How do Oilfield Service Companies protect themselves from financial risk:

A look at the 2002 AIPN Model Well Service Contract

Introduction

Many oil companies have the funding to finance operations and the ability to sell oil in the downstream part of the value chain but not all of them find it necessary to get involved in the nitty-gritty of actually pumping oil out of the ground.


It is in this space that oilfield service companies hold the industry together by providing the upstream equipment and the expertise necessary to produce the oil.


Oilfield service companies occupy a unique space in the market. Whether we are discussing giants like Schlumberger or Halliburton, or whether it is a much smaller outfit. An oilfield service company will be hired by the designated operator, through a well service contract, and will conduct the oilfield activities required to produce oil on behalf of petroleum license holders; in exchange for a fee.


One core objective for the well service company when contracting is to make sure that it gets paid for the work it has done. However, disputes arise, delays occur and clients find themselves unable to pay.


This article will look at the various ways in which the services company can protect itself from financial risk under the commonly used AIPN 2002 Model Well Services Contract. The article will touch on risks such as cost overruns, delayed payment, non-payment, contract termination; as well as looking at mechanisms such as insurance and indemnification. Let’s begin:


Financial risk mitigation mechanisms used by Oilfield Services Companies


Firstly, cost overruns are a contentious issue. Who is responsible for costs when the project becomes more expensive than the parties anticipated and costs run over? Broadly, the service company will be responsible for them. However, it is important to note that the cause of a cost overrun is an essential factor.

The contract provides for scenarios such as cost overrun during a suspension of operations by the JOA members[1], cost increases as a result of legislative changes[2] or as a result of an approved change order by the operator[3]. In these scenarios the operator will pay for this increase in cost.


Secondly, a financial risk that must be addressed is taxes. The parties can agree that the operator takes the responsibility of paying the taxes levied against the service company by the host government; as well as the customs duties, port charges, brokerage fees handling fees and related expenses[4].

These expenses are typically addressed separately from the cost of the actual service but still pose a financial burden that one of the parties must carry, structuring the contract like this shifts this risk to the operator and avoids a scenario where the service company is paid for the service but losses money when paying taxes and duties.


Thirdly, there also exists financial risk in the time it takes for payments to be fulfilled. The model contract allows parties to establish the prompt payment of undisputed invoices. A smaller financial risk mitigation mechanism the services company can use is limiting the amount of time that the operator shall have to dispute an invoice[5].

This has the effect of providing certainty of payment much sooner, thus allowing the services company to respond immediately to any disputed invoice rather than have uncertainty of payment looming for extended periods of time, simply to have an invoice disputed at a crucial time.


Additionally, there exists a risk of non-payment by the operator. A core way to mitigate the risk of non-payment is to obtain payment security. This can take the form of a parent company guarantee, irrevocable standby letter of credit, bank guarantee or other security reasonably acceptable to the contractor. This security can also take the form of a lien or security interest in the oil and gas well, equipment and production that the service company is working on[6]. This will provide certainty of payment.


If the security interest mentioned above is not secured before operations begin, the contractor may reserve the right to file a lien against the operator (after the fact) in the event of the operator failing to pay compensation due in a timely manner[7].


Moreover, there exists a further risk of non-payment through early termination of contract. Although the operator may terminate the contract for any reason, the operator would still be liable for the work to date (or a portion of it) plus costs of termination or cancellation fees[8]. Even in the case of a termination for default, the contractor maintains the right to be compensated for the work satisfactorily performed. This further mitigates risk for the service company.


To add onto this, there are various parts of the operation that may break down due to e.g. weather damage or accidental collision. The model contract provides for the procurement and maintenance of insurance at the expense of the service company (or the service company and the operator). Insurance is taken out against various negative scenarios, to lighten any possible financial burden. Prior to the commencement of work a waiver of subrogation can be obtained by the operator from their insurer, in favour of the service company[9]. This ensures that the service company obtains the proceeds from a specific insurance policy.


Last, but certainly not least, indemnification will form the final component. Within the contract the operator would indemnify the service company for activities that the operator takes responsibility for and for any claims arising out of damage suffered by the operator[10]. Although there are a variety of considerations and specific items to indemnify for (e.g. pollution, taxes, third party claims etc.), this protects the contractor from costs it would not otherwise bear such as cost of well blowouts or subsurface trespass actions.


It is clear that there are a range of protections available to oilfield service companies, provided they are negotiated and structured favorably. The oil business does come with risks, even for service companies, but with the right host of mechanisms the risks can be mitigated. In this instance, a lot of certainty can be provided for service companies regarding the financial aspects of entering into a well service contract.


It is important to note that there is another side to this coin. The operators and investors on the other side of this transaction will also endeavor to ensure their financial interests are protected. To see how they would do that, you can read my follow-up articles titled "Oilfield Cost Overruns [PART 1]: Are investors protected from exposure to operator cost overruns?" and "Oilfield Cost Overruns [PART 2]: How do operators protect from exposure to oilfield service company cost overruns? A look at the 2002 AIPN Model Well Services Contract"

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About the Author

Zach Kauraisa holds an LLM in International Oil and Gas Law and Policy from the Centre for Energy, Petroleum, Mineral Law and Policy. He is currently a Candidate Attorney at Koep & Partners in Windhoek Namibia. For inquiries, email: kauraisaz@gmail.com


Clauses of the AIPN Model Well Services Contract

[1] Article 6.2.4

[2] Article 11.2.5 Alternative 2 and Article 11.5

[3] Article 12

[4] Alternative 2: Article 11.2

[5] Article 11.1.3.1

[6] Article 11.1.5

[7] Article 11.3.3

[8] Article 5

[9] Article 14.5

[10] Article 13