CHAPTER 9 ONSHORE DRILLING CONTRACTS: AVOIDING THE PITFALLS OF FORM DRILLING CONTRACTS

• Jurisdiction: United States

Oil and Gas Agreements: The Exploration Phase
(May 2004)
CHAPTER 9
ONSHORE DRILLING CONTRACTS: AVOIDING THE PITFALLS OF FORM DRILLING CONTRACTS
Lisa Bagley Brown
Occidental Permian Ltd.
Houston, Texas
Harold J. Flanagan
Liskow & Lewis
New Orleans, Louisiana

Lisa Bagley Brown is part of a team of three attorneys who support Occidental Permian Ltd., which is the largest producer of crude oil in Texas. Occidental Permian Ltd. operates in excess of 15,000 wells in the Permian basin and drills an average of 300 wells each year in Texas and New Mexico.

Lisa has been Board Certified in Oil, Gas & Mineral Law by the Texas Board of Legal Specialization for almost ten years. In the past, she has worked as inhouse counsel or contract attorney for Enron Oil & Gas Company, Mobil Exploration & Producing U.S., Inc., Conoco Inc., and Burlington Resources Oil & Gas Company.

She graduated with honors from the University of Texas School of Law in 1984, and she is licensed to practice law in Texas and Louisiana. Lisa has published legal articles on various topics.

Harold J. Flanagan joined Liskow & Lewis in 1995 after serving nine years as a United States Marine Corps infantry officer. He is a member of the firm's maritime section, and concentrates his practice primarily in litigation arising out of insurance coverage, offshore drilling and service contracts, casualty, construction, and commercial disputes. He is frequently associated by other law firms to assist in litigating the insurance aspects of casualty claims. He is also active in offshore contract drafting and negotiation, appellate advocacy, construction contracts, and U.S. Customs compliance.

Mr. Flanagan is a Lieutenant Colonel in the Marine Corps Reserve and is a member of the Tulane Law School adjunct faculty, where he lectures in insurance law. He received a bachelor of science degree in 1984 and a law degree, cum laude, in 1995 from Loyola University where he was a member of the Loyola Law Review.

I. Introduction^*

This paper will address some of the problems and pitfalls in using form onshore drilling contracts and how to avoid them. It will begin with a discussion of the general considerations surrounding the use of form contracts for onshore drilling. This is followed by important risk allocation principles common to all IADC drilling contracts. The paper then addresses specific provisions of the most common and significant IADC onshore contracts, including responsibility for loss, access to the drill site, payment, and related insurance issues with particular emphasis in recent changes to the form. Finally, it makes suggestions for minimizing the risks inherent in using IADC contracts.

II. General Considerations

The International Association of Drilling Contractors ("IADC") ¹ is a world-wide drilling contractor trade organization. Among other things, the IADC drafts and distributes drilling contract forms. These form contracts tend to favor drilling contractors as opposed to operators. Some of the contracts' problematic provisions are obvious, but others are more subtle and dangerous to the operator. There is no way to re-balance these contracts short of re-drafting them. Consequently, sophisticated parties almost always modify these forms to balance the parties' rights and to address specific concerns. ² Some operators also have their own forms, which frequently include provisions specifically designed to avoid problems encountered in their particular experiences. This paper will concentrate on (but is not limited to) the April 2003 revisions of the onshore daywork, turnkey, and footage contracts. But the discussions in this paper are for the most part applicable to most drilling contracts.

Starting with an IADC form puts an operator at a disadvantage. However, if the operator is not in a position to draft or use its own form, using IADC forms can provide operators with certain benefits. First, IADC contracts are the most commonly used forms, and contractors and operators are generally familiar with their base terms. This makes negotiations somewhat faster because contract managers can immediately focus on key provisions. Second, the IADC forms are broad, detailed, and address many undisputed points. Moreover, the form of the contracts and the wording of their provisions are generally designed to meet many jurisdictions' requirements for enforceability. ³

III. Types of Onshore Drilling Contracts

There are three major types of onshore drilling contracts: daywork, footage, and turnkey. ⁴ The significant differences among the three relate mainly to how risk is allocated and how the contractor is paid.

A. Daywork

A "daywork" contract provides that the drilling contractor be paid a certain price or rate for work performed as requested by the operator over a twenty-four-hour period with the contractor assuming only certain risks. ⁵ A daywork contract is a simple matter of contracting out a drilling rig with a specified crew to an oil and gas operator for a flat daily fee. If problems are encountered in the well, the drilling contractor generally continues to get paid a dayrate for as long as it takes to complete the well. ⁶ The amount of the stipulated rate depends on many factors, including market conditions, the type of rig, size of the crew, stage of performance, and specialization of the work. The rate may be proportionately lowered under certain circumstances. For instance, if the rig is on "standby," salaries of the drilling contractor's crew continue; however, operating expenses do not accrue. Thus, the standby rate should theoretically be lower than the daywork rate, but that is usually not the case. Under the daywork contract, the driller is responsible for specified risks whereas the operator assumes the general risk of delay and any other performance risks not assumed by the driller. The drilling contractor is usually classified as an "independent contractor." ⁷

B. Turnkey Contracts

Although they vary in form, all turnkey contracts generally have three features in common. First, a turnkey contract has a basic obligation to drill a well to a certain depth or formation. Second, a turnkey contract has a fixed price in which the contractor earns the entire price if the contractor performs and reaches the specific depth and complies with whatever other obligations are included in the "turnkey obligation." Third, the contractor controls the operation and the drilling methods because the contractor takes the risk of losing the well. ⁸

A pure turnkey contract provides the highest risk and highest reward for the contractor. Under this type of contract, a drilling contractor is obligated to drill a complete well for a lump-sum, fixed fee. The contractor assumes all costs and practically all risks of the job, and it contracts with third parties for equipment and services. Thus, operators use turnkey contracts to limit the risk inherent in drilling wells. If there are difficulties during the operation and the turnkey depth is not reached, the contractor is not paid; obviously, the contractor assumes substantially more risk than it does during daywork operations, at least during "turnkey" operations. This risk transfer accounts for the higher cost to the operator of turnkey operations. The reward can be very lucrative for the contractor if the well is completed ahead of schedule and below budget; however, the contractor could also be exposed to significant potential losses. ⁹

Despite the name, a turnkey contract usually has the operator responsible for the cost and obligation of completing and equipping the well. A turnkey contract, however, may be tailor-made to particular drilling conditions, placing specified risks on the operator and providing additional compensation to the drilling contractor. ¹⁰

C. Footage Contracts

A "footage" contract basically provides that the drilling contractor furnishes the drilling crew, drilling equipment, and certain specified services, and is paid an agreed sum of money for each foot actually drilled; the drilling contractor receives a stipulated price per foot of hole drilled from the surface to a certain depth or to some specified objective. The contractor assumes more of well-related risk under a footage basis than under a daywork contract, which is balanced by a somewhat higher cost to the operator. If the contractor is able to drill more efficiently than projected, the profitability of that contract improves. But if the well encounters problems and costs more per foot of well drilled, the drilling contractor picks up the added cost and may lose money.

Daywork compensation rates may apply when the drilling is suspended or delayed. If daywork rates apply, then so do the risk allocation provisions of a daywork contract. Thus, it is important to specifically define in a footage contract when daywork rates apply. ¹¹ Because the drilling contractor is only paid for footage drilled and for specified daywork, and because the contractor assumes more risk, the footage contract may be more advantageous for the operator.

Under all forms, the operator will generally reserve the right to order that drilling cease at any point in time. The contractor's right to stop drilling, however, is more limited. Generally, a contractor may stop drilling if there is concern over the operator's solvency, if the operator has failed to compensate the contractor in a timely manner, or if unanticipated problems arise beyond the contractor's control. ¹²

IV. Risk Allocation issues Common to all Three Types of Drilling Contracts

Drilling operations can be dangerous to both personnel and property. A blowout, for example, can result in tremendous exposure to liability for property damage, personal injury, pollution, and other damages. ¹³ A proper risk allocation scheme - including indemnity, insurance, and other contractual provisions - can mitigate the effects of casualty risks, foster certainty in the...