Recent weeks have brought oil right back into a bear market, with both WTI and Brent trading well below US $50 a barrel. This is despite renewed pledges by the Organization of the Petroleum Exporting Countries (OPEC) to curtail oil production. Since the 2014 price collapse, the cartel has lost its ability to dictate crude prices, for the most part due to US shale output which can quickly be scaled up and down depending on where the oil prices are.
But US shale becoming the swing producer is just one piece of a much bigger jigsaw: a transition of the global energy markets away from almost exclusive reliance on oil and other fossil fuels. Other factors already have, or will soon have, a major impact on oil prices:
- The growth of renewables for power production, at levelised costs that are increasingly becoming competitive with fossil fuels and nuclear.
- The shift to cleaner and nimbler conventional sources of electricity generation, particularly gas.
- Rapid development of battery technologies that already allow for storage of locally-produced renewable energy.
- A growing fleet of electric vehicles that can serve as batteries for home microgrids.
While the first three factors affect oil demand only to a limited extent, the last factor may be a game changer, particularly when trucks come into the fold. Many experts agree that these trends are only likely to accelerate. Assuming this is right, what does the future hold for countries reliant on oil exports? The available data shows the tremendous impact that the low oil price environment has already had on oil-producing states. A note recently published by the U.S. Energy Information Administration (EIA) confirms that OPEC net oil revenues in 2016 were the lowest since 2004. In recent years, the OPEC countries’ total oil revenues fell from US $1,182 billion in 2012 to US $433 billion in 2016. This is a devastating reduction in income for these largely developing economies, many of which are insufficiently diversified. If US $50 oil is here to stay, economies reliant to a very large extent on oil-sales proceeds, such as Angola, Algeria, Equatorial Guinea, Gabon, Iraq or Venezuela, may undergo a forced rebalancing. Recent events in Venezuela suggest that, unfortunately, this can include large-scale social unrest.
How does all of this translate into the investor-state disputes arena?
The first aspect to consider is investment flows. Oil-producing countries have been recipients of large amounts of foreign direct investment (FDI), much of which has gone into oil and gas exploration and production. For example, the 2016 inward FDI stock for Gabon stood at 52.3% of its gross domestic product (GDP). For Equatorial Guinea, the number is a staggering 115.3% of GDP. In these countries state budgets are as dependent on oil proceeds as their labour markets are dependent on continued investment flows. A collapse in either would spell disaster. Yet, as international and national oil companies are scaling back capital expenditure programmes, investment flows will probably reduce significantly in the coming years. Insofar as investor-state arbitration is concerned, lower rates of foreign investment create less scope for investment protection to come into play. But that ignores the real issue of concern to investors, namely their existing investments.
Investors in many oil producing countries benefit from treaty protections, whether under bilateral investment treaties (BITs) or multilateral investment treaties (MITs), such as the Energy Charter Treaty (ECT). How might a host state extract more value from an existing project without breaching investor protections? Tax increases or royalties are measures that come to mind, as they are often excluded from investor protection arrangements (for example, under Article 21 of the ECT). This does not mean, however, that persistent low oil prices will bring widespread state interference cloaked in the legitimacy of taxation measures. This is largely because there is strong interdependence between foreign owners of oil and gas producing infrastructure and host governments. From the state’s perspective, the more assets there are, and the more these assets produce, the higher the revenues for the state budget. Oil-rich states therefore realise that future revenues are dependent on continued investor confidence at least in two respects:
A loss of investor trust will likely result in cancellation of future projects.
Faced with a grab of proceeds from their existing assets, the international investor in question might be unwilling to continue investing in those assets.
This can lead to markedly lower production. For example, many oil wells can produce more than initially estimated through the use of new extraction technologies, such as horizontal drilling and hydraulic fracturing, but these require both highly specialised know-how and additional investment, none of which is likely to be forthcoming in an environment perceived as hostile to investors. To a degree, this symbiotic relationship is a natural hedge against government interference.
But what is rational in the long term does not necessarily influence immediate actions by governments, particularly ones strapped for cash and trying to combat popular discontent among its citizens. When a state takes over the ownership of a foreign investor’s assets, it can either compensate the investor fairly (a “lawful expropriation”) or not (“unlawful expropriation”). What constitutes fair compensation for a producing asset in a low oil price environment? Fair compensation should reflect the valuation of the asset immediately before the date of expropriation. The lower the price of the commodity, the lower the value of the asset. This can tempt governments to take assets when oil prices are particularly low and to provide compensation to investors based on those depressed prices. If commodity prices rebound a couple of years down the line, the state would keep the benefits.
Where unlawful expropriation is concerned, a number of recent arbitral decisions suggests that tribunals may be willing to compensate the investor for post-expropriation uplifts in asset values. While this might encourage oil-rich countries to engage in strategic nationalisation programmes, in reality, their cash-strapped budgets are unlikely to allow for paying compensation required from a series of lawful asset-taking. This scenario may not prove particularly likely. If expropriations happen in oil-dependent economies in future years, a considerable proportion are likely to be unlawful.
Assume that a state engages in a string of unlawful expropriations over time. This will further depress the valuations of existing (not yet expropriated) assets. Put simply, the asset values will be reduced to reflect the heightened risk of expropriation. A number of ICSID awards involving Venezuela considered whether this depletion of value should be borne by the state or by the investor. Some tribunals held that this further reduction in the asset’s value will reduce the damages due to the investor (who is taken to assume all risks of investing in the host state). Tribunals in other cases took the opposite view. In Gold Reserve v Venezuela, the tribunal disregarded “over-inflated” expropriation risk in awarding compensation to the investor. This latter view appears to be gaining traction, on the compelling basis that it prevents the state from benefiting from its own wrongdoing.
What next for the arbitration community?
In times of popular discontent and civil unrest it is not just the government but also the general population that might seek to profit from foreign-owned projects. Nigeria’s ongoing problems with crude theft and pipeline sabotage in the Niger Delta are a case in point. Investors might try to seek compensation for acts of this kind by invoking the so-called “Full (or Constant) Protection and Security” standard. The main questions that will be relevant in the determination of such claims will be the standard of protection to which the investor is entitled and whether the state has met that standard. If low oil prices persist, the arbitration community is likely to see a number of cases dealing with these matters.
When discussing the oil price, it is easy to ignore the effect that the new economic reality has for states that rely disproportionately on oil revenues to balance their budgets. The potential dangers can be dire and include civil strife, the toppling of governments and, in extreme cases, humanitarian crises. If the trend of low oil prices continues, which appears likely given the macroeconomic context, some of these risks are bound to materialise. They can have significant impacts on international investments. While investors might be able to obtain remedies under investment protection treaties, this will require protracted arbitrations and, in many instances, will only risk exacerbating the underlying issues in the host state. It is in the international community’s interest for oil-rich states to accelerate the diversification of their economies. This appears to be the only path that can guarantee the welfare of their citizens if the energy future is, indeed, green. If these economies become more balanced, risk to existing and planned investments in oil infrastructure will fall exponentially. While this might mean fewer arbitrations, that might not be such a bad outcome.
*This article first appeared on the Practical Law Arbitration Blog on 28 June 2017.