Financial collateral in petroleum projects: Practical aspects

In petroleum projects, collateral support may be provided in many forms but rarely does a single instrument of collateral support cover for all of a party’s obligations under a project.  

While a guarantee can potentially be given for financial support, its enforceability and viability will in effect depend on the financial capability of the guarantor.  

For this reason, no matter the collateral support in place, parties involved in a petroleum project cannot avoid bearing, to an extent, unsupported risk. It is for this reason that parties often like to ‘team up’ with financially sound parties who are capable of funding a petroleum project to ensure its continuity.  

As the price of oil hits lows not seen for a long time providers of finance and concerned counterparties will look ever more closely at the collateral on offer to support transactions. (Alan Jones 2015)

1. Upstream

Most upstream petroleum projects involve complex exploration, deep drilling and/or deep offshore production raising a need to minimize the high cost and spread of the risks. For this reason, the rights granted under a petroleum agreement, such as a license, a production-sharing contract or a service contract, are hardly ever exercised by a single entity but rather by a number of petroleum companies who have agreed to jointly undertake a project and allocate responsibilities and profits amongst one another.

Such approach has led to the creation of the widespread concept of joint ventures since the Petroleum Agreement itself does not deal with the sharing of rights and obligations as between the concessionaires/contractors.

While the central idea is to share costs, property and production in proportion to their respective percentage interests, the synergistic nature of joint ventures allows participants to enjoy the financial standing and the merging skills of their associates.

Therefore, with respect to any discussion of collateral in upstream arrangements, the joint operating agreement (JOA) is crucial, as it is customary for such collaborations to seek an unincorporated contractual association such as the JOA as opposed to incorporated associations (i.e. setting up a company in which co-venturers have shareholdings in proportion to their joint venture interests).

In contrast with an incorporated company, a joint venture operating under a joint operating agreement has no separate legal personality and it simply operates to allow the parties to share costs, risk, property and production among them.

The joint operating agreement is a well-established form of private agreement. It is the constitution for the joint venture, which defines the relationship between the parties to a petroleum agreement and governs the entire lifecycle of the relevant upstream petroleum project: exploration, appraisal, development, production and decommissioning. In simple terms, the contract morphs the ‘joint’ nature of a petroleum agreement into several rights and obligations as between the concessionaires/contractors who are receiving this right from the state.

In the early stages of the project, the joint operating agreement serves the joint venture by allocating capital, operating expenses and risk. If an upstream project is successful and production commences, the joint operating agreement’s role in that phase would be largely to regulate the smooth operation of a field and to allocate the rewards. At the end of the project, further expenditure and risk, including the quantification of decommissioning liabilities would be dealt with by the agreement.

There is usually one party designated as operator who would be responsible for conducting the day-to-day responsibilities (including negotiation and entry into various support contracts with third parties, e.g. seismic surveys, drilling, testing and decommissioning) and the joint operations on behalf of the joint venture. Other scenarios include the appointment of an operator nominated by the terms of the petroleum agreement or by using either a contracted, incorporated or a split operator model.

Generally, the operator’s main duties include:

  • The preparation of programs, budgets and authorizations for expenditure (AFE);
  • The implementation of OpCom approved programs; and
  • The provision to each of the co-venturers of reports, data and information.

As the operator is the de facto day-to-day manager of the upstream project and in most cases the agent of the joint venture, the operator owes a duty of care to the non-operators. In most joint operating agreements, the case would be that the operator acts both as a joint principal with the non-operators as well as an agent of the individual co-venturers (as it is an unincorporated association).

This is important, as the parties must be clear in what capacity the operator is acting, particularly when facing issues of third party contract enforcement or even more importantly when determining whether the operator owes any fiduciary duties to the co-venturers as principals. Generally, it is widely accepted that the role the operator undertakes does inevitably give rise to an agent-principal relationship.

The operator is not remunerated for their operatorship, accordingly they are not held legally liable with respect to any damage or loss suffered by third parties or non-operators when acting on behalf of the venture. The non-operators and the operator (in its capacity as a joint ventue participant) will hold any liabilities that arise because of the joint venture and particularly the joint operations together.

The operator’s liability will be limited to any loss or damage resulting from its willful misconduct or its failure to obtain and maintain insurance even though some joint operating agreements might provide further hurdles before this personal liability is fully met. In practical terms, therefore, a party to a joint operating agreement is effectively delegating authority to a third party either to act on its behalf or on behalf of a company in which it is a shareholder, without any recourse to that third party except in extreme circumstances.

As noted above, there is an expectation that the parties to the JOA will commit to pay their share of the costs of all the joint operations and any exclusive operations that they participate in. In order to meet such financial obligations, the operator would issue cash calls to the parties. In many cases, where a state has a right to participate in the petroleum agreement, some parties may ‘carry’ the host government. They pay the cash calls for their percentage share and are repaid only in the event there is sufficient production available.

This certainly increases capital risk for the carrying parties.  

Most, if not all, joint operating agreements contain detailed mechanisms regulating payment defaults.

These include suspension of the defaulting party’s rights (to voting, property and production share) and forfeiture, by transferring the defaulting party’s entire interest to the non-defaulting parties. The interest is distributed pro rata in proportion to the non-defaulting parties’ percentage interest or, in jurisdictions where the application of forfeiture clauses may be deemed a penalty clause and therefore invalid, according to buy-out provisions.

Regardless of the mechanism used to protect the non-defaulting parties, the main issue remains that any remedy would only be effective if the interest, which is transferred, is at least of equal value to the liability of the defaulting party.

This may not be the case, for example in the event of an early default in an upstream project, which does not progress to production, or even in a later default in respect of decommissioning.

In such circumstances the only potential remedy would be a damages claim.

Although a properly drafted joint operating agreement would include such a claim it would only rank as an unsecured claim and therefore be inadequate, raising the need for collateral support.

Most of the model form joint operating agreements such as the AIPN JOA, AAPL JOA and the OGUK do not require the provision of collateral support.

Where a party is creditworthy, a parent company guarantee (PCG) may not be necessary. In other cases however, for instance for a start-up or a small niche oil and gas company, a PCG may be appropriate.

As a result, there are circumstances where a party is entitled to go into insolvency by its parent to justify the PCG. Nevertheless, any discussion of this possibility depends on the stage of the project and the time of any discussion, for instance, an incoming party seeking consent at a late stage in the project where decommissioning is imminent may be disadvantageous with comparison to a party who joined at the outset of the project.

As mentioned above the position may be slightly different where the joint operating agreement is dealing with third party contractors. Although those dealings will generally be managed by the operator, it is reasonable for a contractor to understand which entity(ies) will be liable for payment.

Where the joint venture is carried on through an incorporated vehicle, this will involve an analysis of the entity and the shareholders behind it. It is in this particular case that a third party bond, guarantee or standby letter of credit may be appropriate. However, where recourse is to the ultimate co-venturers, it is possible that a contractor will require one or more PCGs by way of collateral.

In summary, it is difficult to predict exactly how the climate of financial uncertainty will affect collateral in upstream contracts. It is, however, possible to be clear on two points: first, that in a climate of financial uncertainty it will become the norm for PCGs to be required and that all participants in the industry need to be ready to address this; and, secondly, that the transfer/change of control provisions in joint operating agreements, particularly relating to financial capacity, will be scrutinized even more carefully than in a more benign climate.

The difficulty in recovering a debt from an impecunious party and the potential inadequacy of a contractual remedy under the joint operating agreement emphasizes the importance of taking care when selecting co-venturers from the outset of the upstream project. And when negotiating the joint operating agreement, the issue of collateral support must be prioritized.

2. Midstream 

When multiple parties use a transportation system and inject products of high and low quality, the commingling of hydrocarbon molecules, which are impossible to separate at the delivery point, could mean that one shipper may recover something less valuable than injected while another recovers a higher value product.

Accordingly, it is industry standard practice to ensure that the relevant contractual document balances the parties’ position by including provisions, of a technical and non-technical nature concerning the obligations of the parties with regard to tie-ins, pumping and other field facilities, pressure and consistency of oil or gas. Quality bank agreements may be entered into providing for cash payments or in kind adjustments to be made to reflect the effect of different inputs on the agreed common stream standard.

Before considering the operation of a quality bank and the function of collateral it is important to understand that the fundamental principles involved apply to a wider commercial context than the oil and gas industry – for example where a custodian on behalf of a number of customers holds securities in a pooled account.

Such principles are tested when there is an unforeseen intervening event (for example the insolvency or bankruptcy of one of the participants) and commonly raise complexities with respect to ownership, trust law and balancing of losses between parties. Therefore an assessment of the worst case scenario is crucial, even the 1% must be taken into account.

The volumes and quality of hydrocarbons injected by shippers is tracked by the pipeline systems. Periodically, those who inject lower quality than the average of the stream inputs crude oil are invoiced and pay those who put in high quality hydrocarbons. When hydrocarbons are taken out of the system, those who are delivered lower quality than the average are paid and those receiving higher quality than average pay.

Occasional renegotiation of the unit values of any adjustments is required, this happens as the market for different hydrocarbons changes – such renegotiations may get contentious due to the different evaluations of hydrocarbons made by different refineries. Such amounts are collected and distributed by an account trustee who receives payments from liable shippers and distributes the funds to entitled shippers. The account trustee is given power, acting as trustee, to enforce payment of any amounts which a shipper is liable to pay.

It is not necessary for the payment/collection mechanism operated by the account trustee to be in the same jurisdiction as the pipeline operation and, in some cases, for example where the pipeline jurisdiction does not recognize the concept of a trust fund operated by a trustee, it cannot be the same.

As a result of each calculation some shippers will have financial obligations to the others which are enforceable only through the account trustee. It is therefore common for quality bank documentation to require collateral to be provided to the account trustee either through a parent company guarantee or letter of credit. For the quality bank to operate properly in the relevant timescales it is essential that the accounts trustee can collect this collateral quickly for distribution.

It is important that the account trustee does not become involved in a dispute with a guarantor over whether calculations are correct (which a guarantor would be entitled to raise) or in any difficulties of enforcement, for example because a guarantor is in a different jurisdiction. For these reasons most quality banks will provide that collateral is to be provided by either cash or letter of credit in a form which will allow the accounts trustee to draw down on demand. In this way, all participants in the quality bank can be certain that quality bank payments will be made promptly.

From the perspective of a participant who is owed money by other shippers the provision of collateral as an on demand letter of credit, meaning that the account trustee can simply demand payment without giving any sort of reason, is a very useful feature. For a collateral providing party, however, it is effectively providing a fund, which can be drawn at any time.

As explained above in the absence of manifest fraud, the independence principle will prevent the collateral provider from restraining the account trustee drawing down the letter of credit even if there is a genuine dispute about the calculations.

At the same time, it is likely that the remedies against the account trustee will be limited to willful misconduct.

Accordingly, unless the party is able to restrain distribution of the trust fund after it has been drawn down by the account trustee, which would involve court proceedings in the jurisdiction in which the trust fund is located, its only remedy will be to seek resolution of the dispute in its favor and then recovery from any participants that have been overpaid.

The operation of a quality bank with letter of credit collateral is a good illustration of the benefits and pitfalls of LoC collateral – at one level it is a quick and straightforward way to enforce payment but on another it may leave the paying party in a “pay now sue later” situation.

It also operates as an illustration of the importance of prompt, proactive action if there is a drawdown in circumstances where there is a dispute – although it may not be possible to prevent drawdown it may at least be possible to keep funds held up (in this case in the hands of the account trustee) in a more favorable jurisdiction rather than being forced to take multiple recovery actions. 
 

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3. Downstream

Long-term petroleum sale and purchase agreements create significant payment obligations for buyers, and sellers will often demand collateral support in respect of the buyer’s payment obligations. The type of collateral support given by a buyer is often subject to negotiation and dependent on the respective bargaining power of the parties. Short-term sales agreements, including SPOT market trades, also often require collateral support, which in practice is often given as letters of credit.

Collateral support in downstream contracts is a rather standard feature. For example, clause 19.1 of the European Federation of Energy Traders (EFET) Master LNG (liquefied natural gas) Sales Agreement requires “credit support” in the form of “a parent guarantee, a letter of credit, or other form… .” However, there are no prescribed forms attached to the model contract.

The EFET model LNG sales agreement also contains a “performance assurance” provision, which allows a party to require a re-guarantee. This kicks in when either party reasonably determines that the financial condition of the other party and/or its collateral support provider has become impaired (the collateral support provider could be a parent or other entity that has provided a guarantee or the issuing bank in the case of a letter of credit, etc).

Although such provisions would likely be triggered by a seller requesting new or extra collateral from the buyer, it is not uncommon for a buyer to request (new) collateral from the seller: for example if a seller’s credit rating is downgraded, the buyer might require a guarantee from the seller’s parent or financially stable sister company to cover the seller’s financial commitments to the buyer – such as for shortfall penalties.

The performance assurances listed by the EFET Master LNG Sales Agreement include prepayment, an irrevocable standby letter of credit by a reasonably accepted international bank, or a guarantee from the party’s parent or other entity.

The AIPN model LNG sales agreement also contains collateral support provisions. AIPN’s model LNG sales agreement is drafted as a master agreement. A master agreement is for SPOT trading and contains provisions agreed by the buyer and seller for future (and usually non-obligatory) sale and purchase of product (in this case, liquefied natural gas). When the parties wish to buy and sell LNG, they enter into a contract for each particular sale, which incorporates and supplements their master agreement.

The AIPN model LNG sales agreement’s credit support provision puts a duty on both the buyer and the seller to provide one another with collateral support as required in the confirmation memorandum, which is the contract entered into between the parties to record the terms of a particular sale and purchase of LNG. The model contract suggests an irrevocable standby letter of credit or corporate guarantee of which prescribed forms are annexed to it.

AIPN’s model gas sales agreement differs from its LNG model sales agreement in that it is a long-term contract, i.e. not for SPOT trading. The AIPN gas sales contract requires as a condition precedent evidence of each party’s financial standing and therefore their ability to satisfy their respective financial obligations under the agreement. Such evidence can be in the form of:    
(i)    a guarantee or standby letter of credit issued by a bank;
(ii)    an on-demand bond issued by a surety corporation;
(iii)    a corporate or government guarantee; or
(iv)    such other financial security as is agreed by the buyer and seller.

Clearly, it is standard in petroleum sales agreements for both buyer and seller to be assured of the other’s financial capacity to pay. From the seller’s perspective, it will want assurance that the buyer has immediate financial capacity to stick to its payment obligations and has the credit rating to reassure the same for future obligations. Likewise, a parent or sister company guarantee from the buyer will further reassure the seller that it will receive payment for its sales petroleum should the buyer default.

A seller might also request a parent company guarantee from the buyer after conclusion of the contract should the buyer’s credit rating be downgraded further along the line. A buyer will request collateral support from the seller to safeguard it in the event the seller fails to perform its obligations (e.g. delivery obligations), whereby for example the seller will be liable to pay shortfall penalties. The same rationale behind the seller’s request for collateral support applies to the buyer’s request.

 

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Yanal Abul-Failat

Yanal Abul-Failat studied law at Kingston University and has since completed his LLM in Oil and Gas Law from the University of Aberdeen and an MA in Legal Practice and Business from BPP University. Prior to joining LXL Yanal has worked for a number of law firms specialising in energy law in Jordan, Venezuela and the UK. Yanal has worked for LXL LLP as a legal consultant since 2012 and has commenced his training contract in 2014. Yanal has since assisted in advising state owned companies, utilities amongst other major international corporation in Africa, Asia, Europe and the Middle East. Yanal is an active member of the Association of International Petroleum Negotiators and an associate editor at the Oil, Gas and Energy Law Journal publishing energy law titles regularly.  Yanal is also fluent in Arabic, English, Greek and Italian.

Yanal Abul-Failat
Legal Consultant
LXL LLP
UK

t: +44 (0)20 8439 8810
e: yaf@lawxl.com
w: www.lawxl.com
 

 

LXL LLP

LXL LLP is a boutique international law firm based in London particularly distinguished for energy, infrastructure and commodity projects in developed and emerging markets. Our lawyers advise governments, corporations and individuals on some of the most interesting and significant projects in the world.  "First class" energy boutique...Legal 500 2014
 

 

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