Court of Appeal construes Farm-Out Agreement and Joint Operating Agreement together as a cohesive whole

The Court of Appeal has dismissed an appeal against a decision interpreting the provisions of a Farm-Out Agreement for the sale of an interest in two oil production licences: Apache North Sea Limited v (1) Euroil Exploration Limited & (2) Edison S.p.A [2020] EWCA Civ 1397. Herbert Smith Freehills LLP represented the successful defendants/respondents, Euroil Exploration Limited and Edison S.p.A.

This decision serves as a reminder for parties to think carefully about the intended interplay between associated contracts and to ensure the drafting is clear as to the impact the provisions of one agreement may have in interpreting another, including the effect of any inconsistency clauses.

Background

The dispute related to the sum payable by the first defendant (EEL) to the claimant (ANSL) under a Farm-Out Agreement (FOA). Under the FOA, ANSL sold EEL a minority interest in two UK Continental Shelf Licences and EEL became a participant in the associated Joint Operating Agreement (JOA) for those assets. Under the FOA, EEL was required to pay ANSL “Earn-In Costs” as the purchase price for the transfer.

“Earn-In Costs” were defined in the FOA as “ [x]% of the total costs...incurred, and in respect of all works undertaken…” by ANSL in drilling an exploratory well (the “Earn-In Well”). The percentage of Earn-In Costs payable by EEL reflected the percentage interest in the Licence which EEL was acquiring, plus an agreed uplift as consideration for the sale of that interest.

ANSL, as Operator, used the WilPhoenix rig (“the Rig”), which was on long-term hire to it already, to drill the Earn-In Well. However, at the date of drilling the Earn-In Well, the lease for the Rig was at a rate that far exceeded the market rate for an equivalent rig (almost three times higher).  The parties disagreed as to what “costs incurred” should be payable by EEL to ANSL in respect of the Rig based on the construction of terms contained in the FOA and the JOA appended to the FOA.

Summary of parties’ positions

ANSL claimed it was entitled to recover as Earn-In Costs any costs it paid in drilling the Earn-In Well, without qualification.  EEL objected to paying for the significantly higher Rig rates; its position was that ANSL was entitled only to the rate prevailing for similar equipment at the date when the Earn-In Well was drilled, by virtue of provisions in the appended JOA and the Accounting Procedure therein. ANSL could use equipment from its own resources to drill the Earn-In Well; but as Operator under the JOA, ANSL could only charge JOA participants for use of its own equipment at rates commensurate with the cost of ownership, which were limited to prevailing market rates.

ANSL argued that the JOA was an entirely separate contract and nothing in the definition of “Earn-In Costs” under the FOA imposed such a ‘market rates cap’. ANSL further argued that, due to the presence of an inconsistency clause in the FOA, the FOA was the superior contract and superseded the terms of the JOA when determining the price payable by EEL.

However, EEL argued that the FOA was replete with references to the JOA which required the parties to perform payment obligations “in accordance with the JOA” and its Accounting Procedure. EEL submitted that the phrase “total costs” was not defined in the FOA and there was no mechanism for identifying what “costs” came within that phrase or how such “costs” were to be calculated, but there was a comprehensive mechanism for dealing with that issue in the JOA.

First-instance judgment

HHJ Pelling QC at first instance found that it was plainly intended that the FOA and JOA were to be read together. He found that they were not inconsistent; rather they worked “as a cohesive whole”, and “costs incurred” by ANSL fell to be determined under the JOA for the reasons submitted by EEL. The effect was that the “total costs” of drilling recoverable by ANSL under the FOA were subject to the ‘market rate cap’ contained in the JOA.

Parties’ positions on appeal

ANSL appealed the decision to the Court of Appeal. It argued that terms contained in an ‘entirely separate’ contract (the JOA) should not be ‘imported’ into a sale contract (the FOA), for a number of reasons. The presence of an inconsistency clause in the FOA (as above) meant that the JOA was superseded by the FOA. Furthermore, there was a fundamental difference between (i) a multilateral JOA to which there are multiple parties and which contained rules governing charges that could be made by ANSL to the joint operating account in its capacity as Operator, versus (ii) the FOA which was a bilateral sale contract between ANSL and EEL with a price agreed which the purchaser (EEL) is liable to pay. ANSL argued that it ‘wore different hats’ under these two contracts, as ‘Seller’ under the FOA and ‘Operator’ under the JOA.

EEL argued that ANSL could not be incurring any expenses in relation to the Earn-In Well other than in its capacity as Operator under the JOA (not in any personal capacity), and therefore the Accounting Procedure of the JOA determined what “costs” could be charged to EEL as “Earn-In Costs”. The fact that there were multiple references to the JOA in the FOA demonstrated the parties’ common intention that “costs incurred” were to be determined under the detailed Accounting Procedure set out in the JOA.

Court of Appeal decision

The Court of Appeal dismissed the appeal. Carr LJ gave the leading judgment, with which Lewison LJ and Peter Jackson LJ agreed.

The court rejected ANSL’s submissions, namely that the FOA and JOA were to be treated as entirely separate contracts under which ANSL ‘wore different hats’. It accepted EEL’s submission that the contracts had to be construed in their proper context as a cohesive whole. In doing so, the court had regard to the entire FOA and the multiple references to the JOA throughout, rather than only the FOA defined term of “Earn-In Costs”.

The Court of Appeal was keen to emphasise that this conclusion was a contract-specific one. ANSL had submitted that the court’s finding would have any industry-wide impact by setting a general precedent.  The court noted that neither the FOA nor the JOA was on a standard or model form; rather each was bespoke. The proper construction of a farm-out agreement and analysis of its interplay with an associated joint venture agreement will always turn on the precise terms of agreement between the parties.

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