Manuel A Abdala, Compass Lexecon
This is an extract from the third edition of GAR’s The Guide to Damages in International Arbitration. The whole publication is available here.
The importance of energy and natural resources matters in arbitration
According to the 2016 ICSID caseload statistics report, 26 per cent of currently registered cases are related to disputes in the oil, gas and mining sectors. Similarly, a look at the ICC caseload data reveals that the energy sector made up the largest segment of arbitrations in 2014, comprising 18.6 per cent of the entire ICC caseload in that year. It is no coincidence that about one-quarter of total treaty and commercial arbitration cases are related to energy and natural resources. These sectors share at least two key economic attributes that make them susceptible to disputes: their output prices are subject to substantial volatility and their investments soon become sunk (i.e., cannot be easily moved to alternative uses). These features make energy and natural resources assets particularly vulnerable to opportunism, where the parties with an economic stake in their generation of profits (private or public) are likely to seek to change terms to their favour.
When market prices of natural resources change dramatically, parties that are involved in long-term contracts might have strong incentives to renegotiate – and when renegotiation is not viable or feasible, disputes arise. The increased volatility in commodity prices that started in 2003, for example, illustrates why so many crude oil, natural gas and gold mining arrangements agreed upon prior to this point in time are ending up in renegotiation, mediation, arbitration or litigation.
The likelihood for price renegotiation and changes in the regulatory regime is high in energy and natural resource projects given the high capital investment necessary to develop reserves and unleash production. Once the exploration risks have been overcome and the associated investment costs have been sunk, governments may be tempted to act opportunistically, knowing that investors cannot move their sunk assets to alternative uses. Under these circumstances, sovereigns may attempt to increase their ‘government take’ on natural resources, either through increasing taxation, royalties, fees, rights and duties by altering the pre-existing profit-sharing or revenue-sharing agreements with the private sector, or by demanding that private companies relinquish shareholdings in their companies to the state or to a state-owned oil company. Similarly, private parties may renege to their obligations if deemed to have become too onerous. Disputes among shareholders will equally become more likely given that the volatility of prices may alter the initial allocation of risks between partners in ways that were unforeseen or unexpected.
Key valuation issues affecting damages methodologies in extractive resources matters
Estimating damages compensation in international arbitration disputes in extractive resources industries poses several challenges from the perspective of a damages valuation expert. A valuation expert must ask the following basic questions:
- What is the size and quality of reserves that are economically extractable?
- At what price can these reserves be sold and what is the exposure to price volatility?
- What is the nature of the contractual rights to exploit the resource (i.e., how long is the term of the contract, and what type of exposure to regulatory and country risk exists)?
- What is the underlying legal theory of the case and how does such theory determine the date of valuation?
The size and nature of economically extractable reserves
Assets in energy and natural resources markets derive a significant portion of their value from their potential to extract estimated resources at some future date. As a result, the amount of economically extractable reserves plays a significant role in value determination for any energy or natural resources asset.
Reserves estimates are largely a function of the current and future expected price of that resource in the market. As market prices rise, a greater portion of the resource in the ground becomes economically viable for extraction. The opposite is also true. In fact, the decline in crude oil prices that began in the second half of 2015 and continued into 2016 caused many large oil companies, such as BP, Shell, Total and Exxon Mobil to cut back billions in investment, affecting the size of their future reserves. Similarly, in the Canadian oil sands, where producers have some of the highest break-even costs globally, the price of crude oil plays a significant role in the decision to extract. In August 2015, for example, it was estimated that as a result of low crude oil prices, more than three-quarters of Canada’s 2.2 million barrels per day of oil sands production was no longer economically recoverable.
Economically extractable reserves can be categorised into proven developed (PD) reserves and proved undeveloped (PUD) reserves, a distinction that can provide useful insight when calculating damages in energy and natural resources disputes. PD reserves are those that can be produced with existing wells, or from additional reservoirs where minimal additional investment is required. PUD reserves, on the other hand, require additional capital investment, such as the drilling of new wells, to extract the resource from the ground.
In oil and gas industries, proven reserves are referred to as 1P, denoting a ‘reasonable certainty’, or high degree of confidence, of being recovered.
Valuation experts, however, may also consider the inclusion of unproven reserves weighted (or ‘risked’) by their probability of extraction, since unproven reserves have a lower level of technical certainty of recovery. Unproven reserves are classified as probable (together with proven reserves, referred to as 2P) and possible (together with proven and probable reserves, referred to as 3P).
In mining industries, reserves are simply the part of an identified resource that could be economically extracted or produced at the time of determination. Additionally, in mining, particular attention is paid to the cut-off grade, which is used as the level of mineral in an ore, below which it may not be economically feasible to mine – an important distinction when measuring reserves for use in the valuation of assets.
Valuation experts would typically rely on technical assessments from reserve experts or outfits that certify the size of extractable reserves at any given point in time. Given that output prices are volatile, it is important that the reserve certification be contemporaneous to the date of valuation, as otherwise the size of economically extractable reserves might be overestimated or underestimated.
Impact of price forecasts and volatility on value
Forecasting output prices involves making decisions about future values that might be too volatile and difficult to predict. Valuation experts can seek to mitigate these features by using price forecasts based on either market-based data or by resorting to specialised outfits that model supply and demand so as to obtain expected model equilibrium prices.
Market-based data on price forecasts can be derived by looking at futures contracts and spot prices. Futures contracts are useful in that they provide forecasters with market evidence of contractual agreements between the buyers and sellers of a particular commodity, and therefore might serve as a benchmark for future price levels. Spot prices, on the other hand, provide forecasters with a current view of the market, but could have the shortcoming of not anticipating changes in supply and demand conditions that are expected in the marketplace. Given the wide array of price forecasts that are present in the market for most commodities, valuation experts can derive an opinion of expected output prices based on both existing market information and the myriad forecasts established by specialised outfits.
By using all available information, possibly discarding projections that are considered extreme or outliers to the sample, and adopting a path that is consistent with the majority of forecasts and information from futures contracts, valuation experts can make informed and comprehensive decisions about price expectations in the future.
Contractual terms and adjustment for proper regulatory and country risk exposure
While typically challenging to quantify, contractual, regulatory and country-specific risks play an equally important role in calculating damages in energy and natural resources disputes. Contractual terms and regulatory conditions can significantly impact the risk inherent in the valuation of any asset, and therefore adjustments are required to account for the risk exposure of the specific asset being valued.
Contract length, for one, can have a direct impact on the estimate of reserves at a particular site. Shorter production contract terms imply a lower economically extractable reserves estimate, given the time constraint inherent in the contract itself. For that same reason, contract renewal provisions play an important role in the valuation of natural resources assets, particularly in the calculation of their terminal value.
Similarly, the location of an asset matters, as the associated risks of operating the asset from a particular jurisdiction depend on whether the asset is located in a country with a predictable economy and strong institutions, such as the United States and Germany. The term ‘exposure to country risk’, therefore, is used to capture incremental risks such as:
- the additional volatility of domestic demand, which may be more prone to recessions and booms as compared to a more developed economy;
- the infrastructure of a developing economy, which may expose the asset to supply risks as services, logistics and suppliers may be unreliable;
- governmental actions and macroeconomic policy affecting businesses, which may be unstable, thereby affecting volatility and thus increasing the overall risks of doing business; and
- exposure to changes in taxation, royalties and other forms of ‘government take’.
A distinction must be made between general country risk and the specific exposure that any particular asset might have to this risk. General country risk measures the incremental risk that an average investor faces from investing in a particular country. The specific exposure of country risk, by contrast, is the incremental risk that an investor in the target asset faces taking into account the particular protections and safeguards that such asset might have, which may differ from that of an average investor with assets in any other industry.
Because energy and natural resources assets involve sunk investments and are particularly prone to government opportunism, they typically exhibit characteristics that shield them, at least in part, from the full extent of the general country risk associated with the assets’ location. Most notably, significant portions of revenue from these assets are isolated from country-specific demand risk, given that their products (i.e., commodities) are traded worldwide. In addition, from a regulatory perspective, many contracts include explicit protections against egregious tax measures and the size of the ‘government take’, or simply provide tax stabilisation clauses.
As a result, it is important that valuation experts take into account the specific exposure of the project to country risk, and not simply apply a standardised measure of country risk to the asset, without any adjustment. In fact, in the Gold Reserve v. Venezuela award, the tribunal rejected the discount rate proposed by one of the parties’ experts, noting that it ‘was based on both full and “generic” country risk for an investment in Venezuela’, and therefore did not adjust for the risk that was specific to the assets in question.
The fit to the legal theory and the choice of date of valuation
In addition to the intrinsic value of the asset in question, the valuation expert must take into account the underlying legal theory, which in turn can influence the choice of date of valuation. In international arbitration, the standard concerning remedies for damages arising from an illegal act is the judgment of the Permanent Court of International Justice in the Chorzów case. Under this judgment, restitution in kind is the primary remedy; payment of compensation is to take its place if restitution is not possible. There is some consensus that the Chorzów judgment requires tribunals to award the highest of (1) the value on the date of expropriation (plus interest) or (2) the current value as at the date of the award (plus historical lost profits). Subsequent tribunals have applied this ‘highest of’ standard in cases where the legal theory fits with a principle of restitution (typically related to a finding of an expropriation being unlawful).
The selection of valuation dates and to what extent the damage expert should use the benefits of hindsight information in performing a valuation is of considerable importance, given the volatility of commodity prices. Whereas in cases of lawful expropriation it might be important to value the asset using expectations as of the time of the taking (also known as an ex ante valuation exercise), it is equally important to use hindsight information in cases in which the date of valuation is set as the date of award (also known as an ex post valuation exercise).
In ex ante valuations particularly, the selection of a pre-judgment interest rate plays a central role in the amount of compensation awarded as at a current date. The wrong interest rate could result in a monetary award that does not fully restore the position of the damaged party in the absence of the measures. While the use of either ex post or ex ante information is valid in determining damages in energy and natural resource arbitrations, each is likely to yield a different damages result, mostly due to price volatility over the relevant period.
Unfortunately, there is no established academic consensus as to the selection of the pre-judgment interest rate and this is true not only for international arbitration but also for US litigation cases. This lack of consensus is predictably reflected in tribunals’ decisions, which have granted pre-judgment interest rates using a variety of different criteria, or even granted no interest at all. Notable criteria for a pre-judgment interest rate include interest based on the borrowing rate of the respondent, as proposed by Professors Patell, Weil and Wolfson, use of a risk-free interest rate, as proposed by Professor Fisher, or interest based on the opportunity cost of the lost investment, as advocated by John and Robin Keir.
Methodologies to assess damages in energy and natural resources cases
There are several approaches to value assets in energy and natural resources disputes. In this chapter, I briefly review the most common valuation methodologies used by practitioners.
Income-based approaches, such as the discounted cash flow (DCF) method, are quite suitable to value energy and natural resources assets because they provide a direct way to measure expected revenues (and their corresponding cash flows) into the future. In fact, the DCF method is the most common methodology used in valuation analyses involving assets in the energy and natural resources industries (as well as most other industries). First, it is widely supported by professional literature, and its workings are well understood. Indeed, most investors rely on a DCF analysis to determine whether or not to undertake a particular project. Second, the DCF approach is a widely accepted method to estimate damages and fair market valuations in international disputes; in many energy and mining cases panels have adopted the DCF method without hesitation.
In practice, the DCF method calculates future cash flows for the particular asset to be valued, and discounts them back to the agreed-upon valuation date. The method therefore requires several key inputs, such as revenues, extraction, investment, retirement and cleaning costs, discount rate, and terminal value, in addition to any other project-specific assumptions.
While the DCF method is widely used, some tribunals have been reluctant to adopt it unless the business in question was a going concern at the date of valuation. Imposing this limitation on natural resources assets, however, is counterintuitive from an economic perspective, since once the exploration stage is surpassed and the reserves are certified, there should be little doubt that reserves can be monetised into future cash flows. Operational risks would still exist, but such risks can be modelled through a discounted cash flow analysis, even if the asset is not yet operational.
Relative multiples approaches
A relative multiple is simply an expression of the market value of an asset relative to a key statistic that is assumed to relate to that value. Expressing market value in terms of a specific key statistic such as EBITDA, revenues, asset value or size of reserves standardises the value of the asset and thus allows for comparison across assets of varying absolute value. Generally, multiples can be derived from information about comparable assets or companies that trade in public markets (trading multiples) or from information about recent transactions of comparable assets or companies (transaction multiples).
In the energy and natural resources industries, specifically, multiples are typically based on cash measures, such as EBITDA or net profits, or on a market-specific metric, such as the amount of 1P reserves in the oil and gas industry or to proven and probable equivalent reserves in mining. There are, however, a number of criticisms against the use of multiples as a tool for valuing damages in energy and natural resources disputes. For one, multiples are relatively simplistic and static – that is, they distil a great deal of information into a single number that represents a snapshot of the value of an asset at a particular point in time, and thus do not capture the dynamic and ever-changing nature of energy and natural resources markets. Similarly, multiples are based on historic data or near-term forecasts, which therefore may fail to capture differences in projected growth, expected life term of the reservoir, and performance over the longer term. Additionally, damages valuations based on relative multiples approaches must be adjusted to account for, among other considerations, large or small sample size issues, and control premiums.
Stock market capitalisation
Generically, the market capitalisation approach refers to techniques that use either the stock market price of the underlying asset (or that of its parent company) or stock market indices of benchmark companies, as a tool to evaluate and assess damages.
Computing damages in investment arbitration under the market capitalisation approach is recommended when the equity shares of the target asset under analysis are publicly traded. In addition, when the shares of the parent company of the target asset are traded and the target asset represents a significant part of its portfolio, it is also feasible to identify changes in value of the parent company attributable to changes in the value of the underlying target asset.
Under this approach, one can distinguish at least two techniques that can be used to construct a counterfactual scenario that excludes the effects of the actions by the wrongdoer. These are event studies and market trends of benchmark companies.
An event study is a statistical tool that analyses the response of a stock price to certain market announcements (i.e., events related to expropriation threats, or unfair treatment of investments), controlling for other factors producing stock price movements, such as general market and industry trends, or other company-specific announcements. The assumption behind an event study is that the effect of an event is reflected immediately in the price of the company shares, making it possible to statistically isolate and quantify the impact of the wrongful actions.
The market capitalisation approach that looks at the trends of stock prices from benchmark companies consists of building a but-for scenario in which the stock price of the target company that existed (or would have existed) in the absence of the wrongful actions is adjusted until the date of valuation following the evolution of an index (or a basket of indices) of publicly traded benchmark companies. Using an index of benchmark companies to mimic the but-for scenario of the target asset allows the valuation expert to incorporate two of the major factors affecting stock prices: (1) the movements reflecting economy-wide information; and (2) movements reflecting industry-related information. This method is particularly well-suited for investment disputes involving full expropriation of traded assets, provided that the expert can properly establish the latest clean date before any threats or actions of expropriation, and a set of benchmark companies that are also traded and whose evolution and trends prior to the measures are comparable to the target company.
Various other valuation methodologies exist. Asset-based approaches, utilising either replacement values or book values of assets, and liquidation value can be advocated but are not likely to be very useful in determining damages in energy and natural resources cases because they would typically depart from market values. Such methods provide an historical account of past investments and thus will not represent the value that shareholders can extract from future cash flows, thus failing to account for the true value (and risks) related to the activity.
Liquidation value, in particular, assumes the assets are no longer a going concern and thus assigns value based on prices at which physical assets, such as real estate, fixtures, equipment and inventory could be sold, typically at a discount to market value. Book values, in turn, will incorporate accounting rules and principles that typically fail to track the market value of the assets. In addition, in emerging countries, accounting legislation might not even require companies to attempt to price their assets in the books according to market values. Thus, discrepancies between market values and book values are likely to be common and relevant, in particular given the volatility of commodity prices, which directly affect the market value of natural resource companies.
Cost-based approaches are not likely to be useful either, as they value assets based on the cost of the land and construction, less any depreciation, and would most likely fail to represent the value that shareholders could extract from future cash flows. The only instance in which cost-based valuation approaches may be appropriate would be for valuing energy or natural resources assets that are in an exploration stage, at which point in time the value of the asset may be restricted to its cost given that there would not yet be any reasonable expectations of future cash flows.
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