Expropriation - A very real risk

Expropriation or forced government renegotiation is a big risk for oil companies that is likely to increase in times of lower oil prices. Randel Young and Richard Devine look at how to safeguard against the worst effects

Expropriation and forced government renegotiation events are particularly significant risks in the international petroleum industry, where project lead times are long and the world oil price can be variable and difficult to predict. In periods when world oil prices have risen substantially, international oil and gas developers have often faced pressures from host governments to change the balance of long-term hydrocarbon development contracts, either through outright expropriation and nationalisation, or other, less transparent, means of forcing the stakeholders back to the negotiating table.

Some important examples of these types of renegotiation efforts in the Middle East and North Africa have included Algeria's attempts over the past few years to change its hydrocarbon law retroactively to give Sonatrach greater prominence and Yemen's efforts to cancel Hunt Oil's rights in Marib Block 18 in 2005. Most recently Libya's President Gaddafi announced in January that the country's oil industry might be nationalised. In the same month Ecuador also announced plans to renegotiate its oil extraction contract with Italy's AGIP.

Expropriation and forced renegotiations are not just emerging market phenomena. The UK, for example, doubled its supplementary charge on North Sea operators in 2006, citing rising hydrocarbon prices as the cause, and the US has considered renegotiating royalties on offshore federal leases and has previously imposed windfall profit taxes on oil and gas production using a similar rationale.

While expropriation and forced renegotiations are often explained in terms of a country exerting control over its own resources or 'resource nationalism', in each of the above instances the Government appeared to be reacting to a period of drastically rising oil prices. Accordingly, one might expect that the risk of expropriation or renegotiation would be reduced when oil prices fall and the world is facing dramatically recessionary times, as we are today. On the contrary, as we explain below, falling oil prices and economic recessions, with the political and economic turbulence that accompanies them, can themselves become triggers for new rounds of expropriation and forced renegotiations. This is particularly true in the international energy sector, as the emerging economies (where large upstream projects are often based) are often the hardest hit in tough economic times.

This article will attempt to explain expropriation in more detail, outline some of the competing factors that may lead to expropriation (and the relevance of the economic climate), and explain how important it is to put in place safeguards to mitigate the effects of expropriation - even in times of falling commodity prices.

What is expropriation?

In its narrowest sense, 'expropriation' is the outright taking of ownership or possession of a company's assets within a host country's territory. Governments expropriate in order to increase their economic returns from and/or their control over a project, business asset or industry. Expropriation can take several forms, including indirect or 'creeping' expropriation. Since the practice of outright expropriation is often heavily criticised internationally (and should carry with it the duty to provide adequate compensation under the principles of international law), so-called 'creeping' expropriation has become the most common form of expropriation. Creeping expropriation is often carried out under the rubric of state regulatory action or fiscal reforms and it can involve changing a project's economics through changes of laws, confiscatory regulatory efforts, new fiscal regimes, targeted taxation or forced renegotiation of important project agreements. Tactics designed to invoke renegotiation include public hearings, public interest suits, media campaigns and even economic coercion. If project investors fail to take into account creeping expropriation in planning the project, its effects could be profound. Creeping expropriation can have adverse impacts on project cash flows, increase working capital requirements and decrease reinvestment capital. This uncertainty raises financing costs and heightens early termination/bankruptcy risks.(1)

Impact of the current economic climate

Government expropriation of energy assets took centre stage again in January with Libya announcing it may nationalise its oil industry. Although some energy industry observers think that, for a number of internal and external political and economic reasons, it is unlikely that this threat will be carried out, this type of pronouncement appears to demonstrate Gaddafi's desire to renegotiate the terms of the exploration and production sharing contracts issued to international oil companies (IOCs) and is generally recognised as a tactic to pressure IOCs to do just that.(2) Ecuador's announcement that it plans to renegotiate its oil extraction contract with AGIP, followed the country's December 2008 order that the Italian oil giant halt production in line with OPEC mandates.(3) Notwithstanding the decline in the price of oil, both of these events might be explained in terms of the current economic climate.

In a climate of rising oil prices and 'windfall' profits, it is perhaps easier to understand why projects and IOCs may become the natural targets of populist-minded governments seeking to regain and share the seemingly ever-rising economic rents being created from the exploitation of the host country's natural resources. When oil prices and project revenues fall, one might expect this pressure to ease, but instead other influences can cause it to increase. An economically strapped or overly leveraged government can, as in the cases of Libya and many nations in Latin America today, find themselves inordinately dependent on their now much-reduced oil and gas revenues to run the general functions of the government, and without the liquidity to expand those revenues through much-needed capital investments.(4) Thus, the drop in oil revenues owing to a drop in prices can actually become the general impetus for a government to grab a larger share of a rapidly diminishing economic pie.

In fact, the contractual structure inherent in many oil and gas projects can itself give the government a greater incentive to renegotiate in times of falling oil prices than in times of rising oil prices. Under a production sharing contract (PSC), the contractor is awarded the right to explore, develop and produce petroleum, and in return bears the risk and cost of exploration, at least initially. The contractor is usually made up of a consortium of private companies and might include the national oil company (NOC) (although the NOC's share of costs may be carried by the other contractor parties). In return for taking the risk of exploration, the contractor is able to recover its operating costs out of the first tranche of any oil produced, known as cost oil.(5)

The oil remaining after the cost oil has been deducted (known as profit oil) is then shared between the contractor and the government in accordance with an agreed ratio. If oil prices fall, then cost oil takes up a greater proportion of the total oil produced and it therefore takes longer for the government to enjoy the benefits of the project.

If oil prices remain high, then relatively fewer barrels of oil are allocated as cost oil. The contractor may argue it similarly suffers in times of falling oil prices (on the basis that the cost oil is simply a reimbursement of its operating costs), but this is not likely to convince most governments - particularly if the contractor is engaging its affiliates to assist with operations, charging their affiliates' costs to the joint account and billing them to the other owners under the terms of the joint operating agreement.

In these circumstances, governments that depend on petrodollars can find it increasingly difficult to balance their budgets as world oil prices fall. Commentators are already predicting trouble in countries that fail to deliver on promised social welfare programmes as a result of falling revenues.

In Iran, for example, government oil revenue accounts for approximately 58% of government spending. Iran has apparently prepared its 2008-2009 budget on an oil price assumption of $115 per barrel and it is not clear how any shortfall between projected and actual oil revenues will be made up.(6) Several other Middle Eastern oil-producing states, including Bahrain, Iraq and Oman have also prepared budgets based on an oil price assumption for 2009 that is higher than the oil price assumption for 2008.(7)

Even Russia, the largest non-OPEC producer, set its budget based on an assumption of $95 per barrel, and its energy minister Sergei Shmatko has been quoted saying that a price lower than that could "strain Russia's 2009 budget and put pressure on the rouble".(8) If oil prices remain low, two options that governments might pursue are manipulating the oil price or taking a greater proportion of the project revenues. Expropriation might be a consequence of each of these strategies.

With respect to price manipulation, OPEC members have already indicated that the present oil price is too low and that they will take remedial measures to increase the price. All indications signal that in its continued efforts to increase the price of crude oil to around US$75 per barrel, a price Saudi Arabia's King Abdullah deemed as "fair", the oil producing cartel will continue to cut back production. Mohammed Saleh al-Sada, Qatar's minister of state for energy and industry affairs, was quoted in February as saying "(OPEC) will not be hesitant to reduce (production) further"(9) and that a "reasonable price" would be $70 per barrel.(10) In order to achieve this price, OPEC may need to pressure IOCs to cut back or shut in production.

Understanding the interests of the government stakeholders

The risk of expropriation results from the competing, inter-related interests of host governments. These interests include foreign direct investment in the form of IOC capital, as well as technological and managerial expertise, the desire to increase revenue and profits and local political considerations. Host governments are essentially looking to gain the maximum possible advantage from the exploitation of their natural resources.

Although the gap may be narrowing, it is no secret that IOCs still hold a technological advantage over NOCs and are in a much better position to engage efficiently in exploration and production activities in challenging territories of the world.

NOCs are created to serve the interests of state governments. While many NOCs are operating commercially outside of their home territory, the majority of them are heavily controlled or influenced by their state government when in-country. Accordingly, when dealing with an NOC within its territory the same principles should apply as when dealing with the government.

Methods of mitigating expropriation risk

Project sponsors and stakeholders should expect dramatic changes over the life of projects as long and complex as international energy development/financing projects.

As we have indicated above, these pressures may occur at different stages of the economic cycle and regardless of whether the project is enjoying high or low project revenues. In negotiating these types of projects, project sponsors and other stakeholders should remember that they are essentially 'betting against the house' in dealing with the host government or NOC. Host governments and NOCs can exert tremendous direct and indirect leverage over the project and its stakeholders in order to get them to accept an essentially unilateral change.

In addition, one should also bear in mind that, at some stage during the life of a project, the host government or NOC will likely come under huge economic or political pressures to increase the state's take from a project.

Moreover, when the government decides to change the economic ground rules of a long-term project or investment, there is often less of a legal question as to whether the government had the governmental power to make the change, and more of a practical and legal concern over the consequences that flow from it, and ultimately, the remedies and compensation that will be available to stakeholders based on the investment/financing structure, project documentation, and applicable laws.

Methods of mitigating renegotiation risk should be examined and an investment/financing structure selected based on treaties that give the sponsor and other stakeholders the best leverage in terms of dispute resolution. Bilateral and multilateral treaties/agreements, sovereign and bank guarantees, and credit enhancement from export credit agencies (ECAs) and multilaterals can all help mitigate renegotiation risk. Effective mitigation plans should also:

• Identify all pressure points and not focus solely on direct expropriation risk;
• Identify how pressure points and the economic cycle might change over the life of the project;
• Realistically assess the local courts and local legal system;
• Evaluate the project investment structure, particularly regarding dispute resolution;
• Ensure that key project documents adequately address stabilisation and economic equilibrium of long-term contracts;
• Consider availability and feasibility of political risk coverage;
• Garner political support (for example, from the state, national banks, NOCs and prominent local stakeholders);
• Consider involving multilaterals (such as the World Bank and ECAs) that bring other pressure to bear for the project;
• Include experienced local management, local partners and local counsel to promote communication and ensure accurate, timely reporting;
• Incorporate effective contract management and document retention systems;
• Be reviewed regularly.

Due diligence should be performed on legal, institutional and practical areas, including sovereignty concerns (such as the ability to waive immunity) and constitutional limits on acquiring, owning, controlling and operating project infrastructure and assets. Each government counterparty should be determined to have been duly constituted and empowered to act, and to be solvent, creditworthy and not judgement proof as a matter of law or fact.(11) Attention should be given to the constitutional and other legal limits on local courts and their independence from the executive branch.

Due diligence should be performed to evaluate risks under local procurement laws, determine transparency of local credit assessments, and evaluate bankruptcy laws and contract enforceability. When a project is subject to an expropriation event, local company directors and officers may feel personally exposed.

Understanding each project company's exposure, including vicarious civil and criminal liability of its officers and directors, is essential to understanding practical pressure points over the local organisation.

Contracts most susceptible to forced renegotiation are long-term commitments with the government or state-owned enterprises and those that allocate the economic rent between the government and private sectors. Key provisions include choice of law and dispute resolution mechanisms.

Special attention should be paid to long-term supply arrangements, such as commodity pricing (price renegotiation and re-determination mechanisms); volume commitments (product marketing arrangements, domestic marketing obligations, government take, take-or-pay and tolling/throughput arrangements); liability and damage clauses (floors, caps and deductibles); default, termination and remedies (liquidated damages, step-in rights, collateral rights and perfection/enforcement of security interests); procurement of permits and licences and access to project infrastructure; and exit strategies (put-calls and other buy-outs, business valuation, and piggy-back, tag-along and drag-along rights).

Since it is often difficult to prevent or reverse unilateral governmental action, it is always sensible and pragmatic to include the right to renegotiate project documents within acceptable parameters. This includes focusing on the manner in which renegotiation will take place, agreeing to strict time limits and renegotiation triggers, establishing clear rights for compensation and loss, establishing contractual limitation periods, and agreeing on benchmarks and indexes for adjustment of product pricing and cost recovery.

Recourse to robust dispute resolution mechanisms is vital for contract interpretation. If commercial negotiations fail, sponsors and stakeholders should have an agreed exit strategy and other ways to cut their losses.

A nuanced approach to expropriation events is generally advisable. If local courts will be needed, a less aggressive stance may be appropriate, especially if indirect pressures can be brought to bear on the project company, its stakeholders and employees.

Each project sponsor's and other stakeholder's response will vary depending on multiple factors, including its business culture. Some multinationals will favour litigation, while others will take the long view and prefer dialogue, but where a company's value is at serious risk, it is well-advised to employ a multilayered strategy based on strong contract terms, a complete understanding of dispute resolution options, and employment of various commercial mitigants, all of which should be in place long before an expropriation event arises.

Randel Young is an energy partner and Richard Devine is a senior energy associate resident in the Dubai office of Fulbright & Jaworski LLP. The authors appreciate the assistance of their colleague, Joe Ope, an energy associate based in the Dubai UAE office of Fulbright & Jaworski LLP.

1. We have used expropriation in its broadest sense in the rest of this article.
2. www.ogj.com/display_article/351495/7/ONART/none/GenIn/1/Libya-threatens-to-nationalize-its-oil-industry/
3. www.petroleumworld.com/story09011914.htm
4. In Mexico, revenue from the sale of crude oil and derivatives by Pemex generates roughly 40% of the federal government's annual revenue. http://www.bloomberg.com/apps/news?pid=20601072&refer=energy&sid=aljs7Sa2UKq4
5. Not all PSCs operate in the same way. There are, for example, differences in the way that oil is allocated under PSCs. For instance, royalty oil may be payable before cost oil and there may also be limitations on the extent of oil that can be allocated to cost oil in any given period
6. www.wsws.org/articles/2008/nov2008/opec-n28.shtml
7. http://zawya.com/marketing.cfm?zp&p=/Story.cfm/sidv51n44-3NC17/First 2009 Budget Reports Show Oil Price Assumption Increases
8. www.wsws.org/articles/2008/nov2008/opec-n28.shtml
9. www.businessweek.com/ap/financialnews/D96C500G0.htm
10. www.businessweek.com/ap/financialnews/D96C500G0.htm
11. A judgement-proof individual has no money or property within the jurisdiction of the court to satisfy the judgement or its assets and property are exempt from formal judicial process. See, West's Encyclopedia of American Law, edition 2. Copyright (2008).