Sharing the performance risks
  from: Offshore Engineer
  by: Simon Curtis
  Tuesday, July 08, 2008

The majority of FPSOs are leased by contractors, who are eager to recoup their expenditure in building or converting the FPSO hull, to operators, who need to achieve a specific level of field production. Energy lawyer Simon Curtis analyses the performance risks in FPSO projects and how these are mitigated through production services agreements between contractors and operators.

It is well recognised that the enormous advances made in recent years in floating production, storage and offtake (FPSO) vessel technologies have fundamentally altered the economics of offshore oilfield development.

FPSOs, which essentially comprise a moored or dynamically positioned tanker hull equipped with (i) a sophisticated topsides plant for the initial processing of subsea crude oil and (ii) substantial storage capacity from which the processed oil can be transferred to an offloading tanker, represent both a safe and efficient method of exploiting previously inaccessible deepwater fields; they are also a very cost-effective means of developing smaller, marginal fields which would be incapable of supporting the construction and decommissioning costs of fixed platform development.

Furthermore, while FPSO technology has been primarily developed for the production of oil, recent advances have extended its use to liquefied petroleum gas (LPG) and at least two projects (in one of which CDG is actively involved) are currently being developed for the use of FPSOs in relation to the subsea extraction, processing and offloading of liquefied natural gas (LNG).

Although a significant proportion of the global FPSO fleet is owned by oil companies who have either purchased their units from an EPCI supplier or, more rarely, constructed or converted them directly, the majority of operating FPSOs are leased from specialist contractors under a so-called production services agreement (PSA). Under such contracts, which are essentially long-term time charters, the contractor owns and manages the FPSO, providing a range of services required by the field operator; in addition to receiving, processing and storing the crude oil before it is offloaded to a shuttle tanker, the contractor may, for example, be required to provide gas and/or water injection services to assist the operator in exploiting fully the productive capacity of the field.

This article considers briefly the mechanisms used in such agreements to address issues of performance risk, i.e. the risk that the FPSO, once constructed or converted and installed at the field location, does not for a variety of reasons achieve the levels of processing performance expected of her. Other areas of risk, including credit risks and ‘physical’ risks of incurring loss, damage or third party liabilities by reason of the FPSO’s operations, will be examined in a future article.

The parties’ expectations

From the operator’s perspective, and leaving aside for the time being compliance with health, safety and environmental standards, the success or otherwise of a FPSO project is normally judged by the extent to which the production unit achieves the required level of field production. The economics of the entire field development will obviously be predicated upon minimum daily levels of production (in terms of barrels of processed oil) and the operator is always exposed to the risk that the FPSO will fail to achieve this essential performance target. As with any charterer of shipping tonnage, the operator will wish both to be protected against the possibility of paying for the FPSO when she is not performing the contractual services and to provide for a significant financial incentive upon the contractor to rectify the problems which are preventing or restricting such performance.

The contractor’s perspective will be quite different. He will usually have incurred substantial capital expenditure in building or converting the FPSO hull, installing the mooring system and topside processing equipment and locating the completed unit at the field location – particularly if the unit is not ‘generic’, i.e. has been designed specifically for the field in question, his first priority will be to ensure that these costs are amortised over the life of the project through payment of the capital cost (capex) element of the contractual dayrate.

Additionally, however, the contractor will wish to ensure that receipt of the balance of his remuneration under the contract is not unduly affected by variations in the FPSO’s operating performance. It will be appreciated in this context that the contractor is typically rewarded under a PSA on a fixed rate basis and that he is entitled to none of the ‘upside’ benefit if the field is more productive than originally anticipated – it is not unreasonable therefore for the contractor to argue that his ‘downside’ exposure should be limited.

The usual course is therefore to agree that the contractor will be penalised for non- or under-performance by way of reductions (including in some circumstances to zero) in the contractual day rate payments due under the PSA – the mechanisms used are, however, often complicated by the multiplicity of potential causes of failure in performance and the various components, including capex, operating dayrates and ‘special’ payments for additional services such as water and gas injection, which typically comprise these dayrates. Given the enormous potential for losses where field production is disrupted, it is neverthless commonplace for the contractor to insist that such reductions in day rate remuneration should represent his only liability for performance failures and/or that he should in no circumstances whasoever be liable in damages for the operator’s ‘consequential’ losses, including loss of field production.

Specific issues

Against this background, let’s consider some of the circumstances which commonly cause FPSOs to fail to meet the parties’ performance expectations – either temporarily or permanently – and the allocation of such risks between them under the PSA.

Field issues. The ability of an FPSO to meet its performance targets will normally depend greatly upon various geophysical factors, including the productivity of the field reservoir, the characteristics of the crude oil to be processed (defined usually in terms of viscosity, specific gravity, water and salt content and H2S levels) and the metocean conditions at the FPSO’s field location.

The specifications attached to the PSA will therefore normally define a range of operating criteria for the FPSO and the PSA itself will stipulate that the contractor (i) assumes no ‘reservoir risk’ and (ii) will not be penalised for performance ‘failures’ where such criteria are not met, ie the operator bears such risks.

However, to the extent that relevant operating criteria have not been defined and affect the FPSO’s operation, it is often the contractor who assumes the risk in terms of a reduced or zero day rate. A particularly common problem in this context is the level of calcium napthenate contained in crude oil received by some FPSOs – this leaves waxy deposits causing pipe blockages or other equipment failures and can lead to significant performance shortfalls for which the contractor will (unless specifically protected by the PSA) normally be penalised.

Political issues. A second important factor in securing FPSO performance is likely to be the political environment in which the FPSO is required to operate – the FPSO will almost certainly require a range of permissions from the national and/or local governments asserting jurisdiction over the field and is in any event likely to be highly dependent upon shore-based supply and other support which can be seriously prejudiced by strikes and other adverse local circumstances.

In most FPSO projects, the operator, rather than the contractor, will assume these ‘political’ risks. The contractor will in particular normally wish to be fully protected against the consequences of a change by national or local governments in the applicable tax regime under which he will operate the FPSO – this is especially the case where, as is often found in West African jurisdictions, the relevant regime requires the operator to pay dayrates net of ‘withholding’ or other taxes levied directly on the contractor’s income stream.

Equipment performance. However, perhaps the most significant cause of FPSO performance failures, particularly in the short term, is the incidence of defects and breakdowns in specific items of FPSO machinery and equipment; these may affect not only the processing performance of the unit but also its station-keeping or offloading capabilities.

As one might expect, where the failure leads to a complete shutdown of FPSO production or the withdrawal of other essential services, then (subject to any agreed ‘maintenance allowance’ permitted to him) the contractor will normally suffer a significant reduction, often to zero, in the contractual dayrates payable to him. Depending upon the parties’ respective bargaining positions when the PSA is agreed, this reduction may be limited to the operating element of the dayrate (such that capex continues to be paid during such periods) or may extend to the whole of the dayrate remuneration (including the capex).

However, the real difficulty in this context – and typically the most complex issue in any PSA negotiation – lies in determining the financial consequences of partial (ITALS) non-performance by reason of equipment failure, i.e. where the FPSO is operational but performing at less than her expected capabilities for reasons originating within the unit itself which may or may not have been fully determined.

Given the range of potential factors which can affect compliance, some FPSO contractors have traditionally refused to operate on a ‘performance’ basis and sought to insist on ‘availability’ as the only criteria to determine their dayrate entitlement – in other words, provided that there is no breakdown of equipment onboard the FPSO leading to an instruction to ‘choke back’ production from the wellheads, the operating dayrate is earned by the contractor regardless of the performance of the FPSO in terms of generating processed crude oil.

This system obviously has the merit of simplicity in that there is no need to consider whether any shortfall from expected production levels has resulted from deficiencies of the FPSO itself or from other causes such as declining reservoir production or the characteristics of the crude oil received on board the unit.

However, many contractors are finding this approach difficult to sustain as operators insist upon a ‘payment for results’ approach to FPSO contracting and demand proportionate reductions in dayrate payments where performance targets are not met. In such circumstances, it is plainly vital from the contractor’s perspective that the targets are clearly defined, take into account relevant variable factors (in particular the declining production profile of the field) and incorporate a range of exceptions to protect the contractor from the possibility of day rate reductions for circumstances which are not his ‘fault’ in the sense that they are outside the scope of his control or influence.

It is obviously equally important to ensure that the dayrate adjustment mechanisms are relevant to the operation in hand – there is plainly no commercial point in penalising the contractor for failing to provide water injection capacity where no such operations are then being required by the operator.

Conclusions

The PSA is typically a detailed contract which seeks to regulate the rights and obligations of the operator and contractor in respect of a complex and long-term offshore production project. The issue of performance risk is central to the economic equation underlying all FPSO projects and requires careful analysis and detailed discussion before the PSA is signed.OE

About the author

Simon Curtis, partner at energy and shipping law firm Curtis Davis Garrard, is regarded internationally as one of the most experienced maritime and offshore procurement lawyers. For many years he has advised on new-building contract risks, conversion contracts and contracts for construction and employment of FPSO vessels.

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