October 24 2007
Shipping & Transport Norway
Before the final entry into a floating production, storage and offloading (FPSO) vessel lease contract there is a long and often complicated process of preparation and negotiation. Decisions made and positions taken in this pre-contractual phase may have a significant impact on the final risk allocation and thereby, directly and indirectly, the net income of the project. The contractor should keep this in mind, as early gains could lead to later damage to success and profitability.
Overview
The significance of the FPSO to the overall field development is obvious as the production, and hence the revenues, depend upon it. The FPSO contractor is at the heart of field production and therefore of vital importance to the field operator.
An FPSO project, from contractual commitment to first oil, will take from 15 to 30 months. The contractor will normally finance the assets and the conversion work, and receive payment at a day rate starting at the commencement of field operations. The contractor consequently makes substantial investments according to field-specific requirements before the commencement of revenues. The contractor's financial exposure and risk profile means that it is vulnerable at
the beginning of the project.
Coinciding with this vulnerability is the fact that the FPSO is the last piece in a larger puzzle for the field operator. It must ensure that a larger plan of logistics falls into an ordered sequence. Seismic and reservoir analysis, drilling, subsea work, installation work and oil field services fit into the FPSO schedule. The field operator will endeavour to hold back its risk exposure until a future revenue stream seems certain. Concurrently, it will be eager to push the FPSO contractor for an early schedule. This illustrates how the contractor and the field operator could have divergent requirements in the pre-contractual phase.
Pre-qualifications
The field operator might begin the FPSO project with official pre-qualifications, whereby
they consider potential contractors and various technological solutions in order to determine the optimal development of the field. The investigations could include more informal contact with various contractors in order to find potential partners with a business profile that fits the project.
During this phase, the main focus will normally be on technical solutions. However, the contractor may already at this stage have to prepare a commercial indication together with corporate and contractual structures. Such indications could have an impact on the later tender preparations or contract negotiations, as the proposed legal structure may create an 'anchor' effect, effectively
binding the contractor in later negotiations. Furthermore, the tax perspective should be a part of the contractor's evaluations, starting at this early stage. Proposed confidentiality agreements should also be reviewed. Parties should be aware that such agreements sometimes contain obligations and liabilities that go beyond confidentiality-related issues. The pre-qualifications might also contain formally binding qualifications that should be reviewed and analyzed.
Tender Phase
After completion of the pre-qualifications, the company will single out potential
contractors and decide on a path forward. The most common method of determining the final FPSO contractor for the project will be through an invitation to tender.
Invitation to tender
The invitation to tender is a package of technical, commercial and legal requirements issued by the company together with an invitation to the potential contractors to show how they meet them. The contractor will need to put together a package of technological solutions, delivery schedule and price which constitutes a favourable offer to the field operator.
In addition to the contractor's technical and commercial preparations, there are vital legal issues that must be considered at this stage, for example:
Is the invitation to tender asking for a binding bid and, if so, will it permit legal qualifications?
Are there certain structural requirements included, such as requirements for a potential contracting party?
Must the contractor decide on its own legal structure at this time?
Should a consortium model be considered?
Is there a reference to a certain jurisdiction?
Does the invitation to tender include standard contractual documents?
What are the important tax and import issues in the relevant country?
Does the relevant country require a certain local presence?
Should the contractor initiate negotiations with potential local partners?
These examples illustrate the need for thorough review and suggest prudence in the
choices made.
The price (normally a day rate) which the contractor is offering is implicitly based on a certain contractual risk allocation. The contractor must assess whether this price is coherent with the proposed risk allocation. Taking the costs of finance which are based on revenues (commencement of day rate) from a certain time as an example, delays in the money stream may be due to causes on the part of the contractor, the field operator or due to unforeseen events. It is therefore fundamentally important that the contractor in its bid make the necessary qualifications so that the pricing is coherent with the final risk allocation in the contract. This exercise requires knowledge of the contractual risk allocation and its potential impact on profit.
Single source negotiations
Field operators may approach only one lease contractor in order to start negotiations directly, without a tender phase. For these projects, the points below concerning negotiations will apply.
Front-end Engineering and Design studies from potential contractors
Front-end Engineering and Design (FEED) studies may be ordered before and after a
pre-qualification or independently. The FEED contractor is more of a subcontractor to the field operator and will be paid for the specific service. However, if this delivery results in the later award of the lease contract, the issues under discussion could become a source of contention. The FEED contract should therefore be reviewed with this in mind. In any event, regulation in respect of design protection and general IP protection must be addressed.
Negotiations
Following one of the above stages, the field operator will normally single out one or two
contractors as potential partners for the project.
At this stage the field operator will have two main focuses: (i) to ensure fast-track schedule/commencement of the project; and (ii) the coordination and interface between the completion of the drilling phase, subsea hardware delivery and installation, and hook-up of the FPSO. The field operator will not wish to commit itself to the purchase or charter an FPSO with defined delivery dates without ensuring that other necessary deliverables for field development are available at the relevant time. It is therefore unrealistic to rely on a fully negotiated FPSO contract before commencement of the work in order to secure schedule, and the parties typically negotiate a letter of intent or heads of agreement as a confirmation of the tender award. This phase involves substantial challenges for both parties.
The contractor will normally already have spent several months and considerable resources both
in pre-qualifications and through the tendering phase, and is interested in ensuring the final contract award. However, it is important to keep in mind that, at this stage, important aspects of the risk allocation for the project are established and the contractor must protect its interests, both in relation to the project phase and for the period between the signing of a letter of
intent/heads of agreement and the actual contract execution.
Most importantly, if the contractor needs to start placing orders with subcontractors in order to meet the time schedule, it is imperative to ensure commitment from the company in the letter of intent/heads of agreement in order to cover cancellation fees under such subcontracts. The contractor should also consider whether bank guarantees and/or corporate guarantees should be required accordingly. The same applies to projects where several partners are developing the field, but only the minor partner will be the formal contract party. If the reservoir proves to be unprofitable at this stage, the field development will be aborted. As the contractor is investing in its own name and at its own risk, cancellation fees can end up worthless if backed by a single purpose company. This illustrates how the contractor should already at this stage be focusing on
avoiding any kind of reservoir risk.
If the contractor is dependent on external financing, at a certain commitment level, an order to proceed with the project from the company may be required, and this should be discussed with the relevant bank. Finally, the letter of intent/heads of agreement should include regulation covering the possibility that this part of the pre-contractual phase is extended for any reason. This might result in further orders being made by the contractor and, if necessary, any commitment
fees should be increased accordingly.
The above stages will ideally result in an execution of contract (in which the final risk allocation battle will be fought). It may be difficult to achieve agreement on all of the above points in the pre-contractual phase - or even in the contract itself. However, every contractor must keep in mind that risk allocation, and thus project profit evaluation, starts from the first informal contact with the
field operator and cannot be postponed until the contract negotiations.