TRANSACTIONAL: Transactions: Mitigating Expropriation Risk of Natural Gas Projects by Philip R. Weems and Matt Salo

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[authors: Philip R. Weems, Matt Salo]

The International energy companies often find the most attractive oil and gas prospects to be located in countries where the risk of expropriation, whether full or partial, looms on the horizon. Although the epicenter of recent expropriations has been Latin America, expropriation risk is certainly not limited to that region. As new resources are discovered in new parts of the globe, many nations are for the first time experiencing major oil and gas operations within their borders. Given the right political and social atmosphere and the rising value of hydrocarbons, any of these nations could become the next expropriator.

Expropriations targeting the oil industry have a long history, but examples of expropriations in the natural gas sector are more limited. Although there may be fewer examples, the risk expropriation poses to natural gas projects (particularly LNG projects) is no less significant due to the heavily capital-intensive nature of such projects. And the risk of expropriation in the gas sector appears to be on the rise.

Argentina’s recent expropriation of Repsol’s interest in the formerly state-owned YPF sent shock waves through the natural gas industry, and it came on the heels of Bolivia’s expropriation of Pan American Energy LLC’s 25 percent interest in the Caipipendi natural gas field. And this was certainly not Bolivia’s first foray into expropriations targeted at the natural gas industry. Evo Morales’ 2006 nationalization decree granted state-owned YPFB control over all natural gas production, with foreign companies allowed only to act as service providers to YPFB. The year 2006 also saw Russia’s forced sale of a majority interest in the Shell-led Sakhalin-2 LNG project, an action that closely resembled an expropriation. In 2004, the Mexican state of Baja California expropriated a site Marathon had identified for a LNG storage facility near Tijuana.

The risk of expropriation in the natural gas sector is also heightened (i) by the fact that many exploration and development contracts with host governments contain very few provisions related to natural gas, and often simply create an obligation to negotiate a mutual agreement with respect to the development of a discovery of natural gas, and (ii) by the length of time it takes to market natural gas before it can be produced. These factors were at play in Wintershall’s arbitration dispute with Qatar in the 1980s and can be seen in the on-going dispute in East Timor over the Greater Sunrise natural gas field. In 1980, Wintershall discovered what it believed to be commercial quantities of non-associated natural gas in Qatar, but an agreement with respect to commercialization of the discovery was never reached with the Qatari government. The dispute went to arbitration, wherein Wintershall claimed the government of Qatar had expropriated its contractual rights in part because the Qatari government allowed the relinquishment period to expire on Wintershall’s exploration and production sharing agreement before reaching such utilization agreement. However, applying Qatari law, the arbitration tribunal ultimately rejected almost all of Wintershall’s claims (including its claim of expropriation) causing investors in the project eventually to lose their investments.

Another major disagreement between a host government and an investor is brewing in East Timor and may result in the involved energy companies losing their rights to develop a major LNG project. In 2007, East Timor and Australia agreed to a treaty settling their long-standing boundary dispute and establishing a division of royalties from the shared Greater Sunrise offshore natural gas field. However, East Timor recently threatened to terminate the treaty if an agreement to construct an onshore LNG export facility in East Timor is not soon reached (the Woodside-led consortium is insisting on a floating LNG approach). Across the Arafura Sea another dispute is taking shape—InterOil recently reported that the government of Papua New Guinea has provided notice to the company that it intends to cancel the 2009 LNG Project Agreement governing the Gulf LNG project.

As shown by the examples above, the risk of natural gas project expropriations is real, irrespective of the part of the globe in which the project is located. So, what can an investor do to attempt to mitigate this risk? The time to think about a possible expropriation is not when the host government moves to seize a project, in whole or in part. Below, we briefly discuss a few proactive measures that should be considered during the early stages of a project’s development to mitigate the risk of a government expropriation or lessen the financial impact should one occur.

Be informed.

An investor should, of course, perform sufficient due diligence on a host country before making an investment, but this extends beyond just understanding political and legal risk. Understanding what sort of market is available to monetize a discovery of natural gas is equally important. Some nations that are emerging as major natural gas reserve holders do not have a significant domestic gas market; therefore, thought should be given to what would be required to export natural gas to markets elsewhere. Because gas export projects require advance long term sales at acceptable prices, they may take a long time to develop. This lag time between discovery and actual monetization may expose the project to a greater risk of expropriation. Had Wintershall been able to find a market for its Qatari natural gas discovery in the early 1980s, it may have avoided entirely its impasse due to its inability to reach an agreement with the Qatari government. An extended lag time could also lead to accusations by a host government that an investor is not investing enough in the project, which could lead to an expropriation like Bolivia’s recent seizure of Pan American’s interest discussed above.

Negotiate with a potential large, long-term natural gas development in mind.

An investor should ensure that its production sharing contract, concession, or license contains detailed provisions covering the development of a natural gas discovery. As shown above, a provision that provides an “agreement to agree” on the details of a gas development exposes the project to greater delays and possibly a greater risk of expropriation. Due to the extended amount of time it takes to market and develop a natural gas project, contracts with a host country should give an investor a reasonable gas marketing period (up to 10 years) and have a term that extends for a sufficient amount of time after production begins to allow for full development of the discovered fields.
If host country agreements have too short of a term after production, an investor may be forced to rush into the wrong type of gas project that could ultimately undermine the rewards to the investor. Additionally, rushing into a deal too quickly may cause the long-term effects of a project on investors and a host government to be overlooked. There have been a number of recent examples, such as disputes over the diversion of LNG cargoes to higher priced markets, where project structures were established that ultimately benefitted off-takers and offshore companies at the considerable expense, arguably, of a host government. If the benefits of a gas project are believed to be unfairly skewed away from a host government, a movement towards expropriation may develop.

Develop a strong project structure and solid legal foundation.

A project structure built on a solid legal foundation (including a suitable project agreement between an investor and a host government) can mitigate the risks associated with government expropriation or unwanted intervention in general. Among other provisions, a project’s legal foundation should include the following: (i) a robust “stabilization” clause; (ii) a dispute resolution provision that provides for ICSID arbitration; (iii) a provision establishing the governing international law (e.g., English law); and (iv) a provision establishing the right to keep the project funds outside of the host country.

Stabilization Clauses. Perhaps the most important clause to consider in a project agreement with a host government is the stabilization clause. The general purpose of a stabilization clause is to preserve the deal struck between the host government and the project participants throughout the life of a project—such a provision provides that the economic equilibrium between the parties should be restored should a change in law affecting such equilibrium occur. Inclusion of strong stabilization clauses in a project agreement with a host government (i) will provide a basis for a claim in arbitration for breach of contract; (ii) may support a claim under a bilateral investment treaty for breach of the host government’s treaty obligations; (iii) may lead to higher damages in arbitration by establishing “unlawful” expropriation; and (iv) is necessary to obtain project financing of a major gas contract.

International Arbitration. Any project agreement or other contract with a host government should provide for international arbitration, preferably through the International Centre for Settlement of Investment Disputes (ICSID), in the event of a dispute. Such a clause provides an investor the right to submit claims to a neutral forum outside of the host country, which can act as a deterrent to expropriation and increase the likelihood that an investor receives full damages from a host government. Consideration should also be given to establishing the use of the United Nations Commission on International Trade Law (UNCITRAL) arbitration rules as a back-up to ICSID arbitration.

Governing Law. Choosing English law as the governing law of a contract will enable an arbitration tribunal to consider international law in its decision-making. This is because the laws of England and Wales formally incorporate customary international law into domestic law. Customary international law provides that contract rights are entitled to protection and that a taking of them by a government triggers an obligation of the government to make just compensation for the taking; such a standard may not be present in the domestic laws of a host country.

Right to Keep Funds Outside Host Country. In an attempted expropriation, a host government may seek to seize funds from a project in addition to the project itself. By keeping these funds outside of the host country, the expropriation of funds would be much more difficult for the government to carry out.

Consider structuring the investment to take advantage of Bilateral Investment Treaties.

A bilateral investment treaty (“BIT”) may be in place between an investor’s home country and the host country and govern the terms and conditions of an investment in the host country. However, if the protection under such a BIT is determined to be insufficient, an investment may be structured to take advantage of additional BITs that have broader investment protection.

Consider spreading the risk to other investors.

The risks posed by an expropriation can be mitigated by increasing the number and mix of the project participants. The impact an expropriation would have on an investor can, of course, be reduced by reducing the amount of equity such investor holds in the project. The decision to include additional or different project participants should be made with an eye to such potential participants’ political influence; national oil companies or a gas buyer based in a country with an influential government are prime candidates. Other factors that should be considered include such participants’ ability to support project financing (perhaps by providing Export Credit Agency project financing) and ability to afford the high cost associated with the development of gas reserves. However, reducing the amount of equity an investor holds in a project has its trade-offs. The goal of an investor should be to minimize or spread the risk of expropriation among various parties without losing control or meaningful influence over a project.

Establish strong relations with the host government.

Among the most effective strategies to mitigate the risk of expropriation are establishing and maintaining an open dialogue and good relationship with the host government and engaging in joint ventures with local companies. A lack of transparency and local involvement can lead to suspicion and to arguments that a particular project is not providing enough benefits to the host country’s populace, which can lead to a movement in favor of expropriation. Governments in developing countries may look with suspicion upon large foreign companies that are perceived as exploiting their mineral resources—a suspicion that could lead to a belief that such foreign investor is enjoying hidden or windfall financial gains from a particular project.

Companies should consider establishing solid corporate social responsibility programs; perhaps requiring project participants to make contributions to or carry out certain social and economic development projects in the local communities affected by a project. These programs can have a great impact on how a company is perceived by the public of a host country, and a positive public reputation can be vital to ensuring a project’s development goes smoothly. Local programs could also avoid the perception that a project’s benefits are consolidated in the country’s capital or with its ruling elite. Such a perception contributed to the violence faced from 1976 to 2005 by Mobil’s LNG project in Indonesia’s separatist Ache province. In addition to reducing the likelihood of confrontation or other disturbances, establishing a positive reputation with the local populace may make it politically disadvantageous for the host government to attempt an expropriation.

Additionally, investors should anticipate that the host government will want to require that a portion of the natural gas discovered be kept for domestic use, instead of exported to markets willing to pay a much higher price for the gas. By anticipating this eventuality, an investor should be able to create practical limits on such domestic natural gas sales and any requested pricing discounts.

Maintain meaningful control over project assets outside of the host country.

With respect to natural gas export projects, maintaining control over transportation and shipping assets outside a host country can provide an additional deterrent to government expropriation. With respect to LNG export projects in particular, the availability of LNG ships globally is limited. If a company controls the transportation rights for gas to the eventual markets, a host government would be forced to scramble in an attempt to meet a project’s transportation and long term sales obligations should it decide to nationalize and operate the project on its own. A government may view this risk of breaching sales contracts as a major disincentive to expropriation.

Project financing and Export Credit Agencies.

Another way to mitigate expropriation risk is to structure project financing through international consortiums backed by multilateral or governmental development agencies. The more countries that are involved the better—more countries mean more sources of political pressure in opposition to the expropriation.

Export credit agencies (“ECAs”) provide an important and effective mechanism for mitigating the risk of expropriation in connection with financing. Many export credit agencies have specific project finance programs, and commercial lenders may rely on export credit agencies to support the borrowing of a particular project company. In some emerging-market host countries, ECAs may be the only available source of significant financing. Such host countries may be deterred from expropriating a project if they know such an action would jeopardize the country’s relationship with a particular ECA.

Sell gas to a diversified suite of buyers.

Entering into sales agreements with buyers from a number of different states could increase the amount of political pressure a host government would endure should it attempt to expropriate a project. With respect to LNG export projects, it should be noted that security of supply is of utmost concern to most LNG buyers. The governments that represent the buyers and ultimate end-users of such LNG are likely to oppose any move by a host government that could jeopardize such supply security. If a particular buyer is also a participant in the project itself, the home government of such buyer is even more likely to attempt to oppose an expropriation attempt. The home government of such buyer may view the expropriation as an assault on its foreign interests and its energy security.

Obtain political risk insurance.

Political risk insurance could help mitigate and manage risks associated with adverse actions and omissions by a host government. However, given the capital-intensive nature of natural gas projects (particularly LNG export projects), political risk insurance will be severely limited relative to the overall project cost. Despite this drawback, political risk insurance may provide an important source of liquidity that could help cover certain costs following an expropriation, such as the costs of the subsequent arbitration.

Political risk insurance through the Multilateral Investment Guarantee Agency (“MIGA”) has an added benefit of increasing the political pressure placed on the expropriating government. MIGA is a World Bank agency with 177 member countries. The agency has been successful in resolving a number of disputes before a claim is filed. MIGA makes an active effort to address disputes at a very early stage by working directly with a host government.

Conclusion

In light of the Argentine government’s recent actions against Repsol, the natural gas industry is on high alert with respect to the risk of government expropriation. Although the recent expropriation trend may appear to be contained in Latin America, it would be advisable for all investors in the natural gas sectors of developing countries, regardless of where they are currently investing, to factor government expropriation into their analysis when considering future projects. The topics listed above do not form an exhaustive list of possible pro-active actions, but they may serve as a starting point for an evaluation of an investor’s risk of expropriation of a gas project and may provide a basis for the measures ultimately implemented to mitigate such risk.


 Philip R. Weems
 Singapore
 +65 6303 6001
 Houston
 +1 713 276 7373
 Dubai
 +971 4 377 9901
 pweems@kslaw.com

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   Matt Salo
 Houston
 +1 713 751 3237
 msalo@kslaw.com

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