Legal risks in the oil industry

This article looks at the issue of legal risks that companies face in the international oil and gas industry especially in producing countries with a conflict situation. Typical questions companies need to ask themselves about their investments include: is it safe to invest; are they guaranteed a desirable return; and should they invest in oil producing countries with troubled reputations?

10th August 2007

This article looks at the issue of legal risks that companies face in the international oil and gas industry especially in producing countries with a conflict situation. Typical questions companies need to ask themselves about their investments include: is it safe to invest; are they guaranteed a desirable return; and should they invest in oil producing countries with troubled reputations? Additionally, how these companies reach their decisions and what mechanisms are available to deal with any type of risks when things go wrong depends mainly on the company's own internal management system.

Risk management is vital to the economic consequences of the huge investments in the international oil and gas industry. The most common risks to the industry, which raise important legal implications, include market risks (changes to the oil price, interest rates and exchange rates); credit risks (default); operational risks (equipment failure); geological risks (dry wells); environmental risks (pollution); and political risk (changes to government, regulatory regime and contractual arrangements). Additionally, legal risk includes the kind of conduct, at individual or corporate level, that leads to a devaluation of the company that could include loss of investor confidence; loss of productivity and a negative public reputation.

Today, most of the  oil producing countries in the worlds are associated with a number of uncertainties and problems that are peculiar to that area such as the Middle East (Iraq - terrorism), West Africa (Nigeria - kidnappings), Latin America (Venezuela - nationalization), Far East (East Timor - boundary disputes), US (Gulf of Mexico - environmental, hurricanes) and the UK (North Sea - residual liability from mature fields; and harsh operating conditions).

This scenario necessitates the adoption of a formal type of risk management strategy by the oil and gas companies operating in these areas with relevant legal responses to the above. What the strategy will look like will largely be influenced by the type of risks they face during their operations. They therefore need to make a number of tough decisions on risk management to safeguard the success of their investments, the integrity of their infrastructure and the lives of their personnel. Whether a balance could be found and how they intend to address these three issues would mainly depend on the individual circumstances of the company and the resources available to them. 

Without the adoption of an internal management control system, the further away from the home country the company operates the more vulnerable it becomes to new types of risks which are associated to that area. 

Generally, there are some common aspects that would apply to the oil and gas industry as a whole e.g. political approval and decision-making, the applicable legal framework, the international oil price, the capital-intensive nature of the industry, the geographic scope of the operations, the risky nature of exploration and production operations, development of technology, environmental considerations, intellectual property and patent protection, the diverse nature of the personnel. These aspects would inevitably increase the levels of legal risk for international oil and gas companies.

Furthermore, the oil industry is a particularly risky business as it operates within a challenging international and national regulatory environment with corporate governance & risk management becoming key priorities. Investors increasingly demand a high level of corporate governance from companies including strict financial reporting and greater transparency. The reduction of global corruption has also become a key priority of the international development community and the adoption of the Extractive Industries Transparency Initiative (EITI) is of particular relevance to the oil industry.

While the above problems may be common to these oil-producing areas, the companies operating in each of these countries may have to deal with some or all of these on a daily basis. The legal risk to companies could therefore depend on the areas where they operate. Therefore companies operating in these areas should do their homework and identify the types of legal risks specific to their business, adopt suitable mechanisms to mitigate and, where possible, prevent the legal risks before they cause serious and even at times devastating, economic damage.

Most of the above legal risks could also be exacerbated, or indeed be managed through the type of relationship that the company adopts with the government (regulator and national oil companies), industry (other companies) and individuals (employees and also interest groups). 

At the end of the day, the type of management control system the company adopts should be able to cope with the peculiar nature of the risk that they face. Any deficiencies in the management system should be identified and rectified otherwise the company would be less able to deal properly with a problem that could just escalate as time goes by. The inability to identify and deal effectively with the exact type of risk could not only result in the damage to reputation and image of the company in the international industry but also further result in serious penalties and fines. Nowadays in an increasing number of jurisdictions, the executives and senior managers of the company can face personal, civil and even criminal liability because of the inability to effectively deal with the legal risks involved.

Finally, each company would naturally tailor their own risk management system and deal with risks in their own unique way. However the way how they manage the legal risk in these oil producing areas is itself a major challenge because of the changing nature of the above aspects and the imposing international and local requirements to deal with these. Therefore, detailed knowledge of the local and international conditions would be very important for the company in managing their legal risks and develop and adapt their own risk management systems acordingly.

Leon Moller is a solicitor specialising in energy with UK law firm Shepherd and Wedderburn.
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