Uncertainty reigns in new regime for risk, contract management

Onshore and offshore, contractors seek clarity as traditional protocols for risk allocation no longer taken for granted

By Katie Mazerov, Contributing Editor

As one of the oil and gas industry’s best-loved terms, “game-changer” ranks near the top of the list, typically signifying development of step-change technology or a breakthrough in understanding resulting from an extraordinary event or lesson that serves as a catalyst for change. Since April 2010, Macondo has proved to embody many of those elements. As a result, the industry has moved forward with a heightened awareness of risk management and the need for well control preparedness, while operating under a revamped regulatory framework to ensure safety and environmental stewardship.

“There is heightened awareness throughout the industry of environmental issues – pollution, safety and equipment performance — and contracts are more detailed and specific when it comes to those issues,” said John Buvens, Executive VP, Legal, and General Counsel for Rowan Companies. That heightened awareness, along with more robust regulations, have created an environment that is more demanding when it comes to equipment performance and crew training.

“The regulatory agencies are demanding more of our customers, our customers are demanding more of us, and we are demanding more from our employees,” he said. “Rowan has developed a management system that covers all of our corporate policies and procedures and sets the standard as to how we conduct our business safely, ethically and reliably.

“Deepwater operators want new, high-specification and performance-driven rigs,” Mr Buvens continued. He chairs the IADC Contracts Committee, which will host the IADC Contracts & Risk Management Conference, on 14-15 October in Houston. Rowan recently deployed its first drillship, the Rowan Renaissance, to Angola and will deliver a second ship, the Rowan Resolute, to the Gulf of Mexico later this year. The Renaissance is equipped with managed pressure drilling capabilities and advanced safety features, such as a riser gas-handling system to divert gas away from the riser, preventing hazardous gas-in-riser scenarios.

The effects of Macondo also have trickled down to the way operators and drilling contractors negotiate contracts and ensure they are adequately covered from a risk perspective. Contractual terms that were in place at the time of Macondo are still being debated in federal, state and appellate courts. Companies continue to search for clarity amid a confusing and evolving series of judicial rulings, upending protocols that have been in place for 50 years and transforming what once was a straightforward process into one that is complex and uncertain.

“The Macondo incident was a seminal event that, without question, is challenging all areas of law that we associate with the offshore oil and gas industry,” said Steven Roberts, an attorney with Sutherland, Asbill and Brennan. Mr Roberts is serving as lead counsel for Transocean. “The legal issues are all over the map.”

Much of the ongoing litigation, either still to be decided in federal court or on appeal in the Fifth Circuit, includes the scope of liability under the Clean Water Act, he explained. A recent appeals court panel ruling made clear that an operator remains responsible for oil originating in the well, even if that oil flows through the drilling contractor’s BOP and riser.

The implications for deepwater drilling contractors center on three main issues:

• Contractual indemnity;

• Insurance, specifically “additional insured” provisions, and

• Increased emphasis on bridging documents, or provisions of the contract that specify which party is responsible for which aspects of a job. This includes greater specificity regarding US Safety and Environmental Management System (SEMS) requirements.

For decades, offshore contracts have been negotiated under the basic premise that the party having the most to gain should incur the most risk, Mr Roberts said. “Generally, parties take responsibility for their own employees and equipment, and operators typically accept primary responsibility for pollution because they have the most to gain in the event of a discovery.” IADC model contracts have long served as the basis of understanding for negotiations.

In a milestone 2012 ruling, the US District Court for the Eastern District of Louisiana determined that drilling contractors are not entitled to contractual indemnity from operators for punitive damages resulting from subsea pollution if the contractors are grossly negligent. However, contractors remain entitled to indemnity for compensatory damages, notwithstanding a finding of gross negligence. “Given this ruling, some contractors and operators are considering alternative legal regimes that provide greater flexibility in risk allocation, with many looking to apply laws of other countries contractually to reduce potential ambiguity concerning risk allocation,” Mr Roberts explained. “Clarity is the goal when negotiating the terms of the contract. All of the parties want to ensure that what they’ve negotiated will be upheld by the courts.”

Seeking legal clarity

A trend in recent years is operators and contractors re-domesticating their corporate headquarters – such as to the UK, where they have existing operations. “By contractually incorporating the laws of these countries, companies hope the terms of their agreements will be upheld with greater certainty,” Mr Roberts said. “Even pre-Macondo, it was not clear whether US federal courts and state courts interpreting general maritime law would  honor contractual  indemnity for punitive damages, fines and penalties.”

What is clear is that the “need for clear and precise division of risk and responsibility in bridging documents has become vitally important,” he said. In addition to SEMS specifications, contracts reflect the rise of industry standards. One example is API Standard 97, which requires thorough communication between operators and contractors on explicitly stated technical matters. “In the past, attorneys for both parties would negotiate the basic terms of a contract and then leave it up to their respective technical experts to negotiate the more detailed documents. Now, we’re seeing a much greater participation by legal and risk management experts in these negotiations.”

Seadrill, headquartered in London, is seeing greater attention to detail related to matters of pollution in most contracts. Major operators are supplying updated templates for tenders that reflect their desire for assurance that rig equipment is safe and operating properly, said Faye Johnson, Contracts Manager for Seadrill.

Seadrill has eight drillships and four semisubmersibles either new to the market this year or under construction.

“We’re generally finding that operators are pushing for more robust language around the areas of BOP pools, maintenance programs and inspection criteria,” Ms Johnson said. “Often, the inspection acceptance criteria required before mobilization is more stringent and detailed, beyond conventional industry-accepted inspection criteria.” The trend is occurring across all regions, reflecting corporate policies that are global, she noted.

Clauses regarding third-party contractors, such as cement providers, also have become more stringent, ensuring clear risk separation among the operator, drilling contractor and sub-contractors, Ms Johnson continued. HSE concerns are being addressed directly and specifically in operating clauses, rather than in the appendix of a contract. “When it comes to provisions concerning pollution, operators are wanting assurance beyond regulatory requirements, putting what used to be generally covered under ‘industry practices’ into specific language.”

Contracts typically are being negotiated on a case-by-case basis, with some flexibility on the terms “depending on the operator and how comfortable the company is with the area of operation,” she added. “Human resources also can be an issue, especially in regions such as Africa, where it can be difficult to procure crews with a lot of expertise. From a risk management standpoint, we are maintaining an already-robust safety culture in place, ensuring that all new personnel are adequately trained.”

Ms Johnson acknowledged that, at least for the time being, the UK provides greater legal stability than many regions when it comes to the enforceability of contractual terms. However, the industry is watching for the impact of a case involving a contract dispute over sub-contractor termination and how the UK government will respond to the Wood Report. Released in February, the Wood Report calls for the creation of a new regulatory body to oversee oil and gas development on the UK Continental Shelf. It’s expected to have cost implications for operators and contractors.

The onshore case involved a contract provided by LOGIC, a nonprofit subsidiary of Oil & Gas UK that provides standardized contracts, similar to IADC, in the UK. A High Court ruling backed the drilling contractor’s interpretation of the contract wording that it had a right to terminate a contract based on a sub-contractor’s failure to remedy a defect satisfactorily. “Although the liability case involved an onshore contract, how the courts are dealing with the issue is being watched as closely in the UK as Macondo issues are in the US, so there is some level of uncertainty,” Ms Johnson said.

Contractual laws of the country where a contract is signed generally govern the terms of that contract. However, contracts are also governed to some degree by the area of operation and local laws, she added. That has implications for Mexico, where legislative reforms are under way to allow outside investors to enter production-sharing contracts and joint ventures with Mexican operator PEMEX. Nigeria and other countries in Africa also are attempting to pass oil and gas legislation.

Insuring against risk

Insurance regarding risk protection is also adding complexity to the contract negotiation process. “Setting aside operational safety, companies have two ways to protect themselves via risk allocation: indemnity and insurance,” Mr Roberts noted. “Indemnity provisions are typically ‘insured’ and include an additional insured provision in which one party names the other on its insurance policy to provide additional protection or surety for the indemnities that have been accepted. Historically, many offshore contractors’ underwriters have designated the insurance laws of Texas, where most of their clients are based, to govern the policies. As a result of a now-vacated ruling in Macondo, some underwriters now seek to apply the laws of other countries that they believe provide a greater amount of certainty in limiting the scope of additional insured coverage extended to operators.”

In a Macondo-related dispute involving the scope of BP’s coverage as an additional insured under Transocean’s insurance policies, the federal district court rejected BP’s claim that it was entitled to unlimited coverage under Transocean’s policies for all of BP’s risks, wherever they might occur, during the policy year. The court held that BP’s status as an additional insured was limited to those risks for which Transocean had agreed to indemnify BP. Though the Fifth Circuit initially disagreed with the district court on rehearing, it vacated the original opinion and certified two discrete legal questions to the Texas Supreme Court, as Texas law governs the terms of the policies at issue. A ruling is not expected until next year at the earliest.

Ultimately, insurers, like contractors, seek to apply laws to their policies that will give them the greatest degree of certainty in risk allocation, Mr Roberts pointed out. “The uncertainty surrounding this insurance issue has resulted in two or three changes regarding the way insurance companies deal with drilling contractors. Each change has resulted in greater cost to contractors, which in turn has created a greater need for further negotiations with operators to ensure contractors can recover increased costs from their customers.

“Insurance companies are considering application of laws of states in their policies that they believe may provide them with greater certainty over the scope of additional insurance coverage,” he continued. While awaiting the Texas Supreme Court ruling, insurers are also weighing changes in policy language to further limit coverage amounts available for additional insurance. “For example, if a drilling contractor has a $500 million policy, the additional insured clause may contain a sub-limit of $100 million.

“These legal risk-allocation uncertainties, revisions in contractual wording and sub-limits in insurance policies are creating significant challenges for legal and risk departments in both contractor and operator organizations,” Mr Roberts said. “More importantly, the uncertainty has created tension between operators and contractors in their contractual negotiations. What for years was taken for granted is now being revisited.”

Shift in onshore contracts

On the land drilling side, contractors also are seeing a shift from longstanding contractual provisions related to pollution issues.

“Operators want to allocate risk differently and move away from the traditional protocol of providing complete indemnity below the rotary table to drilling contractors by seeking protection against sole negligence, gross negligence or willful misconduct,” said Scott Keller, Marketing Manager for Sidewinder Drilling.

“This is a direct result of Macondo. However, many land drilling contractors simply can’t take on that kind of liability, as the simple economics of the contract terms don’t warrant the risk associated with such exposure,” Mr Keller said.

The trend is especially evident in the northeast US, where an array of environmental ordinances, along with landowners’ concerns regarding air pollution in the picturesque farmlands of Pennsylvania, have made it more difficult to obtain permits.

So far, Sidewinder, with a fleet of 44 rigs operating in every US unconventional play except the Rocky Mountain region, has been able to negotiate contracts by capping the company’s exposure on willful misconduct and gross negligence liabilities, Mr Keller said. Most contracts start with the IADC model contract, or a version of it, which is often amended to address specific issues, areas or scope of work. “Typically, we provide our customers with the contract, and they come back with their amendments and special provisions. The larger operating companies tend to have their own contracts, which they provide to us as a starting point, and that is where we’re seeing a lot of these proposed changes.”

Land contracts are not reflecting heightened concerns about risk involving well control, but they are specifying newer rigs and equipment for the more demanding drilling requirements, Mr Keller said. “There is greater scrutiny of engines, ventilation systems and the quality control measures we have in force. The majority of our fleet is modern and up to date, so we aren’t feeling the impact of those trends as much as contractors with older-style rigs.

“The land business has really turned into an efficiency game, and operators are focusing on saving time and reducing costs,” he continued. “Improvements in hydraulic fracturing technology are leading to every lateral being longer, and as a result, higher-specification equipment has become much more necessary for these drilling programs.” For example, mud pump capabilities have been taken from 5,000 psi to 7,500 psi. The biggest driver, however, is rigs’ capability to walk from well to well on multiwell pads. 

“Walking systems and the ability to move safely and efficiently from one location to another is the name of the game,” Mr Keller said. Most of the industry’s scheduled 230-plus newbuilds for 2014-2015 will include walking/skidding systems, and many contractors have retrofitted their existing fleet with similar systems to meet the new demands of clients.

“Due to incredible efficiencies in engineering, technology, drilling equipment and proper planning, what used to be a 30-day-plus drilling cycle has now become a 10-day operation,” he added. “This has caused a dynamic shift at the rig level to be much more efficient with time management and, in most cases, have additional crew members on location. Night toolpushers and a third floorhand are becoming much more common on our rigs. The added personnel help meet the increased demand by our clients while still ensuring that safety is our number one focus.”

Supply-chain impact

As the effects of the Macondo rulings extend beyond the US Gulf of Mexico (GOM) to both onshore and international markets, service and supply companies also are being impacted in matters relating to contractual indemnity/release provisions, said Cary A Moomjian, President of CAM OilServ Advisors.

“Contracts are being put under a microscope,” said Mr Moomjian, who previously served as VP and General Counsel for Ensco and Santa Fe International. Recent contracts for work in the US GOM often address new regulatory requirements relating to BOP certification and testing, he noted. “Specifically, operators are proposing provisions that obligate the contractor to act in accordance with the operator’s SEMS requirements, address BOP maintenance, testing and certification, including applicable rates, and specify criteria for rig crew training and certification.”

While equipment manufacturers want their equipment to be operated and maintained in accordance with specifications, they also are concerned about liability exposure. “There is now a concerted effort by BOP manufacturers to renegotiate the terms of their sale and service agreements, especially with drillers, to address pollution liability allocations,” Mr Moomjian said. “Manufacturers are concerned that they might have exposure in case of a catastrophic event.”

As contractors increasingly focus on what their exposure is and examine their risk-management practices, they are looking to bridge the gap by purchasing supplemental or contingent insurance to cover what traditionally has been considered operator risks, such as well control and loss or damage to a well, he added. “Moreover, insurers are challenged to develop products that will respond to the new exposures placed on contracting parties as a result of the restrictions and limitations on contractual indemnities and releases pronounced in the Macondo litigation rulings.” He anticipates that insurance companies will create a market that will cover exposures not subject to indemnification.

Another contractual focus has been “force majeure” (events beyond the parties’ control). “There were a number of disputes during the moratoria imposed by the federal government in the GOM in the aftermath of Macondo, with operators attempting to be relieved of their obligation to pay dayrates on the basis that the moratoria were force majeure events,” he explained. “Contractors contested that claiming certain operations were still permitted and that rigs were not completely barred from conducting certain activities; therefore, the dayrates should apply.” Several disputes ended up in litigation and were settled, so there were no judicial determinations.

“Throughout the history of the industry, significant events have altered the way business is conducted, impacting regulation, operating procedures and equipment, and once again, we are seeing this cycle occur,” Mr Moomjian continued. “However, there never has been an operational event of such financial magnitude in terms of cost and liabilities as Macondo.”