First published in the International Arbitration 1/3LY, Issue 7
To survive in the most bearish oil market for decades, E&P companies must cut costs, minimise risks and maximise returns. Exploration activity suffers as a result, but low oil prices do not relieve E&P companies from minimum work obligations in production sharing contracts (PSCs). PSCs typically include “drill or drop” provisions that make the performance of defined exploration activities a condition of keeping the agreement alive.
A common solution for E&P companies seeking to diversify their exploration risks is to sell or farm out some of their participating interests in a PSC in return for a promise from the buyer that it will fund all or part of minimum work obligations (a carry). A recent English High Court judgment concerning an exploration block in a major new oil province illustrates how drill or drop and carry provisions can be affected by operational contingencies. As market conditions tighten, oil explorers are more likely to use Carry arrangements. Given the industry’s preference for international arbitration, the case of Adamantine Energy (Kenya) Limited v Bowleven (Kenya) Limited offers a rare insight into how English Courts will interpret drill or drop and carry provisions and provides useful guidance to the industry. To avoid an unnecessary dispute, careful drafting is essential and parties should enter into such arrangements with a clear-eyed view of all eventualities.
The contractual arrangements
On 30 May 2012, Adamantine (as contractor) acquired an interest in the East Africa Rift System play by entering into a PSC with the Government of Kenya. The PSC anticipated a six-year exploration phase divided into three periods. Each two-year period contained certain minimum spend (MS) and minimum work obligations (MWO) for Adamantine. The Government was obliged to allow Adamantine to move into the next exploration period if the MS and MWO were completed.
On 14 September 2012, Adamantine transferred a 50% participating interest in the PSC to Bowleven pursuant to a Sale and Purchase Agreement (SPA). In return, Bowleven was required to carry the MS for each exploration period. Bowleven subsequently farmed out a 30% participating interest in the PSC to First Oil.
The SPA provided that no later than three months before the expiry of each exploration period (or any extension thereof) the parties would vote on whether to continue with exploration or to relinquish the PSC. If both parties voted to drill, Adamantine would seek to activate the next exploration period in accordance with the PSC. If both parties voted to drop, they would relinquish the PSC. However, if one party voted to drill and the other voted to drop (the relinquishing party), then the relinquishing party would exit and would be required to transfer its 50% participating interest to the other party for nil consideration.
In accordance with industry standard practice, a Joint Operating Agreement (JOA) dated 12 October 2012 between Adamantine and Bowleven supplemented the SPA.
Both Adamantine and Bowleven acknowledged that they would not complete the MWO for the IEP (initial exploration period) by the deadline of 26 May 2015. Work was already behind schedule when disaffected locals attacked a work camp in January 2015 and caused seismic work to stop. Adamantine had sought, but had not (yet) been granted an extension to the IEP by the Government.
Nonetheless, Adamantine called for a management committee meeting and a drill or drop vote on 25 February 2015 (i.e. three months before the expiry date of the IEP). Bowleven responded that the call for a vote was premature and invalid. Bowleven argued that since it was clear they would not complete the MWO by the IEP deadline, the right to move into the 1AEP (first additional exploration period) did not exist.
Regardless, Adamantine proceeded with the drill or drop vote and voted to move into the 1AEP. During the management committee meeting Bowleven voted "yes" to proceeding, conditional on receiving the extension to the IEP. Bowleven insisted at the meeting that a conditional vote was valid and should be recorded. Adamantine characterised Bowleven as having voted not to move into the 1AEP (i.e. having voted to drop its participating interest). In a follow up email, Bowleven said that, if required to vote, it voted no on the basis that the parties were unable to move into the 1AEP. Bowleven also stated that, if the IEP expiry date was extended, its no vote should be considered invalid and there should be a further vote no later than three months before that extended expiry date.
Adamantine subsequently instigated proceedings to establish that the vote was valid and that it was entitled to Bowleven’s participating interest in the PSC because Bowleven had voted to drop its interest.
The Court said that the commercial rationale for the voting timetable was to balance two competing needs:
- each party’s need to have the maximum opportunity to assess the existing data before being required to make the drill or drop decision; and
- each party’s need to have sufficient time to make the arrangements for the next exploration period should a party elect to continue with exploration (for example, securing necessary finance or farming out a participating interest).
The parties had agreed that holding a drill or drop vote three months before the next exploration period was due to begin struck the right commercial balance between these needs.
The Court held that the drill or drop vote called by Adamantine was not valid. The Court noted that if Adamantine’s call for a vote was valid, and Bowleven had voted yes, then if the Government extended the term of the IEP the parties would have been irrevocably committed to moving into the 1AEP and there would not have been a vote three months prior to the expiry of the extended IEP. In effect, the parties would have taken their decision without the benefit of the results of the data collected during the extension. In addition, this would have hinder the parties’ forward planning as the decision to continue exploration would have been dependent on a variable outside their control, namely, the Government agreeing an extension under the PSC. This outcome was contrary to the commercial rationale for the agreed timetable for the drill or drop vote.
Drill, drop, carry: What you need to know
Drill or drop and carry provisions are useful tools for E&P companies that wish to diversify the risks of exploration and to make investment decisions incrementally based on the latest information. Careful drafting, however, is essential to ensure that they are effective.
It is difficult for transaction documents to cover all eventualities, but the relevant circumstances in this case were reasonably foreseeable. In frontier markets, it is not unusual for work obligations to be delayed or for the commercial solution in such circumstances to be the transfer of MWO from one period to the subsequent period.
To clarify the parties’ intentions, we would suggest that parties entering into a farm-out transaction involving a carry address the following questions when drafting:
- SHOULD THERE BE AN AGGREGATE MONETARY CAP IN RESPECT OF THE CARRY AND, IF THE CARRY RELATES TO MWO, A CAP FOR MWO IN EACH PHASE OF THE EXPLORATION PERIOD? To the extent the carry relates to MWO, this needs to be considered together with the exit provisions in the relevant PSC.
- SHOULD ANY OF THE NEGATIVE COVENANTS THAT TYPICALLY EXIST BETWEEN SIGNING AND COMPLETION OF THE DEAL APPLY DURING THE CARRY PERIOD? For example, should there be an express provision stating that any proposed variation of the MWO/PSC has to be agreed between the parties and that carry obligations only apply to MWO as set out in the existing PSC?
- WHAT RIGHTS SHOULD THE BUYER HAVE TO EXIT THE DEAL? This will be a point of negotiation, but as a starting point, the buyer is likely to want at least the same exit rights as provided for in the PSC. If the seller is willing to provide the buyer with additional exit rights, the seller needs to plan for how it will fund any outstanding obligations under the carry (particularly MWO) if the buyer relinquishes its interest.
- ARE THE RULES DEALING WITH HOW THE BUYER’S EXPENDITURE ON THE CARRY IS ACCOUNTED FOR CLEAR? COULD THERE BE ANY DISAGREEMENT ABOUT WHETHER AN EXPENSE IS DIRECTLY ATTRIBUTABLE TO THE CARRY? With respect to a carry of MS, the PSC accounting procedures should adequately classify expenses, but confirmation is necessary. The parties also need to discuss and agree on what would happen to the carry if MWO from one exploration period were rolled into the next exploration period.
- IF A PARTY HAS THE RIGHT TO REQUIRE A RELINQUISHING PARTY TO TRANSFER ITS PARTICIPATING INTEREST, ARE THERE ANY SELF-HELP MECHANISMS THAT WOULD SUPPORT SUCH A TRANSFER IN PRACTICE? For example, is there any security over the relinquishing party’s participating interest that can be exercised to enforce such a right?
- ARE RIGHTS AND OBLIGATIONS ALIGNED ACROSS THE RELEVANT PSC, SPA AND JOA AND IS THERE PROVISION FOR WHAT HAPPENS IN THE EVENT OF AN INCONSISTENCY? The parties need to ensure in particular that there is an adequate SPA decision-making protocol that feeds into the PSC and JOA decision-making protocols. This case demonstrates the trigger for voting on drill or drop provisions needs careful thought. A trigger linked to the expected date of MWO completion (as indicated in the operator’s progress reports) may in some circumstances be preferable to the date hardwired as the end of the exploration period in the relevant PSC, although if it appeared that the MWO would not be completed by the relevant deadline, the parties would need to vote on how to approach the government with such news.
- WHO WILL BE THE OPERATOR AT EACH STAGE OF THE PSC AND HAVE THE BUYER’S CONTROL OVER EXPENDITURE? While it does not appear to have been an issue in this case, it is also important that the non-operator has adequate access to operational information and data in order to make informed drill or drop decisions.
- IF EXPLORATION IS SUCCESSFUL AND COMMERCIAL PRODUCTION ENSUES, SHOULD THE COST OF THE CARRY BE REPAID TO THE BUYER THROUGH A PREFERENCE ON COST OIL?