Damage evaluation in upstream oil contracts using optimal control theory

• Author: Mohammad N. Zangeneh,Ali T. Fard,Fazel M. Farimani
• DOI: http://doi.org/10.1111/opec.12045
• Published date: 01 September 2015
• Date: 01 September 2015

Damage evaluation in upstream oil

contracts using optimal control theory

Mohammad N. Zangeneh,* Fazel M. Farimani** and Ali T. Fard***

*PhD Student, Centre for Energy, Petroleum and Mineral Law and Policy (CEPMLP), Dundee, UK.

Email: mnamdarzangeneh@dundee.ac.uk

**PhD Student, Centre for Energy, Petroleum and Mineral Law and Policy (CEPMLP), Dundee, UK.

Email: fmoridifarimani@dundee.ac.uk

***Faculty Member, Faculty of Islamic Studies and Economics, Imam Sadiq University (ISU), Tehran,Iran.

Email: taherifard@isu.ac.ir

Abstract

The focus of international investment arbitration is mainly to protect the investor. A critically

ignored situation in legal analysis is where under an international upstream petroleum contract, the

international oil company (IOC) has breached its obligation to efficiently developan oil field in the

hosting country (HC). Although in the economic literature, a few studies havebeen conducted to do

damage evaluation;their methods do not consider the dynamic nature of the oil field development. In

this paper, it is assumed that a claim has been filed bythe HC against the IOC in an arbitration tribu-

nal to claim the damages caused to an oil field. In order to evaluate the damages, an innovative eco-

nomic model based on a dynamic optimisation method is being initiated. It could be helpful for the

tribunals to grasp an idea as to how the issue of evaluation of the damages will look like whenthey

encounter the claims made by the HC in upstream oil contracts.

1. Introduction

In the oil industry,no matter where the geographical location of the investment is, the main

concern of the international oil company (IOC) is in maximising the profit in the shortest

period of time and securing the stockholders’ interests, rather than the cumulative produc-

tion of the oil field. The hosting country (HC) generally aims to maximise the cumulative

production during the lifetime of the oil field and considers the field as an intergenerational

asset (Ghandi and Cynthian Lin, 2012). In fact, the objective of HCs is to maximise the

level of production at the lowest possible costs, at the optimal possible pace of develop-

ment that is consistent with good conservation practices for achieving the highest possible

value (van Meurs, 2008). Nevertheless, there is a long debate about the desirable produc-

tion path for HCs, as they also need petrodollars for their political and social ambitions

(Adelman, 1993). This paper will discuss howboth the political and social concerns of the

HCs could be modelled in a coherent framework.

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In technical terms, the discount rate of IOCs tends to be higher than that of HCs. This

feature leads to a conflict of interests, as the IOC tries to extract more in a shorter time

span, compared with what the HC desires. In most cases, this extra extraction damages the

oil field. For example, it decreases the reservoir pressure dramatically and subsequently

has a negative effect on the ultimate recovery factor.

The energy industry is one of the most dispute-prone industries in the world economy

and in particular, oil and gas contracts generate a high volume of disputes (Rajarao, 2012).

On the other hand, the most striking feature of international investment law remains the

direct access to international arbitration of investment disputes based on treaties, legisla-

tion or contracts (Gazzini, 2009). Nonetheless, a primary aim of investor-state arbitration

is to protect foreign investors from expropriatory, discriminatory or abusive treatment at

the hands of the government (van Harten, 2011). Forthis reason, most of the existing aca-

demic literature written by prominent lawyers deal with compensation foreign investors

may claim against the HC (i.e. it is the investor whois the claimant and the HC that is the

respondent) (Wälde, 2007). Hence, the academic writings provide us with a comprehen-

sive analysis of the main legal questions related to compensation that foreign investors

may claim against the HC. However, they seem to be lacking in terms of the issue of com-

pensation that the HC may claim against the investor for its wrongful actions or defaults.

Although rare, the HC could reasonably file a claim against the investor. HCs, because of

their technological deficiencies, cannot usually control the performance of the IOC during

its operation. Once the contract is terminated or the IOC leaves the project, the HC can

assess the IOC’s performance accurately.This could lead to a dispute—the HC claiming

against the IOC for damages.

The subject of the study in this paper is concerned with the situation where the HC for-

wards a claim to the tribunal against the investorfor the damages caused to the oil field by

the latter under a production sharing contract (PSC). It has to be admitted, however, that

this situation is surrounded by a lot of ambiguity with regards to the methods of evaluation

of the legal remedies availableto the HC. It is noteworthy though, that the evaluation of the

damages caused by the investoris only relevant where the claim made by the state has been

successful and the breach by the IOC has been recognised bythe tribunal. Considering the

fact that the subject of evaluation of damages in non-renewableresource-based upstream

contracts has been largely ignored so far, the introduction of some evaluationmethods in

this context could help the tribunal or evaluationexperts of HCs to calculate the amount of

damages caused to the oil field.

Besides, the extraction of non-renewableresources (such as oil and gas) has a dynamic

nature, in the sense that the decision-making process is a continuous one. More impor-

tantly,the decision in time t1affects the status of the parties in time t2to tn(Weber, 2011).

As an example, choosing the level of production in the third year of the production phase

or determining the number of producing wells in the early stages of the production, affect

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