The era of petroleum arbitration mega cases: commentary on Occidental v. Ecuador, ICSID award, 2012.

Author:Garcia, Julian Cardenas
Position:International Centre for Settlement of Investment Disputes - II. Observations on the Award A. The Execution of an International Farmout Agreement through III. Conclusion, with footnotes, p. 564-588
  1. The Execution of an International Farmout Agreement.

    Literature on international farmout agreements is not abundant despite the fact that farmout agreements are in the heart of the petroleum upstream industry, at an important level, such as host government contracts or joint operation agreements. (125) The reason why farmouts are so relevant for the oil industry is because they allow a party carrying out exploration and production activities to diversify geological, financial and political risk with other companies in the sector. (126) In a transnational industry that cooperates world-wide in joint agreements for upstream operations assignments occur in day-to-day basis.

    As Talus et al. pointed out, "[u]nlike many other industries, the international oil industry has a long history of cooperation. While competition between large IOCs can be fierce in some areas, like the marketing of petroleum or the downstream operations, the exploration and production phase are marked by cooperation between competitors." (127)

    In the U.S. oil industry, a farmout exists as a common practice between private owners of rights. (128) As a country where oil ownership resides privately with persons, and not the state, this arrangement took its shape from practices obtained in that country's agriculture business long ago, where sharecroppers could earn a share in the proceeds from the farmer's crop by working on the farm. (129) This practice was translated to the petroleum industry and it has been recognized and performed internationally. (130) However, when government authorization is required, as it is in most cases dealing with hydrocarbon rights under the control of the State, bureaucracy and government policy priorities may play into the risk and performance of this operation by foreign investors. (131) Governmental approval may or may not occur. (132) For reasons of public policy the state is sovereign to choose its partners in strategic energy projects working in its territory, and this is also recognized by the oil industry. However, in performing international contracts submitted to international arbitration and also under the provisions of a BIT, the state has the duty to comply with international commitments regarding foreign investors.

    The international practice of farmout agreements also has looked alternatives to the performance of this practice. One of them has been the possibility of bifurcating the title, as was tried by Occidental in the present case. (133)

    This consists of executing a farmout agreement in two phases: (1) the earn-in phase; and (2) the transfer-of-title phase which occurs after the farmee has completed his obligations and government approval has been granted. (134) The Occidental case alerts us to be cautious in international operations because of issues that arise out of the bifurcation of title in farmout agreements. However, in standard situations where titles have not been transferred by contracts or "de facto", there is no possibility of liability in breaching contracts and national laws since privity never exists between the host government or the NOC, and the farmee maintaining the farmout operations as a financial transaction. (135).

    According to the Industry practice, the Association of International Petroleum Negotiators (AIPN) published a Model Farmout Contract in 2004 (currently in the process of being updated). (136) It represents the international practice of these transactions. (137) In the Model of Farmout Contract, the requirement of government approval is a fundamental element to conclude the transaction. It establishes that in the case of failure to receive government authorization, the farmor must compensate the farmee for his investment and the farmee has the right to terminate the contract. (138) This unilateral right of termination is a right granted to the farmee in order to protect his position in the worst scenario. The rule is inserted in a model contract from a specialized association in the petroleum industry which shows the generally accepted practice.

    Further, two kinds of farmout agreements can exist: (1) farmout agreements in which the farmee has to perform operations in the country; and (2) farmout agreements in which the farmee only provides capital for investment. (139) In the first case, it is important that the operation comply with the national law in relation to operations carried out in that territory, due to national security, safety and public policy issues inherent in hydrocarbons upstream activities. (140) In the second possible farmout operation, a financial transaction, the lack of contact with the host country allow parties to agree the submission of the operation to other applicable laws different than the laws of the host country. This operation even belongs more to a transnational legal order than a state legal order since, as it was expressed by expert Andrew Derman; it is the farmee acting as a bank. (141) However, transparency, good faith and respect for confidentiality clauses shall prevail between the partners to a host government contract because no government desires to ignore the origin of capital being invested in its territory, As pointed out Tim Martin, also expert in the case, "... many countries' legal systems (particularly civil law jurisdictions) make no distinction between a 'beneficial' interest and a 'legal' title. One has to look to various sources to determine the legal validity of this practice." (142)

    Assignment approaches in civil law countries have two different positions. The traditional approach considers the assignment as a transfer of rights and obligations of the contract (le contenu obligationel). The modern approach, currently accepted by the majority, considers the assignment as an operation that assigns the "quality of party" in a contractual relationship (position contractuel) or privity to a third party. Thus, in the first case, it is the transfer of rights and obligations version (cession de credits ou de debts), and in the second case it is the assignment of the contract version (cession de contrat). (143)

    On this point, the tribunal's discussion relied on the analysis of Articles 16.1 and 16.2 of the participation contract and Article 74 of the Hydrocarbons Law. (144)

    From the point of view of the analysis of sources of law, the tribunal did not consider whether Article 74 of the Hydrocarbons Law was in conflict with the practices of the international oil industry and the nature of the farmout agreement itself. This issue particularly called our attention since among the three main discussions of the award ((1) the performance of the farmout agreement, (2) the application of proportionality analysis, and (3) the method of calculation of compensation), only the analysis of the breach of the participation contract by the farmout agreement remained in an extensive discussion of municipal law and the "de facto" analysis thought document review without the balance of Ecuadorian regulation on assignment with international oil industry generally accepted practice or international law.

    In the other two topics there is a different approach and we can find reference to international arbitration jurisprudence and international courts decisions for the case of the proportionality analysis. Also in order to justify the application of the proportionality analysis the Tribunal determined that Occidental executives, despite incurred in a "de facto" transfer of title, they did not act in bad faith but as "seasoned oilmen" of the petroleum industry, adopting a sociological approach calling a practice that belongs to a specific sector. This argument causes a conflict between the foreign investor's wrongful acts under the contract and Ecuadorian law with an assumption of the arbitral tribunal that the investor did not act in bad faith and according the practice of "seasoned oilmen". This raises the question whether the tribunal is referring to a generally accepted practice in the oil industry, and if this is the case, the tribunal is putting into conflict state sources of law with a non-state source of law that has not yet identified as such. If this is the case the tribunal did not offer any clarity whether is referring whether the farmout agreement is a generally accepted practice? Or whether the earn-in-phase a generally accepted practice that Occidental failed to perform correctly? At this point we found in the analysis of the tribunal a lack of legal construction on what is the rule of law, extracted from a state legal order or from a transnational legal order of the petroleum sector to justify its perception. There is an analysis on the facts, over which the tribunal constructed the belief that Occidental acted as "seasoned oilmen", but, it still remains questions such as how this assumption is created when in 2004, both parties just finished an international dispute on the tax legislation and an anti-American environment dominated the political scene in Quito? Also, what would be the final decision if the tribunal, on the contrary, determined that Occidental acted in bad faith and the consequences of this on the proportionality analysis and the amount of compensation? The issue is discussed briefly in a paragraph, causing a big impact in the award but lacking of theoretical legal clarity.

    Further, deciding the calculation of damages the majority and even the dissenting opinion included reference to arbitral jurisprudence and discussed non-state sources of law such as the International Law Commission's Articles on Responsibility of States for Internationally Wrongful Acts. (145)

    The two different approaches discussed on the use of different sources of law show how to tackle the legal questions in transnational petroleum arbitration. We observed how discussing the farmout agreement the approach was very narrow in terms of legal construction and sources of law ignoring rich discussions on the legal nature of...

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