REUTERS | Chris Helgren

Topical issues in oil and gas production sharing contract disputes

Oil and gas production sharing contracts (PSCs or PSAs) are high-value, high-stakes agreements which often give rise to disputes between contractors and state-owned entities such as national oil companies (NOCs). Many of these disputes are resolved by means of international arbitration and the resulting arbitral awards often enter the public domain, for example as a result of subsequent enforcement or annulment proceedings before national courts. This article briefly discusses some key recurring types of PSC disputes.

Nature of PSCS

By way of introduction, a PSC is typically an agreement in which a government or NOC authorizes a contractor to explore and develop one or more onshore or offshore blocks or areas, without granting title to the hydrocarbons in the ground and on terms that provide for the contractor to recover its costs by extracting and selling hydrocarbons if any produced from the relevant blocks and for the parties to share any remaining production on a defined basis.

Under such agreements, the state or NOC typically has no payment obligations, and the risk of the exploration and development of the block (including the risk that no or no commercial quantities of hydrocarbons will be discovered) which can be very significant, especially where the block is located in deep or ultra-deep offshore waters, resides with the contractor. Payments of royalties or taxes in respect of any production from the relevant block must usually also be made.

Cost recovery disputes

Cost recovery disputes are common and often include issues regarding which costs are recoverable, out of which production and when. Such disputes can have knock-on consequences in determining the amounts of profit production which each party is entitled to take or lift from the block and sell. Disputes of this kind can rapidly result in high-value overlifting disputes, where one party to the PSC claims that another party has lifted and sold more than its contractual entitlement of production.

For example, in Reliance Industries Ltd and another v Union of India, the relevant PSCs entitled the contractor to recover development costs by lifting and selling cost petroleum but subject to a cap referred to as the cost recovery limit (CRL). Development costs were one of the inputs in calculating the investment multiple and the respective shares of profit petroleum which each party was on the basis of that multiple entitled to lift and sell. The parties disagreed regarding which costs constituted development costs for these purposes. The contractor contended that the correct input was all development costs as defined by the PSCs, namely “those costs and expenditures incurred in carrying out development operations, as classified and defined in section two of the Accounting Procedure and allowed to be recovered in terms of section three thereof”. In contrast, India contended and the arbitral tribunal agreed that the correct input was only the development costs below the CRL cap, not those in excess of that cap, the latter costs therefore falling to be borne by the claimants. The effect of this decision was that in calculating the investment multiple, the amount of net profitable production was greater, because the cost deduction amount was capped and therefore smaller, with the result that India was entitled to a greater share of profit petroleum than under the contractor’s interpretation.

Government approval

Many countries have laws requiring that PSCs be approved or ratified by the local government. Such requirements can give rise to contractual disputes (under PSCs or related agreements) as to whether necessary approvals have been obtained and, thus, whether for example termination rights have accrued or whether fiscal incentives provided for in the PSC are effective.

For example, in Monde Petroleum SA v Westernzagros Ltd the parties disagreed as to whether the relevant PSC had become fully operational and enforceable. Was it sufficient that the Kurdistan Regional Government (KRG) had signed and ratified the PSC? Or was it also necessary for the parties to have received a signed copy of a confirmation and support letter from the Iraqi Federal Government? On a proper interpretation of the relevant agreement as a whole and in light of the commercial background known to the parties at the time when that agreement was executed (including the fact that there was a longstanding dispute between the KRG and the Iraqi Federal Government about which of them had the right to grant agreements such as the PSC), the Court of Appeal upheld the first instance decision that the PSC had not become fully operational and enforceable at the relevant time, because the confirmation and support letter had not been received.

In an ICC arbitration between a South African contractor and the Democratic Republic of Congo (DRC), the relevant PSC provided that “this contract shall not enter into force until the date of signature of the order of the President of the Republic approving this contract”. The arbitral tribunal held that the DRC’s failure to obtain and provide such a presidential order constituted a breach of the PSC for which the DRC was liable to pay damages.

Stabilisation and economic equilibrium

Another recurring issue in PSC disputes is a scenario in which local laws, regulations or policies change after the PSC is signed, thereby destabilizing the legal, political or economic basis on which the parties contracted. Many PSCs attempt to deal with situations of this kind by including stabilization or economic equilibrium clauses, pursuant to which a contractor whose rights under the PSC are materially and adversely affected by a change in law or policy can request that the PSC be modified so as to neutralize the effects of such change. If the parties fail to agree on whether such a change has occurred or on appropriate modifications to the PSC, this issue can (if the PSC so provides) be referred to an arbitral tribunal. The arbitral tribunal may then be able to determine whether a change of the relevant kind has occurred and, if so, to make appropriate modifications to the PSC.

For example, in Esso Exploration and Production Nigeria Limited & Anor v Nigerian National Petroleum Corporation, the contractor alleged that the federal tax authority (FIRS) had changed its policy in relation to the application of certain fiscal incentives and that this change had materially and adversely affected the contractor’s rights under the PSC. The NOC denied that there had been any such change. The arbitral tribunal agreed with the contractor and ordered the modification of the PSC, so as to add a new contractual provision that “in the event that the change in policy by the FIRS with respect to the determination of investment tax credit, capital allowances and the tax deductibility of the signature bonus, sole costs or disallowed costs results in a future difference in the determination of tax oil (for example a difference between the tax oil resulting from the application of the policy as it existed upon the effective date of the PSC and the tax oil resulting from the application of the policy as it exists as of 24 October 2011), then, until such time as the profit oil thereafter recovered by the contractor is sufficient to generate proceeds in the amount of such difference, profit oil shall be allocated to the contractor.”

Conclusion

PSCs are typically long-term contracts. This, taken together with the complexity of PSCs and their relationship with local laws, means that there is a real likelihood of high-value disputes arising at some point over the life of the contract. Issues of the kind outlined above are just some of the ways in which PSC disputes can arise and reiterate the importance of careful and detailed drafting (including of the all-important arbitration clause) when the PSC is being negotiated.

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