Impact of Stabilization Clause on Petroluem Agreements

Oil producing countries enter into investment contracts with foreign investors to improve the level of production of their oil fields due to lack of expertise and capital. Due to the nature of Petroleum agreements, the risk involved and the amount of funding required to carry out exploration and exploitation of a particular oil fields, foreign investors are extremely careful of investing. The degree of stability is important to foreign investor because the less stable an investor perceives a project to be the less interested it is to enter into a long term contract. In recent times host states include stabilization clauses to attract foreign investors. There is strong relationship between stability and equity of investments. Stabilization clause plays a role of strengthening the legal relationship between host state and foreign investors. The aim of this study is to examine how stabilization clause affects a state action in implementing new laws during the life of the project.

Petroleum is said to be one of the most significant article of trade in today’s market. In recent times, especially in developing countries ownership of the petroleum resources ultimately belongs to the state or national oil company [1] Usually petroleum agreements requires a huge some of capital and a long term agreements to proceed with exploitation and exploration of petroleum resources which leaves the investors to face the risk for a given period. At the same time with the volatile situation of oil prices, some investors realize that the investment would be unproductive after they have entered into the agreement. These factors and more can persuade the investor to seek adjustments to the agreement in reaction to political and environmental situations. Therefore the investors tries to circumvent the renegotiation of the agreement initially entered into because of succeeding changes to the laws of the host state.

Ultimately, investors have various means to tackle risk inherent in petroleum agreements for instance, distributing out the risk, risk management, insuring the risk and finally shielding the risk. The most common is shielding the risk whereby the investor uses political, economic and financial influence to daunt the host state from changing its existing laws. Stabilization and adaptation clauses are the major ways of sharing risk between parties to a long-term contract to ensure contractual stability. As a final point investors can therefore reduced its risk by including in its contracts clauses like international arbitration, choice of law, adaptation clause as well as stabilization clauses.

Stabilization clause, which is often called the stability clause are inserted in most petroleum and exploration contracts entered into by the host state who owns the resources and a foreign investor to avert any party from taking independent decisions to alter, abrogate or terminate the contract entered into by both parties. For example a production sharing contract between PERTAMINA and CONOCO provides:

‘This contract shall not be annulled, amended or modified in any respect except by the mutual consent in writing of the parties’ [2]

This paper mainly deals with risk management by way of inserting a stabilization clause in the petroleum agreement between a host state and an international oil company. Chapter 1 deals with the definition and scope of stabilization clause; chapter 2 also outlines and examines the different types of stabilization clause found in petroleum agreements. Thereafter this paper would give a short overview of the link between stabilization and adaptation clause, the effectiveness of stabilization clause, the doctrine of of pacta sunt servanda, the doctrine of rebus sic stantibus, the potential impact of stabilization clause and the formal and informal use of stabilization clauses.

Finally, I would examine the role of International arbitration in resolving disputes arising from stabilization clauses and the use of renegotiation in solving constraints from this so called freezing clause found in most petroleum agreements. This in a wide part would involve the role on ICSID In settlement of disputes arising from renegotiations of this contract.

SATBILIZATION- DEFINITION AND RATIONALE.

2:1 DEFINITION

There are numerous contractual agreements by which parties’ makes investments in the oil fields. The most popular methods are concession agreements, service contracts and production sharing contracts. The major concern in petroleum contract is the need to protect foreign investors from the hazard of the business. This raises the issue of whether the inclusion of stabilization clauses in the contract agreement in order to freeze the parties right and obligation is legal, and does not contradict the sovereignty of the host state.

For the purpose of this research paper, stabilization clause are those clause which are inserted in contracts between International Oil Companies (IOC) and Host States(HS) or the National Oil Company (NOC) that tackles the issue of change in law of the HS during the life time of the project. Stabilization clause is said to be a risk mitigation tools to protect the investor from various kind of risks such as political risk which is the risk that the laws of the host country would change to the detriment of the investor thereby reducing the value of the investment which would thereafter hinder their abilities to perform their proposed function which was initially agreed upon at the commencement of the project due to frequent change of laws and legislation of the HC. Not all petroleum agreements have this clause inserted but its common in long term investment. In recent agreements, stabilization clauses are used to avoid the risk of biased legislation from affecting investment [3]

By a stabilization clause, the state accepts that the existing and future laws would not affect the contractual terms agreed upon with the investor and retaining the sanity of contracts by protecting the investor from unaccepted actions by the HS, stabilization and adaptation clauses major aims is to maintain the initial contractual terms and condition as previously signed by both parties. This clause which protects the investor is what they French refers to as aléa de la souveraineté .The principal law of the contract is definitely the law in existence at the time the contract was executed therefore preventing the implementation of new laws to govern the transaction.

However, before a stabilization clause can be enforced in a petroleum agreement, the host state must have accepted the terms of the clause, the act of acceptance means that the host state has alienated its right to unilaterally change the management relied by investors. In recent research, most host state see stabilization clauses as means to attract investors and make available a constructive atmosphere for them to invest in petroleum exploitation and exploration with this intention they accept stabilization as a means to assure the investors of their loyalty. This paper would discuss situations where disputes arises between an investor and its host state over a petroleum agreement, the appropriate law that governs the validity of stabilization clauses is international law since it involves the national law of the host country and the lex mercatoria. It’s a rule in public international law that state should not relinquish its sovereignty for any reason, but the stabilization clauses found in petroleum agreements contradicts this international law provision, but the principle of permanent sovereignty of a state over its natural resources overrides this international law principle.

In developing countries, the host state argues that their national law governs the agreement because it involves the concept of state sovereignty. Thus if stabilization clause in an international petroleum agreement is subject to national law it would be declared invalid. [4] In case of a breach of contractual terms whereby stabilization clause is found, an arbitral award may instruct the state to cease from applying the new laws. [5]

2:2 RATIONALES

The purpose of many international petroleum agreement is to give the host country access to expertise and technology that they can’t afford. [6] . Investors rely on stabilization clauses to guarantee investment stability to ensure a thriving performance of their investment. Since stabilization clause is inserted in an agreement to restrict the unnecessary change of laws and legislation by the host state, disputes are usually going to arise. When such disputes occurs between the investor and the host state, the choice of law to govern this dispute as it relates stabilization clauses is of upmost importance. Conventionally when a dispute arises in concession agreements, the appropriate law that governs that transaction is the domestic law of the host state. Therefore in recent times, when such contract contains a stabilization clause it is said to be governed by international law and it is not subject to the laws of the host state. This issue has risen lost of disputes between developed and developing countries around the world. [7]

Stabilization clause is frequently found in agreements in developing countries because of their supposed under bargaining power at the time the agreement was agreed upon. For example developing countries like Ghana with the recent discovery of oil, would do anything to attract international oil companies to invest in the exploitation and exploration of their newly discovered oil field. The host state due to the desire and desperation to discover how much reserve that exist within their territory is flexible in allocating rights to foreign investors and are willing to accept any terms been inserted by the investor because of their low bargaining situation.

The bargaining right of the foreign investors is at its strongest in the exploration stage, because of the lack of expertise and capital of the host state. At this stage the foreign investors would ensure that it has majority of the decision making right pertaining the exploration, which includes the decision relating to well location, depth and targets zones of exploration wells and the budget for the exploration programme. The authority of the host state becomes stronger after exploration has been concluded which may led to them to either granting license to foreign investors such as the case was in the uk, or to participate in the development of the resources by sharing cost.

3. TYPES OF STABLIZATION CLAUSE

Stabilization clause as discussed above plays an important role in protection IOC in petroleum contracts. There are three categories of stabilization clause found in petroleum agreements Freezing clause, Economic Equilibrium clause and Hybrid clause. These types of stabilization clauses would be examined.

3.1 FREEZING CLAUSE

Freezing clause is that type of stabilization clause whereby the host country agrees not to create any legislation or make any regulatory changes that would affect the agreement throughout the duration of the contract. Freezing clause is the most common clause found in petroleum contracts, although some practitioners are of the view that it is outdated but according to AIPN study discusses freezing clause in most oil and gas contract. It’s called freezing clause because it freezes the right of the host state to enforce new laws relating to the already agreed laws of the investment. Under freezing clause, the applicable law is the law in existence as at the time the contract was entered into, to the exclusion of succeeding legislation. Freezing clause can be sub divided in two categories. Full freezing clause and limited freezing clause. Full freezing clause are those clause that freeze the fiscal and non-fiscal issues, while limited freezing clause aims at freezing a particular set of legislative actions. For example the limited freezing clause may specifically refer to taxations issues. Full and limited freezing clauses are sometimes used informally to shield investors from submitting to new social and fiscal laws or to accept damages from the state for the cost of fulfillment.

Assuming the stabilization clause found in an agreement is a full freezing clause, the IOC would presume that it is exempted from complying with any new social and environmental laws enforced after the agreement have been signed. For example the IOC maybe exempted from a law enacted to raise minimum wage or increase in taxation etc. Therefore the IOC may rely on the freezing clause and would not be accountable to perform the provisions of the new law. Also if it is a limited freezing clause, the details contained in clause would decide whether the IOC can rely on it to evade the application of the new law. [8] In some instances, full freezing clauses are inserted to trim down the efficacy of new laws reason been that they proffer the company the opportunity to rely on it to evade the company from applying the new laws.

In international petroleum agreements, freezing clause enables the investors discuss the rights and obligation in relation to the Foreign Investment Contract (FIC) with the government. The clause offers the company the existing right to rely on the argument that new legislation enacted is not binding on the company. [9] If the host state enacts a new legislation which in terms affect the contractual agreements between it and the international oil company freezing clause would amount to compensation from the host state to the international oil company. Therefore the host state would compensate the IOC in order to enable them comply with the new legislation and laws.

3.2 ECONOMIC EQUILIBRUM CLAUSE

Economic equilibrium clause unlike freezing clause does not aim at freezing the laws of the host state. However its major aim is to maintain the economic equilibrium of the contract. In this type of stabilization clause, where the host state enacts new laws it would generally apply to the contractual agreement but the host state has a duty to pay compensation to the IOC for complying with the new laws. Payment of compensation can be in the form of tax reduction, extension of concession, or monetary compensation. In the process of compensation, the parties have to act in good faith toward ensuring that the economic equilibrium is restored to its initial form i.e. As it was before the change of law.

Like the freezing clause economic equilibrium clause can be divided into full economic equilibrium and limited economic equilibrium. Full economic equilibrium clause refers to those clauses that guards the effect change of law would have financially on the contract, which would finally result to compensation by the host state. Limited economic equilibrium clauses are those types of clauses that include some limitation with respect to application of the economic equilibrium clause inserted in the contract. For instance the clause requires the IOC to incur a particular amount of financial loss before compensation is granted. [10] Therefore under economic equilibrium clause, regulatory changes are achievable as long as efforts are made to reinstate the economic equilibrium. It is also noted that some economic equilibrium clauses inserts guidelines to determine instances where economic equilibrium has been affected. Research has shown that the use of economic equilibrium clause has improved compare to the other types of stabilization clauses. However in some countries, economic equilibrium and freezing clause are used interchangeably in the same contract agreement.

3.3 HYBRID CLAUSE

As the name entails, hybrid clause simply consists of a mixture the characteristic of both freezing clause and economic equilibrium clause. This type of stabilization clause requires the host state to reinstate the IOC to the same position it was before the change of law was made. However just like the other two types of stabilization clause, Hybrid clause has two categories. The full hybrid clause and the limited hybrid clause. A full hybrid clause shields the investors from financial implication caused by change of law by ensuring that compensation is made, while limited hybrid clause shields the investors from financial issues of some limited change of law.

4. THE POTENCIAL IMPACT OF STABLIZATION CLAUSE

The essence of stabilization clause in a petroleum contract is to protect the FI from interference of domestic laws with Foreign investment contracts (FIC).Where a state acts contrary to the stability clause drafted in the FIC, it would be liable for damages and compensation. Stabilization clause as discussed in previous chapter literally freezes the rights of a sovereign state from changing its laws and legislation as it may affect the rights and obligation of an international oil company undergoing exploration or exploitation of an oil field of a host state. In other words by accepting to a stabilization clause, the state has out rightly alienated to unilaterally change terms agreed upon at the beginning of the contract. In discussing the impact of stabilization clause and how it affects international oil company we must first look at the how this clause tends to affect the IOC and what law governs this contract. The applicable law in a contractual relationship between a foreign country and a host state in petroleum agreement is usually international law.

The rationale behind this is that international law ensures more protection for foreign investment than the laws of the host state. International law been the applicable law governing the contract ensures the firmness of the contract throughout the time of the project. Although recent research shows that host state may raise before an international arbitrator an objection relating to the inalienable sovereign rights in order to evade stabilization clause from affect it [11] .In my opinion, once a host state has signed and ratified a contract where stabilization clause is inserted, it is bound by it and cannot impose new laws to govern the contract expect with the mutual consent of the international oil company. Stabilization clauses have played a vital role in petroleum agreements which in recent times brought about its effectiveness.

4.1 VALIDITY AND EFFECTS

International law recognizes stabilization clause and the right of a state to bind itself to the enforcement of such clause. The tribunal in the case of Texaco vs Libyan Arab Republic [12] states that “nothing can prevent a state in the exercise of its sovereignty from binding itself irrevocably by the provision of the concession and from granting to the concessionaire rights” [13] However, FI in accepting the terms of a stabilization clause should be very clear in what they intend to stabilize and also stabilization clauses should expressly state that its terms are binding irrespective of the fact that future amendments or negotiation of the FIC except both parties mutually accept in writing to change the rules if the aforesaid stabilization clause.

No matter how explicit the term of stabilization clauses are, the major question that arises is how effective are these clauses. This question is difficult to answer because it has lingered on for so many years because of the controversy between developed countries asserting the purity of contracts based on the doctrine of ‘pacta sunt servanda’. And also controversy of developing countries claming their sovereignty over natural resources and relying on the principle of ‘rebus sic stantibus’. I would in a few words discuss these principle based on the effectiveness of stabilization clause in petroleum agreements.

4.2 THE DOCTRINE OF PACTA SUNT SERVANDA

The purity of contract is based upon the doctrine of pacta sunt servanda which in spite of some differences between definitions given by various authorities [14] means that any contract entered into by two consenting parties shall be guided in good faith. The doctrine of pacta sunt servanda can also be said to be found in international conventional law.Article 26 of the Vienna Convention on the law of treaties provides as follows:

“Every treaty in force is binding upon parties to it and must be performed in good faith” [15]

In Anzilotti’s description, the doctrine of pacta suny serbanda is an utmost suggestion of the use of international legal system [16]

4.3 THE DOCTRINE OF REBUS SIC STANTIBUS

This doctrine simple means the permanent sovereignty over natural resources. This principle is regarded as an essential principle in modern international law. [17] The issue of sovereignty over natural resources arises in circumstance between host state and international oil companies in the exploration and exploitation of natural resources within the states territory. It is an inherent and inalienable right of the HS to change law within its territory [18] . This principle is relevant to stabilization and adaptation clauses and has gained significant grounds in today’s practice.

The two major doctrines discussed above gives a background for the discussion of the effectiveness and impact of stabilization clause in petroleum agreements. This raises major questions like, ‘Do stabilization clause restrict the state from enacting legislations?’ ‘Do they render the terms of the contract unchallengeable?’. This issue has lingered on in both developed and developing oil producing countries. In my humble opinion, the argument can go both ways. However, stabilization clauses do not restrict host state from enforcing new legislation because the state is a sovereign entity, nor is the terms of the contract immutable because both parties can anytime within the life of the contract agree to change certain terms of the contract. On the other hand, such clause binds the hands of the host state because even though it is sovereign state, it cannot enact new legislation without taking into account the interest of the foreign investors and also obtaining their consent. However I deem it appropriate to answer the question by asserting YES and NO.

5. LINK BETWEEN STABLIZATION AND ADAPTATION

As said earlier, a stabilization clause is a term in a contract that freezes the laws of the HS as at the date the contract was signed, in order to restrict future change of law from affecting provisions of the contract. [19] Adaptation clause is said to be an alternative to stabilization clause which offers the host state and the IOC an opportunity to protect them from hardship caused by change of law. Unlike a stabilization clause, adaptation clause gives the host country an opportunity to renegotiate the terms of the contract in good faith in order to restore the economic equilibrium of the contract instead of independently altering. Adaptation clause is said to be applied in exceptional cases, due to change of law adaptation clauses provides that the aggrieved party should continue with its performance during the period of negotiation. [20]

6 INTERNATIONAL ARBITRATION AND STABLIZATION CLAUSE

6.1 THE ROLE OF INTERNATIONAL ARBITRATION IN STABLIZATION CLAUSE DISPUTES.

A range of dispute arises in international oil and gas agreement for example the host state might without prior notice increase the tax or breach the terms of the contract in relation to stabilization by enacting new laws or legislation which on turn affects the ongoing project of the FI. Therefore a sensible investor would insert an arbitration clause into the petroleum agreement with the view that if dispute cannot be negotiated within themselves they would submit to arbitration. The FI must ensure that the agreement contains a binding international arbitration clause that provides for settlement of dispute arising from the contract. In addition the clause must also state that the award of the arbitration is final and binding on both parties.

In drafting the terms and conditions of a FIC, a provision must be inserted that contains methods whereby dispute arising out of the contract would be settled. Most HS prefer to use their legal system in settling dispute which might not be favorable to the FI reason been that the host state might interfere with the decision. Most FI opt for a neutral and bias free law to adjudicate upon dispute between the HS and the FI. In dispute arising out of validity of stabilization clause, international arbitration is usually used as a means of dispute settlement.

In recent times the two frequently used institutional arbitration are the International Center for the Settlement of Investment Dispute (ICSID) and the United Nation Commission on International Trade Law (UNCITAL) .In situations whereby parties disagree on the validity of stabilization clause or the terms of renegotiation which may eventually give rise to dispute between them, cases like this would be refereed to arbitration according to the clause for settlement of dispute inserted in the FIC. The arbitration clause inserted in the FIC should expressly bestow the power to the agreement and decide on the manner for it exercise as well as state the arbitrators authority.

To determine the extent of power of the arbitrator, it shall first examine the laws of the seat( lex arbitri), and the lex contractus. To determine the extent of power it has to act in its capacity.

6.2 THE ROLE OF ICSID

International Center for Settlement of Investment Dispute (ICSID) is an international institute established to settle investment disputes between nations and between states and foreign investors sponsored by World Bank. [21] The major objective of ICSID is to provide facilities for international investment dispute. However ICSID basically deals with disputes arising from state contracts. However where arbitral clause stated in a petroleum agreement nominates ICSID, then it would be guided by treaties.

In a situation whereby the host state is not a party to ICSID, the rules of ICSID would not apply unless the parties submits to it. It’s important to note that a mere reference that the ICSID rules would govern disputes arising from the contract those not give ICSID the right to adjudicate upon that matter, except the parties in writing and signs that it rests jurisdiction on ICSID. [22]

7 CONCLUSIONS

Stabilization clause has been widely used in numerous petroleum contracts. Its major objective is simply maintain the status quo of the terms of contract thereby restricting the party to the contract from taking selfless decisions to change the laws of the contract without obtaining the consent of the other party.

Considering the sensitive nature of exploitation and exploration of oil fields, such clauses are not only beneficial to the foreign investors but also in the interest of the host state. Stabilization clause has been successful in various arbitration awards, but it has be deeply critized by developed countries relying on the doctrine of sanctity of contract and also developing countries based on the principle of permanent sovereignty over natural resources. It is unrealistic to assert that stabilization clause can freeze the terms of the contract throughout the life span because most of the contracts now have an adaptation clause inserted to enable the parties renegotiate the terms of the contract in good faith.

However the mutual understanding by both the host state and the foreign investor can enhance a dispute free contractual relationship.

BIBLOGRAPHY

PRIMARY SOURCES

Convention on the Settlement of Investment Disputes between States and Nationals of

Other States (Geneva) (1966) at http://www.worldbank.org/ICSID/FrontServlet/

General Assembly Resolution 1803 (XVII) on Permanent Sovereignty over Natural

Resources (1962)

CASES

Texaco Overseas Petroleum Company and Califonia Asia Oil Company .v. The Government of Libyan Arab Republic 19th January 1977 53 I.L.R at 474

CMS Gas Transmission Co. vs. Argentine Republic Award (2005), ICSID Case No.

ARB/01/8/2005 at http://www.worldbank.org/ICSID/FrontServlet

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(United Kingdom, London: Academic Press, 1983).

Dainith, T., The Legal Character of Petroleum Licences: A Comparative Study ed.,

(United Kingdom, Scotland: University of Dundee, Centre for Petroleum and Mineral

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Sornarajah, M., The International Law on Foreign Investment (2nd ed.) (United Kingdom,

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