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Oil price fluctuation and joint operating agreement default

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It is one of the inevitable consequences of any business joint venture that external factors which impact upon the financial viability of that joint venture tend to give rise to stresses and strains in the joint venture relationship. That fact is particularly true in the oil sector in the context of oil exploration and production joint operating agreements (JOAs), against the recent backdrop of oil prices currently being at an extreme low, with supply outstripping demand, and the very limited storage availability being at a premium cost.

These issues are not entirely new for the oil sector, but Covid-19 has exacerbated a pre-existing  downward trend of demand, and, as is inevitable when relationships become far less profitable than anticipated, that environment tends to result in JOA parties falling out with each other, whether over the conduct of agreed operations (including stalling or mothballing), or budget setting, or concerns as to cash calls, accounting procedures and audits of an operator’s expenditure.

It will come as no great surprise that participant default and insolvency are two of the common features of JOA disputes in times of industry hardship. With participants focusing all of their efforts into remaining solvent, and operator cost cutting exercises such as slowing payments to suppliers and other creditors and putting the brakes on larger investments that may assist with cash flow in the short term, those measures undoubtedly strain JOA relationships and cause conflicting interests between JOA parties. Equally, the JOA parties and particularly the operator, will also be mindful of the inevitable inflexibility of exploration and drilling obligations under the host Government licence, and the risk of losing the licence if project work is delayed and the agreed milestones for operations are not met.

Under a typical JOA, when a party defaults in a cash call, one of the other parties is likely to require a default notice to be served on the defaulting party, particularly if the non-defaulting parties also face having to pay the defaulting party’s cash call. It will usually be the operator who serves this and notifies the other non-defaulting parties of the default. If it is the operator itself that has defaulted, the party that serves the notice is likely to be determined by the specific terms of the JOA. The party in default will usually lose its right to vote in JOA matters whilst the default exists, and if that default continues without rectification, under typical JOAs, sanctions will escalate, become more extreme and increase in number, until finally the other parties typically have a right to trigger the forfeiture of the defaulting party’s interest and  acquire the defaulting party’s interest in the JOA, albeit with the additional financial consequences that flow from the acquisition of that interest. 

It frequently follows that a defaulting party will fight hard to avoid forfeiture of a potentially valuable participating interest, or will challenge any cash calls, and the inevitable consequence is that sooner or later the dispute will result in an arbitration or litigation, which itself may be used as a deliberate delaying tactic. Furthermore, in English law governed JOAs, arguments are typically raised by a defaulting party claiming that a forfeiture clause is an unlawful penalty, or that relief against forfeiture should be granted, such as allowing a further period of time for payment, and there remain unsettled legal issues around some of those arguments, which can bring uncertainty as to the outcome

Although history tells us that the oil sector will see a rise in JOA disputes in the current economic climate, parties should still think carefully before triggering an arbitration or litigation for JOA default, as a defaulting party invariably has limited funds and is unlikely to be able to pay the non-defaulting parties’ and operator’s costs of the legal action. Also, frequently, while the concept of seeking to enforce an arbitration award or court order against a company with diverse global assets might seem straightforward, in many cases those assets either do not exist or “disappear”, or are of considerably less value than originally thought. Accordingly, at the outset of any dispute it is always worth undertaking extensive due diligence on the defaulting party’s true financial standing, and factoring that into the decision making about the appropriate course of action to take.  Increasingly we are seeing the defaulting party who pleads poverty being required to allow an independent accountant and lawyer to have access to their financial records to verify their true financial position and the money spent on such an exercise is almost always money well spent.

If you would like to know more about JOA default or our legal experience in the oil and gas sector more generally, please contact David Williams, Partner in our Dispute Resolution Team at david.williams@clarionsolicitors.com

Disclaimer: Anything posted on this blog is for general information only and is not intended to provide legal advice on any general or specific matter. Please refer to our terms and conditions for further information. Please contact the author of the blog if you would like to discuss the issues raised.