ALLOCATION OF RISKS AND LIABILITIES IN UPSTREAM OIL & GAS PROJECTS

• Jurisdiction: Derecho Internacional

International Mining and Oil & Gas Law, Development and Investment
(Apr 2009)
CHAPTER 15A
ALLOCATION OF RISKS AND LIABILITIES IN UPSTREAM OIL & GAS PROJECTS
Andrew J.W. Haynes
Deputy General Counsel (Group)
BG Group plc
Sao Paulo

Andrew J.W. Haynes joined BG Group in January 2004 as BG's Mergers & Acquisitions lawyer. He has since served BG Group as the Regional Legal Manager for the Asia & Middle East Region and the Chief Counsel for BG South America. Prior to joining BG Group, Andrew practiced law with the law firm of Herbert Smith in London, working on a variety of mergers & acquisitions, corporate and commercial transactions. He began his professional career in Alberta, Canada in 1996 with the law firm of McLennan Ross. Andrew is a Solicitor and member of the Law Society of England & Wales, and also a Barrister & Solicitor and member of the Law Society of Alberta (Canada). He holds a Bachelor of Arts Degree from the University of Ottawa, and a Bachelor of Laws from the University of Alberta. Andrew is married to Ana Silvia, and they are now expecting their first child. They make their home in São Paulo. Having grown up near the Canadian Rockies, Andrew enjoys skiing and hiking. Andrew is fluent in Portuguese and French.

The international oil & gas industry is an industry which every day needs to face many risks from deep within the earth to commodity trading floors in financial centers to refineries across the globe. The industry has developed at different stages in a variety of jurisdictions around the world as new oil & gas provinces have emerged, and over time different contractual, statutory and insurance approaches to allocating risk have developed, each of which gives rise to its own peculiarities and incentive structures. This paper seeks to step-back from the day to day detailed issues upstream oil & gas lawyers face and the detailed analysis of individual industry contracts such as the Production Sharing Agreement (PSA) or Joint Operating Agreement (JOA), and to seek to reflect, from the point of view of an upstream exploration and production company, on the overall framework for allocating risk in upstream oil & gas ventures utilizing a variety of common instruments.

1. Risks & Liabilities in Upstream Oil & Gas Projects

Exploration Risk

The most fundamental and intractable risk in the oil & gas industry is exploration risk. Contrary to the understanding of the man in the street and many populist politicians around the world, the vast majority of exploration efforts (principally seismic and drilling) do not lead to commercial discoveries and are a dead loss to oil & gas companies. Upstream exploration & production companies will generally have to commit to substantial minimum work obligations of seismic surveys and wells to be drilled at the start of a concession or PSA term. With seismic and wells in offshore operations now costing up to several hundred million dollars each, exploration risks and the allocation of such risks (and associated rewards) can far outweigh any risks of liability which may arise in connection with any subsequent development.

Commodity Price Risks

Another risk that is common to most extractive industries is the fact that the product produced, in this case oil & gas, is a commodity which is traded daily and can see great variations in price in relatively short periods of time. The complex nature and segregated markets for many hydrocarbon products can lead to even further price variation for specific oils produced (depending on, amongst other things, export restrictions and available refining capacity) and gas produced in various regions (where price will be heavily dependent on the availability of transportation infrastructure and export routes). Given the significant time lags between exploration efforts, through development to arrive at substantial production, large investments are made based on assumptions about commodity prices far in the future which may or may not hold true. Applicable legislation can amplify this risk where it imposes domestic market obligations, export restrictions or price caps which further limit the marketability of the hydrocarbons produced.

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Development Risks

Even where there are successful exploration efforts and a material hydrocarbons reservoir has been discovered, then very significant development risks still need to be overcome. Often, the reservoir will be complicated to develop, due to great depths, high pressures, high temperatures, sand production or salt layers; the technology to develop the reservoir may or may not exist and may need to be developed. If adequate technology is available, then there is the risk that the costs to develop and produce from the reservoir may be high, with the expected production at the assumed prices not adequate to provide an acceptable return on the investment (i.e. that the development will not be "commercial"). Assuming available technology and a development that is prima facie a commercial, there may or may not be available access to adequate transportation infrastructure to allow for offtake and sale of the oil & gas produced. The required development and environmental permits may or may not be available for the development to proceed. Partners in the upstream concession or PSA may or may not all be willing to proceed with the development based on different views they hold, competing priorities or lack of capital. If development planning commences, inflation in supplier and materials costs may render the development uncommercial before development work begins. Overlaying all this is reservoir risk, as reservoir performance and the oil & gas to be produced will usually only be known once there has been substantial drilling and production.

Change in Law

Exploration and production businesses are dependent upon access to upstream oil & gas reserves under upstream licenses, PSAs and service agreements. Decisions to explore, invest and develop are based on the assumption that these upstream legislative and contractual regimes will remain largely unchanged, but in the real world this is often not the case. Even where upstream concession and PSA terms are respected, there may often be material changes in taxes and customs duties which heavily impact the economics of an upstream project. Moreover, legislation which may limit export of hydrocarbons (through domestic market obligations or otherwise) or impose price caps can also very materially impact the economics of a project and actual returns on investment. There is also the risk of changes in laws related to foreign exchange and remittances of profits, as limits on conversion of currency and remittances of profits may severely limit the ability of an upstream investor to actually realize the profits on its upstream investments. These risks have materialized all too frequently in the past and are likely to continue to be a risk for the oil & gas industry to face for years to come.

Accidents

The oil & gas industry operates with tremendous risks each and every day. From exploration drilling at high pressures which can cause well blow-outs, to explosions arising from flammable hydrocarbons, to oil spills from tankers, to lifting equipment weighing many tons in rough seas, there are material operational and environmental risks to be managed in all oil and gas exploration, development & production efforts. Operational risks may give rise to terrible injuries or fatalities of personnel and damage to very valuable equipment. Spills of hydrocarbons or well blow-outs may give rise to very serious environmental damage. With these operational and environmental risks come attendant risks of legal liability.

Decommissioning (Abandonment)

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At the end of a field's life, there will be the need to plug wells, remove facilities and abandon pipelines to ensure safety for the future and that some degree of environmental remediation is undertaken. The costs of these decommissioning activities will often be substantial, and they arise at the end of a field life when there will be limited production to pay for such costs. Risks as to the amount of these future costs and the solvency of partners are risks that may be difficult to assess at an early stage of a development.

Credit risks

Credit risks exist in every industry, but the large capital sums, heavy reliance on partners to share risk, large number of suppliers and contractors, significant risk of operational incidents, exposure to change of law risks and long term payback on investments all give rise to greater credit risks than seen in many other industries. Credit risks will be borne in relation to upstream partners, host countries and national energy companies, downstream customers and suppliers of equipment. As the industry is also heavily reliant on guarantees, letters of credit and insurance there are also significant potential credit risks with counterparty banks and insurers.

2. Legal Instruments for Allocating Risks & Liabilities

Legislation

Given the many parties involved in the oil & gas industry, the fundamental nature of energy to the functioning of any modern state and the large role that governments play in the ownership and distribution of hydrocarbon resources, a great deal of the risk allocation in oil & gas exploration and production activities is addressed through legislation in the relevant jurisdictions.

Legislation impacting oil & gas projects will typically be founded upon legislation establishing upstream licensing or contract regimes, providing a basic framework for exploration, development and production of oil & gas in the jurisdiction.

Given the importance of reliable domestic energy supplies to maintain a properly functioning economy and public order, many nations will also enact legislation seeking to ensure adequate domestic energy supplies. The success of such legislation in ensuring an adequate physical supply of...