CATEGORIZED | 2012, May/June

Drilling contracts evolve with industry expansion, legislative, judicial trends

Posted on 19 April 2012

During the course of this author’s 35-year drilling industry career, he has seen drilling contracts evolve from relatively simple documents to lengthy, complex contractual arrangements. Recent trends in contracting and important new legal precedents resulting from the Macondo well incident are expected to add more complexity to drilling contracts over the next few years.

In the Beginning

In summer 1859, Edwin Drake tried to dig a mine shaft to capture oil under some promising seeps in Pennsylvania.  When mining techniques were unsuccessful, he

In the early days of drilling, a verbal contract was often sealed by a handshake. Standard contracts didn’t come along until the 1940s.

improvised a drilling technique using a steam-powered cable tool rig that enabled him to strike oil at 69 ft.

Colonel Drake did not need a drilling contract as he was both the operator and the driller. When the oil and gas industry emerged, most operators drilled their own wells using in-house equipment and personnel. This trend continued long after the contract drilling industry maturedy.

In 1940, the predecessor to IADC was founded as the American Association of Oilwell Drilling Contractors (AAODC).  According to a presentation at the 1941 AAODC annual meeting, more than 2,000 drilling contractors were operating in the US and owned about 75% of the available 4,000 rotary and 2,800 cable rigs. This was the era of the “mom and pop” drillers.

Further, ahe AAODC reported that more than 10% of the pioneer drillers also were producers.

An article in the May 1945 issue of Drilling Contractor titled “Insurance – A Necessity for Drilling Contractors” illustrates the naiveté that prevailed. Another article from 1945 commented on the fact that lawsuits between producers and contractors were infrequent, noting that “this is doubly significant when considered with the frequency of occasions where the drilling is well under way and sometimes completed before the contract is signed.”

Interest in contracts seemingly intensified during the late 1940s. At the 1949 AAODC annual meeting, a paper titled “Contractor’s View on Revising Drilling Contract Forms” was presented along with an operator’s response. The response agreed with the contractor’s comment that “some of the drilling contracts enforced today are on patchwork forms.” It also endorsed the observation that “a house-that-Jack-built contract should not be recommended to the industry as a fair expression of the contractual relationship between company and contractor, and certainly should not be used as a yardstick to determine risks and responsibilities in a contractual relationship involving the expenditure of thousands of dollars.”

This was supplemented by a statement that an agreement to drill a well should “be as complete, plain and unambiguous as we can make it” because “a drilling contract should express the full agreement of the parties.”

A report on contractual liability was presented by an AAODC special committee in 1949 articulating seven basic principles to “be adopted in the writing of drilling contracts” by member companies “if found to be fair and equitable.”

An article from 1950 titled “Comments on the Drilling Contract” emphasized the “importance of knowing terms of contract in advance” and “checking the terms of the drilling contract.”

Twelve years after the AAODC was established, it issued the first standard drilling contract. Prior to this issuance, contracting practices were sporadic. In many cases, a verbal contract was often sealed by a handshake, according to pioneer driller and originator of the IADC Daily Drilling Report Earle Hellums.

Early contracts were rudimentary, with a focus on basic commercial terms regarding scope of work, rates and the equipment and personnel to be furnished by the contractor. It was not until the late 1940s and early 1950s that Drilling Contractor magazine discussed the emerging concept of including “hold harmless” provisions in drilling contracts.

The original AAODC standard drilling contract was rather rudimentary and apparently was not universally embraced at first. A 1955 DC article contained the following passage: “The need for a standard form of drilling contract has long been recognized as very desirable.  Whether or not it can be achieved is something I am not prepared to say.”

The weak market for drilling rigs in the early 1960s created an environment in which contractors were compelled to accept unfavorable contracts. In a 1961 article, William Clements, then president of Southeastern Drilling Corp who later became Texas governor, commented: “To a large degree, contractors are responsible for the ills of the oilwell drilling industry. We have created some of our problems by our own actions. We have abetted the establishment of others by bowing down to undesirable contractual clauses and practices.”

Standard Contracts

Over the years, IADC has developed a suite of model drilling contracts. The original AAODC standard contract was split into US land model contracts for daywork and footage operations in February 1986. The first international daywork land model contract was issued in July 1983 and was followed by the introduction of a US land turnkey contract in February 1988 and an international daywork offshore contract in February 1989.

The US offshore daywork model contract was issued several years prior to the international daywork offshore model contract. A US offshore turnkey model contract was issued in February 1989, revised in October 1995 and withdrawn in August 2005 due to a dearth of sales.

Although widely utilized for US land operations, IADC model contract forms are infrequently used in offshore or international operations. More often, they are seen as examples of contract language that enables the contracting parties to gauge commercial and legal risk exposures by comparing provisions of a proposed contract to the IADC model forms.

Other organizations, such as the Canadian Association of Oilwell Drilling Contracts, the API and LOGIC (a non-profit subsidiary of Oil & Gas UK) have issued their own model contract forms.

Further, most oil and gas companies have developed their own cadre of drilling contract forms. The contracts proposed by majors and large independents frequently are subject to qualification by contractors that tender for the work, resulting in negotiated contracts.  However, most national oil companies will not deviate from their pro-forma contracts. This creates a “take it or leave it” situation.

Many contractors consider such non-negotiable contracts to be problematic, primarily because they often contain onerous provisions and frequently are ambiguous in important areas, such as allocation of risk for pollution liability or reservoir damage. Contracts of this nature can create significant risk exposures.

A risk exposure generally can be mitigated only by insuring or contractually transferring the risk. If insurance is not commercially available and the risk cannot be shifted contractually, then management must decide whether the risk can be reduced operationally and determine whether the contract exposure fits within a company’s risk tolerance profile.

Drilling contractors often develop their own pro-forma contracts. Such contracts may serve as the starting point for negotiations with an operator. Although sparingly used, they often serve as a comparative guideline. Many drilling contractors also have developed a contract checklist or contract guidelines.

Several supermajors have attempted to create a global master contract for drilling operations, often with input from contractors, but these efforts never seemed to gain traction.

Table 1: The 2010 and 2011 sales of IADC model contracts indicate the extent to which various types of standard contracts are used. *Sales suspended pending revision

Although there have been various attempts to increase standardization of drilling contracts over the years, the reality is that most international and offshore operators prefer their individual contract forms and are unwilling to utilize standard forms. It is unlikely that standard contract forms will become the norm for offshore or international drilling.

To indicate the extent to which various types of standard contracts are used, Table 1 discloses 2010 and 2011 sales of IADC model contracts.

 

Contract Evolution

The early drilling industry was largely US-centric, and expansion into other countries has created many new contractual issues. Additional terms developed for international contracts include provisions regarding currency of payment, exchange rate fluctuation, taxation, customs duties, compliance with local laws and, more recently, ethics and business conduct.

International contracts often include risk allocation provisions addressing expropriation, nationalization, deprivation and confiscation of the contractor’s rig and equipment. Dispute resolution provisions are of greater import and complexity in international contracts as the parties focus on both the designation of the law that governs the contract and the provisions addressing the nature and location of dispute resolution proceedings.

As the offshore industry developed, drilling contracts were revised and supplemented to address aspects of the marine environment. Contract provisions relating to responsibility for transport of personnel and materials between shore and the rig, were added, as were terms addressing responsibility for providing vessels to mobilize, move and demobilize the rig, and revised “sound location” provisions applicable to a marine environment.

Risk allocation provisions addressing responsibility for subsea and mooring equipment loss or damage, marine pollution and wreck removal also were developed.

As drilling contracts evolved, the length and complexity of the associated documentation increased. Today, a long-term contract for a deepwater rig in international operations is likely to be 200-300 pages.

Events impacting Contracting Practices

Drilling contracts have also been impacted by events and developments involving technological, operational, strategic, legislative, regulatory and judicial activities. The advent of the top drive resulted in revised provisions addressing rig time to service the equipment.  Contract terms also have been developed in response to directional and horizontal drilling, addressing excessive wear on the contractor’s drill string as well as liability provisions allocating risk for downhole motor and directional tool loss or damage.

The progression into deepwater prompted provisions addressing rates applicable for rig time consumed while tripping the lower marine package and allocating responsibility for payment during suspension of operations necessitated when evading hurricanes in the US Gulf.

The advent of dual-activity capability beget special drilling contract terms addressing use (or non-use) of the specialized equipment, partial downtime and patent infringement.

Operational events influence drilling contract terms as well. The Piper Alpha platform explosion, Hurricanes Ivan, Katrina and Ike, and Macondo have all caused contractors and operators to refocus on drilling contract terms in general and the risk allocation provisions in particular.

Strategic initiatives have impacted drilling contracts on a transitory basis.  Perhaps the most significant example is Shell’s Drilling in the Nineties program, which attempted to have drilling contractors serve as a general contractor and “bundle” the ancillary well services.  Unveiled during a keynote speech at the 1990 IADC/SPE Drilling Conference, Shell’s initiative was heralded as a means of “revolutionizing” the manner in which operators and drilling contractors would drill wells.

Contracts frequently have been modified to address legislative or regulatory requirements relating to pollution and disposition of waste. In the US Gulf, the Oil Pollution Act of 1990 prompted contractual revisions addressing the operator’s responsibility for provision of a Certificate of Financial Responsibility while the Clean Water Act, Resource Conservation and Recovery Act, Refuse Act and the Rivers and Harbors Act caused contracting parties to further delineate responsibility for pollution abatement and cleanup, fines, environmental damage and disposition of waste.

Court decisions have impacted drilling contracts in several respects, often on a limited basis. In many cases, the decisions have impacted wording of contractual indemnity provisions.

Rulings in litigation involving US admiralty and maritime law have established that a party may lawfully agree to indemnify another party even in the event of negligence or other culpability by means of traditional “knock-for-knock” oilfield indemnities, where each party generally assumes liability for its own personnel, equipment and property, including the operator’s well-related risks, without regard to cause.  To quote the US Court of Appeals for the Fifth Circuit decision in Theroit v. Bay Drilling Corp., 783 F.2d 527, 540 (5th Cir. 1986), such provisions generally are enforceable if they are “specific and conspicuous.”

Indemnity Provisions

Indemnity provisions are among the most controversial aspects of drilling contracts and have frequently been impacted by legislative enactments and judicial rulings.

Courts frequently have recognized and supported the fundamental principles underlying indemnity agreements. They are intended to allocate risks between the contracting parties for purposes of permitting the parties themselves to decide which of them should bear specified risks and minimizing legal disputes.  This avoids unnecessary and costly duplication of insurance coverages and permits each party to assess its risk exposure under the contract.  To achieve this objective, liability and indemnity provisions generally should be absolute and unqualified (“without regard to cause”).

While such risk allocation provisions eliminate determinations of fault, certain limitations upon reciprocal “knock-for-knock” indemnity provisions are commonplace. Examples of provisions that limit the general protection accorded to contractors include terms commonly included in dayrate contracts that require the contractor to redrill a lost or damaged well at a reduced rate or absorb a stated limited amount of subsurface pollution liability in the event of a specified degree of contractor negligence.

Conversely, the general protection accorded to operators for damage or loss of the drilling rig is normally qualified by provisions that place specified liability on the operator for in-hole and subsea equipment loss/damage or rig damage resulting from an unsound location.

Some operator drilling contract forms modify or negate the general risk allocation provisions if a party otherwise entitled to indemnification has committed gross negligence or willful misconduct. Most drilling contractors respond by proposing to delete the “carve out” for gross negligence or willful misconduct. If unsuccessful, contractors often seek to “cap” their liability at a specified dollar amount, propose narrow definitions of gross negligence and willful misconduct, and limit the applicability of the overriding provisions to gross negligence or willful misconduct of personnel at or above a stated level of supervisory authority.

A fundamental purpose of contractual risk allocation is to create a clear line of demarcation so each party will be able to evaluate its risk exposure. Absolute, indemnity provisions eliminate the need for determinations of fault, negligence or the like. Accordingly, the author and many other practitioners believe the preferred means of contracting involves utilization of unqualified indemnity provisions in drilling contracts and often counsel clients to reject risk allocation provisions with carve-outs or overrides that potentially create unlimited “bet the company” exposures.

There is an ongoing debate as to whether an absolute, unqualified indemnity will be enforceable in the event the recipient of the indemnity has been grossly negligent. As yet, the issue has not definitively been resolved in many jurisdictions. The determination will be dependent on facts, circumstances, specific contract verbiage and, perhaps most importantly, the governing law. Since the decision may be based on public policy, the applicable policy under the governing law may be determinative. Public policy, whether based on judicial or legislative pronouncements, can vary considerably between jurisdictions.

As an example, the adjacent states of Texas and Louisiana seemingly have opposite views as most practitioners believe that an indemnity can be enforceable in the event of gross negligence under Texas law but would be unenforceable under Louisiana law and statutes.

A decision issued in April 2011 by the US District Court for the Southern District of Texas in Energy XXI, GOM, LLC v. New Tech Engineering, L.P., 2011 U.S. Dist. LEXIS 41223 (US DC Southern District of Texas), addressed the issue of whether an indemnity under a master service agreement governed by US maritime law would be enforceable in the event of gross negligence. In considering the issue, the opinion stated:

• There is more support for the position that, under maritime law, an indemnification clause purporting to exempt a party from liability for its own gross negligence is invalid than for the position that such clauses are an appropriate means of risk shifting.

Somewhat to the chagrin of many in the offshore industry, the decision concluded “that the indemnity provision in this case, to the extent it encompasses claims for gross negligence, is unenforceable.”

The Energy XXI decision is of questionable precedential value since it was interlocutory in nature and focused on the wording of a specific indemnity provision. Certification to the Fifth Circuit Court of Appeal has been requested.

Impact of Macondo

The 20 April 2010 Macondo blowout caused substantial human, economic and environmental losses. Although the costs relating to Macondo are ongoing, it is clear that the resulting expenses, losses, liabilities and damages will amount to tens of billions of dollars. The event has already impacted drilling contract terms and surely will add complexity to drilling contracts over the next few years.

Macondo is expected to impact all manner of contracts associated with drilling operations, including contracts with oilfield equipment manufacturers and service companies.

In general, the post-Macondo industry maintains the traditional “knock-for-knock” risk allocation principle, and the operator assumes the well-related risks, including costs and expenses in relation to pollution abatement, clean-up and liability, perhaps with a limited carve-out under circumstances involving a specified degree of contractor negligence.

In the aftermath of Macondo, with the renewed focus on contractual provisions addressing liability for pollution emanating from the well, operators are attempting to whittle away at the traditional risk allocation by proposing to qualify the general indemnity relating to subsea pollution so as to exclude coverage for punitive damages, fines or penalties attributed to the contractor. Post-Macondo contracting also has witnessed an increase in proposals by operators to negate indemnity coverage in the event of the indemnitee’s gross negligence or willful misconduct.

Contractors obviously are resisting such fundamental changes to customary risk allocation.

Further, Macondo has and will impact other aspects of contractual risk allocation. In many cases, contractors are proposing to change terms to address post-Macondo concerns. Such changes include expansion of the indemnified parties to include service companies, equipment manufacturers and other parties that have received an indemnity from the contractor, provisions stating that a material breach of contract shall not impact the contractual risk allocations, as well as proposed terms addressing an obligation to fund defense of claims subject to indemnity and recovery of costs incurred to enforce the contractual indemnities.

Recent drilling contracts for work in the US Gulf of Mexico often address new post-Macondo regulatory requirements relating to BOP certification and testing.  Provisions obligating the contractor to act in accordance with Safety and Environmental Management System (SEMS) requirements are also frequently proposed by operators, along with more stringent terms addressing maintenance, testing and certification of BOP, rig crew training, etc.

Another impact of Macondo relates to the offshore drilling moratoria that were imposed by the US government following the oil spill. Post-Macondo, operators frequently propose to modify contractual force majeure clauses so as to include moratoria, stop orders, refusal to issue drilling permits and similar government actions in the definition of force majeure events.  Conversely, contractors frequently propose to include delays and suspensions of operations caused by such activities in the list of events that are subject to the standby rate.

Insurance provisions have been impacted by Macondo as well, especially since BP claimed entitlement to coverage as an additional insured under the drilling contractor’s liability policies.  Post-Macondo, the parties have focused on drilling contract provisions relating to additional assured endorsements and waivers of subrogation. Macondo has impacted the wording of insurance policies and certificates of insurance in several respects.

Macondo may also signal the demise of the traditional takeover clause in drilling contracts. A typical takeover clause provides that the operator is entitled to takeover and operate the contractor’s rig in specified circumstances, which often include unsatisfactory or unsafe performance.  Such provisions have been included in the vast majority of drilling contracts, although they are virtually never invoked. Post-Macondo, operators and their legal advisors have viewed such provisions as problematic since they may impact risk allocation before and after a takeover and could raise questions as to why an operator did not exercise the right to take over operations when it knew or should have known that the drilling contractor was acting in a negligent manner or operating unsafely. Elimination of the takeover clause may be the only contractual impact of Macondo that likely would be embraced by both contractors and operators.

Future Trends

Undoubtedly, drilling contract terms will continue to be impacted by operational, strategic, judicial, legislative and regulatory events, the most significant of which will likely be driven by implications of Macondo. Although the initial impact of Macondo primarily has been in relation to contracts for deepwater drilling in the US Gulf of Mexico, it is anticipated that Macondo will ultimately impact contracts for shallow-water and onshore drilling in the US and elsewhere.

Macondo already has prompted new regulatory requirements and will surely result in additional legislative/regulatory pronouncements.  The Report to the President by the National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling that was released on 14 September 2011, includes many pages of recommendations for proposed new administrative actions and regulatory enactments.

Although the extent to which the recommendations will be implemented or enacted remains to be determined, it is clear that future US Gulf of Mexico drilling contracts have and will be impacted by changes in the regulatory regime. Among the provisions that have and will be impacted are terms addressing change in laws and regulations, payment for rig time consumed for new BOP testing and certification requirements (including time required to pull and run the BOPE and perform remedial work), and payment for rig time consumed during rig inspections.

Although the current focus is largely US-centric, it is anticipated that other countries also will enact new regulatory requirements that will impact contract terms.

Drilling contracts also will be impacted by the results of the litigation relating to Macondo. The plethora of pending litigation involves liability claims filed against the principal parties (the operator, driller and cementing contractor) by a myriad of parties, including individuals, corporations and governmental entities, various claims and counterclaims between the principal parties and a maritime limitation of liability proceeding brought by the rig owner. The results of this pending litigation – especially as respects the interpretation and application of the provisions of the drilling and other associated contracts in general and the enforceability of indemnities in contracts governed by US maritime law in particular – are likely to influence contract terms in several respects and could even cause contractors to relocate their rigs to other jurisdictions. Resolution of the litigation will be a protracted process that will likely span many years.

A 26 January 2012 order ruling on partial summary judgment cross-motions in the BP/Transocean Macondo litigation involving interpretation and enforceability of the drilling contract indemnity provisions determined that:

• BP generally is required to indemnify Transocean for third-party claims resulting from subsea pollution, even if resulting from gross negligence or strict liability;

• The indemnity does not apply to punitive damages assessed against Transocean;

• The indemnity does not apply to penalties assessed against Transocean under the Clean Water Act but does apply to penalties assessed under the Oil Pollution Act of 1990 (which expressly permits contractual indemnification);

• The court deferred ruling on whether Transocean’s alleged material breach of contract would invalidate the indemnities that benefit Transocean; and

• BP was not obligated to fund Transocean’s expenses to defend third-party claims at that time.

On 31 January 2012, an order was issued in relation to partial summary judgment cross-motions in the BP/Halliburton Macondo litigation involving the interpretation and enforceability of the cementing contract indemnity provisions. That order generally followed the above determinations in the BP/Transocean litigation and held that fraud could void an indemnity clause on public policy grounds given that it necessarily includes intentional wrongdoing.

It should be noted that the foregoing rulings were issued by the US District Court for the Eastern District of Louisiana in the context of partial summary judgment cross-motions and relate to contracts governed by US general maritime law. The most significant aspect of the rulings – that oilfield indemnities are enforceable even in the event of gross negligence (when so expressed) – is contrary to the April 2001 decision by the US District Court for the Southern District of Texas in the Energy XXI litigation.

We thus have two District Courts within the Fifth Circuit that are dynamically opposed in respect of their determinations as to whether an oilfield indemnity that expresses an intent to be applicable in the event of gross negligence will be enforceable as a matter of public policy under US general maritime law.

Moreover, the ruling in the BP/Halliburton litigation seemingly indicates that the court would not enforce an oilfield indemnity governed by US general maritime law in the event of willful misconduct or other intentional wrongdoing.

These are interesting and important rulings that are likely to be subject to further clarification at trial, on appeal or in other pending or future litigation.  Although the interlocutory summary judgment rulings in respect of the drilling contract indemnity provisions are of particular import, the author of this article is of the opinion that there are certain significant aspects of the governing contractual verbiage that may prove to be outcome determinative that were not addressed in the motions, the associated briefs or the court’s order.

The results of the ongoing litigation relating to Macondo undoubtedly will impact the indemnity provisions of future drilling and oil service contracts, especially as respects operations in the US Gulf of Mexico. While the litigation is expected to provide clarity regarding the extent to which the parties may or may not be able to lawfully allocate various liabilities, risks and exposures, the rulings also are expected to raise many questions for practitioners, producers, contractors, insurance underwriters and the courts to address over the ensuing years.

Future drilling contracts also are expected to be impacted by various operational, strategic, legislative, regulatory and judicial developments. As an example, the latest evolution in rig design technology that entails provision of dual BOP stacks on deepwater rigs is likely to engender changes in contractual terms.  Moreover, new US and foreign regulations are likely to increase liability and fines for oil pollution, clean-up and abatement. Such new regulations may impact future drilling contract terms addressing the respective parties’ obligations and the allocations of risk.

It should be noted that the impact of Macondo is likely to extend beyond drilling contracts. As an example, the terms of post-Macondo joint operating agreements between E&P companies will probably shift additional liability to the designated operator. Operators that have been compelled to bear more risk than non-operating participants may attempt to modify future drilling and service contracts in order to transfer some or all of that risk.

Indeed, Macondo is expected to impact all manner of contracts associated with drilling operations, including contracts with oilfield equipment manufacturers and service companies.

Conclusions

Since the advent of the drilling industry over a century ago, drilling contracts have evolved to become increasingly more complex. This largely reflects the growth and development of the industry, expansion internationally and offshore, technical innovations, as well as operational, strategic, legislative and judicial developments. Moreover, Macondo has and will impact drilling operations and related contracts.

The future is uncertain and the only certainty is that drilling industry practices, technology, equipment, regulatory requirements and contracts will continue to evolve and change.

This article is based on IADC/SPE 151442, “Drilling Contract Historical Development and Future Trends Post-Macondo:  Reflections on a 35 Year Industry Career,” presented at the  2012 IADC/SPE Drilling Conference and Exhibition, San Diego, Calif., 6–8 March 2012.


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Below are the Drilling Contractor articles referred to in Mr Moomjian’s paper:

“Insurance – A Necessity for Drilling Contractors”

“Comments on the Drilling Contract”

“Standard Drilling Contract for Contractors and Companies”

“Focus on Contracts”

“Presenting Some New Concepts in Drilling Contractor – Operator Relationships”

“Sound Contracting Practices”

“The Operator’s Hey-Day”

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