Risk allocation methods in oil and gas joint venture contracts

¶ … risk allocated in oil and gas contracts?

Petroleum agreements

Joint Venture Agreements (JV)

Contractual indemnity

Indemnity clauses in Oil and gas contracts

The legal interpretation of the indemnity clauses

Relationship between Operator and Contractor

Rights and obligations under the contract

Exclusion clauses

Limitation on liability clauses

Willful misconduct and gross misconduct

Fiduciary relationship: utmost good faith

Types of risks in Joint Ventures

Investment and business risks

Environmental risks

Deficit of human capital

The worsening of fiscal terms

Control of costs

The competition for Reserves

Risk allocation

The allocation of risks in oil and gas contract is a complicated legal process that has different approaches. The preferred methods all have different legal interpretations. In this paper, we analyze the methods and process of allocating risks in oil and gas contracts from the legal perspective. We study the different petroleum agreements with illustrations using relevant court cases. A great deal of attention is given to the relationship that exists between the operator and the contractor.

Petroleum agreements

There are various types of international petroleum agreements. The primary types include; concession agreements, service contracts, production sharing, contracts and joint venture agreements as well hybrids of these IPAs. Other than the political risks involved, the international petroleum usually involves very huge long-term investments that have equally large starting capital. Other risks involved are related to instability both economic and geographical. The long-term uncertainty is further compounded by managerial and technical risks (Rappaport, 2006).Petroleum products are universal products which are needed by all the nations in the world, this is because the products are very important of machines and vehicles. Petroleum is said to be as important as electricity. In most instances the expenses of mining coal which is the petroleum's raw material has become very expensive and many countries with coal have not been able to excavate it by themselves. It therefore implies that in the excavation of coal, many companies do come together with the aim of mining it. In a normal life scenario, it is advisable that when two or more people come together, they must have common goal and norms on how to achieve the goal. It is also advisable that each party should be given a part to play in the group.

In cases where two or more companies come together, the issue of legal obligation and contracts are always introduced. In this case the concerned companies come to mutual agreement on which company is responsible for undertaking which activity. Over the years, international petroleum agreements have evolved considerably in response to a variety of economic, social, environmental and geo-logical factors.For that reasons there are several contracts guiding petroleum agreements including; Concession Agreements (CA), Service Contracts (SC), Joint Venture Agreements (JV), and Production Sharing Agreement (PSA). Concession agreement is where the foreign oil companies were given full ownership of oil and gas and they controlled operations and associated risks by themselves. This form of contract was abolished in early 1940s to pave way for the other three types of agreements which included the task of giving the host government a role to play in the petroleum mining. Joint Venture include an agreement between the Host country and the oil company coming to mutual agreement on how they are going to share the benefits of the products .

Joint Venture Agreements (JV)

Joint venture is a term used in the description of an activity that is carried out by two or more bodies/entities in which the member entities each have certain degree of control. This allows the two parties to participate for the benefits of the venture. Nicola (2010) pointed out that the recent economic downturn has caused a number of joint ventures (JVs ) being announced to the general market by dropping by an approximated 50% in the initial half of the year 2009.The relationship of the contractor and the operator in a joint venture is very delicate and yet clearly defined. The concept of joint venture in the oil and gas industry entails the act of one person undertaking the interest of the other party .A judicial duty easily arises.A joint venture is formed in order to execute a single transaction

. The principle that governs the rights as well as the liabilities of the contractor and the operator are similar to the ones of partnership. The most important characteristic of any given joint venture is that fiduciary relationship based on trust as well as confidence should reign. This implies that each of the concerned party has the right and authority to demand as well as expect a full, open, fair and honest information disclosure on all matters affecting the relationship.

Contractual indemnity

Even though these forms on risk management techniques are not unique to the oil and gas industries, one of the contacting practices which have been adopted in order to regulate and manage the physical risks is the indemnity clause (Gordon, 2006). An indemnity is a form of agreement in which one party agrees to secure the other party against a loss which is anticipated or a damage by means of payment that is made to the other party that has the benefits of the party which is indemnified in the actual event that the party which is indemnified does suffer from a loss that was earlier in agreed by the indemnifier (Lectlaw, 2011).

There are two main types of indemnities; the simple one and the mutual one. The simple one is akin do f a one way traffic in which the burden does fall on the indemnifying party in order to cover for the indemnified party suffers a loss that is described by their agreement. On the contrary, the mutual indemnity which can also be referred to as the knock for knock indemnity has a circular configuration. In this scenario, both the parties do indemnify each other. The existing difference however is that the security used is in relation to different losses which are otherwise related loss species.

Indemnity clauses in Oil and gas contracts

The indemnity clauses are very relevant to the different oil and gas contracts. This is because each and every business does possess the anticipated risks and unforeseen risks that do accompany their actualization. The nature of the Oil and gas investments is that they are capital intensive which makes the risks to be a major event. The concerned parties must therefore ensure that they do an accurate reflection of their intentions in the signed contract in preparation for any form of eventuality. It is important that the ability to shift liability exist via a provision which is contractual for the various participants in the oil and gas industry. This is especially true in the case of fault-based indemnities.

Basing our view on the legal perspective, we realize that the various indemnity clauses are some of the most significant ones in any form of contract. The view is particularly important for the case of Oil and Gas industry which involves various risks with huge potential liabilities (Macattram, 2008). In consideration of the capital-intensive nature of the Oil and gas industry as well as the realization that there exist several parties in the industry transactions, it becomes economically prudent to allocate risks to party which is best suited in the management of a particular type of loss as opposed to the allocation to a party on fault-basis.

As in always the case for every Oil and Gas installation and operation, it is necessary to carry out a quick exploration of the natural resources in order to maximize profits. The fault-based indemnities are therefore best enforced via a time consuming and expensive litigation in order to determine the responsibility and liability which do in turn escalate the legal costs (Maccantram, 2008).

The legal interpretation of the indemnity clauses

In order to make the process of determining responsibility and liability in the oil industry easier and less time consuming, it is essential that an explicit language be used in the litigation process. This is because it has been established beyond reasonable doubt that indemnity never lies in regard to the loss resulting from an individual's own negligence or that caused by his servants, unless words that are clear and adequate are used or unless the case of indemnity could possess no reasonable meaning as well as application as applied in Walters v. Whessoe Ltd. And Shell Refining Co. Ltd.

The perfect illustration of this point is evident in the classic case that dealt with the duty of court when it comes to the indemnity provisions as exercised by Lord Morton of Henryton in the delivery of a judgment of the Privy Council board in the case of Canada Steamship Lines Ltd. v R

In cases where an indemnity clause contains a language that clearly exempts an individual that it favors from the consequences of negligence caused by his own servants, there is a need of effects to be provided to such provisions.

In cases where an express reference lacks, then the courts must come up with a consideration of whether used words in their ordinary meaning are sufficient to cover the case of negligence caused by his own servants.

In cases where the employed words are wide enough for the purposes mentioned above, then the court must make a consideration of whether there exists a different head of damage that can be used as the basis of the claim as well apart from the negligence claim.

Relationship between Operator and Contractor

In Joint venture agreements, the host country and the oil company comes into mutual agreement on how best the petroleum resources shall be utilized after the mining process. This case is mostly found in underdeveloped countries which are not able to set up their own equipments for oil mining; hence they rely on the international developed countries.

In this agreement the oil company agrees to excavate the oil and then share the products with the host country. On the other hand, the host country is suppose to oblige to several conditions in return including; providing unskilled labor to the company, providing the land on which the oil is to be mined from; take the possible risks which are likely to affect the project. At this level both parties have the mandate to fulfill their obligation so as to enable the other have enjoyment to their rights. In achieving this, joint committee from both the operator and Contractor is always formed to create to spearhead the process.

Rights and obligations under the contract

Every contract comes with both rights and obligations. Rights are like the privileges which the party will enjoy once it enters into the contract; while obligations are the commitments the party must make once it enters into the contract. Both Rights and obligations are outlined clearly in the contract and the parties are expected to go through the contract before signing. The rights and obligations are always covered by two major laws; the first law is the common law which is recognized internationally; the second law is the law of the country in which the companies/parties are registered. In this particular case if any party fails to oblige to the agreement then the above mentioned laws shall apply.

In entering into a contract of Joint Venture, the parties agrees to three elements; first being mutual assent by both parties to the transaction; the second is Consideration where each party agrees to perform a task which is not their legal right. The third one is where there is no legal defense to contract information thus both parties are supposed to act with integrity and should not be forced to enter into the contract.In cases where either of a party has failed to perform its obligations in a Joint venture Contract, it is referred to as breach of contract, and in this case the other partner has a right to sue for the its rights to be obeyed

Exclusion clauses

The exclusion clauses are part of oil and gas contracts because they partially demand for the exclusion or rather the limitation of the liability under a given contract through the expression that states that liability will never rise in a party or shall effectively be limited for certain number of or all the defaults in the agreement (Gillhams,2008). The interpretation rules of the contract do state categorically that the exclusion clauses must be expressed clearly and in a manner that is unambiguous. Lack of these would therefore render the contract ineffective and may end up construing against the party they are meant to protect. The nature of the exclusion clauses makes it necessary to instill a control method; the Unfair Contract Terms Acts of 1977 (UCTA) to be used for the regulation of this kind of clauses in a given contract.

Limitation on liability clauses

It has often been pointed out that there is a need of contractors and engineers to utilize a well established and practical principle to be used in contracts in limiting the level of liability

. This is through the use of a financial cap or by referencing to a certain loss type. The application of English law does reflect the degree of freedom of the parties involved in the negotiation of their own terms of contract. The exceptions to this ate the provisions that seek to limit or exclude liability for personal injury or death that arises from negligence (Considered unenforceable under the UCTA act).

Willful misconduct and gross misconduct

Whenever a liability cap is well negotiated, there must be certain provisions that the parties involved want to be excluded and therefore fundamentally be excluded. In a typical way, these may include personal injury and death liability and claims that arise from the willful misconduct or due to gross negligence. Liabilities for defects that are under warranty and intellectual property indemnities are also included here. The terms gross negligence and willful misconduct never have specific meaning in English law. It is therefore appropriate to define the terms if they are employed in a given contract. The covering of the liabilities arising from both cases are a matter of legal negotiation.

In the case of concessions, it is worth pointing out that those done under a merger agreement are never considered as elements of fair value as evident in Allenson v. Midway Airlines

Fiduciary relationship: utmost good faith

Fiduciary relationship is where parties in contract are bound to act with utmost good faith towards each other. This situation is arises in circumstances where there is less trust from one party, the party which is not trusted accepts to be keeping integrity and assumes to accept confidence. The party which raised the concern should not take the advantage from this act and due to good faith involved letters or consents are not always necessary.

Types of risks in Joint Ventures

Investment and business risks

This includes all factors which are associated with investments including the geographical features, financial crisis and facial structures which are necessary for the smooth running of the project. Most of the Investment and business risks are risk which can be mitigated by the operator. The operator should ensure that the project is ensured against all odds to avoid unnecessary closure.

Environmental risks environmental risks involve all factors which can lead to the breach of contract due to unvoiced circumstances which are beyond control; these factors are the factors which are natural in nature and does not involve any financial issues, they include; Natural calamities, civil war, political interference and other non-financial issues.

In entering into Joint venture Agreement, the host country must ensure that all these risk factors are well mitigated. Most cases the operators have failed to enter into agreements with governments who have failed to mitigate the environmental factor.

In cases where the contractors have failed to mitigate some of these risks due to negligence they shall be liable and shall pay the damage, while the cost will be shared where the co-ventures were warned but they took no heed.

Deficit of human capital

The steadily increasing deficit of human capital in the petroleum sectors has been noted to pose a strategic threat to the gas and oil industry. This therefore strongly undermines the capacity of the oil and gas to steadily expand in order to sufficiently meet the demands of future growth. The outcome of the deficit is project delays as well as project abandonment (Jessen, 2008).

The worsening of fiscal terms

This is regarded as high risk to the oil and gas industry. This has been noted to be cause in certain cases by energy nationalism and political opportunism as well as high prices. Changes to the tax regime can cause additional restructuring in the oil and gas industry in certain countries such as Canada, Russia, Algeria and Venezuela. Both political opportunism as well as high prices have been noted to be dominant in the developing and as well as the non-developing world

Control of costs

This is the other threat which affects the oil and gas industry. This is because of the inability to adequately control costs. The threat due to this act is considered to have a strategic impact in the sector. The lack of these controls would inadvertently lead to the undermining of the soil and gas sector competitiveness (Jessen, 2008).

The competition for Reserves

The national oil companies (NOCs) are in a constant quest to compete in the reserves .Cybercrime is considered a serious threat to all the international oil companies (Jessen, 2008).

Risk allocation

In joint venture, the agreement is in such a way that both the host country and the oil company share most of the liabilities hence liabilities are unlimited. As pointed out earlier, some of the liabilities results out of risks which were not mitigated by both parties; in this case the liability will be shared by both parties.

Application of common law to the risk allocation process

The Oil and Gas industry is characterized as being capital-intensive. This is because most of the transactions do run into millions of dollars and involves several parties who are operating together in order to achieve a common target of profitability. Some of the parties usually involve multinational companies. The level of volatility of the commodities that are involved in the industry do suggest that there is a high level of risk which needs to be expected and allocated for by the various concerned parties. The option of engaging several insurance policies for every involved party is therefore never practicable. This is due to the fact that it could be very expensive for smaller parties. The application of the common law approach in the process of risk allocation is therefore an extremely lengthy undertaking in relation to the determination of the cost of liability as well as the cost to be awarded to the parties that are injured. The entire process is therefore time consuming and expensive for the Oil and Gas industry. Several critics do however point out that the various imputation of the indemnity system in the Oil and Gas contracts is extremely unfair and also poses serious danger for the parties that are involved who make use of the contract as a means for modifying of the common law approach in the allocation of risk. Their argument is that the imposition of the will on an inferior party by the dominant party causes a lot of unequal economic power or unfair coercion.Furthermore, the continual rise of the insurance premium causes the amount of money that is spent on the purchase of several insurance policies to be treated as unnecessary, additional expenses. In the process of producing a given Oil and Gas platform, there are usually about twenty or more company representatives on board. The cost of insuring the installation and the personnel would be prohibitively high for smaller contractors. This would make it a wrong use of corporation's financial resources

Conclusion

The concept of risk allocation in the oil and gas industry requires extreme caution since there are various factors involved. The operator and contractor must therefore negotiate contracts that best suit their interest and that may result in quick settlement out of court in case of an incident.