Offshore petroleum investments made riskier

The maritime boundaries dispute’s effect on investors

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In light of the recent Lebanon Investment in Infrastructure Conference as well as the highly anticipated  CEDRE conference (also known as Paris IV), it is undeniable that attracting private investment is Lebanon’s top priority. This comes shortly after the country signed petroleum contracts with international oil companies (IOCs) for the exploration and production of offshore petroleum resources in Block 4 and Block 9. This major step for the Lebanese petroleum sector is anticipated to bring investments not only for the offshore upstream petroleum sector (exploration and production), but eventually to other sectors contributing to the overall petroleum value chain.

To draw in private investment, Lebanon faces the challenge of providing an attractive investment environment. The BMI Report (compiled by BMI Research, a research firm that provides macroeconomic, industry, and financial market analysis) for the first quarter of 2018 stated Lebanon was a relatively high-risk location for foreign direct investment. According to the report, Lebanon scores 54.1 out of 100 in the overall BMI Trade and Investment Risk Index, with 100 being the lowest risk country. Lebanon ranked in eighth place out of 18 MENA countries (between Morocco and Tunisia). A “relatively high-risk” environment for investment could deter petroleum investors.

These investors, especially in the upstream petroleum sector, generally engage in investments that are described as long-term, capital-intensive, and risky. Although they may take on risky investments, investors are cautious when venturing into such projects. They require that the risks associated with their venture are manageable. Managing such risks is a key determinant to invest or not. In upstream petroleum investments, these risks can be categorized into (i) risks inherent to the petroleum sector, and (ii) risks related to the country hosting the petroleum investment.

Managing risk

The petroleum industry bears substantial risks that stem from the uncertainty surrounding the sector. In the upstream sector, for example, this uncertainty derives mainly from the presence or absence of petroleum resources in a defined well, and the amount of such resources once a discovery is made. Further, there is uncertainty resulting from unexpected or unknown technical problems, as well as potential accidents affecting the environment, which could be detrimental to the investment.

The country hosting the investment may subject the investor to an array of risks that can reduce the investment return rate. These risks include, inter alia, macroeconomic instability, exchange rate risk, capital transfer risk, legal and regulatory risk, and political risk. Among the cited, political risk represents one of the highest-ranked factors constituting a main constraint on investment. In the World Bank Group’s 2014 MIGA-EIU political risk survey, approximately 20 percent of executives considered political risk as one of the greatest disincentives to investing in emerging markets.

The Lebanese context

Political risk generally can be defined as the potential damage to a business operation arising from political behavior. Robert McKellar, in his book entitled “A Short Guide to Political Risk,” broadly enumerates the sources of political risk as being: political instability, feeble governance, and conflict.

Political instability is the persistent serious challenge to the longevity and legitimacy of a government. Feeble governance often materializes as inefficient leadership and management throughout a wide range of governing institutions. Conflict generally refers to friction between different interests and is often preceded by a build up in tension over time. At an international level, risk of conflict is represented by political sensitivity or hostility between rival countries.

A simple extrapolation of the above sources of political risk to the Lebanese context leads to the conclusion that Lebanon has a relatively high political risk. This is due mainly to the political uncertainty heightened by the relatively short life of governments, the prolonged time to form a government, delayed parliamentary elections, regional tensions, the ongoing war in Syria, endemic corruption, and the long history of hostility with neighboring Israel.

Heightened political risk in Lebanon decreases its ability to attract investment in general, and foreign direct investment in particular. This negative relationship between political risk and investment could explain why only three IOCs (Eni, Total, and Novatek), forming a single consortium, participated in Lebanon’s first offshore licensing round.

Maritime boundaries

An additional contributor to Lebanon’s political risk is the maritime boundaries dispute with Israel over an area of approximately 873,722 square kilometers (see Executive’s timeline online for details). The recent award of exclusive rights to petroleum exploration and production in Block 9, falling partially within the disputed maritime area, reignited tension in political public statements.

The non-recognition of Israel by Lebanon and the longstanding state of war between them defeat any prospects for cooperation to resolve the dispute. Dispute resolution mechanisms available under international law, namely the UN Convention on the Law of the Sea (UNCLOS), are also undermined as Israel is not a signatory of UNCLOS. Ongoing indirect negotiation lead by a third-party, which seems the only current avenue to resolve the dispute, has also failed to reach any solution thus far.

It could be argued that the disputed maritime area is too small to have a substantial effect on the petroleum industry. However, this increasing hostility caused by the ongoing dispute and the near start of petroleum activities in offshore Block 9 may escalate into violent actions. Any violent action in response to the build up of tension would be detrimental to the overall Lebanese investment climate. Also, the dispute may undermine the attractiveness of future offshore licensing rounds in Lebanon. Therefore, addressing political risk, including the risk generated by the maritime boundaries dispute, is an imperative for fostering an investment-friendly climate.

Mitigate the risks

The ideal scenario for reducing political risk arising from the maritime boundaries dispute would be to resolve it. However, private investors can still play an integral role in mitigating its risks.

Generally, there are available strategies, organizations, and legal instruments for private investors to mitigate political risk in the petroleum industry including the risk of boundary disputes. The strategies include project financing, joint ventures, corporate financing, energy diplomacy, and alliances. Organizations include private and public insurance providers for financial capital and political risk insurance, governmental and non-governmental regulatory agencies, and international energy forums. Legal instruments that can manage political risk include bilateral and multilateral investment treaties, as well as petroleum contracts such as exploration and production agreements (EPAs).

Standard petroleum contracts do not usually deal with the disputed maritime boundaries’ effect on the parties’ rights and obligations. However, the mitigation of risks arising from disputed maritime boundaries can be achieved through well-negotiated contractual clauses inserted in an EPA such as force majeure and indemnification clauses. Such clauses address the rights and obligations of the parties in case of any incident that arises from non-delimited or disputed boundaries.

The Lebanese model EPA, issued by Decree No. 43 (2017), does not address the risk of maritime boundaries disputes per se. Force majeure provisions under the EPA could be interpreted to include adverse events caused by the existing dispute and affecting the performance of the investors’ obligations. The EPA deems transboundary hostilities as an event of force majeure, among others. Despite their relatively broad terms, however, the EPA force majeure provisions may not cover all the scenarios that may arise from the ongoing maritime boundaries dispute. Should the dispute continue to future licensing rounds, a comprehensive and well negotiated contractual clause would largely contribute to mitigating its risks.

Finally, it is crucial that public and private stakeholders jointly undertake a comprehensive effort to mitigate political risk and its sources by taking a holistic view of the potential levers, to attract more investments and to ultimately improve the wellbeing of the Lebanese citizens.

Hassan Khalife is a qualified Lebanese lawyer who advises energy companies on their work in the MENA region.