Contracts refine focus on risk, particularly for high-cost deepwater projects.
The oil and gas industry is still recovering from the greatest global economic shock of more than 75 years. While a mood of cautious optimism has emerged, economic uncertainty remains. In today’s business environment, conditions remain challenging for many, and managing risk remains at the top of every organization’s agenda. The industry should expect a renewed and expanded regulatory focus on safety and environmental risk preparedness and mitigation. This will only highlight the need for companies to be more vigilant in anticipating threats and managing today’s business risks.
In such an environment, prudent risk management practices will necessitate additional management scrutiny for critical contract issues and practices.
Managing and determining risk
Contract risk can be managed and mitigated to a large degree with proper planning. Preplanning is vital to a successful project and becomes increasingly important as projects get bigger and more complex. The oil and gas industry must properly preplan high-cost developments, and a solid execution strategy is absolutely necessary to mitigate the many risks associated with executing complex megaprojects or billion-dollar projects with multiple interfaces and significant challenges.
Preplanning means performing activities such as the conceptual, pre-FEED, and FEED phases of a project that deliver significant benefit-to-cost results. These activities ensure solid strategies are created for the execute or EPCI (Engineer, Procure, Construct, and Install) phase, allowing projects to proceed according to plan and to achieve budget, schedule, and performance goals.
With poor preplanning, projects tend to move prematurely into the execute phase, putting all goals at risk.
Projects cannot “get it right” by starting with a poorly defined execution strategy. The construction strategy should be finalized during the FEED phase of a project and should start by weighing different construction approaches during the concept study phase.
For deepwater projects, this ensures concept selection is performed in light of the restraints related to building and installing the design. Cost, schedule, and risk penalties result if a chosen design proves difficult to build and install, no matter how well the facility might perform once installed.
Beginning the execute phase of a project without a well-thought-out construction strategy leads to missteps, delays, and risks that were not planned for during the FEED phase.
Scope of work definition is a key driver in determining risk allocation. Inadequate scope definition at the front end has inevitably led to problems at the back end, mostly in the form of increased costs and schedule delays. Regardless of whether the contract is cost-reimbursable or lump-sum, it will become increasingly important to have the scope of work and related specifications defined as unambiguously as possible.
Having well defined scope and specifications reduces the number of potential disputes and serves everyone’s interests from the standpoint of planning and expectations as well as execution and dispute mitigation. Given the increasing complexity of projects and the multiple interfaces to be managed going forward – as well as the increased risks associated with them – operators will no doubt ensure scope definition receives the time, cost, and attention it requires.
Liability caps also are becoming increasingly more difficult to negotiate. Good risk management practice requires a total liability cap to capture heads of liability that might not be expressly addressed in the contract. It is a safety net because no contract can address every possible liability or risk. The contractor’s total liability to the customer must be limited to some reasonable amount that bears some relationship to the contractor’s gross margin on the project. Contractors will accept certain carve-outs from a total liability cap; these carve-outs are typically limited to liabilities covered by project insurance, but uncapped liabilities are not acceptable to most prudent contractors. Indemnities are another issue. Contractor indemnities must be limited to the life of the construction project plus one or two years and limited to:
Third-party personal injury and death caused by the contractor’s negligence or fault;
Intellectual property infringement resulting from services or materials supplied by the contractor;
Payment of employee compensation and payroll taxes;
Subcontractor and supplier liens provided the contractor has been paid by the customer; and
Fines and penalties for violations of law. Contractors are not insurance companies and can only be expected to provide indemnification with respect to matters within their control.
Where risk of loss is concerned, contractors want to assume only risks they can control and manage, preferring to limit liability for physical loss or damage during construction either to the proceeds of the customer’s all-risk insurance above some reasonable deductible or, alternatively, for the contractor to furnish the all-risk insurance and assume risk of loss. If the operator elects to provide insurance, the contractor is deprived of the opportunity to properly manage the risk, and thus liability is generally limited to the customer’s insurance proceeds. A contractor’s liability for physical loss or damage to the customer’s other property (not including the project before care, custody, and control passes to the customer) should be limited to a reasonable amount that represents the notional deductible or excess under a typical property casualty policy and further limited to a reasonable aggregate cumulative amount.
Given the increasingly remote and harsh environments where projects are executed, force majeure provisions in the contract need to be as broad as reasonably practicable and not contain an exhaustive listing of what constitutes a force majeure event. It also needs to provide relief, not only from performance, but also for schedule, cost, and other impacts that could directly result from the occurrence of the force majeure event.
Governing law and the method for finally resolving disputes between the contractor and the customer also will get more attention as projects move into third-world countries where there is great uncertainty with respect to the rule of law.
Such uncertainty will adversely impact all parties to the contract.
Exclusive remedies will become more of an issue as projects get more complex and risks increase. Contractors will prefer remedies set forth in the contract to be expressed as the exclusive remedy of the party seeking relief. Express remedies for breach of certain contract terms such as warranty obligations and liquidated damages for delay are commercial arrangements that necessitate good faith negotiation between the parties as part of the bargain and as such are considered in most cases as exclusive remedies. Contracts must explicitly state that the contractually prescribed remedy is in fact the exclusive remedy of the party seeking relief.
Challenges on the horizon
Multibillion-dollar megaprojects are fast becoming the norm instead of the exception. As projects get bigger and more complex and move into areas of increasing uncertainty, prudent risk management practice will demand certainty and clarity in the interest of all parties to a contract. This will ensure the risk balance is conducive to successful project execution and the relationships between contractor and customer will be maintained in a positive manner for the mutual benefit of both parties.