TRANSACTIONAL: International Arbitration: Extra Heavy Crude Oil: An Increased Potential for International Disputes

by King & Spalding

[author: Louis-Alexis Bret]

The discovery and development of massive extra heavy oil reserves over the past decades has dramatically altered the energy landscape: Venezuela now claims to hold the largest hydrocarbon reserves in the world, largely because of the Orinoco Belt’s extra heavy crude deposits. Canada, meanwhile, has become the world’s sixth-largest oil producer thanks to the Athabasca oil sands. From a dispute standpoint, some of the most significant recent arbitral awards pertain to extra heavy oil projects and operations.

Even though the largest portion of the extra heavy crude produced today comes from Venezuela and Canada, a significant number of other countries have started to exploit similar resources in their territories. Energy companies and experts all agree that the importance of these unconventional resources is slated to increase considerably in the near future.

Extra heavy crude oil consists of liquid petroleum with an API gravity inferior to 10° and a reservoir viscosity not exceeding 10,000 centipoises. Extra heavy crude is so dense and viscous as to require special techniques and installations to be economically produced, transported, and refined. Albeit closely related, extra heavy oil, oil sands, and bitumen have different physical properties. This short article, however, does not distinguish between the different types, but instead focuses on indentifying their common vulnerabilities to disputes and suggesting ways for parties to mitigate these risks.

Increased Vulnerability to International Disputes

While extra heavy crude constitutes one of the major energy sources of the future, the magnitude of required investments, its economic and physical properties, and its specific place in the international oil trade all contribute to making extra heavy crude projects particularly subject to international disputes.

First, extra heavy crude projects generally require substantially larger investments than those required to develop and exploit conventional hydrocarbon reserves. Both in Canada and Venezuela, extra heavy crude projects have necessitated billions of dollars in investments: in Canada, for example, recovery of hydrocarbons in the Athabasca oil sands requires an expensive infrastructure to heat, collect, or separate the crude oil from the soil (surface mining or underground technologies). Both in Venezuela and Canada, operators of extra heavy oil projects have come to rely on large-scale upgraders (hydroprocessing plants) to convert the sour and heavy oil extracted from the ground to more valuable and easier to market synthetic crude. Examples of these facilities include the Syncrude, Scotford, Co-Op, and Husky upgraders in Canada and the Cerro Negro, Hamaca, Petrozuata, and Sincor upgraders in Venezuela. The sheer magnitude of these investments necessarily increases the impact of adverse domestic policy changes on the international oil companies developing and operating these projects. A number of significant arbitral disputes between foreign investors and the Venezuelan government over the Cerro Negro, Petrozuata, and Hamaca projects illustrate the negative impact of populist political decisions on extra heavy oil projects.

Second, extra heavy crude generally remains more expensive to produce and transform than most conventional oil resources. This added cost means that extra heavy crude projects present a higher economic limit than most conventional oil operations, rendering them more sensitive to price variations. Not only will extra heavy crude projects cease to be profitable if world oil prices drop below a relatively high level, but the size and complexity of their infrastructure generally prevent a reduction or interruption of production in order to respond to unfavorable market conditions. As a result, extra heavy crude projects might operate at no profit or even a loss for extended periods of time. Operating under these conditions makes for inevitable tensions between the different parties involved: operators, partners, lenders, buyers, and government authorities.

Third, the physical properties of extra heavy crude require a specific trading and refining infrastructure to bring it to market. Refining extra heavy crude or upgraded oil often requires considerable investment to build new refineries or adapt the existing ones to this new feedstock. As a result, refiners will be reluctant to undertake these investments in the absence of a long-term supply commitment. Conversely, extra heavy oil producers will need to secure refining and trading channels before investing in production and upgrading facilities. As a result, extra heavy crude will tend to be marketed on a long-term basis. This long-term structure will generally entail take-or-pay and deliver-or-pay obligations, increasing the financial impact of disruptive events on affected parties.

Fourth, higher production or trade barriers than for conventional oil might affect extra heavy crude. On the production end, the past decade witnessed OPEC repeatedly accusing Venezuela—its only member possessing significant extra heavy oil resources—of exceeding its production quotas. Intense negotiations attempted to determine whether the Orinoco extra heavy crude should be included in Venezuela’s production quota, and whether Venezuela’s quotas needed an update to reflect non-conventional reserves. Significant uncertainty ensued as to whether the largest extra heavy crude projects would be able to maintain production at sustainable levels.

On the trade front, Canada and the European Union have battled since 2009 over an EU proposal to classify crude extracted from oil sands as especially pollutant and to restrict its use throughout Europe. Although the EU represents a very limited portion of the market for Canada’s extra heavy crude, Canada expressed concerns over the precedential value of such a decision and mounted a vigorous counter-offensive, culminating with Canada withdrawing from the Kyoto Protocol and suggesting that it would take its case against the EU to the World Trade Organization. The EU ultimately decided not to adopt the proposed Fuel Quality Directive at that time, but the issue remains outstanding. This environmental and trade war illustrates a risk specific to extra heavy crude, i.e., that production cannot reach certain markets and buyers cannot access adequate supply.

In a nutshell, involved parties must recognize the risks associated with extra heavy crude and adopt a long-term outlook when anticipating the potential disputes and liabilities associated with their operations. In that respect, one can compare extra heavy crude to LNG projects. Both share very high initial capital costs, a need for specific infrastructure throughout the supply chain, and relatively illiquid markets favoring long-term supply and purchase commitments. Additionally, the environmentally sensitive character of extra heavy crude projects can lead to trade restrictions. These particular features increase the possibility and magnitude of disputes relating to extra heavy oil projects.

Available Risk-Mitigation Strategies

Facing these kind of challenges, parties engaged in extra heavy oil projects are advised to pay particular attention to ensuring that they will be able to navigate through potential disputes under the best conditions possible.

  • All parties involved in extra heavy crude projects should actively manage the structure of their investments to obtain or preserve access to investor-state arbitration in case of adverse regulatory actions. A party should invest through a corporate vehicle from a country providing comprehensive treaty coverage (BIT, FTA, or multi-lateral agreements such as the ECT) in order to obtain optimal protection. In that respect, Venezuela’s recent denunciation of the ICSID Convention—the largest forum for investment disputes—does not affect the validity or the investment protections of the BITs entered into by Venezuela.
  • Subject to the provisions of the applicable investment treaty, the definition of investor and investment (enabling treaty protection and investor-state arbitration) will generally cover the investment and activities of the wide array of parties in extra heavy crude oil projects. Operators and direct investors, as well as lenders, long-term purchasers, and traders are advised to evaluate how to structure (or re-structure) their activity in a way to maximize available treaty protection.
  • Adequate investment treaty protection plays a substantial role in procuring political risk insurance (particularly when offered by international organizations or public entities) and/or reducing the insurance premiums associated with international projects and operations.
  • All the parties involved should clearly delineate individual areas of responsibility for the different risks associated with extra heavy crude projects (political, fiscal, trade, environmental, supply, take-or-pay, or price risks—to name a few) and provide for adequate adaptation and dispute resolution mechanisms. Parties may allocate these areas of responsibility on the basis of their respective nationalities, competences, and role in the project.
  • In particular, foreign parties in extra heavy crude projects must obtain or preserve the right to seek resolution of their contractual disputes before international arbitration tribunals. Recourse to a neutral forum has become particularly difficult in a number of countries, including Venezuela, which have sought to impose the jurisdiction of their local courts for public and private contracts involving the hydrocarbons sector.

Thorough initial risk assessment and dispute planning will allow implementing these strategies and help ensure the viability and success of the projected operation.

Louis-Alexis Bret
+1 713 276 7376

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