Over the last several years, legal disputes involving energy companies have been on the rise, increasingly resulting in litigation before courts or arbitration panels. Both upstream and downstream businesses have experienced significant legal attack by other interests over a wide range of activities. This business hostility against energy companies is further fueled by recent news of record earnings and profits and record high prices at the pump.
With such a broad assault against the energy sector, one might at least expect a united front from energy companies. Yet while this might be true in lobbying efforts before Congress, it has not proven to be the case in litigation. To the contrary, energy companies have demonstrated an increased willingness to initiate adversarial proceedings in order to recoup perceived damages, or to enforce rights against fellow industry members.
The goal here is to discuss litigation arising out of allocation disputes resulting from alleged metering and measurement failures and inaccuracies. We believe that operators will find an examination of the general business environment fueling this type of litigation useful; and that they can benefit from some thoughts on how to manage risk better by incorporating contingency language within their agreements.
Energy’s litigious horizons
While not new, several factors are combining to cause a rise in measurement and metering disputes, many of which are ending up in litigation. Some factors, as already alluded to, are economic in nature due in part to the rapid increase in hydrocarbon prices. Simply put, a producer wants to ensure it gets the same value out of the pipe as it put in. Other factors are more cultural within the energy industry, caused in part by tremendous evolutionary change to the organizational structures and personnel in the industry resulting from mergers, acquisitions, and related spin-offs.
This dynamic situation creates an environment where company negotiators are less likely to know each other as well as in the past, giving rise to greater miscommunication. The disappearance of personal relationships also makes informal resolution over a cup of coffee less likely. And finally, some factors are more procedural. For example, a manager might be more willing to litigate if the company’s exposure and costs are moderated by risk limiting or trial avoidance clauses in the controlling contract. For whatever reason, companies are increasingly disputing production and product allocation allegedly caused by metering and measurement errors. Some of the most common measurement and metering disputes are discussed below.
Failed or inoperable meters. Of course, meters are subject to literally dozens, if not hundreds, of mechanical and calibration problems. The problem becomes more unique and complex, however, in situations were multiple parties are commingling production into a common line under an agreement, requiring each party to provide an operable meter. Problems can quickly arise when production is water lift and the commingled production deposits into a common separator, especially when some wells are producing an increasing amount of water.
In this situation, the malfunction of any one meter can compromise the integrity of the final allocation. Consider the situation where certain wells are experiencing erratic meter readings due to hydrate problems (common in deep offshore wells) while other meters generate inflated readings due to increasing volumes of water in relation to the hydrocarbon. Actual hydrocarbon volumes will not be known until after the production stream clears the separator, at which time it is difficult to assess the allocation to which each producer is entitled.
Although this problem might be foreseeable, contracting parties frequently fail to provide adequately for this contingency in their contract. For example, even though many gathering agreements require each producer to provide an operable meter of identical design, and place the risk of a failed meter on the party whose meter fails, agreements frequently fail to adequately define what constitutes a “failed” or “inoperable” meter. In the example above, both meters produce inaccurate readings of the hydrocarbon, one due to hydrate problems and the other due to increased water production. Has one or both failed? Which party bears the risk of misallocation? What is required to remedy the situation? The failure to anticipate adequately and address these and other contingencies within an agreement gives rise to contractual disputes and possible litigation, especially when prices for the production justify the fight.
Pressurization problems. Pressure variations sometimes directly or indirectly result in metering or measurement disputes. Gathering system operators can often inadvertently exacerbate these issues. For example, operators understandably strive to maximize the efficiency of gathering and transmission systems. With this objective in mind, operators of offshore gathering systems frequently shift production from one line to another due to pressure variances. For example, one well with a relatively high wellhead pressure could inhibit production by a well with significantly lower wellhead pressure, if they produce into the same line. Accordingly, the operator might shift production from the high pressure well to another line to allow the lower pressure well to produce more freely.
The operator’s action, however, might result in a metering issue, due to an altered ownership basis of the competing production streams and their respective meters. Further issues might arise due to a greater variance in the quality of the production stream, causing problems with quality bank compliance.
Quality bank disputes. Quality banks are commonly used when multiple producers or shippers are introducing separate production streams into a single pipeline, with the pipeline returning to the shipper a portion of that common stream at the end of the line. The quality bank makes monetary adjustments among the shippers to compensate for commingling of different qualities of hydrocarbon – in essence charging shippers of relatively low-quality hydrocarbon who benefit from commingling, and distributing the proceeds to shippers of high-quality hydrocarbon whose product is degraded by commingling.
While the concept is straightforward, it is sometimes difficult to design and implement a quality bank valuation methodology that is just and reasonable not only at its inception, but throughout the life of the parties’ relationship. The situation can be further exacerbated when multiple quality banks with fundamentally different methodologies are involved.
Not all measurement disputes are mechanical. To the contrary, disputes pertaining to measurement methodology are increasingly common. While royalty owners sometimes initiate litigation pertaining to measurement methodology, shippers contributing to a commingled stream might also contest methodology, both before and after conditioning, or further processing of the production stream. Example criticisms of measurement methodologies include:
- Extracting samples too far downstream, subjecting samples to flow disturbing devices that affect volume measurement
- Using inappropriate measuring containers for samples, resulting in improper pressure and temperature drops
- Improper transfer to “chromatographs” in violation of industry (API) standards
- Improper filtering of heavier-weight hydrocarbons
- Improper testing of samples based on “dry” versus “wet” gas
- Subtraction metering.
Growth in gathering and transmission systems, the rush to move production to market, and occasional mechanical failures often force parties to rely upon subtraction metering when calculating volumes for purposes of allocation. Accordingly, a producer tapping into an existing line in consideration for a fee or tariff, or by existing right contained within a gathering agreement, might be required to rely upon a calculation whereby the sum of all other intake into the primary line is subtracted from the outtake volume, to determine the balance which is then attributed to the producer.
The use of subtraction metering has been accepted as a necessary cost of moving production or product in many situations where a more accurate means of measurement is not feasible or practical. Subtraction metering is increasingly being scrutinized, however, as the problem of volumetric loss becomes more recognized and its economic impact more painfully felt.
Drafting the agreement
Failure to use suitable contract provisions to address possible problems that can arise in operations or from limitations inherent in measurement instruments is often the genesis of a contract dispute. Instead, parties negotiating a contract should:
- Define conditions that constitute instrument failures or malfunction
- Provide methods for resolving instrument failures or malfunctions short of litigation or arbitration
- Provide methods for adjusting product allocation when conditions deviate from those which were assumed upon entering the contract. Without clear contractual provisions, a party may find itself at the mercy of the pipeline or gathering system, the other producers, or both.
In drafting the gathering or pipeline agreements, parties often provide terms that address rights and obligations in the case of a failed or malfunctioning instruments. Such agreements should always provide adequate definitions of a “failure” or “malfunction.” Additionally, they should address the issue of how much random or systemic error (or bias) can be tolerated at receipt or delivery points.
Of course, applications and situations can exist where there is no reasonable way to resolve a controversy involving an instrument failure or measurement error. For example, meters at certain depths and temperatures may have operational problems, perhaps due to hydrate production. In such situations, there may be no practical way to correct the problem. Also, parties may dispute allocations that are adjusted pursuant to quality banks. For example, a party may disagree with its allocation at the delivery point, perhaps due to alleged instrument error or malfunction, sampling error, or improper sampling points and methods. The contract may have no clear way to eliminate the root cause of the dispute, whether it is related to the manner in which the data is acquired or used.
In drafting an agreement, therefore, parties should consider technical issues that can affect their situation, especially if it involves atypical applications or novel technology. The following is a list of issues that merit consideration to minimize the risk of turning to litigation or arbitration to resolve ongoing controversies:
- Whether to require standardized measurement instruments
- Whether to define conditions that constitute an instrument failure
- Whether to permit alternate measurement methods for flow upon a meter failure or malfunction, such as through the use of differential pressure across a choke point or by subtraction using other functioning meters
- Whether to authorize use of independent experts to determine whether an instrument has failed, and whether an alternate measurement method is reliable
- How long and under what conditions to permit a party with a failed instrument to operate using alternate measurement methods
- Whether and under what circumstances to provide for independent technical review of the suitability of instrument installations or calculation methods that affect product allocation or quality adjustments
Notwithstanding a party’s efforts, it may find itself in situations that do not fit well within the terms of the agreement. In these cases, all interested parties may have to negotiate what is, in effect, a temporary amendment to the agreement. In this case, one must consider that despite best efforts, the dispute may end in litigation or arbitration. If there is a reason to believe that this is a possible outcome, a party must act accordingly, and must do so early. Applicable contract law typically allows a party to reach an accommodation and protect its position in the event of future litigation. Further, contractual provisions may provide some guidance.
If the physical equipment allows, parties may resort to a temporary accommodation that permits use of alternate measurement methods; or, the parties may try to resolve their dispute by retaining an independent expert to evaluate technical issues pertaining to measurement and reallocation of gas or oil among the parties. However, reallocation recommendations of independent experts are difficult to contest in litigation or arbitration. Thus, parties pursuing this course of action must do so with the knowledge that it may foreclose future avenues of recourse.
Further, if a party chooses to pursue an accommodation, it should then ensure that its action is not construed as a permanent waiver of its contractual right to insist on installation of proper instrumentation. Documents provide the best evidence of a party’s intention, whether they be correspondence that sets forth the nature and duration of the accommodation and intention to not waive contractual rights, or a side agreement.
Arbitration and litigation
There will be times when neither the contract’s terms nor the parties’ informal efforts will resolve the dispute. In those situations, a party should understand its rights and obligations under the applicable agreement, since most contracts now have dispute resolution provisions.
These provisions often obligate the parties to hold settlement discussions. The settlement discussions are typically set forth as conditions precedent to initiating litigation or arbitration. The majority of current agreements now require parties to use one or more methods of alternative dispute resolution if informal settlement discussions fail to resolve the dispute. A common approach requires the parties to engage in non-binding mediation. Mediation is typically followed by binding arbitration, generally under the rules of the International Institute for Conflict Prevention and Resolution (commonly called the CPR Institute) or the American Arbitration Association. Other agreements also contain provisions that require appointment of a referee or use of a peer review panel to resolve technical and factual disputes.
Dispute resolution clauses may also mandate short time periods to conclude a dispute. Thus, once a party decides that a dispute must be litigated or arbitrated, it should collect its evidence and promptly prepare itself to demonstrate breach of the agreement and the reallocation it seeks. Once that is in place, the party is ready to invoke the dispute resolution clause and move forward.
In those agreements that do not require arbitration, the parties are free to litigate in the courts. In complex disputes, courts may ask parties or parties may choose to engage in mini-trials or summary trials to facilitate settlement of the dispute. The rationale behind these techniques is that parties can present the highlights of their claims and defense to a jury for a non-binding result. They can then use this information in deciding whether to resolve their dispute by agreement.
Preparation is key
An increasingly dynamic industry operating within a hostile and litigious environment will continue to spawn disputes. High oil and gas prices, coupled with frequent metering and measurement inaccuracies, further escalate many of these disputes into costly litigation. As with most business risks, the key to managing these risks and avoiding litigation altogether is anticipation and careful preparation. While a company will not always avoid the confrontation, it can better manage the risk by anticipating areas of potential disagreement, and incorporating within the agreement means of addressing the disagreement short of litigation.