Navigant’s Mark Taylor on the pressures that oil prices exert on contracts in the sector
We all know how the price of fuel at the pump can affect how individuals feel about their own prosperity. For producers in the oil and gas sector, oil price uncertainty is a substantial risk, since it has a direct bearing on a project’s return on investment. Assumptions about future oil prices always weigh heavily on investment decisions, but in recent years severely fluctuating prices have added economic risks for producers, on top of the inherently complex engineering challenges of exploration and production.
Circumstances can change and falling oil prices in recent years have driven behaviours that, in practice, cause disputes, and once parties are in a contentious scenario, oil price expectations have also significantly affected any assessment of the losses suffered.
Oil market trends
Over the last decade, the price of a barrel of crude has fluctuated between $140 and $30. Although oil prices have recovered somewhat in recent months to around $50 a barrel, partly thanks to agreements to restrict supply in major oil-producing countries, there remains volatility in the short term. Historically, the two major drivers of demand have been the transport and petrochemicals sectors. In the longer term, powerful trends will exert downward pressure on demand as industry and consumers look to shift to a low-carbon future.
The oil industry remains a major driver of the economic cycle, especially in regions where the sector is a large contributor to GDP growth. The dramatic fall in the oil price over the past few years has certainly hit hard in economies that are dependent on oil production to fund government spending. This has a knock-on effect on related activity such as construction. Infrastructure spending in the Gulf, for instance, fell 44% in 2016 to $100bn, compared with $178bn in 2015 (and $186bn in 2014) according to the MEED.
Disputes triggered by drop in oil price
Across the worldwide oil and gas sector, we have seen an increase in disputes following the fall in oil prices, ranging from abandoning upstream projects where financial viability is in doubt or when closer scrutiny of upstream costs results in disputes. Abandoning projects has led to a raft of contracts being terminated and significant profits being lost, resulting in numerous claims for damages.
‘Powerful trends will exert downward pressure on demand as industry and consumers look to shift to a low-carbon future.’
Mark Taylor, Navigant
Related disputes have occurred in the supply chain and support functions. A typical scenario would be when orders for oil production equipment or services dry up after a fall in oil prices. For joint venture parties that have seen the value of their company drop alarmingly following the fall in oil prices and a poor trading environment, disputes have ensued, resulting in litigation.
Fluctuating oil price has affected calculations of damages
Future oil prices are often required for damages assessments, as there are many situations where they have a direct or indirect impact on damages.
In addition to causing disputes, the falling oil price has had a significant effect on the level of damages claimed. In any quantum of loss calculation, damages are based on restoring the damaged party to the financial position in which it would have been but for the wrongdoing. In a high-oil price environment, profits are likely to be higher and so damages greater, but in a low-price environment profits are likely to be lower with a downward impact on damages.
In upstream disputes where oil production has been lost, damages are directly related to oil price, so in long-term contract agreements this has had a major impact on damages. The oil price has also had a knock-on effect on damages in related areas. For example, in a recent oil storage dispute, we noted that when oil prices are low, demand for oil storage increases and this exerts an upward pressure on oil storage rental rates, which are used in the calculation of damages.
After the downturn in production, there are tentative signs within the oil industry of a return to confidence, albeit producers are looking at capital investments selectively. Although no-one can accurately predict the future price of oil, expectations about prices will continue to drive investment decisions by producers, and will have an important impact on creating and defining claims for damages in disputes.
Important notice: The views expressed in this article are those of the author and do not necessarily represent the views of Navigant Consulting or any of our clients.
Mark Taylor, managing director, disputes and investigations practice, Navigant ConsultingT: 020 7015 8714
E: email@example.comMark Taylor is an accounting expert with 20 years of experience in the oil and gas sector. He is a chartered accountant and holds a degree in chemical engineering and minerals processing engineering, and is also an associate member of the Institution of Chemical Engineers.