This is Part 2 of an article series comparing procurement and contracting practices between oil and gas industry and construction industry. In  previous Part 1 of this article series, the supply chain framework of these industries were compared focusing on how standard forms of contract for these industries were drafted to deal with its unique risk profile. Whilst there are obvious technical differences between construction of a building as compared to an oil and gas facility, there are certain core provisions of contract that are common for these two industries e.g. instructions and valuation of variations, extensions of time, liquidated damages etc. Therefore it is not surprising that practitioners from construction industry with a good understanding of such contractual mechanism are likely to have transferable skills transitioning into oil and gas industry. To this end it is interesting to note that the bargaining power between contracting parties are more equal under oil and gas industry relative to construction industry. This is likely driven by demand for specialised skills and expertise of relatively limited contractors in oil and gas industry that are conversant with complex off shore construction works. The consequences of disparity in bargaining power between contracting parties directly influences how risks are allocated under contract forms used in both industries which was evident in Part 1 of this article series.

In furtherance of comparison study between these two industries, Part 2 will focus on other pertinent subjects such as the issue of project completion and the associated complexities in determining whether contract had been duly performed. As pointed out in introduction of Part 1, there is significant distinction in definition of completion between constructing say a Grade A office building as compared to an oil and gas processing and storage facility. Whilst such office building is generally to provide top tier real estate space conducive for businesses to operate, the functional purpose of an oil and gas facility is usually defined by objective numerical metric e.g. capacity to process 100,000 barrels of crude oil per day or storage capacity of 1million barrels of crude oil etc. There is greater degree of objectivity in its functional definition under oil and gas industry whereas practical completion is defined more qualitatively under construction industry. Such distinction in definition of completion give rise to different sets of contract administration challenges including how parties may differ in negotiating their specifications in their respective industries. This will be further explored in the next section of this article. 

Another subject that is of interest relates to a unique indemnity provision known as ‘knock for knock’ that is quite commonly used in oil and gas contracts. Whilst this provision is practical and offers great certainty, such indemnification arrangement is radically different from fault based provisions found under construction contracts. The nature and rationale behind such distinction will be explored in subsequent sections of this article as well. 

Definition of Completion / Testing And Commissioning

As alluded to earlier, the definition of completion differs quite significantly between oil and gas project as compared to construction project, of which the latter appears more qualitative and subjective. It is quite common to find terms such as ‘practical completion’ or ‘substantial completion’ used in construction contracts which suggest that the project is not required to be entirely or wholly completed within the stipulated time for completion. As such determination is inherently subjective, the legal ‘safeguard’ is for such assessment to be performed by an independent certifier who is required to be impartial under the law. Such certification is often accompanied by a fairly elaborate and prescriptive contractual procedures. These procedures include amongst others notification for inspection of works deemed completed, creation of outstanding or minor works that requires follow up post completion certification, identification of scope of outstanding works if project is deemed incomplete upon inspection, release of part of retention monies upon practical completion etc. The rationale behind such prescriptive procedure is to provide structure and clarity to the status of the project notwithstanding the inherent qualitative nature of practical completion. The qualitative and subjective nature of completion for construction project is premised on commercial pragmatism. By way of illustration, a condominium development is deemed practically completed upon issuance of certificate of practical completion by certifier of which all health and safety issues are addressed where the owners are able to enjoy beneficial occupation of their homes. The main contractor need not be imposed with liquidated damages if it undertakes to complete say the remaining outdoor water features and club house within a reasonable time after practical completion. In other words, the project does not need to be wholly completed if  the outstanding works are not disruptive the owners’ beneficial occupation of the condominium development. Therefore due performance of contract is achieved based on standard of practical completion. 

By contrast, the completion of an oil and gas facility is less subjective given that the facility had to function for its intended purpose based on a quantifiable capacity as pointed out earlier. In this regard, there are a series of prescribed trials, testing and commissioning regime that are included in the contract to provide an objective determination as to whether the facility is able to function for its intended purpose. By way of illustration using the earlier example, if the facility is designed to process 100,000 barrels of crude oil per day, the Employer may have valid grounds to impose liquidated damages for delay if the facility is unable to achieve the specified capacity by the expiry of time for completion. The contractor is unlikely to be able to successfully argue that the contract is substantially performed as the facility was able to process 90,000 barrels of crude oil per day. The concept of substantial completion is usually not applicable to oil and gas contract.

Given the distinct concept of completion between these two industries, one of the procurement challenges that is unique to oil and gas contract relates to the nature of technical specifications on testing and commissioning requirements. Whilst standard conditions of contract include clauses for acceptance/rejection of Floating Processing Storage and Offtake (FPSO) vessel or taking over of processing facility, these are generic provisions. The specific trials, tests and commissioning requirements are often included in the technical specifications which are found in other sections of the contract document. The types of testing, commissioning and operation trials could be segmented into multiple milestones ranging from mechanical completion to ‘ready for start up’. For ease of discussion, these are collectively referred to  ‘testing and commissioning’ in this article. The commissioning of project refers to holistic system integration test to ensure that various components that may had been manufactured separately by different suppliers are able to function as one complete unit based on overall design requirements. This is usually above and beyond the conventional factory acceptance tests which are usually performed to individual components. These commissioning regime may involve simulating actual offshore operations, pressure and leak tests, safety test and also compliance with any specific requirements set out under offtake agreement (e.g. oil quality analysis, production performance monitoring, quantity measurement and calibration). Notably the actual processing performance trials will validate whether the facility is compliant with feedstock specification. As pointed out in Part 1 of this series, these requirements may be imposed as part of project financing agreements to ensure that the facility is financially viable upon completion. By way of background, offtake refers to future output of the hydrocarbon production facility which will be purchase by a buyer or ‘off-taker’ under an offtake agreement. Feedstock on the other hand refers to raw hydrocarbon material that are meant to be processed by the proposed production facility e.g. crude oil. 

Where the oil and gas contractor does not have any design responsibility, it is naturally cautious about the rigorous testing and commissioning requirements included in technical specifications. From the contractor’s standpoint, even if the construction works were carried out completely in accordance with the design provided by the Employer or its consultants, the facility may not necessarily function at the intended production capacity for a variety of reasons including design issues. If that is the case, is the contractor expected under the contract to ensure sufficiency or adequacy of the design provided? Even if the contractor holds design responsibility under an engineering, procurement and construction (EPC) arrangement, the testing and commissioning regime that is intended to simulate full commercial operations of the facility may interface with various third parties, including supplier of feedstock, offtaker, etc. What happens if the supplier of feedstock does not have sufficient supply with the necessary quality or standard to fulfil the testing and commissioning requirements? What is the EPC contractor’s responsibility if the offtaker is unable to fulfil its minimum offtake obligations under its agreement resulting in excess storage requirement during the duration of testing and commissioning? Should extension of time be granted to the contractor where delays to completion were deemed excusable? At what point should the testing and commissioning requirement be deemed fulfilled if delays continues for an extended period of time? There are various added commercial sensitivity to the usual enforcement of contract provision since the offtaker may be the Employer’s long term client under the offtake agreement.

The complexities described above on testing and commissioning requirements for oil and gas facility is exacerbated with the absence of an independent certifier under oil and gas contract. Under construction contract where independent certifier is usually appointed, an impartial, temporary but binding determination is available for resolution of issues. Such determination is part and parcel of the certification regime. Any dissatisfied party is free to refer any determination under a certificate to a final and binding dispute resolution forum such as arbitration upon project completion. This certification regime whilst may not be perfect, facilitates progress of work by avoidance of contractual stalemate. Therefore, parties to an on shore oil and gas contract may consider adopting an international construction based contract form such as the FIDIC Red or Yellow Book (but not Silver Book) where independent certification regime is available such as the appointment of an ‘Engineer’. 

In reality, the concept of testing and commissioning of an oil and gas facility overlaps with its commercial operation phase. Therefore when the facility is being ‘tested’ for takeover by the Employer, it is actually producing commercial grade offtake as part of the trial where revenue is simultaneously being generated. The facility may be required to operate commercially for weeks before it achieves condition prescribed that is necessary for testing and commissioning. By contrast, a construction project of say an office building would not be generating rental revenue prior to practical completion. The delineation between construction phase and completion/handover phase under construction contract is therefore more distinct and defined. 

Fault Based Indemnity vs Knock For Knock Indemnity

Fault based indemnity regime is quite commonly used in construction contracts. Under this regime, the party at fault will be responsible for the loss or damage caused including indemnifying the innocent party. By way of illustration, if it is established that the contractor was negligent in its site operation resulting in death or injuries to the Employer’s staff or damages to the Employer’s properties, such contractor will be liable for the claims. Fault based indemnity regime is consistent with terms of agreement which require each party to exercise reasonable skill, care and diligence in performance of its obligations.

On the other hand, off shore oil and gas contracts utilise ‘knock for knock’ indemnity provision where each party shall be responsible for its own property and workforce regardless of who is at fault. In other words, the loss lies where it falls. Under this alternative regime, it is the identity of the party that determines liability rather than fault of party. As no proof of fault is required, such simplicity and clarity avoid risk of long drawn legal battle where each party is looking to lay blame on one another. By way of illustration if the Employer’s support vessel collides with the contractor’s works, the Employer will automatically be required to pay for damages to its own vessel whilst the contractor likewise will be responsible for its works that were damaged. Parties need not expend precious time, costs and effort to prove  say whether the Employer was negligent in navigating its vessel or the collision was caused by the contractor misrepresenting the rightful point of approach for the Employer’s vessel. Whilst it is logical for party at fault to be responsible for claims, identifying the party at fault is never straightforward. This is particularly where parties are continuously relying on one another to coordinate and plan its respective next course of action in a dynamic environment, of which certain neutral event such as inclement weather and sea condition may have dominant influence. Therefore certainty and pragmatism takes precedence over culpability when utilising knock for knock indemnity provision. 

Whether the contract adopts fault based indemnity or knock for knock indemnity, the actual risks are insured and underwritten by the insurance companies. The risk of paying out directly from the parties’ balance sheet is usually so financially overwhelming that there is usually a condition requiring that the relevant party procures the appropriate insurance policy and to produce receipt of payment of insurance premium prior to commencement of work. Therefore whether it is fault based indemnity or knock for knock indemnity, these contractual arrangements could only be implemented because it is commercially supported by the insurance market. The insurance companies see profit incentive in either arrangement. It should be noted that under knock for knock indemnity included in standard conditions for oil and gas offshore project, the insurance company is required to waive its subrogation rights. In other words, even if the contractor is at fault the Employer’s insurer could not step into the Employer’s shoes to pursue recovery from the contractor. 

The characteristics of knock for knock indemnity has often been criticised as creating perverse incentive in that the party at fault is not made responsible for claims thereby inducing excessive risk taking. If this is factually true, it is very likely that the insurance companies would not offer insurance policies in response to knock for knock indemnities. Therefore the concerns over knock for knock indemnity may not be entirely supported by realities. There could be a few reasons for this phenomena. Firstly, accidents or site incidents invariably bring about schedule impact. Notwithstanding any types of indemnity arrangement, the contractor continues to be responsible for timely completion of the project and it has an inherent desire to avoid delay. This is not only due to the deterrent effects of liquidated damages but also the desire to avoid prolongation costs resulting from schedule overrun. Knock for knock indemnity does not exonerate the contractor from its fault for project delay. Secondly, contractor that lacks prudence or have the tendency to be excessive in risk taking will face difficulties in procuring insurance policies in future. Such reputation may also be detrimental in securing future projects. Lastly, the party at fault may not completely rely on knock for knock indemnity to be shielded from all types of losses and liabilities due to certain exclusions depending on the governing law of the contract concerned. By way of example, there may be exclusions for statutory liability, consequential losses or when the act of default does not arise from the performance of existing contract obligation. In other words, knock for knock indemnity should not be viewed as a blank cheque for the defaulting party. 

From a practical perspective, knock for knock indemnity is relevant where the labour, plant and equipments from both the contractor and the Employer interface closely on site for an extended period of time. This occurs under the scenario where the Employer self performs part of the project works. An alternative scenario is where the Employer’s vessel is being repurposed or retrofitted into an FPSO vessel where the Employer’s property is at close proximity with the contractor’s work. On the other hand where an EPC contractor that holds single point responsibility design and constructs a new oil and gas processing facility, there is very limited practical difference between fault based indemnity and knock for knock indemnity. Although the Employer may have a team of representatives based on site for supervision and approval of works, these individuals may be named as ‘insured’ under fault based regime. One of the unique aspects of oil and gas contract is the fact that there may be multiple third parties that are neither from the Employer nor the contractor that may be in close proximity to the works on site. As mentioned in earlier part of this article as regards project completion, there may be offtaker, supplier of feedstock etc that may be on site towards testing and commissioning phase of the project. Under knock for knock indemnity, who should be responsible for damages sustained by these third parties? If and when third parties are implicated, then the party at fault will be responsible notwithstanding that knock for knock indemnity was included in the parties’ agreement. In other words, parties utilising knock for knock indemnity may not always benefit from its supposed certainty and simplicity if the accident implicates any third parties. 

Conclusion

The discussions above illuminate clear distinctions between oil and gas contracts and construction contracts, on the subject of project completion as well as types of indemnities provisions. It is noteworthy that basic principles underlying these contracts are similar and the differences only relate to the applications of these principles. By way of illustration, although what constitute completion under oil and gas contract is unique as compared to construction contract, such difference largely emanates from application of ‘performance based specification’. In this regard oil and gas facility is deemed contractually completed when tests, commissioning and trials are fulfilled. Performance based specification are often viewed as diametrically opposite from prescriptive based specification. In design and build construction contracts, performance based specifications are quite regularly used. Consequently challenges associated with such specification are quite similar to that of oil and gas contract. In design and build of a data center, the works are deemed completed when it is able to function based on its intended purpose, much like the oil and gas facility. In summary construction projects and oil and gas projects may share significant underlying common traits notwithstanding the difference in economic sector classification.




Koon Tak Hong Consulting Private Limited