Crude Price Volatility and Energy Arbitrations
Drill, baby, drill? Not for the foreseeable future
The 2008 US Republican Presidential campaign was accompanied by the slogan “Drill, baby, drill!” In the summer of 2008, WTI (West Texas Intermediate) pricing stood at $165 a barrel. The slogan made sense: drilling for oil and gas creates huge numbers of jobs and many projects are undertaken on a scale it is almost impossible to comprehend. In the ultra deep water of the Gulf of Mexico, the subsea development in the Cascade and Chinook fields has the deepest production risers in the world. These free-standing hybrid risers are each over 2000 metres in height from the sea floor. To put this in context, the Burg Khalifa, currently the tallest building in the world, stands at a height of 828 metres. One of the largest oil platforms in the world, the Olympus Mars B, is also located in the Gulf of Mexico. It weighs 120,000 tons, the equivalent of more than 300 Boeing 747s. It is taller and has more floor area than the Superdome in New Orleans. Just as the scale of these projects is almost incomprehensible, so is the cost: the Olympus Mars B is estimated to have cost in the region of $12 billion. High crude prices encouraged oil and gas companies to undertake these mega projects and also to pursue unconventionals in order to increase production.
High crude naturally has an impact on demand, of course. Living in Houston in 2008 I saw at first hand the effect that higher prices at the pump had on consumers that summer. In 2008, however, people were not driving because prices were high. Now people are not driving, planes are not flying and prices are rock bottom. In the oil and gas industry we are seeing both low prices and low demand. This is new.
The Covid-19 global pandemic has shaken supply and pricing expectations, and it has also meant that demand has cratered. This is highly unusual in the oil and gas industry, where demand has historically been relatively stable. Until now it has generally been fluctuations in supply that have created the market dynamics.
At the end of April WTI fell to minus $37 a barrel, the first time in history that oil producers were paying buyers to take oil off their hands. (This was due to a technicality of the global oil market, because oil is traded on its future price and the May futures contracts were expiring so traders were desperate to offload their holdings to avoid having to take physical delivery of the oil and incur storage costs). Today, WTI is at $20 a barrel. The US dynamics are of course different from the UK dynamics, but Brent is similarly affected with prices currently around $26 a barrel. OPEC members and its allies recently struck a record deal – the largest cut in oil production ever - to reduce global output by about 10%. The general view, however, is that this cut will not be enough to restablise the global oil market until demand returns. Oil and gas production companies find themselves in the position that, for almost the first time, they have to worry about demand in a very low price environment. And there is a real risk that demand does not revert to pre-pandemic levels for a long time.
The likely effects on energy disputes
So, what does this all mean for disputes in the energy sector? In a nutshell:
contracts will be terminated and parties will arbitrate the question whether they were validly terminated (largely, I suspect on the basis of force majeure clause, and/or the doctrine of frustration or economic hardship, to the extent it is recognized by the law of the contract);
price review mechanisms will be triggered and parties will arbitrate whether the contractual price review mechanism was properly complied with.
In the best cases, parties will be able to renegotiate terms to avoid a dispute, but the long term nature and high stakes of most energy supply contracts means that this will be hard to achieve.
Force Majeure, frustration and economic hardship
LNG SPAs will usually include a force majeure provision which will seek to justify non-performance of the contract if an event beyond the parties’ control occurs. In extreme circumstances the clause may permit a party to terminate the agreement if the event continues. Whether or not the global pandemic can be invoked as a force majeure event is something that will be arbitrated and litigated in many different fora in the future. Its application will be a question of interpretation of the relevant contract under the relevant governing law. Similarly the doctrines of frustration and economic hardship may or may not be available to the parties depending on the governing law of the agreement.
Price review mechanisms
I chaired a major arbitration over a pricing review clause a few years ago and, reflecting on the case recently, it struck me how different the effect of the decision would have been had WTI been at the levels we saw in last month. Yet although prices have plummeted this will not necessarily trigger a price review, again, it will depend on the provisions of the agreement. Long term supply contracts generally provide for price reviews at certain intervals and they tend not to be triggered by one off events. If any price review is triggered, it is important to establish whether the divergence between the contract and the market price justifies a review. It will be fascinating to see whether the pandemic has caused a temporary price shock (in the short or medium term) or whether crude prices are going to remain depressed for the long term.
The oil and gas industry has always seen boom and bust prices so the vascillation in the price of crude is far from new. Yet, somehow, like almost everything at the moment, things feel a little different this time. There are challenging times ahead for everyone involved in the oil and gas industry. Energy arbitrators must be equally ready to adapt and to rise to the challenge.
