Doak Bishop, Eldy Quintanilla Roché and Sara McBrearty, King & Spalding
This is an extract from the third edition of GAR’s The Guide to Energy Arbitrations. The whole publication is available here.
This chapter will introduce the general nature and organisation of the international energy industry, specifically as it relates to international arbitration practitioners. It is worth noting that the international energy industry is the single largest user of international arbitration, and thus it is of particular interest to arbitral practitioners. Many arbitral advocates and arbitrators will be involved at some point in their careers with the industry. For its part, given its breadth and complexity and the size of many controversies, the industry has need of a truly international, neutral and tailored mechanism for resolving disputes, and that need is addressed by international arbitration.
The breadth and complexity of the energy industry stems from its truly international scope, the multitude of energy sources, transactions, actors and stakeholders, as well as from its evolving nature. Traditional energy sources – oil, gas, coal, and nuclear power – have been complemented recently with the expanding field of alternative energy (e.g., solar, wind, geothermal, biomass, hydrogen and hydropower). The transactions involved in the industry range from bidding arrangements to exploration, drilling, exploitation, transportation, marketing and many more.
Despite various mergers among private oil companies, the actors in the industry are quite robust and diverse. The industry is no longer dominated by the ‘seven sisters’ – the original ‘major’ oil companies – but instead, independent and national oil companies are strong players in the field. In fact, state oil companies today dominate the industry in terms of reserves. Various oil-service companies are also important players in the industry. Additionally, the economic viability of certain projects has changed dramatically, given the level and volatility of oil prices. In turn, this has led in great part to the increased need to carry out decommissioning activities. The availability of new technologies for exploration, exploitation and transportation have also altered the global oil and gas market. All of these developments have spurred new laws and environmental policies regulating the industry.
While defining the breadth and complexity of the international energy industry is difficult, this chapter will outline some general background and areas of focus, although one should note that the industry will inevitably change in the coming years.
Oil and gas: overview of the traditional energy sector
It is estimated that US$48 trillion of investment will be required to supply the world’s energy needs up to the year 2035.According to the International Energy Agency, nearly two-thirds of this investment will take place in emerging economies. And while most of the energy resources are state-owned, private sector investment is essential to meeting energy investment needs. This in turn requires foreign direct investment and the participation of international petroleum companies.
The first half of the 20th century saw the development and rapid growth of the energy sector. In the early years, many governments granted generous concessions to international petroleum companies. Beginning in the 1950s and accelerating in the 1970s, numerous concessions were expropriated or renegotiated, providing governments with a higher percentage of the revenues and greater control over production. Some commentators have suggested that modifications and renegotiations are inevitable given the lengthy lifespan of energy investments, emerging laws and changing political climates. But nevertheless, the sanctity of contractual commitments and legal security remain critical to energy investments.
Most countries follow the regalian or dominial systems regarding ownership of subsurface minerals. Under these systems, subsurface minerals belong to, or are controlled by, the sovereign. Thus, international petroleum companies need permission from the state to operate in these countries. States define the conditions for investors to carry out their activities, and these are ultimately reflected in a granting agreement (i.e., a legal instrument by which the government directly, or through a state-owned company, grants the private oil company the right to certain interests in the hydrocarbons within the country, either in place or after production). The types of granting agreements vary depending on the host country’s laws, economy, and social and political policies.
Generally, but certainly not invariably, one could categorise the granting instruments geographically by saying that international petroleum companies enter into production sharing agreements with governments in Asia and Africa, licences with governments in Europe and service agreements (or risk service agreements) with governments in South America. However, these geographic categorisations are not invariable, and these different types of agreements are adopted by some countries in the other geographical areas as well. Moreover, various elements of each of these types of agreements may be combined in a hybrid contract.
A production sharing agreement often requires the participation in drilling and production activities of a local, government-owned company, often including a carried interest for any exploratory wells. Through the government-owned company’s participation in the project, as well as royalties, bonuses and taxes paid to the government, the government’s percentage ‘take’ of the total revenues of a project is often substantial. The percentage of government ‘take’ will vary from country to country, depending on many factors such as historical agreements, costs, and geological and financial risks. The government ‘take’ is an important consideration for international oil companies in deciding whether to invest in a given country, and at times it can be a matter of competition among governments for hydrocarbon investments.
An international petroleum company entering into an agreement with a government may act on behalf of a consortium of companies, which enter into a joint operating agreement to define, among themselves, their rights and obligations in the venture. The joint operating agreement will typically attach an accounting procedure to determine the method of calculating the costs to be shared. The consortium usually acts through one of its members, which serves as the operator, although the consortium’s decisions are usually made by a committee, with the operator carrying out the decisions. In order to fund operations, the operator issues cash calls to the members, the prompt payment of which is necessary for ongoing operations.
The evaluation, bidding, negotiation, and acquisition phases of a project may be governed among the consortium members by a participation agreement, a study and bidding agreement, or a confidentiality agreement. Companies may agree to areas of mutual interest in which they bind themselves to participate only with one another in acquiring future interests within a defined area. Drilling agreements must be negotiated among oil companies and drilling companies. Many of these agreements today involve expensive offshore drilling platforms or ships, and may involve extensive coordination with other oil service companies. If the drilling is successful and production is economic (commercial), offtake agreements will be entered into by the members of the consortium to set out the method and procedure by which they will nominate and lift their share of the production for shipping and export. If one consortium member takes more than its share in a given period, balancing agreements may be necessary. Transportation agreements of various types will also be necessary for shipment, generally by sea or by pipeline. Finally, crude oil sales or exchange agreements will be negotiated by the companies to dispose of their product. Each of these agreements, and each step of this chain, involves numerous issues that may create a dispute and a need for international arbitration.
International contracts not only deal with oil, but also with natural gas. Natural gas is found in oil reservoirs (associated gas) or by itself (non-associated gas). The traditional methods for natural gas exploration are the same as for oil. In the past, wells drilled for oil that discovered only natural gas were often plugged because of the expense of transporting the gas and the lack of a natural gas infrastructure in most countries.This has changed due to innovations in extraction and transportation technologies, and the development of gas infrastructures in many nations. These innovations have changed the landscape of the oil and gas industry and created new international issues.
The increase in natural gas production has facilitated advancements in transportation technology. In the past two decades, companies have become more willing to bear the expense of facilities to transport natural gas by pipeline, to construct liquefied natural gas (LNG) facilities, or to consume gas locally through power plants. Historically, many contracts with host governments for oil exploration and production included only a short provision stating that if non-associated natural gas was discovered in commercial quantities, then the parties would negotiate a new agreement for the exploitation of the gas. This agreement to negotiate has raised challenges for the international petroleum industry.
Horizontal drilling and hydraulic fracturing, or ‘fracking’, is yet another significant technological advancement. Fracking allows access to oil and gas trapped in impermeable rock. It was pioneered in the United States and has returned the US to ‘the role of energy-producing super-power’. Other countries are considering implementing this technology, including China, Argentina, Australia, Canada, Mexico and South Africa. This is likely to require foreign investment and international partnerships among investors and countries. Although fracking has proven successful for production, there are environmental concerns that may slow down or prevent its implementation in several jurisdictions. Only time will tell the scope and range of foreign investment that will take place in this area, but a need for international arbitration is probable.
Other interests often intersect with the energy sector, such as environmental issues. They have risen to prominence through efforts involving corporate responsibility, brand management, environmental activism and changing regulations. Moreover, environmental legal norms have become increasingly internationalised. Indeed, there are now over 20 multilateral environmental treaties relating to the environment and at least the beginnings of the emergence of a customary international law on the subject. Environmental issues are increasingly involved in international arbitration, and are occasionally raised as counterclaims by respondent states in investment arbitrations.
Upstream, downstream and midstream
The energy industry is essentially divided into three segments: upstream, downstream and midstream. These segments basically represent four main activities necessary to the energy industry: producing, transporting, refining and selling at retail. Upstream refers to exploring for oil and gas reservoirs, drilling wells and producing hydrocarbons, also known as exploration and production. It is the largest segment of the industry. The downstream segment entails refining, processing, distributing and marketing the oil and gas products. Midstream refers to the transportation of oil and gas in-between the initial production and the end user of the hydrocarbons. Note that these three segments are governed by different laws and are subject to different administrative and environmental regulations.
Private energy companies are often classified as a ‘major’ or as an ‘independent’ company. To be classified as a major, a company must be an ‘integrated’ oil company, taking part in producing, transporting, refining, and selling oil and gas products at retail. Independent companies are those that engage in fewer than all four of these four main activities. Initially, the industry was controlled by private international oil companies. However, in recent decades they have taken a backseat to national or state-owned oil companies.
The changing role of host states in the international energy industry
Oil and gas producing states are, of course, essential players in the energy industry. The energy sector has long been considered essential to security, geopolitical and vital national economic interests. This makes investments in the energy sector especially vulnerable to regulatory change and political risk.
As the international energy industry developed, host states evolved from being a ‘passive’ business partner (e.g., old concession contracts) to being active and controlling forces, (e.g., nationalisation, production sharing agreements, state-owned oil companies and regulation). States may participate in the energy industry through a national oil company or through an energy ministry or other governmental agencies. This will vary depending on the country’s national and legal culture. Many countries have hydrocarbon laws defining governmental policies, organising the industry, and creating incentives and disincentives for oil companies.
The position of a host state on various issues may shift over time, from imposing inflexible contractual terms, to promoting investment-friendly conditions, to changing their laws and regulations, often depending on popular sentiment or the need for investments depending on oil prices and whether reserves or production are declining. Take the case of Mexico, for example. In 1938, the Mexican government confiscated all foreign oil companies’ concession rights within the country. This was seen as a patriotic achievement and is still commemorated today. Since then, Mexico’s energy sector was monopolised by its national energy company, Petróleos Mexicanos (Pemex). But 76 years later, in 2014, declining production and the need for new technology pushed Mexico towards instituting energy reforms. Mexico will now allow private investors to enter its market (especially offshore and unconventional fields) and is in the process of instituting more legal reforms to facilitate the transition.
Additionally, host states not only play the role of ‘business partner’, they also fulfil a regulatory role because they decide the energy and environmental policies that an international petroleum company must follow, and they interpret and apply those regulations.
The Organization of the Petroleum Exporting Countries
The creation of the Organization of the Petroleum Exporting Countries (OPEC) in 1960 was a pivotal development in the energy industry. OPEC is a permanent, intergovernmental entity currently consisting of its five founding states: Iran, Iraq, Kuwait, Saudi Arabia and Venezuela, as well as joining members, Qatar, Libya, United Arab Emirates, Algeria, Nigeria, Ecuador and Angola. It is based in Vienna, Austria.
OPEC was first created to prevent a precipitous drop in crude oil prices caused by the discovery of huge new reserves. Over time, OPEC’s role became more prominent, and it became a vehicle for states to challenge the stance of international oil companies regarding ownership rights, to encourage the renegotiation of international oil agreements, and to engage in cartel pricing of oil.
National oil companies
Today, national oil companies play a fundamental role in the industry. Not only do they own approximately 85 per cent of oil reserves, they also represent the majority of volume growth in the industry. They were initially created in response to security and nationalistic concerns, as well as vehicles for state participation in the energy industry. But they are now deemed by some to be the ‘true giants’ of the energy sector.
Indeed, of the 20 companies ranked as the biggest in the industry in terms of ownership of reserves of oil and gas, 16 are national oil companies. National oil companies are usually created by statute or decree. Generally, all their ownership interest is held by the state and they can vary in corporate form.
National oil companies sometimes face issues that private companies don’t necessarily face. For example, national oil companies may be subject to heightened political and social pressure, or they may be required to pay higher wages or adopt inefficient production methods to favour employment. Notwithstanding, the role of national oil companies has grown from local participants to international players, often investing in oil reserves located in other countries.
Natural gas has received separate treatment in the energy industry because of the difficulty and expense associated with its transportation. For this reason, it has traditionally been produced and marketed for domestic consumption, at least in those countries with a developed infrastructure for using natural gas. Thus, cross-border transportation of natural gas was once minimal in comparison with oil. Over the past few decades, however, the landscape has changed due to energy demand, changes in oil prices, technological advances and environmental considerations (since it is a cleaner form of energy).
Natural gas is abundant in comparison with other fossil fuels. However, it is difficult to transport given its physical nature and volatility. These challenges led to the traditional wasteful use of natural gas by flaring it (burning it) on-site.
Many countries have now constructed a domestic infrastructure for using natural gas, often by building gas-fired power plants. Thus, they make use of the natural gas locally without having to transport it vast distances.
The most cost-effective way to transport natural gas is through high-pressure pipelines, but natural gas can also be transported in specialised ships once it has been liquefied (LNG). This process requires the cooling of the gas to -160 degrees Celsius, storing it in insulated tanks, transporting it in specialised ships and regasifying it at destination plants. This requires the construction of multibillion-dollar LNG facilities. But the need for energy sources and the desire to make use of natural gas discoveries have spawned a global market for LNG.
The oil and gas contract
A granting contract typically forms the foundation of an international oil and gas project. These have evolved from concession contracts to production-sharing agreements, risk service contracts and licences.
The oldest of these is the concession contract. It derived from the contracts used in the US mining industry. A concession may refer to various types of contracts, permits, licences or instruments, depending on the applicable legal system. Under the early concession agreements, a host country would essentially concede control over its energy resources to an international petroleum company. These early agreements had certain common features:
- they granted title of the oil in place to the companies;
- the concession areas covered vast tracts of land;
- the term of the concession was often 60 years or more;
- the international oil company had control over the schedule and scale of operations (exploration and production); and
Initially, concession agreements were negotiated on a case-by-case basis as international petroleum companies attempted to discover reserves and operate in new host states.
The industry has generally shifted away from concession contracts in favour of production sharing agreements (PSAs). To a significant extent, production sharing agreements are representative of the changes that the petroleum industry has experienced since the 1970s. They were first popularised in Indonesia, but were quickly adopted by other countries. Under a production sharing agreement, the host country retains ownership and the right to exploit resources while the international petroleum company is more akin to a ‘contractor hired to perform the operations’, although this is not an entirely accurate analogy since under many PSAs oil companies can report in their public filings (e.g., SEC filings in the United States) a percentage of the hydrocarbon reserves as their own. This is particularly important to companies because their stock price may be driven, in part, by their reserve profile. The contractor’s payment under a PSA involves an entitlement to recover costs once operations are successful (commercial) and to a share of the production as profit during a determinate amount of time. If the area under contract is unproductive, the contractor receives no profit. Thus, the financial and geological risk of finding oil in commercial quantities falls on the private oil companies. Typically, the company has a certain number of years to explore for oil in a defined geographic area and drill a minimum number of wells, after which it must relinquish back to the state any area from which there will be no timely occurrence of production.
Some countries use risk service contracts, which are similar to production sharing agreements. Under this type of agreement, the contractor usually provides the funds required for exploring and developing petroleum resources. The host state will allow the contractor to recover its costs through the sale of a certain percentage of the oil or gas once the project is successful. The host state will also pay the contractor a fee based on a percentage of the revenues. The state retains ownership of the resources and production.
Other host countries – the United Kingdom, for example – use a licensing system. The licences vary depending on the location (onshore, offshore) and the stage of the operation (exploration or production). Licences essentially entitle a petroleum company to operate in a specific geographical area in exchange for a royalty or fee. Generally speaking, the government has ample policing powers over the licensee, and the licence can be revoked for a number of reasons.
The Association of International Petroleum Negotiators is a well-known, independent, not-for-profit association for professionals involved in the energy industry. It has developed a robust collection of model contracts, including virtually all of the categories mentioned above, as well as certain commentaries. These can be found on its website and provide a more detailed understanding of the various contracts’ clauses and differences.
Overview of energy-related investment disputes
A foreign investment dispute is a controversy between an investor from one state and a foreign government relating to an investment in the host state. Foreign investment has been given protection through international treaties, conventions and by customary international law, and over time a subset of international law regulating investment disputes has emerged. Today, there are a sizeable number of international arbitral awards relating to the petroleum industry.
Under traditional international law, corporations and individuals did not have standing to bring claims directly against governments. Diplomatic protection was the only remedy available to a citizen of a state with a claim against a foreign government. Under this regime, the foreign investor would bring grievances to the domestic courts of the host state or to the officials of their own country. The investor’s government would then have the discretion to espouse the claim against the foreign government and protect the investor’s rights through an exchange of diplomatic notes, or more recently by bringing a claim before the International Court of Justice.
When the national governments of host states began to expropriate foreign-owned projects in the 19th century, they purported to rely upon the international law principle of territorial sovereignty. Local courts were often viewed as unsympathetic to foreign investors or were required to give effect to the local expropriating decree, leading the investors to turn to their own governments for assistance. The investors’ governments, if they were inclined to help their nationals, responded based on the international law principle of nationality (in this context, the state’s interest in representing its nationals).
Diplomatic protection proved inadequate for many reasons. For the investor, the availability of the remedy was unpredictable and subject to the government’s many other interests. For the government, it was an unwieldy instrument for dealing with foreign investment issues. The intervention of the investor’s government inevitably created conflicts with the host state. It also had the potential to affect relationships with other states. As the problems that governments faced became more complex and governments developed larger organisations to handle them, it became clear that more economical alternatives to diplomatic protection and intervention were necessary. But an analogue to national adjudication was not feasible, for international law at that time did not recognise natural or juridical persons as proper subjects. Thus, the international community looked for instruments that could provide an adequate forum and remedy.
The ICSID Convention
In 1965, under the sponsorship of the International Bank for Reconstruction and Development, the Convention on the Settlement of Investment Disputes between States and Nationals of Other States was executed and came into effect in 1966 (the ICSID Convention). The Convention created the International Centre for Settlement of Investment Disputes (ICSID) to administer arbitrations between contracting governments and nationals of other contracting governments for disputes relating directly to an investment. ICSID, in turn, promulgated sets of arbitral and conciliation rules. ICSID was designed specifically to administer arbitrations of foreign investment disputes. Unlike other major arbitral institutions, ICSID has jurisdictional requirements. As of this publication, 151 countries have ratified the ICSID Convention.
Reports show that almost 40 per cent of all cases registered with ICSID (and its Additional Facility) between 1972 and 2012 involved the energy sector, with oil, gas and mining disputes representing 35 per cent of all ICSID claims in 2014.
The New York Convention
The United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards (the New York Convention) was adopted on 10 June 1958 and entered into force on 7 June 1959. This treaty is the most significant contemporary legislative instrument relating to international commercial arbitration. It provides a universal constitutional charter for the international arbitral process and has proven to be an effective framework for enforcing international arbitration agreements and arbitral awards. It is of relevance in enforcing all non-ICSID investment arbitral awards; ICSID cases exclusively involve the ICSID Convention.
The North American Free Trade Agreement
There are several regional trade agreements in place. But the North American Free Trade Agreement (NAFTA) is of particular importance. NAFTA was concluded by the governments of Canada, Mexico and the United States of America in 1992. It provides standards of treatment that governments must afford investors from other NAFTA states. As in bilateral investment treaties, the governments consent to international arbitration of any investment disputes with qualifying private investors from the other contracting states. Since NAFTA entered into force, each of the contracting governments has been the target of several NAFTA arbitrations.
The Energy Charter Treaty
The Energy Charter Treaty (ECT) first came into effect in 1994. It now includes more than 50 member states, mostly in Eastern and Central Europe, and the European Union and Euratom. It is the only multinational treaty specifically dealing with investment issues in the energy industry. The introduction to the ECT explains that the ‘fundamental aim of the Energy Charter Treaty is to strengthen the rule of law on energy issues, by creating a level playing field of rules to be observed by all participating governments, thus minimising the risks associated with energy-related investments and trade’. It ‘ensures the protection of foreign energy investments based on the principle of non-discrimination’. The treaty also provides governmental consent to ad hoc international arbitration to resolve disputes with foreign investors arising from their substantive obligations. More than 50 arbitrations have been brought under the ECT.
Bilateral investment treaties
Modern bilateral investment treaties (BITs) were first adopted in the 1960s by European countries seeking to protect their nationals’ investments abroad. The United States then followed suit in the 1970s. The proliferation of BITs signalled an important landmark in international relations and arbitration. To date, almost 3,000 BITs have been signed. They contain similar provisions, leading some scholars to conclude that they may now express the customary international law standards for foreign investment. These treaties create actionable standards of conduct for governments in their treatment of foreign investment, and typically provide for international arbitration to resolve disputes arising from allegations of a violation of the treaty.
Over the past few decades, international tribunals have addressed many of the issues and facets of the energy industry. These have included claims under bilateral and regional treaties as well as customary international law dealing with expropriations, unfair and unequal treatment, and denial of justice. This book will address them, with each section highlighting a different facet of the international energy industry.
Hopefully, the reader will find in these pages a useful introduction and worthwhile information concerning the arbitration of international energy disputes.
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