Managing upstream exploration risk during a period of declining capital expenditure

Our first issue in this series noted the widespread reduction in capital expenditure that has been announced across the oil and gas industry due to the recent sudden decline and growing volatility in international oil prices. That trend seems likely to continue for at least another year as major companies undertake their financial planning for 2016 later this year. However, international oil and gas companies define their success in large part through their efficient execution of large, complex oil exploration projects. Faced with fresh expectations from host governments who are keen to increase – or even introduce – oil and gas revenues to their economies, oil and gas companies must carefully address their obligations to host governments with a view to possibly prioritizing their lower-cost projects and allocating their declining capital expenditure budgets away from higher-cost projects. This issue explores certain ramifications for concession holders and production sharing participants tackling such challenges.

For those companies presently negotiating – or re-negotiating – their production sharing contracts or other concession agreements with key stakeholders, one objective should be to seek flexibility in both the minimum work obligations and the relinquishment requirements during the exploration phase. This may prove challenging, however, as host governments will want to incentivize operators to conduct early exploration, particularly during the current oil price climate where exploration costs are relatively low.

Those companies seeking to decelerate their exploration or production activities under existing arrangements should be paying close attention to the default, force majeure, and disputes provisions of their agreements, identifying potential defenses and evaluating the likelihood of government action ahead of relaxing any exploration schedules.

Among the issues that will form part of the analysis to underpin the strategy for any project that is under review will be:

  • The scope of the minimum work program: what flexibility does it present and what parts of it are the contractor parties entitled to reduce, postpone or shelve without liability?   
  • Is there a basis under the relevant agreement to re-negotiate certain terms as the result of change of circumstances? Generally, the fact that a project is less profitable as a result of the downturn in oil prices is unlikely to constitute force majeure or provide a basis for re-negotiation under either stabilization provisions or common law principles. In addition, a term allowing re-negotiation following a change of circumstances is unusual in production sharing agreements and concessions.  
  • What is the attitude of the host government? Is it willing to accept implementation of a project on a smaller scale, recognizing that a solution that balances the interests of the government and the contractor parties may be better than one which drives towards a default or a dispute?
  • What is the position of joint venture partners? If any of them is unable to meet continued capital calls for exploration, reaching a negotiated solution among joint venture partners is in many cases better than pursuing a default. While default provisions are rightly there for a "doomsday" scenario, they carry some risks: if one party defaults, the exposure of the others increases; and default provisions should not be assumed to always be enforceable. There can, for example, be issues relating to the enforceability of a forfeiture provision; and if a defaulting party is driven into insolvency, a provision that permits the non-defaulting parties to be repaid out of the participating share of the defaulting party may be challenged as being an unregistered charge or a preference that is not binding on a liquidator.

In this dynamic period in the oil and gas industry, a proactive analysis of these issues will benefit international oil and gas companies who seek to minimize and control risk rather than letting risks unfold and develop.