The Foreign Investor in Oil & Gas Management

Question: Evaluate the function and aims of stabilisation clauses and comment on how they seek to achieve the stability that parties desire. Answer: The foreign investor who tends to participate in the international petroleum industry is typically a long term investor due to capital intensive nature of the underlying industry. Such ventures are vulnerable on account of any unilateral action by the host government which may adversely impact the interests of the foreign investor (Berger, 2003). A potential remedy for the above concern is in the form of a stabilisation clause which acts as a guarantee against unilateral action on the part of the host nation. These clauses are common in the modern day petroleum contracts especially if the host country is politically unstable. The origin of the stabilisation clause as part of the petroleum contracts can be traced back to the 1930s when the interests of the American oil companies were jeopardised due to the mass nationalisation of strategic assets initiated by Latin American countries. Till the 1970s, the stabilisation clause offered protection against expropriation. During the 1970s, there were several arbitral awards for nationalisation of assets which gave rise to better understanding of mutual interests on the part of host government from 1980s (Cameron, 2006). It was hoped that this would eliminate the need for the stabilisation clause but this has not been the case. Instead, the mechanisms to implement these clauses have got more complex and varied in nature depending upon the credibility of the host nation (Fortier Stephen, 2004). Since the turn of the 21st century, there have been numerous attempts on the part of the host governments of petroleum producing nations to alter the fiscal arrangements present in the petroleum contracts. Although the underlying motive behind these attempts was not uniform, but one factor that paid a crucial role was the surge in international crude prices (Berger, 2003). This led to a fundamental shift in the bargaining power in the hands of the oil producing nations as a result of which, these nations wanted to benefit from this surge in oil prices. This phenomenon is not just limited to the third world countries but also includes the OECD producers such as UK and USA. A case in point is that of UK which in December 2005, increased the taxation burden with regards to petroleum by 100% as it was indicated that returns in the North Sea had reached a level of 40% from the normal levels of 13%. This increase in returns led the government to introduce changes which enhanced their share of the oil frenzy. Similar case was also observed in case of USA with regards to the oil being produced from the Gulf of Mexico (Cameron, 2006). However, it would be nave to believe that this was the major or only factor that led to unilateral actions on the part of the host government. In case of certain third world countries which had oil resources, stabilisation clauses were offered in the 1990s so as to attract investment and mitigate the underlying political risk. However, in a bid to offer exceptionally robust deals to investors, the financial implications of these are often not understood by the host government at the time of extension. This is particularly true for these nations which had limited exposure with regards to implementation of these clauses. However, when later these clauses are put into practice, they are found to be highly inflexible and lead to dispute which leads to alteration of the fiscal arrangements. An example of this phenomenon is experiences in Kazakhstan (Comeaux Kinsella,1994). However, a positive aspect of such alterations is that these are primarily forced and once altered, these are usually backed by subsequent stabilisation clauses which offer protection against future unilateral action. Certain governments alter their tax regim es which tend to have a direct or indirect impact on the fiscal obligations for the foreign investor. In case of absence of stabilisation clause, there are procedures for negotiation and redressed so that the disturbed equilibrium can be again restored. With contracts having the stabilisation clause, arbitration acts as key provision which discourages the government from taking unilateral actions (Coaele, 2002). From the above discussion, it is evident that in wake of the empirical incidents involving unilateral actions which are not limited to any particular geography, stabilisation clauses have become a mandatory component of such agreements leading to the proliferation of the same. In order to implement stabilisation clauses in the petroleum contracts, it is imperative to understand that the most crucial aspect of any such contract is the fiscal regime that essentially drives the division of profits between the host governments or state owned oil company and the foreign investor (Bouchez, 1991). This is essentially wider in scope than just tax and royalties and would also involve clauses related to recovery of cost along with profit sharing ratio. Besides there are other aspects that are critical which involve security of titles, right to sell or export petroleum, repatriation norms with regards to foreign currency along with flexibility on operational norms. Thus, stabilisation is requir ed beyond the fiscal regime only as other aspects may have significant impact on the underlying profits generated (Dolzer, 2002). There are various enforcement mechanisms with regards to achieving stabilisation of both fiscal and non-fiscal regime. One of the most primitive ones in this regard is freezing of the contractual agreement clauses to any unilateral action on the part of the state. A blanket freezing encompassing both the fiscal and non-fiscal clauses of the contract is rather uncommon, however milder forms of freezing are often observed particularly those limiting themselves to the fiscal clauses only. Freezing was common in the era of nationalisation by the government but in the modern day, it inevitably leads to inflexibility and hence is implemented in the form of partial stability provided to the foreign contractor with regards to the key clauses (Cameron, 2006). Another measure to ensure stabilisation is economic balancing. The economic balancing provisions advocate rebalancing if changes in the contract are executed after the conclusion of the agreement and these changes are detrimental to the interest of either of the parties or both the parties involved in the contract. Economic balancing may be achieved in namely two forms one is automatic and the other is through negotiated amendments in the contract with the intention of rebalancing. In case of automatic rebalancing, the stipulated action is clearly stated in the contract for various unilateral actions and is implemented automatically once triggered. However, considering the wide range of unilateral actions possible for the state, usually economic rebalancing is achieved through negotiated amendments (Hansen, 1988). Further, in the event that negotiated amendments cannot be concluded, then the right to arbitration is also included as part of the economic balancing stabilisation clause. Besides, normally a mix of the automatic and negotiated approach is usually adopted so as to resolve the common issues faced through automatic rebalancing while the uncommon issues can be resolved through negotiated approach (Salacuse, 2001). It is imperative to note that it is not always that unilateral action by the host government would be harmful to the interests of the foreign investor and may fact at times be beneficial. Further, it may so happen that at times that state government may not unilaterally take an action but due to alteration of laws in the neighbouring country, the prevalent law may change which may adversely impact the investors interest. The stabilisation clauses do not tend to cover such action which was evident in the case of Kazakhstan where the VAT rate charge was linked to the correspond ing charge in Russia and therefore when Russia hiked its tax, Kazakhstan had no choice but to increase its tax even though it did not had any direct intent to do the same (Cameron, 2006).Therefore, despite the best of intent by both parties, there are limitations to the economic balances stabilisation. Yet another mode of achieving stabilisation is the intangible cause which ensures that no modification in the petroleum contracts would be initiated on a unilateral basis by any of the parties and any modifications what so ever would be enacted only with the mutual consent of the various contracting parties. It is imperative to note that such clauses unlike unfreezing do not provide immunity against the legislative action but merely provide protection against any unilateral action. This is often found in the modern day petroleum contracts when absolute immunity is a rarity and in order to safeguard mutual interests of the parties, such clauses are inserted into the agreements (Dolzer, 2002). Further, another means of providing stability to the foreign investor practised in certain nations is through legislative support. In this, the concluded agreements are ratified by the parliament of the host country so as to accord legal status to such agreements. Usually this provides much secur ity to the foreign investor although this in effect would be notional as alike other statutory laws, this may also be altered by the parliament at the future date and hence may defeat the purpose but yet in certain third world countries, it was a highly popular measure amongst investors as it provided some semblance to them (Amador,1993). Further, there are certain stabilisation mechanisms which are found in international law and seek to protect the aim of the investor against any arbitrary action of the state. One of the most common measure in this regard is the BIT (Bilateral Investment Treaty). This treaty is enacted typically between two nations with the intention of providing protection to the interests of foreign investors (hailing from the two respective countries) against reckless and arbitrary state action. One of the prevalent mechanisms present in BIT is the ISDS (Investor State Dispute Settlement) system which typically calls for international arbitration so as to ensure that the interest of the foreign investor is safeguarded (Bouchez, 1991). In case of petroleum contracts, it is not assumed that international law is automatically applicable but still in the presence of BIT and considering the stakes, diplomatic pressure and international arbitration cannot be denied. But it is advisable, that during nego tiation of the contract, the foreign investor should press for the inclusion of this principle irrespective of the presence of BIT or not. This is especially imperative as the legal system in third world nations is found wanting and can be tardy, corrupt and state controlled (Cameron, 2006). It is imperative to note that the stabilisation clauses are offered by certain nations only where the perceived political risk is high coupled with geological risk. Countries such as OSCD where the political regime is highly stable and based on rule of law, the stabilisation clauses are not offered. Further, countries such as Saudi Arabia and Brazil with proven oil reserves also do not offer stabilisation clauses. However, other nations do use this as an incentive to attract foreign investors (Berger, 2003). While stabilisation through various above mechanisms may lure investors, however there are certain limitations which may limit its scope. Firstly, the stabilisation clauses must be in line with the legal framework of the host country. This is particularly true with regards to freezing clauses which do not stand the test of the time as the laws that would be enacted in the future would prevail over the freezing clause as the sovereignty of the host nation is paramount (Chatterjee, 1988). Secondly, stabilisation clauses tend to be restrictive in scope and therefore focus on mainly the fiscal regime while ignoring the non-fiscal clauses which are increasingly gaining more importance (Cameron, 2006). From the above discussion, it may be concluded that foreign investors aim to achieve stabilisation in petroleum contracts especially when operations are based in countries having high political risk and/or geological risk. However, over the period of time the mechanism of providing stabilisation has altered from freezing to other measures that have been discussed. Typically, a mix of the various measures is deployed in the contracts to provide stability to the investors. The relevance of these clauses continue to remain, however their ambit should expand and seek to include the non-fiscal regime as environment increases is becoming a significant parameter (Cameron, 2006). Further, the host governments on their part should also understand the risks of taking unilateral actions and should aim for actions based on mutual consent and respect for the interests of the various parties involved. References Amador, G 1993, State Responsibility in Case of Stabilisation Clauses, Journal of Transnational Law and Policy, Vol.2 No. 2, pp. 23-50 Berger, P 2003, Renegotiation and Adaptation of International Investment Contracts: The Role of Contract Drafters and Arbitrators, Vanderbilt Journal of Transnational Law, Vol. 36 No. 2, pp. 1347- 1380. 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