“The Best of Times, the Worst of Contracts”George Horsington, Swire Production Solutions “Even a cursory study of human affairs through the ages shows humankind has always dealt with every calamity of war, disease, shortage or financial crisis – and subsequently moved forward. As Samuel Johnson said: “Life affords no higher pleasure than that of surmounting difficulties, passing from one step of success to another, forming new wishes and seeing them gratified.”” Luke Johnson, FT, 20 November 2007It is common knowledge that floating production projects have a risk profile that ismanageable and insurable.Fortunately, FPSOs have an excellent safety record thankfully, with very few spillsand fatalities, as the lessons of thirty years of floating production operations have fedinto higher standards of offshore operation.Unfortunately, many contracts contain provisions which are commercial and legalaccidents waiting to happen. This presentation is an examination of those elementsof contracts which would be best described as toxic and how to avoid the disputeswhich will inevitably ensue.FPSO contractors destroyed more than $600 million of share holder value in 2008with some of the major names like BW Offshore and Prosafe being hit by massivewrite downs on project overruns, unsuccessful investment and asset price falls.Others faced the embarrassment of not being able to finance projects they wereawarded or of finding their client walking away from contracts they believed solid.The risks many FPSO contracts contain do not help the situation of an industrybleeding cash and discredited in the eyes of many equity investors..Some of the more obvious contract and litigation risks are as follows: 1. Installation RiskThe FPSO contractor often bears the risk of costing the installation of the moorings,subsea infrastructure and hook-up of the FPSO. High specification constructionvessels for the riser installation are limited and command very high day rates. Anumber of FPSO contractors have taken heavy budget overruns on the installationcosts when the “indicative” prices given by the installation companies at project bidstage proved to be under-costed two years later when the actual operation wasperformed.Even if the budget is correct, the possibility remains that the flowline installationvessel or the large anchor handler for the mooring pre-tension might not beSwire Production Solutions300 Beach Road #12-04 The Concourse Singapore 199555 Tel: (65) 6294 3088 Fax: (65) 6298 9638 www.swire.com.sg
available, meaning that the completed FPSO has to sit in port waiting for theinstallation to be completed. For deeper water or harsh environment installations, thepool of available equipment is very limited and needs to be booked in advance.Even if the pricing and availability of the installation spread is confirmed, there is thepossibility of lengthy waits on weather to perform the installation, or that delays to thedelivery of the FPSO itself will cause standby costs for the installation spread, or thatproblems with equipment may hinder the installation. Or that the client may put offthe installation.Recent FPSO installations in 2008 in the Philippines and Vietnam could becharacterized as “interesting” or “unlucky” and carried significant financialconsequences for both the oil companies involved (who saw production come on linelate and at much lower oil prices than they would have achieved had the unit beeninstalled on time at the peak of $147 per barrel) and for the operators (who paidlarge standby and remediation costs. 2. Operational liabilities and indemnitiesKnock for knock is a wonderful concept, simple and fair.It is a shame so many charterers are reluctant to embrace the principle. 3. Contract CancellationOften a firm contract is not at all firm. In many contracts in the event of force majeureclients have the right to cancel the FPSO contract without any further payment, orsuspend the contract, or apply a zero day rate.Often the risk exists that termination could leave the FPSO contractor with anexpensively converted unit offhire, and with no immediate employment prospects.Even if the FPSO is performing, poor reservoir performance can lead to the fieldbeing shut in and the contract cancelled. Several Australasian FPSOs have beenredelivered when the oilfield has run dry, most recently Modec’s “FPSO Venture 1”which was released by ConocoPhillips in July 2007 and remains without work.Oceaneering’s “Ocean Producer” will come off Block 3 in Angola in summer 2009and “Glas Dowr” was redelivered from Sable Field in South Africa in early 2009 aswell.Sometimes, the Charterers wish to purchase the production unit at the time oftermination. This is a process fraught with risk for the FPSO operator – as the optionis invariably a one way street with the oil company being able to buy at a fixed priceat its discretion.Sometimes this purchase process is akin to requisition. This is real wording from acontract we were invited to bid this year:QUOTEIf the Company exercises the Purchase Option pursuant to Clause XX (a), theCompany shall pay the "fair market value" of the Unit at the date of the exercise ofthe Purchase Option.
If the Company exercises Purchase Option pursuant to Clause XX (b) above, theCompany shall pay ninety per cent (90%) of the "fair market value" of the Unit at thedate of the exercise of the Purchase Option, less any and all additional costs andexpenses incurred by the Company as a result of the Termination Event and/or theexercise of the Purchase Option,For the purposes of Clause XX the "fair market value" shall be the sum determinedby a firm of international independent shipbrokers appointed by the Company, actingas experts and not as arbitrators and whose decision shall be final and binding andunder no circumstances subject to arbitration or litigation before any court, who shallstate in writing their opinion as to the value of the Unit on the open market asbetween a willing vendor and a willing purchaser at arms length by private treatyUNQUOTE 4. Liquidated DamagesIf an FPSO is late, the oil company loses production and often wishes to share thepain of its lost revenue with the contractor through liquidated damages, whereby thecontractor pays the oil company for every day of delay. Caps are a good idea torestrict liquidated damages so that they are not unlimited.Clients usually try to resist these caps. At current oil prices, 30,000 barrels per day ofproduction foregone is over $2 million of revenue per day lost to the oil company, sothe desire to share the pain is understandable. Whether liquidated damages are fairis an entirely different question. As for wording like the following:“Notwithstanding the foregoing, to the extent that the provisions for LiquidatedDamages are for any reason (or are claimed by the Contractor to be) void orunenforceable, the Company shall instead have the right to claim actual lossescaused by the Contractors delay, including loss of or delayed and deferredproduction, as well as consequential or indirect losses of any other kind. In this case,any exclusion or limitation of liability shall not apply, nor shall the claim be limited byreference to any cap applicable to the Liquidated Damages or any time period forwhich they were expressed to payable. Lost, delayed and deferred production shallinclude the entire lost, delayed and deferred production from the Field, including theCompanys, and any third partys share of production”. 5. Country RiskRecently there has been a wave of US drilling contractors and supply vesselcompanies co-operating with the US Department of Justice over Foreign CorruptPractices Act compliance in West Africa. Not one FPSO contractor has steppedforward, which either tells you that butter wouldn’t melt in the mouth of the operatorsthere, or that other jurisdictions are less stringent than the US Department of Justice.Many of the countries where FPSO contracts are being bid are not signed upmembers of the OECD. Foreign contractors in the oil sector are often seen as fairgame for large tax demands. Taxes on personnel can change, corporate taxes canchange and contracts need to be carefully considered to ensure changes in taxesare covered.
Often oil companies like to try to place all the risks of changes in contractor’s taxliabilities (particularly changes in personnel taxes) onto the contractor. Insisting onclauses whereby the day rate is amended if the tax rates change is a form ofmitigation. Other forms of country risk include restrictions on the availability of visasfor foreign workers, political unrest which may hinder the movement of personneland spare parts, or currency movements on payments to local staff which canchange the cost base for the contractor radically.Some countries, like Nigeria and Yemen have security issues which can makeoperating a vessel dangerous or expensive, or both.Contract risk matters to the FPSO industry because the cost of capital for the sectoris dependent on the risk FPSO contractors are assuming. Under many contracts thatis greater than the historically low returns of the sector might warrant. 6. Pricing FormatNobody likes to share their success, but everyone wants others to feel their pain. Oilcompanies are no exception.A number of so-called “win win” pricing formulae have been devised in the FPSOindustry. These vary from the production tariffs common in the North Sea where thebase opex of the FPSO is reimbursed with the capital repayment to be tied to eitherthe volumes of oil produced or the oil price. This was the mechanism adopted byPremier Oil for Shelley Field’s Sean Marine unit, when Premier assumed theoperatorship of the field after the bankruptcy of Oilexco. A similar mechanism existedfor Bowleven Plc’s arbortive contract with Fred Olsen Production for the “KnockTaggart” to go to Gabon. In Asia Rubicon is understood to have a tariff arrangementwith Salamander on its Thailand FPSO, whereby the FPSO operator receives someof the upside if the oil price exceeds $50 per barrel.George HorsingtonSwire Production SolutionsMay 2009