The Legal Status of Joint Operating Agreements in oil production

Energy, Featured, Legal, Oil Industry, Politics and Government, Underwater Shipping — By on May 12, 2012 at 9:38 PM

This medium, has devoted a number of news and views on Energy. Aglaia Politou’s article comes at no better time, given the energy-spree-oriented period we live in. Legal energy issues are always of high importance not only at an international level in general, but also in Europe, especially in relation to the current oil and gas plans at the sensitive geographical area of Cyprus.’

The Legal Status of Joint Operating Agreements in oil production, by Aglaia Politou*

In the oil and gas industry, the right to explore, exploit, appraise and produce oil and gas is hardly ever exercised by a single entity. Such approach has led to the creation of the widespread concept of joint ventures. By entering into a joint venture, oil companies can mitigate high risks and share in the costs required for capital intensive exploration, development and production activities. The joint venture will also enable costs savings and economies of scale. The operations can be handled with fewer employees, less duplication of equipment and other facilities while the venturers can bulk buy supplies and materials thereby promoting greater efficiency.

A joint venture (or ‘joint adventure’) is an association of persons for the prosecution of a single venture. The usual elements of a joint venture include: firstly, community interest in the object of the undertaking; secondly, pro-rata right to direct and govern the conduct of each other with respect thereto; thirdly, share to the extent of their respective percentage interest in the losses or profits; and fourthly, close, possibly fiduciary, relationship between the parties.

The joint venture can take various forms; for instance, a specifically formed limited company or a partnership but it is the unincorporated joint venture the method commonly used in the United Kingdom Continental Shelf (UKCS) and elsewhere because it brings tax benefits. This idea was used first in the US. However, upstream practice of avoiding incorporated joint venture companies constitutes a significant departure from general commerce.

The current popularity of joint ventures as a form of commercial activity has given rise to a number of important conceptual legal issues; namely, what constitutes a joint venture and aligned with this, whether an unincorporated joint venture differs from a partnership. The advantages of the joint venture, especially in relation to taxation, are only applicable if a partnership is not created. If a joint venture is held to be a partnership, fiduciary obligations can be imposed by virtue of Partnership Law, rather than because of the joint venture relationship. On the one hand, the English courts have not developed a separate concept of joint venture distinguishable from partnership. On the other hand, all standard JOAs contain a clause specifically denying that a partnership exists.

The Joint Operating Agreement is the main vehicle widely used by joint ventures in exploring and producing oil and gas resources. The JOA must provide a set of rules which will govern the parties for the duration of the joint venture. These rules should last a very long time and apply to a vast range of activities. The design of the JOA must therefore address issues which can lead to disputes and threaten the stability and longevity of the joint venture. Conceptually, a JOA comprises the ‘constitution’ which governs the joint venture.

The JOA serves two main functions. Firstly, it defines the proportions of interest of the parties and secondly, it allocates rights. The first function provides the legal basis for the sharing of rights and liabilities under the production licence. The declaration of personal interest is one of the essential provisions in a JOA. All rights and liabilities arising in connection with the production licence will be shared between the licensees in proportion to their percentage interest. The interest clause, as for instance in the UKOOA 20th Round Draft Clause 4 has the effect of taking the unitary form of the licence and changing it into fractions with individual ownership of each fraction of the property. This means that each has a separate undivided share of the total assets. This feature has the effect of making it a chose in action, similar to a debt, share or stock in a company. One effect of this is that it can be sold or mortgaged by its owner by way of novation and assignment although it does not need Governmental approval for this. However, it is UK Government policy not to allow securities to be granted over licensed interests except where the security is used to finance off-shore operations.

In cases where a solvent co-venturer decides to withdraw and sell the share, the other parties may be disadvantaged by a financially inferior replacement. In these situations, restriction like pre-emption clauses and the right of the first refusal, used to be imposed as an attempt to control the manner and the procedure of interest trade. However, these mechanisms may place unjustified restrictions upon the freedom of commerce. It is important to note that in case of a withdrawal, the party will be liable for all obligations and liabilities concerning any activities that occurred before the withdrawal date. Hence if the JOA is analysed as a ‘relationship contract’, then pre-emption clauses may be necessary because a party to a JOA is not just buying equity in a project but also becomes liable for expenditure and that affects other JOA partners. On the other hand, if the JOA is analysed as a ‘proprietary contract’ granting rights to shares, then pre-emption rights look like an unjustified restraint upon commerce. The UK Government in April 2003, probably viewing the issue of pre-emption clauses in the second way, replaced such clauses with the ‘Master Deed’ Reform which standardised the pre-emption regime by providing new transfer and pre-emption arrangement that offer consistency.

Regarding the second function of a JOA, the allocation of rights, the JOA creates contractual duties of performance between the co-venturers and it provides a set of rules for the conduct of operations under the production licence. There are two classes of party to a JOA; the operator and the non-operators. The operator is the party who implements the collective will of the joint venture and is responsible for the day-to-day management of the operations. The other members are known as non-operators. Operation involves designating one of the licensees as operator who is responsible for conducting the day-to-day operations, subject to the supervision of a Joint Operating Committee which is representative of all licensees.

It is clear that such arrangements are suitable for the oil industry. Major international oil companies continue to use Joint Operating Agreements due to their flexible and self-regulatory nature. As a result of its widespread use, nature, standardisation and development, Joint Operating Agreements have dictated relationships and the range of operations in a commercially-oriented manner. Clauses in Joint Operating Agreements protect the co-venturers when dealing with fiscal contributions, liabilities and most importantly, such a framework meets the necessities of such long-term projects.

Moreover, contractual provisions can be put in place to deal with the possibility of default in a JOA. These include suspension of rights, buying out the defaulting party’s interest, with the ultimate sanction being forfeiture of the defaulting party’s interest where default remains unremedied. However, the situation with the forfeiture provision is precarious because of issues with enforceability. As well as being unenforceable, where the provision is found to be penal or where there are issues of insolvency, the defaulter may also be granted relief from forfeiture.

Apart from forfeiture, more ‘grey zones’ regarding the legal implications of JOAs include partnership issues, fiduciary duties, the application of the ‘equitable relief’ doctrine and the enforcement of default clauses. However, unwanted consequences can be avoided firstly, by a well-drafted Agreement, representing precisely the parties’ intentions, rights and duties; and secondly, by the use of ‘contractual devices’ such as the adoption of ‘withering interest’ forfeiture clauses. It is suggested that Model Forms of Joint Operating Agreements, such as the AAPL JOA (American Association of Petroleum Landmen Form 610 Model Form Operating Agreement 1989), the CAPL JOA (Canadian Association of Petroleum Landmen Operating Procedure 2007) and the AIPN JOA (Association of International Petroleum Negotiators Model Form International Operating Agreement 2002), tackle these issues effectively although litigation may invariably result.

Joint Operating Agreements are the contractual nexus balancing exploration and production expectation interests against conflict with the regulatory regime while the development of ‘international friendly’ Model Forms of JOAs reflects a move at an international level towards a greater harmonisation of joint venture agreements. This move has been driven in part, by a desire of the international oil industry to streamline the process of negotiating these types of arrangements and minimise its very high transaction costs by providing a model that is broadly accepted by the international oil industry as a reasonable, practical and tested document.

As in the U.K., there are less players in the petroleum industry than in North America, this explains the absence of comparative judicial authority concerning oil JOAs. Nevertheless, in the near future, it is clear that creativity and inventiveness will be required of the legal profession to devise new answers to the most intractable problems of Joint Operating Agreements.

*Aglaia Politou is a shipping lawyer and a scholar of The City Law School of City University London for the LL.M in Maritime Law. She read law in London and France and she specialised in Private International Law at The Hague Academy of International Law in The Netherlands. Miss Politou has worked for international and European institutions of high prestige in Brussels, Strasbourg and Athens and she is an active member of the Founding and Steering Committee of the Young Maritime Professionals of the London Shipping Law Centre. She is a native Greek speaker while she is fluent in English, French, Russian and Ukrainian. Other articles at www.allaboutshipping.co.uk in relation to Miss Politou include ‘Shipping Scholar-Ships’ and ‘The Admiralty Claimant after The Indian Grace No.2 Ruling’.

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