• Tullow Oil and Total have since hired French bank Natixis to run the joint sale process for Blocks 10 BA, 10 BB and 13T in the South Lokichar Basin in Kenya.
•To understand Tullow's predicament and operational drawbacks, its 2019 annual statements give a glimpse of a company in distress.
The decision by Tullow Oil to exit Kenya and Uganda respectively comes as no surprise to the industry watchers.
Tullow Oil and Total have since hired French bank Natixis to run the joint sale process for Blocks 10 BA, 10 BB and 13T in the South Lokichar Basin in Kenya.
By mid-May, Tullow Oil announced the sale of its remaining stake to Total E&P for $575 million for its interest in Uganda after the China National Offshore Oil Company — a shareholder in the Uganda Oil Project — decided against exercising its pre-emptive rights to acquire part of the 33.3 per cent Tullow Oil stake floated to Total E&P.
It is generally agreed that depressed oil prices tend to force large producers to roll back spending, but what is the the rationale for shedding non-core assets?
Targeted spending in projects that offer the best returns, low costs and cash returned to shareholders appear firmly in favour. Divesting noncore or high-cost assets appears to be a de rigueur part of the oil industry today.
As a result, slash-backs on capital and operating expenditure has become the norm and all the oil majors have either announced capex cuts or plan to reduce their spending significantly. The drive to cut spending, generate cash and shore up the balance sheet could, in theory, make divestment an even more attractive option for large-oil companies this year.
In my previous article entitled, What next for Kenya and Uganda's quest for commercial oil production? in the Star on March 20, I noted that Tullow Oil Plc reported a net loss of £1.7 billion in their full financial year results of 2019.
This was a result of pre-tax impairments and exploration write-offs partly from the reduced output at the Jubilee and TEN fields in Ghana, failure to make progress on crucial projects in Kenya and Uganda and disappointing exploration in Guyana that wiped out nearly half of the company’s market value.
To understand Tullow's predicament and operational drawbacks, its 2019 annual statements give a glimpse of a company in distress.
"The company faces the real risk of bankruptcy if conditions do not improve. If crude persists at its current level—or drops even lower—the company’s finances face a significant threat. If oil prices remain at or below their current levels for an extended period of time, this would adversely have an impact on our future financial results," the statements note.
The company’s free cashflow breakeven for 2020 stands at $45/bl oil equivalent, while Brent crude is currently trading at $39.50/bl. Tullow, therefore, had just enough liquidity to operate for 12 months pre-Covid-19 under the worst-case scenario — in which it fails to meet production guidance and with Brent Crude trading at below $40/bl for a protracted period.
Most significantly, Tullow's board stated in their 2019 annual report that , "It would raise more than $1 billion from portfolio management this year, with West Africa holding the company’s most important producing assets, so East Africa is the most likely source for funds."
The company has since confirmed its interest to divest/exit Kenya, and the farm-down in Uganda is still ongoing. US bank Jefferies believes the assets are worth a combined $958 million at a long-term oil price of $62/bl.
INSTANCES OF GOLD-PLATTING
In a recent report in the Business Daily, it seems that a recent audit on behalf of the Kenyan government has unearthed instances of gold-plating (attempts by companies to inflate costs through overspending on projects). It is hard to believe that a single contractual dispute ( Tullow cites the Kenyan government's decision to change the fiscal regime by introducing VAT post the production sharing agreement in place) is one of the reasons why it is quitting the Kenyan market.
It needs to be first understood that production sharing contracts (PSC)/production sharing agreements (PSA) and the fiscal terms flowing from them are in vogue in over 50 per cent of petroleum-producing countries worldwide.
Profit-sharing arrangements exist in petroleum extraction in over 90per cent of countries. In the Kenyan context, after the oil producing company has recovered its costs, it shares the profits with the government based on a formula related to the rate of return of the producing company.
This formula is the chief item in a bidding round and the successful bidder is the one that offers the highest take to the government. In any profit-based fiscal arrangement, costs will determine the size of revenue left for sharing between the company and the government.
Gold-plating of costs is what might have led the Kenyan government to reject a fraction of the compensation sought by British oil explorer Tullow Oil and its partners amounting to Sh16 billion ($150 million) for the firm’s eight-year work in Turkana oil fields. Tullow has disclosed that the government has dismissed the Sh16 billion out of the Sh204 billion compensation bill it had presented to the Ministry of Petroleum.
It would appear that Tullow requires a commitment from the government that Kenya owes it $2 billion (Sh213 billion) and wants to use the pledge as a sweetener for the sale of its stake in the country.
"The ministry audit has suggested that eight percent of this expenditure (around $150 million – or Sh16 billion) does not qualify for cost recovery. The final audit reports received so far indicate the partners have spent $2.04 billion since 2010.”
I find it hard to believe that the PSA between the government and the Kenya Joint Venture ( Tullow, Total and Africa Oil) didn't have a stabilisation clause. The importance of fiscal stability is a popular mantra for the oil and gas industry. In reality, it is rarely delivered as circumstances are constantly changing. One of the reasons why long-term fiscal stability is difficult for governments to adhere to is simply the existence of significant unknowns when the fiscal regime is first designed at the start of the province opening – which is often before a single exploration well has been drilled.
Invariably, oil and gas basins evolve in an unpredictable way. For example, few anticipated the riches in the North Sea when drilling first began in the 1970s, the deepwater Gulf of Mexico, or the shale revolution.
Stability clauses may cover a broad range of host country laws, including, among others, those relating to labour; the environment; government control over production decisions and share participation; the obligation to provide local infrastructure; and the possibility of nationalisation.
A particular type – so called fiscal stability clauses (FSCs) – deals exclusively with taxes and royalties. FSCs may cover some or all taxes and fees, potentially including income taxes, royalties, duties on imported material and capital equipment, excises, VAT, and other sales taxes on imported and domestic goods and services.
The raison d’être of fiscal regimes and models depends not only on the level of tax, but also on the extent to which the government shares the project’s risks, though companies, unlike governments, have the means to diversify certain levels of risk. Governments, however, can minimise the fiscal risk by providing fiscal stability.
Although the principle of pacta sunt servanda, or strict sanctity of contract, is widely accepted under no legal system has the principle been found to be absolute, and contractual rights can be expropriated.
A stabilisation clause is a contractual risk-mitigating device to protect investments from variations in the legal environment. This would include risks deriving from a possible exercise of host state sovereignty such as expropriation, the obsolescence bargain, or any other change that the government might utilise to impose new requirements on investors.
It is, therefore, imperative to note that lack of agreement on the compensation could force Kenya and Tullow to go for arbitration in the UK in line with the crude oil exploration contracts. I strongly infer that this is probably one of the reasons behind Tullow’s recent declaration of force majeure on the project.
Tullow's Decision to Invoke Force Majeure The latest brief by the Kenya Civil Society Platform On Oil And Gas ( KCSPOG) looks into Tullow and partners' recent move in its dealings with the Kenyan government.
A brief statement from the Kenya Joint Venture released by Tullow states: “Tullow and its partners have called force majeure because of the effect of restrictions caused by the coronavirus pandemic on Tullow’s work programme and recent tax changes. Calling force majeure will allow time for the joint venture and government to discuss the best way forward.'
"These declarations are the result of the impact of the Covid-19 pandemic on the operations, including Kenyan government's restrictions on domestic and international travel, and recent tax changes that adversely impact the project economics. These are exacerbated by the recent unprecedented crash in global crude oil prices."
The Kenyan clause, according KCSPOG reads as below: (1) In this clause, force majeure means an occurrence beyond the reasonable control of the Cabinet Secretary or the Government or the contractor which prevents any of them from performing their obligations under this contract. (2) Where the Cabinet Secretary, the Government or the contractor is prevented from complying with this contract by force majeure, the person affected shall promptly give written notice to the other and the obligations of the affected person shall be suspended, provided that that person shall do all things reasonably within its power to remove such cause of force majeure. Upon cessation of the force majeure event, the person no longer affected shall promptly notify the other persons. (3) Where the person not affected disputes the existence of force majeure, that dispute shall be referred to arbitration in accordance with clause 53. (4) Where an obligation is suspended by force majeure for more than one (1) year, the parties may agree to terminate this contract by notice in writing without further obligations. (5) Subject to sub-clause 50(4), the term of the contract shall be automatically extended for the period of the force majeure.
To review the key arguments on the reasons behind the invocation of force majeure or clause by the companies involved, Covid-19 may not justify force majeure. The declaring party ( Tullow) will need to demonstrate a causal link between the pandemic and the reason it is unable to fulfil its obligations.
Covid-19 pandemic by itself is not enough for a party to declare force majeure. The claimant will need to demonstrate a causal link from an event to the inability to perform its obligation. Force majeure is sometimes referred to as the “act of god” clause - usually to indicate an incident that was not reasonably foreseen by two parties to a contract.
One must understand that force majeure is not an abstract legal concept. From a legal standpoint, it only exists in a contract. Whatever rights one has or does not have would only be as good as those set out in the contract. A deficient clause or one that is poorly drafted, can have different outcomes.
There is also a widespread misconception that if a contract specifies ‘pandemic’ the clause can necessarily be triggered. That reference, in and of itself, may not be enough to get a party over the line. In short, there must be a causal link between Covid-19 and whatever prevented a party from performing its obligations.
According to industry experts, the key test underpinning force majeure is a much broader test. The event in question must not have been foreseeable - certainly by the party seeking to claim, and that party had no control, or means of controlling the event. And, that the event in question prevented, hindered or delayed a party from performing its obligations. If it is truly a force majeure event you are going to know right away. However, there is a series of common considerations. The first is to be aware of “being too imprecise”.
Usually, there is a requirement that to claim force majeure “you do so in the form of a notice, and there is a particular time period to provide that notice and a description of the content of that notice,” says Coriell.
“There will be specific things you have to list, such as the particular trigger. Another is the particular obligation that you are fully or partially relieved from. A third is causation, a link between the triggering event and the obligation that you can no longer, or only partially, perform, [as well as] evidence of that causal link.”
There may be other requirements on the claiming party, such as attempts to mitigate or the provision of an estimate of time that force majeure will apply, he adds. Coriell also cautions that a contract will usually specify a short window to give notice, perhaps seven or ten days, to prevent potential abuse by firms seeking to escape its obligations.
“It is a requirement that tends to get enforced, by international arbitration tribunals in particular If it is truly a force majeure event—an act of God that prevents you from being able to fulfil contractual obligations—you are going to know right away or within a reasonably short period of time after the event occurred.”
Without the benefit of legal expertise, when exactly did Tullow and partners realise that they would be unable to fulfill their contractual obligations given the aforementioned ? It is important to have clarity under force majeure into the timing of events that triggered the claim as there will probably also be an argument about when the situation is resolved.
The government has always upheld the notion that confidentiality about the contracts signed with international oil companies will be upheld because the country does not have a uniform agreement for the various exploration companies. What is, however, unclear is how different companies would demand the same treatment, yet the oil blocks are not homogeneous.
It is now time for the government to release the PSA it signed with Tullow Oil. The government is obliged under Article 35 of the Constitution to publish and publicise/disclose the contents of the contracts signed with Tullow Oil and partners for public scrutiny.
Withholding the same is a gross violation of the Constitution. The VAT changes could indeed have material effect in project economics, A good start would be to avail the original contract signed by Africa Oil and the Heads of Terms agreements signed last year by the joint venture partners.
Once the contracts are released coupled with the project economics, we can then ascertain whether the Kenya Oil Project becomes unviable as Tullow and partners would claim.
Duncan Otieno Ogwang is a petroleum and energy economist