Oil and Gas Service Contracts

1. Oil and Gas Service Contracts Andrew R. Thomas Energy Policy Center Levin College of Urban Affairs Cleveland State University Of counsel - Meyers, Roman Friedberg & Lewis Russell O’Rourke Meyers, Roman Friedberg & Lewis NBI CLE Seminar Cleveland and Youngstown December 2013

2. Agenda • I. Introduction • Service contracting in the oil and gas business • Trends • II. Dispute Resolution and Self Help Remedies • Russell O’Rourke – Meyers, Roman et al • III. Special Problems in Service Contracts • Risk Allocation/Indemnification/Insurance • Subcontracting • IV. Common Service Contracts • Well Services • Drilling • Seismic

3. Part I. Introduction Contract Types Common to Industry • Granting Instruments – grants rights to explore for and produce hydrocarbons • Transfer of Mineral Rights – purchase and sale, assignments, farm outs • Joint Ventures – confidentiality, exploration, area of mutual interest, and joint operating agreements • Service Agreements – contracts for mixture of goods and services usually between producer and technology company. • Hydrocarbon sales agreements – natural gas agreements tend to be complex.

4. The Advent of Form Contracts • Contracts becoming commonly available • Trade associations – AIPN, API, AAPG, AAPL, IADC • Services – Kane’s, Barrow’s • Establish perceptions of fairness • Familiarity bias • Need to know perspective of drafters • Bias of trade association – IADC drilling contract, Bath lease form, etc. • Risk -- parties may execute without reading it. • Can create instead of save work • Risk of superfluous or inapplicable provisions, creating confusion • Risk of contradictory language, failure to read entire document to ensure internal consistency. • Tendency to add special provisions at the end. Economic Potential for the Utica Shale Development in Ohio

5. Age of Complexity in Oil and Gas Contracts • Increasingly Risky Operations • Arctic regions • Tar sands • Deep water • Deep wells, subsalt • Horizontal/unconventional wells • Increasing outsourcing • Shift to more complex chains of subcontracting • More specialization • Increases problems with managing the contract Economic Potential for the Utica Shale Development in Ohio

6. Master Service Agreements • Trends • Increasing complexity • More and longer subcontracting chains • 70% subcontracts for typical well • Wilson & Kuszewski study • More emphasis on social and environmental performance • Primary Tool for managing contractor responsibility: • The legal contract • Change order policy • Result: focus on relationship between operator and first tier contractor • But subcontractor problems can become operator problems

7. Trends For Service Agreements • Challenging operating environments • Increasing complexity • Longer contract chains • “knock for knock” (no fault) indemnification • Indemnification pass through provisions • Dispute resolution provisions • US - still generally resolved in courts • International – resolved through arbitration • Local requirements • Environmental – State by State in U.S. • Local Hiring/Social Justice • Tend to avoid for high risk operations • Not required in US, but desirable Economic Potential for the Utica Shale Development in Ohio

8. Upstream Opportunities for Ohio Industries Economic Potential for the Utica Shale Development in Ohio Pad construction – location liners, limestone, pits, dikes, roads, etc. Water – for drilling and fracturing Mud – bentonite and barite clay Steel pipe (casing) Cement (conventional cements not acceptable) Sand – clean, well-sorted 20-40 mesh in particular Steel tanks, separators, metering equipment, production equipment, etc. Compressors Pipelines Treatment facilities for NGL’s, water, and impurity removal

9. Mid and Upstream – Gathering lines Economic Potential for the Utica Shale Development in Ohio

10. Midstream -- Processing Plants Economic Potential for the Utica Shale Development in Ohio

11. Example Service Contract Problem • Grace Drilling Company enters into a contract to drill onshore prospect for Able Oil Company. • Grace knows Able is underfinanced, so it prepares a contract that requires payment of day rate one day in advance, or Grace can terminate contract. • However Grace must give written notice of termination. • Grace drills to 500 feet short of prospective reservoir when Able stops paying. Grace goes into standby mode pending Able’s next payment. Economic Potential for the Utica Shale Development in Ohio

12. Grace Problem -- continued • Able spends next five days frantically trying to raise the money, but cannot. With another drilling job waiting, Grace finally gives up and moves offsite. • But Grace fails to give written notice. • Able raises the money on sixth day, but Grace has moved to another drill site. Able cannot pay to redrill, and loses the lease. • Able sues Grace for breach of contract, alleging it was not given written notice of termination. Economic Potential for the Utica Shale Development in Ohio

13. Grace Problem -- continued • Able seeks, as damages, the cost of the well ($1 mm) plus the value of the lost reservoir, which it values at $10 mm. • Should Grace have any liability? • Constructive notice? • Should damages be limited to cost of new well? • Are lost reserves speculative? • What if there is a waiver of consequential damages provision? • If no waiver, should damages be limited to drill costs plus the cost of a new lease? • What should be results? Economic Potential for the Utica Shale Development in Ohio

14. Part II. Dispute Resolution and Self Help Remedies • Similar to Construction Industry • Special rules for upstream oil and gas • Midstream? • Russell O’Rourke • Myers, Roman, Friedberg & Lewis • Specializes in representation of contractors and subcontractors involved in the construction industry. Economic Potential for the Utica Shale Development in Ohio

15. Part III. Special Problems in Service Contracts. • Risk Allocation • Subcontracting • Who is in control?

16. Allocation of Risk Risk Management in a Changed World – Rapidly rising costs of insurance Effects of rise of terrorism Major events – Capsized PetroBras platform in 2001 consumed 80% of oil and gas casualty insurance that year. Insurers hate risk that cannot be quantified!

17. Importance of Insurance • Project Financiers require insurance • Failure to carry insurance usually a default scenario. • Underinsured project will carry high interest rates on loan. • Service Contracting is a high risk activity – risk exposure can be very large: • Property or equipment damage • Personal injury or death • Lost profits • Pollution or environmental problems

18. Insurance • Minimum insurance coverage by Contractor: • Worker’s compensation • Commercial general liability • Automobile liability • Excess liability • Vessel/Hull/Protection & Indemnity • Aircraft/Hull/Aircraft Liability • Insurance Endorsement • Obtain waiver of subrogation in favor of Company (can’t recover from Company if Company is at fault).

19. Check List • Types of Risk • Personal injury • Property or equipment damage • Pollution • Third parties • Rules of Law – Public Policy • Governing law • Available resources/strategies • Contractual allocation of risk • Insurance • Assumption • Management

20. Damages • Direct • Foreseeable, readily predictable. • Liquidated • Provided for by contract – where damages are difficult to prove • Intended to replace actual damages • Indirect/Consequential • Attenuated, unforeseen • But cannot be speculative – must be proven. • Punitive • Provided by statute – designed to promote or discourage behavior. • Separate from Civil or Criminal penalties.

21. Consequential Damages • Types • Impacts of delay/time of essence • Lost profits • Lost leasehold/reserves • Lost opportunity • Waivers • Must be clear • Sophistication of parties • Boldface, italics, all caps – not boilerplate • “clear and unequivocal” -- maritime • “magic words” – Louisiana, TX • Problem of purchase orders • Public policy issues • Gross negligence/intentional tort

22. Considerations for Risk Transfer • Fair – not equal – distribution of risk • Should be in proportion to the rewards • No duplication of insurance coverage • Minimal potential for lapses of insurance coverage • Minimal potential for disputes. • Allocate risks to be insurable. • Affordable • Available

23. Difficult Negotiation Problems • Allocation of Risk that is difficult to insure is point of contention. • Biggest issue: pollution • Treatment of allocation of risk provision as mere “boilerplate” – • Language tends to be over-inclusive and tortured. • As a result, dismissed by negotiators as “legalese” and not substantive.

24. Indemnity • One party to the contract promises to protect the other from some specified event that may occur in the course of contract performance. • Often will be regardless of the negligence of the either party. • Usually does not include gross negligence or willful misconduct. • Courts will impose own sense of justice if unclear

25. Forms of Indemnity • Promise based – usually unnecessary • E.g. promise to indemnify other party in the event their equipment is not returned. • Fault based – • Also not legally needed – works by operation of law. • Cannot be completely avoided. • Activity based • Indemnification is based on nature of activity. • Requires some disclaimer of fault. • Control based • Based on “care, custody & control” • Requires fault disclaimer to distinguish.

26. Indemnity Form Problems • Fault based indemnity • Complex fact finding, time intensive • Uncertain outcome • Difficult to allocate fault • Control based indemnity • Designed to reduce expensive litigation • Insurance may be easier to get • In practice – if amount at stake is large, it will not reduce litigation

27. Indemnity Relationships • Unilateral • One party assumes particular risks for certain property or persons • “cram down” • Reciprocal • Each party indemnifies the other for a particular risk • “knock for knock” is example • Unbalanced • One party via contract assumes relatively more risk for a particular circumstance.

28. Knock for Knock Provisions • Mutual or reciprocal indemnity. • Mutual hold harmless provisions. • “Bury your own dead” provisions. • Both parties agree to indemnify the other against claims for injuries or damages that they or their employees sustained regardless of who was at fault or who was negligent. • Theory: • Party in control is best able to manage risk, obtain insurance

29. Goal of Knock for Knock Provisions • Help avoid the cost of litigation that occurs with comparative negligence claims. • Comparative negligence - court determines the percentage of negligence that applies to each party. Damages based upon their percentage of negligence. • Knock for knock creates a simple sharing of the risk where each party agrees to be fully responsible for any damages they sustain or that their employees sustain and not look to the other party.

30. Problems with Knock for Knock Provision • Anti-indemnity Statutes – personal injury • Jurisdiction – choice of law provisions • Third party claims • Subcontractors should be defined as not being a third party • Reintroduces fault –comparative negligence rules apply. • Pollution is big risk for third party damage. • Relative risk • Fair to small service company who does minimal work on the well but suffers property damage or employee injury? • Gross Negligence/Intentional Acts • Re-introduces concept of fault

31. Role of Subcontractors • Not a party to contract – not affected by knock for knock provisions unless they contractually agree. • Not normally third parties for purposes of control. • Can be third party beneficiary to indemnity provision. • Can be part of “group” benefiting from indemnity • Group usually includes: • Officers, directors, employees • May include joint venturers, co-owners, non-operators.

32. Pass Through Provisions • Goal of Pass Through: • Contractor requires subcontractor to provide indemnification language that protects the operator. • Accordingly, contractor’s duty to indemnify operator “passes through” to the subcontractor. • Absent express language, indemnity provisions will not be interpreted to pass through. • Intent to pass through indemnity obligation must be clear. • Problem: sub-contractors could be taking on huge indemnity obligation with small contract

33. Macondo – lessons on k for k

34. Background facts • April 20, 2010 explosion on Deepwater Horizon rig in Gulf of Mexico • BP hired the rig • Owned and operated by TransOcean • Water depth – 1500 meters • 11/121 workers killed • 4.9 mm bbls spilled in Gulf before July 15 cap put in place • Parties: BP, Anadarko, TransOcean, MOEX, Halliburton, Cameron International Economic Potential for the Utica Shale Development in Ohio

35. Application of K for K in Macondo • Facts: • Failure of cement barrier in production casing. • Deepwater Horizon owned by Transocean and rented by BP • Halliburton is cement contractor • Investigation found that BP, Transocean and Halliburton all had varying degrees of fault. • Parties had Knock for Knock provisions. • Jurisdiction: Admiralty? Texas? Louisiana? • Venue: Federal Court -- Louisiana

36. Public Policy Issues for the Courts • Anti-Indemnity rules. • Only personal injury. • Civil Penalties. • Louisiana Courts: if purpose of penalty is to deter rather than compensate, then k for k does not apply. • Criminal Penalties. • K for K does not extend to criminal fines • Gross Negligence allegations. • Louisiana court held that grossly negligent party can benefit from K for K provision • Fraud • Louisiana – can invalidate K for K provision

37. Public Policy Issues for the Courts • Breach of Contract? • Courts have been reluctant to overturn K for K provisions based upon breach of contract. • BP argument: Transocean had breached its contract in a way to materially increase BP’s risk as an indemnitor – thereby voiding the indemnity. • Louisiana Court: “possible that a breach of a fundamental, core obligation of the contract could invalidate the indemnity clause” - but declined to rule on it.

38. Future of Knock for Knock • Unlikely to see industry move away from the K for K provisions. • May start to see Operators insisting on gross negligence carve outs.

39. Part IV. Common Service Agreements • Drilling Contracts • Well Services • Seismic Agreements

40. Drilling Contracts • API forms • Drafted by producers • IADC forms • Favorable to drillers • Advantages • Readily accepted by drillers • Can get done quickly or if rigs scarce • Not especially unfair to producers

41. Drilling Contracts • Drilling contracts often determine the commercial success of a venture. • Especially true offshore or in shale development • Two types of drilling contracts • Turnkey • Driller gets set price • Driller takes some or all risk for mechanical failure • Popular with small producers – no cost overruns • But operator cannot escape responsibility • Less common for risky operations • Daywork • Paid a “day rate” for operations • Producer at risk for mechanical problems of other delays, such as weather

42. Turnkey contracts • Producer concerns: • Price – tend to be very expensive • If not – better look at track record of driller • Problem of underbidding by underfinanced driller • really intend to take no risk • Will come back to renegotiate if problem • May leave producer with unpaid subcontractors • Driller concerns: • Want a low risk drilling opportunity. • Want to ensure paid enough to cover costs in the event of mechanical or other problems. • Want producer to pay up front.

43. Day Work Drilling Contracts • Producer’s concerns: • Low day rates. • Low stand by rates. • Have to pay stand by fees and fishing company fees – can rack up huge costs quickly. • Control over drilling and completion activities. • Payment of subcontractors. • Driller’s concerns • Ensuring other drilling opportunities are not lost during stand by time. • Do not want final decision making authority – producer must have “company man” on site at all times.

44. Key Issues in Drilling Contract • Day Rate • Control • Indemnification/allocation of risk • Consequential damages/limitations in liability

45. Day Rate • This will be area of most negotiations • Controlled by market conditions • Producer can best control price with ongoing relationship, multiple well program. • Stand by rates also subject to negotiation.

46. Control Over Operations • General rule: producer has control over operations in a day work contract. • Producer has “company man” on site at drilling operations. • Commonly these are drilling field hands with years of experience, but not engineers. • Company man has little to no authority given to him by producing company. • Producer will distance itself from control if problems arise. • Argue that the driller and its subcontractors are the experts in using their own equipment. • Often unclear what has gone wrong down hole.

47. Allocation of Risk Issues • Goal: • Dovetail insurance protection with indemnity protection. • Avoid duplication of insurance coverage. • Avoid holes in insurance coverage. • Minimize problems: • Name indemnified parties as additional insured. • Require subcontractors to carry insurance. • Require notice of cancellation of policies to be made to each party.

48. Limiting Liability • Driller will insist on this. • Do not want to take on $20 million in potential liability for a $250,000 job. • But Producer wants full recourse if something goes wrong leading to worst case scenarios: • a damaged reservoir or lost lease. • Usual result: waiver of consequential damage clause. • Needs to be brought to attention of parties. • Will not apply for “gross negligence.” • Some judges say degree of negligence is a jury issue.

49. Well Services Form Contract • Contractor’s Rights & Responsibilities • Independent Contractor status. Why do parties want this? • “Neither Company nor Contractor shall have direction or control of the employees of the other party.” • “Contractor, as an independent contractor, shall have complete control over the manner and performance of its operations” • Instruction and Direction. “Company may instruct Contractor from time to time as the results obtained from the work.” • But not the means to how to do the work. Will this distance Company from control?

50. Representatives • Contractor and Company each have representative on site. • Authority to settle disputes – unless there is no authority to settle disputes. • How does this change anything?