Bankable FPSO Contracts

Topics covered:

• How to establish lease contracts which appeal to financiers;

• Examining the key legal issues in FPSO lease and operate contracts;

• Dangers of lump sum contracting / avoiding costly disputes.

1) How to Establish “Bankable” FPSO Contracts

“A bank is a place that will lend you money if you can prove you don't need it.”

Bob Hope

• Financiers are not interested in taking security in lousy contracts. The FPSO industry needs to move to a ‘win-win’ model, which is premised on a fair and reasonable FPSO contract;

• Financiers should have their own clear criteria for “bankable” contracts; they should know precisely what “bankable” means;

• Most contracting surprises are avoidable. Financiers should engage early with key borrowers to communicate their expectations about bankable contracts;

• Borrowers should understand financier’s expectations and should have their own corporate contract standards /processes that meet/ exceed financier’s requirements;

• Borrowers and financiers should have an on-going dialogue about contract objectives/ bankable contracts - with candid feedback and accountability.

2) Key Legal Issues in FPSO Contracts:

"Risk comes from not knowing what you're doing"

Warren Buffett, Berkshire Hathaway

Good contract risk management is all about knowing the key risks that affect your business and ensuring that these risks are addressed in your contracts. Below are some of the key FPSO lease contract considerations.

a) Non-payment risk:

The paying party must be creditworthy What should you do to mitigate this risk?

- Credit check on counterparties;

- Deal only with a substantial counterparty/or its substantial (parent) guarantor;

- The payer should have wherewithal to pay the day rate over the full term, any early termination fees, and any big ticket indemnity liabilities (especially if uninsured);

- Assignment should only be permitted to an approved creditworthy entity.

b) Day Rate provisions should ensure a debt servicing return:

Typical Payment Schemes:

- Hell or Highwater, i.e. paid every day of the lease, come what may;

- Limited Hell or Highwater, i.e. paid every day of lease but with capped/limited reductions (e.g. hire rate penalty varies 0-20%);

- Pro Rata Reduction (e.g. 70% hire rate for 70% production).

Watch for ‘pay only the undisputed part of the invoice’ language (and ask who should hold $ in dispute?)

What should you do to mitigate Day Rate payment risk?

- Payment tied to the unit being on station/available (hell or highwater or limited range penalty/payment schemes) mindful of minimum debt servicing payment,

- Minimum payment assured throughout charter (debt servicing),

- Subject to termination rights below.

c) Termination:

• Termination provisions and termination fees are as important as the day rate payment provision.

• Rights to terminate should apply for material default (i.e., serious and substantial breach) after reasonable cure period;

• Contractor’s right to terminate for non-payment, total loss, or prolonged force majeure/suspension

• If the lease is terminated for (i) convenience, (ii) force majeure, (iii) prolonged suspension, or (iv) field operator default, a termination fee should be payable (again mindful of debt servicing obligations).

Termination fees:

- full payment (NPV of unrealised lease value) for counter-party breach or for being terminated for counter-party’s convenience;

- A discounted payment for termination for force majeure, which might involve NPV based calculation less profit element (or some other equitable discount)

- Termination fee/total proceeds should be sufficient to cover any outstanding loan

d) Financing Risks (access to finance)

Most of today’s FPSO projects require financing and consideration of lenders’ rights and interests. Lenders will require a 1st priority mortgage over the FPSO and a good bankable contract.

The charter /LQE should acknowledge the following:

• the bank’s position as assignee of the FPSO agreement and mortgagee of the FPSO/facility;

• agreement of lessee to pay hire to a specified bank account and, following an event of default, as directed by the bank;

• a provision for mutual consultation between the banks and lessee in the event of a default by either lessee/lessor;

• a grace period to find a solution (e.g. substituting new operator) before termination;

• confirmation that the lessee will not inhibit the right of the banks to remove the FPSO if hire is not being paid;

• Parent guarantees etc. to be assigned to the banks;

• Lenders (following a default) ability to step into the borrower’s shoes, terminate, and repossess the asset, absent agreed way forward.

e) Change in Law Risks

Changes in law clause allowing for an adjustment of the contract day rates etc for any change in law (especially taxes) taking place after charter is signed.

f) Delayed Acceptance due to Client/ Deemed Acceptance:

A provision needs to be included to address the situation where the FPSO is ready as per Contractor’s scope, but production services are not possible due to riser/subsea facility delay etc..

g) Unbearable Losses and Overall Caps:

• Stay in business clause;

• Paper tiger provisions: beware wide carve outs;

• Like any exclusion/limitation clause requires careful drafting

h) Consequential Loss / Business Ethics/ Variations/Pollution

- Consequential Loss:

Consider that for an FPSO that processes 150,000 bopd/day, the loss of revenue for just one day of shutdown could be $15 million; and for 180 days of shutdown $2.7 billion, using $100/barrel).

Loss of profit element will be less, but could still be an unbearable $300-400 million

Not excluding Consequential Loss effectively can be very costly. Many issues: “direct and indirect loss”, clause too comprehensive, not clear on fault, claims by co-venturers.

Business Ethics Violations:

• Not having an effective “top-down” business ethics programme can lead to criminal prosecutions, fines, damages, irreparable harm to reputation, and withdrawn funding/financing;

• Enforcement and reported cases are on the high rise.

“Just Get on with it” Variations:

“CONTRACTOR shall proceed immediately as instructed even though the amount of the VARIATION may not have been determined…”

• Why perform work and expend money when you know in advance your entitlement is going to be contested?

Pollution risk:

• Pollution indemnity in favour of the Contractor for big pollution, i.e. well and subsea facility pollution;

• Contractor will want to limit its pollution liability to pollution from the FPSO up to a capped limited.

• Take out maximum P&I cover limits (arguably post-Macondo many FPSO

operators are under-insured for pollution).

Dangers of Lump Sum Contracting

“Experience is the name every one gives to their mistakes”

Oscar Wilde

• Optimism about future FPSO growth, but the reality is that there as many casualties as triumphs.

• Many of the key FPSO owners have historically reported significant losses, whether from overruns, losses, casualties, or down-sizing;

• Risks have been too high and returns too low;

• The recent past: crowded field/speculative players; profits down and risks up (including residual value risk);

• Euphoric & overheated market in the past, e.g. 2005-2006 led to vaulting costs, diminishing controls, falling returns;

• FPSO owners/operators are packagers, residing towards the client end of the supply chain (and should beware/decry booming markets);

• Too little contingency for too many things that can go wrong on a fixed price contract.

Way forward:

• better contracts, a bad bargain is bad for all,

• risks always have to be commensurate with the rewards,

• risks and rewards go hand in hand; don’t create functional silos (sales, legal, projects),

• beware the gold rush,

• for some stick to your knitting?