Special Report: The developed & developing worldA look at legal issues facing the industry

David Asmus - Baker Botts, Houston,
Jay Alexander and Steve Hunsicker - Baker Botts, Washington DC

As the oil industry continues to benefit from record profits, high energy prices have created worldwide political difficulties for the industry. Not only have the higher prices boosted government revenues and provided some governments with a heightened sense of economic self reliance, but they have also made the oil industry an attractive political target in the eyes of the general public.

With growing demand for energy in various countries throughout the world, and with few immediate opportunities to significantly expand supply, oil prices (even if they begin to decline) are projected to remain high for several more years. Accordingly, government demands, supported by large segments of the public in some countries, are expected to grow. One of the most significant issues facing the industry will be the legal questions surrounding ex post facto changes in taxes, royalties, revenue sharing, and incentives, and the responses available to those changes.

The words “expropriation” and “nationalization” are reverberating throughout the news as South American countries unilaterally act to increase the government’s share of their energy resources. Ecuador, Bolivia, and Venezuela have either obtained control of energy production or significantly increased royalty payments from foreign energy companies such as Occidental Petroleum, British Petroleum, and Repsol. With oil prices currently hovering around $70 a barrel, expectations are that this trend will continue for the foreseeable future.

Ecuador, for example, seized at least $1 billion in assets from Occidental in May 2006 on the rationale that the government was “enforcing its law.” The company was accused, for example, of breaking production quotas and not filing required reports. Occidental has taken the matter to an international tribunal.

This past spring, Bolivia nationalized its energy industry and sent troops into natural gas fields. Bolivia’s action prompted Brazilian leaders to demand compensation for the impact this action could have on Brazil’s economy. Bolivian leaders also ordered an international pension fund to surrender shares of three energy companies - Repsol’s Andina; BP’s Chaco; and Shell’s Transredes.

Venezuela took a different course of action: its legislators approved the doubling of royalties - from 16.67% to 33.3% - for oil companies such as ExxonMobil and Chevron who are shareholders in four heavy-oil ventures. Additionally, Venezuelan President Hugo Chavez says his country has obtained control over four heavy-oil ventures in the Orinoco belt with total foreign investment of about $17 billion, although the Venezuelan congress has not yet approved that action.

The trend is not limited to South America. For example, some politicians in the US have called for substantial changes in the law that would similarly revise the existing relationships and rights of energy companies. There have been several proposals for federal legislation that would suspend royalty relief that had previously been authorized to promote the development of, and increased production from, costly deepwater wells in the Gulf of Mexico.

On May 18, 2006, the House of Representatives passed an Interior Department appropriations bill that would require the Secretary of the Interior to suspend, on future leases, federal laws that provide royalty relief for oil or natural gas produced from federal lands. The bill also would require the secretary to seek the renegotiation of existing lease terms that suspend royalty payment obligations.

More than 10 pieces of legislation that would impose a “windfall tax” on oil companies have been proposed in the House of Representatives or the Senate. In addition, the broad energy proposal recently announced by Senate Democrats, entitled the “Clean Energy and Development for a Growing Economy Act,” includes provisions requiring major oil companies to pay their “fair share” in taxes and royalties.

Of course, some governmental actions to increase revenue from oil are consistent with the legal and contractual regime to which the investors are subject. In addition, in some nations, there is a well-formed body of law and an independent legal system that may provide avenues for assessing and, where appropriate, redressing government actions that abrogate settled rights. For example, any governmental action in the US that restricts royalty relief that was previously provided under existing federal law or federal leases could face serious legal challenges under, for example, the “takings clause” of the US Constitution. In some other areas of the world, however, the legal remedies may be less certain.

Oil and gas investors are exposed to at least 3 types of expropriation risks by governments: outright takings; so-called “creeping expropriation,” in which the government’s share of the financial benefit is increased or the government’s control over the asset is increased; and losses of future opportunities. Creeping expropriation can be the most difficult to address because of its many forms; these can include, among others:

Changes in tax rates or other government charges
Introduction of new taxes or other government charges
Denial of benefits
Requirements for increased government participation in equity or management

The oil and gas investor may be exposed to these changes for a number of different reasons. For example, the investor may not have an enforceable stability clause in its license or contract with the government, or may have a stability clause of limited scope (for example, many such clauses are limited to taxes, only).

In addition, an investor may, from time to time, need discretionary approvals from the government to conduct its activities. Or, contractual performance standards may be vague or unachieved, leaving the contract open to government challenge. Even if the investor has somehow covered all avenues, the government may ignore the contract and impose changes anyway on the assumption that the investor will not risk the remainder of its investment to challenge a partial loss.

Over the last century, a doctrine of “internationalization” has evolved under international law, which can help protect foreign investors by supporting at least some financial remedy in the event of expropriation. Under this doctrine, a contract between a state and a private investor may be subject to international law, which incorporates the doctrine of pacta sunt servanda: that parties are bound by the contracts they execute. Among the actions that can be taken to support internationalization of a contract are express incorporation of international law, selection of a choice of law other than the law of the host state, and incorporation of a stability clause.

Even the presence of a strong stability clause, coupled with the internationalization of the contract and international arbitration rights, however, will not guarantee that an investor will prevail in an expropriation claim. Governments will seek to assert the principle that host countries maintain “permanent sovereignty” over their natural resources. In addition, host governments can be expected to present various theories of contract invalidity, such as changed circumstances, frustration of purpose, waiver, etc. And, of course, even where liability is established, challenges to the oil and gas investor’s measure of damages may remain. In other words, there will undoubtedly be disputed issues of fact, public policy and law against which the investor will seek to remedy its losses.

There is, however, a mix of international remedies available to foreign investors suffering local mistreatment. Investors can look to their contractual dispute resolution mechanisms and/or local foreign investment laws, which frequently provide for international arbitration by a neutral decision maker.

Often more valuable, however, is the growing network of international investment treaties. Many nations have executed bilateral investment treaties (“BITs”) to encourage capital investment. The United States has signed over 40 BITs with other nations; the UK, approximately 100. Over all, more than 2,300 BITs are presently in force. In addition, there are multilateral treaties, such as NAFTA and the Energy Charter Treaty.

These treaties set international standards of fairness by which the signatory governments’ treatment of foreign investment is measured. Treaty rights can be enforced by investor-initiated arbitration, and even provide grounds for the investor’s home government to take up its interests with the host nation directly. Because of the incomplete network of treaties, however, ensuring availability of a treaty remedy demands appropriate planning of corporate structure and nationalities before a dispute arises.

Whether based on contract, statute, or treaty, it is typically wise (and often required) to pursue negotiation before arbitration. Because capital importing nations sometimes fear the loss of investor confidence, investors can have leverage in these negotiations. Compromise solutions also permit retention of the property interest, whereas arbitral solutions are usually limited to damages.

In summary, safeguarding investors’ rights requires legal planning before a dispute arises. Once the dispute surfaces, however, the advised strategy should be sensitive to corporate objectives and legal requirements, while taking advantage of the world of procedural and substantive opportunities available.