FORUM: Disputes in the energy & natural resources sector
November 2015 | SPECIAL REPORT: ENERGY & NATURAL RESOURCES
Financier Worldwide Magazine
FW moderates a discussion on disputes in the energy & natural resources sector between Jeffrey Sullivan at Allen & Overy LLP, Andy Moody at Eversheds, Ted Greeno at Quinn Emanuel Urquhart & Sullivan LLP and Andrew Hutcheon at Watson Farley & Williams LLP.
FW: Could you outline some of the common causes of disputes seen in the energy & natural resources sector over the past 12 months?
Moody: We have seen a number of warranty and indemnity type claims arising from disposals of businesses, particularly downstream businesses, and also claims seeking to recover historic losses which previously might not have reached litigation or arbitration. We believe these are partially arising as a result of the broader financial pressure oil & gas companies are under due to the fall in the oil price. We have also seen a number of claims resulting from the wider turmoil in the Middle East, broadly around difficulties in relation to payment, and also claims arising from state interference in oil and gas infrastructure assets. A further area of growth is claims in the renewables sectors. We have handled a number of disputes related to solar projects in particular.
Hutcheon: Common causes of disputes include the cancellation of exploration and production (E&P) projects, leading to contract renegotiation or termination. These situations can lead to disputes over contract formation or enforceability issues as well as termination rights. It is well known that long term supply agreements for natural resources commonly retain flexibility to enable the renegotiation of important matters, such as prices or delivery schedules. However, parties to contracts which are no longer competitive due to current market conditions are now making use of these provisions, leading to disputes. By way of example, gas purchasers have commenced price reviews under long term gas agreements which contain flexible pricing mechanisms based on the price of oil. Financial default – for example, in borrowing bases on upstream financings – insolvency and illiquidity in 2014 and 2015 have been frequent dispute catalysts. The collapse of the OW Bunker group has caused multiple disputes between buyers and sellers of marine fuel oil. Fraud often surfaces in adverse market conditions. For example, the Qingdao warehouse fraud, which has given rise to multiple disputes between metal traders, warehouse managers and financing banks. The Petrobras ‘Operation Car Wash’ bribery scandal is another example.
Greeno: The past 12 months has seen the normal range of disputes in the energy and natural resources sector, although perhaps there have been more smaller disputes of a type that would have been quickly resolved in better times. These include the usual diet of disputes relating to pricing under long term contracts, cost overruns, force majeure and under-delivery, pre-emption rights, work obligations under farm-in agreements and construction delay and disruption claims.
Sullivan: In the international arbitration context, there has been a wide range of causes of disputes in the energy and natural resources sector, though there have been some notable trends. These include an increase in the number of disputes against states or state-owned entities, particularly in emerging markets, with foreign investors commencing proceedings to enforce investment treaty protections. One notable trend is the large number of investment treaty disputes arising out of retroactive regulatory changes and the regulatory environment. For example, there has been a significant rise in renewable energy disputes brought under the Energy Charter Treaty against EU countries that have retroactively changed the regulatory regime for renewable energy. Since January of this year, 12 ECT cases have been registered against Spain, three cases against Italy and one against Bulgaria, all relating to legal reforms affecting renewable investments. There also continues to be a high volume of gas pricing disputes – such contracts typically contain periodic price review clauses, a process which has frequently proved contentious. It remains to be seen how falling oil prices will impact these disputes.
FW: How would you characterise the impact of plummeting oil & commodities prices on the natural resources sector? Is this the source of the majority of disputes in recent months?
Sullivan: Tumbling oil and commodities prices have, unsurprisingly, been a significant factor in the types of disputes we have seen over the past 12 months. For example, the downturn has prompted disputes relating to the cancellation of off-take agreements, contractor and sub-contractor agreements, project cost overruns and impairment write downs, to name a few. The falling oil and commodity prices have also triggered insolvency and restructuring issues. Yet it is difficult to characterise the downturn as the primary source of recent disputes, since disputes over the past year are owing to a wide range of circumstances. Also, a re-evaluation of commercial relationships will not necessarily mean recourse to dispute resolution; it may instead result in some market players harnessing market opportunities that are presented by the changing economic environment.
Moody: We do not believe the fall in prices is the source of the majority of disputes yet, but it is undoubtedly having an impact on appetites to fight, and the general approach to disputes among oil companies. Costs are particularly important at the moment. There are normally trickle down and delay factors in relation to changing economic conditions so we anticipate that the fall in the oil price will lead to disputes in 12 to 18 months time. If the price continues to decrease or remains at its current level, we may see an increased appetite to fight in the energy sector in order to maximise returns. We also think that there are many companies which are hedged at the moment, and we will start to see who is really in trouble once those protections run out and are no longer there.
Hutcheon: Plummeting prices following on from the highs of previous years, while punishing to some market participants, may be seen as cyclical or corrective over the longer term. The full impact will only be known once prices find their level after the present volatility. In the short term companies with high production costs or those that have over expanded capacity, carrying large amounts of debt, will struggle. Of course, the fall in price is itself caused by economic drivers such as weak global demand, OPEC policies, oversupply and lack of appetite for investment and in many cases one can link the cause of disputes to lack of proper precautions and risk management during the boom times. There are also other pressures on the market such as global instability, regulatory and environmental pressures which contribute to disputes in this sector.
Greeno: Plummeting oil and commodities prices have naturally impacted the natural resources sector. While the common causes of disputes are typical of the sector, the major difference in a downturn is that there is a magnified focus on saving costs. In particular, parties are prepared to spend time and money on disputes which they would regard as better spent on new projects when prices are high. In addition, in the UK, the aging infrastructure in the North Sea means that there is an increased focus on cost/benefit analysis with regard to project viability. Accordingly, where prices are falling, operations are decreasing or ceasing, resulting in an increased number of contractual disputes regarding facility use and cost allocation.
FW: Are there any lessons we can learn from previous energy & natural resources sector downturns, and the level of disputes that resulted?
Hutcheon: The general lessons about dispute management should always be observed. However, we need to be cautious about comparing the present downturn too closely to previous downturns in terms of sector specific lessons. Although the financial crisis in 2008 led to a fall in commodity prices, they recovered relatively quickly and some of the players, such as trading houses and investment funds, had money and were looking to invest. In earlier downturns the energy market in particular was less diversified with fewer parties involved. In the present market, there is a great diversity of producers, stakeholders and offtakers who will all opt for different solutions. Perhaps some experiences post 2008 in relation to restrictions on transferring assets and assigning contracts – some of which may have been subject to significant and valuable disputes – may be useful during the inevitable post-downturn selloffs and consolidations.
Greeno: During the last big downturn in 1998, crude oil prices fell to less than $10 per barrel. This resulted in companies looking at the commerciality of their contracts and the ways in which they could terminate them, with or without cause. Terminations for cause resulted in allegations and cross-allegations of repudiatory breach. Upon such a breach, the innocent party can, of course, accept the breach as terminating the contract, or affirm it and require performance. When profits are flowing, parties usually want the work performed and so are prepared to affirm the contract and find a way through the problems. But in a downturn, parties are more likely to take the opportunity to terminate, and disputes inevitably ensue. In these circumstances, it is important for the party terminating to avoid being portrayed as using the breach as a pretext for getting out of a contract that has become too onerous. Careful preparation and fact gathering prior to termination is therefore essential.
Sullivan: The link between economic downturns and the level of disputes is not necessarily clear cut. Besides, whether a party decides to initiate arbitration or litigation is highly dependent on the facts of that dispute and the particular nature of the relationship with the potential adverse party. It is therefore difficult to draw specific lessons-learnt from previous downturns; indeed, from an economic standpoint, a comparison of downturns will likely reveal very different causes and corresponding repercussions for both states, or state owned entities, and commercial parties. From a legal perspective, however, there are certain matters that should be considered. Contracts should be clearly drafted and well-negotiated –
including a clear dispute resolution mechanism – to account for the effects any downturn might have. For example, the contract should encompass appropriate contractual mechanisms permitting parties to renegotiate and settle differences when necessary. Firms should also endeavour to effectively manage against the risk of downturns, anticipating what harm a downturn might cause to its commercial relationships.
Moody: Compared to previous downturns, today the energy sector is even more global. There are even more agreements to arbitrate in place and the large energy companies are very sophisticated in how they structure their affairs to take advantage of bilateral and multilateral treaties, in addition to tax treaties. The result is that we will continue to see an upturn in the amount of international arbitrations filed at the leading arbitral centres in the busiest seats. I think a key difference this time is also the rise of the smaller player in the sector. The rise of the shale gas producers and other unconventional suppliers offers a very different dynamic into the market and it may be that these smaller companies will have more of an appetite to roll the dice on a dispute than the historic older, larger players have done.
FW: Across the supply chain, who is being hit the hardest as a result of the weakened state of the energy & natural resources sector? How should firms begin addressing the risks to their reputation and the potential for litigation?
Greeno: The whole of the energy and natural resources sector has been hit hard by falling prices. However, the greatest impact has been felt by the services supply sector. Reduced operations have led to high numbers of redundancies in both oil and gas services companies as attempts are made to make cost savings. Examples of this are Schlumberger, Baker Hughes and Halliburton. In terms of reputational risks in the context of disputes, companies should cultivate a reputation of being ethical and sensible. Notwithstanding this, they should be firm and should be prepared to stand their ground if needed. Companies seen to be a soft touch leave themselves susceptible to being pursued. That said, there are fewer companies with this reputation than in the last major downturn.
Sullivan: Perhaps the most apparent impact of the fall in commodity and oil prices has been at the production end. For commodity producers, the fall in prices has led to reviews in their supply chains, in turn causing contractors to reduce their prices to meet producers’ tighter margins. Likewise, in the oil sector, upstream producers have been hit particularly hard, again, having a knock on effect on arrangements with contractors, predominantly suppliers of drilling rigs and services. This has led to an increased number of early termination disputes between operators and suppliers. Addressing reputational and litigation risk will vary. Generally, such risks are most successfully mitigated by effective management and the maintenance of good communication between stakeholders, including governments, venture partners and contractors, to pre-empt areas of dispute. Where necessary, parties should employ the services of reputed advisers – auditors, lawyers, risk consultants – to anticipate potential problems and deal with them expediently.
Hutcheon: The fall in commodity prices has hit oil companies, which have reacted by cancelling E&P projects for 2015 and 2016 and in some cases for the longer term. These cancellations lead to termination or non-employment of contractor assets such as rigs, other support equipment and vessels for offshore projects. Generally, smaller producers with large levels of debt will be hit hardest. Low oil prices have caused borrowing bases on upstream financings to be reduced leading to repayment obligations on E&P companies. Some contractors involved in existing production facilities may also have rates which are impacted by the price of oil. Some host countries which have a large proportion of their GDP linked to oil & gas or other commodities and large amounts of debt will also feel the impact. Firms should address risks to their reputation and the potential for litigation by being prepared – reviewing important contracts to identify potential threats, ensuring compliance and adhering to contractual provisions. If a dispute does occur, use should be made of any staged dispute resolution clauses.
Moody: The smaller players in conventional exploration and development are, in our experience, the ones being hit the hardest. This is because they are under pressure as a result of the price falls but also because they tend to be the ones governments try to squeeze when they realise that the price falls are also having an impact on how much tax they may receive, so they try to renegotiate terms. Having said that, there is an argument that the super majors are being hit the worst as they are needing to scale back investments and projects where they may have already invested billions but the projects have no hope of being profitable at current price levels. The best thing energy companies can do is get a handle on their own risk and know where potential claims exist in order that early strategies can be put in place. It is also important not to cut investment in operational issues like health & safety where a mistake could costs billions.
FW: To what extent has there been a rise in the number of investor-state disputes following the downturn in the energy & natural resources sector? How transparent are proceedings conducted in this area?
Hutcheon: There are increased Energy Charter Treaty (ECT) disputes in some sectors resulting from changes to national subsidies to renewable energy companies. This includes disputes with Spain and Italy. The fall in oil & gas prices will cause a drop in the cost of conventional energy and there will be a tension between this cheap source of energy and other forms which have arisen due to policies to diversify energy sources. Building energy producing infrastructure such as power plants, offshore wind farms and solar parks is likely to qualify as an investment for these treaties, and changes to laws and regulations making these investments less attractive may therefore result in more investor-state claims. Although awards are often published – unlike commercial arbitration awards – it can still be difficult to know what is happening in the proceedings without any direct involvement and any settlements may also be confidential.
Sullivan: There has certainly been a recent increase in investor-state disputes in this sector, though not necessarily resulting from the sector-downturn. Many disputes instead relate to cancellations or alleged violations of contracts, the nationalisation of state resources, the denial and revocation of licences and retroactive regulatory changes. A significant number of recently registered investor-state disputes concern retroactive changes to regulatory regimes affecting renewables. Further, downturns do not necessarily result in a corresponding rise in investor-state disputes – where there exists an especially commercially significant contract, companies will often focus considerable efforts into resolving matters without recourse to arbitration. Transparency has been a contentious issue in this arena for some time. There have recently been a number of initiatives to address this, including the introduction of the UNCITRAL Rules on Transparency, which came into effect in April 2014, and the adoption of the Convention on Transparency in Treaty-based Investor-State Arbitration, which opened for signature in March. Together, this has introduced a more transparent system, whilst retaining safeguards for commercially sensitive information. Benefits for increased transparency are, of course, manifold, including increased legitimacy; recent developments are therefore encouraging.
Greeno: There has been a steady increase in the number of investor-state disputes in the past few years. Whilst economic cycles such as the downturn in the energy and natural resources sector may have played a part in this growth, increased awareness of, and reliance on, the investor-state process by market players is likely to be a more significant factor. The emphasis on transparency in investment treaty arbitration by institutions and users of arbitration over the past 10 years has made more information available on investor-state disputes. This has allowed more market players and law firms to incorporate this potential remedy into their investment and dispute resolution planning.
Moody: We do not believe that there has been a rise so far, but this may come in due course. In our experience, energy companies do not tend to want to pull the trigger on an investment treaty dispute unless it really is a game over scenario for their future business in the particular state. Whether such disputes are sufficiently transparent is a matter of great debate within the international arbitration community. The system is not perfect but compared to pure international commercial arbitration, it is reasonably transparent in that it is not difficult to learn of the existence of such claims, the procedural history, and the members of the tribunal.
FW: When a dispute arises, what advice would you give energy & natural resources companies in terms of evaluating potential litigation and alternative dispute resolution strategies?
Sullivan: It is difficult to generalise here, as any advice is dependent on the circumstances and legal positions of the parties. But the key point is always to think about the endgame. What is the company ultimately trying to achieve? The legal strategy should be aimed at achieving whatever that ultimate goal may be. Companies should always assess all available options, including whether mediation or negotiation are possible, and insofar as it is left open by any relevant contract, whether litigation or arbitration is preferable. It is the responsibility of the legal counsel to advise as to the options available, together with their relative advantages and disadvantages, including timing and costs, and to provide clients with an evaluation of the merits of a prospective dispute. This advice must always consider the company’s commercial goals. A company should work closely with its legal advisers to ascertain the best course of action and be clear of incumbent risks – energy disputes by their nature often involve a complex political dimension, and are usually high in complexity and cost.
Moody: An early case assessment analysis is pivotal in order to identify the key strengths, weaknesses and potential costs of litigation. It is also important to consider whether there is an ongoing commercial relationship and whether it would be worth referring the dispute for negotiation between more senior executives. It is also always worth thinking about whether mediation could be appropriate and could avoid the need for litigation.
Greeno: In the event of a dispute, it is essential that energy and natural resources companies instruct experienced litigators with real sector expertise as soon as the issue emerges. This will enable them to analyse the matter in detail, advise on how best to position the party in correspondence and to develop a strategy aimed at a satisfactory settlement, at an early stage if possible. That said, it is essential that a party who threatens to litigate is prepared to see it through if no settlement can be reached. If there is any doubt about that, settlement will be delayed. In terms of mediation, this may be a useful process in the later stages of a dispute. However, experience in the sector tends to suggest that mediation is often less successful than old-fashioned without prejudice meetings and correspondence, which allows the pace of negotiations to be managed in the most effective way.
Hutcheon: When disputes arise, in addition to the early legal and factual analysis as to liability and termination issues, steps should also be taken to analyse the value or potential range of values of the claim. If necessary, appropriate experts should be involved. This is particularly important in natural resources disputes and more so in times of volatility where, for example, future commodity prices – upon which many valuations are based – are speculative. If there is no staged dispute resolution process, mediation or other forms of alternative dispute resolution should be considered if appropriate to the client’s strategy. Attention should also be given to whether after the event (ATE) insurance – insurance against adverse costs consequences of unsuccessful disputes – or funding can be obtained for litigation or arbitration. The rules and the market for funding litigation and arbitration have changed significantly since the last downturn.
FW: Given the current energy & natural resources sector scenario, how do you see the sector’s economic cycle developing over the coming years? Is the sector changing irrevocably, and is this likely to lead to an increase in disputes?
Moody: The big issue is the oil price. There are a range of views but I believe we will be in a low price environment for some time. Saudi Arabia seems intent on keeping the spigots open, Iran will be coming on line and perhaps most importantly, we are on the cusp of technological change making previously cost prohibitive areas of supply like shale gas ever more affordable. These factors, plus a slowdown in China, are all disrupting the market and it seems that the sector will not revert to how it was for some time or possibly ever. All things being equal, disruption should lead to greater disputes and possibly also to more consolidation within the sector.
Greeno: The cycle of exploration to development to production is driven by oil prices, which are themselves largely driven by demand and supply. When prices fall due to oversupply, the cycle slows. As everyone knows, it is extremely difficult to predict movements in oil prices. Our view, however, is that oversupply will continue over the next few years and prices are likely to stay at current levels, or even fall further. If that happens, there will continue to be a growth in disputes as more assets become uneconomic.
Hutcheon: It’s uncertain but if I had to guess I would say that prices will recover to an extent – although it will be some time before we see oil regularly over $100 per barrel. However, the present weakness in global demand and oversupply will continue for some time. Eventually the interruption to new E&P projects will fuel another boom. International developments such as Chinese economic growth, OPEC cutting production and significant additional production becoming available or ceasing due to sanctions and global conflict are obviously important. The energy and natural resources sector is changing constantly. Some aspects may be irrevocable, others may not be. Continuing price volatility in natural resources will likely lead to an increase in disputes from time to time. Plus ça change, plus c’est la même chose.
Sullivan: It is difficult to predict how the economic cycle will develop over the coming years – indeed, most observers did not foresee the dramatic price falls that have occurred over recent times. Additionally, it is unwise to draw conclusions on the energy and natural resources sector as a whole, since economic trends will vary between sub-sectors. It may well be the case, however, that given current geopolitical tensions and turmoil in the sector, volatility may remain for some time. As to disputes increasing, the increased internationalisation and complexity of the energy and natural resources sector globally, one would certainly expect this to be the case. However, the number of disputes brought will be tempered by a company’s legal budget. A recent trend – particularly for some oil and gas companies – has been a new focus on cost efficiency and recovery, an institutional change that will likely have a long-lasting effect. This mindset, which often leads companies to litigate, is unlikely to disappear even when prices rise.
FW: What final advice can you offer to energy & natural resources companies on managing, mitigating and resolving their commercial disputes?
Greeno: Energy and natural resource companies view their exploration campaigns on a portfolio basis. For example, they appreciate that the majority of wells drilled in a campaign are likely to be dry and only a few will make commercial discoveries. However, they aim to be ahead overall. But they do not tend to view disputes in the same way. If they have a successful outcome in two cases but lose the third, it is the third that will dominate decision making when the next dispute comes along. That makes no commercial sense, but is probably because companies understand geological and other technical risk much better than they understand litigation risk. In our view, companies that assess their disputes on a portfolio basis, and appreciate that the overall return is more important than individual successes or failures, will maximise the value of that portfolio.
Hutcheon: Continuing the strategic evaluation of disputes is always important because a dispute can run for several years and what is in the interests of the company when the dispute began may not be in the interests of the company at the end of the dispute. Particularly in times of crisis, arguments may be made out of necessity. However, in addition to the risks of having to pay legal costs and interest – which may be acceptable in the circumstances – damage may be done to relationships, reputations and share values by continuing a dispute when conditions improve, rather than mending fences. From the point of view of a claimant, net worth of the defendant and enforceability of any judgment or award should always be kept under review. Individual management of the detail of each dispute is also important and all the options for pursuing, mitigating the effects of, financing and resolving disputes should be kept in mind. Where market conditions contribute to financial default the absence of an easy enforcement option may cause banks to be accommodating in negotiating waivers and amendments to stretch repayment periods or otherwise ease lending terms, but it is important for them to protect their security and other rights. Also, not every project in difficulty results in litigation. The parties may be able to suspend or put matters on hold and innovative solutions can sometimes be found. Keep your advisers close.
Sullivan: Mitigation of disputes begins at the outset of the parties’ relationship. Contracts should be thoroughly negotiated and clearly drafted. This includes an effective disputes resolution mechanism that is not unnecessarily complex, as this in itself can cause disagreements later on, and which may integrate options to mediate or for a period of negotiation prior to the initiation of any proceedings. Investors should always undertake thorough due diligence of the project, prospective contractual partners and the regulatory framework. Good records of documentation and communications between relevant stakeholders should be maintained throughout. Whether it is possible to resolve a dispute will depend on the circumstance; parties should always attempt to do so early-on, thereby increasing the likelihood of an amicable settlement, and conduct such negotiations in good faith. Early communication with the counterparty on the dispute is the key to avoiding protracted litigation. Ultimately, it is people skills and effective management that are imperative throughout any commercial relationship if disputes are to be avoided, especially in the complex energy and natural resources sector.
Moody: Spot the opportunity that arises from any dispute. There will always be some commercial advantage or gain to be had as a result of a dispute. Most importantly, it is important to have a thorough analysis of the strengths and weaknesses of your case as early as possible in order to understand the strategic options. Finally, always make sure you have a strong team on hand to help.
Jeff Sullivan is a partner in Allen & Overy’s international arbitration group and heads the Public International Law team. He specialises in international disputes in the energy and natural resources sectors. Mr Sullivan has been counsel in numerous bilateral investment treaty and international commercial arbitrations, often appearing as lead advocate. He regularly advises states on the negotiation and drafting of trade and investment treaties. He can be contacted on +44 (0)20 3088 2919 or by email: firstname.lastname@example.org.
Andy Moody is a partner in the London office of Eversheds LLP and specialises in international dispute resolution with a particular focus on international commercial and investment treaty arbitration. Mr Moody has deep experience of both upstream and downstream energy disputes and has advised energy sector clients on disputes in Europe, Asia, Africa and South America. He can be contacted on +44 (0)207 919 4585 or by email: email@example.com.
Ted Greeno is a partner at the London office of Quinn Emanuel Urquhart & Sullivan, LLP. He is the chair of the firm’s Energy Disputes practice and has conducted cross-border litigation and international arbitrations involving oil, gas, power and minerals contracts around the globe. He is ranked by Chambers in Band 1 for energy disputes. He can be contacted on +44 (0)20 7653 2030 or by email: firstname.lastname@example.org.
Andrew Hutcheon is a partner in Watson Farley & Williams LLP’s international disputes team, and has a wealth of experience in commercial and financial litigation and international arbitration in the offshore oil & gas, energy, natural resources and shipping sectors. He can be contacted on +44 (0)20 7814 8049 or by email: email@example.com.
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