Thursday, 18 December 2008

Sole Risk and Non-Consent Clauses in Joint Operating Agreement: The Purposes and the Compatibility with the Joint Venture’s principle

I. Introduction

Oil and gas industry is a very high risk and high cost industry, to spread the risks and share the costs an oil company usually cooperates as a joint venture with other oil companies. The vehicle used for the joint venture in exploring and developing a certain geographic area by most oil companies is Joint Operating Agreement (JOA). To conduct day-to-day activities in the JOA, one of the parties will be appointed as the operator. Furthermore, the operator will be supervised and controlled by the operating committee (opcom) which consists of all the parties to the JOA and the opcom will have the power to decide whether to conduct certain project which is proposed by the operator. Decisions taken by the opcom in conducting its supervisory role to the operator will be based on majority votes in accordance with the voting procedures.[1] The voting interest of each party, which is equal to its percentage interest, will provide that the decisions by the affirmative vote not less than a specified amount in the JOA referred to as the ‘passmark’.[2] To conduct certain project in the joint venture, such proposed project has to obtain majority votes in the opcom or at least sufficient to make up the passmark.

The size of the passmark that will be specified in JOA is one of the hardest negotiations in drafting a JOA, as the passmark gives the percentage interest share of votes which must be obtained by the opcom to make a binding decision.[3] If the passmark provided in the JOA is low, it will give the largest interest holder a dominant position and the greater are the chances of the work being carried out, while a high passmark will give smaller interest holders opportunities to make decision on the management of the joint venture but it will be more complicated to decide whether a project can be conducted in the joint venture.[4] In addition, most modern JOAs set the passmark between 50% - 70%.[5]

In practice, joint ventures in the oil and gas industry are frequently not equals, the parties in the JOA often differ dramatically in size, financial resource, technical capability, and in other important respects.[6] This condition gives different perspective and disagreements of priorities for particular project from company to company, for example in deciding where and how deep to drill. Furthermore, it is very common if the parties in a joint venture have different opinions in interpreting geological structure in which petroleum may be found and/or in forecasting profits from an operation, and sometimes, certain political reasons inter parties in the JOA may also cause disagreement in opposing a proposal.[7]

To this extent, some modern JOAs provide sole risk and non-consent clauses,[8] and these clauses are strongly connected with the passmark given in the JOA. Sole risk clauses give an option for some parties to proposed and then conduct certain type of work which has failed to get necessary votes from the opcom to make it a join operation on a sole risk basis.[9] It means that the parties which conduct a project under sole risk clauses will share all the costs of the operation as well as the risks or any liabilities arising out of the sole risk operations and will have a right to the production resulted from such operations between themselves.[10] Contrary to the sole risk projects, non-consent clauses give an option for some parties not to conduct certain type of work or to opt out from a program which already has been approved by the opcom.[11]

One could argue that the impact of these clauses give an impression that they are incompatible with the basic principle and functions of JOA as a joint venture,[12] because as has been said above that the main purpose of JOA is to spread the risks and share the costs and liabilities in conducting a project in oil and gas industry. To this extent, as the purposes and the impact of sole risk clauses are different than non-consent clauses, these clauses will be discussed separately in this paper.

II. Sole Risk: Purposes and Its Compatibility to Joint Venture

As described above, to conduct a certain project, the proposed project has to get the necessary votes in the opcom to make it a joint operation, at least sufficient to make up the passmark. Therefore, when the passmark provided in the JOA is high, it is much harder to conduct an operation because it requires more votes in the opcom. For example, A as a party in a JOA holds 50% interest in the joint venture, while B and C hold 25% interest each and the JOA provides that the passmark should be 70%. As a result if B and C are not giving any vote on such project, even though A is giving his vote to conduct the project, the opcom will decide that the project will not be carried out because the votes are not sufficient to make up the passmark.

The purpose of sole risk clauses is to allow the party who is willing to conduct an operation by himself based on his consideration without being depended to the opcom decision. Therefore, based on sole risk clauses, A as the only party who voted to the project may conduct the project by his costs, risks and enjoy the benefit if the project is successful in the future. Beside that, according to Taylor[13], another purpose of sole risk clauses is to give the opportunity for the members of the JOA to contribute maximum efforts to utilize the license. By sole risk clauses, some members are still have chances to conduct some proposed projects and may exploit the license area to the best commercial advantage in a period of time given by the license even though there is a dissenting opinion in the opcom.[14] For example, when the opcom decides not to drill, but there are some members in the JOA wish to drill under the sole risk clauses because in their opinion some profitable oil reserve in certain geological area may be found, therefore it is better to drill to find out whether there is any oil reserve in such area.

In the presence of sole risk operation, the parties who conduct certain projects under the ground of sole risk clauses will create a sub-venture with their co-venturers in the joint venture who also wish to join in such project. The result of this condition is that the parties included in the sub-venture will have to share costs, risks and rewards exclusively between the co-venturers in accordance with each party’s interest share in such sub-venture. Thus, sole risk clauses are compatible with the aim and function of JOA. The basic principle of a JOA as a joint venture is to share liabilities and benefits in accordance with each party’s interest share.[15] As the sole risk project is taken based on the mutual interest of the parties in the JOA and will be conducted as sub-ventures under the joint venture,[16] the sub-venture will legitimately conduct certain activities as a part of the joint venture under the same license given to the joint venture by its own consideration.

In addition, even though each sub-venture will have its own fiduciary relationship and duties between its parties to its subject matters in certain activity, for example in drilling a well, it may affect the joint venture as a whole. To prevent this circumstance, modern JOAs provide that the sole risk group activities must not interfere with joint operations,[17] and the sole risk parties will indemnify the non-sole risk parties to any consequences caused by the sole risk activities, but excluding to certain consequential damages which have been agreed that in the license should be born equally.[18]

As the sole risk group is working under the same license in the joint venture, most JOA allow the sole risk group to use joint property, data, and information.[19] The opcom will decide to what extent that the sole risk party may be authorized to use the joint property and such authorization is subject to certain terms and conditions. In addition to this, the sole risk party may be charged upon the utilization of the joint property on a reasonable and equitable basis which may be based on the incremental cost arising from such use of joint property, or an arm’s length market price.[20]

III. Non-Consent: Purpose and Its Compatibility with Joint Venture

Whereas sole risk clauses are typically conducted by the operator which has bigger interest in the JOA but failed to get necessary votes from the opcom to conduct certain project in the join venture,[21] non-consent clauses are usually carried out by parties which are having small interests.[22] The existence of non-consent clauses will be very helpful for the parties with small interests in the joint venture when the passmark provided in the JOA is low to legitimate their decision to opt out from certain project.[23] For example, A as a party in a JOA holds 50% interest in the joint venture, while both B and C hold 25% interest each and the JOA provides that the passmark is 50%. As a result if A is giving its vote to conduct particular project, while B and C are not giving any vote on the project, the opcom will still decide to carry out such project as A’s vote itself is already sufficient to make up the passmark. Without non-consent clauses, it will be unfair for B and C as the minority interests to always abide A’s decisions.

In practice, non-consent clauses are not as common as sole risk clauses, except in the case of development of a discovery. This is merely because development of a discovery is frequently much more expensive than any other type of operation.[24] For this reason, some modern JOAs often provide non-consent clause to allow the parties to opt out from the joint venture because they are not brave enough to face the possible consequences in the future or having a financial and/or technical incapability to participate in the development.[25]

In comparison with the sole risk operation which creates a sub venture in the joint venture, Bean[26] says that non-consent operation may also be seen as sub-venture but of a larger kind. There is no further explanation about this statement, but it can be analyzed that the parties who will create a sub venture are the members who decide to opt in to carry out a project, not the non-consent parties. From this point of view, it may be deemed that non-consent clauses are not compatible with the principle of joint venture. The principle of a joint venture is to share liabilities, benefits, and bear the risks in accordance with each party’s interest share.[27] In contrast with the premise of joint venture, non-consent clause allows the members of a joint venture to opt out from a project, and the parties who decide to opt in for the project will bear a greater share of the costs, risks and liabilities.

IV. Conclusion

From the discussion above, it can be concluded that the purpose of sole risk clauses is to give opportunities for the parties who really confident about their interpretation to certain geological map in which petroleum of potentially commercial significance may be found, to prove their interpretation and to carry out the project without dependent to the joint venture. Beside that, another purpose of sole risk clauses is to take full advantage of the license area to the best commercial advantage in a period of time given by the license, preferably with the participation of every member of the venture, or (if not) with the members who are willing to do so.

In conducting sole risk project, the parties in the project will form a sub-venture with their co-venturers under the joint venture. They will share liabilities, costs, risks and benefits in accordance to the interest shares in the sub-venture. This result is considered in line with the premise of joint venture, moreover these clauses will give a mutual benefit to the parties to conduct exploration and/or development into a series of different groupings within the whole as long as these activities will not interfere with joint operations. [28]

Different than sole risk clauses, non-consent clauses may be deemed not compatible with the premise of joint venture to share liabilities, and spread the risks among all of the members. These clauses allow the non-consent party to refuse giving any contribution and/or to avoid the risk by walking out from the project which actually has been approved by the opcom to be carried out in the joint venture. However, the only reason why some JOAs provide non-consent clause is to give a fair option for the parties who do not have the same capability in terms of financial, technical, or any other important respects. As mentioned before that, joint ventures in oil and gas industry frequently unequal, therefore to protect the members who are incapable to bear the costs of a project and/or to bear financial or technical risks, they are given an option to opt out from the project.

[1] Taylor, Michael P. G. Taylor and Winsor on joint operating agreements. (London : Longman, 1992), pp. 23 & 187.

[2] Ibid.

[3] Paterson, Greg Gordon and John. Current Practice and Emerging Trends. (Dundee University Press, 2007), pp. 287.

[4] Ibid.

[5] Paterson, pp. 287.

[6] Taylor, pp. 47.

[7] Ibid.

[8] Ibid. pp. 48.

[9] Ibid.

[10] Paterson, pp. 25, see also Taylor, pp. 48.

[11] Taylor, pp. 48.

[12] Paterson, pp. 288.

[13] Ibid., pp. 49.

[14] Ibid.

[15] David, M.R. (editor). Upstream Oil and Gas Agreements. (Sweet and Maxwell, London, 1996), pp. 16.

[16] Bean, Gerard M. D. Fiduciary Obligations and Joint Ventures. (Clarendon Press, Oxford 1995) Ch. 1, pp. 199.

[17] Taylor, pp. 62.

[18] Ibid.

[19] Ibid.

[20] Ibid.

[21] Ibid., pp. 23, see also Paterson, pp. 289.

[22] Ibid., pp. 23 -24.

[23] Ibid.

[24] Taylor, pp. 72.

[25] Ibid.

[26] Bean, pp. 18.

[27] David, pp. 16.

[28] Bean, pp. 18.

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