Comment: Disputes in a low oil price environment
Revenue streams will enable the oil and gas industry to weather the immediate low oil price storm and its effects on profitability and to adjust the business to the new reality
Prices change every day, buffeted by global economic data, rumours of war and peace and unexpected changes in production. Whenever one of these seismic price shifts occurs, existing contracts come under intense scrutiny. So what issues does that create in the industry?
The starting point is to understand how the players in the industry react to dramatic changes in price. There are two broad reactions, both rational. First, they try to reduce costs. Second, they seek to protect their income. It is that income that, hopefully, will enable the business to weather the immediate low price storm and its effects on profitability and, in time, to adjust the business to the new economic reality. Both of these reactions have led to disputes arising across the entire value chain from upstream to downstream.
First, there are the trading disputes arising from non-payment. These remain prevalent as parties suffer cashflow problems or simply delay payments to improve their financial position. Key for sellers in this environment is to ensure strict compliance with the contract. Then careful internal credit control procedures and satis factory security for payment.
Supply agreement pricing disputes
While many transactions in the oil products markets worldwide take place in the spot market, a few long-term oil contracts still survive. In natural gas and, more importantly, LNG, long-term supply agreements remain commonplace. Parties now often price piped gas by reference to hubs, but LNG, without a reliable, liquid international price marker, is still often sold using price formulae indexed to Brent or oil products. So, although local demand for gas remains the main driver of hub prices, the collapse in oil prices will have led to some LNG contract prices for deliveries to those local gas market falling dramatically. This unexpected potential dislocation between the LNG price and the local gas price immediately raises the prospect of disputes, using price review or hardship clauses in long-term contracts.
Price volatility makes parties more willing to trigger price reviews and hardship clauses because the sums at stake can be huge. In present market conditions, parties should keep long-term contracts under review to check when the next price review falls due and to prepare the economic and legal arguments if a request is made.
Joint venture disputes
Another area where good contract management may pay dividends is joint venture agreements. We have seen the desire to cut costs resulting in disputes between operators and other participants and between joint venturers. From the operator’s perspective, it should ensure that all other participants agree to detailed budgets and work programmes to avoid challenges later. It should get all necessary approvals for expenditure (AFEs) and issue cash calls as soon as possible with proper documentary support. If it becomes clear that a budget overrun is likely, the operator should ask the Operating Committee to approve a revised budget as soon as possible.
One issue we have seen several times in the past year is the remedies available if one participant fails to pay a cash call or its share of the joint venture’s costs. Most joint venture agreements contain sanctions for parties in default. The final sanction is often forfeiture. Forfeiture provisions may or may not provide for the defaulting party to receive some form of compensation in return for losing its equity interest. The question of whether these terms amount to a penalty, certainly under English law, has been circulating without a clear answer for several years.
In a joint venture, all parties have a legitimate interest in ensuring that every party pays its share of costs. If a party fails to do so, knowing the severity of the sanctions that the other parties may apply, it should expect to suffer the consequences. However, while a judge may enforce a forfeiture clause during the exploration phase of a project, s/he may feel less happy doing so during the production phase.
Associated with disputes between operators and other participants, we can expect to see the same effect cascading down into infrastructure disputes between operators and contractors, including an increase in enquiries about building contracts for both new onshore and offshore facilities signed before the oil price fall but reaching completion now. Owners/operators, under costs pressure, are more willing to hold contractors to lump sum prices by (1) vigorously defending variation and delay claims through both substantive and technical arguments and (2) making big counterclaims for defects or under-performance.
When oil prices are high, so are costs because there is demand for skilled people and specialised materials, equipment and services. If prices fall dramatically, a retrenchment occurs and there is downward pressure on costs. For many contractors, this is a fact of life and re-negotiations will occur, either to reduce payments or stretch commitments over a longer period in the hope this mitigates the immediate impact of lower prices. However, we have seen a growth in contract terminations where a negotiated solution proves impossible or impractical. After all, if you no longer need a drilling rig for the foreseeable future, reducing the hire rate or stretching the time frame is not going to work.
Therefore, I am receiving enquiries about the enforceability of “termination for convenience” clauses combined with termination payments and limitations and exclusions of liability. From the operator’s perspective, these enquiries are a precautionary step before pulling the termination trigger. From the service provider’s viewpoint they are usually after the gun has been fired and they are trying to work out if they can squeeze some more cash out of the operator.
We are in interesting times as the global energy industry adjusts to the new norm. Once the volatility has subsided and the initial pain has been endured, the industry will march forward again. However, the created shock waves will continue to fuel disputes for the foreseeable future as the dust settles.