Sovereignty and Petroleum

Harry W. Sullivan, Jr.

International Energy Attorney

Plano, Texas, U.S.A.

June 25, 2015

Foundations of a Petroleum

Contracting System

• Constitution

• Petroleum Law

• Petroleum Regulations

• Petroleum Contracts

Typical Constitutional Provisions Relating to

Petroleum

• Constitutional provisions may have an important impact on how

petroleum resources are developed, and whether capital is

available.

• Most national constitutions make mineral resources state property.

– USA is an exception.

• Some constitutions go further and require that petroleum exploration

and development be performed by a state company; e.g., pre-2014

Mexico.

• Some go even further, reserving the revenues from

minerals to the state (ie. Kuwait)

3

Iraq Constitution

Article 111: Oil and gas are owned by all the people of Iraq in all the regions and governorates.

4

People’s Republic of China Constitution

Article 9: All mineral resources …are owned by the state, that is, by the whole people …

UN Recognizes State Ownership

• UN General Assembly Resolution 626 (1952); 1803

(1962); 2158 (1966); 3281 (1974); 61/295 (2007)

– Nation States enjoys full and permanent sovereignty over its natural resources

– Expropriations are lawful

• Limitations – “Public purpose” (“formality” largely left to HG) – “Non-discriminatory” – “Due process of law” – Compensation is paid – “Non-retaliatory” (relatively recent suggested

limit) – Not contrary to investment contract obligation

Ownership and Control

• In the beginning . . . the sovereign owns minerals.

– Can keep them or transfer them to private ownership.

– Can develop minerals itself.

• by a national oil company (“NOC”)

• by contracting with private companies (“IOCs”)

• By some combination.

6

Why Did the Host Governments (HGs)

Look to IOCs?

• They were there

• HGs needed cash

• HGs lacked capital

• HGs lacked financial muscle

• HGs lacked technical expertise

• Internal Politics

7

HOST COUNTRY CONCERNS

ABOUT WORKING WITH IOCs

• Economics

• Reliability

• Social costs

– Cultural

– Environmental

• Political costs

8

Techniques to Address Host Country

Concerns

• Limit participation.

– % of control

– Type of enterprise

• Host participation in management.

– State company/nationals as managers.

• Segregation.

• Direct regulation.

– Laws/rules/regs.

– Domestic subsidiaries.

9

Why Do Nations Look to IOCs in the 21st

Century?

• IOCs are used to Risks of Oil and Gas

• IOCs have superior technology.

• IOCs have experience using/knowing when to use

technology.

• Access to capital still a factor, but high oil prices [if

present] diminish its importance for some NOCs.

10

What Do IOCs Want?

• Access to equity

– “book” reserves; Algeria, Libya.

• Acceptable rate of return

• Incentives for enhanced recovery

• Minimization of risks

• Clear and Stable Investment Environment

• Opportunity for repeat investments

11

Life Is Harder for IOCs in the 21st

Century

• High prices

– NOCs able to fund developments themselves.

• Resource nationalism

– Venezuela, Bolivia, Russia, Chad

• Increased competition, both upstream and downstream.

– Government to Government

• China, India

– NOCs becoming “internationalized” and “integrated.” Have moved from resource holders to competitors.

12

Increasingly Hard for IOCs to get

Equity Access

• Only about 20% of world reserves in countries without NOCs.

• 80% of world reserves in countries with NOCs.

• 58% of world reserves held by NOCs in states where IOCs can

get only service contracts or technical service contracts.

13

National Oil Companies

• Over 100 NOCs

• Control 75-85% of world’s oil reserves and 75% of oil production

• Similar figures for gas

• 25 of the world’s top 50 oil companies are NOCs

• Significant political, social, fiscal and developmental impact

14

15

Why Do Countries Use a National Oil Company?

• Their markets or other infrastructure were undeveloped;

sought development.

• Economic emancipation.

• Politics

• Nationalism

• Opportunities for corruption???

16

Not All NOCs Are the Same

• Some are wholly government-owned and have upstream

monopolies; e.g., Saudi Aramco, Pemex

• Some are wholly government-owned but have upstream

competition; e.g., Ecopetrol [Colombia].

• Some are partly-privatized and shares are publically

traded; e.g., PetroBras, CNOC.

• Some are domestic only and others have international

operations.

17

But all NOCs are different from IOCs:

Objectives

IOCs

• Commercial goals dominate: maximize return on equity.

• Corporate social responsibility goals playing a greater role. Question whether they can execute?

NOCs

• Effective development of nation’s oil and gas.

• Support the nation’s social/economic development.

• Politics.

18

Why Do NOCs Continue?

• Assertion of national sovereignty

• Protect the national interest

– Oversee a strategic industry, implement government policies, control reserves

• Develop the national economy

– Educate and employ population, attract investment, acquire technology and expertise.

• Guarantee supply

• Attract and manage foreign investment

19

Recognize the Tensions

• NOC/IOC:

– NOCs’ “culture” recognizes duty to the nation, not just the bottom line.

• More than just a concern with sovereignty; want to manage reservoirs to maximize them long term.

– IOCs’ focused on the market and the short term.

– Danger: may become a self-fulfilling prophecy.

• NOC/Government: Governments’ need for cash may send

them to IOCs or impoverish the NOC.

20

A Modern Industry Structure

Agency Role/Responsibility

Sector Ministry • Policy

• Legislation

• Licensing

• NOC oversight

Regulatory Agency • Technical/HSE oversight

• Information/analysis

Private Sector/NOC • Commercial operations 21

DIFFERENCES BETWEEN PRIVATE

AND STATE CONTRACTS

* FORMATION

* LEGAL INTERPRETATION

* SPECIAL LEGAL CONCEPTS

* REGULATORY POWER

* FINANCIAL EQUATION

* IMPREVISION

* WHERE DOES AN 800 LB. GORILLA SIT?

22

PACTA SUNT SERVANDA

PARTIES MUST RESPECT THEIR AGREEMENTS

(EVEN SOVEREIGNS).

* BUT A SOVEREIGN HAS THE RIGHT AND

(MAYBE) THE DUTY TO ACT TO CHANGE

AGREEMENTS THAT TURN OUT TO BE NOT IN

THE PUBLIC INTEREST.

23

Police Power v. Indirect Expropriation

• In deciding whether Host Government has gone beyond its

legitimate police power, tribunals will look at substance

over form

– Sole-effect doctrine:

• Has IOC lost substantial control or value?

• Has IOC lost its long-term expectations?

• Has Host Government breached the “fair and equitable treatment” principle?

• Did Host Government act with proper proportion in light of its legitimate police-power objectives?

Compensation Standards International Law (comparatively recent):

• “Appropriate,”“fair,” or “just” compensation

– Suggested in UN Resolutions and to be decided exclusively by expropriating state!

• “Equitable” (Kuwait v. Aminoil)

• “Effective” (hard currency)

• “Prompt, adequate, and effective” (“just”)—US standard, found in BITs and Iran

Commission treaty

• “Full reparation…in the form of restitution, compensation, and satisfaction”—UN

International Law Commission

• BITs (varied requirements)

• Tricky issues for “creeping expropriation” claims:

– When did liability arise?

– As of what time should the taking be valued?

BITs & Regional Trade Agreements

• Generally the most effective protection against confiscation

(expropriation without compensation)

• BITs typically address:

– Expropriation protection

• Conditions for expropriation

• Assurances of adequate and effective compensation

– Fair and equitable treatment

– Non-arbitrary and non-discriminatory treatment

– National treatment (no less favorable treatment than nationals)

– Most-Favored-Nation treatment

– Full protection and security

– Umbrella clause (contract claims become treaty claims)

– Transfers of funds assurances

– Dispute resolution

27

Business Planning: Secure BIT Benefits

Through Parent-Affiliate Ownership Chain

• Companies may be able to structure their corporate

ownership chains to obtain BIT protection

• Identify and carefully review BITs of Host Government

– Review BIT definitions of “investment” or “investor”

– Determine whether any provisions give Host Government special benefits

• Then structure investment so that it is owned by

affiliate(s) organized under the laws of a state that has

the most useful and suitable BIT with Host Government

28

Compare BITs and Contracts

• Treaties are governed by international law

• Contracts are governed by local (state) law

– Governing law and forum may be chosen by parties

• “As to the relation between breach of contract and

breach of treaty in the present case, … Articles 3 and 5

of the BIT [expropriation and fair & equitable treatment]

… set an independent standard. A state may breach a

treaty without breaching a contract, and vice versa . . .”

– Vivendi II (Annulment Decision) (2002)

Valuation of Just Compensation

• Net Book Value (favored by governments)

– Assets minus liabilities as carried on books (looks backward)

• Fair Market Value (immediately preceding the taking)

– Sales price between willing buyer and seller

– Timing for valuation is key in “creeping” cases

• Going-Concern Value (historically controversial)

– Net book value + goodwill + future profits (looks forward)

• Replacement Value

– Determined as of date of taking

• Discounted Cash Flow Value

– Rate of Return

• Legitimate Expectations Value

• Comparable value (uses proxies)

• Option value (alternative uses)

• Moral damages for violent expropriations (e.g., Lusitania)

• Specific performance

Alternative valuation profiles through typical project life

Moyes & Co.

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23

Va

lue

, U

S$

MM

Year

Net Cash Flow Capitalised at 10%

Net Profit Capitalised at 10%

Net Present Value at 10% Discount Rate

Replacement Cost

Net Book Value

Assessing damages in disputes requires a careful understanding

of the law because FMV and NPV/EPV are different

• FMV: a certain cash sum received in exchange for a risky future

cash flow, presumably and usually at a discount

• “Lost profits” or “loss of bargain” damages may be more

appropriately represented by NPV or EPV than FMV despite, for

example, typical BIT language, e.g.,

“Such compensation shall amount to the fair market value of the

investment expropriated immediately before the expropriation or

impending expropriation became known in such a way as to

affect the value of the investment (hereinafter referred to as the

“valuation date”).” – Article 4.2, Denmark-Algeria BIT

• FMV is determined by the circumstances of the market

• Seller value is determined by seller’s circumstances

Moyes & Co.

Forum for Determining Compensation

• Direct negotiations with taking country

– Usually between taking country and IOC

– Possibly between taking country and IOC’s home country on behalf of its investor group

• Local courts or arbitration in taking country

• International courts or international arbitration

– E.g., ICC or ICSID, ICJ etc.

• Foreign courts where taking country has assets

• Special Commissions

– E.g., US—Iran Claims Commission

Problems With Seeking Redress Against

Sovereign States

• Defenses:

– Sovereign immunity – Act of state doctrine – “Calvo” Doctrine

• Enforcement

Sovereign Immunity

• Host Governments are often immune from suit in their own courts.

• Host Governments are generally immune from suit in the courts of another state

– The Schooner Exchange 11 U.S. (7 Cranch) 116, 137 (1812).

– Restatement (Third) Law of Foreign Relations of the United States Pt IV Ch.5 (1986 main Vol.)).

– Sovereign immunity results in lack of jurisdiction

• Sovereign immunity runs to state, its subdivisions, agencies, and instrumentalities, e.g., state-owned companies, such as NOCs

Sovereign Immunity

• 20th Century: Sovereign Immunity has been qualified by treaty, custom, and international law

– Waivers of sovereign immunity by treaty or contract

– Illegal acts under international law (e.g., confiscations without due process and compensation)

– Growing “commercial-activity” exception

– UK and US governments began to carve out restrictions and exceptions to this general grant of immunity

• In US, this led to Foreign Sovereign Immunities Act of 1976 (FSIA) (Pub. L No 583, 90 STAT. 2892 (1976) 28 USC

§§ 1330, 1602 et. seq.)

Commercial Exception

• FSIA, 28 U.S.C. § 1605 lists exceptions, including a

“commercial activity” exception:

“A foreign state shall not be immune from the jurisdiction of

courts in the United States or of the States in any case … in

which the action is based upon a commercial activity carried on

in the United States by the foreign state; or upon an act

performed in the United States in connection with a commercial

activity of the foreign state elsewhere; or upon an act outside the

territory of the United States in connection with a commercial

activity of the foreign state elsewhere and that act causes a direct

effect in the United States….”

Voluntary Waivers

• FSIA, 28 U.S.C. § 1605 also recognizes that a State may waive its immunity expressly (e.g., by contract, law, or treaty) or implicitly (e.g., by failing to plead it as an affirmative defense).

• In Granting Instrument

• In applicable BIT

• In regional or other Treaty

Act of State Doctrine

• A state must respect the sovereignty of other states

– A court in State A will not sit in judgment of the Acts of State B that are confined to State B’s own territory

• Restatement (Third) of Foreign Relations Law § 443 :

“(1) In the absence of a treaty or other unambiguous agreement regarding controlling legal principles, courts in the United States will generally refrain from examining the validity of a taking by a foreign state of property within its own territory, or from sitting in judgment on other acts of a governmental character done by a foreign territory and applicable there.

(2) The doctrine set forth in Subsection (1) is subject to modification by act of Congress.”

• Rationale rests on principles of separation of powers, political question, and judicial abstention from foreign affairs

Act of State Doctrine

• Possible Exceptions:

– When State Department opposes application of doctrine

• But likely to be applied if State Department favors application

– When Host Goverment is engaged in “commercial” activity

– When BIT applies

– When there is a confiscation (expropriation without compensation)

– When Host Government expressly waives Act of State Doctrine

– When “motives,” not lawfulness of actions, of foreign government officials are at issue

• “Hickenlooper Amendment,” 22 USC § 2370(e)(2) (1988)) and U.S. Courts have limited this doctrine in expropriation cases but will generally defer to State Department recommendations on whether to exercise jurisdiction

Calvo Doctrine (1868)

• Largely a Latin American doctrine

– Advanced by Carlos Calvo, Argentine Legal Scholar

– Foreigners have same rights and privileges (meaning no more rights or privileges) as citizens of the state

• Thus, no right to arbitration with state (foreigners must use local courts)

• State may not waive its immunity where it would not do so for a national

• Foreign states acting on behalf of its own national cannot use diplomacy or force against a HG on behalf private claimants

– Fell out of favor in South & Latin America in 1990s but resurrected in early 2000s in some countries

Drago Doctrine (1902)–

– Luis Drago, Argentine Foreign Minister

– Foreign state cannot use military to enforce payment of public debt to Foreign state’s nationals.

Calvo Clause

• Specifies local forum (courts)

• Specifies local law

• Investor waives right to diplomatic protection and provides for automatic

forfeiture if diplomatic help is sought by investor

• Investor waives rights under international law

• Can be used in contracts between private parties

• But Panama Convention—ratified by some Latin American states,

recognized arbitration and enforcement of arbitral awards

Enforcement of Compensation Awards

• New York Convention (1958)

– http://www.uncitral.org/pdf/english/texts/arbitration/NY-

conv/XXII_1_e.pdf

• Panama Convention (1975)

– http://www.oas.org/juridico/english/treaties/b-35.htm

• ICSID (1966)

– https://icsid.worldbank.org/ICSID/StaticFiles/basicdoc/CRR_English-

final.pdf

• BITs

• Contract provisions

– But be wary of HG or HG entity’s authority to provide for enforcement

QUESTIONS????

Contact Information: Harry W. Sullivan, Jr. International Energy Attorney ph: +1-214-517-2438 E-mail: sullivanhw@aol.com