International Petroleum

INTERNATIONAL PETROLEUM TRANSACTIONS
Ernest E. Smith John S. Dzienkowski Owen L. Anderson Gary B. Conine John S. Lowe
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Rex G . Baker Centennial Chair in Natural Resources Law : The University of Texas School of Law
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Owen L. Anderson
Eugene Kuntz Professor in Oil, Gas and Natural Resources Law The University of Oklahoma
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as issued, works of the federal and state governments, including all the courts as well as all legislative and administrative histories, studies the public domain. As compiled, arranged and edited, however, such contained in this publication are subject to the foregoing copyright notice.
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s expressed in this volume are solely those of the authors. They should not bep-d-(rxt,) the views of the Rocky Mountain Mineral Law Foundation. This publication the understanding that neither the publishers nor the authors are engaged in or other professional services. In no event, including negligence on reviewers, or the publisher, will the authors, reviewers, or the indirect, or consequential damages resulting from the use of
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The plans for this book were initiated several years ago by Professors Ernest E. Smith and John S. Dzienkowski of The University of Texas School of Law. Aware of the increasingly global scope of both the economy and legal arrangements, they set out to design a book that could be used to teach how law and legal arrangements function in the context of international business transactions and to do this by examining a single subject of international trade: energy resources-primarily petroleum. This focus reflects their shared belief that the interrelationship between the structure of cornrnerical transactions and the development of public and private law is nowhere more pronounced than in the transactions involving the extraction, transportation, and sale of petroleum. Historically, oil has been the subject of the most important international agreements and disputes. Many of the legal doctrines applicable to transnational private arrangments have been developed in response to the arrangements by which oil has been extracted and sold. Moreover, different issues are raised along each link in the chain of transactions that begins with obtaining rights of exploration and ends with a sale in the world market place. These issues are not solely matters of private law. Along this chain the rights and interests of different governments come into play, including national policies aimed at vindication of sovereign rights, energy self-sufficiency, taxation, and environmental protection. International agreements and international organizations also must be considered. Documents as diverse as the Convention on the International Sale of Goods, the United Nations Resolution on Permanent Sovereignty over Natural Resources, the General Agreement on Tarrifs and Trade, and the Geneva Convention on the Continental Shelf are all highly relevant. Few other subjects of international trade provide an opportunity to examine such matters at various points in its stream of commerce. Moreover, no other commodity, either historically or currently, can match the importance of petroleum to the world's political and economic order. As the scope of the book expanded and the movement of world events accelerated, the need for contributions by additional co-authors with special expertise in new or changing areas became clear. The dissolution of the Soviet Union, attempts at privatizing the petroleum industry in the Russian Federation, growing concern over the environmental impact of mineral development, and the desirability of
including comparative studies dealing with solid minerals and expanded

materials on joint development agreements immediately suggested the addition of Professor Gary B. Conine of the University of Houston Law
11
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Preface
Center. Professor John S. Lowe's reputation as an authority on petroleum, natural gas regulation and oil and gas transactions made him the obvious person to deal with the issues raised by transboundary sales of natural gas, oil transportation, and the creation of free trade areas in North America. Professor Owen L. Anderson is a recognized authority in domestic and international petroleum and natural gas law whose added experience in commercial law permitted him to take primary responsibility for the chapters on oil marketing and oil sales. He also made significant contributions to the sections dealing with environmental issues. The material in this book can be used in several different ways and in several different contexts. It can be used in law schools and business schools as the primary text for a course in international petroleum arrangements and petroleum law. An instructor who teaches a course that focuses primarily on domestic oil and gas law will find it a useful supplement, providing students with information on how international petroleum arrangements both parallel and diverge from equivalent arrangements in the United States. Used in conjunction with the International Petroleum Foms Manual it can serve as a coursebook for C.L.E. seminars and institutes dealing with international petroleum transactions. The book can also be used to teach either a basic or advanced course in international business transactions. Several of our professional colleagues merit special thanks for their aid with this enterprise. These include Russell Weintraub, who generously shared his material and ideas and who will shortly publish his own book on international litigation; Michael Sturley, who reviewed and suggested revisions for the sections dealing with transportation of oil; and Jay Martin, who provided valuable help and suggestions with respect to natural gas contracts. We would like to thank Gordon Barrows, of Barrows Company, Inc., for his efforts in making world petroleum laws and agreements accessible to American scholars and practitioners. Above all, we owe a special debt of gratitude to Professor Hans Baade for the invaluable information provided by his pioneering work in this field and by his many comments and suggestions. Each of us would also like especially to thank the variety of people who provided research and support assistance. Professor Smith is especially indebted to the late Rex G. Baker, his son, Rex G. Baker, Jr., and his grandson, Rex G. Baker, 111, for the support provided by the Rex. G. Baker Centennial Chair in Natural Resources. He would also like to express his appreciation to the the faculty and staff of the Centre for Petroleum and Mineral Studies of the University of Dundee, Scotland, to Foreign and International Law Librarian Jon Pratter of Texas Law School, and to his student assistants, Rachel Baker, Richard Beller, Valerie
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Fulmer, Jane Hoffman, Marcos Mufioz-Ruiz, Keith Rowley, Kelly Cope, Lisa Wickstrom, and most especially to Krista Bush Edgette for the aid provided him in researching and preparing this manuscript. The preparation would not, of course, have been possible without access to the excellent resources of Tarleton Law Library of the University of Texas and the Harvard Law School Library. Professor Dzienkowski is indebted to Dean Mark Yudof and the University of Texas Law School Foundation for research support during the project. Specific support was provided by the Tom Sealy Research Professorship in Energy Law from Summer 1989 to Summer 1990 and from the Roy and Grace Whittenburg Faculty Fellowship in Law from Fall 1992 to the present. He would like to thank his secretary Margaret Francis for her work during the final stages of this project and Anna Grassini, a graduate of the University of Texas School of Law, for her editorial work on several chapters in this book. He would also like to thank the faculty and students at the St. Mary's Institute on World Legal Problems for the experience of teaching a draft of these materials in Innsbruch, Australia in July 1991. Professor Anderson thanks Peter Goplerud, Dean of the University of Oklahoma College of Law and his colleagues, Fred Miller and Anita Hill, for their review of portions of the chapter on crude oil sales. Professor Conine wishes to express his gratitude to Eugene Kuntz, Dean Emeritus at the University of Oklahoma Law Center, and David N. Smith, Vice-Dean at Harvard Law School, for their initial instruction on domestic and international petroleum law and policy, which provided an understanding and appreciation of the unique role the petroleum industry plays in our world. Special thanks also go to Mr. Dave Trapnell, whose substantial gift of resource materials to the International Petroleum Program at the University of Houston's International Law Institute, has provided access to basic research data in this developing field. Appreciation is also expressed to his former students from Mexico, Peru, Colombia, Argentina Saudi Arabia, Nigeria, Thailand, and the Russian Federation for sharing their countries' insights on the problems and concerns over the development of natural resources. Special credit is also due to Mr. Robert LaRaia and Ms. Sherri B. Manuel, whose research on International Environmental issues as graduate students at the University of Houston Law Center provided great assistance in identifying some of the materials and summarizing some of the concepts included in this text. Most importantly, Professor Conine thanks his wife, Carol, not only for encouragement and steadfast support during the preparation of this work but also for her constant and unending inspiration.
iv
Preface
Professor Lowe thanks C. Paul Rogers 111, Dean of the Southern Methodist University Law School, William L. Hutchison, Esq., and the Hutchison Endowment, for their support of his work on this project. He appreciates also the assistance provided by Thomas D. Cuadle, Lanty Winford Dean, Tiffany Haertling, Richard Howard, and Paul Seve, while they were law students at SMU, as well as his secretary, Dolores McKnight. This book would not have been possible without the patience, computer skills, and common sense of Debbie Steed, who typed, re-typed, and formatted the book. Her persistence and co-ordination of the contributions of the various authors have added immeasurably to the quality of the book. We are also grateful to Pauline M. Simmons, whose special talents as an editor greatly enhanced the form, style, and consistency of the final product. Finally, we thank the Rocky Mountain Mineral Law Foundation, which provided significant financial and moral support for this project. We have used several conventions in this book. We have frequently omitted both footnotes and citations from cases and other materials without inserting ellipses or otherwise signaling the deletions. All footnotes, including those in cases and excerpts from books and articles, have been numbered consecutively from the beginning of each chapter. In a few instances materials in cases has been slightly rearranged to enhance clarity. Staying current with the rush of world events has been a principal difficulty in preparing this book. Segments on the new "openness" in the Soviet Union had to be replaced after the Soviet Union dissolved. The United States Congress approved NAFTA as the book went to press. Other events may make portions of the book obsolete within months after it is published. While already planning for a second edition, we believe that the basic structure and contents of the book as written will provide valuable tools for instruction in international transactions as conducted during the decade of the 1990s. Ernest E. Smith John S. Dzienkowski Owen L. Anderson Gary B. Conine John S. Lowe November 1993
ACKNOWLEDGMENTS
Permission to reprint portions of the following materials is gratefully acknowledged: Agreement Between Petroleum Concessions, Ltd. and Sultan of Muscat and Oman. Reprinted with permission of Gordon H. Barrows, Barrows Company, Inc. Anderson, Owen L., "Mutiny: The Revolt Against Unsuccessful Unit Operations," 30 Rocky Mtn. Min. L. Inst. 13-1 (1984). Copyright O 1985 by Matthew Bender & Co., Inc., and reprinted with permission from 30 Rocky Mountain Mineral Law Institute. All rights reserved. Aster, Charles E., Note, "Imported Natural Gas: Conflicts Between International Politics and Regulatory Safeguards," 15 J. Int'l L & Econ. 431 (1981). Reprinted with permission of George Washington Journal of International Law and Economics. The Journal of International Law and Economics has changed its name to George Washington Journal of International Law and Economics. Blakeney, Michael, Legal Aspects of the Transfer of Technology to Developing Countries (1989). Reprinted with permission of Sweet & Maxwell Ltd., London, England. Blinn, Keith W., Claude Duval, Honor6 Le Leuch & Andr6 Pertuzio, International Petroleum Exploration and Exploitation Agreements (1986). Reprinted with permission of Gordon H. Barrows, Barrows Company, Inc. Brownlie, Ian, Principles of Public International Law (1990). Reprinted with permission of Oxford University Press. Cameron, Peter, "North Sea Oil Licensing: Comparisons and Contrasts," 4 Oil & Gas Law and Taxation Rev. 99 (1984-85). Reprinted with permission of Sweet & MaxwellESC Publishing, Oxford, U.K. Cassese, Antonio, International Law in a Divided World 376-80, 384-86 (1986). Reprinted with permission of Oxford University Press. Cattan, Henry, The Law of Oil Concessions in the Middle East and North Africa (1967). Reprinted with permission of Oceana Publications, Inc., Dobbs Ferry, N.Y. 2 A Collection of International Concessions and Related Instruments 28082 (edited and annotated by Peter Fischer with the collaboration of Thomas Waelde, 1982). Reprinted with permission of Thomas W. Waelde. Colombian Participation Agreement. Reprinted with permission of Gordon H. Barrows, Barrows Company, Inc.
..
Acknowledgments
Daintith, T(3tnce & Geoffrey Willoughby, A Mmnal of United Kingdom 2nd Gas Law (1977). Reprinted with permission of sweet &
Of/
MaxwellESC Publishing, Oxford, U.K. Daintith, Terence C. & Geoffrey D.M. Willoughby, United Kingdom Oil and Gas Law (2d ed. 1992). Reprinted with permission of Sweet & MaxwellESC Publishing, Oxford, U.K. Dam, Kenneth W., Oil Resources: Who Gets What How? (1976). Reprinted with permission of University of Chicago Press, Chicago, Illinois. Dispute Between Texaco Overseas Petroleum Corporation/California Asiatic Oil Co and the Government of the Libyan Arab Republic, 17 I.L.M. (1978). Reproduced with permission from 17 I.L.M. 1 (1978), O American Society of International Law. Fabrikant, Robert, "Production Sharing Contracts in the Indonesian Petroleum Industry," 16 Harv. Int'l L.J. 303 (1975). Reprinted with permission of Harvard International Law Journal. Federal Energy Bar Association, "Report of the Committee on Natural Gas Imports and Exports," 6 Energy L. J. 149 (1985). Reprinted with permission of Energy Law Journal, Federal Energy Bar Association. Folsom, Robert H., Michael Wallace Gordon & John A. Spanogle, Jr., International Business Transactions in a Nutshell (4th ed. 1992). Reprinted with permission of West Publishing Corp. Folsom, Ralph H., Michael Wallace Gordon, & John A. Spanogle, Jr., International Business Transactions (4th Ed. 1992). Reprinted with permission of West Publishing Corp. Gore, Albert, Earth in the Balance (1992). Copyright O 1992 by A1 Gore. Reprinted by permission of Houghton-Mifflin Co. All rights resewed. Higgins, Rosalyn, "Abandonment Of Energy Sites And Structures: Relevant International Law," Energy and Resources Law '92 (1992). Reprinted with permission of International Bar Association. Hollis, Sheila, Energy in the United States: Legislative and Regulatory Developments, Petroleum Economist (February 1993). Reprinted with permission of Sheila Hollis. Hossain, Kamal, Law and Policy in Petroleum Development (1979). Published by Nichols Publishing Company. INCOTERMS 1990, International Chamber of Commerce. Reprinted with permission of ICC Publishing S.A., Paris, France. International Association of Geophysical Contractors, Environmental Guidelines for Worldwide Geophysical Operations, Draft January
Israel: I
Janis, E Janis, 1 Joiner,
Kaem
Acknowledgments
vii
lom :t & Oil Neet 176). ress,
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;ore. ights ures: '92 Bar atory inted
29, 1992. IAGC Environmental Policy Statement. Reprinted with permission. Israel: Ministry of Foreign Affairs Memorandum of Law on the Right to Develop New Oil Fields in Sinai and the Gulf of Suez. Reprinted with permission from 17 I.L.M. 432 (1978), O American Society of International Law. Janis, Mark W., An Introduction to International Law (1988). Reprinted with permission of Little, Brown & Co. Copyright 1988. Janis, Mark W., An Introduction to International Law (1988). Reprinted with permission of Little, Brown & Co. Copyright 1988. Joiner, Christopher C., U. S. Mexican Energy Relations in the 1980's: New Resources Versus Old Dilemmas, 12 Case West. Res. J. Int'l. L. 485 (1980). Reprinted with permission of Case Western Reserve Journal of International Law. Kaempfer, William H. & Henry M. Min, Jr., "The Role of Oil in China's Economic Development, Growth and Internationalization," 11 J. Energy & Dev. 13 (1986). Reprinted with permission of Journal of Energy & Development. Kimerling, Judith, "Disregarding Environmental Law: Petroleum Development in Protected Natural Areas and Indigenous Homelands in the Ecuadorian Amazon," 14 Hastings Int'l. & Comp. L. Rev. 849 (1991). Reprinted with permission of Hastings International and Comparative Law Review. Copyright O 1991 by University of California, Hastings College of Law Knight, H. Gary, "The Draft United Nations Conventions on the International Seabed Area: Background, Description, and Some Preliminary Thoughts." Excerpted from 8 San Diego L. Rev. 459 (1971). Copyright 1971 by the San Diego Law Review. Reprinted with permission of the San Diego Law Review. Law of the Russian Federation Concerning Subsurface Resources (1992), Russian Federation Act No. 2395-1; Russian Federation Supreme Soviet Decree No. 2396-1 (1992) Law on the Transfer of Technology and the Use and Exploitation of Patents and Trademarks, Dec. 29, 1981, Diario Official, Jan. 11, 1982, Doing Business In Mexico (Gordon, ed. 1991). Reprinted with permission of Transnational Juris Publications, Inc., Irvington-On-Hudson, N.Y. 10533. Lippman, Thomas W. & Mark Potts, "Oil Traders: Turning on a Dime;
inted ental "JW
Opec, Energy Firms Now Lesser Players in the Pricing of Crude,"

Washington Post, A1 (January 11, 1991). Copyright O 1991, The Washington Post, reprinted with permission.
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...
Acknowledgments
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Mankabady, Samir, "Energy Law," Euromoney Publications PLC 101-102 (London: 1990). Reprinted with permission of Euromoney Publications PLC, London, U.K. Martin, Jay G., Summary of Significant Gas Market and Transportation Changes Affecting Producers in the 1990's, 37 Rocky Mtn. Min. L. Inst. (1991). Copyright O 1985 by Matthew Bender & Co., Inc., and reprinted with permission from 37 Rocky Mountain Mineral Law Institute. All rights reserved. McDade, Paul, "The Petroleum Bill: The Removal of Offshore Installations and Pipelines," [I9861871 6 Oil & Gas Law and Taxation Review 158. Reprinted with permission of Sweet & MaxwellESC Publishing, Oxford, U.K. Mikesell, Raymond F., Petroleum Company Operations and Agreements (1984). Reprinted with permission of Resources for the Future. Model Production Sharing Contract Between Pertamina and Private Companies (1977). A Collection of International Concessions and Related Instruments Vol. VI (Peter Fischer ed. 1985). Neto, Jo5o Santos Coelho, "Risk Bearing Service Contracts in Brazil," 3 J. Energy & Nat. Res. L. 114 (1985). Reproduced with consent of Sweet & Maxwell Ltd., London, England. Nicolazzi, Massimo, "Petroleum Law and Petroleum Joint Ventures in Italy," 8 Journal Energy & Natural Resources L. 30 (1990). Reprinted with permission of International Bar Association, London, England. Norton, Patrick M., "A Law of the Future or a Law of the Past? Modern Tribunals and the International Law of Expropriation," 85 Am. J. Int'l L. 474 (1991). Reprinted with permission of 85 AJIL 474 (1991). O The American Society of International Law. Note, "General Principles of Law in International Commercial Arbitration," 101 Harv. L. Rev. 1816 (1988). Reprinted with permission of Harvard Law Review Association. Note, "From Concession to Participation", 48 N.Y.U.L. Rev. 774 (1973). Reprinted with permission of New York University Law Review. Note, "Developments in The Law - International Environmental Law," 104 Harv. L. Rev. 1484 (1991). Reprinted by permission of Harvard Law Review Association and American Bar Association. Ottino, Peter J., "Crude Oil Futures and Options in London," [I9881891 7 Oil & Gas Law And Taxation Review 179. Reprinted with permission of Sweet & MaxwelVESC Publishing, Oxford, U.K. and Peter J. Ottino, Clifford Chance, London, England. Park, Choon Ho, "The South China Sea Disputes: Who Owns the Islands and the Natural Resources," 5 Ocean Development & Int'l L. J. 27
Acknowledgments
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ation in. L. Inc., nerd ;hore and et & lents

d.
ivate
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rcial with j73).

:W.
aw," n of on. 191 7 with
U.K.
ands
(1978). Reprinted with permission of Taylor & Francis Ltd., London, England. Pfeiffer, Steven B., "Legal Issues in International Crude Oil Trading: An Update," Energy Law '88 (International Bar Association Section on Energy and Natural Resources Law, Sydney, Australia: March 1988). Reprinted with permission of International Bar Association. Rich, Loretta D., Note, "American Oil Interests in China," 6 Loy. L.A. Int'l & Comp. L. J. 119 (1983). Reprinted with permission of Loyola of Los Angeles International Comparative Law Journal. Schmidt, Richard, "Futures Market in Natural Gas," Unpublished University of Texas Law School Seminar Paper (1989). Reprinted with permission of Richard Schmidt. Smith, Ernest E. & John S. Dzienkowski, "A Fifty-Year Perspective on World Petroleum Arrangements," 24 Tex. Int'l L. J. 13 (1989). Reprinted with permission. Copyright by Texas International Law Journal, University of Texas School of Law. Smith, David N. & Louis T. Wells, Jr., Negotiating Third-World Mineral Agreements: Promises as Prologue ( 1975). Reprinted with permission of David N. Smith. Smith, Ernest E., "Making Sure It Happens: Techniques for Assuring Compliance with Abandonment and Reclamation Requirements," Energy and Resources Law '92 (1992). Reprinted with permission of International Bar Association. Snider, Judith A., Drafting Gas Sales Contracts to Meet Canadian Regulatory Requirements, 6 Natural Resources & Environment 29 (Spring 1992). Reprinted with permission of Judith A. Snider and the American Bar Association. Solow, Andrew R. & James M. Broadus, "Global Warming: Quo Vadis? (It's Not Easy Being Green: Ecopolitics in the 90s)," 14 Fletcher Forum of World Affairs 262 (1990). Reprinted with permission of Fletcher Forum of World Affairs, Medford, Massachusetts. Stein, Ted L., "Jurisprudence and Jurists' Prudence: The Iranian-Forum Clause Decisions of the Iran-U.S. Claims Tribunal," 78 Am. J. Int'l L. 1 (1984). Reprinted with permission of 78 AJIL 21 (1984). 0 The American Society of International Law. Sturley, Michael F., The History Of Cogsa And The Hague Rules, 22 J. Mar. L. & Com. 1 (1991). Reprinted with permission of the author. United States: Department of State Memorandum of Law on Israel's Right to Develop New Oil Fields in Sinai and the Gulf of Suez.
Acknowledgments
Reprinted with permission from 16 I.L.M. 733 (1977), O American Society of International Law. Usher, Peter, "Climate Change and the Developing World," 14 Southern Illinois Univ. L. J. 257 (1990). Reprinted with permission of Southern Illinois University Law Journal, Carbondale, Illinois. Vagts, Detlev, Transnational Business Problems (1986). Reprinted with permission of Foundation Press. Vagts, Detlev, International Business Problems (1988). Reprinted with permission of Foundation Press. verzariu, Pompiliu, Countertrade, Barter, and Offsets: New Strategies for Profit in International Trade (McGraw-Hill Book Co.: 1985). Reprinted with permission of McGraw-Hill Book Co. Von Glahn, Gerhard, Law Among Nations (Macrnillan Publishing Co., 6th Ed. 1992). Von Mehren, Robert B., "Transnational Litigation in American Courts: An Overview of Problems and Issues" (1984). Copyright c. 1985 by Matthew Bender & Co., Inc., reprinted with permission from Problems and Solutions in International Business in 1984 by the Southwestern Legal Foundation. Waelde, Thomas, "Environmental Policies Towards Mining in Developing Countries," 10 J. Energy & Nat. Res. L. 327 (1992). Reprinted with permission of International Bar Association Willheim, Ernst, "Australia-Indonesia Sea-Bed Boundary Negotiations: Proposals for a Joint Development Zone in the 'Timor Gap,"' 29 Natural Resources Journal 821 (1989). Reprinted with permission of Natural Resources Journal, Albuquerque, New Mexico. Winship, Peter, Energy Contracts And The United Nations Sales Convention, 25 Tex. Int'l L. J. 365 (1990). Reprinted with permission of Texas International Law Journal. Yuan, Paul C., "China's Offshore Oil Development: Legal and Geopolitical Perspectives," 18 Tex. Int'l L. J. 107 (1983). Reprinted with permission of Texas International Law Journal. Zillman, Donald, "An Introduction to Public and Private International Law," Part 3, I-IV, Rocky Mountain Mineral Law Foundation (1991). Reprinted with permissionof Donald Zillman. Zwart, Sara, The New International Law of Sales: A Marriage Between Socialist, Third World, Common, and Civil Law Principles, 13 N.C. Int'l L. & Com. Reg. 109 (1988). Reprinted with permission of North Carolina Journal of International Law and Commercial Regulation.
334
Concessions, Production haring, Participation Agreements

I
Ch. 5
The term "state participation" is in widespread use in the extractive industries but is rarely encountered in other areas. Traditionally, the state has been content to secure the exploitation of its natural resources through the device of the concession awarded to a private, specialised enterprise, of which the major oil companies are but the most notable modern examples. An alternative to this system is for the state to undertake the activity of exploitation itself, through a government department or state enterprise, calling on private enterprise, if at all, to provide only specific services on a contractual basis. When such arrangements are installed in place of a concession system, as in Mexico and, later, Venezuela, we are apt to use the term "nationalisation"; but such arrangements may also operate without any takeover of private interests, as was the case with the early governmental explorations for petroleum in Great Britain, carried out State through the agency of S. Pearson and Sons Limited. participation, on the other hand, takes place within a framework of private enterprise involvement, and expresses a degree of state control of, and involvement in, the activity of exploration and production which is greater than that afforded by the usual concession arrangements. This may, for example, be expressed in a different type of contractual arrangement offered to the private enterprise, such as the risk service contract or (now common) the production sharing contract. In the United Kingdom, however (and also in Norway), state participation has not involved any change in basic licensing arrangements. Instead, private companies obtaining licences have been encouraged or required to form joint ventures with public enterprises, either existing or specially created, for the purpose of operations under the licence or for more limited purposes. Depending upon the composition and terms of such joint ventures, a variety of policy objectives of the state can be advanced; control of exploration and production operations; participation in profits arising therefrom; obtaining of information and expertise; control of disposition of petroleum produced; and so on. The objectives sought by United Kingdom governments have not always been entirely clear * * * .
Terence C. Daintith & Geoffrey D.M. Willoughby, United Kingdom Oil and Gas Law 1-302 (2d ed. 1992).
. PRODUCTION SHARING AGREEMENTS

In the late 1950s and early 1960s, some countries, specifically Iran and Indonesia, turned to the production sharing agreement. In fact, except for the O P E C production sharing arrangements have become a opular form of developing a country's reserves. The country grants to %e multinational a contractual right to explore in a specified area in exchange for the company's opportunity to recover its costs and a specified profit. In return, the country contributes the acreage and
Sec. C
Production Sharing Agreements
335
receives a share of production. Note, however, that if the acreage is unproductive, the company receives no guaranteed profit. This section examines representative clauses that can be found in a production sharing agreement. Many of the clauses rely on the Indonesian production sharing system, because the Indonesian agreements have been widely circulated as models for this form of arrangement. More specifically, we will first examine the management clause that gives the state oil company significant involvement in the operation of the enterprise. Second, we will analyze the different means for requiring investment and work commitment from the multinationals. Finally, we will examine company and government take.
1.
MANAGEMENT CLAUSES
One rimary oal of a production sharing arrangement is to attract a multinatia d r a t i o n that is w . dh . g - t o risk mptahd~ndrouwiLF te>hnological expertise to develop a country's reserves for eventual operation by a delegate of the sovereign. Therefore, in the majority of production sharing arrangements, the sovereign has a state oil company that is expected to learnfrom the multinational so that the reserves can eventually be turned over to the state oil company for operation. In light of this goal, the relationship between the state representative and the multinational corporation must delegate significant responsibilities to the state company. The Indonesian production sharing arrangement defines the relationship and responsibilities of the multinational (the Contractor) and the state oil company (Pertamina) as follows: MODEL PRODUCTION SHARING CONTRACT BETWEEN PERTAMINA AND PRIVATE COMPANIES
(1977)7
Section V Rights and Obligations of the Parties

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VI A Collection of International Concessions and Related Instruments 59 (Peter Fischer ed. 1985).
336
Concessions, Production Sharing, Participation Agreements
Ch. 5
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(dl be responsible for the preparation and eneoution of the Work program, which s h a m m p l e m e n t e d in a workmanlike manner. * * *
(g) &ave the right to sell, assign, transfer, convey or otherwise dispose of any p a r ? ts ngnts and interests under this contract * * * with the prior written consent of PERTAMINA which consent shall not be unreasonably withheld.
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(n) k v e the right during the term hereof to freely lift, dispose of, export its share of Crude Oil, and retain the proceeds therefrom; (0) ilpvoint an authorized representative for Indonesia with respect to this contract, who shall have an office in Jakarta; -ion commences, fW its o b w o n in Indonesia. CONTRACTOR agrees to INA a pof.tion of the share of the Crude Oil to which it is entitled * * * calculated for each year as follows: [complex formula roughly equaling 8% or less of production. A subsequent clause provides for the sale of such production at 20 cents per barrel for 5 years and at market price thereafter but with the proceeds in excess of 20 cents to be used to assist financing CONTRACTOR projects in Indonesia.].
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and to make available from the resources under PERTAMINA's control. In the event that such_facilities,s~lpplies or personnel are not shallp_romptly secure * * *-t<ereadily available then PERTAMINA -- --" use of such * * * from2Iternative sources. Expenses thus incurred by PERTAMINA by CONTRACTOR'S request shall be reimbursed to
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Sec. C
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PERTAMINA by CONTRACTOR and included in operating cqsts ***. CONTRACTOR shall advance to PERTAMINA before the beginning L*4kfLhidnuo v r k > o g r a m a minimum amount ot * * * . drP h~s t , ($75,000).* * * If any amount advanced hereunder is not'exsended by PERTAMINA .p-.,..-- axnob"2 shall be =gram period * * * .
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(e) h u t l e to all original data resulting from he petroleum operations * * * as CONTRACTOR may compile during the term* . hereof provided, however, that all such data shall not be disclosed to third parties without informing CONTRACTOR and giving CONTRACTOR the opportunity to discuss the disclosure of such data
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The involvement of Pertamina as a manager - of the operations after the contractor has performed the work program is a significant departuiefrom the clauses in the ola co ments. 'lhus, ln a production sharing contract, the country maintains much closer continuing csntrol through this approval system than in many modern concessions. In addition, the Indonesian contract requires that the contractor pay Pertamina a management fee for facilitating the work program; thus, the state oil company retains management control and receives another source of compensation in the arrangement. Indonesia first introduced the c o ~ of t state oil company management in 1966 and, in fact, received significant resistance from the large multinati~nals. One commentator . who conducted extensive personal interviews of almost one-hundred persons involved with th; Indonesian petroleum industry made the following observations about the management provision:
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. The "management" clause and related provisions were the source of much concern when Indonesia renewed its efforts in 1965 to engage foreign companies in the petroleum sector. In the mid-1960's. this clause represented a radical departure from contractual arrangements subsisting in other parts of the world. The "major" companies were indisposed to relinquish managerial prerogatives to inexperienced and not always friendly public servants, and pointed to the inequity of divorcing managerial and capital risk bearing functions. The "majors" suspected, further, that this clause would simply provide Indonesia with the legal means to conveniently eject the companies. An additional, if not dispositive, reason for the refusal of the "majors" to accede to the management clause was that it would precipitate the inclusion of similar clauses in their contracts with other
338
Ch. 5
oil exporting countries. Moreover, there was some apprehension that companies which did not possess management rights would be disqualified from receiving a depletion allowance under the United States income tax law.
Robert Fabrikant, "Production Sharing Contracts in the Indonesian Petroleum Industry," 16 Harv. Int'l L.J. 303, 313 (1975). From 1966 to 1975, the management clause may have deterred some majors from entering into the Indonesian production sharing agreements; however, many independents did not see this as an. obstacle. From a 1975 viewpoint and undoubtedly leading to the retention of these provisions in the 1977 model agreement, Mr. Fabrikant made the following observations:
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clause has yet to be fully felt. While the companies have not been Pertamina, Pertamina has thus far quite sparingly exercised the range This self restraint may be attributable to the following of its powe factors:&during the exploration stage, t h e r ~ k c t t l e likelitpod th&--Co~tra~@rs . w i l ! & ~ ~ ~ i~sestost country. Thus, the present need for Pertamina to closely supervise Contractors is minimal. Contractors unanimously e x w a r n a n a g e r i a l role to ihxease if and when is discovered. Pertamina's supervisory efforts commercial ~etroleum to date seem to have been partially motivated by a desire to keep the companies "honest" and to satisfy those asertamina that they were fulfilling their contractual wishes .-." to avoid - - management , either of discouraag a d d i t i o n ~ ~ n t r a c t o fromignmg rs contracts, provi%ng existing Contractors with an excuse for curtailing their operations. Pertamina is fully of its lack of technological and - cognizant management skius, ana aware l r toebstitute its own views on petroleum exploitation for those of the actors. Its authority to s and potentially selfdestructive. In the short run, therefore, Pertamina has adopted the more sensible goal of educating itself.
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Id. at 3 16-17. One commentator characterized the management clauses of the Indonesian production sharing agreements as much "weaker in practice than they might appear to be." Kamal Hossain, Law and Policy in Petroleum Development: Changing Relations Between Transnationals and Governments 140 (1979) [hereinafter cited as Hossain]. Mr. Hossain's argument is supported by the fact that the state oil company
Sec. C
339
usually had 30 days to propose changes to the multinational's plan and that in light of the company's lack of expertise it would be difficult to make important changes. Further, he found that companies would generally only provide the state oil company with raw data and thus complicate any efforts to provide meaningful input into the management process. Although the existence of a state oil company seems almost necessary in the modern production sharing arrangement, at least one country, Guatemala, does not have a state oil company even though it uses production sharing agreements for its oil development:
The Guatemalan government has no operating responsibility in petroleum production and apparently does not expect to have any in the future. The official responsible for oil and gas is the secretary of mines, hydrocarbons, and nuclear energy, with ministerial rank but not under any of the regular ministries. * * * Both technical and policy advice are provided by the United Nations Development Program (UNDP) through a Canadian advisory group. * * *
Raymond F. Mikesell, Petroleum Company Operations and Agreements in the Developing Countries 84 (1984) [hereinafter Mikesell]. Accordingly, the Guatemalan production sharing agreement is much more specific with respect to the multinational's drilling and investment requirements. The information requirements are simply for reporting and compliance purposes and not for educating a sovereign body for eventual takeover of local production and exploration. A third possibilitv in lieu of repod,u_otn 2 q t w ra ministry is the creation of' a ioint entity that&& the management decisions. This hybrid form of arrangement was used in the EgyptianEsso arrangement signed in 1974:
The non-profit joint company was to come into existence within 30 days after a commercial discovery, to undertake all development and production operations. Prior to the coming into existence of a joint company, an exploration advisory committee of six persons, three to be appointed by EGPC and three by Esso, would be consulted and would advise on exploration operations and work programmes would have to be approved by it.
Hossain, 154. Compare and contrast the approaches used in the various arrangements. What are the benefits and detriments of each approach?
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Notes 1. The management control feature creates a resemblance between the production sharing agreement and the typical joint venture. 2. It is possible that a company could use the management clause solely for compensation and not for educational purposes. In such an instance, the multinational would compensate a state owned entity for employment of nontechnical personnel and for ensuring that the company fulfills all of the requirements under the sovereign's legal system. Many multinationals may view this as a worthwhile benefit because the technical of such requirements can, in some cases, lead to termination of he agreement.
2.
INVESTMENT AND WORK COMMITMENT CLAUSES
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The second objective of a production sharing arrangement is to develop an area of mineral reserves with the capital and technological expertise of the multinational corporation. In the production sharing arrangement, the multinational solely bears the risk of any nondiscovery of minerals. In light of the fact that the contract allows the multinational issues: (1) the existence of a work program or minimum dollar contribution towards development; (2) the duration of the exploration and development phase; and (3) the sharing of the benefits of production between_thetinational and state oil company if production is achieved. In the traditional concessions, the foreign corporation had sole control over the timing and extent of its exploration and development activities. In the modern concessions, sovereigns insist upon a detailed work program to ensure that a multinational will contribute significant efforts to the discovery of petroleum. In a production sharing agreement, a sovereign needs to decide whether it wishes to include a minimum dollar contribution or a minimum activity provision to ensure that the corporation will seek to discover petroleum under this arrangement. The Indonesian production sharing agreement requires that the contractor drill one well during the first year of the agreement and agree to spend a minimum amount in each of the first 5 years of the agreement:
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d n yr + QPG( Mikesell, 63 (1984). Note that the Indonesian agreement would have terminated 6 years after the effective date if petroleum had not been discovered in commercial quantities. The 1971 model production sharing contract used by Peru required that the multinational agree to perform a specified program of exploration as well as the drilling of several wells, even if the geological data is unfavorable. See id. at 70-71. In this arrangement, the corporation had to arrange to place a guarantee bond that would be forfeited if the program sharing was not fully completed. The 1978 Peruvian model -ion .. contract changed this the activity at the company had fulfilled during the term of the agreement:
First year Second year Third year Fourth year Fifth year
US 3.7 million US 4.7 million US 1.9 million US 3.3 million US 1.9 million
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for two phases within the exploration was to be completed within two years, either (a) to complete and required production test a previously drilled exploratory well; or (b) to drill a new well. The contractor was also required during the first phase to install pipelines and production facilities necessary to conduct a pilot test of one of the wells and to conduct seismic and other geological and geophysical studies of the contract area. Following the signing of the contract, the contractor was required to provide Petroperu with a bank guarantee of $8 million. If the contractor decided to relinquish the contract area before the completion of phase I, the entire $8 million was forfeited. However, upon completion of phase I the penalty was reduced to $3 million. Phase - I1 of the e x p h w g m d was to b e a e t e d within four years f w v m f the con~&&bjs.included the drilling of two additionalexploratory wells in the contract a L ! a Upon completion of each exploratory well, the penalty was reduced by $1.5 million. If the contractor decided to relinquish the contract after drilling two additional wells, there was no further penalty.
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342
Ch. 5
Most production sharin ,arrangements have- t exoressly gefined in the arrangement: xploratory and deve ent phase and 3 @rodustion p ~ The.durati?f the exploratory ~h=?~ill depend upon several factors, including the difficulty of discovering oil in the contract area, the size of the contract area, the need to attract investment in this area, and the type of technology that will need to be used in the Some contr&ts, such as the Indonesian production exploration sharing arrangement, are generous on the size of the concession area and the duration of the exploratory period, yet they use a relinquishment clause to recover some of the acreage and force the multinational to develop fully the productive areas within the exvloratory Others - period. . grant small tracts -of land and have a relatively short exploration period.. I n fact, this grant m o ~ e s e m b l e s the farmouts that are commonlv usedin the UnitedStates-h a ane well obligation and a one- or two-year
3.
CLAUSES RELATING TO GOVERNMENT AND COMPANY TAKE
The final set of considerations involves the sharing by the multinational and the sovereign of the proceeds of production from the territory once commercial quantities have been discovered. These require decisions on: (1) which costs of the multinational will be reimbursed; (2) whether any interest or bonus will be made upon such costs; (3) how such costs will be reimbursed; (4) how much the sovereign receives during the reimbursement period; (5) whether such royalties, bonuses, taxes, and other payments will be deducted from one or both party's share; and (6) what occurs after the multinational has been paid. In studying these issues, it is useful to study one of the first profit formulas. The 1966 Indonesian production sharing agreement contained the following formula:
[A] maximum of 40 percent of the annual o * t of p be recovered by a f o r e i g ~ _ c o ~ - m ~ ~ , j & p r ~ ~ @ u ~ ~ ~ - a n d , production cqsts. After deducting production costs, the balance of the petroleum produced was split 65 percent to the state company and 35 percent to the foreign company. The Indonesian income tax for which the foreign company was liable was paid by the state company. The contractor was free to market its share of the output without repatriating the foreign exchange from the sale.
Mikesell, 60. Under this formula, many companies recovered their invested capital costs within 3 to 5 years. See Hossain, 148. The 1977
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343
! @ a JPon tract this the tion and lent to Gd. fin
Indonesian Model Agreement contained the following clauses relating to the profit recovery formula: MODEL PRODUCTION SHARING CONTRACT BETWEEN PERTAMINA AND PRIVATE COMPANIES
(1977)8
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of the sales auantitv of crude oil equal in value in such operating costs which is produced and saved hereunder * * * .
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as including "(a) current year's noncapital costs; (b) current year's depreciation for cap~talcosts; and current year's allowed recovery of last year's operating costs. Noncapital costs, including exploration and intangible costs, may be expensed, and capital costs are depreciated by the double declining balance method." R. Mikesell, Petroleum Company Operations and Agreements 65 (1984).] Title to CONTRACTOR'S portion of Crude Oil under section 1.3 * * * as well as such portion required to recover operating costs shall pass to CONTRACTOR at the point of export, or in the case of oil delivered to PERTAMINA, at the point of delivery. CONTRACTOR will use its best reasonable efforts to market 1.5 the Crude Oil to the extent that markets'are a v a i l a m c h party shall be entitled to take and receive their respective portions in kind.
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V1 A Collection of Internahonal Concessions and Related Instruments 59 (Peter Fischer ed. 1985).
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equal to 20% of the capital investment cost directly required for developing crude oil production facilities out of deduction from gross production before taxes * * * .
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Crude Oil sold to third parties shall be valued as follows: (a) * * * net realized value f.0.b. Indonesia received by CONTRACTOR [or PERTAMINA if sold by CONTRACTOR for PERTAMINA] for such crude oil.
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1.2 Crude oil sold to other than third parties shall be valued as follows: (a) by using a weighted average per unit price received by CONTRACTOR and PERTAMINA from sales to third parties excluding, however, commissions and brokerages paid in relation to such third party sales * * * . (b) if no such third party sales have been made during such period of time, then on the basis used to value Indonesian Crude Oil of similar quality, grade and gravity * * * .
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CONTRACTOR shall pay to PERTAMINA as compensation held by PERTAMINA the sum of $ - (US) * * * Pertamina $20.1 million signature bonus. See R. Mikesell, Petroleum Company Operations and Agreements 66 (1984).]
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1.2 CONTRACTOR shall pay to PERTAMINA the sum of $ million US dollars after daily production from the contract area averages thousand barrels per day for a period of 120 consecutive days * * * . [In 1979, Gulf agreed to pay Pertamina $10 million for output in excess of 50.000 barrels per day; $50 million for output in excess of 100,000 barrels; $100 million for output in excess of 200,000 barrels. See R. Mikesell, Petroleum Company Operations nd Agreements 66 (1984).]
1.3 Such compensation and production bonus payments shall & solelv borne bv CONTRACTOR and not included in the opera tin^ c s
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Three related issues in every production sharing agreement are any provisions exist for recovery of the m u l t i n a t i o n a l ~ t s ,
Sec. C
345
a h e t h e r any bonus or interest is added to such costs, and ow such costs will be reimburs_ed. These issues bear upon the extent to which the country will share in the costs of exploring and developing the reserves that are the subject of the arrangement. As is illustrated above, the 1977 Indonesian production sharing arrangement provides for the recovery of zosts through a current depreciation deduction in the operating costs brmula: The duration of the producbon snaring arrangement is 3U years, and thismethod of cost recovery approximates the accounting system that the multinationals must use within their host country on their financial statements. Note, however, that Indonesia provides a 20 percent bonus for such capital costs. Sovereigns with a n k d to encourage oil and gas investment must usually provide for a more accelerated cost recovery provision. For example, several 1976 Malaysian contracts provide for recovery of costs through a 20 percent of gross production set aside with the excess developmental costs being carried forward to next year. See Mikesell; 87. m he Philippine production sharing arrangements provided for a 60 percent and 70 percent of gross production cost recovery provision. Id. at 89. At the other extreme is the Guatemalan production sharing arrangement in which there is no cost recovery provision. Id, at 77. stead, the multinational must recover all of the costs from its share of production, which is graduated from 45 percent for production under 15,000 barrels per day to 25 percent for production over 100,000 barrels per day. Id. a58-4 ~he,/z1b~a-~ob i)roduction il sharing agreement bears some -mention: \--
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Under _,. *_... this agee~cRt,exploration expenditures would be borne be rec~verable even i y a b j the contractor, and c o m m e r c l a l l y ~ f i c a n tdiscovery was made. In case of such a discovery, production wou7F6e d l v s c e n t to the government and 15 per cent to Mobil in on-shore asas, and 81 per cent to the government and 19 per cent to Mobil in off-shore areas. A s u b s t a l b proportion of the development costs would d v a n -..-- ,--be a Government-85 ver cent in the case of on-shore discoveries and 50 _ * o + a r cent rn the case ot o ~ ~ e ~ a d v a w a ns m ce e Kid back t o m twenty annual in~tallments. with interest (except that 30 per cent of the advance made of any off-shore discoveries would be interest-free).
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Hossain, 151. The next set of issues relate to the compensation the sovereign will recelve during the reimbursement period and whether such rovalties, frnm n n c t r hQth
346
Ch. 5
party's share. In the 1977 Indonesian agreement, after taking a deduction for operating costs, the production is split 65.0901 percent to Pertamina and 34.0909 percent to the contractor. Furthermore, the agreement calls for significant bonus payments to Pertamina if production reaches certain specified levels for 120 days. Other contracts contained a sliding scale of production sharing to the government: From 0 to 15,000 bpd From 15,001 to 30,000 bpd From 30,001 to 50,000 bpd From 50,001 to 100,000bpd From 100,000 on 55% 60% 65% 70% 75%
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Mikesell, 84. In other arrangements, the company would offer to the sovereign a certain share of production at reduced cost. However, a characteristic of the early production sharing arrangements was the split in production with the government share viewed as a split of profits. The . government "take" aspect ~f these arrangements was premised ulon the belief that such payments were creditable as taxes paid to foreign gvernmeats, Joseph Isenbergh, "The Foreign Tax Credit: Royalties, Subsidies, and Creditable Taxes," 39 Tax L. Rev. 227, 248-49 (1984). In 1975, the Congress limited the foreign tax credit on foreign extraction income to the united States corporate tax rate. See I.R.C. $907. In 1976, the Internal Revenue Service ruled that payments made under the model Indonesian production sharin? m n t were not foreign taxes paid to* Indonesia:
The Service ruled that no tax was paid under this agreement and that the total amount received by the Indonesian government (directly and through its alter ego Pertarnina) was merely one big royalty. The crucial vice of the arrangement in the Service's view, was the combination of (1) a guaranteed return for Indonesia predicated on the amount of oil extracted by the company and (2) the failure of the contract to allow cost recovery above 40% of production: 'Thus, the effect of the 40 percent limitation and the other prohibitions is to assure that the Government will retain a fixed percentage of oil qroduced in anv vear regardless of whether [the taxpayer1 has any neL o n gain from such ~roduction. Such an assured share of retained by the mineral owner is characteristic of a royalty and not of a ~ c e p t - or t rms.
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Sec. C
347
Based upon negotiations among the IRS, Indonesia, and the oil companies, the IRS subsequently issued the following guidelines in approving a direct tax provision in a renegotiated arrangement:
such minerals in dace. a foreign tax will not be recognized as a tax fqr U.S. Federal-tax Durooses, unless that government also rgquires payment of an appropriate royalty or other consideration for the payment that is commensurate with the value of the concession. Such royalty or other consideration yust be calculated separatelyxd independently of the foreign tax. * * * -In order for the foreign tax to be credited under section 901, it must qualify in substance and In rorm as a U.S. tax under U.S. c o n c a s . Generally, in the absence of other factors which have contrary implications, payments to a foreign government owning the minerals in place extracted by the U.S. taxpayer will be treated as a creditable U.S. tax if all of the following characteristics are present: (1) The amount of the income tax is calculated separately and independently of the amount of the royalty and of any other tax or charge imposed by the foreign government. (2) Under the foreign income tax and in its actual administration the income tax is imposed on the receipt of income by the taxpayer nd such income is determined on the basis of arm's length amounts. Further, these receipts are actually realized in a manner consistent with U.S. income taxation principles. (3) The taxpayer's income tax liability cannot be discharged from property owned by the foreign government. (4) The foreign income tax liability. if any, is computed on the basis of the taxpayer's entire extractive operations within the foreign
(5) While the foreign tax base need not be identical or nearly identical to the U.S. tax base, the taxpayer, in computing the income subject to foreign income tax, is allowed to deduct, without limitation, the significant expenses paid or incurred by the taxpayer. Reasonable limitations on the recovery of capital expenditures are acceptable.
Rev. Rul. 78-222, 1978-1 C.B. 232. The tax was placed on income at 45 percent and on company dividends at 20 percent and was paid directly to the Indonesian treasury instead of Pertamina. Even prior to this revenue ruling, multinationals in most production sharing arrangements paid an come tax on revenue received in the country. In light of the position of the IRS, however, Indonesia and other countries revised their contracts to provide for higher levels of taxation and some form of royalty to attempt to meet the Service's standard for a payment of tax that meets the foreign
348
The final set of financial decisions involve what occurs after the multinational has recovered all costs. Most of the production sharing arrangements do not modify the financial terms after the multinational's costs are completely recovered. However, one could make an argument for a different formula once the company recovers its capital costs. In fact, a production sharing agreement with India includes a clause that allows the state oil company to acquire the entire interest in the area once the multinational has earned three times the capital investment. See Hossain, 152.
Notes
1. A production sharing agreement bears some resemblance to a farmout transaction or carried interest arrangement in the United States. See John S. Dzienkowski & Robert J. Peroni, Natural Resource Taxation 505-08 (1988). In the United States, many forms of carried interest arrangements have developed to take advantage of the tax benefits of the pool of capital doctrine. In a typical farmout arrangement, a lessee contracts to transfer acreage to a company if the company drills a well. Once payout occurs and the driller recovers all of the costs of drilling the well, the driller and the lessee share the proceeds of production according to a predetermined formula. For an exhaustive study of farmouts in the United States, see John S. Lowe, "Analyzing Oil and Gas Farmout Agreements," 41 Sw. L.J. 758 (1987). In theory, no reason exists why landowners in the United 2. States could not enter into arrangements analogous to the production sharing agreements used internationally. In fact, some domestic oil companies have used net profits arrangements that are similar to the production sharing agreements in use today. See the net profits arrangement at issue in Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25 (1946). Indeed, some sophisticated leases containing an express obligation to drill a test well, a provision for an increased royalty upon well payout, clauses giving the lessor access to well information and permitting the lessor to conduct his own well tests, and extensive development provisions come reasonably close to the typical production sharing arrangement. See Form # 6, Texas Landowner's Oil and Gas Lease, Eugene 0. Kuntz, John S. Lowe, Owen L. Anderson & Ernest E. Smith, Forms Manual to Accompany Cases and Materials on Oil and Gas Law 25 (1987). One commentator has recommended joint development agreements, under which the landowner will share in net profits rather than in receiving a royalty, as a viable and possibly desirable alternative to the traditional oil and gas lease. David E. Pierce, "Rethinking the Oil and
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Sec. C
349
Gas Lease," 22 Tulsa L. J. 445, 475-479 (1987). However to the extent that these more complex arrangements have been entered into by U.S. landowners, they represent a very small fraction of the total arrangements for developing U.S. petroleum reserves. 3. Many oil and gas companies viewed production sharing arrangements to be preferable to concessions on the ground that the country was unlikely to impose additional costs or taxes, because this would extend the recovery period for the multinational.
4 m
D. PARTICIPATION AGREEMENTS
The participation agreement involves the creation of a joint venture between the country and the multinational corporation. As in the case of typical joint ventures in other contexts, the participation arrangement may take many different forms. The parties can form a jointly owned entity that is responsible for developing the mineral reserves, or the parties can simply define their relationship through a contractual arrangement. Under each form of joint venture, the goal of the agreement is to allow the sovereign or its state oil company to participate as a partner or joint venturer in developing and producing the mineral reserves.
4n later joint v( not agree 0, yhj, its "sole rJsk Americ, - uA entlusbd to (FAI ~ ~ Jsituation: JS
1.
EQUITY AND CONTRACTUAL JOINT VENTURES
The earliest participation agreements were formed in 1957 by the Italian state oil corporation in its dealings in Egypt and Iran. See Hossain, 121. In both of these agreements, the Italian state corporation formed an operating entity in which ownership was split 50-50. This is called an equity joint venture b s h e sovereign and the multinational share joint ownership in an entity. Id. In these early agreements, the multinationals bore the entire risk of loss of their capital investment, with ((h a) a special recovery provision for investment if production resulted. - Id. In 1958, the Iranian Oil Company and the Pan American Oil Company form of arrangement. Id. at 127. agreed to a joint venture in a This structure, referred to as a contractual joint venture or joint structure, defines the parties' relationship in a contract and not in an entity. The decision on whether to adopt an entity or a contractual joint venture depends upon many factors such as the local law in the foreign country, the corporate and tax law in the multinational's home country, and whether ownership of assets and production is to be in a joint entity or in the individual parties. One would expect that the entity joint venture ?
350
can delegate much of the decisionmaking to the board of directors of the joint entity; however, contractual joint venture arrangements have made use of a nonprofit decisionmaking committee to guide the partners' decisions. Thus, apart from the legal consequences of a jointly owned company or of a contractual definition of the joint venture, a multinational and sovereign can accomplish much the same arrangement through the two types of joint ventures.
2.
MANAGEMENT PROVISIONS AND WORK PROGRAM
In light of the fact that the participation agreement involves a joint venture, the arrangement must in some way define the manner in which decisions are made by the participants to the venture. This definition is usually accomplished through a management committee. In the early arrangements, the foreign corporation was given significant control in the structure that was established:
The formal structure of management was based on the parity of shareholding of NIOC and AGIP, which was reflected in the composition of the Board, half of the directors being appointed by Y O C and half by AGIP (Article 4). In practice, however, the effective technical management is vested in the foreign company. [ S e managing director is appointed by the foreign company and] *** technical management of the company would be entrusted to personnel designated by AGIP andor appointed by the Managing Director.
See Hossain, 121-22. In this arrangement, the Italian oil corporation and the Iranian NIOC agreed to a fairly specific work program that obligated the multinational to spend $22 million during a 12-year period. In fact, this agreement even contained a relinquishment clause. Such an approach is similar to the result that would have been reached under a modem concession agreement. m e innovative 4novel style of participation arrange involves the implementation of a management l m e r a t i o n a l decisions. Seve to such an arrangement. m n e must exa voting control over the decisions of the join example, if the sovereign has a 51 percent voting control, many of the decisions will be controlled by thi sovereign. arrangements may give certain issues over to a co,mrmttee; however, tnese x g r l m m i opt-out provisions for participation in development operations.
Sec. D
Participation Agreements
351
Although many participation agreements contain standart1 woik commitments and obligations for exploration by the multinational corporation, the decision on whether to develop the properties that are explored is an important one. In other words. the multinational's activities may result in the discovery of petroleum; however, the company may feel that this discovery is not commercially feasible for a variety of reasons. The field may be too costly to develop or the quantity or quality of the petroleum may significantly hinder the profitability of the project. Thus, the participation agreement must address how the two parties will resolve this decision. The following excerpt provides several examples of provisions that deal with this issue:
KAMAL HOSSAIN, LAW AND POLICY IN PETROLEUM DEVELOPMENT: CHANGING RELATIONS BETWEEN TRANSNATIONALS AND GOVERNMENTS
124-126 (1979)9
A more efficient mechanism was developed and incorporated in later joint venture agreements to deal with situations where the parties did not agree on the commercial prospects of a discovery. A clause was included which enabled either party to undertake to develop a discovery at its "sole risk." Thus, the "sole risk" clause incorporated in the Pan American-UAR Agreement of 1963, under which operations were entrusted to the joint operating company, the Fayoum Petroleum Company (FAPCO), provided the following framework for dealing with this situation:
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In the event of the failure of the board of directors of the operating company to approve any drilling, exploration or other development operations under the agreement, due to a difference of opinion between the two principals, the party S . _ Othe specific operation may go ahead on its own after following a specific procedure. Such party, referred to by the agreeznt as the ',proposing p ~ ~ h o u l d propose in writing to the other party, referred to as the "non-proposing ~ a rty," that such particular work be done; and a copy of the proposal should be furnishkd to FAPCO. ~ c non-proposingparty e -&thin 60 days from the receipt of such broposa< elkct to participate equally 1 1 0 1 do so, then the proposing result, such n s c e servlng as ad horization by the said party to the operating c o m p a n i o ~ o u t
Published by Nichols Publishing Company.
352
Concessions, Production Sharing, Participation Agreements operations, FAPCO ----- will be acting as the sole agent of the proposing party, a n d n o t , f n t u r e . @ -----'"-'VQcLVI The proposing party is then entitled to receive and own all the petroleum extracted in the sole-risk operation it had financed unilaterally. It continues to do so until it has realized the following
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For each wildcat well an amount equal to: (a) The costs and expenses incurred and paid by the proposing party for the drilling, testing, equipping and completing of the well, plus (b) three hundred percent of such costs and expenses. 2. For every other well, an amount equal to: (a) The costs and expenses incurred by the proposing party for the drilling and development operation, plus (b) one hundred percent of such costs and expenses. 3. For other projects, an amount equal to: (a) The costs and expenses incurred by the proposing party, plus (b) seventy-fivepercent of such costs and expenses. After the proposing party recovers these amounts, the operating serves notice on the n o n t y x o & X i J & ~ u c % ' recovery. -.-* is event, G ~ n - ~ r E ~ oparty s i nis~entitled to p a r t i c i p a m e G r i s k operat= wxtTi"e3roposiniarty upon makrng a payment to the latter party of 50 percent of the total expenses incurred. If such payment is made within 90 days of the receipt of notice, then the well, wells or other projects involved shall pass to the joint venture, and be jointly owned and controlled by Pan American and EGPC under the agreement. If the non-proposing p ~ d to pay its share of the said -* --- 1 . P * ~ P ~ . 'expenses, ~ then t h e ~ p p s i n ~ -sa"i,r_em--perman- - &[,+-4 3 <*L 't o m f the W c t or pro&t,sso_d,gkeloped at its sole risk, with - -+*- . , . . , a aF~heir,jg$a_tkn-Cl&~ Thereafter, FAPCO cont~nues to ' E b :r f - - 9 r : ~ e ? 9 f . operate and maintain such projects as the agent of the proposing party. i , a 4 ~ : 3 ~ at its sole cost and expense. All the petroleum produced from such p< 8 wells is owned by the proposing party alone. ++y On the other hand, if any well drilled at the sole risk of the proposing party turns out to be a dry hole, then it is sealed and abandoned by FAPCO at the sole cost and expense of this party.
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An instance where the sole risk clause was invoked was the Abu Qir gas discovery in Egypt by Phillips in 1969, which the company did not regard as commercial, but which the government decided to develop at its sole risk in order to meet domestic requirements. The "sole risk" clause has been commended as "one of the admirable i n ~ t a n c e s l f l e x l b i l i tmade ~ possible by the joint venture structure." Another instance of flexibility is provided by the mechanism, embodied in the Pan American-UAR Agreement of 1963, to deal with a
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Sec. D
353
situation where a project is approved by both parties but one party is either unable or unwilling to share in financing it. This mechanism operates in the following manner:
After a project is approved by the board of directors of the operating company, the only party willing to pay, called " t b paying party," may advance to the operating company the necessary fun@. After the &mpletion of the project in question, the other party is entitled to use the facilities of the project equally with the paying party, and starts sharing with it equally all the expenses of operation and maintenance following completion. However, in order to compensate fVLfBI; e u l n c u r r e this uartv d has the riphffo receive. , -or f an amount equal to half the costs a a ~ e n s e mfAmdhy s the non-paying party, plus 75 percentof this amount. These refunds are paid monthly at a rate equal to double t a o i tn rate fixed by the joint-venture agreement. However, the non-paying party may avoid the above provision if it is able to make payment on the approved project within nine months from the date it was due. In such event, the paying party is entitled to an interest of one-half percent per month on such payments to compensate for the delay. After the above payments are made by the non-paying party, this party acquires an interest in the approved project or investment equal to that of the paying party, and the project is operated by the operating company as a part of the joint venture.
With regard to the production phase, an obligation was imposed on the joint company to use all its possible efforts in order to raise to a maximum the sale level of petroleum and for this purpose to develop the production of such fields so that production was achieved within the limits compatible with the most modern technical procedures in the oil industry (Article 12).
An example of specific clauses on this topic are reproduced from the Colombian participation agreement:1
Keith W. Blinn, Claude Duval, Honore Le Leuch & Andre Pertuzio, International Petroleum Exploration and Exploitation Agreements: Legal and Economic Policy Aspects 108IM I l n o L \
354
Concessions, Production Sharing. Participation Agreements
Ch. 5
CHAPTER ( ) EXPLOITATION CLAUSE 9. - TERMS AND CONDITIONS 9.1

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In order to initiate the joint operation under the terms of this contract, it is considered that exploitation begins on the date in which the Parties recognize the existence of a commercial reservoir or when the event stipulated under Clause 9.5 has been fulfilled. The existence of a commercial reservoir shall be determined through the drilling by the CONTRACTOR within the proposed commercial reservoir, of a sufficient number of wells, which will reasonably indicate the commerciality of the reservoir.
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9.2# If ECOPETROL accepts the existence of the commercial reservoir, it will give notice to this effect to the CONTRACTOR within the period of sixty (60) calendar days referred to in Clause 9.1 and will enter to participate within &t terms of this contract in the ~~S%O~""-~~NTRACTOR. ECOPETROL reimburse the CONTRACTOR f G n t (50%) of the o f d r i l l i n m d comoktkVe&s which, having been by the CONTRACTOR as exploratory wells within the commercial reservoir referred to in Clause 9.1, have been completed as producers and put on production by the Operator.
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If ECOPETROL does not accept the existence of the reservoir as referred to in Clause 9.1 i t ~ indicate n to the CONTRACTOR the additional reasonable work which ii I,wu~td cznsiders necessary to demonstrate the t5xislence _,_-of -- -- a ' , 4 c g m m : r c i d - ~ s ~ b u the t cost ofsaid~wkpm3yng!ex,c,e,e< US $1 million nor the time required for its execution be greater ----_.__ than one (1) year, in which case the period of exploration for the Area Contracted will be extended automatically for a time equal to that which may be necessary to do the additional work requested by ECOPETROL in this Clause without prejudice to the stipulations of Clause 8.1 as to reduction of areas.
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If ECOPETROL, after the work referred to in Clause 9.3 has been completed, does not accept the existence of a commercial
355
reservoir, the CONTRACTOR will have the right to do the 'F k ~ + ! ~ c r ~ u work which it deems necessary r o i tne x e j&b.. ,G-+~< TeEent (200%12f the total cost or all the work done at its cost and risk, from the value of all the petroleum produced, less seT out in Clause 13, deducting the costs of g m n and sale. For the purposes of the clause herein, the value of each barrel of crude produced from said reservoir during a calendar month will be the average price per barrel which the CONTRACTOR receives from the sale of its share in the crude produced in the Area Contracted during the same month. When the CONTRACTOR has reimbursed wells drilled, the installations and all kinds of assets acquired
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ECOPETROL, at any time, may enter into participation of the Joint Operation of the reservoir discovered and developed by the CONTRACTOR without prejudice to the right of the CONTRACTOR to reimburse itself for the investments made for its account in the manner and at the percentage stipulated in
3.
FINANCIAL PROVISIONS
In some participation agreements, the financial provisions resemble the provisions in the concession or the production sharing agreement. In other words, the sovereign retains a right to receive a bonus and delay rentals as well as a royalty on each barrel of production and a tax on the profits of the venture. In other agreements, the provisions establish a profit sharing that is similar to a partnership-that is, the profits are shared according to the percentage ownership in the venture. As in the case of the other arrangements, in some agreements the participation percentages for the sovereign increase as production increases. The one difference between many participation agreements and the h e a typical partnership is that t in the costs of the venture until the decision has been made that' b i e marketable quantities of the mineral exist.
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356
Concessions,Production Sharing, Participation Agreements
Ch. 5 Sec
agreements provide for the recovery of exploration costs out of the production; other agreements provide no such provisions for recovery.
Notes
d e ~ 6 from d the original concession agreements in t h e - ~ i d d l e East; thus, their structure was developed through compromise rather than through an initial decision to create such an arrangement. Since few of the participation agreements began with undeveloped and unproducing properties, it is difficult to determine how such agreements would handle the risks and uncertainties of exploration. 2. In the Saudi participation agreements, the sovereign insisted on sharing in the profits from all phases of the operation including refining, transporting, and marketing. Hossain, 124-126.
4.
OPTIONS TO CONVERT A CONCESSION OR PRODUCTION SHARING ARRANGEMENT INTO A PARTICIPATION ARRANGEMENT
In light of the significant risks that a sovereign or its representative may incur upon entering into a participation arrangement with a multinational corporation, many sovereigns prefer to use a concession or production sharing arrangement, with an option to convert the. arrangement to one of participation. As illustrated above, in the participation arrangement, the sovereign can decide to contribute only its land to the joint arrangement and thus avoid the financial risk that may result from the failure to discover petroleum reserves. However, in light of the historical background in the Middle East of concession to participation, c o u m ~ , . a y . L r n o r e comfortable_x&dhee~~,,t9 convert certain fields or projects. The option to partcGPate clause may be broad and give the m p t at anv time to kame a participant, or the clause may be narrow and limited. The following clause illustrates an example of a broadly worded clause.
--
ABU DHABI CONCESSION AGREEMENT

Article 44. Government's Option (A) At any time after the date of discovery of Crude Oil in Commercial Quantities, the Government may by notice in writing to the Company elect either by itself or by an entity it nominates to
Sec. D
357
acquire a non-assignable undivided participating interest of sixty (60) percent (or such lesser portion as the Government shall then determine) in all rights and obligations under this Agreement and in the Concession Area. (B) The Government shall pay for such participating interest a sum equal to sixty (60) percent or such lesser proportion as the Government shall have elected to acquire of the total accumulated costs and expenses recorded in the book of the company * * * as of the date of discovery of the Crude Oil * * * (excluding the bonus and rental paid by the Company before the date of discovery of Crude Oil. * * * Payment of such sums shall be made by the Government in ten equal annual installments together with interest * * * .
An example of a narrowly worded option to participate clause can be found in the Model Indonesian production sharing arrangement. As you examine this clause, identify the situations in which the sovereign would want to exercise its participation rights. MODEL PRODUCTION SHARING CONTRACT BETWEEN PERTAMLNA AND PRIVATE COMPANIES'
1. PERTAMINA shall have the right to demand from CONTRACTOR that an X% undivided interest in the total rights and obligations under this contract be offered to either a limited liability company to be designated by PERTAMINA the shareholders of which shall be Indonesian nationals or to an Indonesian entity to be designated by PERTAMINA (the Indonesian participant). 2. The [participation] rights * * * shall lapse unless exercised by PERTAMINA not later than three months after CONTRACTOR'S notification * * * of its first discovery in the Contract Area, which * * * can be produced commercially * * * . PERTAMINA shall make its demand known to CONTRACTOR by registered letter. 3. CONTRACTOR shall make its offer to the Indonesian participant within one month after the receipt of PERTAMINA's letters * * * . 4. The offer by CONTRACTOR to the Indonesian participant shall be effective for a period of six months * * * . 5 . In the event acceptance by the Indonesian participant of the CONTRACTOR'S offer, the Indonesian participant shall be deemed to have acquired the undivided interest on the date of CONTRACTOR'S notification to PERTAMMA.
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358
Concessions, Production Sharing, Participation Agreements 6.1 For the acquisition of a X% undivided interest * * * the Indonesian Participant shall reimburse CONTRACTOR an amount equal to X% of the sum of operating costs which CONTRACTOR has incurred up to the date of the notification * * * . 6.2 At the option of the Indonesian Participant, the said amount shall be reimbursed: (i) either by a transfer of the said amounts within three months * * * or (ii) by the way of payment out of production of 50% of the Indonesian Participant's production entitlements under this contract * * * equal in total to 150% of the said amount * * * . 6.3 [The method of reimbursement shall be stated at the time of acceptance of the offer.]
Ch. 5
Sec.
intc Th! ter: Th
Notes
1. What are the consequences to the corporation when a sovereign exercises the right of participation? 2. Under each of the option arrangements that appear above, when might a sovereign decide not to exercise the option to convert the arrangement into a participation agreement?
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12
E. COMMON CLAUSES FOUND IN INTERNATIONAL PETROLEUM AGREEMENTS

The prior sections have sought to differentiate among the three agreements: the concession, the basic types bf international productibn sharing arrangement, and the participation agreement. As stated before, al@ough one can attempt to offer cokeptualand theoretical dfferences among the three, in reality it may be dittipetroleum agreements precisely into one category. This difficulty may result from a harmonization of the agreements ;;;hereby the parties are borrowing the best of each type of agreement to fit a particular situation. It may also result from the fact that these alternative agreements evolved over time and not in a vacuum at the same time. The actual content and organization of particular agreements differs significantly. Some agreements are organized around the concepts of responsibilities of each of the parties. Other agreements simply scatter topics within different articles. Despite the variation in organization, all modem petroleum agreements contain common clauses. This section will offer some examples of these clauses under the subdivision of clauses benefiting the host country and clauses benefiting the multinational corporation.
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Sec. E
Common Clauses Found in International Petroleum Agreements
359
1 .
CLAUSES BENEFITING THE HOST COUNTRY
Even in the early concessions, a prime consideration in entering into the arrangement was the investment of capital in the local economy. This investment served the dual function of providing jobs in the short to operate the venture in the long term. term and trainin local citizens _ _ ___- -The Abu Dha i agreement contained the?ollowing local l@ hroviPi6i:
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ARTICLE 20. CONTRACTORS. (B) In selecting of contractors, the Company shall w m r
conditions are competitive with-ose work.
of other contracts for such
The burden of the local labor provision depends upon the cost of training and employing local labor. Many multinationals may indeed prefer local labor because of the lower salary costs and the absence of unions or strong labor laws. A second dimension of local investment involves the requirement that the multinational purchase materials from local suppliers. The early aBreements included a provision that the multinational prefer local suppliers if the quality was equal to foreign suppliers. An example of such a clause is contained in the Abu Dhabi agreement.
ARTICLE 24. EMPLOYMENT OF PERSONS. Subject to.-rthe a-w a p p l i ~ g b ! e ~ l a w ~ , a $ ~ ! ? & n ~ i , " ~ Dhabi, A ~ , " the Governmgnt and the Company agree that in the s e m m 5 i f t of the
shall, as far as consistent with the-anagement Company and its unde nited Arab Emirates,
More assertive host countries may require that a certain percentage of purchases must be from local manufacturers. There may be a constant percentage or an increasing percentage. To the extent that the local supply issue involves equivalent goods, price becomes the predominant issue for the multinational. However, in some instances, price may be a secondary factor--quality may be the more predominant issue. In the China case study in Chapter 7, we have included a provision requiring the
360
Concessions, Production Sharing. Participation Agreements
Ch. 5
multinational to favor materials from local suppliers. Compliance proved difficult for certain materials that required a high degree of technical sophistication. For example, Chinese suppliers could produce pipe for domestic production, but their product was less suitable for the rigors of the offshore drilling projects than other available pipe. . . Host countries also commonly require a certain portion of its profits in a related industry in the host country. An example of such a provision is the following clabse in the Abu Dhabi concession agreement.
ARTICLE 45. INVESTMENT. (A) When the production of Crude Oil from the Concession Area shall have reached and maintained an average daily rate of one hundred thousand barrels per day for ninety consecutive days, the company shall make or cause to be made studies as to the feasibility of carrying on one or more of the following hydrocarbon activities: ' $,rtf + 1 FP (1) Production and export of Methanol. &it4 DQQC B ! J & ? (2) Recovery and Export of Liquid Petroleum Gas. w+&\ 3u a$$ *.* (3) Nitrogen fertilizer. 4h B M s !' (4) Crude Oil Desulpherization. C(5) Export of Liquefied Natural Gas. (D) The Company u n to invest at least ten percent of its P5t& "%ormore of the .- - . = n r e w -E e .--N,. economic viability has been established.
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In some instances, such an investment provides another profit-making opportunity and, in other cases, il is part of the cost of entering into the petroleum agreement.
Notes
1. In the modern concession section earlier in this chapter, we mentioned the use of the relinquishment clause in reducing the acreage committed to a multinational in a modern concession. In both production sharing arrangements and in participation agreements, host countries use the relinquishment clause to recover acreage that can be the subject of a new arrangement. The clause also provides an incentive to the multinational to develop the reserves early so that it can make a more informed decision on the acreage that will be retained and the acreage that will be released. 2. Early concessions sought to hold the multinational to a certain standard of conduct by tying the contract performance to "good oil field practices" or "industry standards." At first, such clauses were designed to allow a host country to complain when a multinational was
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not fulfilling the expectation of the agreement. T5ese clause-, we;e asserted when a multinational was performing its role in a substandard manner or when the company's negligence led to an accident injuring persons or property. These clauses were also used to create a minimum environmental standard for cleanups and closing down the facilities. Examples of such clauses are included in Chapter 9.
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2.
CLAUSES BENEFITING THE MULTINATIONAL
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Apart from the clauses that set forth the obligations of the multinational under the agreement, there are two ~ Y D Q of provisions that &ses that will allow the are important to the multinational: multinational to realize its profit and clauses that protect its investment. In international petroleum arrangements, the nature of the commodity simplifies the multinational's realization of the profit. In the majority df early concession agreements, the multinational sought payment through the export of petroleum into the world market. The world valuation of oil and the ability to sell a cargo of oil in many different markets for a hard currency significantly simplified the manner in which multinationals realized their profits. Even in cases in which the primary purpose of the arrangement was to produce oil for domestic consumption, the host country could pay the multinational in oil. Whenever oil was used for payment, a price mechanism provision had to be included in the contract. As we stated earlier in this chapter, the major multinationals controlled the posted price of oil in the first part of this century. Today, many spot and commodities markets exist for the product and a price mechanism can be established relatively easily. The multinational will also seek to include clauses in the agreement that help to protect its investment. In Chapter 2, we examined the desirability of including an alternative dispute resolution clause and a choice of law clause in an international petroleum arrangement. These clauses are particularly important when one of the parties is a sovereign. In Chapter 3, we examined the risk of expropriation in an international energy transaction. As included in this discussion, multinationals have sought to use the stabilization or equilibrium clauses in an attempt to curb slow or dramatic changes in the agreement. That clause seeks to freeze the legal and regulatory climate within the host country at the time of the agreement. It seeks to prevent a country from enacting new legislation that partially or completely changes the terms of the international agreement.
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There are many types of stabilization or economic equilibrium provisions. The most basic type states that the host country agrees not to enact any legislation or make any regulatory changes that will affect the agreement for its duration or for a set period. This type of provision was used several times during the period of renegotiation of the early concessions between OPEC and the major oil companies. The LiamcoLibyan agreement included the following language:
This concession shall throughout the period of its validity be construed in accordance with the Petroleum Law and the Regulations in force on the date of the execution of the Agreement * * * . Any amendment to or repeal of such Regulations shall not affect the contractual rights of the Company without its consent.
62 I.L.M. 140, 170 (1980). The more recent clauses do not attempt to reject the application of the new law or regulation upon the arrangement. They state that if the economic benefits of the agreement are adversely affected by the new law or regulation, the parties shall adjust the economic benefits of the contract to give the multinational the same benefits that would have been received in the absence of the new legislation. Some provisions provide that the host country must make an adjustment to the satisfaction of the multinational. Other provisions state that the changed regulation shall require that the parties enter into negotiations for a certain period. If the negotiations do not lead to an agreement, the parties will enter into binding arbitration. In Chapter 3, we examined the consequences of a stabilization clause as against an outright expropriation. Although a stabilization clause will not offer a multinational corporation the right to specific performance of the clause, it often will affect the measure of damages that the company can receive in an arbitration. A recent article discussing the ways in which risk should be reduced in an international agreement offers the following advice in drafting stabilization clauses: "The first [lesson] is that a stabilization clause should be very explicit in what it is meant to prohibit. The clause should provide that the State expressly waives its rights to nationalize. The second lesson is that a stabilization clause should provide that its terms are binding regardless of subsequent compromise, negotiation, or amendment of the contract unless both parties provide expressly, in writing, to change the meaning or binding effect of the stabilization clause." Paul E. Comeaux & N. Stephan Kinsella, "Reducing the Political Risk of Investing in Russia and Other C.I.S. Republics: International Arbitration and Stabilization Clauses," Russian Oil & Gas Guide 21,24 (Apr. 1993).
to gi vet== is a be P any to s: mull and agre mu1 seril obtz tran for nee, to i lanl the pet] Cer cor Otl aY car Un uni fro ter
Ch. 5
Sec. E
Common Clauses Found in International Petroleum Agreements
363
ilibrium :s not to 'fect the ion was e early iamco-
Notes
1. The purpose for many international petroleum agreements is to give the host country access to technology and expertise that would be very expensive to purchase outright. In some instances, this information is a trade secret of the particular multinational; in other instances, it may be protected by a patent owned by the multinational or another entity. In any event, the multinational may have an incentive or a legal requirement to safeguard closely the expertise or information. In such circumstances, multinationals frequently include provisions that address the protection and sharing of such technological information. Examples of such agreements are included in the next chapter. 2. In countries with a highly bureaucratized government, multinationals will often seek to obtain blanket or relaxed permission on a series of items that might be otherwise time consuming and expensive to obtain. Such basic items include visas for key personnel, rights to transportation facilities at set rates, custom import and export permission for materials without delays and tariffs, and rights to power and water needed to conduct operations. In some cases, the state oil company is paid to arrange such services for the multinational and, in other cases, the language is directed at government subdivisions that may be in charge of the permit process. 3. In addition to the economic stabilization clause, international petroleum agreements also typically contain a force majeure provision. Certain force majeure clauses are relatively vague as to the types of conditions that will allow one or both parties to terminate the agreement. Other provisions are more specific and in some cases use a period (such as a year) for which the circumstances must exist before the multinational can claim a force majeure defense. One agreement in the former Soviet Union used language that required the circumstances to last for an uninterrupted period of one year and to make the agreement unprofitable from the multinational party's perspective; then the contract could be terminated upon thirty day's notice.
ition of t if the ew law :ontract :ceived hat the of the n shall If the :r into
ization ization pecific ;esthat ing the offers son] is :ant to ves its clause equent parties fect of nsella, C.I.S. Lussian
536
Joint Development and Operations
(reproduced in the Tri-Star case) did not automatically remove Oakwood from its operatorship. The court instead determined that, although no waiting or notice period was required, nevertheless "[tlhere is some positive election required on Norcen's part indicating that it wants to exercise its right to become operator." Id. Moreover, Oakwood had filed for protection under the Companies and Creditors Arrangement Act, R.S.C. 1985, c-36 [CCAA] and, based on the court's application of CCAA, was able to obtain a stay of its removal as operator under CCAA. Apparently the court accepted Oakwood's argument that its removal as operator would be fatal to its attempts to restructure its financial obligations. The court interpreted Section 11 of the Canadian statute to permit such interference with the contractual rights of the parties, even though Norcen was not a creditor of Oakwood. For an analysis of the decisions of the courts in the Tri-Star and Norcen cases and an examination of some of the policy arguments behind the decisions, see Clifford D. Johnson, "Non-Operators' Rights Under the CAPL Operating Procedure," 28 Alta. L. Rev. l , 2 - 12 (1989).
C. UNITIZED OPERATIONS
In some instances a reservoir underlies two c;r more blocks subject to different licenses held by different companies; in others it crosses a boundary between two countries. Competitive development of the reservoir can lead to excessive drilling near the license boundaries, wasteful production, and controversies over property rights in oil drained across license lines. Enhanced recovery operations, which may be crucial to full reservoir production during the later stages of reservoir life, may be impossible or less effective unless carried out by all operators in the reservoir. In these situations the host country or countries frequently require unitized operations, whereby the reservoir is developed jointly by all of the licensees. OFFSHORE PRODUCTION LICENSE
Model License Clauses for the United Kingdom
Unit Development 26-(1) If at any time in which this license is in force the Minister shall be satisfied that the strata in the licensed area or any part thereof from part of a single geological petroleum structure or petroleum field (hereinafter referred to as "an oil field") other parts whereof are formed by strata in areas in respect of which other licences granted in pursuance of
Ch. 8 -
Sec. C
Unitized Operations
537
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be
the ltly by
the Act of 1934 or of that Act as applied by the Act of 1964 are then in force and the Minister shall consider that it is in the national interest in order to secure the maximum ultimate recovery of petroleum and in order to avoid unnecessary competitive drilling that the oilfield should be worked and developed as a unit in co-operation by all persons including the Licensee whose licenses extend to or include any part thereof the following provisions of this clause shall apply. (2) Upon being so required by notice in writing by the Minister the Licensee shall co-operate with such other persons, being persons holding licences under the Act of 1934 or that Act as applied by the Act of 1964 in respect of any part or parts of the oil field (hereinafter referred to as "the other Licensees") as may be specified in the said notice in the preparation of a scheme (hereinafter referred to as "a development scheme") for the working and development of the oil field as a unit by the Licensee and the other Licensees in co-operation, and shall, jointly with the other Licensees, submit such scheme for the approval of the Minister. (3) The said notice shall also contain or refer to a description of the area or areas in respect of which the Minister requires a development scheme to be submitted and shall state the period within which such scheme is to be submitted for approval by the Minister. (4) If a development scheme shall not be submitted to the Minister within the period so stated or if a development scheme so submitted shall not be approved by the Minister, the Minister may himself prepare a development scheme which shall be fair and equitable to the Licensee and all other Licensees, and the Licensee shall perform and observe all the terms and conditions thereof. ( 5 ) If the Licensee shall object to any such development scheme prepared by the Minister he may within 28 days from the date on which notice in writing of the said scheme shall have been given to him by the Minister refer the matter to arbitration in the manner provided by clause 41 of this licence.
Notes
ister reof ield by : of
'
1. In the United States, unitization during the primary stage of production is relatively uncommon. This is the stage in which the internal reservoir energy resulting from highly compressed gas, water pressure, geologic pressure, and other sources can be used to bring oil or gas to the surface. Once the pressure is depleted, production can often be maintained by various enhanced recovery mechanisms, ranging from injecting water at designated locations to using miscible substances, various forms of subsurface heat, surfactants, and polymers that generally
Joint Develop~nent and Operations
increase the fluidity of the underground oil.* Unitization, either as the result of voluntary agreement or regulatory compulsion, normally occurs at this later stage when competitive development becomes physically impractical, and institution of any type of enhanced recovery program requires control over all or virtually all of a reservoir. For a discussion of the various methods of enhanced recovery and how unitization is achieved in the United States, see Eugene 0 . Kuntz, John S. Lowe, Owen L. Anderson & Ernest E. Smith, Cases and Materials on Oil and Gas Law 8 1 1-51 (2d ed. 1993). 2. The language of the U.K. model clause indicates that unitization can be required if the Minister determines that it is necessary "in order to secure the maximum ultimate recovery of petroleum and in order to avoid unnecessary competitive drilling." It clearly authorizes forced unitization during the primary stage of reservoir production; but can the Minister require unitization to carry out a system of enhanced recovery when there is no danger of "unnecessary competitive drilling"? OWEN L. ANDERSON, "MUTINY: THE REVOLT AGAINST UNSUCCESSFUL UNIT OPERATIONS"
30 Rocky Mtn. Min. L. Inst. 13-1, 13-3 to 13-8 ( 1 9 8 4 ) ~
* * *
Achieving unitization is usually a lengthy and involved process. The process may begin when the working interest owners form a fieldwide operating committee. This committee, or a specially formed unit committee, investigates the feasibility of enhanced recovery from both engineering and economic standpoints and determines which enhanced recovery method will obtain the maximum recovery of hydrocarbons from the field. Because implementing an enhanced recovery plan may be very expensive, the amount of expected increased recovery must be sufficient to recoup all costs and produce a reasonable If the committee decides that unitization is warranted, tract participation formulas must be calculated for the allocation of production from the unit and for the allocation of unit costs. In contrast to pooling,
Techniques such as water flooding that partially restore internal reservoir pressure are referred to as secondary recovery mechanisms, whereas use of the more sophisticated chemical or thermal techniques is known as tertiary recovery. Copyright O 1984 by Matthew Bender & Co., Inc., and reprinted with permission from 30 Rocky Mountain Mineral Law Institute. All rights reserved.
where production and costs are customarily allocated on a surface-acreage basis, unitwide allocations are usually based on a combination of factors, such as the acreage of each tract, the net acre feet of pay and the volume of oil in place beneath each tract, the differences in porosity within the field, current production, cumulative production, the projected primary recovery from each well, and other factors. Reaching an agreement on a fair allocation formula is difficult, especially when some tracts may have no past or existing production. [The committee must also allocate costs among the working interest owners. As existing wells and equipment will be used for unit operations, the committee must consider development expenses already incurred by each owner.] To secure the payment of each working interest owner's share of unit costs, the unit operator and each working interest owner are given a lien on each other's share of unit production. To encourage an owner to advance his share of costs, unit agreements give an owner the option of advancing his share of costs, having his share of costs taken out of his share of production, or, in some cases, selling his interest in return for a bonus or overriding royalty or both. Once the unit committee has reached accord on the basics of the unit plan and allocation formulas, it will draft a unit agreement and unit operating agreement. The unit agreement is the basic document which identifies and combines the various tracts and interests forming the unit. The agreement outlines the basic plan for unitization and the formulas for allocating costs and production. In addition, the agreement will designate the unit operator, usually the owner of the largest share of the unit production. The unit operating agreement governs the day-to-day operation of the unit. This agreement sets forth the specific responsibilities and duties of the unit operator and working interest owners, voting procedures for working interest owners, insurance, valuation of equipment contributions, accounting procedures, winding up provisions, and other matters. Once the plan, unit agreement, and unit operating agreement have been formulated, the proposal is submitted to the state oil and gas conservation commission for approval. After notice to all interested parties, the plan and agreements are outlined at a hearing. Following the hearing, if the commission finds that the proposed unit is economically feasible and will prevent waste and protect correlative rights, it may enter an order approving the plan and agreements. In issuing its order, the commission may require modifications to the plan or amendments to the
agreements, which may be proposed by interested parties or may originate with the commission itself. Often, however, the plan and agreements are approved as submitted.
Notes
1. How does the process for achieving unitized operations in the United States described by Professor Anderson resemble that contemplated by Clause 26 of the U.K. license? Would you anticipate that achieving unitization in the U.K.would involve as lengthy and as involved a process as in the U.S.? Why or why not? As the excerpt from Professor Anderson's article indicates, 2. allocation of unit costs and unit production is based on tract participation formulas. One unitization agreement in the U.K. sector of the North Sea, executed shortly after a new reservoir was discovered, recognizes that the initial tract participation formula is based on estimates and provides for redetermination of the formula after a specified number of development wells have been drilled and for a second redetermination after still more wells are drilled. assume to be the basis for the initial tract What would y ~ u participation formula? Does the provision for periodic redeterminations adequately address the problem of devising a fair formula for unitized blocks during the primary stage of production? What provision should the parties make if reservoir development reveals that prior formulas were inaccurate? 3. The first international unitization agreement in the North Sea was between the United Kingdom and Norway and involved the Frigg Field, a large gas reservoir that underlies the boundary between the two countries. The agreement provides that each government will require its licensees to enter into agreements among themselves and with the licensees of the other country to regulate production and to carry out the international agreement. The basic provisions for allocating production are contained in Article 2 of the agreement and are as follow:
(2) The two Governments shall consult with a view to agreeing to a determination of the limits and estimated total reserves of the Frigg Field Reservoir and an apportionment of the reserves therein as between the Continental Shelf appertaining to the United Kingdom and the Continental Shelf appertaining to the Kingdom of Norway. For this purpose the licensees shall be required to submit to the Governments a proposal for such determinations. (3) The two Governments shall endeavour to agree to apportionment of the reserves of the Frigg Field Reservoir before production of the reserves commences. If they are not able to do so,
Ch. 8
Sec. C
Unitized Operations
54 1
inate 3 are
1 the
then pending such agreement, the production shall proceed on the provisional basis of a proposal for the apportionment submitted by the licensees, or, if there is none, on the provisional basis of equal shares. Such provisional apportionment shall be without prejudice to the position of either Government. When the apportionment is agreed, the agreed apportionment shall be substituted for the provisional apportionment as if the agreed apportionment were a revision made under Article 3.
that .pate d as
ates, ltion Sea, t the ; for nent nore :ract ions ized the irere Sea rigg two e its the t the :tion
There are many situations in the United States where either regulatory agencies or oil companies attempt to adjust rights in production from a common reservoir that underlies land owned by different persons. State conservation agencies typically attempt to regulate production to assure each owner a reasonable opportunity to receive his "fair share" or ')just and equitable share" of production. The Model Conservation Act of the Interstate Oil Compact Commission defines "just and equitable share of the production" as
4.
that part of the authorized production from a reservoir that the amount of recoverable Oil and Gas under the Developed Area of the separately owned tract or tracts bears to the recoverable Oil or Gas in the total of the Developed Areas in the Reservoir.
Is this the same concept as used by Norway and Great Britain in the Frigg Field Agreement?
D. ABANDONMENT, REMOVAL, AND RECLAMATION
Petroleum licenses, production sharing arrangements, joint operating agreements, and even petroleum codes have tended to focus almost exclusively upon exploration and operations during production. Although some abandonment requirements, such as well plugging, have been in effect for many decades, widespread recognition of the environmental damage and health and safety hazards resulting from unreclaimed energy projects and the need to plan in advance for field abandonment did not occur until the 1970s and 1980s. For example, Norway did not enact special legislation dealing with abandonment of offshore facilities until 1985; Britain followed suit two years later. Most states now impose reclamation requirements by a variety of legal mechanisms, including statutes, license provisions, administrative regulation, or some combination thereof. Such requirements raise several serious issues. In many instances they have retroactive effect, creating new legal and financial obligations
542
Ch. 8
for existing mineral ventures and requiring the development of new scientific and engineering technology. They have also raised questions of international law, especially in their application to offshore installations.
1.
IMPOSITION OF RECLAMATION STANDARDS
The following article was written while the U.K. legislation on decommissioning offshore production platforms and other installations was being debated and describes the principal provisions of the act. PAUL McDADE, "THE PETROLEUM BILL: THE REMOVAL OF OFFSHORE INSTALLATIONS AND PIPELINES"
[1986/87] 6 Oil & Gas Law & Taxation Rev. 1581
Abandonment Provisions of the Bill In a number of recent pronouncements, the Department of Energy has made it clear that the objective of any alterations in the current system is to secure the timely and financially equitable abandonment of large producing fields and the installations and pipelines which are located upon them. A cornerstone of this objective is the power to approve in advance abandonment programmes which oil companies, as owners of the fields upon whom, in the Government's opinion, the onus of removal rests, would be required to produce. In addition, since the current sanction available under the model clauses for failure to comply with the obligations of abandonment is revocation of the licence, provisions to prevent the likelihood of default and to mitigate its consequences where it occurs, would have to be phased into the legislation. All of these objectives are now set out in the Bill. Clause 1 provides that the Secretary of State may by written notice call for abandonment programmes to be provided. * * * Content of the Abandonment Programme The programme is required to set out the measures proposed to be taken in connection with the abandonment of offshore installations or submarine pipelines. * * * In addition to the estimated cost of removal, the programme must also specify the time at or within which the measures proposed are to be taken. Alternatively, provision must be made as to how these times are to be determined. Clause 1(3)(c) states that where it is proposed that an installation or pipeline be left in position or not wholly
lo
Reprinted with permission of Sweet & MaxwellESC Publishing, Oxford, U.K.
Ch. 8
Abandonment, Removal and Reclamation
543
new 1s of IS.
removed, it shall include a provision as to any continuing maintenance that may be necessary. * * * One of the most important aspects of clause 1 is the fact that the partial removal of an installation or leaving it in place is now expressly envisaged. * * *
Those Required to Submit a Programme It will be recalled that the government criticism of the existing abandonment provisions were threefold. They did not enable the Government to set standards, they did not empower the Minister to approve abandonment plans nor were the sanctioiis which the Minister was empowered to employ against defaulting licensees at the end of production regarded as sufficient to protect the taxpayer. Thus, the expansion of the range of persons who might be required to submit plans and, ultimately, to foot the bill was a key to the Government's new strategy. Those who may be required to submit abandonment programmes are defined in clause 2. * * * With respect to installations, notice is to be given to four categories of person. The first is the person who has registered the installation under section 2 of the Mineral Working (Offshore Installations) Act 1971 or where there is no such person, the person having management of the installation or of its main structure. The person who has registered the installation is in all respects the "owner" and the person having management will, in the normal course of events, be the operator. The second is the concession owner in relation to the installation for the purpose of the 1971 Act or the person who was the concession owner for those purposes when an activity within section 12(1) of that Act was last carried on from, by means of, or on the installation. The concession owner is defined, inter alia, as a person who has the right to explore for or exploit mineral resources in any area and may be the licensee under a production license or any person duly licensed to store or recover gas. The third category upon whom notice may be served is any person who owns any interest in the installation. The final category is any company associated with a company falling within the preceding three categories as defined by the Bill.
* * *
Approval or Rejection of Programmes By clause 4, the Secretary of State may either approve or reject the programme. Approval may take place with or without modification of the programme and may be subject to conditions. Where the Secretary of State does propose to modify the programme or attach conditions to his
544
approval, the persons who submitted the programme are given an opportunity to submit written representations. * * * The ultimate sanction for failure to submit a programme, or for submitting a programme which the Secretary of State rejects, is that the Secretary of State may himself prepare an abandonment programme, in the process requiring persons upon whom notice could otherwise be served to provide him with records, drawings and other information as may be so specified. Finally, the Secretary of State may recover from the persons to whom notice was given any expenditure undertaken by the Department of Energy with interest and including the fee payable. The system does have a degree of flexibility in that, by clause 6, revision of the programme is envisaged. The Secretary of State either alone or acting with the person who submitted the programme may propose an alteration to it or any condition to which it is subject. * * *
* * *
Default Clauses and Financial Provisions One of the main thrusts of the Government approach to abandonment has been that the taxpayer should not be left to foot the bill should any companies, and particularly those less financially wellendowed than the majors, default in the carrying out of programmes or be found to be financially unsuitable. Thus, clauses 9 and 10 are amongst the major aspects of the Bill from the Government point of view. Clause 9 removes failure to comply with revocation of the license as the ultimate sanction for an approved abandonment programme. Instead, a two-stage procedure is instituted. If an abandonment programme approved by the Secretary of State or a condition to which any approval is subject is not complied with, the Secretary of State may by written notice require any of the persons who submitted the programme to take remedial action. The consequences of failure to comply with the notice are twofold. First, the penalty for failure to comply is that there is strict criminal liability. The person who fails to comply will only escape such liability on proof of due diligence. Second, the Secretary of State may himself carry out the remedial action required by the notice and may recover any expenditure from the person to whom notice was given with interest calculated at a rate the Secretary of State may determine. Obviously such a solution would be worthless if the Secretary of State were not sure of obtaining redress on behalf of the taxpayer. To that end, clause 10 gives him power to require any person, once a clause 1 notice has been served, to provide documents and information relating to the financial affairs of the company. He may also require such information of persons who have a duty to carry out abandonment
for the , in be as the the
programmes under clause 8. Again, the provision of false information or failure to provide any information is an offence. As an ultimate sanction under clause 10, where the Secretary of State is not satisfied that a person with a duty to ensure that a programme is carried out is capable of doing so, he may require that person by written notice, to "take such action as he may specify." Failure to comply is an offence.
Financial Provisions
The Bill does not address the nature of any new financial structure to deal with abandonment costs. * * * The function of the Bill is to redefine the powers of the Government and certain obligations of companies in relation to abandonment rather than to address abandonment-related fiscal problems. However, the Bill does provide a power which enables the Government to repay petroleum royalties particularly as regards abandonment costs. Producing fields which are licensed under the pre-1975 terms pay a royalty. Against this conveying and treatment costs are allowable deductions. Since some 70 per cent of platform costs are generally allowed, 70 per cent of abandonment costs will be eligible for royalty relief. * * *
to bill ell)r be t the Ise 9 mate ;tage j the 3 not 1y of The t, the The f due t the liture I at a
Notes
1. Almost all offshore drilling in the United States has been in or near the territorial sea. The drilling has been concentrated in the Gulf of Mexico, much of it within sight of land. The waters have been relatively shallow, and the rigs used can normally be floated into place. Removal of drilling and production platforms in the Gulf of Mexico poses no significant engineering problems and, while obviously more expensive than onshore installations, is not remarkably costly. Indeed, the value of the installations, even for salvage, may exceed the cost of removal. North Sea drilling installations present much different problems. Typically located miles from land in very deep water, the production platforms resemble small islands in size, and even partial removal presents a formidable engineering challenge. The cost of removal is even more challenging. In 1979 a United Kingdom agency estimated the cost of total removal of offshore installations in the U.K. area alone as over 4,000,000,000. Ten years later estimates ranged from 6,000,000,000 to f 8,000,000,000. Partial removal, which would leave most of the submerged portions of the platforms in place but allow ordinary surface
ry of I that use 1 ng to such lment
third.
to pass over the area safely, would reduce the cost by about on
:i
\,
I" I
1
i
I
!
14
The British legislation has presented financial and accounting problems for companies operating in the North Sea. A discussion paper prepared by the U.K. Oil Industry Accounting Committee suggests that the cost of removing offshore installations should be viewed as a cost of producing the underlying oil and gas; hence decommissioning costs should be recognized in current financial statements of the oil companies. In the case of many North Sea fields, however, the years of peak production have already passed. It is now recognized in the financial statements that these costs may more than offset the revenues from re&ced production. The financial statements will show either a loss 01 much smaller profits; but additional delay in recognizing these costs will result in production in the late 1990s bearing an even ~ ~ o r e dispmpoflionate share of such costs. Deferring the recognition of decommissioning costs to the end of a well's life may result in a "cost" of & 1,000,000 to produce the last barrel. Compliance with the accountants' suggestion presents other problems. As the committee itself recognized, "achievement of the * * * accounting objective is particularly problematical in the case of decommissioning costs, since, perhaps uniquely, the cash outlays required to meet them lie entirely in the future, beyond the revenue earning period. They will, therefore, almost certainly be subject to the effect of increasing prices, the magnitude of which is difficult to forecast with any precision. This difficulty is compounded by the degree of regulatory uncertainty surrounding the obligation and the technological uncertainty regarding its implementation." The U.K. tax laws have presented a further obstacle to instituting the Accounting Committee's proposal. Although the 1987 Petroleum Act discussed by McDade encouraged license participants to establish abandonment funds in advance of actual decommissioning, the tax regime did not permit contributions to such funds to be taken as expenses because the costs had not yet actually been incurred. See Catherine Redgwell, "Abandonment and Reclamation Obligations in the United hngdom," 10 J. Energy & Nat. Resources L. 46,83-84 (1992). This negative effect was somewhat mitigated by the Finance Act 1990, which provided for a variety of types of abandonment-related tax relief, including a right of carry back for abandonment costs. 3. There is dissent from proposals to allow oil, gas, and mining operators to treat future reclamation costs as current costs of operation to be charged against current production for tax calculation purposes. Such tax provisions have been criticized as artificially reducing the cost of
2.
Abandonment, Removal and Reclamation
more
operations that are environmentally damaging and req~~iring all taxpayers to subsidize reclamation efforts instead of passing these costs on to consumers through higher prices. See U.S. Department of Treasury, Tax Reform for Fairness, Simplicity, and Economic Growth 240 (Nov. 1984) (partially reprinted in John S. Dzienkowski & Robert J. Peroni, Natural Resource Taxation: Principles and Policy 273-78 ( 1988). Moreover, unless carefully drafted, tax provisions may not assure the existence of a fund to pay for reclamation costs, especially in situations where the operator and other participants have become insolvent. Are these criticisms valid? If reclamation is of sufficient importance to warrant special financial incentives, would a direct subsidy be a more efficient mechanism than indirect encouragement through tax deductions? Norway provides an example of this latter approach. Under the Norwegian Removal Act of April 15, 1986, the government has assumed a specified share of the costs of removing offshore drilling platforms. The system is intended to be tax neutral. Grants are made to each licensee for each "unit" to be removed. These grants are not taxable as income, and the licensee cannot deduct its share of the costs of The Norwegian system of government grants and its relation to the country's tax code are discussed in Hans Bull & Knut Kaasen, "Abandonment and Reclamation of Energy Sites and Facilities: Norway," 10 J. Energy & Nat. Resources L. 37, 42-43 (1992). The authors make the following comment:
The main reason for choosing a grant system instead of a solution within the tax system seems to have been political/administrative considerations: "the responsible political institutions are given real control over the question of costs". Also, such a system would eliminate uncertainty for the companies, and especially the foreign companies. Finally, a grant system was considered easier to administer than a solution within the tax system.
4. Joint operating agreements commonly provide that the operator will have the same primary responsibility for operations onnected with abandonment and reclamation as it does for other types of
chniques for Assuring Compliance with Abandonment and Reclamation quirements" in Energy and Resources Law '92 at 293,305-06 (1992).
Joint Operating Agreements commonly treat the costs associated with abandonment and reclamation like all other costs incurred in authorized operations. They are borne by the parties in accordance with their proportionate interest in the area subject to the agreement. These provisions are not particularly well designed to deal with the distinct problems posed by abandonment and reclamation costs. They assume that costs of any authorized project are borne initially entirely by the operator, who then bills the nonoperators. Unlike most other project costs, however, reclamation costs are not incurred while the venture is on-going and there is some expectation of ultimate profit; rather, they occur at the end of the venture when no additional income is expected. Not only may non-operators have less incentive to pay their shares of reclamation costs than of drilling costs, but the traditional remedies for assuring payment will be less effective than they were earlier. These remedies commonly include a lien upon the defaulting nonoperator's working interest, a security interest in his share of production and equipment, and a right to collect proceeds from the sale of the defaulting nonoperator's share of petroleum and use the proceeds to reduce the debt owed. If the well is to be abandoned, none of these security interests, liens and rights of sale are likely to afford an unpaid operator effective recourse. Although the machinery, installations, well equipment, casing and other material may have salvage value, especially where the well is located on-shore or in shallow waters, this value is quite unlikely to equal reclamation costs.
* * *
Although the most commonly used American and Canadian printed form agreements do not deal with the special problems posed by reclamation requirements, other agreements address them directly. An example is the 1988 C.A.P.L. model form for exploratory operations in frontier areas. Unlike traditional forms, it specifically defines abandonment as including well-site restoration as well as plugging, and makes the non-operators liable for their proportionate share of the cost of environmental studies as well as abandonment and restoration costs. These provisions evince some recognition that abandonment costs should be dealt with specially. Whether they are entirely satisfactory is open to question; for although the operator is authorized to charge the joint account for the costs of any operation required by reclamation regulations, there do not appear to be specific provisions for determining these costs in advance and establishing an existing fund to deal with them. This latter approach has been used in many specially drafted
Sec. D
Abandonment, Removal and Reclamation commentator has reported that there the preferred industry technique is to require each party to make periodic payments into a trust fund that will meet the estimated cost of abandonment. The trust device has apparently been chosen in order to protect the fund against claims of creditors in the event one participant becomes insolvent.
549
5 . Although statutes, license provisions, regulatory authorities, and private agreements among joint venturers invariably place the primary responsibility for reclamation upon the operator, the nonoperators may be secondarily liable if the operator defaults, becomes insolvent, or ceases to exist as a legal entity. For example, in Railroad Comm'n v. Olin Corp., 690 S.W.2d 628 (Tex. App. 1985, writ refd n.r.e.), nonoperators were held liable for costs of controlling and plugging a gas well even though they had chosen a non-consent option with respect to the reworking operations that caused the well to blow out. For a discussion of nonoperator liability under the U.K. statutes, see Richard Beazley, "Abandonment of UKCS Installations: Security Against Default," [1986/87] 1 OGLTR 6. A detailed discussion of regulatory, statutory, and judicial imposition of reclamation liability on parties other than the operator is contained in Gunther Kuhne, "What Happens When the Operator Fails to Meet its Obligations?" in Energy and Resources Law '92 at 308 (1992). The author concludes that there is a clear trend "to multiply responsibility and liability in connection with abandonment and reclamation obligations by establishing chains of descending responsibility." Persons who may be held responsible if the operator defaults include the licensee (who may be different from the operator), nonoperators, joint venturers, previous owners, subsequent owners, and even the state itself. As an example of the latter possibility, he cites the Decision of February 16, 1970, (published in BGHZ 53, 226 ss and also discussed in Gunther Kuhne, "Abandonment and Reclamation of Energy Sites and Facilities: Germany," 10 J. Energy & Nat. Resources L. 4, 16 (1992)), where the West German Federal Supreme Court (Bundesgerichtshof) held that the state was responsible for compensating landowners for property subsidence when they were unable to obtain damages from mine operators. The court reasoned that the state had exposed the surface owners to losses equivalent to an expropriation when it initially licensed the mining operations.
550
Joint Develo~ment and O~erations
Ch. 8
2.
INTERNATIONAL LAW CONSIDERATIONS
Reclamation responsibility is not solely an issue of domestic law. Article 5 of the 1958 Geneva Convention on the Continental Shelf and Article 60(3) of the 1982 United Nations Convention on the Law of the Sea deal with removal of decommissioned offshore installations. The implications of these conventions and of customary international law for British and Norwegian legislation that authorize partial removal are discussed in the following article. ROSALYN HIGGINS, "ABANDONMENT OF ENERGY SITES AND STRUCTURES: RELEVANT INTERNATIONAL LAW"
Energy and Resources Law '92, at 255 (1992)~
The most critical and contentious issue has been as to whether installations are to be removed; or whether they may be left fully or partially in situ. Under the 1958 Continental Shelf Convention the exploration and exploitation of the continental shelf must not result in any "unjustifiable interference" with the rights of others. The construction and operation of installations is subject to this general provision. However, the question of abandonment is not to be tested against this broad proviso. Instead, the Convention contains its own specific rule [in Art. 5(5)]: "Any installations which are abandoned or disused must be entirely removed." The provision seems clear enough. It is equally clear that there is a marked disinclination on the art of many states to accevt entire removal, coupled with attempts to articulate acceptable standards of ~ a r t i aremoval. l *** a rule of customary international law. * * * Although the status of the shelf and the sovereign rights of the coastal state in relation thereto have become part of general international law, the same is not true of the abandonment provisions of Article 5(5). It is first to be made clear that the Convention as a whole has not passed into general international lawthat is to say, become so widely accepted, even by nonsignatories, as having normative effect, that it has become an articulation of new customary international law. Only 54 states became parties to the 1958 Convention. * * *
Reprinted with permission of International Bar Association.
c law. If and of the The lw for 11 are
and ?able 3n of 3n of I, the "Any i." :re is ntire s of

I
We ;ents f the have the that
Is it possible, nonetheless, that, just as the specific provisions on the status of the continental shelf have passed into general international law (even when the Convention in its entirety has not), so have the specific provisions on abandonment? The answer must again be in the negative. The test would be to see if there was a clear and unequivocal practice, reflecting a sense of legal obligation, by the majority of nonratifying states. There clearly has been no such practice. In the first place, actual abandonment has yet to begin in the various shelf jurisdictions. * * * Quite simply, there is no sufficient international practice and absolutely no possibility that the requirement of total removal in Article 5(5) of the 1958 Convention represents a general obligation under international law. Of course this does not mean that non-parties to the 1958 Convention can simply abandon installations. They are under a general international law obligation to act on the shelf in a manner consistent with the international law rights of others, including navigation, fishing and environmental rights. That provision clearly does reflect customary international law. But that clearly leaves a certain latitude on the question of removal. What then of the position of the ratifying parties of the 1958 Convention? Does the total removal provision of Article 5(5) remain a treaty provision binding on them? * * * In principle the answer will be in the affirmative, unless the provision can be said to have fallen into desuetude or in terms otherwise to have ceased to have legal effect. We now examine these possibilities. First, the question of desuetude. There is nothing to support the suggestion that this could in fact be a ground for rendering the complete removal provision without legal effect. The International Law Commission (the body where most of the drafting of the 1958 Convention was done) thought otherwise. It is not one of the permitted grounds for change which the Convention itself provides. Moreover, it is hard to insist that a provision is in disuse before the moment has in fact come for its use. For the most part, decommissioning offshore still lies ahead. the fact that the provisions of Article 5(5) are not reflected in the various national laws is not enough to render the provision non-binding.
Third, I do not believe that the international law principle of rebus sic stantibus-fundamentally changed circumstances-detracts from the binding quality of the 1958 rule on those who are parties to that Convention. * * * The test is that the change is such that, had a party known of it at the time, it would not have entered the treaty. Further, this provision cannot simply be unilaterally invoked at the moment that it suits a state to do so. The criteria for rebus sic stantibus simply are not met. Of course, matters have not stayed as they stood in 1958. In 1982 there was concluded the new UN Law of the Sea Convention (UNCLOS). Article 60(3) of UNCLOS confusingly provides:
* * * Any installations or structures which are abandoned or disused shall be removed to ensure safety of navigation, taking into account any generally accepted international standards established in this regard by the competent international organization. Such removal shall also have due regard to fishing, the protection of the marine environment and the rights and duties of other states. Appropriate publicity shall be given to the depth, position and dimensions of any installation or structures not entirely removed. [Italics added.]
This ambiguous provision appears to envisage a basic rule of removal, with something less being possible by reference to certain international standards. The 1982 UNCLOS Convention is not yet in force and many of the key shelf countries, such as the United States and the United Kingdom have not ratified it, so they would not be bound by Article 60(3) even when the treaty comes into effect. * * * If the 1982 treaty comes into force soon, and if the UK ratifies, then the partial abandonment provision will apply to the UK. What the legal situation would be as between the UK and a state that remains under the 1958 treaty is clear as to law, but not as to the legal consequences. As between the UK and a state that is bound only by the 1958 Convention, the latter provisions should apply. But the reality is that the UK cannot partially remove abandoned installations in respect of some other users, and totally remove them for yet others. But for the moment UNCLOS is not legally in effect. Nor does Article 60(3) reflect any existing current international law. Nor has decommissioning practice so developed that new customary international law is consistent with Article 60(3), but independent from it. But we are witnessing what is likely to be the beginning of that new customary law, through certain international practice. International practice, engaged in by the vast majority of states, and in the belief that it is obligatory, forms new international law. The point of departure for this evolving practice has been the reference in Article 60(3) to removal,
ple of rebus ts from the ies to that had a party ;urther, this that it suits not met. i8. In 1982 UNCLOS).
;used :ount this 1oval arine briate . any
)f removal, iternational : and many the United rticle 60(3) eaty comes landonment .auld be as is clear as UK and a provisions Ily remove llly remove
I
Nor does Nor has ~ternational ing of that ~ternational elief that it ure for this o removal,
"taking into account any generally accepted international standards established in this regard by the competent international organization." Although no organisation is mentioned in terms, the International Maritime Organization (IMO) has rapidly moved to assume the mantle.*** After prolonged negotiations with interested states, international organisations, and representatives of other users, the IMO adopted on 19 October 1989 Guidelines and Standards for the Removal of Offshore Installations and Structures on the Continental Shelf and in the Exclusive Economic Zone. * * * The provisions are complex, but may be sumrnarised thus. The general requirement is said to be that of removal. This general requirement is subject to an exception permitting non-removal or partial removal, consistent with certain guidelines and standards. The basic requirement of removal, whether in whole or in part, arises from a coastal state having jurisdiction over an installation or structure when (1) it no longer serves the primary purpose of which it was originally designed or installed or (2) it serves a new use or (3) where no other justification under the guidelines and standards exists for allowing it, or parts of it, to remain on the seabed. The coastal state can decide whether an installation or structure can remain in whole or in part, by reference, on a case to case basis, to a list of factors: safety, effect on other uses of the sea, environmental effects, risk of shift, costs, technical feasibility, risks of injury to personnel engaged in removal, and determination of new use or other reasonable justification for allowing - the installation or structure or parts thereof to remain. This is a broad shopping list, the appraisal of which is left to the coastal state. There follows a listing of standards to be taken into account when making this determination. Importantly, certain indicators requiring total removal (notwithstanding the checklist of factors) are specified: (1) installations and structures standing in less than 75m of water and weighing less than 4000 tonnes in air, excluding the deck and superstructure; (2) all new installations or structures that will be placed on the seabed after 1 January 1998, standing in less than lOOm of water, and weighing less than 4000 tonnes. All installations and structures emplaced after that date (regardless of depth of location or weight) have to be of a design and structure that entire abandonment or permanent disuse would be feasible. It is not clear just what is meant by "permanent disuse" as a criterion of construction. The only exceptions to these "total removal" categories would be where entire removal is not technically feasible, or would entail "extreme cost" or unacceptable risk to persons or the marine environment. A third total removal category is subject to no exceptions a t all-namely, where
554
structures or installations no longer serve their primary purpose and are located in navigation routes. The vested problem of legal title of (and thus potential liability for) structures after removal is addressed, but not substantively. The standard is that title must be "unambiguous"-but where that title should lie is left to the coastal state. * * *
* * *
The substantive content of the Guidelines and Standards is obviously interesting enough. To an international lawyer, there are other extremely interesting aspects. It is intriguing to see standards emerging through non-binding resolutions of an international organisation, not mentioned by name in a UN Treaty not yet in effect, and whose institutional competence had not hitherto been regarded as stretching to all the areas touched on in the formulation of abandonment principles. The problem of institutional competence is not too troublesome, in my view. The point is not that the IMO does or does not have certain competences, or that its resolutions may or may not legally bind. The point is rather that it provides a focused forum for state practice. The Guidelines are the first outcome of that state practice. Action under it still lies ahead. If national legislation around the world now broadly approximates to these standards, and if abandonment actually starts to occur within these parameters, then we will see state practice being converted into customary international law. * * *
* * *
Notes
1. The requirements of international law may have some practical bearing upon an oil company's liability for injury resulting from an abandoned installation left wholly or partly in place. Will compliance with British or Norwegian provisions for partial removal be a defense if a surface or subsurface vessel and its crew are injured when it hits a remaining portion of the installation? Although there may be no liability under English law, the suit may be filed in a U.S. court that is asked to apply U.S. law. As Richard Beazley, General Counsel to Mobil North Sea Ltd., has pointed out, "Liability under US law would of course present no problem for companies having no assets in the US. However, such is the international nature of the industry, very few companies are in this position." See Richard Beazley, "Abandonment: Current Legal Issues of Interest to Oil Company Lawyers," [1986/87] 8 OGLTR 202.
I
I
Sec. D
Abandonment. Removal and Reclamation
555
2. T o most environmentalists there are more pressing issues than whether offshore installations should be totally or partially removed. These issues include problems ranging from oil spills on the high seas to destruction of the worlds rain forests. The following chapter examines in more detail the international environmental implications of mineral development and the various means for imposing responsibility for environmental protection.
ation, not nd whose
my view. ipetences, mather that e the first f national ;tandards, ters, then
,e some ing from npliance ense if a it hits a asked to orth Sea esent no :h is the in this

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CHAPTER ( ) EXPLOITATION CLAUSE 9. - TERMS AND CONDITIONS 9.1

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