Long-term participants in the energy sector have weathered significant fluctuations in oil and gas prices in the past, most recently during the 2014/2015 oil price crash. However, the current circumstances are unprecedented. The severe disruption to the global economy caused by COVID-19 has significantly impacted energy consumption, with sharp falls in demand around the world – the IEA has reported that energy demand globally will fall by 6% in 2020 (seven times the decline after the 2008 global financial crisis), with advanced economies predicted to see the biggest declines.
This comes at a time when markets are awash with a glut of oil. Whilst some corrective steps have been taken, including an announcement from OPEC+ in early April of a three-month agreement to reduce production levels, these measures do not appear to have been enough to ease the pressure, as the price of West Texas Intermediate fell into negative in mid-April for the first time in history and remains historically low. Against this bleak market backdrop and with cash flows stretched, energy companies are also tackling the immediate operational challenges of COVID-19 including restrictions on movement of workers, difficulties with supply chains and a significant amount of uncertainty as to when “business as usual” can be resumed.
As energy sector participants grapple with these challenges, there will inevitably be an increase in complex disputes in the coming months and years as parties argue about how the huge costs of COVID-19 should be allocated. Given the prevalence of international arbitration in energy market disputes, a corresponding increase in arbitration is also likely.
This article will consider several key issues facing the energy sector as a result of COVID-19 and the potential implications for arbitral disputes.
The collapse in oil and gas prices, coupled with the operational difficulties caused by COVID-19 are likely to have a reverberating impact across the whole sector. Particular areas of concern that may give rise to disputes include the following:
Should prices stay low over the medium- to long-term and lockdown restrictions remain in place, contracting parties may be compelled by unfavourable commercial circumstances to look at all options for relieving contractual burdens, including force majeure (FM), change in law, termination at will and frustration. The economic pressure on companies will also put strain on commercial relationships. With most industry (and particularly upstream) assets owned by several parties through unincorporated JVs which establish ‘owner-operator’ models, disputes between co-owners and/or owners and operators in relation to the management of assets are likely.
Each FM clause is unique, and usually contains a list of qualifying events that may or may not expressly include epidemics and acts of government but often includes “any other event beyond a party’s reasonable control” as a catch-all. Where a FM event arises, the affected party will generally be relieved from performing its contractual obligations. Thus if a refinery had to shut in or dramatically scale back as a result of government COVID-19 quarantining measures it may be entitled to force majeure relief for contracts it is unable to perform.
However, a drop in oil or gas price or demand is unlikely to constitute an FM event, even where very substantial, and may in fact be expressly excluded depending on the wording of the particular clause. Notwithstanding this we are seeing FM notices being issued across the sector for what appear to be economic reasons. This might be a tactical effort to push counterparties to engage in renegotiations.
Notably, the 2014/15 oil price collapse was largely not considered a FM event as oil price fluctuations were considered to be “legally foreseeable”. However, current negative prices may push the industry into uncommercial lows and, combined with other factors (e.g. inability to staff projects, government restrictions, increased health & safety obligations), this may result in triggers for widely drafted FM clauses.
For more information about force majeure amid COVID-19 please read our global guide.
Contracts that do not contain FM clauses may be frustrated by the current circumstances, if they are impossible to continue performing. However, a temporary change in circumstances is unlikely to amount to frustration, and so whether COVID-19 amounts to frustration is likely to depend on the particularities of each operating environment and each jurisdiction.
A frustrated contract terminates immediately. Accordingly, it is an extreme remedy that parties should only consider if there are no other options.
Insolvency and liquidity issues
Falling demand has already resulted in significant pressure on certain companies’ balance-sheets; a US-based mid-stream contractor recently filed for insolvency citing the unprecedented impact of COVID-19 and an oil price war as the key contributing factors. Companies operating on thin balance sheets with high operating costs and falling revenue will be particularly exposed to insolvency risks should current market conditions continue.
Most contractual arrangements will have triggers (for review, suspension or termination) upon one party’s insolvency. The result will vary depending on the mechanism for declaring (and emerging from) insolvency in the relevant country, and on the drafting of the clause. However, it is likely that the market will see an increase in restructuring, either through consensual settlements or through formal insolvency processes.
Insolvency and liquidity concerns are likely to have a greater impact in oil and gas than in other industries, especially given the rise of smaller participants over the past few years. Particular concerns include co-owners struggling to meet cash calls under joint operating agreements (JOAs), operators facing challenges to get budgets approved by co-owners and resistance from co-owners to cover the additional “COVID-19” costs of operational performance.
In such circumstances, parties may seek to review JV agreements, JOAs and/or other agreements to assess options for enforcement of their contractual rights (which can include self-help remedies, such as forfeiture) or to seek contractual relief from performance. Inevitably, some disagreements between contractual counterparties will develop into dispute resolution processes, including arbitrations.
The energy sector has always accounted for a high proportion of recorded investor- state disputes. Steps taken by states in response to COVID-19 may adversely impact the investments of international energy companies in other jurisdictions and investors may look to the stabilisation provisions in their concession agreements and the protections in bilateral investment and similar treaties for recompense. For additional information about energy disputes please read our prior article A Global overview of dispute trends in the energy sector.
The most immediate impact of the supply/ demand imbalance is on global oil storage capacity. As demand dramatically falls, many producers are attempting to store crude until a rebound in price makes selling more economical. However, storage options are quickly approaching maximum capacity, and by mid-April some producers were forced to pay buyers to take barrels they could not store.
As a second resort, many producers have stored barrels on offshore supertankers. However, faced with dramatically increased demand, the cost of offshore storage has grown significantly and is now at a significantly high premium.
With the potential for global storage capacity to dry up in a matter of weeks, and with many parties physically unable to take receipt of barrels, parties may increasingly seek to rely on FM or the doctrine of frustration for relief from contractual obligations to take delivery of oil.
Natural gas: Price reviews
While historically the price of oil and the price of gas have not always correlated, the global economic shutdown has led to a corresponding drop in the price of natural gas as well. Many long-term gas sale and purchase agreements, including LNG SPAs, have price review mechanisms which allow parties to review the contract price, which is typically indexed link to the price of oil or oil product, either periodically (e.g. every three years) or when there is a substantial change in the market which means the price is no longer ‘fair’ or ‘competitive.’
While individual cases will depend on the contract language, buyers will no doubt be looking to take advantage of market movements to trigger price reviews and sellers will be considering their exposure.
Health and safety
With most countries introducing lockdown measures, which only allow “essential services” to operate, many companies are facing operational challenges. For the energy sector, shortages in personnel can be particularly acute with occupational health and safety (OHS) risks and environmental concerns.
In recognition of this issue, countries such as the UK, Australia and Canada have designated oil and gas production as an “essential service”, subject to significantly increased OHS restrictions. However, although this may be helpful for cash flow, continuing operations during lockdown may present challenges for operators under “reasonable and prudent operator” obligations and could give rise to disputes about what exactly that and similar standards such as “good oilfield practice” mean in the current environment.
The current climate is uncertain for almost everyone, and that is certainly true for those in the energy market which is truly globalised, is connected to almost every other industry and is often highly political. There are many potential disputes on the horizon, as oil and gas prices remain at historic lows and operations both up and downstream become uncommercial.
Each dispute will likely contain multiple complex elements and parties will need to consider their options under existing and contemplated contracts in order to ensure they are maximising their contractual options and entitlements.
With thanks to Maja Mazur, trainee, for her contribution to this article.