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Risk Allocation in Upstream Oil and Gas Contracts

The upstream oil and gas segment of the oil field is both capital intensive and high risk. It is important for participants to have sophisticated and comprehensive risk allocation schemes in place. For most, this starts with the standard Joint Operating Agreement, or JOA. As a promulgated form, the JOA does a fairly god job of outlining basic risk allocation between the operator and non-operating parties. However, in many cases, the parties need enhanced risk allocation structures that do a better job of isolating risk to the incurring parties and protecting the other parties to the agreement.

In a typical JOA, the non-operating parties agree to indemnify the operator for any losses it may incur while undertaking its duties under the JOA. This should be the starting point for further negotiations regarding liability and the party ultimately responsible. The non-operating parties will want to carve out and except from liability, actions for which they will not indemnify the operator. A primary example of this is excluding acts of gross negligence and willful misconduct. A well drafted JOA will not require non-operating parties to bear the loss resulting from gross negligence or the willful misconduct of the operator. As it can be difficult, expensive and time consuming to prove what is considered gross negligence, a strong risk allocation clause will define gross negligence as well as describe what types of actions would fall under the willful misconduct exclusion.

Non-operating parties may also seek to avoid indemnification of the operator in situations where the operator has acted negligently or unlawfully, or outside the scope of authorized conduct contemplated in the JOA. Again, careful drafting can help to protect the non-operating parties. While an operator should find it difficult to avoid liability for unlawful conduct, depending on the wording of the law purportedly violated, a poorly drafted risk allocation clause could result in non-operating parties indemnifying the operator for losses.

Another area which requires special consideration when drafting risk allocation clauses is the burden for losses incurred by third party contractors. An important consideration here is the capacity in which the operator or contracting parties enter into subsequent agreements with third party. Is the operator doing so as an agent for all the parties to the JOA, or acting on his own behalf, similar to an independent contractor for the parties? If the operator is acting as an agent, then both the operator and the non-operating parties can be liable for losses incurred by the third party contractors. If the operator is acting as a principal, then liability should be limited to the operator and the non-operating parties should be shielded or indemnified. This is another instance where careful drafting by the parties can be used to allocate risk properly and ensure that any losses are borne by the proper parties.

One last, yet very important consideration, is liability for losses caused by third party contractors. Should the liability for injury or loss move up the chain to include all the parties to the JOA or should there be appropriate barriers established so that losses can be contained and isolated to the incurring parties. A third party contractor may seek the indemnification of the operator and/or non-operating parties in order to mitigate some of the costs of insuring against or curing a loss. As the non-operator, or even the operator several steps removed from privity with the contracting third party, it is important to insure that liability lies with the incurring party.

Oil and gas contracts have evolved to address both situations. For example, if a third party contractor incurs a loss to its own people or equipment, because of its own actions, it should bear that loss independently from the other parties, and indemnifying the other parties up or down the chain privity. This is called “knock-for-knock.” Each party bears its own loss.

In situations where one party bears a loss caused by the actions of another party, then typically fault must be determined and apportioned between the two parties, with indemnifications flowing to the other parties. This is simple fault based liability, but can be expensive as determining fault is not always simple.

One final barrier the parties may wish to implement is to group parties together and corral liability within that group. For example, the drilling company may be grouped together with any sub-contractors it needs to accomplish its duties under the contract. Any losses incurred by the drilling contractor, or one of its subcontractors, caused by another member of the same group, should not be borne by any party outside that particular subgroup to the agreement. In this case the operator and non-operating parties to the JOA would be indemnified by the drilling company and the members of its group.

As the cost and expense for oil and gas exploration and production increases, the more important it is to understand the risks involved and who has to pay for them. Each new party that joins the operation brings with it a new set of risk variables and potential solutions, and each must be considered independently as well as part of the larger group encompassing all parties to the project. Now more than ever, understanding how to contract around liability and minimizing exposure to loss is key to ensuring ongoing success in the oilfield.