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Article: December 2019: Exiting Long-Term Contracts with Governments: Trends in Production Sharing Agreement Disputes in the Oil & Gas Sector

Business Litigation Reports

The Rise of Disputes Under Production Sharing Agreements

With growing political and economic instability in many parts of the world, a number of long-term investors have been bringing their operations to a close and withdrawing from troubled States. Simultaneously, many of the original Production Sharing Agreements (under which those investments had taken place) are reaching the end of their contractual life. Both developments - often connected - have led to a significant number of disputes between international investors and host Governments. This article looks at recent trends in those disputes and considers how best corporations can protect themselves.

            The history of Production Sharing Agreements (“PSAs”) is well-known in the industry.  First developed in Indonesia, they became a common instrument to regulate hydrocarbon production from the 1990s (especially in the developing world). PSAs are also long-term in nature. Typically, they provide for a term of 20 or 25 years from the commercialization of the asset. From those two facts alone - 25 year terms and a start date in the 1990s - one can see that many earlier PSAs have either just ended, or will do so soon. Equally, it is no surprise that a number of PSAs concern some of the more challenging areas of the world, forcing even the largest oil companies to reassess their on-going engagement in those jurisdictions.

            Whether for reasons that are perceived by a State to be legitimate, or for opportunistic motives to have one final push to monetize a departing investor (or “Contractor”), the termination of PSAs has created a new wave of disputes. Those disputes cover most aspects of petroleum operations. And it is something for which surprisingly few investors are preparing.

            It has required - or should require - oil and gas companies to take their internal, end-of-PSA planning activities seriously. That will help them minimise the likelihood of a final dispute. Or, more likely, maximize a favorable settlement or successful defence against a State claim when they come to depart from the asset.

            This article begins by illustrating certain areas in which we have seen many claims arise. Thereafter, it identifies ways in which a Contractor can best mitigate those risks and prepare for the inevitable claims. Whilst these disputes cover most aspects of petroleum operations, our focus is on two core categories:

(a)        First, what one might describe as Operational Disputes. Within that broad category, three sub-topics are particularly relevant: allegations by the State of environmental damage; disputes concerning project assets; and issues regarding abandonment and/or decommissioning.

 

(b)        Secondly, we highlight disputes concerning Cost Recovery. In particular, we will consider how past and current audit claims are often raised by State entities at the end of a PSA, either in their own right or to exercise leverage over other claims.

 

            After describing each of those elements in more detail, we then close with a practical overview of what can be done by the Contractor by way of preparation. Put simply, to prepare is to protect.  And whilst the natural focus of that advice is what the Operator should be doing, it should not be forgotten that co-ordination amongst the other Contractor parties (typically under a parallel Joint Operating Agreement) is also likely to be important.

 

Issues Arising from Operational Disputes

As noted above, we have seen three operational topics arise frequently in any end-of-PSA planning: allegations of environmental damage; asset disputes; and (perhaps the most important of all) abandonment and decommissioning. What are the key risks and issues with each?

            For the first two, the key battleground in any dispute is likely to be on the evidence. Most problems arise with evidencing the existence (or non-existence) of alleged environmental damage. Or evidencing whether project assets have been damaged or poorly maintained, as States will often argue. At that stage, of course, most of the assets will typically have passed to the State.

            On the environmental side, it is helpful to ensure that all of the Operator’s records are up-to-date and accessible. That is obvious, but what does that mean in practice? That the Operator has a copy of the original Environmental Impact Assessment (even if were carried out before it came onto the asset); that the Operator has records of the monitoring programs implemented by it, and the reports that have been prepared as a result; and that the Operator has proper records of its waste management activities.  Perhaps more important is any proof that the Government (or the relevant State entity) has been involved in those activities, or at least has been aware of what has been happening. States will often claim to have had no knowledge of their earlier involvement.

            On the asset side, it is helpful to prepare and maintain a proper asset register. Beyond that, the Operator would be advised to keep up-to-date maintenance records, including a clear statement of the Operator’s inspection and maintenance procedures. Equally, it would be helpful to be able to demonstrate the date and results of past inspections, as well as the maintenance work undertaken. As with environmental claims, it would be important to be able to demonstrate the Government’s knowledge of, and participation in, those activities.

            To that extent, then, evidence is king. However, that is not to say that the Contractor will have the burden of proof in any dispute. As noted below, quite the contrary. Rather, in any pre-termination negotiations (or dispute that might follow), it is simply helpful to have as powerful an arsenal as possible against any allegations advanced by the State. The burden should remain on the State to prove environmental harm or asset damage.

            Whether the Contractor bears any liability for abandonment and/or decommissioning features in almost every end-of-PSA debate. Here, a distinction can be drawn between wells that have already been abandoned before termination (where the debate is often whether they have been abandoned properly), and on the other hand which party carries the burden of paying for the future abandonment of wells, after the Operator has departed.

            On the former, we are back primarily in the realm of evidence. For wells that have already been abandoned, it is helpful for the Operator to have maintained good records showing, amongst other things: (a) the steps taken by them to plug and/or abandon wells; (b) the results of any monitoring of abandoned wells; and (c) the status of any abandoned wells at the end of a PSA. Once again, that is not to shift the burden of proof. It seeks only to fortify the Contractor’s position as far as possible.

 

            On the second question, we move outside the strict realms of evidence. We are now in the realm of law and contract. Ultimately, whether the departing Operator is responsible for the costs of future abandonment or decommissioning will depend on the terms of the PSA. Many older PSAs contain no such provision. Absent such a provision, the Contractor’s position should be that it has no such responsibility, despite inevitable arguments by the State to the contrary.

            A related topic concerns wells which have been suspended before termination, but not yet abandoned. There, we return to the importance of evidence. It would be helpful (at the very least) to maintain the contemporaneous records justifying the Operator’s decision to suspend rather than abandon (and ideally showing the Government’s buy-in to those proposals as well).

 

Disputes Concerning Cost Recovery

This brings us to the second of our core categories. Cost recovery provisions are the economic heart of a PSA.  Yet this is rarely a closed issue when the PSA ends. Why so?

            Unsurprisingly, during the earlier stages of a PSA, cost recovery audits are often resolved commercially.  The Operator does not wish to rock the boat, and will often agree - on a commercial, sometimes even expressly without prejudice, basis - to certain audit exceptions asserted by the State, however illegitimate those exceptions might have been.

            However, that flexibility often comes to an end at the close of a PSA. States often seek to reverse recovered costs; Contractors have little incentive to concede points; and the State often seeks to leverage cost recovery issues to settle other end-of-PSA claims.

            For an Operator, two points are important: one practical, one legal. From a practical perspective, and echoing the points raised earlier, it is helpful for the Contractor to have documented its position on cost recovery comprehensively, with well-reasoned explanations for its position in any exchanges with the auditors. This is particularly important for the later PSA audits. In short, a Contractor needs to be mindful of these disputes years in advance and plan accordingly.

            On the legal side, there are at least two further tools in the Operator’s armoury. First, the role of burden of proof (a subject broached above); secondly, the relevance of limitation periods.

            On the former, unless the PSA terms say otherwise, the better argument is that the burden is on the State to prove that certain costs are not recoverable, rather than on the Contractor to prove that they are. That can have a critical impact on the outcome of any Cost Recovery disputes. On the latter, most PSAs will contain time-limits for audits, which would supplement any prescription periods that have effect under the applicable law. Relying on those terms can be an effective tool in defeating some of the more egregious attempts by the State to reverse long-since recovered costs.

 

What Practical Steps Should an Operator Bear in Mind when Planning for the End of a PSA?

Having touched upon those two core categories - operational disputes and cost recovery - what next? How best to sum up the practical steps that any Operator should take in the lead-up to the termination of a PSA?

            First, and self-evidently, any Operator (and PSA party) should identify early on likely areas of risk (operational; environmental; handover). At the very least, that will guide the focus of document management and preservation activities, as well as help direct the pre-handover actions to mitigate that risk. On this, one further point is worth emphasizing. It is critical to ensure that all of this is done in conjunction with the Operators legal teams. That is often forgotten, as the operational teams get carried away with their own planning. Yet those analyses should be covered by privilege - they cannot be confused with, or be seen to be, operational documents (which thereby run the risk of falling into the hands of your counterparty).

 

Secondly, given the long-term nature of a PSA (and the fact that the Operator may well not have been there from the outset, having farmed-in at some point during the life of the asset), effective document management will be also key. The relevance of evidence has been highlighted throughout this note. In short, the operational records need some AWE: they need to be Accessible; Well-Organised; and Exhaustive. But there is a particular nuance in PSA disputes. They also need to be user-friendly to those unfamiliar with either the operations or the records, as disputes often arise long after the relevant people have departed.  On that point, the Operator should also consider entering into formal retainers for key, departing staff who were involved materially in either the operations or the handover process.  Their evidence is likely to be important. Attention too often is on the preservation of documents, rather than live witnesses who can bring those documents to life.

            As well as being AWEsome, the Operator’s documentary record also needs to be maintained securely and confidentially. That is obvious. But often forgotten is the need to ensure that you have copies available (whether in hard or electronic format) out of the country. Once you have left, access can often be difficult, if not impossible. Drilling down further, at an early stage the Operator should also ensure that it has developed a register of all formal exchanges with the Ministry and its relevant departments, and a system for capturing the e-mail correspondence of key officers and employees. As noted above, when it comes to a dispute States can often forget how active their involvement has been.

            We are therefore talking about a lot of information (which is one reason, of course, why it needs to be marshalled carefully). With the Operator’s records for handover, however, it is also essential to create a system which recognizes that those documents are merely a sub-set of the Operator’s own records.  A thorough exercise needs to be completed to filter out any legal advice or commercially-sensitive materials, including exchanges with JV partners, from any “handover materials”. That includes, but is often forgotten, the Operator’s records left on site.

            Finally, should there be settlement discussions with the relevant Ministry in the lead-up to (or following) the termination of the PSA, one further aspect is worth underscoring. Be wary of the practical ambit of any without prejudice discussions that you believe you have agreed. The concept of “without prejudice” is not always a term of art, and documents you believe are protected may end up on the record, even illegitimately (or at least attempts made to place them on the record). As a basic principle, a Contractor should ensure that a member of its legal team is involved actively in leading those discussions, to maximize the chance of clothing anything sent with privilege. Beyond that, just be careful - even if you believe that your communications are protected, never say anything that you would not want a future arbitral tribunal to hear.

            Thereafter, should a settlement be reached, great care needs to be taken to ensure that it provides the actual closure that the Contractor desires. States can be determined; Governments and Ministries change; Ministers often need to be seen to be tough. Any settlement needs to be documented properly; it needs to be stated to be comprehensive and final; and needs to address each of the risk areas identified in the Contractor’s initial analysis. Chief amongst those are likely to be: (a) unresolved cost recovery audits; (b) any discrepancies in lifting allocation; (c) the condition of the block upon departure (with a particular nod to environmental and abandonment issues); and (d) the condition and status of all assets, fixed and mobile.

            It is inevitable that more of these disputes will arise as more PSAs come to an end. Armed with these observations, however, parties to long-term contracts should be able to identify many of the key risks and have additional insight into how best to prepare for them.