International Oil and Gas Law in a Developing Nation - Coursework Example

of East Anglia Norwich Law School LAW- M614 INTERNATIONAL OIL AND GAS LAW PG WORK REGISTRATION NUMBER Word count without bibliography 4826 S.NO TABLE OF CONTENTS PAGE NUMBER 1 Introduction 3 2 Answer to Question 1 4 2.1 Various Types of Arrangements for Development of Oil Reserves in Jupitus 4 2.2 Concession 5 2.3 Contemporary Concession Contracts 6 2.4 Participation Agreements 7 2.5 “Production Sharing Agreements (PSA)” 8 3 Answer to Question 2 11 3.l Recognition of Risks: 11 3.2 Commercial Risks 11 3.3 Political Risks 12 4 Answer to Question 3 14 4.1 Legal System for Addressing Investment Disputes 14 5 Conclusion 16 6 Bibliography 17 1. Introduction Colonel Drake can be said to be the father of the oil & gas industry as it was he who made the first successful drilling at Titusville, Pennsylvania on 27 August 1859. At the end of the First World War, petroleum was declared as necessary for the economy of a nation as blood is to the human body. German army endeavoured to take control of oil fields around the world during the Second World War. In 1941, the German tried to gain control of the Russian oilfield situated in the Volga region and also later directed its war forces towards the Middle East as abundant deposits of oils was found out in Kuwait and Saudi Arabia. Hence, petroleum has become a strategic commodity for the nations around the world now. Oil is a strategic commodity which is likely to uphold its vital role in the near future also as it is extensively used in transport, generating electricity, etc. It is estimated that the demand for the petroleum is likely to soar up in the coming years to reach a level in excess of 4 Gt/y1. The development and exploration of Oil & Gas involves both high return and risk. The development of petroleum reserves needs the allocation of expertise and massive investments and capital which involves high risk. There can be significant return if the exploration and production of petroleum resources turned to be successful. Due to this double-edged sword nature of petroleum exploration industry, a number of business contracts and arrangements’ namely fiscal regimes that are never employed in other industries are being used in O&G industries2. The expertise of major oil companies around the world has contained the functions like production, refinery, transportation and sales or marketing. The oil exploration needs the adoption of modern contracts, which are footed upon either wholly or partly on participation arrangement instead of the traditional concession contract system. The main objective of this research essay is to advise Jupitus (J) a developing nation, where there is the absence of both environmental and commercial laws as well as the absence of the adequate international banking system for the purpose of identifying its oil resources and to explore the same as the oil is available, mainly in a habitat of indigenous people. Further, for advising the Jupitus, the factors like absence of oil industry expertise and absence of established legal or banking systems have been taken into consideration. Further, in Jupitus, there are very few commercial or environmental laws. Jupitus is also a relatively poor country and does not have the resources to develop any of the oil reserves itself and hence, it has to depend upon foreign oil companies (FOC) to explore its petroleum reserves. This research essay will advice Jupitus on three fronts namely the forms of contract to be entered by J with the oil exploring companies , the inherent risks associated with the O&G exploration contracts like environmental ,political and commercial risks and ways and means to minimise the same and the need to develop an international banking system and to have international investment agreements so as to attract more foreign direct investments in the field of oil and gas exploration in Jupitus. 2 Answer to Question 1 2.1 Various Types of Arrangements for Development of Oil Reserves in Jupitus Various types of contracts or arrangements for development of oil reserves can be explained through the following chart for easy understanding: 2, 2 Concession This section will elaborate the three most commonly employed fiscal regimes in the development of O&G industry namely tax systems/ royalty, which is known as concessions , and the two chief contractual systems employed – service agreements and production sharing agreements . This essay will conclude with the discussion with potential strategic positioning preferences for Jupitus government. Concession is a type of contract between oil exploring company and the government that explains the commitments of host government to the project. Under the concession, the host government offers to the oil exploring company the right to develop the project by making access the land to the company in barter for a stream of revenues or payments –in-kind and it includes any of the following forms. “Royalties (footed upon sales)” Fixed rents Profit overrides “Taxes on income or other taxes “ The exploring company has to pay some bonus to the host government at the juncture of contract is signed or at specified periods during the development or production. Further, a concession contract may include a provision that the oil exploring company should pay royalties to the host government some specified share of the value of O&G produced or in-kind payment like physical quantities of O&G produced instead of payment in money. Further, the contractor (Oil Company) is accountable for all the costs incurred and should bear all the risks inherent with exploration, production without reimbursement from host government. Moreover, the concession agreement will be in force indefinitely, so long as oil continued to be explored from the leased area by the contractor3. An all-inclusive concession agreement for a giant O&G project should include the host government’s commitment to offer a framework for negotiating with a variety of perils that may obstruct funding of O&G projects and such risks include currency risks (exchange fluctuations) and political risks like military coup, general strikes and civil unrests. If there is a failure upon the part of host government of any promises given to the oil exploring companies, then there should be provision in the concession agreement for the financial compensation to be offered mainly through a compensatory reduction of government’s share of income stream or through contingent payment commitments.4 Traditional concession agreements in the earlier period like in 1900s often covered massive land areas. For instance, in 1901, Shah of Persia granted to William D Arcy, a concession of 50,000 square miles for O&G exploration purposes. Further, the phase of the concession period offered was meant to be relatively for a long period and for instance, the early concession contracts were given for 82 years in Middle East Countries. Further, financial consideration received by a host country in the traditional concession contracts was meagre. 2.3 “Contemporary Concession Contracts “ There is wide difference between traditional and modern concession agreements. Modern concession agreements have provisions for higher sharing of revenues by O&G contractor. Thus, the variance between the traditional and modern concession contract is visible in the enhanced percentage of royalty or income-tax levied but also higher level of engagement in managerial decisions by host nations. Further, modern concession contract has provision that the contractor has the obligation to explore commercially the proven oil resources within a stipulated time else it has to handover the allotted land to the host government. Modern concession contracts are having provision where the contractor has to relinquish to the host government of the land allotted for E&P within certain years from the contracted date5. 2.4 Participation Agreements Participation agreements in Oil & Gas industry is frequently employed, which is also known as joint ventures. Under this, oil exploration companies will incorporate an operating company for exploration and development purposes in joint collaboration with the host nation. This type of structure is unique from that of production sharing agreements (PSA) as in the latter case, the oil companies and the host nations remain separate and do not incorporate a third corporation6. Under PA , the host government will either directly or through its government-owned oil companies , will hold a percentage of equity in the joint venture exploration company as a joint or co-venture along with the oil exploration companies and shall proportionately finance its share .PA can be entered into in four ways, and the same is outlined as under: Fixed State Participation – Under this, the host nation is allowed to hold a specific percentage of shareholding in joint venture Company which remain analogues throughout the period of the contract. Progressive State Participation- under this, host nation’s participation will vary if there is an accelerated level of oil production or vary with any other criterion mentioned in the contract. Optional State Participation- Under this, the host nation will participate in the joint venture only when a given condition stated in the contract. Carried Interest- Under this, the government owned Oil Company is allowed to partake in the day to day affairs of the joint venture company through their representatives posted in operation committee7. It is significant to note that there are chances to face uncertainties and risks if the host nation associates itself as a partner or engaged in joint-venture with oil exploration Company whereas such perils will be met by the Foreign Oil Companies under PSAs. Thus, in case of countries with potentially large oil resources, participation agreement will be more useful. Further in joint venture operations, the host nations are expected to play a dominant role in mastering and administering its petroleum resources, there is a necessity to have qualified and expertise personnel which the majority of the developing nations are not competent to have the same as compared to well developed nations. 2.5 “Production Sharing Agreements (PSA)” PSAs came into force during 1960s, and Indonesia is the first nation where PSA was introduced as host governments started to employ alternative efforts to maximize their revenues from E&P projects. PSA has been defined as a major departure from the concession. In PSA, the host nation holds partial ownership of the oil explored. The PSA apportions part of the oil explored to cover the costs of exploration and production, which are known as cost oil and earmarks the residual oil which is known as profit oil to be divided between the exploration company and the host nation8. In PSA, host governments not only interested to increase their aggregate share of petroleum associated revenue streams but also interested in expanding their part in the management of petroleum exploration operations. Maximising revenues and legal obstructions associated with the ownership of petroleum minerals mainly compelled the host governments to switch to production sharing agreements from the traditional concession agreements. Under PSA, a contractor consent to pay the host government an up-front bonus for signing the exploration agreement and this is known as signature bonus or signing bonus. Further, the contractor may phase out the bonus at the time signing and at the time of actual production so that he can pay only when there is adequate production of petroleum resources to the host government. The contractor is not required to pay any additional bonus to the host government if there is no petroleum in the allotted land, or it does not reach to the agreed level of production9. PSA can be entered into for some parts of the subsurface as per schedule approved by the law of host nation and in the presence of special legally acknowledged yardstick for the award of subsurface privileges on a production sharing basis. In some nations, PSA is related to not for subsurface use contracts but contract for carrying out petroleum explorations. In nations where production sharing agreements are buttressed by a legislative basis, certain warranties are often offered by law to make sure that the terms of such PSA contracts remain stable10. The unique provisions of PSA, which contains a provision that the contractor shall bring all required technology and finances for the exploration activities, including its owned or leased machinery and equipments11. Further, PSA shall also include work commitment and investment clause, which requires the quantum of oil wells that must be explored, the quantum of annual investment to be made and the type of technology that is to be employed in the upstream sector. PSA may also contain stipulations that may require the contractor to transfer its technology to the host nation so that it can prolong to exploit its natural resources when PSA concludes. Likewise, it may contain to employ the local work force during the exploration process, and the host nation may be required to submit its technical data, which is related to the exploration areas to the contractor. Further, PSA will always have clauses stipulating that all machineries, equipments, installations employed in exploration activities shall remain the property of the exploration contractor else these may be expropriated by the host nation once the PSA concludes12. There are many advantages for Jupitus government to employ PSA for its E&P allocations like a) contractor shall bring all required technology and finances for the exploration activities, b) there would be work commitment and investment clause, which requires the quantum of oil wells that must be explored c) there would be conditions like the quantum of annual investment to be made and the type of technology that is to be employed in the upstream sector and d) to employ the local work force during the exploration process and so on. In view of the above, it is suggested that PSA can be used by Jupitus government for allocation of its E&P projects to the FOC. Jupitus can peruse either of the following for allocation of Exploration and Production of Petroleum Reserves. Through open-door system, Jupitus government can have negotiations with American Petroleum and Nobel Oil either through solicited or unsolicited expression of interest. Under licensing system, Jupitus can allocate the E&P rights by employing a set of yardsticks defined by the Jupitus government through the administrative adjudication process. Alternatively, Jupitus government may indulge in auctioning of these E&P rights and in such cases, licences can be awarded to the top bidder13. Jupitus can employ either of the open-door system or licensing system to award E&P rights which are most beneficial to its interest. However, if American Petroleum is being selected, then it should place adequate conditions in the contract that heavy penalties will be levied if there are violations of environmental regulations as American Petroleum has recently been prosecuted in the nearby country of Ruritania for breaches of that country’s environmental regulations. 3. Answer to Question 2 3.1 Recognition of Risks: Risk is commonly used to refer to the chance of damage, injury, loss as contrasted with some erstwhile norms. Risks are measurable probabilities .Risk in Oil & Gas exploration projects is a dynamic concept that centres on the probability of changes. Present conditions are not termed as risks; instead, risk emanates from changes in those stipulations. The conditions and rules concerning an investment are a present parameter at the juncture of investment decision is taken. Thus, risks are future happenings that may alter or change the rules. The probable risks in O&G industry can be classified as political, commercial and environmental risk. Risk sharing or risk management is an important task in O&G operations to maximise the revenues14. 3.2 Commercial Risks Price risks connote to improbability over the scale of cash flows due to possible transformations in input and output prices of oil. Output price connotes to the peril of transformations in the prices that a company can demand for its oil and gas. Input price risk connotes to the peril of transformation in the prices that a company must pay for its materials, labour and other raw materials to its production process. Evaluation of price risk is connected with the production and sale of future and existing oil production that plays a pivotal part in strategic management. Commercial risks also include shortfalls in project revenues caused by uncertain sales and prices, cost overruns, not able to find sufficient amount of oil, fall of the oil prices, the civil unrest, and foreign exchange inconvertibility. Again, commercial risks can be classified into three categories .They are price risks, exchange rate risks and interest rate risks. Commodity price risks happen from volatility in the prices of oil and gas which are inputs for some companies and output for others. Due to globalisation of economic activities, Oil and Gas companies are vulnerable to foreign exchange rate risks. High volatility in interest rates may affect a company’s revenue stream by impacting both the velocity the customers would pay for the oil and gas on credit, and the terms of credit allowed. Further, cost of borrowing funds to fund its operations will be impacted due to changes in interest rates. One of the main risks that Jupitus can face is the price risk. Thus, the risk of volatility of prices of oil in the international market can be mitigated by entering into a long-term contract with the buyer and is also known as take or pay contract. The output price may be controlled by Jupitus or even the quantum of oil purchased by them. Jupitus should secure its contracts by getting the guarantees from the FOC (Foreign Oil Company) which it is going to engage that any future increase in the oil price will be allowed only after mutual discussion and understanding15. Moreover, the supply risk is linked with paucity of raw materials or unanticipated surge in its prices. The supply risk can be mitigated by entering into a long-term supply contract with the major project suppliers who would supply to the FOC with the necessary resources at a fixed price. In case, if the suppliers fail to meet their commitments, the supply contract should have a provision for levy of compensation or penalty for the damages suffered by the FOC. Likewise, cost overruns or delays in execution of risk will have to borne by other parties of the project16. To mitigate any possible future losses due to unproductive oil wells, the FOC in Jupitus should carryout due diligence audit as regards to geographical and technical information and also environmental impact study so that they can avoid unproductive investments in such projects. 3.3 Political Risks Political risk (PR) can be explained as the risk that regulations of a nation which will be likely to change unpredictably to the disadvantage of investor’s after the investor has made massive investment in a host nation thereby minimising the value of the individual’s investment17. Political risks also cover events like expropriations or nationalisation, war, confiscation, national currency depreciation, uprising and restrictive measures by host government through any adverse legislation or ethno –linguistic factionalism18 . Political risks also cover like refusal by Jupitus to adhere with the terms of contract entered with O&G companies, introduction of new foreign exchange rules and regulations that might hamper the value of currency trades, enacting new laws as regards to royalty, taxes, labour or other economic interventions that might impact revenue or costs streams of O&G companies’ functioning in Jupitus or expropriation of the O&G operations by Jupitus government. Political risks can happen due to political instability like terrorism, sabotage or kidnapping. Political risk can create actions by states-nations in the economic field that may be disadvantageous to the interest of O&G exploration companies. Any political unrest may drastically and unexpectedly impact a company’s operation which is known as political risk. There could be low levels of consistency and stability in the political sphere of a nation-state if there has been a higher level of political risk present in the country. Political risk may happen from operational risk, transfer risk and ownership risk. For doing business internationally, it is essential to make a reliable and valid evaluation of a host nation’s political risk. Such an evaluation will include the assessment of the relative power relationship, individual groups, decision-making processes and ideologies of the host nation’s political system. Due to political unrest that existed in Indonesia in 1990s, many European and US O&G companies relocated to other Asian nations and in Latin America. Since, Jupitus is not politically very stable and has had several coups over the last twenty years. The most recent one, which saw General Millapot take power, occurred two years ago and several hundred people were killed and hence, it is having substantial political risk. An oil company that desired to take up its operations in Jupitus can hedge its political risks through insurance. Multilateral Investment Guarantee Agency of the World Bank (MIGA) and Overseas Private Investment Corporation (0PIC) which offer low interest rate funding and insurance cover for their O&G operations in many lesser developing and poor countries. Both MIGA and OPIC offer political risk insurance up to $ 200 million. This will cover the foreign operations of O&G companies in Jupitus against expropriation, inconvertibility and political violence for investment and returns in Jupitus with necessary insurance policies. These insurance policies will cover various guises of investments like loan guarantees, in-kind contributions and capital. Further, MIGA offers extra insurance cover against the decline in profits of an O&G company due to changes in the contract that may be inflicted unilaterally by the host government. It is to be noted that OPIC charges higher premium for O&G functions against political risks as compared to inconvertibility, expropriations or interference with operations. Hence, political risk is not just a country specific but rather it is industry-specific within a nation and function specific within an industry19. Political risks can be minimised by the FOC operating in Jupitus if Jupitus provide them with a guarantee where Jupitus government agrees to carry out all its commitments toward FOCs as per key clauses of concession agreement or PSA20. Further, FOC operating in Jupitus can take insurance against political risk from MIGA or from OPIC or political insurance risk insurance policy offered by AIG, Lloyds, etc21. 4. Answer to Question 3 4.1 Legal System for Addressing Investment Disputes It is to be noted that Jupitus does not have established legal or banking systems. Consequently, there are very few commercial or environmental laws in Jupitus. Due to globalisation, the global investment economy is on the rise as the foreign direct investment (FDI) is being considered as the most vital instrument in augmenting economic development. Since there is the dramatic upsurge in the international investment and sudden surge in the both multilateral and bilateral investment treaties thereby protecting foreign investment have encouraged salient dispute resolution mechanisms. To instil confidence in the international investors in its O&G industry, Jupitus should either enter a bilateral investment protection treaty with the government of O&G companies. Thus, foreign investors in O&G industry in Jupitus can now bank upon investment protection treaties signed between their home governments and with the Jupitus government for the purpose of raising their claims before international arbitration tribunals22. The Convention on the Settlement of Investment Disputes (ICSID) is the only institutional system of the international arbitration system that exclusively tailored for addressing investment disputes. The ICSID arbitration offers binding effect of arbitral awards. It is strongly recommended that Jupitus should join ICSID as it helps to restore confidence on the FOC to start their operations in Jupitus as it will give some confidence that their investment will be protected by resorting to the international arbitration. Investment treaties signed at a multilateral level also offer for the safeguard international investment as in the NAFTA (North American Free Trade Agreement) which regulates the foreign investment between USA, Canada and Mexico. Further, there is ECT (Energy Chapter Treaty) which helps to serve to safeguard the investment made in the energy sector mainly through the arbitration process. Jupitus may enter into multilateral convention or BIT (Bilateral Investment Treaty) or ECT as it gives much confidence to foreign investors in its O&G industry as it facilitates the resolution of investment disputes through the arbitration process. It is to be noted that English law has been widely acknowledged as the law of choice, particularly for oil and gas contracts, and it was revealed by a survey that 40% claimants preferred English law as the governing law whereas 17% claimants preferred the New York law as governing law for resolution of investment disputes through international arbitration. Further, a study conducted by International Chamber of Commerce (ICC) found that English law was the most frequent choice of governing law in ICC arbitrations. Hence, foreign investors may resort to ICC also for redressal of their investment disputes through ICC arbitration23. It is advised that Jupitus should enact statutory laws at the domestic level to safeguard and protection of foreign investments. Such laws would serve to promise and protect the privileges of foreign investors as such laws include general consent provisions that offer for redressal of investment disputes raised by the foreign investors through the arbitration process mainly through ICSID Convention. It is to be noted that any commitments entered into by Jupitus under public international law, which includes both FTA and BITs if ratified by Jupitus will form the part of domestic law of Jupitus24. 5. Conclusion This essay has in brief explained the nature of the oil and gas industry in the background of providing a comprehensive advice to Jupitus government in its intention to award E&P contract to American Petroleum or Nobel Oil. To sum up, there are a variety of major issues that must take into account when awarding contract to American petroleum or Nobel Oil to determine which type of contract is most suitable, the ownership of the produced oil, the level of control and participation in the E& P activities and who has to bear the perils namely the peril of barren or unproductive wells, possible impediments in terms of developments plans and the decline in oil product’s price and to cover such losses. The essay has also covered how to combat against political and commercial risks by taking appropriate preventive measures and also discussed about the redressal of future investment disputes through ICSID or ICC arbitration process, mainly to instil confidence to foreign investors who can bring both FDI and technology to Jupitus which will help for the economic development of Jupitus in the long run. 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