BRIEFING

FLUCTUATING OIL PRICES: CONTRACTUAL PRESSURE POINTS LESSONS LEARNT

AND

JANUARY 2016 ● AN OVERVIEW OF THE

EFFECTS OF FLUCTUATIONS IN THE PRICE OF OIL.

“WE HAVE SEEN THE LOW OIL PRICE CAUSE SERIOUS DIFFICULTIES IN A NUMBER OF AREAS.”

Fluctuating commodity prices cause contracts to come under scrutiny. Industry analysts have voiced opinions that the current oil price slump could last for as long as 18 to 24 months. Some said even longer. There have been brief rallies, but the pain looks set to continue. We have seen the low oil price cause serious difficulties in a number of areas. Given the apparent unpredictability of oil prices, those involved in the industry should be alive to these issues both at the negotiation stage and during the life of the contracts they have entered into. The considerations in this article will also be relevant to banks and companies looking to re-structure funding arrangements. As a consequence of the low oil prices, oil companies slashed exploration and development budgets, rig day rates came under pressure and service providers to the oil & gas sector faced renegotiation of contracts fixed at attractive rates during the times of high oil prices, or even worse, contract defaults. Whilst cost-cutting may be a sensible step with regard to budgeted costs, as opposed to fixed costs, what happens where commitments are locked in which are no longer attractive, for example, where oil companies have firm commitments to fulfil work programmes and budgets (WP&Bs) but inadequate cash-flow? Where charters are fixed at rates that are no longer sustainable? Where owners face non-payment under lucrative charters that are nearing their end? Where contractors are facing project suspensions or cancellations of projects mid-stream?

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When times are good the finer points of contracts are frequently overlooked. However, when the tide turns, contracts are examined very carefully and methods to exit are explored. Set out below are some points to consider. Force majeure and frustration One question we are frequently asked recently is whether reliance can be placed on force majeure.

“UNDER ENGLISH LAW, THERE IS NO GENERAL PRINCIPLE OF FORCE MAJEURE…”

Under English law, there is no general principle of force majeure. Essentially, force majeure is what the contract says it is. If a contract provides that a party is entitled to suspend performance if prescribed circumstances beyond the control of that party prevent it from performing its contractual obligations, it will usually include a longstop discharge of all contractual obligations if the force majeure continues for a specified period. However, the courts are unlikely, in most circumstances, to find that financial difficulty caused by the oil price slump will amount to force majeure. Similarly, arguments that contracts have been “frustrated” (rendered impossible to perform) are unlikely to succeed if performance has merely been rendered uncommercial or non-viable. Renegotiation Rigs under construction that were ordered on a speculative basis during the rigmarket zenith may be looking somewhat less appealing with day rates low and good forward charters more difficult to secure due to over-supply. To address this oversupply, in collaboration and with the encouragement of banks, many rig owners have been scrapping or stacking tonnage. As a first step, purchasers may wish to consider approaching yards to voluntarily delay the delivery of rigs. This would allow the buyer time to scrap older tonnage, thereby decreasing opex and raising capital, or finding a charterer for the rig. This strategy is most likely to work with larger, more established buyers who have longterm relationships with yards and greater bargaining power. Also, it is recognised in the industry that the market is cyclical and penalising long-term customers for shortterm benefit may ultimately be counter-productive. It is in both parties’ interests to seek to assure mutual survival and this is the approach that is being promoted in the sector. Often, deferrals come with an alteration of the payment structure under the contract. Where the contract might originally have provided for a deposit of 20% of the contract price, with the 80% balance payable on delivery, we have seen contracts renegotiated to provide for a 30:70 split. That is all very well when compromise is an option. However, the situation is different for less established buyers, whose very survival is on the line, or buyers who simply no longer have the means to fulfil their contractual payment obligations. In such circumstances, desperate times may call for desperate measures.

Fluctuating Oil Prices: Contractual Pressure Points and Lessons Learnt

“FOLLOWING THE 2008 GLOBAL FINANCIAL CRISIS THE BOTTOM FELL OUT OF THE SHIPPING MARKET.

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Termination or cancellation Following the 2008 global financial crisis the bottom fell out of the shipping market. We saw one example where, within a period of five months, the day rate of a capesize vessel plummeted from US$285,000 per day to US$5,000 per day. Speculative buyers in that market, i.e. purchasers with no future employment for the vessels, looked for ways to legitimately avoid performing contracts. We are seeing precisely the same thing in the current rig market. One strategy then, and again now, was to attempt to push the delivery or completion beyond contractual longstop delivery or completion dates. The method most frequently employed in construction contracts is to identify defects that must be repaired prior to delivery. Whilst this may sound far-fetched, this precise strategy was successfully employed by the purchaser of several ships which were no longer wanted in the aftermath of the global financial crisis. In one case, the purchaser was able to point to deviations from the Common Structural Rules (“CSR”), including, excessive “cocking-up” (arching) of the vessel’s aft. Whilst the excessive arching was measured in millimetres it was sufficiently serious to enable the purchaser to refuse delivery and ultimately cancel the contract. In that case the yard refunded the instalments already paid as part of a global settlement in relation to this, and other, disputes. Technical deficiencies are also being relied upon, although probably to a lesser extent than in the shipbuilding market, among rig purchasers seeking to exit unattractive contracts. Readers may recall the incident at Jurong shipyard in December 2012 when the jacking system of a jack-up rig failed, causing the rig to tilt to one side, injuring numerous people. The same jacking system was being installed in numerous rigs around the world, which required attention and caused delay. However, this was at a time when the market was buoyant and rigs were in demand. Buyers were generally accommodating. The story may have been very different if this had occurred in the market conditions that prevail today.

“LOW OIL PRICES HAVE DRAMATICALLY CHANGED THE ECONOMIC VIABILITY OF SOME FIELDS. WHAT WAS ONCE A PROMISING FIELD CAN QUICKLY APPEAR TO BE A LIABILITY.”

Termination for excessive delay is one of the more common tactics considered, but buyers must pay careful attention to provisions in the contract dealing with permissible delay. Purporting to exercise a right to terminate for excessive delay too early may itself amount to a repudiation of the contract. If such a repudiation is accepted by the counter-party, the repudiation could entitle the party to accept the repudiation and itself terminate the contract and claim damages. Forfeiture Low oil prices have dramatically changed the economic viability of some fields. What was once a promising field can quickly appear to be a liability. Issues can arise where the joint venturers hold differing views on the field’s potential and the way forward in respect of the field’s exploration and development. Low oil prices have meant that many oil companies have scaled-back exploration and development budgets. However, when oil companies are locked into minimum work programmes, and yet face funding difficulties, the ramifications can be serious.

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The most common significant default under joint operating agreements (JOAs) is the failure of a joint venture partner to meet cash-calls. Typically, the JOA will provide for a cure period within which the payment default must be remedied after which the defaulting party forfeits its participating interest (PI) with the other joint venture partners taking over its PI. Historically, payment defaults have commonly occurred towards the beginning of a field life (i.e. during the development phase when cash is tight) or at the end of the productive life of a field (when parties may be less concerned about forfeiting a PI). However, with oil prices being low, and funding difficulties being encountered, defaults during the production phase may increase with parties being reluctant, or simply unable, to invest large sums in what have become marginal or un-commercial investments. Minimum work commitments, and approved WP&Bs, however, remain unchanged and some governments may be quite unsympathetic to oil companies.

“DEFAULTS AT THE END OF A FIELD LIFE ARE LESS LIKELY TO RESULT IN FORFEITURE…”

Defaults at the end of a field life are less likely to result in forfeiture (and a take-over of the defaulting party’s PI) as this may in practice release the defaulting party from its responsibilities regarding matters like decommissioning. Forfeiture of a PI is arguably the most draconian of the remedies to the nondefaulting parties under a JOA. There has been considerable academic discussion on the question of forfeiture, not least because of its severity. This discussion has included the question of relief against forfeiture, i.e. where the declared forfeiture of a PI is not upheld. This equitable relief would normally be in the form of additional time to remedy defaults. This is an area of law that requires development and where case-law is sparse, not least because most JOAs are governed by arbitration provisions meaning the outcome of disputes is not reported. Joint venture (JV) members are rightly concerned to ensure they do not expose themselves to the risk of losing their PI through forfeiture. However, with the change in a field’s attractiveness due to the current oil prices, JV members may be less concerned that forfeiture will be invoked. With the oil price drop, the field becomes less profitable, and non-defaulting JV members may well be unwilling to cover the defaulting party’s cash-calls and increase their PI in a field which is less appealing than it previously was. With forfeiture less likely, JV members may consider that there is little real risk to deferring payment of cash-calls for the time being. Obviously, taking such a position can have a significant negative effect on the relationships within the JV. Further, a default would still expose the defaulting party to other remedies under the JOA (e.g. for damages or debt in relation to the unpaid cash-calls). Additionally, the risk of forfeiture may still be real in situations where the remaining JV members consider that the field is still viable despite the current low oil price, or where those companies consider that oil prices will recover. That said, whilst the writer has seen the successful acquisition of a defaulting JV partner’s PI by exercising contractual forfeiture rights, in many cases the remedy of forfeiture is something of a blunt axe. The writer has also seen JOAs legitimately terminated and forfeiture rights asserted (with the relevant PI transfer documents being executed by the non-defaulting party by means of pre-signed powers of attorney etc.) with no success in practical terms. In one case, where the defaulting JV partner was the operator under the JOA, the partner simply ignored the default and termination notices, and the assignment of its PI, went on to develop the field and go

Fluctuating Oil Prices: Contractual Pressure Points and Lessons Learnt

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into production, keeping the revenue generated for itself. This is an on-going case, so we have not necessarily had the last word. However, what we have seen is the fact that legitimate contractual attempts to transfer the defaulting party’s PI in accordance with the JOA and Production Sharing Contract (PSC) are not always straightforward. Of course, a claim in damages is a possibility, but this raises a host of complex issues outside the scope of this briefing.

“THE TRANSFER OF A PI IN A PSC WILL GENERALLY REQUIRE THE CONSENT, OR SIGN-OFF, OF THE GOVERNMENT IN WHOSE JURISDICTION THE CONCESSION LIES.”

The transfer of a PI in a PSC will generally require the consent, or sign-off, of the government in whose jurisdiction the concession lies. Such approvals can take up to two years, or more in certain jurisdictions. This may mean that the defaulting party cannot be jettisoned prior to production, giving it ample opportunity to remedy any defaults. In circumstances where a default has been remedied, despite the duration of the default being longer than the long-stop period in the JOA, a court or tribunal (under English law) may look upon the equitable remedy of relief against forfeiture, by granting addition time to comply, with some sympathy. Thus, in effect, the defaulting party would have been given a non-contractual “carry” of its obligations (albeit repayable) ex post facto. However, planning to use this mechanism for escaping current cash crunches would be a high risk strategy. Being an equitable remedy, the usual provisos (such as “clean hands” etc.) will apply, and deliberate and orchestrated defaults to avoid contractual obligations would be less likely to attract relief against forfeiture. Potentially of more concern for the non-defaulting party is the fact that certain jurisdictions appear reluctant to become embroiled in PSC/JOA disputes and disinclined to recognise contested PI transfers. The upshot of this may be that the defaulting party remains the ostensible titular holder to a PI entitled to receive revenue from sales. This is of particular concern where the defaulting party is the operator, as it will normally have control of the JV accounts which may be difficult to counter due to enforcement difficulties in certain jurisdictions. Securing operatorship would mitigate against this particular risk.

“WHILE OIL PRICES CONTINUE TO SLUMP, COMPANIES IN THE OIL & GAS INDUSTRY WILL CONTINUE TO FEEL PRESSURE ON THEIR BUSINESSES.”

The law on penalties applies to JOA forfeiture provisions. If a clause provides for a remedy which is disproportionate, unconscionable or “in terrorem”, it may be unenforceable as a penalty. Thus, for example, a clause that requires the forfeiture of a PI during the development phase for a payment default (regardless of severity) may be considered penal. To avoid penalty arguments standard form JOA’s frequently provide for buy-out mechanisms. Conclusion While oil prices continue to slump, companies in the oil & gas industry will continue to feel pressure on their businesses. In such circumstances, contractual relationships can become strained. Whilst we have not seen defaults on the same scale as in 2008 in the shipping sector (possible partly due to differences in the oil & gas sector and partly due to the fact that lessons were learnt from the 2008 crisis), many contractual relationships are being stretched to breaking-point, and may snap in the future. A bounce back in the oil price may help to alleviate some of this strain, but until the markets rally, companies face some challenging conditions in which to operate and during this period need to carefully examine new and existing contracts.

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FOR MORE INFORMATION Should you like to discuss any of the matters raised in this Briefing, please speak with the author below or your regular contact at Watson Farley & Williams.

MARCUS GORDON Partner Singapore +65 6551 9157

[email protected]

Publication code number: 57383152v1© Watson Farley & Williams 2016

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