CHAPTER 23 BUSINESS & OPERATIONAL RISKS, REMEDIES AND DEFENSIVE TACTICS FOR CONSORTIUM PARTICIPANTS FACED WITH PRE-DISCOVERY DEFAULT

• Jurisdiction: Derecho Internacional

International Mining and Oil & Gas Law, Development, and Investment
(Apr 2015)
CHAPTER 23
BUSINESS & OPERATIONAL RISKS, REMEDIES AND DEFENSIVE TACTICS FOR CONSORTIUM PARTICIPANTS FACED WITH PRE-DISCOVERY DEFAULT
Robert Attai ¹
Partner
Husch Blackwell LLP
Denver

[Page 23-1]

ROBERT P. ATTAI is a partner with Husch Blackwell LLP in Denver, Colorado. Robert's practice is global in nature and focuses on domestic and international joint ventures of corporate and partnership entities, public and private equity financings, and M&A transactions. Robert is a seasoned deal lawyer who has managed joint ventures and complex commercial relationships in more than 40 countries. With a unique breadth of experience spanning strategic, financial, and operational levels, he has counseled clients through transactions valued in excess of $5 billion. Robert negotiates transactions and has advised companies on the conduct of their exploration activities in Central and South America, Eastern Europe, Africa, Asia, and the Middle East. He has supported client projects in over 40 countries.

Presented at 13th Special Institute on International Mining and Oil & Gas, Law, Development and Investment

Cartagena, Colombia

April 2015

Abstract

[Page 23-2]

The term "Frontier Play" refers to exploration plays involving a license or concession in an area not previously known to have significant accumulations of hydrocarbons, or in an area having known accumulations without existing infrastructure to readily extract and market hydrocarbons from a discovery. Frontier Play projects are capital intensive and carry a significant amount of inherent risk, which industry participants seek to mitigate by entering into joint venture relationships or consortiums. Most negotiations to organize a joint venture in international upstream oil and gas exploration projects rely on template agreements that are standard in the industry such as the AIPN Model International Joint Operating Agreement (or "JOA"). These template agreements, however "standard" they may be, provide contractual remedies that sometimes run contrary to reasonable expectations of the parties, and can leave non-defaulting parties no effective remedy as a practical matter.² As a result, consortium parties in good standing are sometimes forced to negotiate creative terms of a Defaulting Party's exit from the venture, despite contractual remedies or expectations to the contrary.

Consortium members³ can and should mitigate the risk of a Default by another party to the JOA by doing more than relying only on the contractual remedies set forth in the JOA. Having worked successful and unsuccessful joint venture projects on and offshore in various jurisdictions across the globe, the author discusses contractual remedies for Default set forth in Article 8 of the 2012 AIPN Model Joint Operating Agreement ("JOA")⁴ and practical approaches to mitigate the risk or effect of a pre-discovery Default by a member of the joint venture consortium.

I. Introduction

We focus our discussion on challenges present during the exploration phase of upstream petroleum projects, and those in Frontier Plays in particular. In these early-stage exploration projects the risk of default is high. At this stage the consortium has no project-based revenue and usually has no expectation of production or revenue for a number of years. The venture initially burns through cash to fund license acquisition costs and the Minimum Work Obligations set forth in the license.⁵ The Operator may also negotiate contracts with service providers who may require payments that must be funded in advance from the Joint Account or that will be the

[Page 23-3]

subject of future cash calls (sometimes called "AFEs") such as in the case of progress payment obligations.

The failure by any Party to make timely cash payments or to post credit support during the early stages of an exploration program defeats a primary purpose of the consortium, which is to distribute risk, ultimately has the potential to kill the consortium project and may even disrupt other exploration projects in the region.⁶

In Frontier Play joint ventures, especially in the pre-discovery phase when the consortium is often comprised of junior to mid-sized market participants, Default by even a small interest holder in a consortium may subject the non-defaulting members to liability to the sovereign, third party sources of financial support and third party service and equipment providers. Damage to reputations following a series of failures to pay third parties may limit access to future opportunities in the region.

II. Overview of the JOA Relationship

Hydrocarbons and the right to exploit them remain the property of the sovereign in almost all jurisdictions outside of the United States.⁷ Exploration companies must bid for, negotiate and secure a license from the sovereign government controlling the exploration area. A typical license or concession allows the recipient to survey, explore and exploit the area within a prescribed geographic boundary for a limited period of time.⁸

Upstream exploration projects are the source of what many agree to be a high degree of risk and commensurately high level of complexity. The right to explore, appraise and produce hydrocarbons from a Frontier Play is rarely exercised by a single entity. Companies often form a consortium via participation agreements and JOAs for a number of reasons, including a desire to reduce risk⁹ and to combine individual strengths (be they financial, technical or other) to qualify for a license award and to pursue the Minimum Work Obligations.

Jointly Qualifying

The consortium is sometimes formed to apply for a license when any one member could not qualify under the minimum criteria. For example, the Israel Ministry of Energy and Water Resources requires prospective licensees to present a team to manage exploration activities that consists of an exploration manager with a minimum tenure working exploration projects of a minimum size plus geology, geophysics and engineering team members with stated minimum

[Page 23-4]

years of experience specific to each area of expertise.¹⁰ Applicants in Israel must also demonstrate that they have certain minimum amounts of cash to fund estimated costs of the exploration work program and a percentage of the estimated drilling costs included in that program.¹¹ Other countries have similar requirements and some allow applicants to satisfy minimum application criteria by aggregating the skills and resources of consortium members.

Sharing of Fees and Expenses

Even before proceeding with the Minimum Work Obligations required under a license the parties face immediate and oftentimes significant expenses.

First, there is the fee to apply for the license, which is on top of the cost and expense of the applicant's legal and technical due diligence to determine whether or not to apply. License fees vary depending on the jurisdiction, size of the area covered by the license and type of license. Fees can be significant and may repeat annually over the term of the license in the form of annual rental payments based on total km2 or surface acreage.

Second, many Frontier licenses Play require a variety of one-time or annual payments that can add considerably to the total commitment required by the license. Such obligations include:

• training fund contributions that require the licensee to provide and fund training and technical skills development opportunities for host government employees or private sector citizens in the host country,

• environmental defense reserve fund contributions, and

• secondment of national oil company employees to the joint venture for technical and management skills training.

Sharing of Performance Obligations

The JOA allows the parties to share technical and performance obligations associated with obtaining and maintaining the license. Most licenses require parties to satisfy Minimum Work Obligations and spending obligations during various time-periods in order to exploit and retain the license. Many licenses also have a minimum spending obligation that requires the parties to conduct a certain amount of work or spend at least a certain amount of money conducting exploration activities. Satisfaction of the Minimum Work Obligations and spending

[Page 23-5]

obligations for each phase of the license is a prerequisite to proceeding to the next phase. Failure to satisfy these obligations may require the payment of a "fee" to the local government or forfeiture of the license. Most often the minimum amount of work includes acquisition and processing of data and of course drilling wells.

III. Typical Parties to the JOA in Frontier Plays

Frontier exploration projects typically are pursued by small to mid-sized companies that are formed for the purpose of, or otherwise specialize in, Frontier Plays. While it is common for these companies to have a theme or area of focus in their portfolio (such as "offshore West Africa" or "onshore South America") many players cast their nets far and wide. Even though they often develop what appears to be a diversified portfolio of projects in multiple blocks or even multiple blocks in different countries, these entities, while ambitious and critical players in the global markets, sometimes do not have the resources to single-handedly explore and exploit hydrocarbons. Instead these smaller participants often hope to conduct desktop studies and conduct 2D and 3D surveys to collect favorable geological and geophysical data (or "G&G") indicative of an accumulation of hydrocarbons as a means to "derisk the play" thus enhancing the market value of the opportunity.¹²

Once "derisked" the larger regional, major and super-major players are solicited to farm into the play on economic and performance terms deemed to be attractive to all involved.¹³ A significant interest along with Operatorship usually is...