September 2012
Offshore oil and gas exploitation involves property and equipment of enormous capital value. This equipment is utilized within a restricted area, together with a large number of contractors, in operations with an inherent risk of pollution. Consequently adequate contract regulation is required to limit the involved parties’ risk exposure.
Significant efforts have been devoted to drafting standard form contracts and to the development of contractual mechanisms intended to assist the parties deal with these risks. The LOGIC standard contracts are well known, as are the Norwegian standard contracts NTK 07 (Norwegian Total Contract) and NSC 05 (Norwegian Subsea Contract). The distribution of risk often varies significantly between different standard contracts, and in addition oil majors may require extensive deviations from these standards. There is also an increasing tendency for the oil majors to use their own contract forms, further shifting the risk distribution compared to the standard contracts. The contractors’ risk exposure increases even further as offshore projects expand in size, depth and complexity. These days contractors not only have to compete on price and product, but also on their willingness to accept risk.
PROPERTY AND PERSONNEL – “KNOCK-FOR-KNOCK”
The customary distribution of the risk of loss or damage to property and personnel in offshore contracts is commonly referred to as the “knock-for-knock” principle. This principle provides that each contracting party agrees to assume responsibility for (and to indemnify the other party against) the risk of liability for loss or damage to its own property and for personal injury or
death to its own personnel.
The benefit of the “knock-for-knock” principle is that it gives certainty by providing a clear and unarguable allocation of liability. It also enables cost savings by avoiding that both parties take out insurance covering the same risks. Despite these undoubted benefits, there is an increasing tendency in the offshore sector to deviate from the “knock-for-knock” principle.
It is common for each party to indemnify the other not only against its own losses, but also against losses suffered by other companies within that party’s “family” or group (such as other
contractors, subcontractors, suppliers or agents). However, there are extensive variations in the extent of which such other companies are covered. For example, the LOGIC standard contracts commonly used in the UK sector embrace the “small family” concept. Careful drafting is required to ensure that the indemnities in a contract cover the right group of companies, and that
subcontracts or associated agreements are interlinked correctly to provide the level of indemnity required.
The mutual indemnities the par-ties give each other were originally intended to be effective regardless of fault. However, offshore contracts now frequently include provisions that exclude losses caused by the indemnified party’s “gross negligence” or “wilful misconduct” from the indemnity regime. Although such carve outs may be viewed as more reasonable in a specific circumstance, they erode the benefit of clearly pre-allocating the risks. Such carve outs may also
result in a risk exposure not covered by insurance.
CONSEQUENTIAL LOSS
It is a well-established principle in off-shore contracts that the parties indemnify each other against their own consequential losses. Although the principle may be well established, the scope of the indemnity often varies greatly. Key issues are whether the indemnity applies regardless of fault and whether it embraces other companies in the family or group, or only the parties
themselves.
Any indemnity needs to be care-fully drafted to ensure that it excludes the full extent of the losses intended to be excluded. This is particularly important where the contract is governed by
English law. Under English law, the definition of consequential loss may be narrower than Norwegian law’s definition “indirect loss”. An example is loss of profit arising directly in the natural course of events. English law does not consider this to be a consequential loss (and thus not excluded) whilst under Norwegian law such loss would normally be considered an indirect loss.
POLLUTION LIABILITY
Pollution liability is an important part of risk management in offshore con-tracts due to the extensive liabilities that may potentially arise. Most off-shore contracts will contain provisions whereby the operator indemnifies the contractor from claims arising from a blow out or pollution from the reservoir, well or property of the opera-tor. The contractor’s liability is usually restricted to pollution emanating from his own equipment. In the aftermath of the Deep-water Horizon, liabilities on contractors are likely to increase. Exceptions from the pollution indemnities are
increasingly being seen, for example where the pollution is caused by the contractor’s gross negligence or wilful misconduct. The contractor should aim to restrict its liability to pollution emanating from its own equipment and not elsewhere, even where this is caused by his own fault. If this cannot be achieved, then the potential risk exposure on the contractor is enormous and additional insurance cover will need to be obtained – if available. The contractor should also be aware of the potential exposure arising under the law in the jurisdiction where the services
are performed. All potential risks should be covered by insurance and if needed, additional protection required from the operator should be included in the contract.
TERMINATION PROVISIONS
Although termination provisions are found in most offshore contracts, the wording of the
provisions varies. For example, the LOGIC contracts entitle the operator to terminate for any default, as opposed to only for a material breach of contract. The condition of material default is however still the more common provision found in both English and Norwegian law, and in many standard contracts such as the Norwegian Fabrication Contracts and Supply time 2005. For
the contractor, it is important to restrict the operator’s right to terminate only to material default situations. Otherwise, the right to terminate becomes very fluid, leaving a high degree of uncertainty for contractors. Termination for convenience on the other hand can only occur where an express contractual provision allows it. Such provisions are common in offshore projects. When accepting a termination for convenience clause, the contractor needs to ensure that it will be entitled to compensation sufficient to cover its losses. Often contracts only provide for
compensation to be paid for the work performed to date, with no or limited compensation for losses that may be caused by the early termination.
EXCLUSIONS AND LIMITATIONS OF LIABILITY
Most offshore contracts define or limit the contractors’ aggregate liability (both contractual and at law) by inserting caps on liability, either as a fixed amount or as a percentage of the contract price. This is a risk management tool aimed at limiting the contractor’s overall exposure resulting from, for example, liability for delay, damage, and/or replacement and default. The agreed cap needs to represent a fair allocation of risk based on the contractor’s risk and remuneration.
The liability cap is often combined with an exclusive remedy clause, stating that the sole remedies are set out in the contract, to the exclusion of any other rights or remedies available at law. A common example in offshore contracts (and other contracts) is liquidated damages being the sole remedy for delay. In the Norwegian sector of the North Sea it is quite common to find limitations of liability capped at 25% of the contract sum, with separate caps for delay at 10% of the contract price and 15% for defects liability. In the UK sector contracts show a greater range, and in other sectors one often finds no cap on the contactor’s liability at all.
FINAL COMMENT
Managing risk in offshore contracts is a constant challenge. As the number of projects increase in differing parts of the world, contractors face a wider diversity in the way risk is managed. Despite the development of standard contracts for many projects, contract terms in the offshore sector are often dictated by oil companies or national governments. The allocation of risk is increasingly
dependent on such matters as the commercial requirements of the national oil companies, local law requirements and the concern for safety and environmental protection in the aftermath of serious casualties.