Stabilization clauses in international petroleum transactions.

• Author: Coale, Margarita T.B.

1. INTRODUCTION

   During this century, petroleum (1) has been one of the most important commodities in the modern world, referred to as "critical to national strategies and crucial to international politics." (2) As the modern petroleum industry emerged in developing countries, where ownership of petroleum almost universally belongs to the state, (3) international oil companies with the necessary capital and expertise controlled petroleum exploration and exploitation. (4) Even though almost all petroleum producing countries today have state-owned oil companies, this situation has not changed substantially. (5) This reality demands that the international oil company and the state reach some agreement about the development of those resources. (6)

   Exploration and exploitation of petroleum resources places the international oil company in a uniquely complex business arrangement with a foreign country. This arrangement links the government, who owns the resources, with the companies, who have the technology, capital and equipment necessary for development, in a sector where the stakes, risks and possible profit margins all can be very high. (7) The questions of how to contribute to this "partnership" and how to allocate the profits are fundamental issues in the arrangement among the foreign country and the international oil company. (8)

   Since these petroleum agreements require a large initial outlay of capital, and long-term investment in projects including exploration, appraisal and development (9) that must be recouped from earnings, these investments expose the international oil company to substantial risk for an extended period. (10) Simultaneously, because petroleum prices are unpredictable, an apparently profitable agreement for the country can look undesirable after it is entered, especially if the international oil company's work proves highly productive. (11) These factors combine to encourage the foreign government to seek adjustments to long-term agreements in response to both political pressure and changed circumstances. (12) On the other hand, the international oil company tries to avoid the renegotiation of the agreement, the effect of subsequent changes to the country's law, or even outright nationalization of the company's assets. (13)

   Over time, companies have tried to deal with the risks involved in petroleum transactions either by: spreading risk; insuring against risk; defending against the risk; structuring and managing risk; or creating contractual mechanisms for risk management. (14) When a company tries to "spread the risk" it usually tries to form joint ventures to create a united and stronger front against an interventionist host country. (15) A company can also try to "insure against the risk" by buying an insurance policy to protect the company from contractual changes in the agreed upon financial regime, including foreign exchange guarantees. (16) "Defending against the risk" is a strategy that requires the foreign company to try to use economic, financial, and political persuasion and leverage to discourage governments from abrogating investment agreements. (17) Companies have also tried to "structure and manage" through actions that include association with the host state, low visibility in the project, and flexibility in investment to be able to adapt to changing pressures and expectations. (18) Finally, the oil company can try to reduce risk by contract through clauses that provide for international arbitration, choice of law, and offshore accounts, as well as with stabilization clauses. (19)

   Out of this broad field of risk management devices, (20) this article focuses on the use of stabilization clauses to protect the international oil company. Part II defines and describes the types of stabilization clauses. It also reviews the risks stabilization clauses are intended to reduce, including financial and non-financial concerns. Part III reviews the criteria used to apply and interpret stabilization clauses, both under municipal law and principles of international law, and Part IV surveys how those criteria have been applied to stabilization clauses in eight arbitrations. Part V concludes with some general observations about the treatment of stabilization clauses in those arbitrations.

2. STABILIZATION CLAUSES DEFINED

   An international oil company may try to minimize risk through contract provisions. (21) Many risks are difficult or impossible to control by contract, such as commercial (price volatility), financial (interest rate volatility), geological (no deposit found), technical (failure of the installations to perform as planned), managerial (labor problems) and natural disasters. (22) Stabilization clauses address one specific type of risk that a contract can affect: political risk. (23) This part will describe that risk and then review the types of stabilization clauses available.

   1. Risks

      A central question about the security of a petroleum transaction is the nature and degree of risk to which the investment is exposed. (24) Long-term resource and energy projects such as oil and gas exploration and mining have a serious need for stability that goes beyond short-term projects. (25) Key financial requirements of these investors include rapid investment recovery through accelerated depreciation and amortization, long loss carry-forward periods, reasonable royalty rates responsive to mineral prices and a flexible system of income or cash-flow based taxation triggered only after investment recovery. (26)

      To avoid financial uncertainty about these requirements, companies frequently ask for assurances of stability of the status quo. (27) Sometimes these promises are made as administrative orders or regulations, however they are more frequently made through legislation or in specific contract provisions. (28)

      Other non-financial concerns are also important to foreign companies. (29) The greatest worry, of course, is that the foreign country would expropriate or nationalize the company's operation. (30) This can occur directly, through legislation, or indirectly, through interference with the investors' freedom to control the enterprise and make a profit. (31)

      Similarly, companies want protection from changes in labor law that could result in increased employment costs, government intervention in production decisions, (32) unexpected increases in energy and infrastructure usage costs, (33) changes to accounting rules which would result in increased taxes, unexpected obligations to provide infrastructure, or mandated local service and supply contracts. (34) Currently, the issue of most concern in this area is the imposition of new environmental obligations by subsequent regulation, or by administrative or judicial rulings interpreting existing law. (35)

   2. Types of Stabilization Clauses

      A concession agreement differs from a standard contract in that one of the parties is a sovereign state. (36) A state has sovereign power over property and can change its laws. To reduce the tension between these powers and the imposition of a contractual limitation on them, an oil company can ask the country for specific assurances that can be enforced under international law. (37)

      Stabilization clauses "specifically seek to secure the agreement against future government action or changes in law," either legislative or regulatory. (38) More specifically, a stabilization clause is a specific commitment by the foreign country not to alter the terms of the agreement, by legislation or any other means, without the consent of the other contracting party. (39)

      Stabilization clauses can be divided into a number of categories. (40) By agreeing to a stabilization clause, the foreign government purports to alienate its right to unilaterally change the rights promised to and relied upon by the foreign oil company. (41) A clause that provides the government may not unilaterally modify or terminate the contract has been called an "intangibility clause." (42) Another variety, usually called a "stabilization clause stricto sensu," states that the governing law of the contract shall be that of the contracting state at the time the contract was executed, thereby preventing the application of subsequent changes in the contracting state's law. (43) Another type of stabilization clause provides that the agreement shall be performed consistently with "good will" or in "good faith," thus precluding unilateral modification or termination. (44) For example, since international law does not prohibit expropriation but does require some type of compensation, a stabilization clause can help give the company some type of protection in the event of appropriation. (45) These clauses may appear in either a broad form or a narrow form that stabilizes only limited aspects of the contract, such as the applicable tax regime. (46)

3. APPLICATION AND INTERPRETATION OF STABILIZATION CLAUSES

   When a dispute arises between a foreign oil company and its host state over a concession agreement, the choice of law governing the dispute, especially as it relates to the validity of a stabilization clause, is very important. Because the interpretation of a stabilization clause in an international agreement can involve strands of arguments from international public law, national law, and possibly an international lex mercatoria, the resulting issues are arguably some of the most complex in international business law. (47)

   Traditionally, most disputes related to concession agreements were thought to be controlled by the domestic law of the nation granting the concession. (48) More recently, a theory has developed in which the contract is considered to be "internationalized" because it contains a stabilization clause, and is thus not subject to the law of the host nation. (49) The question of whether municipal law governs the contract or whether the contract has been internationalized has caused much dispute between developed and developing...