The case against international investment

Venezuela's President Hugo Chavez, seen here in front of an image of South American liberator Simon Bolivar, nationalized the oil and gas sector in that country. Venezuela currently faces 15 cases against it in one arbitration forum alone.

Wayne Wilson, UHY Advisors, Houston

It's almost something from Hollywood. Two high speed freight trains racing toward each other on the same track.

The problem is this is occurring in the real world, and the looming crash of interests between the governments of many reserves-rich countries and the foreign companies they rely on to produce those reserves is threatening to blow-up the economics of international exploration and production projects.

One of the trains is the recent increase in nationalizations, or expropriations, and changes being made in severance tax rates, royalty rates, dividend repatriation, and the overall tax structures of producing countries. The global economic downturn and rising demands for services from the populations of host foreign countries has put these governments into a tightening financial squeeze that leaves them two choices: cutting spending or increasing government revenues. Nationalizations in the oil and gas sector typically rise when commodity prices are high. This is best shown by Venezuela's large number of nationalizations beginning in 2007 and continuing through 2009. Venezuela currently faces 15 cases against it in one arbitration forum alone and that number is expected to rise.

The other train is the voracious need to find and produce larger amounts of oil and gas on an economically viable basis to meet global energy demand that has increased by more than one-fifth since 2000, and is projected to expand another 20% by 2020, or approximately 16 billion barrels of oil equivalent.

The rules of the game

Although the terms under which oil and gas are produced and the host country and producing company receive compensation are hammered out in extended negotiations at the beginning of projects, often new conditions or opportunities arise during the course of the project that bring one party or the other to seek a change in the agreement.

To establish an agreed system for handling differences or disputes that can develop in international investments and projects, a variety of bilateral and multilateral investment treaties (BIT and MIT respectively) have been signed between countries across the globe. These treaties are designed to provide foreign investors with a level playing field when they invest abroad.

For instance, if an investor from the United States chooses to invest directly in a foreign country which has an investment treaty with the United States, that investor is usually supposed to be provided the same treatment afforded to domestic investors within the foreign countries. The Office of the United States Trade Representative lists six core benefits to investors of BITs:

• US BITs require that investors and their investments be treated as favorably as the host party treats its own investors.
• BITs establish clear limits on the expropriation of investments and provide for payment of prompt, adequate, and effective compensation when expropriation does takes place.
• BITs provide for the transferability of investment-related funds into and out of a host country without delay and using a market rate of exchange.
• BITs restrict the imposition of performance requirements, such as local content targets or export quotas, as a condition for an investment.
• BITs give covered investors the right to engage the top managerial personnel of their choice, regardless of nationality.
• BITs give investors from each party the right to submit an investment dispute with the government of the other party to international arbitration.

Some of these treaties, such as the North American Free Trade Agreement (an MIT), are very well known by the general public. Other examples of these treaties, such as the US BIT with Albania or the Israel Free Trade Agreement, are less well known.

Typically, when an event such as nationalization occurs that may require international arbitration, two documents govern that process: first, the relevant investment treaty; and second, the actual investment contract signed by the investor with the foreign country.

The number of forums for international arbitration is growing. Some of the longer-existing forums are the International Centre for Settlement of Investment Disputes (ICSID), the International Court of Arbitration of the International Chamber of Commerce (ICC), the London Court of International Arbitration (LCIA), and the Permanent Court of Arbitration (PCA). Other forums for international arbitration have been created in the United Arab Emirates, Egypt, China, Africa, and Russia.

The arbitration process

Duration - International investment arbitration is typically a long and potentially expensive process. The average length of time from filing to initial award has historically been 3.4 years at ICSID, and rises to 5.8 years if there is any type of challenge to the award. The costs associated with a three- to five-year process can be quite large in terms of professional fees for attorneys and experts, and ICSID also requires additional fees to compensate the arbitrators. As a result, it is not unusual for a complex ICSID case to cost millions of dollars in professional fees alone.

Claimant Success Rate - The complexities of international investment treaty law make it nearly impossible to predict the likelihood of success on legal issues. Overall, 118 of the 224 cases listed as concluded by ICSID in 2008-2009 resulted in an award of some type. Claimants (companies) and respondents (states) split the awards 50/50 in 2008, with the 2009 balance shifting to respondents in 60% of cases according to Investment Arbitration Update. This gives companies a record of winning some type of award approximately 28% of the time. Clearly, judging simply on these odds, international investment arbitration may not be a company's first choice.

Amounts of Awards – The bottom line question for energy companies facing international investment arbitration is, if they prevail, the size of award that can be anticipated. Historically, when ICSID arbitrators grant an award to the claimant, it has been around one-third of the amount claimed, or about $0.33 on the dollar, according to Investment Arbitration Update. In 2009, this percentage increased to 41%. In cases involving exproporiation, claimants received an average of 55% of the amount claimed when ICSID tribunals ruled in their favor.

However, the largest public ICSID award ever granted was $185 million in a 2001 matter between Azurix and Argentina. Compared with an original damages claim of slightly over $600 million, the $185 million award represented roughly 30% of the original claim. Additionally, the decision was challenged and final resolution confirming the award occurred on September 1, 2009, meaning the process took almost eight years from filing to completion.

Impact of arbitration on investments

The fact that more international arbitration claims have been filed in the past seven years than in the preceding 32, is a good indicator of the international environment for investors.

This increase reflects both a rising trend of nationalizations and other actions by governments that can have a negative effect on the value of a foreign investment.

Arbitration and investment decision

While the strategic reasons for foreign investment related to supply needs for downstream operations are relatively straightforward and not necessarily impacted by international arbitration, arbitration risk can have a notable effect on hurdle rate analysis. Hurdle rates typically represent the rate of return required by an energy company for an investment to make economic sense including the external cost of capital and opportunity cost.

The rate of return on a given project is the product of many variables, predominantly the timing and size of expected cash flows from the investment. When energy companies are negotiating international investments in foreign countries, there are often sizeable up-front costs such as the purchase price of the concession or license from the government, the upfront geological and geophysical costs, any environmental permits that are required by the host government, the costs of the exploratory well, the cost of the developmental wells, and the cost of all of the necessary infrastructure necessary for production and transportation of the reserves (which is often not present in lesser developed countries).

After these sizeable investments made in the first few years of the life of the project, the energy companies then receive positive cash flows from production and sale of the reserves. Usually the reserves also carry a royalty, tax, tariff, or some combination of the three that are paid to the host government. Finally, the project's life is estimated and the cash flows are calculated over that life.

This analysis is greatly complicated by the threat of nationalization or other adverse actions by the host government, and exacerbated by the prospects of international arbitration. Consider a range of implications:

• If a project with 3 years of up-front investment, 20 years of expected positive cash flows, a one-eighth royalty on the production, and a defined tax structure is changed dramatically, the rate of return is likewise dramatically altered.
• If nationalization is a risk, it could shorten the reasonable life of the project to 5 years in total, leaving only 2 years of positive cash flows to offset the 3 years of negative cash flows.
• If nationalization occurs, and the company assumes that it wins an award at ICSID, the most recent data suggests that they may receive, on average, 55% of their claim. However when you evaluate their expected value, assuming the 28% success rate of the claimant receiving an award and the 55% rate of compensation, the expected value before beginning international arbitration is roughly 15% of their anticipated claims, less costs of the arbitration. This expected value results in a very small expected recovery of the value of their investment.
• Even if the company assumes that it is victorious in getting an award granted and that they are victorious in winning that award, they are still facing roughly 55% of their claim being awarded, based on the most recent data. Historically, this percentage is 33%.
• Finally, the company will have to wait on average 3-5 years before the award and potentially face years of annulment proceedings before reaching a point where they then have to collect from the foreign government.

Unquestionably, nationalization negatively affects the rate of return on an investment. However, since nationalization historically occurs after the decision to invest has been made, how it impacts a company's analysis of the expected rate of return for a project can be unclear. Due to the rise in nationalizations in the energy industry worldwide, it is reasonable and likely prudent for companies to consider this risk in their evaluation of projects and when negotiating their investment terms with foreign governments.

This type of analysis should lead companies to revisit their rate of return analysis for foreign investments. Given that ICSID has never published an award in the billions of dollars, energy companies have just cause for concern at this point in 2011, a year that should see the decision of a key dispute over the nationalizations in Venezuela. Many of the claims before ICSID for the Venezuelan nationalization will likely be in the billions of dollars. If ICSID tribunals continue to rule on cases in a manner consistent with history, it could have negative ramifications for international investment.

The ironic reality is that the flip side of a 15% expected value for a company's international arbitration claim is that the respondent country's expected value is 85%, without costs of the arbitration. Even if a country loses at every stage in the arbitration and must pay an award, the nationalization will only cost them $0.55 on the dollar based upon historic statistics. Most serious energy investors would agree that purchasing operating energy assets for 55% of their value would usually be a good deal.

The future of international investment and international arbitration

The question facing the energy industry today is how to protect their investments in this environment. Several basic avenues are available to companies:

1. The first obvious opportunity for improving the economics of international investments is to negotiate lower up-front fees to the government for concessions or licenses, shorten and simplify the environmental permitting process, lower the royalties or other fees associated with production, and stabilize tax regimes. This all sounds good, but in application may be nearly impossible. Energy companies vie with one another for concessions in foreign countries, making aggressive negotiation of up-front fees impractical in order to avoid losing opportunities. Royalty rate negotiation also seems straight forward, but given changes in regimes, in economic realities, in commodity prices, or in perceptions of the environmental impact of energy production, any negotiated rate can, and probably will, change. Finally, tax regimes in stable countries change without warning. It is unlikely that a developing country's promises of tax stability carry any lasting use.
2. A second alternative is to develop some sort of boxed or negotiated arbitration through the arbitration clause in the investment contract. By agreeing to a common discount rate that is reviewed annually, requiring annual valuations of the investment to be reviewed by the host government, or simply by agreeing on a set of cash flow assumptions that would be used by both parties for valuation, companies could eliminate some of the variables that are consistently the topics of heated debate in international arbitration. Other options include placing tighter time limits around the arbitration itself to require that it occur more quickly. Additionally, companies could ask for a rolling escrow of the government's share of the production revenue for one year to reduce the risk of nationalization.
3. Third, energy companies can hope that international courts of arbitration send a strong negative message to countries that nationalize. If the costs to nationalize become overwhelming for countries and they are forced to either fairly compensate companies for their nationalized assets or face a worse scenario in arbitration, the rate of nationalizations may slow. The most important thing for foreign countries to remember if they are moving toward nationalization is that they originally sought foreign investment for a reason. Usually, it was to attract needed capital or to utilize a technical expertise that was not available domestically. Rarely do nationalizations result in increased efficiency, profitability, or safety of the investment. Often, the opposite occurs and the investment grows inefficient, loses money, and becomes a danger to the public.

Conclusion

The historically small awards granted in international arbitration provide energy companies with little hope of full reparations and compensation for losses. The potential impact on global international investment could be devastating as western companies seek safer havens for investment, decrease the prices they are willing to pay for investment opportunities either in taxes or fees, and ultimately pursue new and innovative ways to invest internationally.

The recent investment structure between BP and Rosneft may be an example of a foreign investor trying to achieve two goals. The first is the historic goal of international energy companies to secure reserves for exploration and production and to then distribute those reserves through the various segments of their organizations. A second goal seems to be to achieve some stability in their investment by investing with, in this case, a partially government owned energy company. It is a unique and timely strategy that could also be followed by other international energy companies.

About the author

More Oil & Gas Financial Journal Current Issue Articles
More Oil & Gas Financial Journal Archives Issue Articles
View Oil and Gas Articles on PennEnergy.com