The Commercial Court was recently tasked, in Vitol E & P Ltd v Africa Oil and Gas Corporation [2016] EWHC 1677 (Comm), with deciding whether the words “commencement of drilling” in a sale and purchase agreement for an oil company meant “spudding” of a well or an earlier stage in drilling operations. The decision is a timely reminder of the importance of clarity in contractual terms dealing with deferred consideration in oil and gas M&A transactions.

Background

On 18 July 2005 the Republic of Congo issued a Research Permit for the offshore area known as “Marine XI”. The beneficiaries of the relevant Research Permit were the parties to a Production Sharing Contract (“PSC”) made with the Republic of Congo on 19 August 2005. Their interests in the PSC at the relevant time were Raffia Oil SARL (“Raffia”): 18.75%, Lundin Marine SARL (“Lundin”): 18.75%, SOCO Exploration & Production Congo (“SOCO”): 29%, Société Nationale des Pétroles du Congo (“SNPC”): 15%, PetroVietnam Exploration Production Corporation (“PVEP”): 8.5% and Africa Oil and Gas Corporation (“AOGC”) 10%.

The permit lasted for up to three consecutive exploration periods. In order for a second or third exploration period to be granted, the beneficiaries of the permit had to have drilled at least one “Commitment Well” in the preceding period. If they then decided to drill another well in the same exploration period it would become known as a “Discretionary Well”.

The second exploration period commenced on 1 April 2011 and was due to expire on 30 March 2013. By the end of 2011, a Commitment Well for that period had been drilled and accordingly the parties were then entitled to apply for a third exploration period if they so decided. However, in March 2012 SOCO proposed that the existing Work Programme and Budget be expanded so as to include the drilling of a Discretionary Well at the site known as Lideka East (the “Well”). Raffia was opposed to this because it had already formed the view that the Marine XI project was not going to yield significant results. Lundin took the same view but the other parties did not.

Facts

Vitol E & P Limited (“Vitol”) was owner of Padina Energy Limited (“Padina”). It in turn owned a Congolese company called Raffia. By a Sales and Purchase Agreement dated 24 January 2013 (the “Agreement”), Vitol sold its shares in Padina to AOGC.

It was common ground that in late 2012 the value of Raffia’s 26.11% interest in the PSC was about $20 million. The cash consideration payable under the Agreement was US$12.6m. This would increase to the extent that Vitol had to pay any cash calls in the period between execution of the Agreement and completion. There was also provision for Deferred Consideration of US$7.4 million.

The Deferred Consideration was payable only in certain circumstances. Clause 7.1 of the Agreement provided as follows:

“7.1 The Purchaser shall pay the Seller the Deferred Consideration if one of the following conditions is satisfied:  (A) at any time prior to the date of expiry of the Second Exploration Period… the drilling of the Lideka East Well no longer forms part of an approved work program or budget under the Marine XI Joint Operating Agreement, as either firm or contingent expenditure; or  (B) the drilling of the Lideka East Well is not commenced before the date of expiry of the Second Exploration Period…”

It was common ground that it approximated to the estimated costs of the Well which AOGC would have to bear if it went ahead, which was approximately US$7.2 million.

It was further common ground that the underlying purpose of Clause 7.1 was to some extent at least, to protect the buyer from a situation where it had to pay full value for the shares in Raffia namely US$20m and a further sum of around US$7.2m by way of its costs contribution for the Well.

Under normal circumstances, of course, one would expect a party to the PSC to have to make costs contributions. However, the position here was that both Vitol and the buyer considered that the Well was not worth drilling and was unlikely to produce any benefit. Therefore, as they saw it, any costs incurred if the Well stayed in the Work Programme and Budget and was drilled, might be wasted.

Vitol contended that “commencement of drilling” meant “spudding”. However, AOGC contended that this expression is “not confined to operations beginning with the spudding… Rather, the words refer to a phase of operations including, in addition to the spudding of the well, various activities preparatory to, associated with or consequential upon the spudding. Such activities include, but are not limited to the procurement, mobilisation and demobilisation of machinery and services required in connection with the spudding of the well.”

At trial the question arose whether commencement of drilling meant spudding or mobilisation of the rig.

Decision

The Commercial Court emphasised that Clause 7.1 was put in negative terms:

“Vitol is entitled to the Deferred Consideration if either the Well is removed from the WP&B or drilling thereof is not commenced. Otherwise it is not. But the protection afforded to the buyer is limited because it operates only up to the end of the second exploration period (ie 30 June 2013) and not indefinitely.

So if the Well is not removed from the WP&B and drilling is commenced before the end of the second exploration period, no Deferred Consideration is ever payable - but on the other hand, AOGC will have the costs liability in respect of it. However, if the Well was not removed from the WP&B, and drilling was not commenced by the end of the second exploration period (so that the Deferred Consideration is payable in any event) but it did commence in the third period, AOGC will still incur a costs liability without any protection. It will, in effect, pay out twice.” (Court’s emphasis)

The Commercial Court considered that the most recent decision of the Supreme Court in this area,Arnold v Britton [2015] AC 1619, was the relevant starting point to deciding the meaning of the relevant clause.

In accordance with Arnold v Britton, the proper approach was to first consider if there is a “natural” and “ordinary” meaning of the words “commencement of drilling”. The Commercial Court decided that there was such a meaning, and it is the physical penetration of the seabed i.e. spudding.

The Commercial Court considered that:

“This is to be distinguished from preparations for drilling. Drilling is itself not a momentary process and so it is perfectly sensible to speak of when drilling starts, in the spudding sense, and when it stops. That is the sense in which one would define drilling the road or the drilling of one’s teeth by a dentist. I further find that “commencement” naturally means the beginning of drilling, not the beginning of preparations for drilling.”

The Commercial Court found that some support could be found for this approach in:

  1. Excalibur v Texas Keystone [2013] EWHC 2767 Christopher Clarke J (as he then was), when reciting the history of Garth’s oil exploration at a well in Kurdistan said, at paragraph 1285: “on 28 April 2009, Garth announced the spudding (i.e. commencement of drilling) of the first… exploration well”; and
  2. Amoco v British American Offshore Limited 16 November 2001, were Langley J said “……The Clause also refers to BAO ensuring that all BOP elements are new or like new "at the commencement of drilling operations". That means what it says. Not mobilisation, not commencement of the contract, but commencement of drilling. "Prior to spud of the well" has the same connotation. It also accords with all the evidence that the well control equipment must be and is tested prior to drilling, and at no more than fortnightly intervals thereafter… Clause 10 provided for Amoco to provide BAO with a well-drilling programme prior to spudding of the well. “Spudding” is the commencement of drilling.”

In making its decision the Commercial Court refused to apply a number of United States court decisions. It identified:

  1. Terry v Texas (1920) 228 SW 1019 (where two oil and gas leases in question would be of no effect unless the lessee “commenced to drill a test well…” within 8 months); Cromwell v Lewis 1923 OK 1028 (where the expression in the lease was “to commence to drill a test well”); and Ferrell v Russell Creek Okl. 645 P 2d 1003, a yet further decision of the Oklahoma Supreme Court.
  2. Quite apart from the fact that Terry, as with the other US cases, is not binding authority, the Commercial Court considered that it can be seen that the result derived from case-law about a different phrase.
  3. Furthermore, in Caltex Oil v Commissioner of Internal Revenue 12 January 2012, 138 TC 18, the US Federal Tax Court took a different view to Terry. In Caltex Oil, in the tax context, a right to make certain deductions in a particular tax year, depended on whether “drilling of the well commences” within 90 days of the end of the tax year. In this case, the site had been prepared but there had been no spudding within that period. The court took the ordinary meaning of drilling as, in effect, spudding and defined “commence” as “begin” and concluded that drilling began when the drill bit penetrated the ground. It had to be noted, though, that this view was held to be consistent with the title of the relevant section in the tax statute which referred to “special rule for spudding of oil and gas wells”. The Court distinguished the Oklahoma cases where, for the purpose of a lease preparatory acts were sufficient and said that those cases (most of which as quoted here concerned leases where the term referred to the commencement of “operations for drilling”) did not assist in the different contexts of interpreting federal tax law.
  4. All in all, the Commercial Court did not find the US cases relied upon by AOGC to be of much assistance.

Further, the fact that clause 7.1(A)’s reference to “drilling” being “part of an approved work programme” did not assist the Commercial Court. The context in Clause 7.1 (A) was simply different. The contingency catered for there is the removal, effectively, of the entire drilling project for the Well because in that case, there is no prospect of AOGC, ever having to incur costs in relation to it. So the fact that “drilling” there may be interpreted in a wider sense is irrelevant. Moreover, there is of course no direct comparator because Clause 7.1(A) does not use the expression “commencement of drilling".

Comment

It is common for oil and gas M&A transactions to have to deal with costs incurred by the seller between financial close/execution and completion.

If those costs might include the drilling of wells, or the development of a discovery, they may be substantial. If those costs might include drilling a well, they will likely evolve in incremental stages including procurement, mobilisation, spudding, drilling operations and demobilisation.

It is for this reason that sophisticated sale and purchase agreements traditionally use industry recognised phrases such as “spudding” or technical descriptions of spudding (or other activities) to define contractual obligations, where that event gives rise to a trigger event for liabilities to be incurred.

The use of such terms enhance contractual certainly. Although the Commercial Court was able to reach a conclusion in this case, it is a useful reminder of the importance of clear drafting when dealing with trigger points for deferred consideration.

Link to Decision