This is Part 1 of an article series that compares contract management and procurement practices between oil and gas industry with construction industry. Whilst oil and gas industry is considered a different economic sector from construction industry, there are various common contract management and procurement practices between these sectors. In this regard most of the relevant contract and procurement skills of construction practitioners are transferable to oil and gas industry, notwithstanding the distinction in trade activity and economic classification. In particular the thought process as regards choice of procurement pathway, use of standard conditions of contract, risks management philosophy and contract administration challenges are relatively similar between these two industries. Contrary to popular belief, the application of construction law is not exclusive to construction industry. Construction law in essence comprises two main branches of law namely contract law and tort law within the domain of civil law. The principles of contract law and tort law are very much relevant to oil and gas industry. Much like in the construction industry, parties enter into an agreement for the purposes of constructing a facility with a very unique processing function. As part of free market, parties assess their risk profile of such undertaking and make commercial decisions on how risks ought to be distributed between themselves. In doing so, decisions are made on the economic benefits in exchange of risks allocated. Therefore the final agreement is an expression of the ultimate bargain reached between the parties, with provisions for their respective rights and obligations.

To embark on a meaningful comparison of contract and procurement practices between these two industries, it is crucial to understand some of the technical differences between construction of a building or infrastructure to that of an oil and gas processing facility. Whilst the construction of both a building and an oil and gas processing facility are to fulfil a specific function, the latter is arguably more narrowly defined with lower margin of error. By way of illustration, given that an oil and gas facility is designed to extract and process crude oil at a certain productivity cycle or performance requirement, what constitute project completion can be objectively defined based on the above mentioned criteria. On the other hand, whilst the completion of building is often signified by issuance of practical completion certificate by an independent certifier, it is quite common for a list of outstanding minor works or defect rectification works that shall be completed after practical completion. The certifier for a building project will therefore make a professional but subjective assessment as to what constitute beneficial occupation by the Employer (or its tenants) and what could reasonably be tolerated as ‘minor’ outstanding works. The implications of such disparity will be elaborated further in Part 2 of this article series particularly in relation to drafting of specifications included in their respective agreements. 

One common trait in contract management between these two industries relate to the use of standard forms of contract. Although there are still contracting parties in respective industries that continue to utilise ‘legacy’ bespoke contracts, there is an increase in adoption of industry wide standard forms of contract that are led by independent industry groups. By way of example, the oil and gas industry uses LOGIC forms of contract which refers to Leading Oil and Gas Industry Competitiveness which was first established in 1999 in the United Kingdom, which was developed under CRINE (Cost Reduction In the New Era) initiative. The LOGIC standard form is available for main contract and subcontract that cater to both onshore and offshore projects. By contrast as regards construction industry there are comparatively more types of standard forms of contract such as JCT, FIDIC, NEC as well as a variety of model agreements under each jurisdiction to cater to local legislation requirements. In this regard, the development of new editions of standard forms and availability of case precedents on interpretations of various clauses therein appear more established in respect of construction industry. It will be discussed further in subsequent sections of this article on factors influencing the choice of different types of standard forms for both industries including any provisions that are unique in its application to either industry.

Supply Chain And Contracting Framework

Supply chain of construction industry vary quite significantly from that of oil and gas industry where the latter appear slightly more complex and broadly distributed. A comprehensive understanding of supply chain of any given industry forms the basis of appreciating its procurement and contracting practices. Supply chain refers to the network of production entities (or companies) that are involved in the development of raw materials (concrete, steel, glass, stones etc) and provision of logistic to facilitate the assembly, installation and subsequent completion of the final product namely building, infrastructure or processing facility. 

As regards construction industry, it is extremely rare for any one entity to self perform all the required trades of work relevant to a project. Subcontracting is a fairly common practice where the lead contractor (also known as ‘main contractor’ or ‘general contractor’) that enters into direct contract with the Employer (that initiates and funds the project) outsources majority of the works to its subcontractors. Subcontractors in turn are organised by different trades of works (e.g. concreting, facade cladding, carpentry, metal works, mechanical and electrical etc). The main contractor mainly provides construction management, inter-trades coordination, supervision of works and overheads for site operation. As the economic value of completed building particularly those of higher end commercial grade may be affected by its aesthetic appeal, design management and clarity of specification are usually common sources of disputes. Whilst aesthetic may be the root cause, the consequential claims and disputes often manifest in other forms such as schedule delay culpability, liability for liquidated damages, interpretation of specifications, contention over classification of remedial works as opposed to variation works. The cause and effect may not be as evident as it should be. As alluded to earlier, since the main contractor outsources much of the scope of works, it becomes the proxy of claims between actual contesting parties due to contract privity. If the Employer takes issue and rejects certain scope of works, the relevant subcontractor would have to commence legal action against the main contractor over withholding of payments. Therefore supply chain influences contracting framework which in turn affects structures of standard forms of contract. 

The oil and gas industry supply chain differs quite significantly which affects the nature of its contracting framework. As alluded to earlier the supply chain of oil and gas industry can be complex which consists of a chain of processes that are often described in three distinct segments namely upstream, midstream and downstream. Upstream generally refers to exploration, extraction and drilling from oil and gas reserves. Midstream is the next stage of supply chain where the extracted hydrocarbon resources are subject to distillation, cracking, storage and distribution. Finally the downstream segment involves further refinement for creation of finished petrochemical product for purposes of retail distribution. The design and construction of any oil and gas facility may be intended for any one of the three segments or it could fulfil a combination of functions across multiple segments. By way of illustration, a fixed oil rig that operates in shallow waters of no more than 500m is mainly to drill and extract crude oil from seabed and it primarily serves upstream segment of the supply chain. On the other hand an FPSO vessel (otherwise known as Floating Production Storage and Offloading) has certain processing and separation functions capable of fulfilling upstream and partial of midstream segments of the supply chain. Consequently, the design, engineering and construction of oil and gas project is highly bespoke to the specific function that the facility plays within the entire value chain. A project to repurpose an existing vessel into an FPSO vessel is entirely different in its engineering and construction as compared to say construction of a fixed oil rig, although both projects are considered part of the oil and gas industry. Despite the fact that each project are highly bespoke and unique to its specific function, every project is inter-connected in that an upstream project must be able to functionally integrate with say a midstream project so that there is a seamless transmission of oil and gas through these chain of sequential processing facilities. Any change in design of an upstream project may have ripple effect on the design considerations of a related midstream project or even downstream project although these in theory are distinct projects. The complexity is further compounded by the fact that there is very low margin of error in its engineering and design due to transmission of highly volatile, flammable and hazardous substance. 

Therefore, the contracting framework and associated risks allocation philosophies are influenced by the above mentioned supply chain considerations. Certain companies that may have the engineering and design expertise may not have the balance sheet to cushion any economic losses arising from a capital intensive project. The capital intensive nature of oil and gas contracts are often subject to complex project financing. Such project funding complexity often exceeds conventional bank loan arrangements. Equity investors, joint venture partners and debt syndications are likely to impose their requirements on the project agreements to address their risks concerns. Therefore some of the conditions included within the agreement for construction of oil and gas facility might be so fundamental that any breach of it goes to the root of the contract. By way of illustration, the financier might require that the proposed project shall secure offtake agreement to ensure there are ready customers to purchase the end product from the proposed facility immediately upon completion. Such commitments may be crucial for financial viability or bankability of the project. Therefore, ‘time is of the essence’ in such project unlike regular construction project where the completion date could be extended under certain grounds.  

In summary, construction projects may be viewed as a relatively standalone initiative where its risks, purpose and viability are ring fenced from other construction projects. By contrast oil and gas projects are much more interconnected with one another within the web of value chain. 

Use Of Standard Forms Of Contracts In Both Industries

Although supply chain and associated contracting framework of both industries are significantly different for reasons set out above, one of the more notable common trait is use of standard conditions of contract developed by a neutral professional body or trade association within the respective industries. When the standard conditions of these two industries are compared, there are various common provisions used. As alluded to earlier, much of the contract administration skills of construction practitioners are generally transferable to oil and gas industry, with proper understanding of the distinct technical and procurement practices. 

There are good reasons why certain provisions included in standard forms of both industries are substantively similar. These common provisions include amongst others, power to instruct variations, valuation of variations, extensions of time, liquidated damages, notification and disclosure requirements etc. Regardless of whether the project involve constructing a building or that of an oil rig, there are three fundamental objectives that had to be delicately managed namely time, cost and quality. A project had to be completed within a defined duration with cost certainty and the completed project had to perform at the specified level of requirement and prescribed quality. By way of illustration, extension of time and liquidated damages provisions are necessary to manage commitment to project schedule. Likewise power to instruct variations and valuation of variations are necessary to ensure that the project is able to adapt its specification to evolving needs to achieve its intended quality and functional requirements whilst managing cost associated with these changes. Therefore the standard clauses within these model agreements are in essence mechanisms to both balance and fulfil these competing objectives. When issues arise in these projects, there are certain recurring similarities. By examining the project risks profile, there is a recognisable pattern of issues which in turn facilitates the adoption of standard conditions. Parties do not need to negotiate terms of agreement from scratch when overwhelming majority of issues stemmed from few common root causes. A standard condition is considered worthwhile and productive means of contracting if 20% of the clauses are capable of addressing 80% of the recurring issues. 

As alluded to earlier, the variety of standard conditions of contract in the construction industry is relatively more established than oil and gas industry due to similarity in risk profile of construction projects. One of the more unique example of recurring issue for building construction project relate to risk of adverse ground condition. Whilst both the Employer and main contractor may have carried out certain soil investigation prior to commencement of contract, the effectiveness of such due diligence effort is rather limited. However the consequences of such risk materialising can be extremely overwhelming particularly to the time and cost of the project. Therefore different types of standard forms of contract for construction industry provide its own unique risk allocation approach. Where such risks are predominantly allocated to the main contractor, there are no contractual grounds for the main contractor to claim for loss and expense as well as extension of time as the contract sum is deemed ‘lump sum and all inclusive’. Where certain standard forms of contract offers an alternative approach of risks sharing between the Employer and main contractor, there are grounds to claim for extension of time as well as loss and expense if the main contractor provide timely notification and the event is deemed ‘not foreseeable by a reasonably experienced contractor’. Therefore whilst parties entering into construction contract are not expected to negotiate terms from scratch, they will be well served to be reasonably knowledgable about the types of standard forms available and the distinction in their respective risk allocation philosophy. From time to time, parties may introduce particular conditions to vary certain standard clauses to reflect ad-hoc and bespoke arrangement.

On the other hand, the risk profile of oil and gas projects are more unique. Unlike building and infrastructure construction projects that invariably had to be developed on a plot of land (thus the recurring unforeseeable and adverse ground condition), oil and gas facility could either be on shore or off shore. Occasionally it could be a blend of both on shore and off shore where certain off shore processing module may be initially constructed on shore within a controlled environment only to be eventually transported for off shore assembly and integration into a larger facility. Certain oil and gas project may even be more similar to shipbuilding rather than building construction. By way of example, an FPSO or FSRU (floating platform for storage and subsequent regasification of liquefied natural gas) may be repurposed or converted from an existing vessel to incorporate hydrocarbon processing and storage capabilities. Consequently in the application of standard conditions of contract for oil and gas industry, there are versions which cater to both on shore and off shore construction, as well as model agreements that are originally meant for ship and vessel construction. Given the significant physical permutations in the types of project and the variation in associated risks, opportunities for standardisation of terms and conditions is relatively limited as compared to regular construction industry. Notwithstanding that, there are two notable standard conditions available for oil and gas project namely LOGIC contracts and BIMCO contracts (refers to Baltic and International Maritime Council). 

It is also noteworthy that as certain oil and gas projects becomes more niche and specialised e.g. conversion of existing vessel to an FPSO, it demands contractors with a blend of technical expertise including shipping and oil and gas. The availability of such specialised contractors is far more limited than say general contractors in construction industry. This dramatically changes the parties’ bargaining power which will be evident in the drafting of standard clauses included in these model agreements. The BIMCO contracts that generally cater to shipping industry offers a version named CONVERSIONCON (launched in 2022) that caters to repurposing or converting of ship to oil and gas floating processing and storage platform. Clause 21 of this contract deals with the issue of variations. Much like regular construction contract, the Employer or Owner has the right to order variations and for the contractor to be compensated accordingly. However what is also notable and unique is that the contractor likewise has the right to request for variation to the Owner’s design and specification of which the Owner’s written approval to such request cannot be unreasonably withheld. In other words, if the contractor carries out minor variations from the Owner’s issued design and specifications, it is technically not a breach of contract. This is in stark contrast to construction contracts. The contractor may be motivated to vary the design particularly when there are limitations to its ‘local conditions and facilities’ as well as lack of availability of certain materials and equipment for the works. Such contractor initiated variation may result in changes to contract sum which could translate to additional costs and additional time. In other words, the Owner may be required to pay additional cost to the contractor for issues that are traditionally considered to be part of the contractor’s risk.

Whether certain variations requested by the contractor are considered necessary and minor are ultimately decisions made by the Owner’s representative subject to certain reasonableness. Much like the Employer’s representative under construction contractor, the Owner’s representative under CONVERSIONCON is also responsible for the approval of plans, drawings, calculations, including on-site attendance of tests, trials and inspections of the works pursuant to Clause 19. Such approvals are crucial to the contractor in that it facilitates progress of works and cashflow. However, another notable distinction from the construction contract is that the contractor shall have the right to initiate the replacement of certain Owner’s representative if it could be shown that such representative discharges duties in an unreasonable manner to the extent that it is detrimental to the proper progress of the works. By contrast, the Owner does not have reciprocal right to initiate the replacement of the contractor’s representative. This unique arrangement again reflect the equal bargaining power between the contractor and Owner, which is a glaring difference from that of construction contract.

There are also instances where certain suite of contracts that are widely used in construction industry that could be considered for oil and gas project. This is particularly relevant for Engineering, Procurement and Construction (EPC) pathway under oil and gas projects where the contractor holds a single point responsibility. The EPC approach is also described as turnkey contract. By way of illustration, the FIDIC Silver Book may be used for EPC on shore oil and gas project which by origin is meant for international construction project. However, there may be significant modifications required for such contract form to be used for off shore oil and gas projects. Parties should approach any bespoke modifications to standard contract forms with care because change to certain clause may bring about unintended implications to the interpretation of the contract as a whole. The reduction in certainty in the meaning of the clauses may nullify the benefits of adopting model agreements. 

Conclusion

Part 1 of this article series provides a general comparison of contract and procurement practices between construction industry and oil and gas industry. Whilst there are various technical differences between these industries, such differences could be rationalised with a proper understanding of the respective supply chain framework and associated risk profile. Standard forms of contract or model agreements are usually drafted based upon an identifiable recurring pattern of issues arising from these risks profile. To this end, there are basic contractual mechanism that are similar for both these industries. These similarities stemmed from a common need to delicately balance three competing objectives namely time, cost and quality. The very approach of balancing these fundamental objectives may differ between these industries given some of the commercial realities such has bargaining power.




Koon Tak Hong Consulting Private Limited