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

(Editor’s note: This is the second in a series of articles on risk management for oil and gas operators. The first appeared in the Aug. 22, 2005, issue of Insurance Journal–Texas/South Central.)

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 with these contracts. The first includes the indemnities contained in these agreements, e.g., the mutual indemnification for injuries to employees, the operator’s indemnifying for control of well costs, etc. The second includes the insurance specifications, or rather the lack of them. The widely used International Association of Drilling Con-tractors (IADC) drilling contract is a well drafted instrument, but insurance specifications are virtually non-existent in it.

Let’s begin our journey down the Contractual Trail. The first stop is at the Mineral Lease. There is very little negotiation associated with it, however, be sure the operator holds the mineral owner harmless for all losses and the operator carries liability insurance including underground resources damage.

Next is the Farmout Agreement. This is an agreement whereby the operator that owns the lease does not want to or cannot afford drill on it, so he “farms it out” to another operator who drills the well and after he recoups his costs, i.e., payout, the Farmoutor comes back in for an agreed interest. These are not standard agreements, so the insurance specs need attention, especially the definition of “payout,” (if your client is the Farmoutor). Very briefly, it should say that payout includes the cost of drilling and completing the well less any insurance proceeds. This qualification is to keep the Farmoutee from getting the proceeds of control of well insurance and then recouping his payout, also.

The next stop, and one of the most important, is the Joint Operating Agreement (JOA). This is the agreement by which the mineral lease owner gets others to invest in the well. 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 this transaction is American Association of Professional Landmen (AAPL) Form 610. This 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 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. Since this 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, that is, state who is responsible, have an enforceable hold harmless agreement, etc.

Then we visit the Drilling Contract. As with the JOA, various forms exist but the most commonly used 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 these agreements, some that can be negotiated, some that can be modified and many that are firm. And, as in the JOA, the insurance specs are woefully lacking.

Read the reservoir damage, pollution damage, in-hole equipment and other indemnifications clauses. 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 these 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 not a benchmark contract to work against. While all MSAs should aim toward the same goal, each operator and each well service company has its own version, and there can be 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, you must 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, make a side visit 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.

There are many more contracts to which the operator is exposed but we have looked at the main ones. Do not shy away from studying them, 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 hard to separate the two.

Carson is vice president in the Energy Division of Higginbotham &
Associates in Fort Worth. An insurance consultant and expert witness, his expertise is in oilfield contracts, well control and liability coverages.