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Blockchain and smart contracts: how does it work in the oil and gas sector?

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The modern international circulation of hydrocarbons is becoming more and more autonomous and decentralized. This is facilitated not only by the introduction of such network technologies as smart contracts and blockchain platforms into contractual practice but also by the widespread use of sources of non-governmental regulation (lex petrolea). In the context of the network paradigm of private international law, the classic problem of the conflict of laws is aggravated. We will consider the conflict aspects of the use of smart contracts based on blockchain technology in cross-border oil and gas transactions, taking into account that the use of computer algorithms does not create a new contract, but is only a special form of transaction. Such “automated” transactions in the oil and gas sector, involving multiple jurisdictions, generate uncertainty in their legal regime. In the absence of a full-fledged substantive regulation, as well as in connection with the lex petrolea phenomenon, the collisional method of regulation is in fact dominant. In this article, we discuss the possibility of extending to smart contracts Regulation № 593/2008 of the European Parliament and of the Council of the European Union “On the law applicable to contractual obligations (Rome I),” from which we conclude that the existing regulation is quite applicable to smart contracts that execute cross-border oil and gas transactions. It is another question whether the law, applicable by virtue of the conflict of laws rule, offers a suitable substantive basis. To date, only a few US states have adopted specific legislation on smart contracts. It is predicted that in the future, private international law will not only determine the law applicable to smart contracts but will also become a conductor spreading the positive experience of legal regulation of smart contracts in different countries.

I. Blockchain and smart contracts: how it works
in the energy sector?

Every day, millions of barrels of oil and cubic meters of gas are bought and sold on international markets. This is preceded by a complex chain of relationships, therefore, in the structure of the hydrocarbon business, it is customary to distinguish three cycles of operations: exploration, development, and production of resources (upstream); handling, storage, transportation by pipelines or by sea vessels (midstream); chemical processing, marketing, sales (downstream). All these operations are formalized by contracts, which are proposed to be called cross-border oil and gas transactions. These are the most common contracts for the sale of crude oil and gas in the oil and gas industry, concession, license, oilfield service agreements, production sharing agreements (PSAs), joint activity agreements (JOAs), etc. As a rule, they contain a foreign element (most often — multi-national entities, location of property abroad, execution of an agreement on the territory of different states), which makes them actually cross-border, opening the door to private international law.

As noted by C.O. Garcia-Castrillon, “in practice, for the exploration and development of oil or gas fields, various types of contracts can be used simultaneously, forming a network that reveals the complex nature of the relationship between the parties” (Garcia-Castrillon C.O. Reflections on the Law Applicable to International Oil Contracts // Journal of World Energy Law and Business. 2013). To manage this network and facilitate the international circulation of oil and gas, the parties to cross-border oil and gas transactions have begun to actively implement blockchain platforms and smart contracts**. As a technology that stores and transmits data, the blockchain itself, of course, cannot generate or transport energy resources, but it is favorably distinguished by its focus and applicability to regulating relations.

** In November 2019, Chevron, ConocoPhillips, Equinor, ExxonMobil, Hess, Marathon, Noble Energy, Pioneer Natural Resources, Repsol, and Shell established The OOC Oil & Gas Blockchain Consortium.

The document is available here

** In 2018, Vakt, a consortium of major oil companies, energy trading firms, and banks, launched a blockchain platform to facilitate trade in crude oil and other commodities, successfully completing a paperless trading project and abolishing traditional bills of lading. In the gas market, BTL Interbit uses blockchain and smart contracts to speed up cumbersome contract negotiation processes.

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For example, a bill of lading is used for the international sea transportation of oil or liquefied natural gas. Blockchain is intended to replace bills of lading, make the trade and transportation of hydrocarbons “paperless”, and the associated controls less human.

In addition, upstream companies are often dependent on oilfield service companies and other contractors, and each project is a nexus for multiple, overlapping, and decentralized supply chains. Many entities are involved in the supply of goods: manufacturers, importers, exporters, forwarders, couriers, import and export terminals, carriers, and banks. Effective supply chain management is critical to success: There are many interdependencies where a supplier’s failure to deliver on time through a chain reaction leads to the disruption of several other deals. Blockchain smart contracts solve this problem as well.

In joint venture agreements (JOAs), blockchain can reduce, if not eliminate, the need for negotiation between counterparties, as well as speed up the processing of data controlled by third parties. Smart contracts enable partners to vote on new projects, perform the billing of joint interests, and report co-production revenues. Simply put, this game-changing technology provides insight into who, along the chain, is properly or improperly fulfilling their obligations (Dentos. Global Energy Game Changers — Blockchain in the energy sector: evolving business models and law).

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Comprehension of what is happening is successfully integrated into the context of T. Kuhn’s scientific paradigms with their inherent methodological pluralism and interdisciplinarity. The paradigm approach makes it possible to study and evaluate new legal or quasi-legal realities, burdened by economic globalization and the development of technology, which until then, it seemed, could not even be explained in legal language. If nevertheless, we talk about a new paradigm of law (Domingo R. Gaius, Vattel, and the New Global Law Paradigm // European Journal of International Law. 2011. Vol. 22 (3)), then the most suitable theory, in our opinion, is the concept of “network law,” generated by no less mysterious “network state” and “network society.” The Spanish urban sociologist Manuel Castells describes them as dynamic open systems based on networks of production, power, and experience (Castells M. The Information Age. Economy, Society, and Culture. The Rise of the Network Society. N.Y., 2010). Energy, like the modern world as a whole, also consists of numerous industrial, economic, political, legal, informational networks, strengthened by the Internet and the introduced network technologies.

Playing in contrast to the positivist legal paradigm, private international law in the network economy plays a special role, which is predetermined by the very subject of regulation — cross-border private law relations that are at the forefront of globalization processes. This correlates with a unique toolkit — conflict and substantive methods of regulation, unification and harmonization, ways to resolve conflicts of jurisdictions, the possibility of applying non-state sources to cross-border transactions, and much more.

II. Aggravation of the conflict problem

Agree, it is curious to observe how the law reacts to changing conditions. The proliferation of blockchain platforms and smart contracts has sparked an explosion of scientific research.

The document is available here

The blockchain is a decentralized digital database that contains information about all completed transactions and operates on the basis of cryptographic algorithms (Sulkowski A.J. Blockchain, Business Supply Chains, Sustainability, and Law: The Future of Governance, Legal Frameworks, and Lawyers? // Delaware Journal of Corporate Law. 2019). Closely related to blockchain technology is the concept of a smart contract, which was first described by Nick Szabo as a “computerized contract-enforcing transaction protocol” aimed at “satisfying general contractual terms … minimizing their breaches, both malicious and accidental, reducing intermediaries as well as reducing losses from other transaction costs. Blockchain and smart contracts work like a vending machine. If the correct coins or bills are inserted into the slot, the water bottle will tip over into the container; if the bottle does not tip over or is missing, the money is returned to the buyer.

Smart Contracts: Building Blocks for Digital Markets
 Copyright © 1996 by Nick Szabo
The document is available here

M. Lang and M. Müller, in relation to energy, ask the question whether smart contracts are contracts in the legal sense, or are they automated computer protocols that fulfill the obligations contained in this contract, based on the conditions stipulated in it and agreed outside computer code. While the answer to the question will depend on the jurisdiction concerned, even if smart contracts do not qualify as contracts by themselves, there is no doubt that classical contract law applies to the underlying transaction and that smart contracts expressed in computer code should comply with certain applicable law.

The document is available here

Without interfering with the debate about the legal nature of smart contracts, the following should be considered for conflict of laws purposes. The use of computer algorithms does not create a new contract. This is purely a matter of the form of the deal. The parties conclude a cross-border oil and gas deal in the traditional form, where part of the obligations that can be automated is written in a programming language. Some experts believe that we are talking about “an element of the contract, which is concluded in electronic form with automated execution of the obligation arisen using a computer program.” In their opinion, “the essential characteristics of such agreements are reduced to their electronic form, as well as to the automated fulfillment of obligations under them by performing digital transactions in the sequence specified by the relevant agreements and upon the occurrence of appropriate circumstances (predetermined transaction parameters).”

Determining the applicable law in cross-border oil and gas transactions presents a certain difficulty. The use of blockchain platforms and smart contracts in this case leads to an aggravation of the collision problem. The reasons seem to be as follows.

First, the lack of a wide range of unified material and legal sources makes the collision method of regulating cross-border oil and gas transactions actually dominant.

The question of the application of the 1980 Vienna Convention to contracts for the international sale of hydrocarbons is still being resolved ambiguously. If by virtue of clause f of Art. 2 electricity is directly excluded from the scope of the Convention, there is uncertainty with regard to oil and gas. According to A.V. Asoskova, the Vienna Convention of 1980 still applies to energy trade. This should be accepted, given the absence of an explicit prohibition in the Convention. This view is sometimes shared by national courts**. The 1994 Energy Charter Treaty and bilateral international treaties on the encouragement and protection of foreign investment, often applied to cross-border oil and gas transactions, are investment instruments that limit their scope to a state-foreign investor relationship.

** The Austrian Supreme Court, by decision in case 10Ob518 / 95 (Propane case) of February 6, 1996, recognized natural gas as a material thing within the meaning of the Vienna Convention of 1980, regardless of its state — liquid or gaseous.

Second, the unprecedented growth of sources of non-state regulation and the broadly interpreted concept of “rules of law” forces us to look at the lex voluntatis principle in private international law in a new way. The autonomous “transnational oil and gas law” — lex petrolea, is spreading, based on the philosophy of legal pluralism, according to which qualification as “applicable law” does not depend on its authorization by the state, but on whether it has been approved by the professional community in a particular sector of the economy. Risks of a conflict of law and “wrong” are increasing.

Thirdly, the very existence of smart contracts and blockchain technology catches lawyers by surprise, creating uncertainty about applicable law and conflict of laws regulation. The latter needs some comments.

III. Reflections on the law applicable to smart contracts

For centuries, philosophers, economists, and lawyers have sought an answer to the question of how people can trade with each other regardless of national laws and government control. In recent years, the discussion has been fueled by the digitalization phenomenon, in particular the emergence of blockchain and smart contracts. Initial hopes that smart contracts would free the exchange of goods and services from national laws did not seem to materialize. Classic contract law not only has not outlived its usefulness but also continues to actively develop in new conditions. Like all other contracts, smart contracts require the law to react to them. Thus, the decisive question is not whether smart contracts are subject to the law, but which law they are subject to.

To date, the states of Delaware, Arizona, Nebraska, Tennessee, Wyoming, Illinois, and California have adopted special legislation to recognize the legal consequences of smart contracts. These states recognize automated smart contracts even if they are not matched by a traditional written contract. Thus, the parties can be confident that their transaction will be valid if they choose the law of any jurisdiction that recognizes the legal consequences of smart contracts as the applicable law. However, one should bear in mind the general rule of US conflicts of law, according to which the autonomy of the will of the parties is limited by the law of the state having a “substantial connection” with the contract (§ 187 Restatement (Second) of Conflict of Laws).

The document is available here

In the European Union, the law applicable to contractual obligations is determined, as is known, in accordance with the Rome I Regulation. By virtue of Art. 1, this Regulation applies in situations of conflict of law to contractual obligations in the civil and commercial fields. As a consequence, there can be no doubt that the scope of its application also encompasses smart contracts. However, subject to one important caveat: the Rome I Regulation applies to contractual obligations in the legal sense. A smart contract, as noted earlier, is a piece of software code that can be reduced to a form that automates the fulfillment of obligations. From this, we can conclude that the provisions of the Rome I Regulation do not apply to the smart contract as such, but only to the contract that it helps to execute (to the main transaction). However, the direct application of the Regulation to a smart contract will be possible if it is legally valid under applicable law (for example, the law of the states of Delaware or Nebraska). Thus, a smart contract operating in a virtual and decentralized environment is “legalized” due to the autonomy of the will of the parties (Article 3 of the Rome I Regulation), which provides much-needed legal certainty. The final opinion on this issue could be formulated by the Court of Justice of the European Union, but so far this has not been done.

If the parties have not chosen the applicable law, the judges or arbitrators will do so on the basis of Art. 4 of the Rome I Regulation. In this case, it is of paramount importance to answer the question of what kind of transaction is executed using a smart contract (clauses “a” — “h”, paragraph 1, article 4 of the Rome I Regulation). The choice of law governing a smart contract should take into account the form and substance of the underlying transaction, its business case, technical complexity, number of participants, and jurisdictional coverage. If the contract does not fall within the scope of § 1, then a conflict of laws binding about the right of the party performing the performance that is decisive for the contract is included. Finally, if the applicable law cannot be determined taking into account the above rules, then the contract is governed by the law determined by the principle of closest connection (§ 4 Article 4 of the Rome I Regulation).

The document is available here

There are some general factors that judges and arbitrators take into account when determining the law that is most closely related to a cross-border oil and gas transaction (most often it is in the nature of a mixed contract). These include the place of conclusion of the contract; place of negotiations; location of a natural resource or oil and gas reservoir that is the subject of the contract; place of residence of the parties; location of the insurer; the language of the contract; the law governing any related relationship; the form of the transaction and the legal concepts that make up the contract; the currency used for contractual obligations.

To solve the conflict problem, it is proposed to use the theory of splitting the contractual statute (Dépeçage).

With regard to cross-border oil and gas transactions, characterized by a complex structure, when one applicable law cannot cover all the constituent parts of one contract, the use of Dépeçage is updated. One such transaction can be divided into parts for operation, design, construction, installation, international transport, insurance, dispute resolution, safety, and environmental aspects. Despite their logical separability, they must work as a single organism for the contract to be effective. Subordination of parts of such a transaction to different legal orders simplifies its execution, which is in the interests of the parties.

In addition, in cross-border oil and gas transactions, clauses regarding the implementation of “good practice in the development of oil and gas fields”, “best practice”, “best international practice”, “leading practice of the oil industry”, etc. are spreading. These provisions can be seen as a practical embodiment of the Dépeçage theory. In other words, the principles of “good oilfield practice”, which are widely used by multinational oil and gas companies, will apply to the relevant parts of the contract, while the main applicable law will govern the rest of the contract.

In conclusion, it should be noted that the existing conflict of laws regulation is quite applicable to smart contracts executing cross-border oil and gas transactions. The question is whether the law, applicable by virtue of a conflict of laws rule, offers a suitable legal basis for smart contracts. In the future, parties will increasingly use autonomy of will (lex voluntatis) to choose jurisdictions with developed legislation. As G. Ruehl correctly notes, in the long term, private international law will not only determine the law applicable to smart contracts, and thereby contribute to legal certainty, but also demonstrate which law is best suited to solve digitalization problems from the point of view of the parties.

The document is available here

This, in turn, will affect the processes of harmonization and reform of national law, which will lead to improved legislation for smart contracts in different countries.

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