Analyses foresee 2015 as being the toughest year for drilling companies since 2009. On the back of falling oil prices, contractors are facing increased pressure as operators shift risks and liabilities, often in contradiction with entrenched industry-accepted allocations. Offshore contracts are changing and contractors need to adapt with respect to implementing new legal structures and insurance coverage.
Increasing pollution risk
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Image of Deepwater Horizon. From USCG. |
The offshore industry has seen the rise of several risk drivers, such as drilling in deeper waters with harsher environments, or drilling in less developed jurisdictions with unpredictable legal and regulatory regimes. However, one main risk driver in the current market is an increasing tendency for the offshore operator to place more pollution risk on the contractor. This has considerable ramifications for the accepted contractual chain on the contractor side.
Much of this can be traced back to the 2010 Deepwater Horizon tragedy. The Macondo well blowout in the Gulf of Mexico resulted in massive losses and extensive litigation which has yet to be concluded. To date total losses for BP have been estimated at around USD 42 billion.
From a legal perspective, a striking part of this is that despite the fact (according to public sources) the Deepwater Horizon offshore contracts contained the usual indemnities, whereby BP was responsible for pollution from below the surface of the earth (including blowouts), Cameron, as a supplier of the blowout preventer, ended up paying US$250 million to BP. Offshore contractors should view this payment as a disturbing outcome, and one with far-reaching implications.
Shifting of risk
In addition to results, such as the above payment, setting aside the protection intended under an agreed “knock-for-knock” regime, we are seeing a growing tendency to dilute established “knock-for-knock” provisions through contractual mechanisms. This is typically done through carve-outs for certain losses, or for certain risks/types of behavior, including willful misconduct, gross negligence, breach of warranties, and safety regulations.
In addition to such carve-outs, oil companies are pushing for contractors to be liable to a certain "minimum amount", typically in the $1-10 million range, for when the contractor has caused pollution by simple negligence – even if the pollution emanates from the reservoir. Oil companies see this as a way to incentivize contractors to avoid incidents, but the result is an erosion of the well-established principle of liability allocation for well pollution.
Moreover we are seeing an increasing reluctance by buyers of offshore equipment (often yards) to provide traditional pollution indemnities to the equipment suppliers. Instead yards are requiring the contractors to issue such indemnities.
Contractors and indemnities
In offshore contracts, risk allocation is normally based on the "knock-for-knock" principle, which means that each party (and its defined “Group” of third parties) bears the risk for damage to its own property and personnel, irrespective of cause or fault. This is typically coupled with an obligation to indemnify each other from any liability caused by negligence of its group to third parties (i.e. persons falling outside of the parties’ groups). In most jurisdictions liability for pollution suffered by a third party, is treated as any other claim in tort against the wrongdoer. In cases where the contractor has caused pollution damage, it is critical to have a contract whereby the operator is obligated to indemnify the contractor from any pollution emanating from the reservoir/well. This is also a standard industry solution. However, where the operator has been able to include liability carve-outs in the contract, this clear-cut solution becomes confused.
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Image from BP. |
For instance if the contractor has accepted liability for losses caused through his own "gross negligence", the contract will often not define exactly what constitutes such behavior. The contract will then need to be interpreted in light of the background law, something which can provide for very different outcomes depending on the jurisdiction. It is particularly important to be aware that under English law “gross negligence” is a vague concept which requires contractual clarification.
Further, operational warranties and safety regulations can cover a wide variety of different issues in respect of crew, machinery and operations, especially in thoroughly regulated areas such as the North Sea. Breach of such obligations can happen, even by prudent contractors, without great blameworthiness whereas a carve-out for liability can have enormous consequences.
In the event that a contractor, in order to have a rig built, has been required to provide an indemnity for well pollution to the yard/equipment supplier, the contractor may not later be able to obtain a similar indemnity under the drilling contract (e.g. because the definition of the "Contractor Group" does not cover the yard or its suppliers). If an incident occurs, the contractor may then be forced to hold the supplier of the drilling package (such as Cameron) harmless from any pollution damage, but will not be able to present a recourse claim against the operator. Needless to say could find themselves stuck in the middle of potentially enormous pollution claims.
Challenges for the insurance market
Given the traditional regulation of liability for pollution, it is questionable whether a contractor who accepts liability for pollution from the well will be covered by their standard offshore insurance under such circumstances.
The erosion of the traditional knock-for-knock contractual division of liability unsurprisingly poses major challenges for the field of liability insurance. The majority of mobile offshore unit operators, as well as practically all contractors in the offshore support vessel industry, source liability insurance from the traditional marine liability insurance market – notably mutual P&I Clubs. The applicable insurance conditions in this market are fairly standardized and largely assume that an insured contractor contracts on industry standard terms. Any departure from the knock-for-knock principle therefore usually represents an insurance challenge for contractors.
P&I Clubs (and other insurers) providing liability insurance for the offshore energy industry do, to varying degrees, offer additional insurance cover for certain non-standard (or “onerous”) terms of contracts. Whereas such additional “comprehensive general liability” (or similarly labelled insurance) comes at an additional cost and with lower limits than for standard cover, such additional insurance would, to large extent, cover the needs of support vessel contractors. On the other hand, for mobile offshore unit operators working on live wells there would only be very limited insurance cover available for pollution liability from wells, holes, and reservoirs. None of the usual additional insurance coverage available to the offshore contractor industry would cover cost of controlling a wild well. The latter type of cost would represent a significant part of the loss amount from well incidents, such as the Macondo disaster.
Oil companies, who traditionally have assumed all liability for a blow-out or other well incident, can and do insure this risk in the wider energy insurance market. Here, there is considerable capacity for such large-scale liability insurance. However, the energy insurance market has never been readily available to the vast majority of contractors.
As result of the current trend of shifting pollution risks from the oil company to contractors, contractors increasingly have to look for insurance cover not usually available. Such insurance cover also comes at considerable additional cost. Contractors would have to pass these costs on to clients through increased day rates, and there is no evidence that oil companies would actually reduce their energy insurance costs by transferring oil pollution risk to contractors.
Based on experience, less clear-cut contractual indemnity provisions result in more disputes and increased legal costs for both sides. From an industry point of view, the current trend of eroding knock-for-knock would thus seem counterproductive and result in overall increased insurance and legal costs for the industry.
It remains to be seen when and how the insurance market will respond to the increasing risks in the offshore industry. So far it seems that most insurers are focused on pushing back against the shifts in liability allocation. But it is safe to say that whoever adapts the best to changing circumstances and market demand will come out ahead.
Torgeir Willumsen is a Senior Lawyer in Wikborg Rein's Singapore office and is part of the firm's Shipping Offshore practice. His work involves maritime law, in particular casualty work, marine insurance, sale, purchase and lease of vessels and dispute resolution within the maritime sector. Willumsen was previously the firm's Japan Representative and in charge of the firm’s Kobe office. Torgeir is recommended by Legal 500 in the category Shipping.
Terje Holte is a former master mariner with 29 years in the marine insurance industry. Over the last 25 years Terje has worked as underwriter for various entities in the Gard group, with a particular focus on offshore energy risks. He is currently a senior underwriter with Gard Singapore.
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