The Four C’s of Risk Management for Oil and Gas Operator – Managing Contracts

Editor’s note: This is the second article in a series on risk management for oil and gas operators. The first article appeared in the Aug. 22, 2005, issue of Insurance Journal West region edition on page 66.

In the first article of this series we discussed the importance of the retail broker reading, studying and comprehending the various contracts that control the oil and gas operator’s world. There are two areas of concern in studying those contracts. The first includes the indemnities that are contained in those agreements, e.g., the mutual indemnification for injuries to employees, the operator’s indemnifying for control of well costs, etc. The second, and perhaps most obvious, includes insurance specifications, or rather the lack of them.

The widely used International Associa-tion of Drilling Contractors (IADC) drilling contract is a well-drafted instrument, but insurance specifications are virtually non-existent.

So, let’s begin our journey down the contractual trail. The first stop is at the mineral lease, but because there is very little negotiation associated with it, we won’t tarry long. Just be sure the operator holds the mineral owner harmless for all losses, and be sure the operator carries liability insurance including underground resources damage.

We slow down a bit at the farmout agreement. This is an agreement whereby the operator that owns the lease does not want to or cannot afford to drill on it, so he “farms it out” to another operator who drills the well and then after he recoups his costs, i.e., payout, the Farmoutor comes back in for an agreed interest. Those are not standard agreements, so the insurance specifications need some attention, especially the definition of “payout,” (if your client is the Farmoutor).

Very briefly, the agreement should say that the payout includes the cost of drilling and completing the well less any insurance proceeds. That qualification is to keep the Farmoutee from getting the proceeds of control of well insurance and then recouping his payout, as well.

The next stop, and one of the most important, is the joint operating agreement (JOA). That is the agreement by which the mineral lease owner gets others to invest in the well. Such investors become working interest owners. An operator is appointed-usually the mineral lease owner, who typically owns the largest interest-and the investors become non-operating working interest owners.

By far the most frequently used instrument in that transaction is American Association of Professional Landmen (AAPL) Form 610. That form states the relationship between the operator and the non-operators concerning the drilling and production of the well(s). There is one small clause that says that the operator is not responsible for damages or liabilities unless he or she is grossly negligent. And that is all that is said about the subject.

The insurance section merely says that the operator will carry workers’ compensation insurance and then references exhibit D. The problem is that there is no exhibit D proffered from the AAPL. Each exhibit is whatever the operator puts in, and they are all different, ranging from very sophisticated to almost ineffectual. Because that document becomes the linchpin in the event of a loss, the insurance specifications should be well drafted, and they should expand the concept that the operator is not responsible for losses unless grossly negligent, i.e., state who is responsible, have an enforceable hold harmless, etc.

The next station we visit is the drilling contract. As with the JOA, there are various forms in existence, but the most commonly used forms are those promulgated by the IADC. Other forms range from heavily operator-weighted ones used by large, sophisticated operators to extremely simple ones offered by small one- or two-rig drilling companies. There are various indemnifications in those agreements, some that can be negotiated, some that can be modified and many that are firm. And, as in the JOA, the insurance specifications are woefully lacking.

Read the reservoir damage, pollution damage, in-hole equipment and other indemnifications clauses. A main point of concentration should focus on the operator’s liability for damage to the drilling rig assigned in the sound location and the environmental damage clauses. The drilling contractor indemnifies the operator for any damage to the drilling rig, except for damage occurring under those two clauses.

Since 2003, this is the operator’s sole responsibility, i.e., he gets no relief from any insurance the drilling contractor is carrying. And, a recent court case broadens what losses are considered under the sound location clause. To make matters worse, the operator seldom carries insurance that will pay for the rig, or at least for the total replacement cost.

Also, compare the warrantee in the Control of Well policy regarding the BOP (Blowout Preventer) to the contractor’s warrantee concerning the same subject, then note the indemnification of the contractor for control of well costs. In short, the policy says the operator will inspect the BOP to make certain it is working. The drilling contract says the drilling contactor will inspect it for the same reason.

The gumbo gets real thick later in the contract, however, when the operator indemnifies the drilling contractor for costs of well control, damage to the hole and damage to the reservoir, i.e., everything that can happen if the if the BOP is not inspected and the well blows out.

You must make certain that there are complete insurance specifications substituted for the very meager ones that are contained in the contracts.

For all work done on a well except the actual drilling, the governing instrument is the master service agreement (MSA), our next stop. This is a different animal from the JOA and the drilling contract in that there is no benchmark contract to work against. While all MSA’s should aim toward the same goal, each operator and each well service company has its own version, and there are sometimes great differences.

Primarily, your concern is that your client is using an MSA. Make sure that the terms contain, at best, the indemnities found in the IADC drilling contract concerning mutual indemnities for injury to employees. And, in Texas, make certain that the MSA follows the restrictions and exceptions prescribed in the Texas Oilfield Anti-Indemnity Act, which should be required reading for any broker handling operations in the state.

If your client has any operations in the water, either state or federal, a side visit should be made to the Charter Agreement. Wet operations require tugs and barges to be chartered quite frequently. As with the MSA, the Charter Agreements vary greatly. Compare the agreement with charterer’s legal liability insurance policy-a must for anyone operating in the water-particularly looking at the bare boat exclusion and its relationship to work barges.

While there are many more contracts to which the operator is exposed, we have made stops at the main ones. Do not shy away from studying them. You must realize that your input in this area is important.

The next article in this series will concern coverages, or perhaps we should say contracts coverage. It is difficult to separate the two.

Robert L. Carson, Jr. is
vice president in the Energy

Division of Higginbotham

& Associates, a Fort

Worth, Texas, insurance
brokerage firm. His expertise

is in oilfield contracts, well
control and libility coverages.

He is the author of “Blowout,” and is currently
working on a new book, “PRIMER” (Petroleum

Risk and Insurance Management Educational