Stabilisation clauses: helping international oil firms navigate price-related changes of law

Out-Law Analysis | 28 Jul 2015 | 11:34 am | 5 min. read

FOCUS: The oil price crashes of the 1970s led to a wave of nationalisation and changes to petroleum legislation by oil-producing states. Contractual stabilisation clauses could help international oil companies (IOCs) protect their interests should the same occur again.

Petroleum contracts are inherently susceptible to imposed changes to the terms of the deal – whether as a reaction to fluctuation in the price of oil or gas, a policy shift upon a change of government or a state's desire to exercise its sovereignty over natural resources and improve its financial returns. Stabilisation clauses give IOCs a means to mitigate or manage these risks.

Although analysts do not expect reactions to the 2014-15 crash in the price of crude oil to be as radical as those in 1973 and 1979, we have nevertheless seen governments reacting to the change of environment by asking IOCs to accept greater risk sharing, albeit with limited success. In Iraq, for example, the Iraqi federal government issued a formal letter in February 2015 to IOCs operating in Iraq, requesting that IOCs "freeze or reduce new spending on developments" and "suggest modifications to their petroleum contracts", noting that "plans drawn up in the '$100 world' are no longer viable in a '$50 or less world'".

Stabilisation clauses can be an effective tool to improve an IOC's negotiating position when dealing with a change in law affecting the terms of an upstream petroleum contract. It is important to have the right approach to negotiating stabilisation clauses to achieve a mutually beneficial position for the IOC and the host state.

Assessing your position

An IOC's bargaining position will depend on a variety of factors; commercial, political and legal. Indeed, a savvy negotiator will balance these carefully while conducting negotiations.

From a legal standpoint, the underlying terms of the petroleum contract will be crucial to determining the legal position of the state and the IOC, and will therefore impact on negotiation strategy. In particular, the negotiator will need to consider whether the contract includes a stabilisation clause and, more crucially, what that clause provides for and how it purports to protect the parties to the contract.

This analysis will be important at the early stages of a project when the parties are negotiating the terms of the petroleum contract, as well as in circumstances where the petroleum contract has already been executed.

Types of stabilisation clause

In order to conduct an analysis of a stabilisation clause and assess its impact on a party's bargaining position, it will be necessary to determine what category of stabilisation clause the text falls under and what objectives it seeks to achieve.

Freezing clauses

Historically, this has been the most common form of stabilisation clause. This type of clause seeks to stabilise the effects of a change in law by effectively freezing the laws of the host state which were in force on the date that the contract came into effect, and to therefore shield the IOC from any changes in legislation occurring after this date.

Variations of this type of clause have been negotiated over the years and, as a result, a distinction can generally be made between two types of freezing clause:

  • full freezing clauses, which seek to freeze all the laws of the host jurisdiction as at the date the petroleum contract was signed. Arguably this type of clause is the most controversial, as it is often criticised as an attempt by an IOC to limit the host state's exercise of its sovereign power to amend and update its laws. The effectiveness of full freezing clauses is often limited due to issues of implementation and enforceability;
  • limited freezing clauses, which seek to achieve stabilisation through a partial freeze of legislation. This is usually done in one of three ways: by identifying specific laws or legal areas, such as tax laws, to be frozen; by identifying areas which are not included in the freezing clause; or by defining a remedy in the event of a breach by the host state - which is usually damages.

Economic equilibrium clauses

This type of clause seeks to re-establish the economic position of the contract following changes in law which have an economic impact on the bargain struck between the IOC and the host state. To stabilise the investment, the parties agree that when a specified trigger event occurs, certain 'balancing provisions' will come into force which seek to put the parties back in the economic position they were in at the effective date of the contract.

There are a number of approaches that can be adopted to achieve this objective once a trigger event occurs:

  • automatic stabilisation, where the clause automatically adjusts the contract when the host state introduces a measure which is prejudicial to the IOC. However, this may be difficult to negotiate with the host state and potentially reduces the parties' flexibility to achieve a nuanced or tailored stabilisation measure;
  • open-ended stabilisation, based on the parties mutually agreeing to reach an outcome which stabilises the bargain without specifying either the specific measures required or a definitive deadline for implementing these measures. This approach is sometimes adopted as a compromise when the parties are unable to negotiate a form of stabilisation clause but agree on the principle of its inclusion in the contract;
  • achieving equilibrium through negotiation by committing the parties to a process of negotiation with the ultimate aim of restoring the economic equilibrium of the contract. This third approach generally provides for a fall-back position of third party determination, such as arbitration, in the event that the parties are unable to agree on the stabilisation measures to be adopted.

Of the three approaches outlined above, the third approach based on negotiation is the most effective. The clause will usually include the following elements:

  • The trigger event, which can either be widely defined (for example, 'any change in law') or narrowly defined (for example, 'any change in tax law'). A wider definition may appear to give most comfort to the IOC but may be difficult to prove unless the triggering event is set out in detail. Alternatively, or in addition, reference could be made to a specified result as the trigger event for the clause (for example, 'an adverse economic impact' on the IOC);
  • Outcome of the negotiation process, which will usually be specified as putting the parties in the economic position they would have been in had the trigger event not occurred. This can be achieved through varying the contract, compensating the IOC or shifting the burden of performance of any additional obligations upon the host state;
  • Renegotiation procedure, including the contractual provisions for notification of the trigger event and the procedure(s) governing the negotiation process. A deadline for completion of the negotiation process might be imposed, with reference to a reasonable period of time after which either party may escalate the matter under terms specified in the clause;
  • Binding third party determination provisions in the event that the parties have been unable to reach agreement on the outcome of the negotiations.

Hybrid clauses

These clauses seek to combine the unambiguous nature of freezing clauses with provisions commonly found in economic equilibrium clauses. This type of clause reflects the recognition that freezing clauses may prove difficult to enforce without the inclusion of more collegiate-type provisions based on negotiation.

IOCs must be aware of the practical and legal issues attaching to each type of clause. For reasons of implementation and enforcement ,which we will consider in a separate article, the best position for an IOC may not be a full or limited freezing clause. An IOC might therefore consider an economic equilibrium clause, which seeks to realign the parties' financial positions and share risk in accordance with the new circumstances.

George Booth , Niazi Kabalan and Leo Shaw are experts in international oil and gas projects at Pinsent Masons, the law firm behind Out-Law.com.