The impact of the COVID-19 pandemic on oil and gas contracts

By: Richard Devine and Ana Severova, who are partners at Devine & Severova, a UAE-based legal consultancy

As the world struggles to contain the novel coronavirus, oil demand has shrunk by an estimated 30 million barrels of oil per day.  Inevitably, the price of oil has collapsed and whilst commodity cycles are an integral part of the industry: “This is a once-in-history demand shock being met by a once-in-a-generation supply shock going the other way” end note reference (1).  Surprisingly, the pandemic initially coincided with a short-lived oil price war. Key producers such as the Kingdom of Saudi Arabia and Abu Dhabi offered big discounts to customers and promised to materially increase production, even as air travel was suspended, factories closed and oil stock tanks neared capacity. 

After an intervention by President Trump and pressure from the G20 to shore up oil prices, an armistice to the price war was agreed. OPEC+ agreed to cut supply by almost 10 million barrels per day in May and June with lower cuts in subsequent months. At the time of writing, there is little evidence that the OPEC+ deal will reverse the downward price trend.  Since the deal was agreed, Brent crude has fallen to its lowest level for over 20 years and the WTI crude for May delivery futures contract ignominiously fell into negative territory, with some desperate sellers having to pay buyers in excess of US$35 per barrel to take the contracts off their hands. Quite simply global demand has collapsed and whilst lockdown has economies in suspended animation, it is difficult to see how changes to the supply side can materially increase prices.

Indeed, commentators are now beginning to ask if demand will ever return to pre-pandemic levels. Some of the established market practices that propped up oil demand are now being stress-tested in unique ways. Businesses seeking to protect their bottom line are weighing up the benefits of stretched, global supply lines and frequent air travel against the threat of contagion. Since the political environment supports fewer carbon emissions, demand reductions may be permanent. Some major European cities are starting to introduce ambitious schemes reallocating street space from cars to cycling and walking. The result is that the future for oil and gas companies is likely to be uncertain for longer. 

In our experience, precipitous falls in the oil price increase legal risk. Cash is king and companies must focus almost exclusively on cash preservation to survive, sometimes at the expense of contractual commitments. Moreover, the economies of the GCC countries and public spending budgets depend heavily on oil. Given the prominence of state-owned entities in the GCC, the price crash will increase risk across most sectors. The additional complication in the present scenario are the risks relating to the COVID-19 pandemic.  We highlight some of these risks in the context of contracts common in the industry and provide some tips on managing the crisis.

Risks in typical oil and gas contracts Deferral of expenditure on exploration and development operations

The oil price crash is likely to have a significant impact on the relationship between (1) companies investing in oil and gas exploration and governments (which are typically governed by production sharing agreements, concession agreements, and licences (Concessions)) and (2) companies working in consortium to explore for oil and gas (which are typically governed by joint operating agreements (JOAs)). 

Pursuant to Concessions, companies usually have an obligation to undertake certain exploration activities within a defined time period. The commitments may include obtaining, processing and interpreting seismic data, and drilling exploration wells. Low oil prices are a commercial deterrent to exploration, but not a legal excuse to stop work. If companies do not complete their minimum work obligations, they can lose their Concessions and become liable for damages. That said, with the government’s consent, it is possible to defer work commitments. This is an option that has the potential to be a “win/win” solution, if the companies can demonstrate it results in lower exploration costs. 

Development operations are typically much more capital intensive than exploration operations. Companies want to preserve cash and, accordingly, there is an even greater incentive for companies to seek to defer these obligations. In addition, access to external finance (through debt or equity markets) is likely to be constrained for all but the biggest companies and, to the extent debt finance is available, it may be expensive with onerous covenants. However, once a development work programme and budget has been agreed, companies must usually comply with the programme or risk having to relinquish their discovery. Companies therefore face the same quandary as they do with minimum work commitments. Similarly, there may be a commercial benefit for both parties to renegotiate and defer capital commitments if it avoids supplying additional oil into a falling market.

Low oil prices can also escalate tensions under JOAs. The parties to JOAs have different portfolios and their concerns during bearish oil markets may differ. For example, consider the positions of a major international oil company with multiple assets and ready cash, and a highly leveraged independent company with a single asset and limited cash flow.  Each will have very different priorities. Whilst the oil price is likely to accentuate differences, most JOAs do not permit a party to opt out of minimum work obligations, although they may be able to non-consent to development operations. To prepare, parties should look very closely at provisions relating to exclusive operations, default, non-consent, withdrawal and annual work programmes and budgets. 

The potential impact of a co-venturer’s insolvency on a JOA should also be considered and the consequences of such insolvency on the related Concession and oilfield services contracts. Insolvency of the company appointed to act as operator of the Concession may be particularly problematic.

Industry standard JOAs often contain default provisions and remedies that are drafted from a common law perspective and which may operate differently in civil law jurisdictions. The rights of non-defaulting parties may not be exercisable to their fullest extent in all jurisdictions. It is critical that the enforceability of these provisions (as a legal and practical matter) be factored into any decisions. 

Co-venturers are typically jointly and severally liable under a Concession and the insolvency of one may put the whole Concession at risk. With respect to the operator, the JOA may well give co-venturers an absolute right to remove an insolvent operator but the Concession or applicable law may require government consent to a change of operator. If there are concerns that the operator or another co-venturer may become insolvent, preparing a plan of action with the other co-venturers (which includes discussions with the relevant government stakeholders at the appropriate time) is a necessity. 

Financing challenges

Accessing or refinancing debt whilst oil prices and revenues are low will be challenging. The downgrading of oil companies’ reserves that results from lower oil prices affects certain industry financing in particular.  Reserve-based lending facilities are secured (in part) by the borrower’s reserves of hydrocarbons. Subject to the mitigating impact of any hedging arrangements, falling prices diminish the value of the security. The lender could require the deficiency to be repaid or increase the collateral.  Both options are unattractive in the current environment. Borrowers should use the breathing space offered by any hedging arrangements to discuss refinancing options with potential lenders. Unless they find accommodating financiers, cash-strapped borrowers may have their assets cherry-picked by opportunistic buyers.

Supply chain interruption

Oil companies rely on extensive supply chains, often contracting with oilfield services providers for services, people and materials essential for oil and gas operations. The pandemic has led to manufacturing facilities in several countries shutting down or operating at limited capacity. Lockdowns have made impaired operations and schedules whilst travel restrictions have affected the availability of labour. 

All of these circumstances have the potential to delay or prevent the performance of a party’s obligations. Companies should carefully evaluate how (or if) their contracts deal with such risk and consider relevant provisions regarding force majeure; extension of time; variations (and impact on timing and payments); and termination. 

Change in scope

Engineering, procurement and construction (EPC) contracts are common in the oil and industry. As companies seek to defer or cancel capital commitments in order to preserve cash, “descoping” of projects is common. In the current circumstances, scheduling and payments obligations are also likely to be affected. 

The contracting parties’ ability to vary the scope of work will generally depend upon the specific contract. Contractual provisions that will be relevant to this analysis are: variations (whether they permit descoping and the impact on timing and payments); advance payment and performance guarantees (are the amounts guaranteed still appropriate?) and schedule for delivery, key milestones and timings of payments.

Practical tips on dealing with the impact of the oil price drop and pandemic on oil and gas contracts

The upstream industry often involves international investments and government partnerships or participation. Two issues that should always be front of mind are: (a) what laws apply to the affected projects and workforce; and (b) how will the pandemic affect government decision-making (e.g., should longer lead times be factored in?). We set out below seven practical tips for dealing with the impact of oil price drop and the COVID-19 pandemic on oil and gas contracts. 

1. Be proactive, rather than reactive. Prioritise contracts by their importance to the business and undertake high-level due diligence to identify potential pressure points and opportunities. If a project is severely affected, consider whether suspending work, declaring force majeure or terminating the relevant contracts is the most advantageous course of action. Carefully evaluate termination provisions and, if a dispute is in prospect, consider whether you are likely to be able to enforce a court judgment or arbitral award before incurring sizeable legal fees. Remember that some companies will want to ensure that the crisis does not go to waste. Scrutinize causation to confirm that companies are not using the pandemic as an excuse to delay or avoid performance. 
2. Identify any implied obligations under the contract. Consider the governing law of your contracts and its implications for interpreting obligations and potential causes of action. For example, would the governing law impose duties of good faith, or give parties relief from certain obligations on the basis of hardship or force majeure?
3. Communicate with counterparties. Comply with any obligations to provide notices or information to counterparties.  Being aware of your contractual rights can make decisions about next steps easier.  Remind counterparties of outstanding obligations in compliance with applicable notification provisions. Consider also whether the solution lies outside of the contract and how open discussions can help.  In the oil and gas industry competitors often collaborate as co-venturers and relationships are highly valued.
4. Monitor the financial strength of your counterparties. The financial position of your counterparty may have changed since you struck the deal.  Closely watch unpaid invoices. Consider whether existing credit support (if any) is sufficient.  If the counterparty is in serious financial difficulty, think about terminating the contract and commencing legal action as soon as possible having taken advice on applicable insolvency laws.
5. Good housekeeping. With the potential for litigation, it is essential to document all communications (whether by telephone call or in person) and preserve all emails and documents.
6. Remember to consider risk mitigants. Are any of the costs and expenses incurred as a result of dealing with the pandemic covered by insurance? What steps must be taken to take advantage of any such insurance?
7. Be alive to consolidation. Oil price downturns typically result in some level of consolidation. Acquiring reserves through M&A rather than by the well-tip is often cheaper in a low oil price environment. Companies should be alive to the threats and opportunities the current circumstances present. 

 This feature first appeared in the May issue of Pipeline Magazine

Ana Severova

Richard Devine