There will be a number of potential investors and stakeholders involved in any oil and gas chain, each bringing their own assets and skills to the negotiating table. National oil companies (NOCs) may bring the principal asset - access to oil or natural gas. International oil companies (IOCs) may bring a variety of assets, such as technical skills, technology licences, access to markets and the ability to bring complex, high-cost and difficult projects to production on time and within budget.
Tensions will frequently arise between NOCs and IOCs. When it comes to resolving these tensions, the extent to which each party requires the other, in order to conclude upstream, mid-stream and downstream aspects of an oil and gas chain, will have a strong effect on the relative strengths of the respective parties’ bargaining positions. These relative strengths will vary at different stages of the oil and gas chain.
The objective should be to resolve issues in a sensible and balanced manner. Lasting partnerships are generally based on each party’s willingness to share their skills and assets, and the strongest relationships are those that seek to be mutually transformational over time and not merely on a transaction by transaction basis. Unfortunately, this is not always the case, as recent tensions between host states and foreign investors in Bolivia, Ecuador, Russia, Venezuela and other parts of the world have shown.
Value extraction and value sharing is perhaps the most critical issue between NOCs and IOCs. The number of places that value may be extracted from an oil and gas chain by a particular party will depend on the extent to which the NOC or the foreign investor is vertically integrated at each stage of the chain (up-stream, midstream and downstream).
Significant upstream value extraction is increasingly difficult for IOCs to achieve. The host state invariably dictates the structure and terms for exploration and production activities. Host states are increasingly transferring more risks and offering fewer rewards to investors whichever regime (service contract, production-sharing contract, or tax and royalty) it operates.
For example, in Ecuador, President Rafael Correa has instigated a renegotiation of the country’s oil contracts with IOCs, claiming this is necessary to prevent companies abusing the country. Correa hopes to switch all existing oil contracts to service contracts and in the process increase value for the state. In Iraq, the recent first licensing round had a similar aim, to minimise IOC profits and maximise returns for the state. BP and CNPC’s acceptance of the $2 a barrel fee will make these Iraqi barrels among the lowest margin barrels in the world.
However, the limited success of Iraq’s first licensing round - only one of six oilfields offered were awarded - and the scaling back of operations in Ecuador by IOCs shows that companies are generally unwilling to accept such tight margins.
The host government will often wish to ensure that it or its NOC retains control over upstream projects and other strategic assets in the country (such as LNG-export plants) and in some cases also over other strategic parts of the oil and gas chain abroad. In the LNG context, some NOCs are increasingly seeking more involvement in and control over the entire LNG chain. This is partly related to the issues of value extraction; greater control may help an NOC prevent revenue leakage from the chain. It may also give the NOC an opportunity to participate in decisions to realise occasional upside opportunities. NOCs may also want to be involved in day to day decisions such as: where and on what terms to sell uncontracted cargoes, short-term spot cargoes or long-term excess volumes; and arbitrage opportunities.
To maintain control, NOCs may become shareholders (often owning a majority stake) in companies that participate in the oil and gas chain, both in its own jurisdiction and sometimes also abroad. For example, Qatar Petroleum (QP) has sought to retain a high level of control from the wellhead, through to LNG regasification terminals in countries such as the UK and Italy. This allows QP to keep control over its natural resources while benefiting from the valuable intellectual capital, proprietary technologies and access to markets offered by its partners, ensuring Qatari gas is used efficiently and marketed for the benefit of the host state.
IOCs will bring their best practices, technology, engineering, financial and commercial experience and expertise to any project. Naturally, host states see this as an opportunity not only to monetise reserves, but also to share the benefits of these intangible assets with the NOCs and local citizens. NOCs have, therefore, been increasingly pursuing national development and protection initiatives. Indeed, host countries may set absolute legal requirements that must be met.
These objectives often take the form of: local-content objectives or obligations - to increase utilisation of and further develop local industry and skills; knowledge-transfer requirements, under which investors are encouraged or obliged to hire and train local citizens; and stringent health, safety and environmental compliance’ requirements. These can give rise to competing objectives and issues between IOCs and NOCs. Russia’s Sakhalin-2 project, for example, suffered significant problems as a result of “environmental compliance” issues.
Foreign investors may be in search of investment incentives or exemptions from certain requirements. This may be driven because, although the fundamental requirements for the project exist, such as the gas resource and a ready market, a number of additional factors may make investing in the project difficult, such as high local taxes, contaminated land issues or problematic local legal requirements. Accordingly, investors may seek concessions or protection from the host state in relation to matters such as tax holidays; an indemnity in relation to costs for remedial work in the case of contaminated land; and exemptions from or changes to problematic local legal requirements.
Foreign investors will want a clear and stable legal, fiscal and regulatory regime. The applicable legal and tax treatment will need to be investigated and understood. Ideally, due diligence will reveal a satisfactory regime, although in reality this is unlikely to be the case. Having understood the baseline position, investors must consider the political risks associated with investing in a particular state and ensure the legal and fiscal regime is not subject to radical change. Expropriation has always been a risk and recent problems in Algeria, Bolivia, Ecuador, Russia and Venezuela show that political risk remains a significant problem in certain parts of the world for IOCs and other investors.
Unfortunately, contractual provisions do not always provide as much comfort as foreign investors expect. There are various examples of foreign investors running into difficulties when seeking to enforce contracts that a government or a state entity wishes to avoid, particularly where a previous administration or regime entered into the contract. Even if an IOC is successful in bringing a claim, it may find it impossible, for example, to enforce a valid arbitration award in the host state because of interference with the courts by the state entity with which the contract was made and is in default.
There are a number of extra-contractual mechanisms open to foreign investors to assist in protecting their investment. A bilateral investment treaty (BIT) is entered into between two states to protect investments made by a national of either of the states into the other. It also aims to provide a level of legal protection to the investor. Many BITs contain broadly similar protections.
To qualify for protection under a BIT, there must be an investor with an investment in the host state. A dispute would qualify for protection under a BIT if it is between the investor and the host state. Each BIT contains the definition of an investor and an investment. International arbitration is usually the neutral forum used to resolve disputes. But a number of treaties provide for arbitration under World Bank’s International Center for Settlement of Investment Disputes (ICSID).
The protections commonly found in BITs are: the right to fair and equitable treatment; the right to national treatment, requiring a host state to treat foreign investments no less favourably than the investments of its own nationals and companies; the right to most favoured-nation-treatment; the right to compensation for civil disturbance; protection against expropriation and nationalisation; the right to repatriate profits and property; protection against breach of contractual obligations/umbrella clauses; and dispute resolution/arbitration.
It is advisable to carefully consider protection under a BIT before a project commences so that the investor can take advantage of any BITs signed by the host state. The protection afforded by BITs is extra-contractual, so will apply to an investment contract even if not expressly referred to. The host states signature of the BIT is sufficiently binding for it to apply to the investment contract.
The importance of BITs continues to grow, with the total number rising to 2,676 at the end of 2008. Despite the intense BIT negotiating activity of some countries, over the last four years, there has been no change in the ranking of the top ten signatory countries of BITs (see page 3 of the UNCTAD’s Recent Developments in International Investment Agreements (2008–June 2009)).
Multilateral investment treaties (MITs) are similar to BITs. The Energy Charter Treaty (ECT) is an example of a MIT that seeks to protect and promote foreign investments in the energy sector in member countries. Disputes under the ECT can either be settled by: arbitration between parties to the ECT on the interpretation or application of the treaty; various dispute-settlement mechanisms for investors to take host governments to international arbitration; a specialised conciliation procedure; a mechanism for settling trade disputes between member countries (provided that at least one of them is not a WTO member); and bilateral and multilateral non-binding consultation mechanisms for disputes arising out of competition or environmental issues.
The ECT came into force in April 1998, but it is difficult to assess the effect of the treaty as only 22 disputes have been brought under it to date - 15 of the 22 reported ECT disputes are under ICSID. ICSID is an institution that administers and provides facilities for the conciliation and arbitration of international commercial disputes between states and nationals of other member states. It is available only in respect of disputes where a state is a party to the convention. The primary purpose of ICSID is to promote foreign investment.
The importance of ICSID
The importance of ICSID has significantly increased in today’s world - it now has 156 signatories and has been ratified by 144 countries. So far, 167 ICSID cases have been concluded with 127 cases pending.
ICSID arbitration can arise in two ways: either contractual (where the contract between the investor and host state contains an express reference to ICSID for dispute resolution); or non contractual (where arbitrations arise from indirect consent to ICSID arbitration contained in either the host state’s national investment legislation or a BIT or MIT). Interestingly, 75 per cent of ICSID arbitrations have been brought under the latter category.
The essential criteria for ICSID arbitration is that: parties must have consented to it in writing; the dispute must be between a contracting state and a national of another contracting state; and the dispute must be a contractual legal dispute arising directly out of an investment. Although recourse to ICSID is voluntary, once the parties have given their consent to it, they cannot unilaterally withdraw their consent.
The advantages of ICSID arbitration include: arbitration proceedings are administered by the World Bank; it is a neutral and self-contained system; it is transparent; and it has clear and reasonable legal-cost schedules. However, it is imperative for investors to include a waiver from sovereign immunity clause in their contracts in order to bring a claim against a state entity - mere reference to ICSID arbitration is not sufficient.
In relation to the recognition and enforcement of ICSID awards, each contracting state to the ICSID Convention: will automatically recognise the award as binding; will enforce the financial obligations imposed by the award within its territories as if it were a final judgment of a court in that state; and may enforce an award though its federal courts, providing such courts treat the award as if it were a final judgment - non-financial awards must be enforced by other means, such as the New York Convention.
A failure by a contracting state to enforce an ICSID award is a clear breach of its international treaty obligations. Similarly, and perhaps more crucially, a lack of enforcement may have implications for the state’s World Bank membership. This provides a valuable incentive for states to comply, offering notable protection for investors.
As overseas investors, IOCs are exposed to a myriad of risks. As host states seek to extract more value from their oil and gas resources and pass fewer rewards to investors, IOCs must be increasingly vigilant when negotiating contracts and examining the commercial and legal risks of a project. Foreign investors should always consider both contractual and extra-contractual means of minimising risks and protecting their investment, ideally before investing, but also if contracts start to run into difficulties.
This article was first published in Petroleum Economist’s World Gas 2009 book.