Basics of Energy Contracts
Oil & Gas contracts are agreements between parties that strictly outline the specific obligations of each party. In most cases, oil & gas contracts are signed as an exchange of consideration (payment) for a specific task, good or service. These agreements are useful because they create a well-defined legal obligation for both parties. Fundamental to the oil & gas industry are contracts for land leases, joint ventures and supply agreements. These contracts ensure the legal framework for exploration, production and sale is clearly established.
Landowners, oil & gas companies and service providers all sign oil & gas contracts. These contracts are more important than ever because of the changing structure in the industry. For example , an oil & gas company may wish to enter into a Division Order, Farmout Agreement or a Joint Operating Agreement with other not directly a party to the Lease Agreement. Other oil & gas contracts can include but are not limited to Production and Processing Agreements and Separation Agreements.
Given the recent market downturn, more and more oil & gas companies are entering into Farmout and Joint Venture Agreements than ever before. The reduction of this steady demand for oil & gas means that companies that are still in business are looking at other ways to produce oil & gas, as this would not normally be possible.
Categories of Oil & Gas Contracts
Each of these agreements serves a specific purpose in the exploration and production workflow, and their structure reflects those purposes. For example, an oil exploration contract may relate directly to the risk or speculative nature of a drilling operation. There is a huge difference in risk between a company or individual alleging to have oil, and one who is actually drilling and producing oil. A lease agreement, on the other hand, is a contract of possession. In order to lease land, the landowner must be willing to relinquish the rights to the property. In addition to a consideration payment, the landowner usually receives a production royalty as part of the agreement. A joint venture agreement is for the intentional pooling of resources. A joint venture usually contains a provision for the splitting of profits and losses from the production take. It, like the lease, is a contract of already given rights, but adds the aspect of subdivision of the profits from production. Service contracts provide pay for services rendered, whether those services are in the form of transportation, technology and research, or employment contracts. In the Gulf of Mexico, the Outer Continental Shelf Lands Act made service contracts "the major vehicle" for contracting with private enterprise.
Provisions of Oil & Gas Contracts
In addition to these rights and obligations, agreements governing oil and gas leases typically will also contain terms necessary to define the scope of the grant of rights to the lessee (the company or person to whom the lease is granted rights), such as the duration of the lease, termination, financial terms and liability:
Duration – Many leases will grant the lessee the right to explore and develop the property until they find a commercially viable source of oil or gas, at which point the lease will usually last for a specified period from the date of commencement of actual extraction (usually around 20 years) and then for so long after that as oil or gas is being produced.
Termination – If authorization is not granted by the board, the lease will usually be able to be terminated by either party prior to the point that oil or gas is discovered.
Financial terms – The lease will set out terms regarding the quantum of the bonus or consideration payable and the time periods within which the money must be paid, as well as the royalty and/or overriding royalty payable (usually a specified percentage of the value of the hydrocarbons calculated at the point that they change from one form to another, such as from gas to oil).
Liability – The lease will often contain clauses that set out how losses will be apportioned in the event of an incident and will usually either expressly allocate liability to one party or the other and/or provide that liability will be apportioned in accordance with the degree of responsibility of each party (i.e. shared liability).
Negotiation and Drafting Tips
In negotiating and drafting Oil & Gas Contracts, the practitioner needs to understand, among others, the specific matters to be covered in the contract, the structure of the contract, clarity and completeness of the contract, applicable provisions of law, and the intentions of the parties as to how to cover important aspects of the relationship. The contracts should include all terms agreed upon by the parties and should exclude all terms not agreed upon by the parties. When deciding on which matters to be included in the contract, the practitioner must balance the extent to which the contract should clearly define the rights and obligations of the parties against the need for flexibility in the event of future contingencies. None of the contractual rights and obligations of the contracting parties should be left to either party’s discretion. Similarly, the contract should be clear and unambiguous, so that a court will be able to ascertain the party’s intent in the event of a dispute. Conversely, when drafting a contract, the practitioner should take into consideration what would happen if there was an unforeseeable event — such as the sudden increase in oil prices — that rendered one or more of the contractual obligations too costly to perform. For this reason, boilerplate clauses are often included in contracts, especially contracts pertaining to exploration and production agreements, which include force majeure clauses that address the possibility of surprise and unanticipated circumstances. However, care should be taken to ensure that these clauses are written so as to avoid abusive interpretations and interpretations that would otherwise confer unfair advantages on one of the parties. The contract should also be complete. The parties may believe that they have fully set out their agreement, but some may assume that their obligations have been sufficiently defined, while others may assume that they have no further obligations. Practitioners should be aware that parties may have agreed to additional terms not reflected in a signed agreement. An experienced Oil & Gas lawyer should therefore be able to spot these potentially hidden terms and to revise the contract in light of the actual intentions of the parties. Other considerations that the practitioner may want to take into account include the identification of the proper forum and choice of law. Certain states provide favorable legal environments for oil and gas exploration, particularly Alaska and Texas, while others less favorable. These and other factors are relevant when negotiating and drafting Oil & Gas Contracts.
Petroleum Legal Issues and Dispute Resolution
Many legal issues can arise when negotiating the terms of an oil and gas contract. Whether in Texas, Oklahoma, or any of the other major oil and gas producing states, contracts for the development of oil and gas must often anticipate fluctuating economic conditions. The market for oil and gas has historically been cyclical, with periods of low prices followed by periods of very high prices. Thus, companies have to be smart with their contract language and recognize the importance of developing well-written documents that accurately represent the expectations and obligations of all parties. In addition, the oil and gas industry in the U.S. is highly regulated, and those who overlook the significance of compliance with government regulation will face unnecessary regulatory and legal exposure.
One common challenge is in determining the reasonable cost associated with improved surface facilities. Without limiting the kinds of improvements included in the term "facilities," many questions arise with regard to costs, including (i) which costs should be capitalized (as opposed to expensed), (ii) costs attendant to environmental compliance necessary to bring compliance prior to drilling, (iii) costs associated with pre-drilling agency applications, (iv) costs associated with construction management, (v) whether to hire a governmental consultant, and (vi) costs associated with procuring governmental authorizations.
Another area of conflict can involve royalties. There are often disagreements over the role of the oil and gas company in the payment of royalty. For example, some oil and gas companies have used creative financing arrangements to finance the drilling of wells, with the net result that some landowners may receive less on the royalty than anticipated. Even the most well-settled contracts can still encounter legal challenges at the time of enforcement by either or both parties . For example, in the Texas case El Paso E & P Co., LP v. Deutsche Bank Nat’l Trust Co., 132 S.W.3d. 472, 478 (Tex. App.—Ft. Worth 2004, pet denied), El Paso interpreted a $1.4 billion "prepayment" for the development of oil and gas assets as a loan, while Deutsche Bank asserted that, pursuant to the oil and gas contract, the consideration should be viewed as the purchase of interests in the business. The parties presented their dispute to an arbitration panel. To address the conflict, the Texas Supreme Court applied a presumption in favor of arbitration in both the convention and non-convention settings that, absent an express provision to the contrary, there is a general policy in favor of deciding all issues related to the contract in question because the parties have agreed to arbitrate.
Again, in the Texas case Davilla v. Enable Midstream Partners, LP, No. 04-17-00449-CV, 2018 WL 1876486, at *3 (Tex. App.—San Antonio Apr. 18, 2018, pet. denied), the Texas Supreme Court reaffirmed that, unless the parties expressly reserve agreement concerning an issue only for court determination, the scope of the arbitration agreement includes that issue. In Davilla, the trial court determined that arbitration was inappropriate given that parties to class action lawsuits have a right to adjudication in a court of law. However, the Davilla court stated that class action lawsuits are "generally waivable" and that what is arbitrable under an arbitration agreement is up to the parties.
Similarly, in articulating the differences between arbitration and traditional litigation, many courts have treated arbitration agreements as contracts separate and distinct from the underlying substantive agreement, and have noted that agreements to arbitrate, while integral to the controversy, do not affect the fundamental arrangement between the parties.
Current Trends in Contracting for Oil and Gas
As the oil and gas sector continues to evolve, several emerging trends are reshaping the landscape of contracts. To begin with, the industry is undergoing digital transformation; the sector is a late adopter of technology, but new business models leverage tools such as cloud-based software, artificial intelligence and IoT capabilities to streamline operations and provide decision-making and optimization support. Digital transformation is changing contracts, as they increasingly must address the interdependence of revenue, cyber and vendor risks. The trend brings with it the need for better resource management, cost reduction, operational flexibility and improved production forecasting, and necessitates an environment in which contract compliance by service providers and vendors is ensured and monitored.
At the same time, pressures for biodiversity protection and on carbon emissions are influencing the sector and pushing for sustainable projects. According to Deloitte, shareholders and stakeholders are requesting more transparency on E&S issues, pushing for investment sustainability ratings, and encouraging stronger processes for ethical decision-making with regard to project development. This, in turn, impacts the manner in which projects are structured to address environmental, social and ethical considerations.
On the geopolitical side, some countries in the Middle East and elsewhere have announced plans to gradually stop burning fossil fuels. The prohibition of burning coal for energy generation in Europe, has increased the amount of natural gas supplied therefrom, which, while it reduces global carbon emissions, has also increased competition in LNG matters.
The change in approach regarding coal-burning, coupled with other negative publicity of fossil fuels, has prompted calls for a 10-year moratorium on new fossil fuel projects in South Africa. The proposed moratorium is said to be the first of its kind in the world. It means any new projects that have not already attained regulatory approval will not be permitted during that period. It is unclear whether or not this moratorium is actually going to happen, the intended effect is to force project developers to focus on enabling renewable energy projects. This includes seeking different gender, race and social contribution targets (again, see sustainability matters above).
Summary Conclusions and Industry Standards
In this discussion, we have reviewed the primary types of oil & gas contracts, and some of the business considerations they may drive. We began with the importance of the JOA or joint operating agreement. For many oil & gas operations, the JOA is "the contract" that drives how business is conducted. It is certainly the contract to which the business people and lawyers will refer most often.
We also covered the drilling agreement, which governs the relationship between a well operator and various contractors who provide drilling or completion equipment and services. We also discussed geophysicist’s services contracts, and acquisition, exploration and production contracts . Finally, we touched on sales contracts, which often involve transfer of title to the oil & gas itself, and transportation contracts, which typically involve deliveries of oil and gas from the field to a place of business.
As these and other contracts are negotiated, modified, or terminated, all parties should aim to achieve the four fundamental contract construction objectives we described.
The oil & gas industry is currently facing trials that are causing many of its players to re-evaluate their businesses. One lesson can be drawn from this process, that being: businesses and business relationships should continually learn from events and adapt to their environment. As long as contract ratification processes are observed, parties can meet their business objectives by using contract law to shape business relationships in an organized manner.