Contract Risk Management - A Post Macondo Primer

Fortune favours the brave, as the saying goes. But when catastrophe strikes, fortune has clearly cast a blind eye on the proceedings.

How organisations ensure that these unpredictable turns of fortune do not wreak devastation on their operations is largely down to how they manage risk.

It’s a lesson the financial industry learned only after it was been brought to its knees in 2007-2008. And it’s one that the oil industry is scrabbling to formulate its own response to after the 2010 Deepwater Horizon blowout in the Gulf of Mexico.

It’s safe to say the $40 billion clean-up bill on the BP balance sheet, filed under exceptional items, signaled a watershed for the oil industry.

It has already triggered a paradigm shift in the nature of risk management and in the complex oil contracts that underpin an industry where potential liabilities are enormous.

Contracts After Macondo

As the protracted and costly legal battle between BP, Transocean and Halliburton continues to be played out in the courts almost two years after the Macondo disaster, the importance of contractual obligations is hard to overstate.

The industry is far more cautious than ever about the risks inherent to joint ventures and the increased importance of clearly defined contractual responsibilities to mitigate these.

Going forward, operators will seek to limit liability for environmental damage from pollution as well as for fines and penalties.

With the size and scope of projects increasing in complexity, regulatory regimes around the world continuing to change and evolve, and the cost of dispute resolution rising a pace, upstream operators need to know that their contracts are covered for every eventuality.

High-Risk Overseas Jurisdictions

Risks are not restricted to costly offshore ventures. On the contrary, they pervade every corner of the industry. With seven of the world’s top ten oil producers in the developing world, and much of the remainder in Latin America and Asia Pacific, the risk matrix for any project is likely to be highly involved.

The events of the Arab Spring only served to underline the fact that companies increasingly need to factor in interruptions to supply - as well as the risk to manpower, infrastructure and equipment.

Contracts will often be drawn up with not only with a list of contractors, but equally with government agencies and security firms too, which brings its own challenges.

As the Independent Petroleum Association of America (IPAA) suggests, the golden rule for international exploration should be that: "the largest reserve potential lies in regions with high political risks and large entry costs, countries where judiciaries are not always independent, where corporate governance standards are low, and where there are often entrenched patterns of corporate and government graft."

International Concessions

Any US oil company considering international concessions should also be aware that petroleum laws can vary dramatically from country to country. Hence the need for contract specialists with a unique grasp of local and international laws, not to mention the manifold risks involved in any project. Upstream contractors need to be comprehensively insured for all scenarios, from kidnapping to expropriation or even the possible nationalisation of acreage.

During what can be drawn-out negotiations with government officials, contract specialists will help you to move risk away from your organisation and guide you through common obstacles during negotiations.

Governments may insist, for instance, on certain types of contracts - such as EPIC (engineering, procurement, installation and construction) or ‘lump sum’. They may also demand that local law is enforced. Negotiations are critical in ensuring you obtain the deal that puts your organisation’s interests first.

Types of contract

There are a number of different contracts that US Oil Companies developing overseas assets may resort to. Joint Operating Agreements (JOAs), one of the most significant, are often being replaced in countries like Nigeria by Production Sharing Contracts (PSCs) granting oil companies the right to explore a certain acreage in exchange for the host government receiving a share of production.

Risk Service Contracts (RSCs) are more widespread in Latin America and countries where there are constitutional limits on foreign oil production and ownership. There are also Royalty Agreements that regulate the majority of worldwide production from Algeria to Brazil, Canada to the UK.

In addition to these common international contracts, upstream operators will also need to sign ‘model form’ agreements with their contractors such as LOGIC/CRINE, or the AIPN International Model Well Services Contract.

Only the largest oil companies like BP, ExxonMobil and Shell tend to have their own service contracts. They generally set out a reciprocal indemnity regime where "each party indemnifies the other against claims arising out of personal injury, illness, death, or property loss or damage suffered by the other party, irrespective of cause," as note Andrew Thompson and Jon Karolczak of law firm Minter Ellison.

Choice of Law

When drawing up contracts, one of the most important considerations is choice of law. Particularly in countries where common law is not recognised, parties should insist that the contract is governed by common law. This is particularly vital for indemnity clauses which may not be enforceable in certain territories.

In Kazakhstan, for example, there is only a remote chance that the courts would endorse an agreement where the operator is indemnified for its own negligence. In Western Australia, contracts must explicitly rule out the application Part 1F of the Civil Liability Act, otherwise reciprocal indemnity clauses are unenforceable. The Texas Anti-Indemnity Act also prohibits certain forms of indemnity agreement that saddle the contractor with liability for the operator’s own negligence.

Conclusion

The Macondo blowout has focused the attention of the industry on the risks inherent to oil exploration and production and the need for risk mitigation that is contractually managed. Going forward, it is likely that the scope of reciprocal indemnities will be narrowed as operators seek to spread their risk to their contractors. Special indemnity structures may also be introduced for catastrophic losses. Contract specialists will be critical in ensuring that every cause in the contract is clear - so that organisations can safely operate with the risk they know they have assumed.