Litigation Risks for Oil and Gas Companies and Investors

The global energy industry is currently dominated by the sudden and dramatic decline in crude oil prices. What litigation risks does this present for oil and gas companies and investors?

E&P and Joint Ventures

Litigation risks increase whenever there is a dramatic change in global economic conditions. In the upstream oil and gas sector, the recent fall in oil prices has caused the interests of host governments in oil producing countries and exploration and production (E&P) companies to collide. On one hand, host governments in the countries expected to be worst hit want to maximise oil and gas revenues for their economies. Consequently, E&P companies should be prepared to face an increased risk of expropriation, as a result of which we expect to see an upsurge in investment disputes with host governments, as well as contractual claims under production sharing contracts and other concession agreements as E&P companies seek to maintain agreed revenue sharing arrangements.

On the other hand, oil and gas companies are looking to reduce investment, prioritise their lower cost projects, and decelerate their exploration and production activities. In doing so, they must pay close attention to the default, termination, force majeure, and dispute provisions of their agreements in order to minimise the risk of government action as a result of any relaxation of their work programmes. Generally speaking, the fall in oil prices and resulting decline in profitability of production operations is unlikely, in itself, to amount to a force majeure event or provide a basis for terminating or renegotiating a production sharing contract (subject to the possible relevance of "stabilisation" or "economic equilibrium" clauses), so an increase in disputes is the likely outcome as exploration and production activities are moderated in line with new economic realities.

The position of joint venture partners is also a potential area of risk. If one party to the joint venture is unable to meet capital calls for exploration, the exposure of the other parties increases. The operator under a joint operating agreement will also be exposed to litigation risk if it fails to diligently pursue joint operations or meet its minimum work obligations.

Financing arrangements

Oil and gas companies also face significant litigation risk in relation to their financing arrangements. The junior and mid-cap independent E&P companies, which tend to be highly leveraged without the strong balance sheets or diversified revenue streams of the majors, are feeling the stress of substantially reduced production revenues. By the same token, reduced rig utilisation has negatively impacted oilfield services companies. As a result, financial covenants in loan facilities and public notes are being tested and lenders are assessing the size and health of their exposure in the oil and gas sector. If oil prices continue to stay low, oil and gas companies can expect to see lenders become more aggressive in refinancing negotiations leading to increased risk of loans being accelerated and insolvency proceedings being commenced.

This may, of course, create opportunities for some oil and gas companies with strong balance sheets and access to financing to consolidate their position in the sector by acquiring quality businesses, equipment, and personnel at depressed prices. Any upturn in M&A activity may also result in a risk of litigation for both buyers and sellers as the former seek to recover for unexpected liabilities they have inherited, for example in relation to environmental or health and safety issues.

Price review

The fall in oil prices will also impact upon price review negotiations under long term gas and liquefied natural gas supply contracts, which is likely to lead to a further increase in associated price review disputes. Over the last five to ten years there has been a significant rise in the number of gas price review arbitrations. This trend has been caused primarily by the divergence between prices at gas hubs and oil-linked prices under historic gas supply contracts, as a result of which many buyers under oil-linked supply contracts have been out of the money and have looked to renegotiate prices and link their new long term import contracts to hub prices. There have, however, also been a number of instances where price review disputes have arisen as a result of producers seeking to renegotiate prices upwards in gas and LNG supply contracts that were concluded in the low oil price environment of the early 2000s and imposed low caps on crude prices into the pricing mechanisms.

How will the recent dramatic fall in both oil and gas prices affect the position? It depends largely on the terms of the relevant supply contract and its price review mechanism, in particular whether the price is oil-linked or linked to gas hub prices, when the price was most recently reviewed, and the circumstances that trigger a price review. But in general terms, whenever there is volatility in the market, the scope for price review disputes increases. Both producers and buyers should therefore carefully examine the price review mechanisms in their supply contracts.