Oil & Gas: Court of Appeal deals with JOA budget overruns and operator pension deficits

In Spirit Energy Resources Ltd & Ors v Marathon Oil UK LLC [2019] EWCA Civ 11, the Court of Appeal dealt with an appeal concerning whether an operator, under a joint operating agreement, was entitled to charge joint venture participants for pension fund shortfalls in excess of sums in the approved work programme and budget. In a decision that is likely to have great significance for the global industry, the Court of Appeal upheld the Commercial Court decision that the operator was entitled to recover sums properly incurred to close the pension shortfall from other joint venture participants. The reasoning of the Court of Appeal might also apply to any work that an operator has carried out that exceeds the original approved budget.

Facts

The facts of the case are set out in our earlier law-now concerning the Commercial Court decision and can be found here.

In summary, Marathon Oil UK LLC (“Marathon”), Spirit Energy Resources Limited (formerly Centrica Resources Limited), TAQA Bratani Limited and TAQA Bratani LNS Limited are, and were, parties to a joint operating agreement (“JOA”) and a unitisation and unit operating agreement (“UUOA”) for operations in the Brae fields in the North Sea. Marathon (the “Operator” and/or the “Respondent”) was, and is, designated as the operator.

The terms of the JOA and UUOA were materially similar, namely:

“5.2 In accordance with approved programmes and budgets and under the overall supervision and direction of the Operating Committee, and subject to this Agreement, Operator shall have exclusive charge of and shall conduct all operations under this Agreement either by itself or by its duly authorized agents or by independent Contractors engaged by it.

…

7.2 On or before the 15th day of December of each year, the Operating Committee shall agree upon and adopt an operating programme and budget for the 12 month period beginning on the 1st day of January of the following year and for such further periods as the Operating Committee deems appropriate, which shall include as a minimum the work required to be performed under the Licence in respect of the Contract Area during such budget periods and the requirements of [the] Operator having regard to previously approved programmes and budgets and its obligations hereunder. At the time of agreeing upon and adopting an operating programme and budget, the Operating Committee shall provisionally consider, but not act upon or adopt, an operating programme for the calendar year next succeeding the period covered by such approved operating programme and budget.

…

10.1 All costs and expenses of all operations under this Agreement in or in respect of the Contract Area or the Licence, including the handling, treating, storing and transporting, whether within or outside the Contract Area, of Petroleum produced from the Contract Area, and all costs and expenses properly incurred by the Operator in its performance of the relevant provisions of the Decommissioning Security Agreement except for costs and expenses which are solely attributable or relevant to a Party, shall be borne by the [p]articipants in proportion to their respective Participating Interests from time to time except as herein otherwise specifically provided. Furthermore, the costs of all assets, including materials and equipment acquired for the Joint Account of the [p]articipants shall be for the account of the [p]articipants in accordance with their Participating Interests from time to time, and, similarly, liabilities shall be borne in such proportions.

10.2 All costs and expenses of whatsoever kind that are incurred in the conduct of operations under this Agreement shall be determined and settled in the manner provided for in the Accounting Procedures hereto attached and marked Exhibit A, which is hereby made part of this Agreement, and Operator shall keep its records of costs and expenses in accordance with such Accounting Procedure. In the event of conflict between the main body of this Agreement and the said Accounting Procedure, the provisions of the main body of this Agreement shall prevail.

In addition, Exhibit “A” to the JOA was entitled “ACCOUNTING PROCEDURE”. The Exhibit began with this statement:

“The purpose of this Accounting Procedure is to establish equitable methods for determining charges and credits applicable to [all operations conducted in accordance with the Agreement by or on behalf of any party with a Participating Interest] under the Agreement and to provide that Operator neither gains nor loses by reason of the fact it acts as Operator. In the event of a conflict between the provisions of this Accounting Procedure and the provisions of the Agreement, the provisions of the Agreement shall control.”

The question between the parties concerned the costs of staff employed by the Operator (in practice through an affiliate) in connection with the operations.

More specifically the question is whether the Participants were liable to meet a share of a proportion of deficit recovery charges (“DRCs”) in respect of a defined benefit pension scheme (the “Scheme”) of which some of those employees were beneficiaries.

The reference to a ‘share’ was the share of the costs of operations for which Participants were, between them, responsible. A proportion only was involved because the Scheme included some employees who did not work on operations in the Brae fields, and some who worked on operations there for some periods and on other unrelated tasks for other periods.

At first instance, the Participants argued that they had no liability as a matter of contract under the JOA and UUOA. The Participants accepted that the Operator was entitled to select employees and their hours of work and their remuneration (including benefits such as pension provision). However, they argued that the Operator’s ability to recharge the cost was, and remained, subject to the provisions for approved operating programmes and budgets and the direction of the Operating Committee. They argued that the JOA made it clear that the Operator is not entitled to incur any expenditure in the nature of remuneration without the approval of the Operating Committee as part of a work programme and budget found in the business management plan (“BMP”).

In their appeal, the Participants maintained that, properly construed, they were not liable under the JOA for the DRCs and that, it follows, the Operator must be the sole bearer of these costs. It had been in the Operator’s power to take steps to ameliorate pension liabilities and having failed to do so, they should now be held responsible for these “runaway costs”.

The Participants added to this that under the JOA they were not required to pay for future liabilities which they never foresaw nor contemplated when the Operating Committee approved and authorised the operating programme and budget. Moreover, that there was nothing in the background knowledge available to the Participants, to indicate the existence of a requirement to bear such unforeseen costs.

As at first instance, the Participants argued that the Operator’s approach that it was entitled to such costs, even when outside the agreed budget, involved their signing a “blank cheque”.

In their appeal, the Participants also contended that the hold-neutral provisions in Exhibit A of the JOA were “not an absolute” and should not be accorded substantial weight as a guide to the construction of the JOA.

Decision

In rejecting the Participants’ appeal and finding in favour of the Operator, the Court of Appeal started its analysis with the specific provisions of the JOA, which impose liability upon the Participants for costs incurred by the Operator.

It considered that, under the scheme set out in the JOA, once the operations and budget had been approved on an annual basis by the Operating Committee, the Operator was entitled (authorised) to charge the related costs to the Joint Account and these costs were then to be borne by the Participants. It was not in dispute that the additional pension costs were a cost that was consequential upon the prior approval by the Operating Committee of the operations. The Court considered that several articles in the JOA make clear that the Participants are required to pay the pensions costs:

1. Article 7.2 imposes an obligation (“shall”) on the Operating Committee to “agree upon and adopt” the Operators requirements “having regard to” previously approved programmes and budgets.
2. Article 10.1 concerns “all” costs and expenses of “all” operations and stipulates that they “shall” be “borne” by the Participants. The language used is mandatory and not discretionary.
3. Article 10.2, which governs settlement of costs as between Participants, referred in the broadest possible terms to “all costs and expenses of whatsoever kind that are incurred in the conduct of operations”. It went on to provide that these “shall be determined and settled in the manner” set out in Exhibit A, which is a part of the JOA. The article was mandatory (“shall”) and, as with Article 10.1, was all encompassing. This is confirmed by “all” and reinforced by the phrase “of whatsoever kind”. There was nothing in the contractual language which carved out costs the full nature and extent of which was unknown and/or unknowable at the point in time when the head of cost was first approved and authorised.
4. In respect of the “overall purpose of the clause and the [agreement]”, Exhibit A (Accounting Procedure) of the JOA required an equitable allocation of costs and benefits as between Participants, and an Operator ‘hold-neutral’ principle. These lead to the conclusion that the Participants are liable for the pension cost overrun. The ‘hold-neutral’ purpose supports the conclusion that nothing in the accounting procedures should lead to the Operator bearing a loss.

On this basis, the Court of Appeal concluded that the normal and ordinary meaning of the JOA was that the Participants must bear the cost of the pension shortfall.

The Court of Appeal then turned to the “commercial common sense” of the JOA scheme. In one regard, it considered this exercise unnecessary, as the commercial rationale was identified in the terms of the JOA. That said, the Court of Appeal found that commercial common sense supported the natural and ordinary meaning of the JOA, including:

1. The rationale behind the Operator being required, annually, to spell out its future operating programme and budget accompanied by relevant estimates, assumptions and contingences was to enable the Operating Committee to consider, and if appropriate, revise and then approve or disapprove the budget. If the budget was approved then the Operator is authorised to incur the expenditure. Having exercised this “judgment call” and “expressly authorised the operations” the Participants assumed responsibility for those liabilities and cannot argue that it wass the fault of the Operator. It was their decision of approval and authorisation that was at fault for a cost overrun, and not that of the Operator.
2. There was “no identifiable logic whereby the Participants can take the benefits but avoid the risks”. On the Participants’ analysis, having approved the Operator’s operations and its budget, and thereby induced the Operator to expend money including on pensions, the Participants, or each of them according to their own narrow self-interest, could refuse to agree to pay (bear) their allotted portion of the costs leaving the portion they would otherwise bear to be borne by the Operator (who also happens to be a Participant). They could “take the benefit but none of the burden”. The Court of Appeal was unpersuaded that this could “ever be considered commercially rational in the context of an agreement of this sort”.

In relation to the risk of Operator non-performance, the Court of Appeal considered that Participants were adequately protected by the law. They would not be liable for any costs incurred by the Operator in bad faith or dishonestly. The Operator accepted that where the JOA conferred a contractual discretion it was under an implied duty to exercise that discretion genuinely, honestly and in good faith (see Socimer International Ltd v Standard Bank London Ltd [2008] EWCA Civ 116).

In the alternative, the Operator relied upon Article 5.7 JOA, which grants an indemnity to the Operator. It argued that if it were wrong as to its primary argument about the construction of the JOA then it relied upon this clause as plugging the gap and imposing a duty upon the Participants to indemnify the Operator. As the Operator succeeded, the Court of Appeal did not feel it necessary to deal with this issue.

Comment

As it stands key points arising from the decision for joint venture participants seem to be: (1) it gives comfort to operators regarding the ‘hold neutral’ principle, but (2) might lead to Operating Committees requiring more detailed information and imposing greater financial scrutiny about the conduct of operations from the start. That said, it is not entirely apparent that the joint operating agreement in this case has all of the provisions seen in the model forms widely used in the United Kingdom and internationally. As such, there is likely scope for arguments in the future as to the application of the Court of Appeal’s decision.

The ‘no loss, no gain’ principle (‘Operator hold-neutral principle’) of operatorship is contained in most joint operating agreements and regularly referenced in disputes concerning operator reimbursement. As with the Commercial Court, the Court of Appeal was clearly swayed by the fact that it considered the Participants enjoyed the benefit of the employment of the staff in question and it would be wrong to require the associated costs/liabilities to fall to the Operator.

As set out in our previous Law-Now on the Commercial Court decision, interestingly, the text of the decision suggests that the relevant JOA and UUOA only expressly dealt with additional authorisation for cost overruns in the context of decommissioning budgets. It follows that the JOA and UUOA did not contain the clauses found in many JOAs, including the AIPN Model Form and Oil & Gas UK Model Form, which specifically authorise limited cost overruns by the operator for the budget as a whole and/or specified line items of the budget. As such, the Court of Appeal was not required to ask whether recovery of such cost overruns by the Operator was limited to the extent permitted by such clauses in the absence of additional approval.

That said, the Court of Appeal’s decision:

1. Provides a clear ‘road map’ as to the scheme of many JOAs and the balance to be struck between operators and participants in respect of cost overruns.
2. Adds to the debate about the circumstances in which an Operator is entitled to recover costs in excess of an approved budget, which arise under joint operating agreements governed by a variety of national laws.

In the context of pension fund liabilities, the consequences are potentially significant. The Operator in this case is far from alone in finding itself with a pension deficit. Other Operators will doubtless be considering whether to adopt the same approach and prepare plans to recover pension shortfalls from joint venture partners.

Conversely, non-operators will wish to consider whether the absence of the usual provisions dealing with operator cost overruns in the JOA/UUOA in this case means that the decision of the Court of Appeal is limited in its application to the facts of the case.

When it comes to drafting joint operating agreements, non-operators might also wish to consider whether pension liabilities should be specifically addressed in accounting procedures. The issue might be more important where the operator is an established oil company with a final salary pension scheme (or similar).

Finally, although the facts of the case relate to the pension liability for staff of an operator, the decision could be equally applicable to almost any cost-overrun concerning joint operating agreements on similar terms.

A report by EY in 2014 suggested that cost overruns in oil and gas mega-projects were in the order of US$500 billion. Of 365 oil and gas mega-projects surveyed by EY, 64% were facing cost overruns. In absolute terms, the cumulative cost of the projects reviewed had increased to US$1.7 trillion from an original estimate of US$1.2 trillion. According to EY: “Geographically, the proportion of projects facing cost overruns is highest in the Middle East (89%), followed by Asia-Pacific (68%), Africa (67%), North America (58%), Latin America (57%) and Europe (53%)”. Similar research conducted by Oil & Gas UK suggested that the average project on the United Kingdom Continental Shelf was 35% over budget.

As initial work programmes and budgets are often closely aligned to original FID estimates, the potential exposure of participants in the oil and gas industry to budget overruns is significant and issues relating to the liability for those overruns critical to financial success.

Therefore, the decision has potentially wide and market critical implications.