The Global Lawyer: Did Conoco Hit a Gusher in Venezuela?
We predicted this summer that the Occidental v. Ecuador $2 billion record for the largest investment arbitration award would not last long. The only question after this month's liability award in Conoco v. Venezuela is whether Conoco matches that record, or breaks it eight times over. Our projection is toward the upper end.
In 2007, as ConocoPhillips Company refused to accept Venezuela's sharp tax and royalty hikes, then-President Hugo Chavez seized Conoco's stakes in three oil projects that now produce about 367,000 barrels of oil per day. On Sept. 3, an ICSID arbitration panel found that the tax and royalty hikes were lawful—but Venezuela had acted unlawfully by failing "to negotiate in good faith" to compensate Conoco for its nationalization. (For Luke Eric Peterson's usual exhaustive coverage, see here.)
Conoco was officially seeking over $30 billion in damages, backed by the lawyering of Freshfields Bruckhaus Deringer (partners Alex Yanos, Brian King, Lucy Reed and Jan Paulsson) and James Crawford of Matrix Chambers. About one third of the damages claims flowed from the creative argument that Conoco should recover losses on forgone U.S. tax credits on foreign oil and gas. That $10 billion disappeared when the panel ruled that it lacked jurisdiction over the U.S. claimant. Billions more disappeared when the arbitrators accepted Venezuela's numbers for the applicable tax and royalty rates.
What's left depends on compensation formulas. Venezuela wants to reckon damages by the formulas that Conoco agreed to in advance with Petróleos de Venezuela (PDVSA). If those low formulas apply, then the final award will range from $2 billion to $4 billion, depending on what discount rate is chosen to determine the present value of future cash flow.
But if the arbitrators reject PDVSA's compensation formulas, then I expect damages to range from $12 billion to as high as $17 billion. The numbers are pleasingly round. Based on the size of Conoco's stakeholdings, an oil price of $100 a barrel and the applicable tax regime, I estimate $1 billion a year of cash flow. The arbitrators have already determined that, because there was an unlawful taking, the correct time of valuation is the time of award. Since Venezuela has enjoyed six years of actual production, we must start with $6 billion plus interest. A low-end value for future production would be $5 billion, based on the highest discount rate proposed by Venezuela in its similar arbitration with Exxon (about 20 percent). A high-end value for future production would be $10 billion, based on a more claimant-friendly discount rate of 10 percent. I'll leave the bells and whistles to the economists.
In an extraordinary letter—posted on PDVSA's website and tweeted by the oil minister—Venezuela is asking the arbitrators to reconsider their basic finding that the state refused to negotiate in good faith. "There were a lot of issues in the case, but they never actually accused us of bad faith," Venezuela counsel George Kahale of Curtis, Mallet-Prevost, Colt & Mosle said in an interview with The Global Lawyer. "It's flabbergasting to us. It just comes out of nowhere."
The letter reads as if Venezuela got to write its own dissent (while awaiting the actual dissent). It argues that the panel must hold a new evidentiary hearing on the issue of bad faith, and must examine WikiLeaks cables suggesting that Venezuela entertained paying fair market value in 2008. More fundamentally, it argues that Venezuela's preseizure offer of $2.3 billion was far from the sort of token sum that should be considered bad faith. How could it be, asks Venezuela, when that sum is in the range of damages under the formulas that are still in dispute? As the letter puts it: "We do not understand how it is possible to find that the Republic did not negotiate in good faith when the relevance of the compensation formulas...has yet to be decided."
Conoco is apt to say that a new hearing is uncalled for, and bad faith was already in the air. If a hearing is held it may argue that the cited cables were too late and contradicted by other evidence. More fundamentally, Conoco may argue that Venezuela's settlement offer was in bad faith, no matter its dollar value, because it was based on book value rather than fair market value. As for the compensation formulas, Conoco says that they bind only PDVSA, and not the state.
Unfortunately for Venezuela, the panel's findings make little sense if the panel plans to apply PDVSA's compensation formulas. I conclude that the arbitrators plan to reject the compensation formulas. Accordingly, I project that damages will range from $12 billion to $17 billion. The projections of analysts (for instance $3 billion to $4.5 billion by BankTrust & Co.) are far too timid. Indeed, it's likely that the Conoco damages award will blow Occidental off the top of Arbitration Scorecard's all-time state-investor chart—though by the time it comes out it may be blown out in advance by Yukos v. Russia.
Students of arbitration can't resist comparing Conoco and Exxon, the other U.S. super-major whose heavy oil fields were seized by Chavez. Exxon briefly had $12 billion of Venezuelan funds frozen by a London court in 2008, only to win less than $1 billion in its commercial arbitration with PDVSA. (A parallel investment treaty claim by Exxon against Venezuela is pending).
One potential knock on Exxon is that it was too ambitious in requesting a risk-free discount rate of 4 percent, which left the arbitrators little choice but to go with PDVSA's mid-range request of 18 percent. But no invidious comparison may be made until we see how Conoco fares on the discount rate.
A limited point that may be made now is that Exxon documented its budding dispute too carefully. In both cases, Venezuela argued that the Dutch entities formed by the oil companies to take advantage of the Dutch-Venezuelan investment treaty were "corporations of convenience." This argument failed against Exxon with respect to the nationalization of its assets, but succeeded with respect to some preexisting tax and royalty claims—perhaps because there was copious documentation of a dispute developing before the Dutch entities were formed. (The scope of preexisting claims remains in dispute.) Conoco defeated the same argument completely, partly because it lacked that sort of damning correspondence, and partly because it kept investing significant sums in the project after the restructuring.
The lesson for companies: If you smell trouble, it's smart to restructure to take advantage of investment protection—but don't be too diligent about documenting the emerging dispute, and keep putting money in until your local Hugo Chavez sends in the troops.