Oilfield Cost Overruns [PART 1]: Are investors protected from exposure to operator cost overruns?

Introduction

Once the structural considerations, such as appointing an operator and a well services company to execute the operations, have been dealt with then the plans can be put into action. The operator presents budgets and operational plans to the investor group, the investor group approves the funds and the operator proceeds to spend the funding in the agreed manner (including paying the well services company).

However, oil is a risky business and plans don’t always play out smoothly. It is not uncommon for the cost of operations to become more expensive as they are being conducted. In these instances the questions becomes, who is responsible for the increased costs? The well services company? The operator? The investor group?

Is the investor group liable for operator cost overruns?

An important dynamic to address is the relationship between the operator and the non-operators, particularly as far as exceeding the Authorization For Expenditure (AFE) is concerned. The core of the relationship is governed by the ‘no loss, no gain’ principle of operatorship, which dictates that the investor group will absorb any expenses the operator faces and the operator must equally distribute any additional earnings. The operator takes no loss and makes no gain from operatorship.

However, it is important to consider that the reason the AFE exists, which is to ensure that the operations can be conducted in a calculated fashion and so that expenditure can be controlled. This minimizes financial risk to the investor group. As a result, no investor wants to be liable for operator expenditure that exceeds the agreed amount.

The answer lies in the court decisions of the busiest oil jurisdictions: The U.S. and the U.K.

In the US, M&T, Inc. V Fuel Res. Dev. Co. held non-operators under a JOA responsible for their share of cost overruns, even in cases where the cost of drilling was nearly twice the budget. The rationale being that AFE's are estimates and that there are inherent risks in drilling ventures that industry experts are aware of; further adding that the industry would not function if forced to act within the exact calculations of a budget[1].

Non-operators can successfully challenge the liability for overruns, but only if the operator has incurred them in bad faith or if expenses are clearly excessive, unreasonable or unauthorised by the AFE[2].

In the UK, Spirit Energy Resources Ltd & Ors v Marathon Oil[3]  holds true to the same principles. Lord Justice Green states there is “no identifiable logic whereby the participants can take the benefit of operations without incurring the risks” as justification for non-operators paying their share of the larger than expected employee expenses of the operator.

In summary, the other investors cannot be protected from the good faith cost overruns of the operator and thus any protection against cost overruns must be clearly addressed by the operator in the well service contract.

To see how exactly an operator would endeavour to ensure that it doesn’t take on liability for cost increases, you may want to read my follow up article: “Oilfield Cost Overruns [PART 2]: How do operators protect from exposure to oilfield service company cost overruns? A look at the 2002 AIPN Model Well Services Contract”

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About the Author

Zach Kauraisa holds an LLM in International Oil and Gas Law and Policy from the Centre for Energy, Petroleum, Mineral Law and Policy. He is currently a Candidate Attorney at Koep & Partners in Windhoek Namibia. For inquiries, email: [email protected]

References

[1] M&T, Inc. V Fuel Res. Dev. Co. 518 F. Supp. 285 (D.C. Colo. 1981). As cited in Martin,T. Giblert, J. Martin, G. A Global Review of Joint Operating Agreement Disputes. ( Texas, U.S. AIPN. 2020).

[1] Parejo Ltd. 1981 v. Getty Oil Co CV F-85 – 150, CV F-85-217, 1991 WL 260436 (E.D. CAL.May 28, 1991)

[2] Martin,T. Giblert, J. Martin, G. A Global Review of Joint Operating Agreement Disputes. ( Texas, U.S. AIPN. 2020). Pg 36.

[3] Spirit Energy Resources Ltd & Ors v Marathon Oil UK LLC [2019] EWCA Civ 11. Available at https://www.lexology.com/library/detail.aspx?g=281e9a3e-76a8-43b4-bb47-64ece8673724#:~:text=In%20a%20recent%20decision%2C%20Spirit,employees%20engaged%20in%20joint%20operations. (last accessed 08/08/2020)