Disputes arising from oil price decline
01 April 2015
Ronnie King is a Partner at Ashurst LLP and consulting editor of Dispute Resolution in the Energy Sector published by Globe Law and Business.
An understanding of dispute resolution mechanisms has rarely been more important to companies in the oil and gas sector. If past experience is anything to go by, the recent significant drop in oil prices is likely to lead to a variety of disputes. This decline in oil prices has had a serious effect on oil and gas companies around the world and connected parties (eg, contractors and offtakers), all of which may now face problems arising from decline in investment, price reductions, payment delays, employee redundancies, cash flow difficulties and takeover bids. These difficulties create fertile ground for disputes. Some of the potential areas are outlined below.
Oil exploration and drilling contracts on hold
As oil prices fall, oil exploration and drilling contracts are likely to be put on hold or cancelled altogether. The number of oil and gas rigs in operation is already beginning to drop, indicating that exploration companies are starting to reduce their investments; this will also have an effect on the companies supplying the rigs.
Offshore oil contractors are more likely to be affected than oil exploration companies because profits are generated by drilling rather than oil production from completed wells. When drilling slows or stops, profits are affected immediately. In addition, while oil exploration companies should benefit from rising profits on existing production if oil prices start to increase again, drilling companies will have idle assets until drilling recommences.
Restrictions on cargoes
In some instances, it may be more profitable for oil and gas companies to divert their cargoes. This is often subject to restrictions in supply agreements. Disputes may arise where parties seek to renegotiate these terms.
Gas price reviews
For historical reasons, many gas supply agreements link the contract price to oil prices. However, the gas market transformed in recent years, eroding the link between oil and gas production as better facilities for liquefied natural gas import and export provided more liquidity in the gas market, causing gas prices to fall. As oil prices increased or remained stable, many gas buyers found that they were tied in to lengthy and expensive agreements, where price had no relation to market reality.
Most gas supply agreements contain a mechanism for determining the contract price for the supply of gas, usually by reference to various specified factors. They also contain provisions allowing for a review of the price and price formula (a price review clause). When triggered, the provisions of the clause will usually require the parties to attempt to renegotiate the contract price and price formula to reflect a change in circumstances or, failing agreement, to refer the request for a price review to arbitration.
As a result, when oil prices were at their height, large numbers of gas buyers sought to trigger the price review mechanisms in their agreements, in many cases commencing arbitration. However, now that oil prices have fallen significantly, the original pricing may in fact be more commercially attractive to buyers. Sellers may themselves want to commence price reviews to readjust any formulae which were amended during times of high oil/low gas prices, and buyers may seek to withdraw from arbitrations where a revised price has not yet been determined.
Insolvency filings in the oil and gas sector are expected to increase. Powerful oil companies are reportedly demanding 20% to 30% price reductions and extending payment periods, creating serious cash-flow gaps for service companies (eg, drilling and equipment firms and oilfield service providers) which may have weak balance sheets.
Companies filing for insolvency will experience a knock-on effect for their contract counterparties, which may suffer financial loss and/or be unable to perform their obligations under related contracts, which may again lead to further disputes.
The smaller companies that manage to stay afloat will remain vulnerable to takeover bids. For those companies able to capitalise on the weakened players in the market, restructuring and consolidation will enable them to cut costs through synergies and obtain specific valuable assets at attractive prices. This could give rise to competition and regulatory issues.
The profitability squeeze and ensuing insolvencies and consolidations are likely to result in large numbers of redundancies across the oil industry, which in turn will inevitably cause an increase in employment disputes, creating an additional cost for struggling employers.
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