Basic Concepts related to Oil and Gas Contractual Structure

 

Basic Concepts related to Oil and Gas Contractual Structure

 

 

 

 

 

 

 

 

 

 

The diagram below illustrates the basic contractual structure of a simple financed oil and gas project done by an EPC contractor under an EPC Contract.

 

EPC Contractor Arrangement in Contracts

 

The detailed contractual structure will vary from project to project. However, most projects will have the basic structure illustrated above. As can be seen from the diagram, the operating company will usually enter into agreements which cover the following elements:

 

- An operating agreement with the Joint Venture Participants (JV) which gives the operating company the right to construct and operate the oil and gas facility. Usually, each JV participant will sell its own share of the product. This is even the case if participants jointly market the product. Traditionally the operating agreement is a Joint Operating Agreement (JOA) between the JV participants whereby one of the participants operates the facility.

 

There is a significant advantage in this structure as it means that one body is responsible for the delivery of projects, relationships with Government, customers and contractors. The JOA governs how liability is spread amongst participants with respect to any liabilities or obligations incurred by the Operator. Generally, the participants have several liability and the Operator makes cash calls on them in proportion to their respective JV shares to fund capital expenditure. As special purpose vehicle can also be created to fulfil this role but usually the control of this vehicle will be in the hands of one of the JV participants.

 

- Many oil and gas companies are large companies and many projects are financed from the balance sheet without finance. However, this is not always the case. There are a number of small companies looking to develop assets that are regarded as stranded or too small for large companies to operate profitably. These companies need finance to carry out these developments. In these cases the EPC Contractor is required to be a large, experienced participant in the industry who the sponsors and lenders are confident can successfully deliver the project and is large enough to cope with losses if it does not. Further, companies with a successful track record means that insurance for the project is easier to obtain. The larger Owners will still use an EPC Contract or Design and Construct Contract for parts of large projects even if self management, EPCM or Project Management are used for the greater project.

 

- There are a number of contractual approaches that can be taken to construct an oil and gas facility. A Contract with an EPC contractor is one approach. Another option is to have a supply contract, a design agreement and construction contract with or without a project management agreement. The project management can be, and often is, carried out by the proponent itself. Alternatively, an EPCM or project management contract can be used for the management. The choice of contracting approach will depend on a number of factors including the time available, the lenderís requirements, the sophistication of the proponent and the identity of the contractor(s). The major advantage of the EPC Contract over the other possible approaches is that it provides for a single point of responsibility. This is discussed in more detail below.

 

Interestingly, on large project financed derivative projects the EPC contractor is increasingly becoming one of the sponsors ie: an equity participant in the project company. This is not the case in traditional oil and gas projects. EPC contractors will ordinarily sell down their interest after financial close because, generally speaking, EPC contractors will not wish to tie up their capital in operating projects. In addition, once construction is complete the rationale for having the EPC contractor included in the ownership consortium often no longer exists. Similarly, once construction is complete a project will normally be reviewed as lower risk than a project in construction, therefore, all other things being equal, the EPC contractor should achieve a good return on its investments.

 

- Large over arching Operating and Maintenance Agreements ("O&M Agreement") are uncommon in the oil and gas industry. Industry participants are generally in the business of managing these facilities. However, components of the operations are usually contracted out.

 

- Off take agreements govern the sale of the product of the project. For gas projects and hydrocarbon derivative projects these agreements are crucial to the development proceeding. Financiers will not lend the funds and boards will not approve the project if there are no customers locked in to take the product. The impact of the offtake agreement is on practical completion. If there are take or pay agreements it is vital that the project is ready to deliver product from inception date of the off-take agreement or it will face penalties. It may even have to buy product on the open market to meet its obligations. As these markets are usually thinly traded these can be a costly exercise. Oil projects can be under pinned by long term contracts but it is not the norm.

 

- Financing and security agreements with the lenders to finance the development of the project.

 

- Accordingly, the construction contract is only one of a suite of documents on an oil and gas project. Importantly, the promoter or the JV participants of the project operate and earn revenues under contracts other than the construction contract. Therefore, the construction contract must, where practical, be tailored so as to be consistent with the requirements of the other project documents. As a result, it is vital to properly manage the interfaces between the various types of agreements.

 

Source: Consulting Engineers