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Dealing with Cost Cuts in the Oil & Gas Industry – Legal & Strategic Considerations

30 March 2020

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By: Dr. Constantin Frank-Fahle, LL.M.

 

Following the decline in the oil price, Saudi Aramco announced on 15 March 2020 that the company would cut spending in the wake of the coronavirus outbreak. The Abu Dhabi National Oil Company (ADNOC) has notified contractors and suppliers that it will review existing contracts to cut costs due to the steep slide in oil prices. This article deals with the legal implications of such cost cuts, and strategic consideration direct and indirect suppliers should undertake.

 

1.   What has happened so far?

A price war ensued between two oil-producing giants, namely, Saudi Arabia and Russia on On 8 March 2020. This has resulted in a sharp decline in the price of oil. In particular, the US oil prices have dropped by 34%, crude oil has dropped by 26%, and brent has taken a hit of 24%.[1] The price war resulted due to the failure to reach an agreement between the Organization of the Petroleum Exporting Countries (OPEC) and Russia to reduce the capacity of oil production following the outbreak of coronavirus. Since the beginning of the year, the price of oil had already declined by 30% due to lower demand.

In the aftermath of the oil price crash, Saudi Aramco announced on 15 March 2020 that the company would cut spending in the wake of the coronavirus outbreak.[2] On 24 March, the Abu Dhabi National Oil Company (ADNOC) approached its suppliers and informed them that ADNOC would review contracts to cut costs due to the oil price crash.[3] On 25 March 2020, similar measures were announced by Kuwait Petroleum Corp., requesting all subsidiaries to cut capital and operating spending.[4]

 

2.   What are the typical rights of national oil companies?

Generally speaking, agreements with the national oil companies cannot amend existing contracts unilaterally. It should be noted that the national oil companies (NOCs) typically include wide-ranging termination rights to their agreements. This, in conjunction with the NOC’s de facto market power, will usually make it hard to avoid agreeing on cost-cutting measures.

 

3.   What is the impact on direct suppliers?

While direct suppliers will feel the cost-cutting related pressure promptly, it may take a while until the effects trip down the supply chain. Direct suppliers will effectively need to review their cost structure. As such, suppliers will need to consider their business operating costs, business overhead costs, and equipment operating costs. Depending on the nature of the business, suppliers will also review the cost structure of their supply chain. Therefore, it is expected that tier-1 suppliers will pass the NOC’s cost-saving pressure on to their suppliers. Depending on the nature of the supply/services agreement, the parties may have agreed on a price adjustment clause, which will work in favour of the tier-1 supplier.

From a localisation point of view, tier-1 suppliers will need to keep in mind their localisation related obligations. E.g., under ADNOC’s In-Country Value program, first-tier suppliers will have submitted a binding Improvement Plan.[5] The plan is a part of the commercial bid and cannot be revised. The plan will be evaluated during the tender and integrated into the final agreement as an Appendix.

ADNOC has included two measures to safeguard compliance with the ICV Improvement Plan:

  • Termination; and
  • Payment Mechanism.

 

In case of non-compliance with the ICV Improvement Plan, the bidder shall notify ADNOC and use its best endeavours to remedy the breach before the date of completion. Failure to comply with the ICV Improvement Plan by the end of the agreement constitutes a material breach and entitles ADNOC to terminate the contract. ADNOC reserves its right to recover any losses and damages from the supplier incurred due to early termination of the agreement (e.g., additional costs for completing outstanding services).

Saudi Aramco has a corresponding tool in place: the IKTVA Action Plan.[6] The IKTVA Action is a detailed plan on increasing the IKTVA score in the next five years. It includes targets on Saudization and investment.

In light of the Covid-19 crisis and the oil price crash, suppliers that have committed to localisation goals should communicate with the NOCs if such goals cannot be fulfilled. In the case of agreements on cust-cutting, suppliers should ensure that they also revise their localisation goals accordingly.

 

4.   What is the impact on indirect suppliers?

Based on the above, indirect or sub-suppliers (suppliers of tier-1 suppliers) will most likely feel the increase in cost-saving measures shortly as well. It is expected that tier-1 suppliers will reach out to their suppliers and ask for price reductions. Pro-active sub-suppliers should, therefore, review their cost structure in anticipation of the NOC’s measures. As long as the localisation related improvement obligations have not been passed on back-to-back to sub-suppliers, sub-suppliers will not feel any effects due to stagnation or decrease of localisation scoring.

 

5.   Conclusion

In the shadow of the Covid-19 crisis, businesses are currently faced with various legal challenges (e.g. travel & transport restrictions, quarantine, supply-chain related delays, etc.). Additionally, suppliers in the oil & gas industry will need to review their cost structure against the NOC’s increasing cost pressure in light of the recent oil price crash. Based on this, the following measures should be implemented at short notice:

  • First-tier suppliers that have been or will be approached by the NOCs to offer more competitive prices, should review their cost structure and review if and how they can offer more competitive prices;
  • First-tier suppliers that have contractually committed to achieving localisation goals should notify the NOCs that – in case of compliance cannot be achieved due to the impact of the effects of Covid-19 and/or oil price crash – the goals cannot be achieved;
  • Sub-suppliers should anticipatingly review their respective cost structure.

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Dr. Constantin Frank-Fahle, LL.M.
Managing Partner | Attorney at Law
+971 (0)2 694 8562 | frank-fahle@germela.law | www.germela.law
GERMELA LAW LLP | Al Sila Tower, 24th Floor | Abu Dhabi Global Market Square | Abu Dhabi | UAE

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[1] Clifford Krauss, Saudi Oil Price Cut Is a Market Shock With Wide Tremors, New York Times, 9 March 2020 <https://www.nytimes.com/2020/03/09/business/energy-environment/saudi-oil-price-impact.html> (last visited: 29 March 2020).

[2] Summer Said/Benoit Faucon, Saudi Aramco Cuts Spending, Hikes Dividend Amid Price War, The Wall Street Journal, 15 March 2020 <https://www.wsj.com/articles/saudi-aramcos-2019-profit-falls-21-on-weak-oil-prices-lower-output-11584259869> (last visited: 29 March 2020).

[3] Alexander Cornwell/Hadeel Al Sayegh, UAE’s ADNOC tells contractors it plans cost cuts after oil price crash – sources, Reuters online, 24 March 2020 <https://www.reuters.com/article/emirates-adnoc/uaes-adnoc-tells-contractors-it-plans-cost-cuts-after-oil-price-crash-sources-idUSL8N2BH464> (last visited: 29 March 2020).

[4] Arab News, Kuwait’s KPC to cut spending on ‘unprecedented’ oil price slide, Reuters online, 25 March 2020 <https://arab.news/r8ckt> (last visited: 29 March 2020).

[5] Constantin Frank-Fahle, ADNOC’s In-Country Value Program – Improvement Plan and PaymentMechanism, Gulf Legal Advisor, 6 March 2020 <www.lexismiddleeast.com/pn/AbuDhabi/ADNOC_s_In-Country_Value_Program_-_Improvement_Plan_and_Payment_Mechanism> (last visited: 29 March 2020).

[6] More details on Saudi Aramco’s IKTVA Action Plan can be found on the Saudi Aramco’s website: <https://iktva.sa/participating-in-iktva/> (last visited: 29 March 2020).