Out-Law Analysis 5 min. read

Oil and gas contractors can build compensation case for cost rises

Contractors involved in the construction of new liquid natural gas (LNG) and oil infrastructure in the Middle East should consider how they can avoid being left to carry substantial cost increases that have arisen as a consequence of recent global events.

Several new projects in the Middle East, including for example Qatar’s North Field Expansion project and the expansion of Jubail Industrial City in Saudi Arabia, have been launched at a time when global events are having a significant economic impact. In particular, the timing of the invasion of Ukraine by Russia happening shortly after the Covid-19 pandemic, has led to sharp rises in inflation coupled with price escalation across the supply chain and practical disruption of the flow of goods.

The Middle East is seeing a trend whereby contractors’ commercial bids – typically built on a fixed ‘lump sum’ model – are quickly turning out to be unviable, as the consequences of these global events are resulting in the cost of delivery rising sharply. Contractors are now having to deal with increased costs to materials, equipment, plant and machinery, as well as revised shipping and freight charges. Other cost increases have arisen due to transportation disruptions resulting from these events, such as a shortage of shipping containers and lower availability of warehouse space. We have also heard of certain shipments to Middle Eastern ports being pulled back because of delays in shipping and congestion.

Pamela McDonald

Pamela McDonald

Partner, Head of Office, Doha, Co-head of International Arbitration

For contractors on ‘fixed price lump sum’ contracts, the value of change, the cost of delays, and the interpretation of price escalation clauses can be the cause of disputes

The issues the Middle Eastern contractors are experiencing reflect wider recent study findings.

A Reuters and JLL survey of more than 170 supply chain managers published earlier this year found inflation is the dominant the concern in Europe, the Middle East and Africa. According to the study, a significant amount of that inflationary pressure is a direct result of the conflict in Ukraine, as well as supply issues increasing energy and fuel costs, labour shortages, input material inflation and instability among suppliers.

In the oil and gas sector specifically, S&P Global Commodity Insights reported that the cost of upstream O&G assets increased by 1.8% in the third quarter of 2022 and that the Ukraine invasion will keep O&G prices elevated throughout most of 2023, which will add to supply chain disruption and mean project costs and building material prices continue to rise.

In addition, the London Court of International Arbitration, a popular arbitral institution, reported an increase in disputes arising from transport and commodities, from 14% of its total caseload in 2021 to 37% of its total caseload for 2022, and further cited “the fluctuation in energy prices impacted by the war in Ukraine” as a reason for that. Those findings chime with those from Pinsent Masons’ own study on the future of international energy arbitration, undertaken in collaboration with the Queen Mary University of London last year, where the volatile price of raw materials and energy supply were predicted to be the primary cause of disputes in the energy sector over the next five years.

To combat rising costs increases, businesses are increasingly responding by innovating – using technology to help them understand and anticipate supply chain disruption. Examples include the use of supply chain monitoring solutions, forecasting technology, process automation, and analytics. Other efforts are focused on cutting energy use – by optimising transport networks, moving warehouses closer, and refurbishing assets to improve energy efficiency.

However, for contractors on ‘fixed price lump sum’ contracts, the value of change, the cost of delays, and the interpretation of price escalation clauses can be the cause of disputes.

One issue for contractors across the Middle East is that their contracts for delivering the projects are typically heavily weighted against them. Specifically, there are often a lack of contractual remedies to account for the significant and unexpected costs they have experienced since entering the contracts.

However, since these contracts are ‘administrative’ contracts, issued by quasi-governmental bodies and for a public benefit, with onerous conditions, contractors do have potential rights to remedies as a matter of public law. Pursuant to public law principles, relief may be granted if the circumstances of a situation change, such that performance of the contract becomes excessively burdensome for one party. This is sometimes referred to as ‘economic hardship’, or in the French public law system from which it originates “théorie de l’imprévision”, which translated literally means ‘theory of unpredictability’. The logic behind it is that enforceability of a contract is always subject to the continued existence of the circumstances which prevailed at the time of contracting and which formed the basis of the contracting parties’ bargain. The consequence if those circumstances change is an exception to the fundamental principle of freedom of contract.

Helpfully, the principle is codified in many Middle Eastern civil codes. For example, it appears in Article 171.2 of Qatar’s Civil Code and Article 249 of the UAE Civil Code. This means that if an unforeseen event arises, which causes the contractor significant loss, then there should be an intervention to rebalance the contract and that intervention is necessary because of the overriding principle of good faith which applies to the contract.

Dr Abdel Razzaq Al Sanhouri, an eminent jurist and draftsman of the Egyptian Civil Code upon which several Middle Eastern Civil Codes are based, has written about the principle and cited ‘war’ as an event that gives rise to entitlement.

He said: “The first World War was the incident which the French courts accepted to consider in the very well know case Bordeaux City. In the said case it has been evidenced that a company was obligated to import gas to the city at a certain price, then the gas price increased after the war had been initiated from 28 French Frank for one ton in 1913 to 73 French Frank in 1915. When the said case was raised to the French court, the court decided to amend the contract in a way that is reasonable with the new price. The said judgment has been followed by other judgments from the administrative courts’’.

Parallels can be drawn to the economic consequences being observed as a result of Russia’s invasion of Ukraine.

In Qatar, the principle has been explored by lawyers several times over the past decade, first as a result of the political blockade, then as a result of Covid-19, and more recently as a result of the Ukraine war. Following the pandemic, many contractors in Qatar successfully recovered compensation under this principle because the government of the state of Qatar justly acknowledged entitlement on the grounds that Covid-19 was an unforeseen event and those contractors engaged on administrative contracts should be compensated for the additional costs incurred as a result. The process of recovering such compensation was, and continues to be, managed by the Public Works Authority, Ashghal.

The Ukraine war and the effects of it constitute a different event scenario to Covid-19, and the oil and gas industry must now consider the extent to which the war itself, and the economic consequences of it, were foreseeable at the time the contract was let – and whether the impact on the specific contract constitutes grounds for recovery such that it entitles the contractor to compensation.

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