ASSESSING AND MANAGING RISK AND REWARD IN A VOLATILE OIL & GAS MARKET
Following a breakdown of negotiations between Saudi Arabia and Russia, on March 8, 2020, oil prices experienced the largest one-day price drop since the 1991 Gulf War, falling to $30 a barrel. This occurred in the context of a sharp fall in demand for oil and petroleum products caused by the COVID-19 pandemic.
The resulting volatility in the oil & gas markets is significant and could ripple throughout the global economy. These events serve as another reminder of the importance of proactively assessing and managing contractual risk (or opportunity) in a quickly changing environment. Below, we consider some of the possible consequences of the current situation. We then identify steps that affected players can take—both to manage risk and to pursue available opportunities.
What are the Possible Effects of the Current Situation on the Oil and Gas Markets?
The drop in oil prices observed after the Russia-OPEC meeting of March 6, 2020 is already generating significant attention, among other reasons because it triggers memories of the oil price crash of 2014. The 2014 shock affected not only oil and gas exploration, production and sale, but also dependent industries (including shipping, mining, energy and manufacturing), as well as international financial markets. This year’s drop may have even worse effects, given the slowdown caused by the COVID-19 pandemic worldwide.
When oil prices have exhibited extreme volatility in the past, the immediate impacts have included:
- Oversupply and potentially saturated markets. Due to the breakdown in negotiations among Russia and OPEC, oil production might continue more or less unabated, with both OPEC and non-OPEC members choosing to produce at will. In addition to putting further downward price pressure on oil products, this could also raise issues related to the allocation and use of limited transport and storage infrastructure;
- Potential for record low prices. The combination of oversupply and depressed demand has been (and will probably continue) to increase market volatility. On March 10, 2020, the VIX, an index quantifying the market’s expectation of 30-day forward-looking volatility, indicated volatility at a level of 46.84 at 3:00 pm (EST). At the same time on March 16, 2020, volatility soared to a level of 83.05. Some analysts predict that the price of Brent crude oil may drop as low $20 per barrel, which would bring the price of Brent within a range effectively not seen since before the 1980s. WTI prices have followed a similar trend, hitting the $20 per barrel mark on March 18, 2020;
- Impact on LNG prices. Lower oil prices—especially if sustained—could have a significant impact on LNG prices. Lower oil prices depress the prices of oil-linked LNG cargoes. As the gap between spot prices and long-term LNG prices becomes smaller, short-term or spot buyers may see substantial advantages while sellers might end up taking a substantial hit. Moreover, as roughly 70–75% of the LNG market operates under long-term contracts, exporters with oil-linked contracts—often based on oil prices averaged over several months—might also see their revenues impacted by a sustained drop in oil prices. In the same manner, sustained low oil prices might impact negotiations for the renewal of long-term LNG supply contracts expiring within the next few years and for new supply contracts;
- Exploration & Production as a whole might suffer as well. The drop in oil prices will cause lower earnings for oil companies and a correspondingly lower capacity to invest in Exploration & Production. U.S. shale producers will notably suffer from lower prices, as shale oil production requires higher prices to remain profitable. A price war may expose U.S. oil companies to significant risks, especially where a barrel goes for less than $30.
Whatever happens, the best strategy is to be as prepared as possible to manage the risk and seize the opportunities. Below we highlight a number of immediate steps that can be taken.
Key Steps to Best Handle the Effects of the Oil & Gas Market Developments
Some steps that can be taken to help facilitate effective risk management include:
- Review of the Contract: at the highest level of generality, the first step is to review carefully the terms of your contracts. Where a contractual remedy needs to be exercised, review carefully both the substantive and formal requirements to be fulfilled and assess whether they are met prior to sending the relevant notification;
- Modification of the Contracts: in some situations, accommodations to existing contract terms can help recover from a situation of stress. Carefully review the contractual provisions relevant to contract modifications, assess whether and how the contract can be adapted to accommodate the new circumstances before engaging discussions with your counterparty;
- Price Review Mechanisms: certain contracts may contain a price review mechanism, under which changed circumstances may give rise to a right to adjust the contract price so as to take into account and address the relevant changes. For such contracts, it is important to assess the particular mechanism and to determine the extent to which you or your counterparty may need to invoke it. Key considerations to bear in mind include: (i) the circumstances in which a price review can be triggered (and whether they can be said to exist at present); (ii) whether either or both parties has at its disposal the right to invoke such mechanism; and (iii) what procedural requirements need to be met in order to invoke the mechanism (e.g., a written request for price review, a certain prescribed period of negotiation, etc.);
- Force Majeure: the way force majeure events are defined can vary greatly from one contract to the other. Express force majeure provisions tend to be broad and generally cover “acts of god,” but can include other specific factors. The question of whether one specific type of event should be considered as a case of force majeure depends on how the provision is drafted. For instance, whether the sudden drop in oil prices and the spread of the coronavirus may or may not be considered as force majeure events will largely depend on how the provision is drafted. A careful review of the contractual terms is necessary to assess whether you or your counterparty will need to—and can—invoke this clause in order to excuse the non-performance of any contractual obligations in whole, or in part;
- Hardship Clauses: hardship clauses are not systematic and vary from one contract to another. They typically provide for the possibility to renegotiate certain contractual terms in case pre-defined events occur, which render continued performance of the contract unduly burdensome. Usually, the economic equilibrium of the contract must have been significantly altered as a result of a general event;
- Termination of Contract: in circumstances where continued performance of the contract becomes impossible or impracticable, some contracts allow the affected party to terminate the contract. Wherever you want to initiate or avoid termination, it is necessary to understand the contractual conditions for terminating to able to defend your position;
- Efficient Breach: sometimes it is cheaper to default on a contract and pay the agreed compensation (e.g., shortfall compensation) than it is to perform it in a changed economic climate. Accordingly, if all the remedies above fail, parties may consider a so-called efficient breach as a temporary solution.
In addition, the law governing your contract(s) may provide other remedies to deal with unexpected changes. For example:
- French law acknowledges the principle of good faith, which does not exist under other legal systems, and which can give rise to obligations that are not expressly stated in the contract’s written terms. As a corollary of the principle of good faith, since a 2016 legal reform, contracts can be revised when unforeseen circumstances disturb the initial equilibrium of the contract, pursuant to the so-called unforeseen circumstances doctrine (doctrine de l’imprévision);
- Egyptian law and those of other jurisdictions whose legal systems are based on Egyptian law such as UAE law, Bahraini law, Omani law, Qatari law, Kuwaiti law also recognize the unforeseen circumstances doctrine. It is likely that in numerous business relationships the question will arise whether a trade war and/or a pandemic qualify as unforeseen circumstances that affect the equilibrium of the contract;
- English law recognizes the concept of frustration, under which obligations under a contract may be discharged when circumstances render them physically or commercially impossible to fulfil, or transform the obligation to perform into a radically different obligation from that undertaken at the moment of the entry into the contract;
- New York law contains similar concepts—namely, the doctrines of impossibility and frustration of purpose. The former excuses a party’s performance in circumstances where an unforeseen event has destroyed the subject matter of the contract or the means of performance, making performance objectively impossible. Frustration of purpose under New York law occurs where a contracting party’s performance, although still possible, will no longer provide it with the benefit it bargained for when concluding the contract. The standard for proving frustration of purpose is high: the triggering event must be unforeseeable and the loss of benefit must strip the contract of value for the affected party; and
- Texas law, while similar to New York law, contains a slightly different concept referred to interchangeably by Texas courts as “impossibility of performance,” “commercial impracticability,” and/or “frustration of purpose.” If performance is made impracticable without fault by the occurrence of an event, the non-occurrence of which was a basic assumption on which the contract was made, the duty to render such performance is discharged unless the circumstances indicate otherwise. Texas courts apply this doctrine narrowly and usually in only one of three instances: (1) the death or incapacity of a person necessary for performance, (2) the destruction or deterioration of a thing necessary for performance, and (3) prevention by governmental regulation.
- Certain civil law jurisdictions (notably, Scandinavian jurisdictions) allow for a contract’s terms to be adjusted or set aside by a court or arbitral tribunal in circumstances where their application would lead to an unfair result.
The Oil Price Drop will also Generate Opportunities
Oil price volatility (or even a significant and sustained a drop in oil prices) will not spell doom and gloom for all. For example, economies that are net importers of oil might stand to benefit from cheaper oil prices. Similarly, the plunge of oil prices will also offer companies opportunities to acquire assets or distressed companies, and grow. For more on this topic, please see https://www.shearman.com/perspectives/2020/03/buying-assets-from-distressed-companies.
The situation presently unfolding thus sets the stage for new business opportunities and for new contracts to be executed.
The contracts prepared in the context of these transactions need to be well thought through, in particular with respect to long-term viability and dispute resolution. Very often, transactions are done quickly and, due to time pressure, parties tend not to pay enough attention to long-term protections or to effective dispute avoidance and resolution. For example, when drafting arbitration clauses, it is essential that an appropriate seat of the arbitration be chosen, as this will inform the procedural rules applicable in an arbitration and will come into play in determining which courts will review a potential award.
We have listed some key items to be checked in times of volatile oil prices. Our International Arbitration team is experienced in these issues and remains available to discuss them with you and answer specific questions you may have.