It is no exaggeration to say that the industry is currently facing a perfect storm. On the one hand, at present there appears to be no real prospect of a resolution to the geo-political instability in the Middle East and in the Ukraine. On the other, Opec, driven by Saudi Arabia and varying political motives, has refused to cut their own production in an effort to safeguard their market share.

In response, the price of oil has crashed and there is widespread industry confusion over whether this is a short-term dip, the “new normal” or there is further for the price to fall, perhaps even well below US$60 per barrel – in early January 2015, the price of Brent crude oil fell to below US$50 a barrel for the first time since May 2009. Consequently, the only certainty for the industry in 2015 is uncertainty.

What is clear, though, is that the current environment presents both risks and opportunities for players of all sizes and those involved in all market segments. This article considers some of the critical factors that companies must bear in mind as they seek either to reduce their financial exposure or to take advantage of market conditions to increase their asset portfolios.

Risks in reducing financial exposure to existing projects

The press is currently full of reports of oil and gas exploration projects that either have already been, or are about to be, cancelled. For example, Chevron has apparently postponed plans to drill in the Artic Beaufort Sea off the north coast of Canada and Shell has reportedly decided not to continue with its Jackpine mine expansion for its Athabasca oil sands project in Canada. Shell will also not be progressing plans to build a liquefied natural gas export terminal in British Columbia. If some of the largest players in the market are feeling the pain, then it is only to be expected that it will be more keenly felt by those at the mid-market level and below.

Any such company may, therefore, be considering whether or not the projects in which it is currently involved can be economic with oil trading at or around US$50 – 60 per barrel. If the conclusion is that the project will in fact now lose money, there are difficult decisions to be made.

Understanding legal and financial effect of terminating contracts

Clearly, any company in this situation will look at the contracts it entered into in relation to each project to see what the termination rights allow. Any analysis of these rights and their effect in practice must be careful and strategic in considering what action should or should not be taken. A careful balancing act must carried out in relation to the risk of terminating the contract wrongfully, which could lead to a significant claim for damages from the contract counterparty (not to mention reputational damage), against the losses that could ultimately flow from pursuing the project.

Operator case study

The difficulty of such a scenario is illustrated well by looking at the position of an Operator involved in the exploration of an offshore block. The Operator and its partners in the exploration will face the huge daily costs of hiring a drilling rig, which can range between US$60,000 to US$600,000 per day. In most cases, it is likely that only the Operator will have entered into the contract with the rig operator (even if the partners are obliged by the terms of the joint operating agreement to reimburse the Operator for their share of the cost in line with their participating interests). In addition, it is again usual practice for the Operator only to enter into the contracts with those companies providing support services to the drilling operation.

Yet, with the price of oil as low as it is, it could quite quickly become obvious that even if wells which were drilled met the top end of their predicted production, the exploration would ultimately be far from economic and the Operator would be likely to suffer a substantial loss. However, if the Operator simply ignored its obligations or tried to avoid them by seeking to terminate its contract with the drilling rig and the support services providers, it could face a storm of litigation in the form of claims for damages from the drilling rig provider, the support services providers and its partners under the joint operating agreement. Further, it could also become liable to payment/guarantee obligations arising out of the licence to exploit the block, secured from the local government ministry, for failure to meet the milestones required by the minimum work programme. It may even lose the concession altogether, preventing later attempts to exploit when the oil price recovers.

The strategic solution

The solution to this problem is not easy: the Operator cannot change market conditions and it cannot immediately, or perhaps ever (if counterparties will not agree to amend the relevant terms), change the scope of its contractual obligations. There may be a temptation for parties in this situation to seek to rely on the force majeure provisions that are undoubtedly incorporated into these contracts. Whilst each clause should be looked at carefully, the exemptions are usually specific and restrictive such that they would not include a change in economic conditions such as a fall in the price of oil. Added to this, in most situations, it is notoriously difficult, even if an event falls within the scope of the clause, for a party successfully to rely on a force majeure clause as a way of avoiding its contractual obligations.

What the Operator, and players involved in projects of any nature, can do is look at its contracts now, with a particular focus on the termination provisions, to gain a clear understanding of the practical reality of its legal obligations. This evaluation can then be factored into the economic analysis and it is only on that basis that a proper strategic plan can be put in place for the way forward. Furthermore, by taking early legal advice, the termination exercise can be properly managed so as to minimise potential exposure to claims.

If a dispute has already arisen, then involving skilled litigators/arbitrators as soon as possible can increase the chances of early settlement. Practitioners who understand formal dispute procedures are also experienced at using informal alternative dispute procedures to resolve a dispute before proceedings are even issued.

Merger opportunity?

As with any industry in crisis, merger activity can substantially increase as players take the opportunity to purchase distressed companies to gain access to potentially valuable assets at a discount. This activity is already evident at the top of the market with the recently concluded deal by which Repsol agreed to buy Talisman Energy for US$8.3 billion and from the on-going merger negotiations between Halliburton and Baker Hughes.

Gain through acquisition

In 2015, however, there is likely to be consolidation among companies at the mid and lower end of the market as the effect of the fall in the price of oil starts to make projects and businesses uneconomic. As such, the year could well be one of gain for those companies that can afford to be acquisitive and one of profound loss, both in terms of business and stress and uncertainty for employees, for those companies which become targets as a result of their financial fragility.

In these circumstances, it is possible that we could see a feeding frenzy as aggressive purchasers pursue weak sellers for their assets. Yet, as well as opportunity, this scenario also presents risk to parties on both sides of the deal. There may be the temptation for purchasers to accelerate the timetable for, or even reduce the scope of, the due diligence exercise that is to be carried out with respect to a target. This would be a mistake.

Areas of risk in M&A deals

Time and expense saved in limiting the due diligence could ultimately result in a substantial cost if, in the pursuit of choice assets, a purchaser ends up acquiring a company that also has buried problems. There is a similar risk for targets if they do not invest in preparing properly for a sale. Deals could be lost if policies and procedures, particularly in the bribery and corruption space, are not up-to-date or properly implemented. Further, a less than meticulous approach to due diligence enquiries could open up exposure to breach of warranty claims in the future. Clearly, this could raise serious issues and potential substantial financial liability for those that gave warranties in the sale and purchase agreement, whether they were individuals or a parent company.

These problems can be avoided if purchasers and targets start considering their deal approaches now. Purchasers can map out, and seek advice on, the scope of the minimum due diligence exercise that would be needed in any acquisition. Targets can review now the detail of their financial performance, policies and procedures and other issues, such as environmental liability and outstanding litigation claims, so that they can put themselves in the best position to respond to any approach.

Final thought

There is no escaping the uncertainty that 2015 will bring, but this does not mean that there is nothing that can be done now to prepare for it. Resisting the urge to cut corners and obtaining early legal advice can mitigate the risks and maximise the opportunities that come with this almost unprecedented turbulence in the oil & gas industry. Truly, a stitch in time can save millions.