Farm-Out Agreements and JOAs: a Joined-Up Approach to Construction

OVERVIEW

Apache North Sea Ltd v Euroil Exploration Ltd [2020] EWCA Civ 1397

In what circumstances will one contract be construed by reference to another? In the energy sector, the issue will often be an important one, given the prevalence of suites of contracts dealing with different aspects or layers of involvement or activity. The general rule is that “A document executed contemporaneously with, or shortly after, the primary document to be construed may be relied upon as an aid to construction, if it forms part of the same transaction as the primary document”: see Lewison, Interpretation of Contracts, 6th Edn, section 3.03. But this relates to different contracts which are “in truth one transaction” or “as it is called in modern jargon, a ‘composite transaction’” (Lewison). But what if the transactions are different ones, involving the same but also additional parties, but are related transactions?

Apache v Euroil: Summary and Take-Away Points

The Court of Appeal’s decision in Apache North Sea Ltd v Euroil Exploration Ltd [2020] EWCA Civ 1397 addressed this question in the context of a Farm-Out Agreement (the FOA) between Apache as and Euroil for the sale and purchase of minority interests in respect of a UK Continental Shelf production licence relating to the Val d’Isere block and for Apache’s participation in the associated Val d’Isere Joint Operating Agreement (the JOA) as Operator.

The Court of Appeal (as the Commercial Court before it) held that, on the terms of the specific contracts in issue, it was wrong in principle to treat the FOA and the JOA “as entirely separate contracts with Apache wearing different hats in each” and that would “not reflect the true nature of the parties’ dealings at the time” [39]. The contracts were to be construed together, and “in their proper context as a cohesive whole” [42]. 

While the Court stressed that it was dealing with the contracts before it and emphasised that it was not setting a “general precedent” for all FOAs and JOAs [70], the decision is significant in demonstrating a realistic approach to construing contracts which are meant to work together. As the Court stated, “Farm-out agreements do not typically exist in a vacuum. Where there is more than one owner, the parties will regulate their relationship in relation to that asset under a joint operating agreement. Farm-out agreements need to take account of and interact appropriately with those joint operating agreements to avoid inconsistencies and minimise the prospect of dispute.” [2]

The arguments in Apache v Euroil in the Court of Appeal

The issue arose out of the incurring of drilling costs by Apache in relation to an exploration “Earn-In Well”, using a drilling rig on a long-term lease. The rate for the drilling rig as incurred by Apache was one which was significantly above market rates at the time of drilling. 

Apache sought payment of the drilling costs in full from Euroil in full under the FOA. In the very detailed terms of the FOA drafted, as was common ground and as the Court accepted, by “sophisticated parties represented by experienced lawyers” provision was made for the “Val d’Isere Earn-In Costs” which Euroil agreed to bear: “twenty six point twenty five percent (26.25%) of the total costs (other than the Back Costs) in relation to the Val D’Isere Earn-In Well, whensoever incurred, and in respect of all works undertaken pursuant to the Well Programme in connection with the Val D’Isere Earn-In Well”. 

Euroil contended that the recovery was necessarily capped at market rates and relied upon the combination of the payment provisions in the FOA (requiring it to pay all Earn-In Costs “upon receipt of an invoice from [Apache] … in accordance with the relevant JOA within the applicable time periods as set out in the relevant JOA”), read together with provisions in the JOA to which both Apache (as Operator) and Euroil (and another) were parties. Euroil relied upon the usual ‘no gain no loss to the Operator” provision in the JOA and the detailed accounting procedure in the JOA which was used to be used for billing under the FOA, which had no billing procedure of its own. As part of that billing procedure, the cost of equipment leased by the Operator “not exceed rates currently prevailing for like…equipment”.

Apache responded that:

i.    the FOA and the JOA were entirely different contracts with different mechanisms and purposes and separate parties;
ii.    The FOA was a bilateral sale contract with a price agreed which the purchaser is liable to pay. The JOA on the other hand was a multilateral joint venture contract with a joint venturers’ account. 
iii.    Apache wore different hats at different times, depending on which contract is being considered.
iv.    To hold otherwise, would be impermissibly to incorporate a joint venture accounting convention in a multilateral joint operating agreement into a bilateral farm-out sale and purchase agreement so as to reduce the price there agreed;
v.    That would be “a significant development for the oil and gas industry, given that joint operating agreements are attached routinely to farm-out agreements by way of appendix”. 

The decision in the Court of Appeal

The Court of Appeal rejected Apache’s arguments and held that the recovery of the drilling costs was capped at market rates given the provisions of the JOA. This was essentially for three reasons identified in the judgment of Carr L.J.

First, the artificiality of trying to construe the FOA as if it stood alone and without reference to the JOA. As the Court stated, this was “an ex post facto theoretical argument that does not reflect the true nature of the parties’ dealings at the time” [39] in circumstances where, by the time that the FOA was executed, the terms of the JOA, including the Accounting Procedure, had been negotiated and by the terms of the FOA they were to be deemed to be in full force and effect before and after completion of the FOA. The two contracts were “part of a package” and fell to be read together. As the Court said at the outset, FOAs do not exist in a vacuum and necessarily need to take account of and interact appropriately with those joint operating agreements to avoid inconsistencies and minimise the prospect of dispute.

Secondly, and building on that, not only was the JOA part of the “Agreement” which made up the FOA (because the JOA was attached by way of schedule to the FOA), but the FOA also contained what the Court described as a “plethora of references throughout the FOA to compliance with the provisions of the JOA” which showed that they were intended to interact with each other. 

Thirdly, the argument that the FOA was an entirely separate and self-contained agreement could not sit with the parties’ express agreement for issuing AFEs, invoicing and payment under the FOA “in accordance with the relevant JOA”. The critical factor was that all billing under the FOA was to be done using the JOA accounting procedure and therefore invoicing Euroil for the Earn-In costs was subject, without qualification, to the JOA accounting procedure and the principles set out in it, in particular the ‘fair and equitable’ principle, reflected in market rates, and the ‘no gain no loss’ principle. 

Discussion

In one sense, it is difficult to see how the Court could have reached any other conclusion given the express inter-linking of the JOA into the FOA and the use of the JOA provisions for the accounting procedure. Looking at the language of the FOA in isolation, the Court found that Apache’s argument had at least an “initial attraction”. But the decisive factor was the fact that the proper construction of Euroil’s payment obligation fell to be determined on the basis of the text of both the FOA and the JOA, and sense made of each taken together. 

The realistic approach of construing multiple contracts used in the energy sector is a continuing one. There are different routes by which the approach can be deployed, for example by treating the other contract or contracts as part of the factual matrix in which the subject contract was made and against which it must be construed, even if not part of the same transaction and even if not directly inter-related (as they were in Apache v Euroil). 

The earlier decision of Teesside Gas Transportation v Cats North Sea Ltd [2020] EWCA Civ 503 illustrates this in perhaps an extreme form. In that case, the terms of a cost sharing formula in a Capacity Reservation and Transportation Agreement dated 1990 and relevant to the usage of the pipeline were construed in the light of the concepts found in the later Transportation & Processing Agreements with third party shippers (“TPAs”) were concluded by the CATS Parties and with which it was to be assumed the CRTA was to work in the future. A “separate contracts” / “subsequent contract” argument was rejected by the Court on the basis that “the concepts used in those later contracts (such as “Daily Reserved Capacity Rate”) were within the contemplation of the parties in 1990 even if the names given to them and the detailed terms of the TPAs were not” (per Males LJ at [84]).

Coda: “Precedence Clauses”: any use?

As so often, reliance was placed on a conflicts or inconsistencies precedence clause in the FOA (“If there is any conflict between the provisions [the FOA and the JOA], the provisions of this Agreement shall prevail”). Apache argued that this established that the FOA ‘trumped’ the JOA. Again, as equally so often, the Court emphasised that such clause was only of any utility in the case of true conflict, which would usually not arise once the terms had been construed together and for which, in Carr L.J’s words, it had to be shown that “one clause in one document emasculates another clause in another document”. [36]

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