC regime provides for royalty
and/or state participation. In some PSCs in Trinidad and Tobago,
the host government’s share of profit oil has been used
up in the face of additional fiscal obligations.
3. Enforcement
The
context for enforcing petroleum agreements has changed dramatically
since the last wave of contract revisions. If
a host government decides to unilaterally amend any of the
key fiscal provisions, it will find that the legal landscape
has become both complex and international. Globalization has
greatly benefited law and lawyers. Firstly, there has been
an expansion in the number of professional dispute settlement
bodies, rather than being limited largely to the ad hoc tribunals
that figured in awards made 20 or 30 years ago. The International
Centre for the Settlement of Disputes (ICSID) is perhaps the
best example of this, and has been active in recent cases involving
Argentina and other Latin American states. Bodies such as this
are increasingly taking on cases that involve disputes arising
from foreign investment transactions involving states and private
parties. Secondly, there has been a considerable expansion
in the number of BITs concluded between states to provide protection
to private companies. These may lend treaty status to stabilization
provisions contained in a host government’s petroleum
regime by way of a ‘fair and equitable treatment’ provision.
They are playing a greater role in disputes that go to arbitration,
particularly with respect to claims of indirect expropriation
and denial of fair and equitable treatment. Once again, this
is a new factor compared with the classical period of the 1970s
and 1980s: there are now more than 2,300 BITs in existence.
Moreover, there is a multilateral investment treaty, the Energy
Charter Treaty, specifically addressed to the energy sector,
which has enjoyed something of a renaissance as a basis for
arbitration claims, so far usually in Central and East Europe
2.
With
respect to enforcement of a stabilization provision, the
NOC as signatory
to the contract might improve the likelihood
of the IOC obtaining specific performance and not just lump
sum damages from a tribunal. However, there are (as far as
this author is aware) no known arbitral awards for the more
modern stabilization mechanisms that involve some re-balancing
of the economic interests of the parties in the event of a
unilateral change by the host government 3. Guidance on the
enforceability of such clauses is only available by analogy
with recent arbitral awards that address expropriation, indirect
and direct, and ‘fair and equitable treatment’ or
more recently with ‘freezing’ of contractual provisions,
where only lump sum damages are available. Evidence of reasonable
due diligence before conclusion of the petroleum contract is
an essential requirement for the IOC before trying to rely
on a stabilization clause.
4. Looking Ahead
Two
cautionary remarks may be made with respect to unilateral
changes in
petroleum agreements and their consequences. Firstly,
in certain non-fiscal areas a host government will
normally be very reluctant to agree to stabilizing a petroleum
agreement.
These include: environmental, and safety and health matters.
Coincidentally, these are areas where the risks to investors
have grown considerably in recent years. In these areas, some
IOCs have sought to develop mechanisms that ‘manage’ the
resulting risks and provide them with a measure of stability.
In the BTC cross-border pipeline project in the Caucasus, for
example, the parties introduced an innovative form of environmental ‘index-linking’ that
recognized the volatility in this area but attempted to set
parameters for possible changes. Claims for greater ‘public
participation’ by local communities can also be expected
to impact on the stability of petroleum agreements in certain
parts of the world in future. In such cases, the risk to investors
is less from a deliberate act from a host government than from
changing public perceptions about what governments or NOCs
should be doing, as well as the impact of new treaty obligations,
better quality information about, for example, environmental
impacts and the open-ended and voluntary character of many
of the terms and concepts used in these new areas. Secondly,
the legal principle of pacta sunt servanda (contracts
are binding) in the petroleum sector has been challenged in
both developed
and developing countries: it has been challenged by the UK
(in the last wave, in 1975-76 4) and more recently by the US
5. Other countries – Kazakhstan
is a notable example – have
elected to change the overall contract environment, especially
for future contracts, but have done little to challenge the
terms of existing contracts, even if the host government has
made known its dissatisfaction with such contracts (signed
at a time of eagerness for foreign investment).
In both the design of petroleum agreements and in their enforcement,
the issues of contract stability have become more complex and
the stakes are higher for host governments, their NOCs and
for foreign investors. They would be well advised to be prepared.
Notes:
1.
The study was carried out for the Association of International
Petroleum Negotiators (AIPN) in 2006, and is available at
http://www.aipn.org or through the author at peterdcameron@btinternet.com.
2. Among the observer countries to the Charter are: Algeria,
Bahrain, China, Islamic Republic of Iran, Kuwait, Morocco,
Oman, Qatar, Saudi Arabia, Tunisia, UAE and Venezuela.
3.
The leading arbitration awards from the 1970s and 1980s do
include
rulings in favor of the validity of stabilization
clauses: Agip v Congo; BP v Libya; Liamco v Libya, and
TOPCO v Libya. However, the focus of the clauses was to ensure that
the concession agreements were operative for the full term
provided in the contract and so targeted expropriation (or
a similar confiscatory measure) as the ‘event’ to
be prohibited.
4.
See the account in the author’s ‘Property Rights
and Sovereign Rights: The Case of North Sea Oil’, Academic
Press, London, 1983.
5. The House of Representatives approved a plan to renegotiate
Gulf of Mexico petroleum leases in May 2006, addressing leases
granted between 1998 and 1999 that exempted petroleum companies
from fees from exploitation regardless of how high prices went.
Neither the UK nor the US offers investors stabilization clauses.
Peter D Cameron is
professor of international energy law and policy and Director
of Research at the Centre of International & Comparative
Petroleum Law and Policy( CEPMLP), University of Dundee
, UK . He
is a prolific academic and legal author of publications on
petroleum and energy topics. His most recent publication
is "Legal Aspects of EU Energy Regulation: the Implementation
of the Electricity and Gas Directives across the EU" (Oxford
University Press, 2005), while the earliest can be traced
back to the book, "Property Rights and Sovereign Rights:
the Case of North Sea Oil", published by Academic Press
in 1983. He was until end 2002 Joint Editor of the Journal
of Energy and Natural Resources Law and has served on the
Editorial Board of the Oil and Gas Law and Taxation Review. Petroleumworld
not necessarily share these views.
Editor's Note: This article was published by Middle East Economic Survey
MEES, VOL. XLIX, No
22, 28-May-2007. Petroleumworld
reprint this article in the interest of our readers. Petroleumworld
reprint this article in the interest of our readers.
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