Volume 42 | Number 1 Fall 2006
Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field
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I. Introduction
Islamic finance has become a significant source of investment activity in both the Muslim world and, more broadly, the global marketplace. Islam forbids the charging of interest, and otherwise limits the kinds of commercial activities in which people of the Islamic faith may engage, rendering traditional Western approaches to finance (such as loans, bonds, and other debt instruments) largely incompatible with Islamic law. Modern Islamic finance techniques—shaped by traditional Islamic legal principles and an evolving body of jurisprudence, known collectively as Shari’a—draw upon centuries of religious scholarship, enabling devout Muslims in contemporary society to participate in capital markets. Despite the growing prominence of this form of investment, its use in the energy business has been isolated and tangential. Shari’a-compliant transactions in the oil and gas sector have predominately been focused on “downstream”1 projects in the Middle East. These applications have typically merely supplemented more conventional sources of capital investment (primarily through the introduction of Islamic finance tranches in the context of conventional project financings).2 Potential “borrowers”3 operating outside the Middle East and those involved in “upstream”4 oil and gas operations, even within the Middle East, have yet to access Islamic financing.5 A potentially significant source of funding for the voracious energy industry remains almost entirely untapped, and Muslim investors have yet to participate in oil and gas transactions in the United States, with one notable exception. The existing disconnect between potential Muslim investors and Western oil and gas companies has yet to be resolved, but the potential for fruitful economic relationships certainly exists. If this multi-trillion dollar opportunity is approached correctly, however, the enormous potential of Islamic finance for the oil and gas industry may be realized.
Due to the nature of oil and gas assets under American law, there exist few legal impediments to structuring Islamic finance transactions tailored to fit the needs of both the oil and gas industry and Muslim investors. In fact, oil and gas law in most U.S. states is a near perfect fit for the principles of Islamic finance. As a threshold matter, oil and gas assets (including the real and personal property connected with petroleum operations) constitute permissible assets for purposes of Islamic investment because oil and gas operations do not violate Shari’a prohibitions on involvement in inherently “sinful” activities. Shari’a encourages shared risk through joint ownership of productive assets (such as oil and gas reserves) and business enterprises (such as drilling or hydrocarbon production). In key U.S. states, the laws governing oil and gas interests allow for investors to benefit from the security of holding well-recognized real property interests yet to remain largely passive investors; Muslim investors can benefit from partial ownership of productive assets without having to participate in the operation of the oil and gas properties. In Texas and Louisiana, for example, mineral estates (i.e., ownership of oil and gas in the ground) and interests carved out of them (such as royalties) are considered to be real property. As real property with well-defined rights under the laws, ownership in oil and gas can be cleanly transferred, in whole or in part, in a variety of ways. Both privately-owned and government-administered oil and gas leases can be severed, subleased, assigned, encumbered, or otherwise manipulated, often without altering their characterization as real property under the law. Oil and gas law further allows for the transfer of certain kinds of partial ownership rights; for example, one party may control the “working interest”6 and operate the leasehold while other parties may hold “passive” royalty interests (i.e., interests that neither participate in operations nor bear any costs of development). Ownership can be tailored to the needs of a particular transaction, allowing for the creation of indirect beneficial ownership interests that can be held by Islamic investors, a key to Shari’a compliance. If structured properly, interests in oil and gas leaseholds may also enjoy certain protections in bankruptcy, thereby potentially increasing the “lender’s” security. Finally, oil and gas assets can be mortgaged and investors are allowed to hold security interests therein, potentially providing valuable collateral in the event of a breach of contract by the “borrower.” In short, Islamic finance and American oil and gas law are ideal partners.
Given this compatibility, perhaps cultural differences and mutual suspicion have kept financial institutions, energy companies, and the attorneys that serve them from pursuing the potentially lucrative possibilities. The latency of Islamic financial instruments as sources of funds for energy companies operating outside the Muslim world may be explained by a simple lack of information and communication. But the economic realities of the global economy and the increasingly interconnected nature of the international financial markets mean that Islamic finance should no longer remain isolated. Islamic banks, investors, and energy companies are all becoming more sophisticated and, hopefully, more open to working together in the context of Islamic finance deals. Even where conventional finance is adequate, it can be expensive or may include onerous conditions. Islamic finance and investment adds flexibility to the marketplace and may prove to be a competitive alternative. The expansion of Islamic finance into new markets potentially lowers the costs of capital for “borrowers,” including exploration and production companies. With the application of the proper legal, cultural, and financial acumen, Shari’a-compliant finance potentially represents a major new source of funds for the oil and gas industry in the United States, as well as in other jurisdictions that apply similar laws with respect to mineral rights. The intersection between the ancient religious traditions of Shari’a law and the financial appetite of the energy industry (the largest sector of the world economy) has the potential to become one of the key sources of economic development in the coming years, matching the money of Muslim investors (and in some instances conventional investors, who may also find certain Shari’a-compliant investment products attractive based on economic fundamentals if not religious faith) with capital-hungry companies looking to develop energy resources. This emerging field, however, will only be successfully tapped if the lawyers, investors, borrowers, and bankers involved in the oil and gas industry approach the subject with an informed understanding of the complexities of this emerging form of finance. To date, the author is aware of only one transaction (as discussed in detail in Section V below) that has taken advantage of the synergies between U.S. oil and gas law and Islamic financing techniques, but with proper planning, many more may come to market in the coming years.
The purpose of this Article is to provide lawyers, and their clients, a broad understanding of the applicability of Islamic funding techniques to oil and gas financing transactions. Although this Article addresses opportunities related to Islamic financings backed by oil and gas assets in particular, its content also applies to other industries that can benefit from Shari’a-compliant finance and should therefore be of interest to any attorney exploring the expanding role of Islamic finance in the global economy. First, this Article presents an overview of the fundamentals of Islamic finance, followed by an explanation of the existing uses of Islamic finance in the oil and gas industry outside of the United States. The Article then analyzes the compatibility of Shari’a-compliant funding arrangements with certain types of common asset-related financings in the oil and gas sector (including the sale of overriding royalties and production payments); this section also discusses comprehensively the legal principles of certain key American jurisdictions with respect to the characterization of oil and gas assets located both onshore and on the outer continental shelf (OCS) of the Gulf of Mexico. The discussion includes key bankruptcy considerations and the application of state law regarding mineral estates, with particular attention to Texas and Louisiana law (where a large portion of domestic activity takes place and which largely governs offshore Gulf of Mexico leasing). Finally, the article provides a brief overview of the first ever Sukuk transaction backed by U.S. oil and gas assets, which operates not only as a pioneering example of the potentially lucrative intersection of energy deals with Islamic law, but also as a possible foundation for future activity in this emerging field.