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“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 2007

It is common knowledge that floating production projects have a risk profile that is
manageable and insurable.
Fortunately, FPSOs have an excellent safety record thankfully, with very few spills
and fatalities, as the lessons of thirty years of floating production operations have fed
into higher standards of offshore operation.
Unfortunately, many contracts contain provisions which are commercial and legal
accidents waiting to happen. This presentation is an examination of those elements
of contracts which would be best described as toxic and how to avoid the disputes
which will inevitably ensue.
FPSO contractors destroyed more than $600 million of share holder value in 2008
with some of the major names like BW Offshore and Prosafe being hit by massive
write downs on project overruns, unsuccessful investment and asset price falls.
Others faced the embarrassment of not being able to finance projects they were
awarded 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 industry
bleeding cash and discredited in the eyes of many equity investors..

Some of the more obvious contract and litigation risks are as follows:


      1. Installation Risk
The FPSO contractor often bears the risk of costing the installation of the moorings,
subsea infrastructure and hook-up of the FPSO. High specification construction
vessels for the riser installation are limited and command very high day rates. A
number of FPSO contractors have taken heavy budget overruns on the installation
costs when the “indicative” prices given by the installation companies at project bid
stage proved to be under-costed two years later when the actual operation was
performed.
Even if the budget is correct, the possibility remains that the flowline installation
vessel or the large anchor handler for the mooring pre-tension might not be

Swire Production Solutions
300 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 the
installation to be completed. For deeper water or harsh environment installations, the
pool 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 the
possibility of lengthy waits on weather to perform the installation, or that delays to the
delivery of the FPSO itself will cause standby costs for the installation spread, or that
problems with equipment may hinder the installation. Or that the client may put off
the installation.
Recent FPSO installations in 2008 in the Philippines and Vietnam could be
characterized as “interesting” or “unlucky” and carried significant financial
consequences for both the oil companies involved (who saw production come on line
late and at much lower oil prices than they would have achieved had the unit been
installed on time at the peak of $147 per barrel) and for the operators (who paid
large standby and remediation costs.


    2. Operational liabilities and indemnities
Knock for knock is a wonderful concept, simple and fair.
It is a shame so many charterers are reluctant to embrace the principle.


    3. Contract Cancellation
Often a firm contract is not at all firm. In many contracts in the event of force majeure
clients have the right to cancel the FPSO contract without any further payment, or
suspend the contract, or apply a zero day rate.
Often the risk exists that termination could leave the FPSO contractor with an
expensively converted unit offhire, and with no immediate employment prospects.
Even if the FPSO is performing, poor reservoir performance can lead to the field
being shut in and the contract cancelled. Several Australasian FPSOs have been
redelivered 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 2009
and “Glas Dowr” was redelivered from Sable Field in South Africa in early 2009 as
well.
Sometimes, the Charterers wish to purchase the production unit at the time of
termination. This is a process fraught with risk for the FPSO operator – as the option
is invariably a one way street with the oil company being able to buy at a fixed price
at its discretion.
Sometimes this purchase process is akin to requisition. This is real wording from a
contract we were invited to bid this year:
QUOTE
If the Company exercises the Purchase Option pursuant to Clause XX (a), the
Company shall pay the "fair market value" of the Unit at the date of the exercise of
the Purchase Option.
If the Company exercises Purchase Option pursuant to Clause XX (b) above, the
Company shall pay ninety per cent (90%) of the "fair market value" of the Unit at the
date of the exercise of the Purchase Option, less any and all additional costs and
expenses incurred by the Company as a result of the Termination Event and/or the
exercise of the Purchase Option,
For the purposes of Clause XX the "fair market value" shall be the sum determined
by a firm of international independent shipbrokers appointed by the Company, acting
as experts and not as arbitrators and whose decision shall be final and binding and
under no circumstances subject to arbitration or litigation before any court, who shall
state in writing their opinion as to the value of the Unit on the open market as
between a willing vendor and a willing purchaser at arm's length by private treaty
UNQUOTE


    4. Liquidated Damages
If an FPSO is late, the oil company loses production and often wishes to share the
pain of its lost revenue with the contractor through liquidated damages, whereby the
contractor pays the oil company for every day of delay. Caps are a good idea to
restrict liquidated damages so that they are not unlimited.
Clients usually try to resist these caps. At current oil prices, 30,000 barrels per day of
production foregone is over $2 million of revenue per day lost to the oil company, so
the desire to share the pain is understandable. Whether liquidated damages are fair
is an entirely different question. As for wording like the following:
“Notwithstanding the foregoing, to the extent that the provisions for Liquidated
Damages are for any reason (or are claimed by the Contractor to be) void or
unenforceable, the Company shall instead have the right to claim actual losses
caused by the Contractor's delay, including loss of or delayed and deferred
production, 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 by
reference to any cap applicable to the Liquidated Damages or any time period for
which they were expressed to payable. Lost, delayed and deferred production shall
include the entire lost, delayed and deferred production from the Field, including the
Company's, and any third party's share of production”.


    5. Country Risk
Recently there has been a wave of US drilling contractors and supply vessel
companies co-operating with the US Department of Justice over Foreign Corrupt
Practices Act compliance in West Africa. Not one FPSO contractor has stepped
forward, which either tells you that butter wouldn’t melt in the mouth of the operators
there, 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 up
members of the OECD. Foreign contractors in the oil sector are often seen as fair
game for large tax demands. Taxes on personnel can change, corporate taxes can
change and contracts need to be carefully considered to ensure changes in taxes
are covered.
Often oil companies like to try to place all the risks of changes in contractor’s tax
liabilities (particularly changes in personnel taxes) onto the contractor. Insisting on
clauses whereby the day rate is amended if the tax rates change is a form of
mitigation. Other forms of country risk include restrictions on the availability of visas
for foreign workers, political unrest which may hinder the movement of personnel
and spare parts, or currency movements on payments to local staff which can
change the cost base for the contractor radically.
Some countries, like Nigeria and Yemen have security issues which can make
operating a vessel dangerous or expensive, or both.
Contract risk matters to the FPSO industry because the cost of capital for the sector
is dependent on the risk FPSO contractors are assuming. Under many contracts that
is greater than the historically low returns of the sector might warrant.


    6. Pricing Format


Nobody likes to share their success, but everyone wants others to feel their pain. Oil
companies are no exception.
A number of so-called “win win” pricing formulae have been devised in the FPSO
industry. These vary from the production tariffs common in the North Sea where the
base opex of the FPSO is reimbursed with the capital repayment to be tied to either
the volumes of oil produced or the oil price. This was the mechanism adopted by
Premier Oil for Shelley Field’s Sean Marine unit, when Premier assumed the
operatorship of the field after the bankruptcy of Oilexco. A similar mechanism existed
for Bowleven Plc’s arbortive contract with Fred Olsen Production for the “Knock
Taggart” to go to Gabon. In Asia Rubicon is understood to have a tariff arrangement
with Salamander on its Thailand FPSO, whereby the FPSO operator receives some
of the upside if the oil price exceeds $50 per barrel.


George Horsington
Swire Production Solutions
May 2009

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George horsington

  • 1. “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 2007 It is common knowledge that floating production projects have a risk profile that is manageable and insurable. Fortunately, FPSOs have an excellent safety record thankfully, with very few spills and fatalities, as the lessons of thirty years of floating production operations have fed into higher standards of offshore operation. Unfortunately, many contracts contain provisions which are commercial and legal accidents waiting to happen. This presentation is an examination of those elements of contracts which would be best described as toxic and how to avoid the disputes which will inevitably ensue. FPSO contractors destroyed more than $600 million of share holder value in 2008 with some of the major names like BW Offshore and Prosafe being hit by massive write downs on project overruns, unsuccessful investment and asset price falls. Others faced the embarrassment of not being able to finance projects they were awarded 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 industry bleeding cash and discredited in the eyes of many equity investors.. Some of the more obvious contract and litigation risks are as follows: 1. Installation Risk The FPSO contractor often bears the risk of costing the installation of the moorings, subsea infrastructure and hook-up of the FPSO. High specification construction vessels for the riser installation are limited and command very high day rates. A number of FPSO contractors have taken heavy budget overruns on the installation costs when the “indicative” prices given by the installation companies at project bid stage proved to be under-costed two years later when the actual operation was performed. Even if the budget is correct, the possibility remains that the flowline installation vessel or the large anchor handler for the mooring pre-tension might not be Swire Production Solutions 300 Beach Road #12-04 The Concourse Singapore 199555 Tel: (65) 6294 3088 Fax: (65) 6298 9638 www.swire.com.sg
  • 2. available, meaning that the completed FPSO has to sit in port waiting for the installation to be completed. For deeper water or harsh environment installations, the pool 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 the possibility of lengthy waits on weather to perform the installation, or that delays to the delivery of the FPSO itself will cause standby costs for the installation spread, or that problems with equipment may hinder the installation. Or that the client may put off the installation. Recent FPSO installations in 2008 in the Philippines and Vietnam could be characterized as “interesting” or “unlucky” and carried significant financial consequences for both the oil companies involved (who saw production come on line late and at much lower oil prices than they would have achieved had the unit been installed on time at the peak of $147 per barrel) and for the operators (who paid large standby and remediation costs. 2. Operational liabilities and indemnities Knock for knock is a wonderful concept, simple and fair. It is a shame so many charterers are reluctant to embrace the principle. 3. Contract Cancellation Often a firm contract is not at all firm. In many contracts in the event of force majeure clients have the right to cancel the FPSO contract without any further payment, or suspend the contract, or apply a zero day rate. Often the risk exists that termination could leave the FPSO contractor with an expensively converted unit offhire, and with no immediate employment prospects. Even if the FPSO is performing, poor reservoir performance can lead to the field being shut in and the contract cancelled. Several Australasian FPSOs have been redelivered 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 2009 and “Glas Dowr” was redelivered from Sable Field in South Africa in early 2009 as well. Sometimes, the Charterers wish to purchase the production unit at the time of termination. This is a process fraught with risk for the FPSO operator – as the option is invariably a one way street with the oil company being able to buy at a fixed price at its discretion. Sometimes this purchase process is akin to requisition. This is real wording from a contract we were invited to bid this year: QUOTE If the Company exercises the Purchase Option pursuant to Clause XX (a), the Company shall pay the "fair market value" of the Unit at the date of the exercise of the Purchase Option.
  • 3. If the Company exercises Purchase Option pursuant to Clause XX (b) above, the Company shall pay ninety per cent (90%) of the "fair market value" of the Unit at the date of the exercise of the Purchase Option, less any and all additional costs and expenses incurred by the Company as a result of the Termination Event and/or the exercise of the Purchase Option, For the purposes of Clause XX the "fair market value" shall be the sum determined by a firm of international independent shipbrokers appointed by the Company, acting as experts and not as arbitrators and whose decision shall be final and binding and under no circumstances subject to arbitration or litigation before any court, who shall state in writing their opinion as to the value of the Unit on the open market as between a willing vendor and a willing purchaser at arm's length by private treaty UNQUOTE 4. Liquidated Damages If an FPSO is late, the oil company loses production and often wishes to share the pain of its lost revenue with the contractor through liquidated damages, whereby the contractor pays the oil company for every day of delay. Caps are a good idea to restrict liquidated damages so that they are not unlimited. Clients usually try to resist these caps. At current oil prices, 30,000 barrels per day of production foregone is over $2 million of revenue per day lost to the oil company, so the desire to share the pain is understandable. Whether liquidated damages are fair is an entirely different question. As for wording like the following: “Notwithstanding the foregoing, to the extent that the provisions for Liquidated Damages are for any reason (or are claimed by the Contractor to be) void or unenforceable, the Company shall instead have the right to claim actual losses caused by the Contractor's delay, including loss of or delayed and deferred production, 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 by reference to any cap applicable to the Liquidated Damages or any time period for which they were expressed to payable. Lost, delayed and deferred production shall include the entire lost, delayed and deferred production from the Field, including the Company's, and any third party's share of production”. 5. Country Risk Recently there has been a wave of US drilling contractors and supply vessel companies co-operating with the US Department of Justice over Foreign Corrupt Practices Act compliance in West Africa. Not one FPSO contractor has stepped forward, which either tells you that butter wouldn’t melt in the mouth of the operators there, 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 up members of the OECD. Foreign contractors in the oil sector are often seen as fair game for large tax demands. Taxes on personnel can change, corporate taxes can change and contracts need to be carefully considered to ensure changes in taxes are covered.
  • 4. Often oil companies like to try to place all the risks of changes in contractor’s tax liabilities (particularly changes in personnel taxes) onto the contractor. Insisting on clauses whereby the day rate is amended if the tax rates change is a form of mitigation. Other forms of country risk include restrictions on the availability of visas for foreign workers, political unrest which may hinder the movement of personnel and spare parts, or currency movements on payments to local staff which can change the cost base for the contractor radically. Some countries, like Nigeria and Yemen have security issues which can make operating a vessel dangerous or expensive, or both. Contract risk matters to the FPSO industry because the cost of capital for the sector is dependent on the risk FPSO contractors are assuming. Under many contracts that is greater than the historically low returns of the sector might warrant. 6. Pricing Format Nobody likes to share their success, but everyone wants others to feel their pain. Oil companies are no exception. A number of so-called “win win” pricing formulae have been devised in the FPSO industry. These vary from the production tariffs common in the North Sea where the base opex of the FPSO is reimbursed with the capital repayment to be tied to either the volumes of oil produced or the oil price. This was the mechanism adopted by Premier Oil for Shelley Field’s Sean Marine unit, when Premier assumed the operatorship of the field after the bankruptcy of Oilexco. A similar mechanism existed for Bowleven Plc’s arbortive contract with Fred Olsen Production for the “Knock Taggart” to go to Gabon. In Asia Rubicon is understood to have a tariff arrangement with Salamander on its Thailand FPSO, whereby the FPSO operator receives some of the upside if the oil price exceeds $50 per barrel. George Horsington Swire Production Solutions May 2009