Service contract liability after Deepwater Horizon

5 November 2010

Every operator of an offshore oil and gas project will typically enter into one or more service contracts for services required for the project. The nature of these projects exposes operators and contractors alike to significant risk of liability arising from the actions of the other party and other service contractors. To manage this risk, service contracts typically include terms and indemnities intended to allocate and limit the liability of the parties.

An indemnity is a legal device that holds the beneficiary harmless from loss and damage flowing from a specified event. In Australia, the traditional indemnities in oil and gas service contracts are 'knock for knock', otherwise known as 'mutual hold harmless' or 'reciprocal' indemnities. They generally provide that each party indemnifies the other against claims arising out of personal injury, illness, death, or property loss or damage suffered by the other party, irrespective of cause.

This paper discusses reciprocal indemnities in model service contracts in light of the Deepwater Horizon incident in the Gulf of Mexico. In particular, we consider the common liability regimes in Australian offshore oil and gas model service contracts and the possible need to change to the reciprocal indemnity regime.

Typical suite of offshore services in Australia

A typical offshore drilling operation in Australia involves these types of contractors

Mainstream Operators including BP, Chevron, ExxonMobil, Shell and ConocoPhillips typically use their own standard service contracts. Even so there is widespread use of industry 'model form' contracts from organisations including the Association of International Petroleum Negotiators (AIPN) and the International Association of Drilling Contractors (IADC). We have selected two for analysis:

  • 2002 International Model Well Services Contract (Well Services Contract), published by the AIPN, which addresses the rights and obligations of both Operator and Contractor in the provision of ancillary services such as mud logging, fuel supply and transport.
  • International Daywork Drilling Contract – Offshore (November 2007) (Drilling Contract), published by the IADC, which addresses the rights and obligations of both Operator and Contractor in the provision of drilling services.

'Model Form' approach to risk allocation

AIPN Well Services Contract   IADC Drilling Contract  
The AIPN Well Services Contract contains reciprocal indemnity provisions pursuant to which each party indemnifies the other party against claims arising out of personal injury, illness, death, or property loss or damage suffered by the party, regardless of cause. This reciprocal indemnity is subject to any gross negligence or wilful misconduct on behalf of the party seeking the benefit of the indemnity.

Notwithstanding this indemnity, the AIPN Well Services Contract provides that the Operator is liable for:

  1. '[r]egardless of Cause…the costs of repair of any equipment of any member of the Contractor Group that is lost or damaged Down Hole;

  2. [r]egardless of Cause…Claims arising from a Work Site fire or explosion or blowout, cratering or any uncontrolled well condition, including, without limitation, the cost of controlling a wild well, underground or above the surface, and the removal of debris…;

  3. [r]egardless of Cause…Claims for damage to the subsurface including, without limitation, damage to the reservoir and the well; and, amongst other things,

  4. [r]egardless of Cause…Claims of pollution arising out of spills emanating from the equipment of any member of Company Group provided such equipment is in the care, custody and control of any member of the Company Group.'

The IADC Drilling Contract also contains reciprocal indemnity provisions pursuant to which each party holds harmless and indemnifies the other party against damage to its own and its subcontractors' equipment, and against all claims and causes of action arising out of bodily injury, death or damage to its own personnel and their property. This reciprocal indemnity is not subject to any gross negligence or wilful misconduct on behalf of the party seeking the benefit of the indemnity.

Notwithstanding this indemnity, the IADC Drilling Contract provides that the Contractor is liable for 'control and removal of pollution…which originates above the surface of the water…[and is]directly associated with Contractor's equipment and facilities', and the Operator is liable for:

  • '…loss or destruction of or damage to Contractor's drill pipe, drill collars, subs, reamers…[and]other in-hole equipment;
  • …[i]n the event the [blowout preventer]stack angle exceeds one (1) degree from vertical...loss or damage to Contractor's subsea and in-hole equipment which may result…;
  • …damage to or loss of Contractor's subsea and mooring equipment…;
  • [i]n the event the hole should be lost or damaged…such damage to or loss of the hole, including all downhole property therein;
  • …all claims…arising directly or indirectly from all pollution and contamination…including, but not limited to, that which may result from fire, blowout, cratering, seepage or any other uncontrolled flow of oil, gas, water or other substance…;
  • …the cost of removal of debris (including Contractor's Items)…[and]the cost of regaining control of any wild well; and, amongst other things,
  • …claims…on account of injury to, destruction of, or loss or impairment of any property right in or to oil, gas or other mineral substance or water…and for any loss or damage to any formation, strata, or reservoir beneath the seabed.'

Deepwater Horizon April 2010

On 20 April 2010, the explosion of Transocean Ltd's Deepwater Horizon oil rig in the Gulf of Mexico, killed eleven people and caused an unprecedented amount of damage, environmental, economic and otherwise, to the Gulf and surrounding environs.

In this case British Petroleum (BP) was the operator with Transocean contracted to provide the drilling services. Separately BP also engaged Halliburton to carry out the cementing and temporary plugging of the well.

The exact cause of the Deepwater incident remains unclear. BP's investigative report released on 8 September 2010 concludes, amongst other things, that Transocean's drilling crew did not recognise that there was a leak in the well for over 40 minutes after the blowout had occurred and that Halliburton used an unstable cement mixture which contributed to the leak. Transocean and Halliburton have rejected these findings. We speculate that the extent to which liability for the blowout and resulting environmental damage will be apportioned and the relevant parties indemnified is largely dependent on the service contracts between BP and Transocean, and BP and Halliburton.

Applying the 'model form' approach in Australia

If an incident like Deepwater Horizon occurred in Australian waters, liability and indemnity provisions similar to those of the Well Services Contract and Drilling Contract may apply. In that context, it would appear that the operator would bear ultimate liability for the resulting pollution and environmental damage unless they could prove gross negligence or wilful misconduct by one or more of the relevant contractors.

Reciprocal indemnity under each 'model form' contract means that each party would indemnify the other for losses to its own personnel and property, regardless of where the fault lies. For example, a well services contractor's loss may extend only to the damage to its equipment caused by the blowout. For the operator the loss may extend further, to the environmental damage, clean-up and equipment recovery costs. The operator and a drilling contractor would have a similar reciprocal indemnity under which the drilling contractor would be liable for the loss of its oil rig, its above-surface drilling equipment, and any pollution leaking from its above-surface equipment. It would not be liable for the loss of control of the well or consequent environmental damage flowing from the subsurface blowout.

In this scenario, the operator would bear the majority of liability following a Deepwater-like disaster in Australian waters. Given the potential damage to a company and its balance sheet an operator of a future offshore oil and gas project may well seek to allocate more risk to other project contractors. They may seek to narrow the scope of reciprocal indemnities, pushing contractors to provide at least partial coverage for blowouts and any consequential pollution, instead of the operator remaining wholly liable even in the face of manifest gross negligence or wilful misconduct from the contractor.

Time to move away from reciprocal indemnity?

We are not convinced it is. The reciprocal regime requires parties to insure only the risk of damage to their own people and property, not the risk of damage to an entire facility. In the absence of a reciprocal indemnity arrangement, or in the event that the scope of reciprocal indemnities were narrowed, expensive insurance premiums would be a drain on the financial resources of contractors and operators alike and may prohibit smaller contractors from entering the oil and gas market.

A drilling contractor, for example, may argue that it could not afford the ongoing exposure to liability for blowouts and pollution if the scope of the standard reciprocal indemnities were narrowed. A drilling contractor already has to deal with the potential, and in the Deepwater context actual, loss of its oil rig. If these companies were to assume liability for the loss of well control and the environmental damage that follows a blowout they could be open to greater risk, have to pay increased insurance premiums and, consequently, charge substantially more for their services.

Some commentators have suggested that the reciprocal indemnity regime should be replaced with a fault-based system where each party bears the consequences of its own fault or wrongdoing, and compensates the innocent party with damages. This mechanism is unlikely to be suitable for the offshore oil and gas market because the determination of fault following an incident often involves time-consuming and costly litigation, with resultant delays in production. For the capital-intensive oil and gas industry these delays are unacceptable.

Reciprocal indemnities provide a clearer allocation of liability: When an incident occurs, liability is determined by reference to the service contract which is drafted with the aim of avoiding a long and protracted determination into which party is at fault.

WA Civil Liability Act

It is worth noting that, in service contracts where the laws of Western Australia are applicable, operators should ensure that they expressly exclude the application of Part 1F of the Civil Liability Act 2002 (WA) so that any reciprocal indemnity provisions take effect as drafted. Under Part 1F of the Act a contractor's liability is limited to the proportion of the damage or loss that is attributable to them. This is inconsistent with the reciprocal indemnity regime and limits the protection afforded to an operator by the indemnity clauses in the AIPN Well Services Contract and the IADC Drilling Contract.

The Deepwater Horizon incident put operators in Australia on notice in relation to their potential liability for subsurface blowouts and the consequential environmental pollution that these blowouts can cause. While it is a wake-up call for the offshore oil and gas industry it is not sufficient cause to alter the prevailing reciprocal indemnity provisions in standard contracts such as the AIPN Well Services Contract and the IADC Drilling Contract.

Replacing or even narrowing the reciprocal indemnity provisions in these contracts will likely increase the cost of contractor insurance premiums and, consequently, the cost of engaging service contractors. These increased costs will outweigh any benefit that a move away from reciprocal indemnities may provide.

Rather than considering alternatives to the reciprocal indemnity regime, operators and their contractors should review their contracts in light of the Deepwater Horizon incident to ensure they are receiving adequate indemnification from the other party on any areas of concern, together with suitable carve outs for gross negligence and wilful misconduct where appropriate. Operators of service contracts applying Western Australian law should make certain that Part 1F of the Civil Liability Act has been expressly excluded from their contracts to ensure any indemnities take effect as drafted. 

This article is from our November 2010 edition of Energy & Resources newsletter.

Author(s) Andrew Thompson, Jon Karolczak