This provision is inevitably controversial because it provides for the parties not simply to overlift crude oil that may have been scheduled to be lifted by one party, but for the parties to take a party’s entitlement and sell it.
The Sale of Underlifted Entitlement conditions should be different from the Lifting Agreement which provides for the operator (or ‘responsible entity’) to take and sell the defaulting party’s entitlement instead. In one sense, this condition is more realistic in expecting other parties to intervene because the operator is unlikely to have the transportation resources and access to markets to enable it to lift a cargo or crude oil parcel ‘at the drop of a hat’ unless of course, the operator is a party in its own right with its own entitlement to lift.
Furthermore, the operator’s accounting and tax systems may be set up to manage upstream operations, exclusively upstream of the delivery point, on a ‘no profit no loss’ basis. Conducting crude oil sales beyond the delivery point and outside of the jurisdiction of its normal operations will be a headache for the operator.
The provision is activated when the party fails to nominate to lift its entitlement, usually well in advance of the scheduled lifting dates, giving the other parties sufficient time to take and sell the entitlement in its place.
The provision also applies when a party fails to take delivery of its entitlement even in circumstances when it has nominated to do so. This leaves the other parties substantially less time in which to step in. It may be possible to charter in another marine tanker or rail tank car train, but most trunk oil pipelines do not have the flexibility to enable a party to ship an extra parcel of crude oil on such short notice. This agreed condition would oblige the operator to give the other parties as much notice as possible, but the condition does not explain what happens if several parties wish to exercise the right of sale.
Many lifting agreements have provisions which allocate a defaulting party’s entitlement pro-rata between parties wishing to take and sell it; this may not be the optimal solution when the key objective is to ensure that production is not curtailed. The better solution may be to allocate the task of taking and selling the defaulting party’s entitlement to the party which can demonstrate a reliable ability to lift as much as possible of the entitlement as soon as possible.
Another potential weakness of this condition is that the right of sale is only triggered when it can be shown that the failure to lift breaches operator’s or such party’s obligations under the contract or threatens to cause curtailment of production. Most likely the relevant failure to lift is caused by an event of force majeure, and the need to prove a breach of the host government agreement is unnecessarily burdensome.
The key objective is to prevent curtailment of production which should be easier to demonstrate, but the defaulting party may always raise the argument that its failure is temporary and best addressed by ordinary underlifting/overlifting procedures. The right of sale is only likely to arise and be implemented as a last resort when overlifting by other parties is not possible. If overlifting by the parties is not possible, it is unlikely that other parties can take and sell the entitlement at short notice either.
This feature purports to apply only ‘to the limited extent necessary to avoid disruptions in joint operations’; in reality, such disruptions are likely to be addressed in the short term by underlifting and overlifting, with the right of sale being used to allow the parties to replace a defaulting party for several months before its ability to lift can be restored (Fowler 2018).
From the defaulting party’s perspective, the consequences of the sale of underlifted entitlement conditions are more serious than a simple underlift; the defaulting party will not be compensated at a later date by the opportunity to overlift production in order to bring its liftings back into balance with its entitlements. The implication of the last sentence is that the defaulting party may be entitled to the balance of proceeds from the sale of its entitlement, less transportation and marketing costs, and usually an administration fee. Unless the lifting agreement so provides, the defaulting party may argue that the provision will operate as a ‘penalty’ under the law and may be subject to judicial challenge.
Finally, it will be important to review the contract to establish whether there is flexibility for the parties to lift and sell each other’s entitlements in this way without triggering an argument that the parties have unlawfully transferred interests under the contract between themselves without the state’s consent. There are likely to be tax implications in any event.
Further, the condition does not make it clear, and the lifting agreement should clarify, whether the lifting parties take title to the defaulting party’s entitlement, or actually sell the defaulting party’s entitlement on its behalf; if the latter is the case, the lifting agreement should provide for each party to put in place a power of attorney in favour of the other parties empowering the latter to sell the entitlement when the relevant conditions arise.
In many ways, an alternative would provide a sensible set of starting principles for a lifting agreement. Unfortunately, these conditions seek to explain and describe issues to be addressed in that lifting agreement without any specific provision which explains how the lifting agreement will operate in practice. Thus, the investing parties should elaborate the principles to the point where they are operational in the event that no fully termed lifting agreement has been agreed by the date of first oil. Indeed, the parties will need production forecasts at least six months ahead of first oil.
Alternative #1
- The parties shall in good faith, and not fewer than six (6) months before the anticipated first delivery of crude oil, as promptly notified by the operator, negotiate and endeavour to conclude the terms of a lifting agreement to cover the offtake of crude oil produced under the contract.
The condition recognizes the need for the parties to agree a lifting agreement before first delivery of crude oil and obliges the parties to commence negotiating it six months beforehand. it provides no guidance as to the starting principles for negotiations.
This alternative is the ‘counsel of despair’ in the sense that it provides no guidance as to the format of the lifting agreement and assumes the parties will successfully negotiate it ‘from scratch’ inside six months – in fact, prudently, the lifting agreement should come into force at least three months before first oil so that the first month of lifting can be properly scheduled by the operator.
Significantly, the conditions here do not provide that the parties will nonetheless lift their respective entitlements in accordance with agreed terms of the Right and Obligation to Take In-Kind if they fail to agree a lifting agreement in time for first oil. This may be realistic; unless the parties expect to deliver crude oil into a single pipeline in which they all have adequate capacity rights, it is highly unlikely that the parties will be comfortable to proceed until the lifting agreement is agreed.
However, there is room for potential dispute here, if some parties are ready to lift absent a lifting agreement, and other parties are holding out for specific terms to be agreed under the lifting agreement. If this alternative is used, the investing parties should sensibly specify whether the obligation to lift will apply regardless of whether the lifting agreement has been agreed.
