Conoco-Phillips and Exxon-Mobil v. Venezuela: Using Investment Arbitration to Rewrite a Contract

During the mid-1990s, Venezuela’s national oil company, PDVSA, implemented a policy known as the Apertura Petrolera (oil opening), which sought to mobilise the capital, technology and managerial capabilities of international oil companies in order to maximise the production of crude oil while simultaneously reducing drastically the fiscal burden on hydrocarbons exploration and production activities in the country. The Apertura achieved its objectives to a large extent, albeit in a fashion reminiscent of those operations which are hailed as a medical triumph though the patient winds up dead: production à outrance by Venezuela was a key factor behind the oil price collapse of 1998, and the paltry fiscal income generated by some of the Apertura-era projects made them the most unfavourable—for the State—in the history of the Venezuelan petroleum industry.[i]

The standard-bearers of the Apertura were four large, costly and complex projects dedicated to the production, upgrading (i.e. partial refining) and marketing (as synthetic crude) of extra-heavy oils from the Orinoco Oil Belt (OOB), an immense reservoir with over 1 trillion barrels of dense—heavier than water—hydrocarbons in place. Today, three of these projects (Petrozuata, Hamaca and Cerro Negro) are at the centre of the arbitration proceedings that ConocoPhillips (COP) and ExxonMobil (XOM) initiated against Venezuela at the International Center for Settlement of Investment Disputes (ICSID) in late in 2007.[ii]

These arbitrations feature some of the largest claims ever to have been brought against a state by international investors: US$30 billion in the case of COP and more than US$15 billion in the case of XOM. However, a careful reading of dispute’s factual background suggests that these claims bear little connection with the deals that these oil firms actually agreed to in Venezuela.

A pure and simple contract?

At the root of these arbitrations was the decision by the Venezuelan government to re-structure the OOB projects to bring them in line with the legal requirements and fiscal conditions applicable to all other companies with oil activities in Venezuela, as set out in the 2001 Organic Law of Hydrocarbons. This included a requirement that the projects be transformed into mixed companies in which PDVSA affiliates would have a shareholding of 60 per cent; to comply, COP and XOM would have had to reduce their equity in the projects by selling part of their stakes to PDVSA. The companies’ rejection of the government’s terms led to their exit from Venezuela, with PDVSA taking over their shareholdings completely

The legal questions at the heart of these arbitrations are highly complex, and even explaining them in summary form took a paper running to around one hundred pages of text.[iii]  And yet, paradoxically, XOM CEO Rex Tillerson says “[o]ur situation in Venezuela is a pure and simple contract. The contract was disregarded.”[iv]

In a nutshell, COP and XOM allege that, in changing the fiscal conditions for the upgrading projects, and then re-structuring them along the lines sketched above, the Venezuelan government rode roughshod over their vested rights, treating contractual undertakings “as the proverbial ‘scrap of paper’ that they can disregard at their convenience … breaking all the commitments … made to induce … investment.”[v] As to what exactly those commitments were, however, COP and XOM studiously avoid going into specifics, which is hardly surprising because key documents on the record show that these alleged commitments are figments of over-active corporate imaginations.

The COP and XOM investments were only able to happen thanks to the legal régime d’exception defined in Article 5 of the 1975 Venezuelan Oil Nationalisation Law which—”in special cases and if convenient for the public interest”—allowed state entities to “enter into association agreements with private entities …. [with] the prior authorisation of the [Congressional] Chambers in joint session, within the conditions that they establish”.[vi]  Among the numerous conditions that the Venezuelan Congress stipulated for all upgrading projects is one that is fatal in terms of the companies’ claims of governmental undertakings to the effect that neither the fiscal nor the legal framework of the upgrading projects would be altered. In the case of the Cerro Negro project, a joint-venture between XOM, PDVSA and British Petroleum,[1] this condition was expressed in the following language: “[t]he Association Agreement, and all activities and operations conducted under it, shall not impose any obligation on the Republic of Venezuela nor shall they restrict its sovereign powers, the exercise of which shall not give rise to any claim, regardless of the nature or characteristics of the claim…”.[vii] As can be clearly appreciated, this condition amounts to a full reservation of sovereign rights by the Republic (which, furthermore, was not a party to any of the association agreements).

An inconvenient truth?

There exist documents in the public domain, contemporary to the measures, which show that COP and XOM knew full well that their situation vis-à-vis the Venezuelan government was not one of “pure and simple contract”. These documents are of special interest because the statements and opinions contained therein were made in the belief that they would remain confidential, but which came out in the open with the publication of 250,000 US diplomatic cables by Wikileaks. One such cable reported that the petroleum attaché in the US embassy in Caracas was told by an “ExxonMobil executive … on May 17 [2006] that his firm did not believe it had a legal basis for opposing the tax increases” resulting from “amendments to the Organic Hydrocarbons Law (OHL) that raise income taxes on the strategic associations from 34 to 50 percent and introduced a 33.3 percent extraction tax.”[viii]  This candid confession is irreconcilable with the fanciful COP and XOM allegations of fiscal guarantees. But the cable contains an even more revealing disclosure, which goes to the heart of the quantum of compensation COP and XOM are owed for the nationalisation of their interests, and makes a mockery of their colossal damages claims:

… each of the strategic association agreements has some form of indemnity clause that protects them from tax increases. Under the clauses, PDVSA will indemnify the partners if there is an increase in taxes. However, in order to receive payment, a certain level of economic damage must occur. In order to determine the level of damage, the indemnity clauses contain formulas that, unfortunately, assume low oil prices. Due to current high oil prices, it is highly unlikely that the increases will create significant enough damage under the formulas to reach the threshold whereby PDVSA has to pay the partners.[ix]

The indemnity clauses mentioned above were inserted in the association agreements between PDVSA and its foreign parties pursuant to yet another condition established by Congress for all the associations, and intended to compensate foreign parties for the economic effects of adverse governmental measures, such as tax increases and nationalisation of their interests.[x] The compensation for which PDVSA affiliates would be liable, however, was not open-ended and unlimited. Instead, the foreign parties would be deemed not to have suffered any economic damage when the (inflation-adjusted) price of a benchmark crude oil (Brent) in the international market exceeded a certain threshold. In the case of Cerro Negro, this price was 27 USD/B (in 1996 dollars) while for Petrozuata and Hamaca it was 25 USD/B (in 1994 dollars) and 21 USD/B (in 1996 dollars), respectively. Any cash flows generated at prices beyond these thresholds (which might look modest nowadays, but were perceived as unattainable when negotiated[xi]) that were to be appropriated by the government would not be compensable by PDVSA affiliates, regardless of how such appropriation occurred. Thus, the income of the projects was, in effect, subject to a cap, whose activation was entirely at the discretion of the government.

Conclusion

When seen through the prism of documents produced in fulfillment of the procedures contemplated in Article 5 of the Nationalisation Law, the picture that emerges of the actions of the Venezuelan government is at sharp variance with the COP and XOM accounts of them. According to these companies, their legal proceedings were prompted by a commitment to uphold the principle of sanctity of contract. However, the documentary record shows that all OOB projects were authorised by the Venezuelan Congress subject to the express and essential condition that the State was to reserve all of its sovereign powers, including the power to enact and change laws and taxes.  Precisely because of this broad reservation of sovereign rights, COP and XOM bargained with PDVSA to obtain protection for their investments through specific compensation mechanisms, which made explicit reference to a limitation of liability on the part of PDVSA, and provided that foreign investors would be deemed not to have suffered any adverse economic consequences from government measures when the price of crude oil exceeded a certain threshold level. Thus, the bargains that COP and XOM insist they are defending are nowhere to be found within the four corners of the agreements that they actually signed. The COP and XOM ICSID arbitrations, therefore, amount to an attempt on their part to use international arbitral tribunals to re-draft contracts and provisions which they themselves had negotiated, so as to secure a windfall (for which they never bargained) upon their exit from Venezuela.

Author: Juan Carlos Boué is a senior research fellow at Oxford Institute for Energy Studies