CHAPTER 7 A STRATEGIC LOOK AT THE BIGGER PICTURE -RISK ALLOCATION IN OIL AND GAS OPERATIONAL AGREEMENTS

• Jurisdiction: United States

Strategic Risk Management for Natural Resources Companies
(May 2008)
CHAPTER 7
A STRATEGIC LOOK AT THE BIGGER PICTURE -RISK ALLOCATION IN OIL AND GAS OPERATIONAL AGREEMENTS^*
William W. Pugh
Liskow & Lewis
New Orleans, Louisiana

TABLE OF CONTENTS

I. INTRODUCTION

II. OVERVIEW OF RISK ALLOCATION IN OPERATIONAL CONTRACTS

A. Typical Risk Allocation Scheme in Drilling Contracts

B. Effect of Broad Reciprocal Indemnity Provisions

C. "Pass-Through" Indemnity Protection

1. Why is "pass-through" protection necessary?

2. Obtaining pass-through protection

D. Implementing the Risk Allocation Program With Master Service Agreements

E. Making Sure Other Contracts Fit with the Risk Allocation Program

III. SPECIFIC INDEMNITY REQUIREMENTS

A. Basic Requirements for Obtaining Indemnity for the Indemnitee's Negligence

1. There must be a clear intent to indemnify for the indemnitee's fault

2. The indemnity obligation must be "conspicuous"

B. The Scope of the Indemnity

IV. MAXIMIZING INSURANCE PROTECTION

A. Summary of Important Insurance Requirements

B. Insurance and Indemnity Interplay

1. Insurance provisions may prime indemnity provisions

2. Important vessel coverage endorsements

V. RESTRICTIONS ON INDEMNITY AND INSURANCE

A. The Louisiana Oilfield Indemnity Act

B. The Texas Anti-Indemnity Act

C. The Wyoming Anti-Indemnity Act

D. The New Mexico Anti-Indemnity Act

E. Section 905(b) of the LHWCA

VI. APPLICABLE LAW: STATE LAW, MARITIME LAW, AND THE OCSLA

A. Applicable Law in General

B. Application of State Law Under OCSLA

1. OCSLA situs

2. Federal law applying of its own force

3. State law inconsistent with federal law

4. Effect of choice of law provisions

5. How is the "adjacent" state determined under the OCSLA?

VII. RISK ALLOCATION ISSUES RELATED TO SPECIFIC OPERATIONAL CONTRACTS

A. Drilling Contracts

B. Master Service Agreements

C. Construction Contracts

D. Vessel Charters

E. Flight Service Agreements

VIII. CONCLUSION

I. INTRODUCTION

Risk management for an oil and gas company is a very broad topic, and it is difficult to understand the nuances of each area of risk. However, it can be critically important to understand the general risks inherent in different facets of the company's business. The purpose of this paper is to provide an overview and general understanding of some of the most important risk management issues presented by "operational" agreements -- contracts used by oil and gas companies to get things done -- such as drilling contracts, master service agreements, vessel charters, flight service agreements, and construction contracts. The first parts of this paper will look at the issues from a general standpoint, and the risks related to specific contracts will be discussed thereafter.

Operational contracts typically involve a common workplace and a relatively high risk of bodily injury and loss or damage to property. Because of a common workplace and the potentially dangerous working environment, these contracts frequently interact, which makes it critical that the contractual risk allocation provisions in the different contracts are consistent. Otherwise, provisions that might work well in isolation may, when acting together, achieve the opposite of the desired result and leave the company facing significant unanticipated risks.

II. OVERVIEW OF RISK ALLOCATION IN OPERATIONAL CONTRACTS

One of the distinctive features of the oil and gas industry today is that most of the operational contracts allocate much of the risk, if not all, on a "regardless of fault" basis, with indemnity being owed by the party that employs the injured party or owns the damaged property, regardless of negligence or other fault of the indemnified party (the "indemnitee"). This approach has developed for a variety of reasons, including difficulties and expense involved in determining proportionate fault in a common workplace and the availability of and reliance upon insurance.

For many years, oil and gas companies have been asked by their contractors to assume certain high dollar risks, such as pollution, loss or damage to the hole and down hole tools, and underground or reservoir damage. While the breadth of these assumptions vary from contract to

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contract, the primary underlying justification is either that a risk is too high for a contractor to assume or too expensive for a contractor to insure. On the other hand, all contractors already carry liability insurance for bodily injury claims, and most either have property insurance covering damage to their property or have made the decision that they prefer not to carry such insurance. As a result, at least historically, a typical operational contract might allocate risk of bodily injury or property damage to the contractor while the company assumed some or all of the potentially more expensive risks.

The intent of these indemnity provisions was to allocate these risks without regard to the negligence or other fault of the indemnitee, but, as discussed further below, a series of judicial decisions mandated that such intent be clearly evidenced in the contract. In addition, the parties often expected insurance to support these indemnity obligations, which has led to a need for much more specific insurance provisions. Also, some states have imposed restrictions on these risk allocation provisions in the form of anti-indemnity statutes. Consequently, enforceability of these risk allocation provisions creates issues that must be understood and addressed.

An important continuing development in the approach to these provisions has been the contractors' efforts to obtain broader and broader protection through broad reciprocal indemnity agreements, whereby each party assumes the risk of any claims of damage to its own property or injury claims by its own employees. This typically began with the drilling contractors, who have historically taken the position that the company should be responsible not only for claims by its own employees (and its own property damage) but claims for injury and property damage by its other contractors as well. This broad "knock for knock" indemnity, or broad reciprocal indemnity, places a significant risk on the company, which would owe indemnity to each drilling contractor for claims by every other contractor at the work site. The scope of risk is even greater if the drilling contractor excludes (or "carves out") those risks that operators have historically been asked to assume, such as damage to the contractor's tools when down hole, and any pollution, loss of hole, or reservoir damage, even if caused by the fault of the contractor. While the merits of the broad reciprocal indemnity can be debated, the justification for such a broad assumption of risk by the company is more justified in a drilling contract (where the contractor supplies a large number of personnel and an expensive property item -- the drilling rig) than in a master service agreement or other types of operational contracts. Consequently, one of the threshold issues for developing a contractual risk allocation program is for the company to understand that it will be entering into various different types of contracts and that the risk allocation provisions in each may well need to be different but still need to fit together.

The most common operational contracts entered into by an oil and gas company are drilling contracts and master service agreements, and the operator cannot effectively develop its approach to risk allocation in its master service agreements (or its other operational contracts) without understanding the fundamentals of indemnity and insurance and the pivotal role that the drilling contract will likely play.

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A. Typical Risk Allocation Scheme in Drilling Contracts

A typical drilling contract¹ will allocate a variety of risks on a broad reciprocal basis, particularly liability for bodily injury/death claims and damage to property. As discussed above, these indemnity obligations will almost always apply regardless of fault.² The impact of this broad reciprocal indemnity structure must be understood to develop a cohesive risk allocation program.

B. Effect of Broad Reciprocal Indemnity Provisions

The effect of a broad reciprocal indemnity is that the company will owe indemnity to the drilling contractor every time there is a casualty involving anyone other than the drilling contractor (or its subcontractors, if any).³ If the company agrees to accept such risks, it must make certain that it has obtained back-up or pass-through indemnity and insurance protection from its other contractors in the applicable master service agreement or other underlying contracts.⁴ Otherwise, the operator may be entitled to insurance or indemnity protection from its other contractors, but not be able to extend such protection to the drilling contractor.⁵ Ultimately, the measure of the risk that is being assumed by an operator in a drilling contract as a result of a broad reciprocal indemnity is determined, to a large extent, by what indemnity and insurance protections the operator has obtained, or will obtain, in its underlying contracts, and who besides the operator is entitled to such protection.⁶ The other major component that determines the magnitude of the risk, which is discussed further below, is enforceability.

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C. "Pass-Through" Indemnity Protection

1. Why is "pass-through" protection necessary?

Absent express language, an indemnity provision will not be held to cover the indemnitee's contractual liability to a third party. The presence or absence of pass-through protection can be critical. The operator will have no back up indemnity from its other contractor unless there is a pass-through indemnity provision in the underlying contract. Without a pass-through provision, the operator may end up with more liability exposure than it would have had in the absence of...