Middle East Economic Survey
VOL. XLIX
No 22
28-May
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. Professor Peter Cameron of the University of Dundee (CEPMLP) carried out an extensive study of the strains on fiscal stability in contracts in the international petroleum industry and their implications1. 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 Europe2.
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 government3. 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 1975-764) and more recently by the US5. 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.
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.