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ILN-ergy | Part Two: PEAK OIL – Are We There Yet?

ILNergyOil and Natural Gas Boom and Bust Cycles and Their Impact On The Practice of Law

Part One of this article examined the peak oil theory, and specifically discussed the significant increase in world-wide production of oil and natural gas caused in part by the prolific use of hydraulic fracturing and horizontal drilling in oil shale formations. Thanks to these and other technological innovations and heavy capital investments coupled with aggressive entrepreneurial risk taking, world-wide production has reached new records. These production records are occurring at a time when relative consumption is beginning to level off and even decline in certain regions(1). Producers were encouraged to see the price of oil stabilize at around $60 per barrel during April, May and June(2), encouraging some resurgence of drilling activity. Static demand combined with economic chaos in Greece, continued discussions between the West and Iran over Iran’s nuclear program(3)  and the resurgence in United States production(4)  has caused the price of oil to again slide to the low $40s per barrel.

Admittedly, it is becoming increasingly difficult to predict the medium term market for oil and natural gas, partially because price is impacted by many unrelated factors, e.g., global politics, regional regulatory oversight, free market speculation, and market manipulation by major producers, not to mention the variations in demand created by increases and decreases in economic activity.

Historically, however, we can observe that the boom in oil and natural gas prices seen over the last several years has come to an end, albeit temporarily, and we can probably safely predict that the world’s oil market will remain weak absent some significant world event.

What does all of this do to the practice of law?

The simple answer – different things to different practices.

Burgeoning oil prices have traditionally created an abundance of work for lawyers specializing in mergers and acquisitions, commercial transactions, land, tax, intellectual property, regulatory, environmental and related compliance, permitting and employment just to name a few disciplines. In the United States at least, a strong oil market does not usually result in increased litigation. Admittedly, there will always be some level of litigation, in good economic times and in bad economic times. Generally, however, corporate clients aggressively strive to avoid litigation, or at least resolve litigation quickly, during strong economic times. This trend is particularly true in the oil and gas industry. When lucrative projects are plentiful and profits high, companies are much more concerned with maintaining the deal flow and preserving favorable business relationships, while avoiding the cost of litigation, both in dollars spent and business distraction, than they are with pursuing actual or perceived business grievances.

In a scenario to illustrate the point (loosely based upon an actual 2014 matter), a working interest owner in an offshore oil field raised concerns and objections over the operator’s proposed project to plug and abandon several offshore wells. The dispute was over the timing and costs projected by the operator. Specifically, the AFEs (authorizations for expenditures) submitted by the operator reflected the use of a very expensive 6th generation dynamic positioning semisubmersible drilling unit, when a far less sophisticated and less expensive drilling unit would have been more suitable. The working interest owners believed that the operator wished to use the 6th generation drilling unit because it was already under long term contract to the operator, and the operator had no other work for it to perform. In other words, the operator planned to use an overpriced drilling vessel to perform abandonment work, spreading that costs to the working interest group.(5) The working interest owners objected to this costly misapplication of resources, but ultimately refrained from initiating suit because of the existing business relationship with the operator and a potential joint venture.

That was last year – now, with capital being increasingly hoarded instead of being invested in long-term and risky ventures, that same client is more willing to resort to litigation to protect its business interest, namely avoiding being charged millions more on a project than necessary.

In another scenario (this time loosely based upon an actual 2015 matter), a dispute arose over the oil and gas leases held by a producer in a large field in southwest Texas containing large reserves of shale oil and gas condensate. The particular leases at issue contain continuous operation provisions arguably forfeiting the lessee’s rights in the event there ever is 60 continuous days without actual drilling on the leasehold. When oil prices were in excess of $100 per barrel during 2014, the producer was not motivated to contest the lessor’s overly broad definition of “drilling operations”. Instead, the producer simply maintained a continued drilling program to increase production and in turn increase revenue for the lessee / producer and the lessor / royalty owner. When prices dropped below $50 per barrel, however, the producer was more motivated to legally dispute the lessor’s contractual interpretation, primarily because the cost of continuous drilling were no longer justified by the reduced margins.

Of course, boom and bust cycles do not typically impact litigation arising out of a catastrophic incident involving loss of life, serious personal injury or significant property loss. Such tragedies generally result in litigation regardless of the economic landscape. Boom and bust cycles do, however, impact litigation over more moderate claims such as minor bodily injuries(6) or relatively minor injury to land.(7)

What does the future hold?

With all the historic precedent it should be relatively easy for law firms to plan for future legal needs in the oil and gas industry, right? Unfortunately, no. One of the more important characteristics to any boom or bust cycle, for purposes of gauging the potential impact it might have on the legal profession, is the predictability of the cycle’s duration. If the duration of the cycle is uncertain, or if its impact is arrested due to business realities unrelated to the underlying cause of the cycle, then the impact could be significantly delayed. While the present bust cycle is believed to be long-term, and an increase in litigation has occurred in certain sectors, the increases have not followed historic trends. Similarly, the impact on commercial and other non-litigation legal work has not followed historic trends.

For example, the current modest level of oil and natural gas prices appears to be a long-term event caused by the simple mathematical reality that more oil is being produced than is being consumed. Low prices should cause a reduction in drilling activity which in turn should cause a predictable reduction in production, which should eventually allow for a price adjustment assuming consumption remains the same. This present cycle, however, is not having the traditional impact, partially because of OPEC’s decision to maintain record levels of production despite soft prices coupled with eased demand. Another reason, perhaps a dominant reason, is the fact that many producers in the United States are forced(8)  to continue development even when low prices reduce margins below levels that would ordinarily support development. This phenomena is made even worse by the “fracklog” in the United States. Fracklog is a term describing the enormous inventory of drilled wells waiting to be hydraulically fractured, i.e., they have been drilled but are uncompleted and therefore have not yet started to produce oil. As of April 2015, producers in the United States reported 4,731 drilled but uncompleted wells. The fracklog has tripled in size over the last year as producers delay producing oil from these wells while prices are low. It is estimated that the additional production available from the fracklog wells is over 322,000 barrels per day!

In conclusion, the various disciplines of the legal profession servicing the oil and gas industry are closely linked to the fortunes of that industry. Boom and bust cycles continue to have a predictable, albeit less so, impact on our profession. The current bust cycle is producing some of these impacts, but is also changing the paradigm, especially with respect to the immediacy and magnitude of the impact felt by the legal profession.

1 For example, China, the world’s second largest importer of oil, imported 10% less oil the last 12 months (June 2014 to May 2015) than the preceding 12 months.
2 The West Texas Intermediate oil price was $117 per barrel in April 2014.
3 Even if sanctions are lifted, it could take months for Iranian incremental supply, estimated at 600,000 barrels a day, to hit the markets. The Iranians have 30 to 40 million barrels in floating storage, however, that could be on the market quickly.
4 At the beginning of 2015, forecasters predicted a gradual reduction of oil and natural gas exploration in the United States due to the lowering price of oil and natural gas. Activity did in fact decline, and while it was predicted to take several months, a reduction in production was expected by the 3rd Quarter of 2015. Recent reports suggest, however, that oil production is set to increase again due in part to the stabilization of oil prices in April and May. In fact, the last week of June witnessed the first weekly increase in drilling rig activity this year. Only time will tell whether this trend will continue, especially as oil prices began yet another move downward in July, dropping nearly 8 percent July 5th, with West Texas Intermediate down to $52.53 per barrel.
5 A sixth generation deep water drilling semisubmersible generally contracts out for $550,000 to $700,000 per day (not to mention the additional support services). Such unit are generally used to drill for oil and natural gas wells in 5-8,000 feet of water or even deeper. They have very powerful motors and sophisticated drilling and station keeping equipment. Plugging and abandonment work, on the other hand, does not require such units and can instead be accomplished by earlier generations of tethered / moored vessels costing approximately $250,000 per day. When an operation is projected to take many weeks to complete, this variance can result in a sizable and unnecessary additional expense.
6 For example, during high oil prices, the rig count, i.e., the number of drilling rigs and crews engaged in drilling, soars. Rig employees can make good salaries and even performance bonuses. A rig employee is much less likely to file suit for a minor injury which in turn could jeopardize continued employment. When the rig count starts to decline, especially if the decline is perceived to be a long lasting condition as opposed to a brief trend, however, rig hands are much more likely to file suit.
7 Similarly, a land owner who receives lucrative royalty payments might be less likely to bring suit against a producer who allowed contaminates to escape the well polluting the soil. While the land owner will certainly negotiate the best remediation he can negotiate, many are reluctant to file a suit thereby jeopardizing the rewarding relationship with the producer. When prices fall and the royalty payments decrease, however, litigation becomes more likely.
8 As previously noted, some oil and gas lease require continued development in order to maintain the lease, and the producer / lessee runs the risk of losing the lease if he discontinues development.

About the Author…

Brit Brown, chair of the ILN Energy Specialty Group, is the Managing Partner of Beirne, Maynard & Parsons, L.L.P., a litigation focused law firm with its main office in Houston, Texas. A large percentage of the firm’s cases and transactions involve the energy industry, and more than 30 of the attorneys focus their practices in this area. They have tried many complex commercial cases touching on contract, intellectual property, gas supply, and employment issues within the energy industry as well as numerous oil-field injury cases. In addition to disputes, the firm provides advice on commercial and contractual matters. The firm also has extensive experience in alternative dispute resolution, arbitration, and mediation, which is an increasingly important method in resolving disputes in the energy industry.

About the ILN Energy Specialty Group

Chaired by Brit Brown of Beirne, Maynard & Parsons LLP in Houston, Texas, the Energy Group brings together energy practitioners from around the world to discuss issues of mutual interest. The group services the legal needs of a wide range of clients in the energy industry around the world, addressing almost every kind of issue confronting the energy industry today.