168 The Law Review 2017

On the Contractual Risk Allocation in Oil and Gas Projects

Wan M Zulhafiz*

Abstract

This paper focuses on the contractual mechanisms that will help to achieve
a fair allocation of risk between operators and contractors in the oil and gas
projects. Companies that are actively dealing with a wide range of activities
which engage volatile hydrocarbons are exposed to substantial risks and
liabilities. In this regard, most of the petroleum contracts for upstream projects
depart from the common law tradition of risk allocation by shifting the risk to
another party; this is done to protect commercial interests. To achieve this goal,
contractual provisions are used in allocating the risks; especially those related
to people, property and the environment. Risk allocation provisions deal with
hypothetical events—this means that the identity of the person bearing the
liability which will accrue if certain events take place is determined in advance.
Such clauses are intended to ensure that, where harm arises, oil companies
take responsibility for such harm and can meet the costs of mitigating that
harm, including requirements for insurance and the allocation of liability.
These clauses are also known as risk allocation provisions. Contractual risk
allocation is one element of risk management between or among the parties
involved in an undertaking. This is particularly challenging in the oil and gas
industry where several parties are involved in one project. A range of risk
allocations are used in oil and gas contracts, including exclusion of liability
and liability caps. The paper discusses several mechanisms of risk allocation
in oil and gas contracts and the issues pertaining to this matter.

1. Introduction

Risk can be defined as the possibility or probability of not achieving the

desired result, or the extent to which the adverse outcomes of an event may

This paper is a revised and expanded version of a paper entitled “Risk allocation in the
oil and gas contracts” presented at the “15th Management in Construction Researchers”
Association (MiCRA) Annual Conference and General Meeting 2016” at Kulliyyah of
Architecture and Environmental Design, International Islamic University Malaysia, Kuala
Lumpur, on December 8, 2016.
* Assistant Professor, Ahmad Ibrahim Kulliyyah of Laws, International Islamic University
Malaysia. E-mail: [email protected]. Phone No: +603-6196 4305. Dr Wan Mohd
Zulhafiz Wan Zahari is an Assistant Professor at the Civil Law Department, Ahmad Ibrahim
Kulliyyah of Laws, International Islamic University Malaysia (IIUM). He holds an LLB
(Hons) from IIUM, an LLM (Corporate Law) from UiTM and a PhD in Oil and Gas Law
(Contracting) from the University of Aberdeen, Scotland, UK. He is a committee member
of the Malaysian Corporate Counsel Association (MCCA), and an Advocate and Solicitor
of the High Court of Malaya (non-practising).

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 On the Contractual Risk Allocation in Oil and Gas Projects 169

negatively affect the expected outcome.1 The most common risks to the oil
and gas industry, which raise critical legal repercussions, include:

(1) market risks such as changes to the oil price, interest rates and exchange
rates;2

(2) credit risks such as default;3

(3) operational risks such as equipment failure, manpower and CAPEX/

OPEX overrun;4

(4) geological risks such as dry wells;5

(5) environmental risks such as pollution;6

(6) political risks such as change of government;7

(7) war/terrorism, expropriation and change of regulatory regime;8 and

finally,

(8) legal risk such as, contractual, tort and statutory duties, consequential
loss, exclusion of negligence, liability and indemnities.9

This paper, however, will only focus on legal risk, which is also known as
insurable risk.10 According to Aleka Mandaraka-Sheppard:
“risk” generally means the taking of chances in the hope that everything will
turn out to be both safe and profitable, depending on the circumstances of
the risk-taking. Risk also carries an additional connotation of a hazard that
needs to be covered by insurance. For the purpose of proper risk management,
however, risk has a special meaning. It is understood as the possibility of
harm or loss associated with an activity or the likelihood of an accident

1 Berends, Kees, “Engineering and Construction Projects for Oil and Gas Processing Facilities:
Contracting, Uncertainty and the Economics of Information” (2007) 35 Energy Pol’y 4260; MJ
Greaves, “Understanding and Managing Risk in Real Estate Investments” (1983) 1 Surveyor
and Valuer (SISV) 21.
2 Moller, Leon, “Legal Risks in the Oil Industry”, (2007) 5 OGEL 1.
3 Sorge, Marco, “The Nature of Credit Risk in Project Finance”, (2004) 6 BIS Quarterly Review
91.
4 Rose, Peter R, “Chance of Success and Its Use in Petroleum Exploration: Chapter 7: Part II.
Nature of the Business”, The Business of Petroleum Exploration (AAPG, 1992).
5 Van den Hoek, Marcus, “Oil and Gas Trends and What They Mean for Contractors”, Dutch
Oil and Gas Conference on June 26, 2012 in Rotterdam (Deloitte 2012), p 42.
6 Katzman, Martin T, “Pollution Liability Insurance and Catastrophic Environmental Risk”,
[1988] J R & I 75.
7 Lax, Howard L, Political Risk in the International Oil and Gas Industry (Springer, 1983), p 8.
8 France, Diana, “Accurately Assessing, Quantifying and Defining Risk during Contract
Negotiations (Presentation)” (2004) 3 OGEL 2.
9 Keeton, Page and Jones, L Jr, “Tort Liability and the Oil and Gas Industry”, (1956) 35 Tex L
Rev 1.
10 Marsden, Eric, Risk Regulation, Liability and Insurance: Literature Review of Their Influence on
Safety Management (France: FONCSI, 2014), p 25.

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170 The Law Review 2017

happening that may result in danger to life, property or the environment

or may lead to commercial disputes and litigation.11

Insurable risks are inherent in any project; however in major oil and gas
projects, there is predominantly a wide range of risk.12 This is because, by
nature, offshore work and activities to do with production, such as drilling,
extracting, transporting and refining engage a huge number of different
technologies and involve dangerous substances.13

With the inherent dangers of the industry in mind, some bodies in the oil
and gas industry have implemented health and safety measures as well as
environmental measures. In spite of the existence of these measures, the
dangers are not totally eliminated and accidents can still occur.14

Significant lessons can be learnt from the Deepwater Horizon disaster which
happened in the Gulf of Mexico in 2010.15 Redressing the financial consequences
of such an incident can be very costly and may cause enormous financial
setbacks to the business.16 The salient factors to be taken into consideration
before a party agrees to accept or assume an insurable risk, such as, whether
insurance transfers the particular risk and secondly, whether insurers are
willing to pay for that risk.17 Therefore, in order to minimise the risk and
exposure, industry players usually exercise risk management.18 In a broad
context, risk management contains prevention and mitigation of risks and
remediation of loss in the event of occurrence.19

2. Concept of risk management

“Risk management is the systematic approach of taking safety precautions

at all levels of business, perhaps intuitively, including the management of

11 Mandaraka-Sheppard, A, Modern Maritime Law, vol 2: Managing Risks and Liabilities, 3rd edn
(Informa Law, 2013), p 5.
12 El-Shehaby, M, Nosair, I and Sanad, Abd El-Moniem, “Risk Assessment and Analysis for
the Construction of Off Shore Oil & Gas Projects”, (2014) 2 Int’l J Scientific Res Ed 317.
13 Timur, Makarov, “Indemnity in the International Oil and Gas Contracts: Key Features,
Drafting and Interpretation”, (2009) 12 CEPMLP Ann Rev 2.
14 Wagner, J and Armstrong, K, “Managing Environmental and Social Risks in International
Oil and Gas Projects: Perspectives on Compliance”, [2010] J W E L & B jwq002.
15 National Commission to the BP Deepwater Horizon Oil Spill and Offshore Drilling, “Deep
Water: The Gulf Oil Disaster and the Future of Offshore Drilling” (2011); http://www.eoearth.
org/view/article/162358 (accessed on December 26, 2015).
16 According to the Guardian the Deepwater Horizon incident has led to a dip in BP’s profits
by 35%: see The Guardian, “BP’s Deepwater Horizon costs rise $847m” Tuesday July 31, 2012;
http://www.guardian.co.uk/business/2012/jul/31/bp-deepwater-horizon-costs (accessed
April 12, 2013).
17 Bordage, Pierre, “Integrating Contract Risk Management Into Project Risk Management—
Some Tools of the Trade”, (2004) 2 OGEL 1.
18 Moller, supra, n 2, p 2.
19 Aven Terje, Vinnem, Jan Erik and Wiencke, H  S, “A Decision Framework for Risk
Management, with Application to the Offshore Oil and Gas Industry”, (2007) 92 Reliability
Engin Syst Safety 433.

Electronic copy available at: https://ssrn.com/abstract=3052064

 On the Contractual Risk Allocation in Oil and Gas Projects 171

financial and commercial risks and the obtaining of insurance cover.”20 It

is important to reduce the total cost of risk to a project as a whole, not the
costs to each contracting party individually.21 A contract is used as a tool to
distribute risk and clearly identify who bears that risk; a contract also provides
mechanisms for general administration of the project, dispute resolution and
management of claims.22

Risk management practice usually involves risk identification, risk analysis,

risk response, and risk monitoring.23 Risk identification is usually the logical
starting point in a risk due diligence process because it may uncover and
record any potential risk that might affect the project.24 Risk analysis (also
known as risk assessment) is the process of evaluating risks by assessing their
probability of occurrence and their impacts on the project.25 Risk response
is the process of formulating a management strategy including establishing
risk allocation and developing a management plan for resolving the risk26 in
any situation where more than one party is involved in a project.27

A contract is used to allocate risk in larger or smaller amounts that may be

defined qualitatively or quantitatively.28 Those quantitative risks that can be
quantifiable are computed by special software to analyse the risks, where the
risks would be calculated and included in the price.29 However, with regard
to the qualitative risk, it would be distributed between the parties through
contractual risk allocation.

2.1 Common law risk allocation

Historically, “[t]he common law tradition originates in the laws of England,

and has been transplanted through conquest and colonization to England’s

20 Mandaraka-Sheppard, supra, n 11, p 5.

21 Wilson, Dennis J, Allocation of Insurance-Related Risks and Costs on Construction Projects (Ed
Rusty Haggard Publication, 1993); Groton, James and Smith, Robert J, Realistic Risk Allocation
(CPR 2010), p 6.
22 Hooker, Vincent, “Major Oil and Gas Projects—the Real Risks to EPC Contractors and
Owners”, (2010) 26 Const L J 98.
23 Lyons, Terry and Skitmore, Martin, “Project Risk Management in the Queensland
Engineering Construction Industry: A Survey”, (2004) 22 Int J Project Mgmt 51.
24 Walewski, John and Gibson, G, International Project Risk Assessment: Methods, Procedures,
and Critical Factors, vol 31 (Center for Construction Industry Studies, University of Texas
at Austin, Report 2003).
25 Al Salman, A and Sillars D, “Modeling the Effects of Sub-Optimal Risk Allocation in the
Construction Industry”, Engineering Project Organization Conference (EPOS 2013), Devil’s
Thumb Ranch, Colorado July 9–11, 2013).
26 Lam Ka Chi et al, “Modelling Risk Allocation Decision in Construction Contracts”, (2007)
25 Int J Project Mgmt 485.
27 Zaghloul, Ramy and Hartman, Francis, “Construction Contracts: The Cost of Mistrust”,
(2003) 21 Int J Project Mgmt 419.
28 Triantis, George  G, “Unforeseen Contingencies Risk Allocation in Contracts”, (2000) 3
Encyclo L Econs 100.
29 Akintoye, Akintola  S and MacLeod Malcolm  J, “Risk Analysis and Management in
Construction”, (1997) 15 Int J Project Mgmt 31.
172 The Law Review 2017

colonies, including the United States, Australia, Canada, and many countries
in Africa and Asia”30 as well as Malaysia. For the purpose of this paper, unless
otherwise stated, “common law” refers to rules of customary law, which has
been recognised by the English courts.31 Common law grows incrementally
over time and is based on precedent.32

The common law sets out the basic responsibilities of the parties in terms of
risk and liability. In general, risk allocation under contract law and tort law in
a common law jurisdiction is subject to number of elements. Those elements
are, inter alia, breach of duty of care, remoteness of damages, mitigation of
losses, compensatory damages, and whether the party that has breached the
contract or duty is under the obligation to bear the losses suffered by the
non-breaching party.33

A contract is a fundamental understanding and promise between two or more

parties which clearly sets out their duties, liabilities and obligations towards
one another.34 Under contract law, parties are generally obliged to comply
with the terms specified in the contract.35 Contract law is a body of rules
that oversee a contractual arrangement between parties, which regulate the
validity of the contract including its respective terms and conditions. It also
provides remedies to the innocent parties in the event of breach of obligations
and contractual liabilities, where the aggrieved party may be entitled to bring
an action for damages.36 However, the recoverable damages will be subject
to the doctrine of remoteness.37

Conversely, under tort law, liability is established by obediential or legal

obligation. It deals with any dispute about liability of one person to another,
whether such liability was caused intentionally (e.g. assault) or without any
intention (e.g. negligence and strict liability).38 If the obligation is breached,
for instance, if a person has been injured or harmed by others, the wrongdoer
owes a duty to the injured party and will be held responsible and ordered to
pay monetary damages to the victim.39

30 Glaeser, Edward L and Shleifer, Andrei, “Legal Origins”, (2002) 117 Q J Econ 1193.
31 Caenegem, R C, The Birth of the English Common Law, vol 24 (Cambridge: CUP, 1988), p 1.
32 Ibid, p 15.
33 Alramahi, Moe, Oil and Gas Law in the UK (London: Bloomsbury Professional, 2013), para
[3.294].
34 Smith, Stephen A, Contract Theory (Oxford: OUP, 2004); Stone, Harlan F, “The Equitable
Rights and Liabilities of Strangers to a Contract” [1918] Colum L Rev 291.
35 Mulcahy, Linda and Tillotson, John, Contract Law in Perspective, 4th edn (Cavendish
Publishing, 2004) p 51.
36 Craswell, R, “Contract Law, Default Rules, and the Philosophy of Promising”, [1989] Mich
L Rev 489.
37 Mandaraka-Sheppard, supra, n 11, p 361.
38 Winfield, Percy H, “The History of Negligence in the Law of Torts”, (1926) 42 Law Q Rev
184.
39 Landes, William M and Posner, Richard A, “Tort Law as a Regulatory Regime for
Catastrophic Personal Injuries”, [1984] JLS 417.
 On the Contractual Risk Allocation in Oil and Gas Projects 173

Under the principles of the tort of negligence, where there is a breach of duty
of care, the party at fault will be held liable and must pay compensatory
damages for any losses incurred.40 In sum, liability is based on fault and
follows a breach of duty.41 On the other hand, it is important to note that the
provisions of the contract can impute or exclude liability of the parties.

The key difference between tort and contract law is that tort is an externally
imposed obediential obligation, whereas a contract arises as a result of
agreement. Jackson LJ explained the difference between contractual risk
allocation and tort in Robinson v PE Jones (Contractors) Ltd.42 The court held:
[c]ontractual obligations spring from the consent of the parties and the
common law principle that contracts should be enforced. Tortious duties
are imposed by law, as a matter of policy, in specific situations.43

2.2 Contractual risk allocation

As discussed above, companies active in the petroleum industry are exposed

to substantial risks and liabilities, since they are dealing with a wide range
of activities which engage volatile hydrocarbons.44 In this regard, most of
the petroleum contracts for upstream projects depart from the common law
tradition of risk allocation by shifting the risk to another party; this is done
to protect commercial interests.45 To this end, contractual provisions are used
in allocating the risks; especially those related to people, property and the
environment.46

Risk allocation provisions deal with hypothetical events—this means that the
identity of the person bearing the liability which will accrue if certain events
take place is determined in advance.47 Such clauses are intended to ensure
that, where harm arises, oil companies take responsibility for such harm
and can meet the costs of mitigating that harm, including requirements for

40 See Dugdale, Anthony M, Jones, Michael and Simpson, Mark, Clerk and Lindsell on Torts,
19th edn (London: Sweet & Maxwell, 2005), paras 9.01–9.04.
41 Gordon, Greg, “Risk Allocation in Oil and Gas Contracts”, in Gordon, Greg, Paterson,
John and Usenmez, Emre (eds), Oil and Gas Law: Current Practice & Emerging Trends, vol 2
(Dundee: Dundee University Press, 2011).
42 [2011] EWCA Civ 9; [2011] 3 WLR 815 at [75].
43 [2011] EWCA Civ 9; [2011] 3 WLR 815 at [75].
44 Martin, Timothy, “Model Contracts: A Survey of the Global Petroleum Industry”, (2004)
22 J Energy & Nat Resources L 281, 48; Zulhafiz, Wan M, “An Empirical Study on the
Contractual Risk Allocation Provisions and Indemnity and Hold Harmless Clauses in
the Oilfield Service Contracts in Malaysia”, Paper Proceedings on Second International
Conference on Interdisciplinary Legal Studies (ICILS) 2015, on June 9–10, 2015 in Toronto,
Canada (Unique Conference Canada, June 2015).
45 Gordon, “Risk Allocation in Oil and Gas Contracts”, supra, n 41.
46 Ibid.
47 Uff, John and Odams, A Martin, Risk, Management and Procurement in Construction (London:
Construction Law Press, 1995).
174 The Law Review 2017

insurance and the allocation of liability.48 These clauses are also known as
risk allocation provisions.

Contractual risk allocation is one element of risk management between or

among the parties involved in an undertaking.49 This is particularly challenging
in the oil and gas industry where several parties are involved in one project.50 A
range of risk allocations are used in oil and gas contracts, including exclusion
of liability and liability caps.51 Indemnities are an important element of this
suite of risk allocation provisions.52 The indemnity clause is often used to
allocate risk pertaining to property, personnel and pollution.

A contract can be considered as a trade-off between the contractor’s price for

undertaking the work and his willingness to accept both the controllable and
uncontrollable risks.53 Whether the party is willing and aware to bear the risk
will affect its response to risk.54 The cost of improper risk allocation could be
seen from the response from contractors such as adding a high contingency
(premium) to the bid price or delivering low quality work.55 Some questions
should be resolved before the parties allocate risks, such as:
Which party has the greater degree of control over the eventuality?; which
party has the greater capacity to absorb the risk?; which party can best
assess, evaluate and make allowance for the risk?; and which party normally
undertakes such risks in the course of his business?56

In short, the allocation of risk is one of the important decision-making processes

leading to project success. The most challenging aspect of drawing up an
oilfield service contract is deciding how to fairly allocate risk between the
parties, while at the same time achieving the commercial goals of the contracts.

2.3 Mechanisms of contractual risk allocation in oilfield service contracts

Risk can be allocated in a contract if the contractual terms set out which
party will be liable for or exempted from certain risks; the contract could use

48 Peirano, Marta and Boykett, Simone Boria Tim, Oil Contracts—How to Read and Understand
a Petroleum Contract, version 1 (Austria: Times Up Press, 2012).
49 Badiru, Adedeji B and Osisanya, Samuel O, Project Management for the Oil and Gas Industry:
A World System Approach (CRC Press, 2013).
50 Halman, J I M and Braks, B F M, “Project Alliancing in the Offshore Industry”, (1999) 17 Int
J Project Mgmt 71.
51 Gordon, “Risk Allocation in Oil and Gas Contracts”, supra, n 41, p 443.
52 Ibid.
53 Flanagan, Roger and Norman, George, Risk Management and Construction (Oxford: Blackwell
Scientific, 1993).
54 Ward, S C, Chapman, C B and Curtis, Bernard, “On the Allocation of Risk in Construction
Projects”, (1991) 9 Int J Project Mgmt 140.
55 Fisk, Edward R and Reynolds, Wayne D, Construction Project Administration (Prentice Hall,
2000).
56 Robinson, M Nigel and Lavers, P Anthony, Construction Law in Singapore and Malaysia
(Butterworth & Co (Asia) Pte Ltd, 1988), p 68.
 On the Contractual Risk Allocation in Oil and Gas Projects 175

exculpatory provisions such as a limitation of liability, exemption or indemnity

clause.57 It could also require one or more parties to take out a set level or
certain types of insurance.58 In theory, the rationale behind this technique of
risk allocation is that the party with the most control over the risk is responsible
for any financial loss.59 That said, “strength of bargaining position plays a
dominant role in the scope and breadth of such risk allocations”.60

2.3.1 Exemption clauses

Under common law, an exemption clause allows one party to exclude himself
from liability. There are two types of exemption clause; 61 firstly, an exclusion
clause—where one of the parties excludes liability.62 Secondly, a limitation
clause, which, instead of excluding the liability, limits the aggrieved party’s
right to seek compensation or reparation after a breach of contract or where
there is negligence.63 The most common example is where the amount of
damages to be paid for breach of contract or negligence is limited.64

2.3.2 Exclusion clause

An exclusion clause can be defined as “any clause in a contract or term in a

notice which purports to restrict, exclude or modify a liability, duty or remedy
which would otherwise arise from a legally recognised relationship between
the parties”.65 Exclusion clauses are a common feature in contracts and can
be seen in different forms.66 Exclusion clauses can be broadly classified into
three main types. First, the clause may exclude legal duties which would
otherwise arise from the contractual relationship between the parties. Second,
the clause may limit or exclude liability in respect of a breach of duty. Third,
an exclusion clause may be only procedural in manner and purport to alter
the normal burden of proof or provide that one matter will be treated as
conclusive of another or provide a time limit within which a suit must be

57 Gordon, “Risk Allocation in Oil and Gas Contracts”, supra, n 41; Zulhafiz, Wan, “Unfair
Contract Terms Act 1977: Does It Provide a Good Model in Regulating Risk Allocation
Provisions in Oilfield Contracts in Malaysia?”, (2015) 8 International Journal of Trade & Global
Market 3.
58 Downie, David and McBratney, Malcolm, Contractual Risk Allocation: Using Warranties,
Exclusions, Indemnities and Insurance Provisions to Mitigate and Manage Risk (Australia: Inter
Alia Publishing, 2012), p 17.
59 O’Neil, William E, “Insuring Contractual Indemnity Agreements under CGL, MGL, and
P&I Policies”, (1996) 21 Tul Mar L J 359 at 360.
60 Ibid.
61 Charman, Mary, Contract Law (London: Routledge, 2013), p 119.
62 Marson, James, Business Law (Oxford: OUP, 2013), p 193.
63 Gillies, Peter, Concise Contract Law (Federation Press, 1988), p 95.
64 Chitty, Joseph, Chitty on Contracts: General Principles (London: Sweet & Maxwell, 2012),
p 1877; MacQueen, Hector L and Thomson, Joe, Contract Law in Scotland (London: Tottel,
2007), p 277.
65 Yates, David and Hawkins, Arthur, Standard Business Contracts: Exclusions and Related Devices
(London: Sweet & Maxwell, 1986).
66 McKendrick, Ewan, Contract Law (Marise Cremona ed), 6th edn (Palgrave MacMillan, 2005).
176 The Law Review 2017

brought.67 The effect of an exclusion clause is that it would release a party

from responsibility for loss arising from an identified risk in respect of any
risks arising from the contract.68

The difference between an exclusion clause and an indemnity clause is that

the exclusion clause may entirely remove liability for the party who seeks
for such exclusion.69 Its effectiveness therefore does not really depend on
the financial position of the other party.70 In contrast, as we shall see below,
an indemnity clause involves the repayment of liability already incurred.
Therefore, its effectiveness may very well depend on the financial position
of the indemnifying party.

2.3.3 Limitation of lability

Limitation clauses slightly differ from exclusion clauses since they operate to
limit or cap liability rather than entirely remove a party’s potential liability.
In the House of Lords case of Ailsa Craig Fishing Co Ltd v Malvern Fishing Co
Ltd,71 Lord Wilberforce said:
[c]lauses of limitation are not regarded by the courts with the same hostility as
clauses of exclusion; this is because they must be related to other contractual
terms, in particular to the risks to which the defending party may be exposed,
the remuneration which he receives, and possibly also the opportunity to
the party to insure.72

Limitation clauses allow the party relying on them to calculate the responsibility
for remedying loss arising out of an act of the benefiting party and cap their
potential liability up to a certain amount.73 The cap may be on the basis of a
predetermined portion of the loss or a fixed sum.74 Such limitation has clear
commercial advantages in assuming liability, especially where indemnity and
insurance are concerned.75 That said, it is important to note that in the case of
a very low limitation, it has much the same effect as an outright exclusion.76

67 Yates and Hawkins, supra, n 65, p 5.

68 Farstad Supply AS v Enviroco Ltd [2010] UKSC 18; [2010] SLT 884.
69 Zulhafiz, Wan M, “Enforceability of Knock-for-Knock Indemnities in Oilfield Service
Contracts in Thailand”, The Fifth International Conference on Advancement of Development
Administration 2016–Social Science and Interdisciplinary Studies (The 5th ICADA 2016–
SSIS) held on May 26–28, 2016 at National Institute of Development Administration (NIDA),
Bangkok (2016).
70 Koffman, Laurence and Macdonald, Elizabeth, The Law of Contract (Oxford: Oxford
University Press, 2010), p  158; Samuel, Geoffrey, Law of Obligations and Legal Remedies
(London: Routledge, 2013).
71 [1983] 1 WLR 964.
72 Ibid, at 966.
73 West, Glenn D and Lewis, W Benton Jr, “Contracting to Avoid Extra-Contractual Liability—
Can Your Contractual Deal Ever Really Be the ‘Entire’, Deal?”, [2009] Bus Law 999.
74 Harris, Robert J, “Limitation of Liability Clauses: Allocating Risky Business”, (1993) 13
Constr Law 18.
75 Bailey, Julian, Construction Law (CRC Press, 2014) p 1059.
76 Gillies, supra, n 63, p 96.
 On the Contractual Risk Allocation in Oil and Gas Projects 177

2.3.4 Indemnity clause

Generally, under an indemnity clause, a party agrees to indemnify the other

for any losses suffered in the case of some specified event. Indemnity is
defined as “[a] duty to make good any loss, damage, or liability incurred by
another”.77 It is “a contract between two parties whereby one agrees to cover
any liability, loss or damage sustained by the other from some contemplated
act or condition, or damage resulting from a claim or demand of a third
person”.78 An indemnitee is the person to be indemnified or protected by the
other, whereas, an indemnitor is the person who is bound to indemnify or
protect the other.79 To indemnify means:
(i) to restore the victim of a loss, in whole or in part, by payment, repair,
or replacement;

(ii) to save harmless; to secure against loss or damage; or to give security

for the reimbursement of a person in case of an anticipated loss falling
upon him; and

(iii) to make good; to compensate; or to make reimbursement to one of a

loss already occurred by him.80”

Indemnification enables one party who is legally responsible for a loss to shift
that loss to another party.81 It is important to note the distinction between the
obligation of indemnity and the obligation to indemnify and hold harmless.
In this respect:
[i]ndemnity generally refers to the obligation that one person has to pay for
any loss or damage another has sustained by acting at his request or for his
benefit. Stated differently, indemnity is the right that a person suffering a
loss or damage must be made whole by another. Indemnity may be imposed
by contract or by operation of law (i.e., common law or statutorily). The
most common example of legal indemnification is reflected by the doctrine
of vicarious liability, which imposes liability on a party whose liability is
“secondary” or “passive” in comparison to that of the party who owes
indemnification (e.g., employer-employee or principal-agent). Also, legal
indemnification exists where necessary to prevent an unjust result, such as
when a person has a non-delegable duty of care (e.g., landowner’s duty to
protect against hazards or nuisances). Further, legal indemnification exists
to address personal injury or property damage caused by defective products
(i.e., product liability). … In contrast, contractual indemnity is a covenant or

77 Black’s Law Dictionary, 9th edn (2009).

78 Parker, Penny L and Slavich, John, “Contractual Efforts to Allocate the Risk of Environmental
Liability: Is There a Way to Make Indemnities Worth More Than the Paper They Are Written
On”, (1990) 44 Sw L J 1349.
79 Black’s Law Dictionary, 6th edn, p 769.
80 Ibid.
81 Stark, Tina L, Negotiating and Drafting Contract Boilerplate (ALM Publishing, 2003), p 248.
178 The Law Review 2017

agreement by one party (“the indemnitor”) to indemnify or “save harmless”

the other party (“the indemnitee”) by way of compensation for a loss or
damage suffered by the indemnitee.82”

The use of an indemnity and hold harmless clause as a contractual provision

in an oilfield service contract represents an attempt by the parties to distribute
risks arising from the transaction of the project. The clauses usually employ
phrases such as “arising out of or in consequence of this contract”, “arising
in connection herewith” or “relating to or arising out of this contract”;
these phrases are read broadly to “unambiguously encompass all activities
reasonably incident to or anticipated by the principal activity of a contract”.83
The courts have previously ruled that commercial parties must be left free to
decide how to allocate commercial risks.84

To give an indemnity is a very serious commitment, since it offers

indemnification to someone should a particular event occur, much in the
same way as an insurer does.85 Indemnification provides the ability to shift
the financial risk associated with some conduct to another party.86 As such,
the benefiting party or the indemnitee may avoid bearing the financial costs
of some event despite being liable in law. Therefore, it is essential to consider
the financial capacity of the indemnitor as it may cause financial setbacks
to the indemnitor in the event that forecast incidents actually happen and
the indemnitor has no financial strength to cover the losses.87 It can be said
that the indemnity provisions are probably the most important part of a
contract, particularly in the oil and gas industries, where liability is potentially
significant.88 Thus, the terms of an indemnity clause should never be considered
“boilerplate” and should be carefully considered by both the indemnitor and
indemnitee before they are agreed upon.89

82 Gesellschap, Vickie A and Hicks, Ronald  L Jr, “The Interplay Between Indemnification
Provisions and Insurance Clauses in Contracts for Goods and Services”, [2014] Assoc Corp
Counsel 47.
83 O’Neil, supra, n 59; see also Fontenot v Mesa Petroleum Co, 791 F 2d 1207, 1214 (5th Cir 1986)
(quoting Corbitt v Diamond M Drilling Co, 654 F 2d 329, 333 (5th Cir 1981)) 10; Concast v AMCA
Systems Inc, 959 F 2d 631, 632 (7th Cir 1992) (applying Illinois law); Poole v Ocean Drilling
& Exploration Co, 439 So 2d 510, 512 (La Ct App 1st Cir 1983) (“The indemnity phrase ‘in
connection with’ has been defined as being related to or associated with, but not the primary
or only purpose of an insurance policy.”) (citations omitted).
84 Homburg Houtimport BV and Ors v Agrosin Private Ltd & Anor [2003] UKHL 12; [2003] 2 WLR
711, 57.
85 Downie, David, Indemnity and Exclusion Clause: A Practical Approach under Australian Law
(Inter Alia Publishing, 2012), p 1.
86 Randall, Vernella  R, “Managed Care, Utilization Review, and Financial Risk Shifting:
Compensating Patients for Health Care Cost Containment Injuries”, (1993) 17 U Puget Sound
L Rev 1.
87 Gerber, Daniel W and Biggie, Brian R, “The Global Supply Chain: Understanding, Measuring,
Mitigating and Managing Exposure in a Supply Chain Dependent Globalized Market”,
(2012) 79 Def Counsel J 412.
88 Hewitt, Toby, “Who Is to Blame? Allocating Liability in Upstream Project Contracts”, (2008)
26 Journal of Energy & Natural Resources Law 177.
89 Stark, supra, n 81, p 249.
 On the Contractual Risk Allocation in Oil and Gas Projects 179

It is worth noting that, the indemnity clauses that are used to allocate risk in
most of the standard oilfield service contracts are drafted under the perception
that the party in the best position should accept liability and insure against the
loss or absorb it. In this sense, the liability is not based on fault or breach of
duty.90 In brief, contractual indemnification as regards risk allocation, is used
by the industry to depart from the general principle of the tort of negligence.91
However, some of the contractual indemnification provisions that are used
in the industry have been criticised for being biased because of inequality of
bargaining power between powerful oil companies or operators compared
to weaker contractors.92

The rules for construction and interpretation of indemnity clauses are similar
to those for contractual provisions in general.93 An indemnity clause is to
be interpreted in accordance with the plain meaning of the language used;
if the language was ambiguous then it should be interpreted in light of the
surrounding circumstances so as to manifest the intention of the parties.94
Even though insurance contracts are usually construed against the insurer,
an indemnity provision would be construed against the indemnitee and not
against the indemnitor.95

There is no set form for an indemnity. However, there are three types of
indemnity which are frequently seen in practice. These include:

(1) Party A indemnifies Party B for claims by Party C;

(2) Party A indemnifies Party B for breach of contract by Party A; and

(3) Party A indemnifies Party B for claims made by Party A due to the
negligence of or breach of contract by Party B.96

It is important to note that an indemnity can arise in any event specified in

the contract, and is not limited to these examples. The indemnity may or
may not be subject to any limitation or exclusion under the agreement.97
This makes the indemnity clause an excellent mechanism for passing risk to
another party to an agreement.

90 Gordon, “Risk Allocation in Oil and Gas Contracts”, supra, n 41.

91 Parker and Slavich, supra, n 78.
92 Alramahi, supra, n 33, para 3.293.
93 Circo, Carl J and Little, Christopher H, A State-by-State Guide to Construction and Design Law:
Current Statutes and Practices (American Bar Association, 2009), p 441.
94 Furst, Stephen et al, Keating on Construction Contracts (London: Sweet & Maxwell, 2012),
p 90.
95 Rasmussen, W E, “Insurance and Indemnification Provisions and Mining Contracts”, (1985)
31 Rocky Mtn Min L Inst 11.
96 Courtney, Wayne, “The Nature of Contractual Indemnities”, (2011) 27 JCL 1; Downie, supra,
n 148, p 1.
97 Courtney, Wayne and Carter, John, “Indemnities Against Breach and Settlements of Third
Party Claims”, (2011) 27 JCL 265.
180 The Law Review 2017

An indemnity can be further categorised as a “unilateral” or “mutual”

indemnity.98 A mutual indemnity is different from an unilateral indemnity;
under an unilateral indemnity, one party bears the responsibility of the
indemnity, while the other party benefits from being indemnified.99 On the
other hand, under a mutual indemnity, all parties are concurrently prospective
indemnifiers and beneficiaries of an agreed indemnity.100

Under a unilateral indemnity, party A will agree to take up responsibility

to indemnify party B in the event that party B suffers losses arising from the
contractual relationship.101 A unilateral indemnity is also described as “simple
indemnity” or “one-sided indemnity”.102 On the other hand, under a mutual
indemnity in the oil and gas context, party A will agree to indemnify party B
against claims in respect of any death of, or personal injury to, party A’s
employees; loss of, or damage to, party A’s property; and pollution emanating
from party A’s property, where the indemnification given by party A to party
B is irrespective of party B’s negligence or breach of contract or breach of
statutory duty that may have caused or contributed to the death, personal
injury, loss, damage or pollution at issue.103 Party B, conversely, will agree
to provide a reciprocal indemnity in favour of party A. Mutual indemnity is
also known as, a “reciprocal indemnity”, a “cross-indemnity” or a “knock
for knock” indemnity.104 Olsen claims that:
[t]he norm of reciprocity is related to a fair distribution of rewards between
the parties. In many cases, no objective criteria by which the parties can
clarify what characterizes a fair distribution of rewards will exist, and the
parties must develop a “give and take” attitude. In the long run, however,
reciprocity and perceived fairness is a precondition for relations to remain
stable. Flexibility addresses the willingness and motivation to change plans
and strategy according to new circumstances in the best interests of all
actors involved.105

The practice of adopting “knock-for-knock” indemnities is widely accepted in

the oil and gas industry since such an apportionment of liability compels the
party best able to deal with the particular risk to do so and helps the parties
stay away from fault-based allocation of risk.106 This is appropriate because

98 Gordon, “Risk Allocation in Oil and Gas Contracts”, supra, n 41.

99 Ibid.
100 Ibid.
101 Ibid.
102 Ibid.
103 Egbochue, Chidi, “Reviewing Knock for Knock Indemnities Following the Macondo Well
Blowout”, (2006) 4 C L Int 7.
104 Gordon, “Risk Allocation in Oil and Gas Contracts”, supra, n 41.
105 Olsen, Bjørn Erik et al, “Governance of Complex Procurements in the Oil and Gas Industry”,
[2005] J Purchasing Supply Mgmt 4.
106 Curry, Michel E, “Liability for Environmental Contamination and the Model Form Operating
Agreement: A Practical Discussion of the Operating Agreement and Environmental Liability
Under CERCLA and RCRA in the Context of Oil and Gas Exploration” (1992) 23 Tex Tech
L Rev 739, 758.
 On the Contractual Risk Allocation in Oil and Gas Projects 181

the use of fault-based indemnity could lead to expensive and time-consuming

litigation in ascertaining the liability of the parties.107

In sum, the goal of a reciprocal indemnity is to set up an efficient risk allocation

in proportion to the best returns.108 Some of the model form contracts have
adopted a modified form of the knock-for-knock indemnity,109 since it is
regarded as a unique contractual feature in the oil and gas industry.110

3. Issues on unfair risk allocation

Under a contractual indemnity, the rights and obligations of the parties

would be modified so as to allow the indemnitee to recover damages from
the indemnitor, irrespective of whether it was partly or solely caused by
the indemnitee’s negligence.111 That said, the enforceability of indemnity
provisions may be affected by common law, statutes, and related insurance
obligations.112 For example, indemnity provisions that require one party to the
contract to indemnify the other party’s own negligence can raise public policy
concerns because the indemnity agreement might have been influenced by the
inequality of bargaining power between the negotiating parties.113 This situation
could lead to the imposition of oppressive, unfair and onerous contractual
indemnity clauses towards the party with weaker bargaining power.114 Thus,
it is important for the law to oversee these contractual provisions that have
diverged too far from common law indemnity principles.115

Indemnity provisions in oil and gas contracts may take the form of either hold
harmless and defend or exculpatory or release from liability clauses which
limit or exclude a party from liability in respect of its own tortuious act.116
The key issue which leaps out for consideration is the indemnification of the
operator and subsequent claims arising out of their own negligence, gross

107 Schiavon, John J, A Guidebook for Developing and Sharing Transit Bus Maintenance Practices
(Transportation Research Board, 2005), p 107.
108 Korobkin, Russell, “Bounded Rationality, Standard Form Contracts, and Unconscionability”,
[2003] U Chi L Rev 1203 at 1250.
109 Hewitt, Toby, “An Asian Perspective on Model Oil and Gas Services Contracts”, (2010) 28
Journal of Energy & Natural Resources Law 331 at 333.
110 Egbchue, supra, n 103, p 7.
111 Macattram, Genevieve, “How Can the Indemnity Clause Expand or Limit the Responsibility
For Liability of the Parties in International Oil and Gas Contracts?”, 10 CEPMLP Ann Rev 2.
112 Gerald, Patrick S and Williams, Holly B, “Injuries to Third Parties Arising from Oil and Gas
Operations: An Analytical Framework for Examining Indemnity and Additional Insured
Issues”, (1999) 15 J Nat Resources & Envtl L 21.
113 Anderson, Eugene R, Stanzler, Jordan S and Masters, Lorelie S, Insurance Coverage Litigation
(Aspen Publishers Online, 1999).
114 Miller, Roger and Jentz, Gaylord, Cengage Advantage Books: Business Law Today: The Essentials
(Cengage Learning, 2010), p 206.
115 Morris, Clarence, “Torts of an Independent Contractor”, (1934) 29 Ill L Rev 339 at 343.
116 Ayanruoh Felix, “Deepwater Horizon Oil Spill: Is Indemnification Clause in Service Contract
Contrary to Public Policy?” (CEPMLP, 2011); http://works.bepress.com/felix_ayanruoh/1
(accessed October 15, 2015).
182 The Law Review 2017

negligence, wilful misconduct, strict liability or other legal fault.117 Recently,

some of the contracts have included gross negligence, wilful misconduct, strict
liability or other legal obligations in the indemnity provisions as a means to
exempt the indemnitee from liability. Some companies (especially in the US)
impose a corporate policy where they do not accept any indemnity provisions
that operate in such manner as to permit a party to escape from its own gross
negligence or wilful misconduct. On this point, Simon Rainey remarks that
an indemnity clause should not shield a party contractually from liability for
his own gross negligence.118

The judicial approach in respect of such indemnity provisions is that they

are contrary to public policy and unenforceable.119 Consequently, the burden
of proof lies on the party relying on the indemnity clause.120 However, it is
important to note that an indemnitor may be made liable if there is no disparity
in bargaining power or in the absence of undue influence.121 In reality, however,
it is problematic to strike a balance; moreover, the imposition of non-fault
based indemnities may lead to prolonged litigation; in addition, it is virtually
impossible to completely avoid a fault-based system of risk allocation.122 In
other words, the contracting parties should be fully acquainted with the risk
management knowledge and the risks associated with a particular project in
order to produce efficient and fair contractual indemnities.123

3.1 Contractual freedom

Contracts can be used as a risk-transfer mechanism.124 This is also true for oil
and gas contracts. It appears that one of the major dissimilarities between civil
law and common law is the approach taken with regard to risk allocation.125
Under the common law countries, risk is allocated by the terms of the contract,
whereas under the civil law countries it is allocated by the civil code, where the
parties to the contract may allocate the risk by the terms of the contract within
the statutory legal framework. It is important to highlight that risk allocation
under the common law is governed by the law of contract, as well as relevant
statutes.126 The operation of contract law in respect of risk allocation is very

117 Macattram, supra, n 111, p 2.

118 Rainey, Simon, The Law of Tug and Tow and Offshore Contracts (CRC Press, 2013), p 264; Canada
Steamship Lines Ltd v The King [1952] AC 192.
119 Byrd, Edwin H III, “Reflections on Willful, Wanton, Reckless, and Gross Negligence”, (1987)
48 La L Rev 1383.
120 Sweeney, Construction Law Update 2013 (Aspen Publishers 2013), p 54.
121 In Re Oil Spill by Oil Rig “Deepwater Horizon” in the Gulf of Mexico, on April 20, 2010 (2012
MDL No 2179) 841 F Supp 2d 988 (Dist Court, ED Louisiana) para 1001.
122 Macattram, supra, n 111, p 10.
123 Edgerton, William W, Recommended Contract Practices for Underground Construction (SME,
2008), p 35.
124 Hooker, supra, n 22.
125 Axel Volkmar Jaeger and Götz-Sebastian Hök, FIDIC: A guide for practitioners (Springer,
2009).
126 Ibid.
 On the Contractual Risk Allocation in Oil and Gas Projects 183

important since it is connected to the responsibility to overcome the risk in

the event that it eventuates127 and this responsibility leads to liability.128 There
are two important principles of the common law in establishing the primary
nature of contracts, firstly, freedom of contract, where the parties are free to
contract in any way they wish; and secondly, the binding force of contract,
where the contract is enforced and upheld in accordance with its terms.129

Regarding the principle of contractual freedom, Kessler claims that:

[it is] the inevitable counterpart of a free enterprise system. As a result, our
legal lore of contracts reflects a proud spirit of individualism and laissez-faire.130

According to this principle, the prospective contracting parties are the ideal
persons to decide on the contractual terms and conditions for their own interest.
Thus, the law should uphold any commercial terms that have been chosen by
the parties, as reflected in the contract. However, it is important to note that, in
order to preserve contractual fairness, the principle of contractual freedom can
be subject to a number of exceptions. For example, some jurisdictions recognise
a concept of unconscionability. “Unconscionability” means that where any
contractual term and condition in the contract, or anything that is an integral
part of the contract was so inherently unfair, the contract simply should not
be allowed to stand in its particular form.131 The rationale is to ensure fairness,
therefore, in determining the existence of unconscionability, the court will
consider amongst other factors, whether one party has a dominant position
towards another party, which could lead to inequality of bargaining power.132
That happens when one party to a contract, has more power and is in a better
position in terms of bargaining power compared to the other party, which
results in the party with greater power gaining more favourable terms.133 In
this situation, contractual freedom ceases to be real freedom.

3.2 Inequality of bargaining power

The [petroleum] industry developed this risk management model—the
contractual indemnification provision—to shift the risk of liability from the
negligent party (the indemnitee), to an innocent party (the indemnitor) … The
contractual indemnification provision as employed by the industry has been
criticised as being inequitable and an exertion of unfair bargaining power

127 Ibid.
128 Bunni, N G, “The Four Criteria of Risk Allocation in Construction Contracts” [2009] ICLR
4.
129 Roberts, Peter, “Liability Allocation”, in Petroleum Contracts: English Law and Practice (Oxford:
OUP, 2013), p 20.
130 Kessler, Friedrich, “Contracts of Adhesion—Some Thoughts About Freedom of Contract”,
(1943) 43 Colum L Rev 629.
131 Trebilcock, Michael J, “An Economic Approach to the Doctrine of Unconscionability”, in
Reiter, Barry J and Swan, John (eds), Studies in Contract Law (1980).
132 Barnhizer, Daniel D, “Inequality of Bargaining Power”, (2005) 76 U Colo L Rev 139 at 151.
133 Beale, Hugh, “Inequality of Bargaining Power”, (1986) 6 Oxford J of Legal Studies 123 at 124.
184 The Law Review 2017

on small contractors by the big oil companies and oil well operators in some
common law jurisdictions,134 while some other common law jurisdictions
have embraced the provision.135

In the oil and gas industry, the risk drivers for the two parties to an oil and
gas project are often directly conflicting. Theoretically, the risks should be
allocated to the party best able to control them,136 however, there is often little
parity in the allocation of risks in the oil and gas industry where the risks
are not necessarily allocated or re-allocated to the party that is best able to
manage them most efficiently and effectively.137 To this end:
[t]he question is, which party wants or needs the contract more, and
what other alternative does each of them have? The party with the better
bargaining position will have advantage in the negotiation and should be
able to convert this into contract terms that are favourable to it. Historically
in the upstream the party with the bargaining power has used it to impose
its preferred terms on the other.138

In this regard, some contractors claim “they are required to take on onerous
responsibilities without appropriate margins to absorb the consequences of
the associated risks”.139

It is important to note that the oil and gas industry heavily relies on goods
and services supplied by third party vendors and contractors.140 These service
contractors provide various specialised services. Contract documents are
used to facilitate the administration of the performance of these services.141
Because of their terms, oilfield service contracts are unique and are therefore
different to joint operating agreements.142 As an illustration, under joint
operating agreements, a party might at one time be an active participant
and hold a dominant position over another, while at another time, the same

134 See White, Hunter H, “Winding Your Way Through the Texas Oilfield Anti-indemnity
Statute, The Fair Notice Requirements and Other Indemnity Related Issues”, (1996) 37 S
Tex L Rev 161 at 163. See also Getty Oil Co v Insurance Co of North America 845 SW 2d 794,
803 (Tex 1992).
135 Alramahi, supra, n 33, paras 3.292–3.293.
136 Pitkethly, Garth and Wilson, Ross, Construction Costs of Major Projects (Australian
Government Publishing Service, Canberra), p 28.
137 Al Salman and Sillars., supra, n 25.
138 Thorpe, Chris, Fundamentals of Upstream Petroleum Agreements (C P Thorpe Ltd, 2008), p 282.
139 Franklin, Helen, “Irretrievable Breakdown? A Review of Operator/Contractor Relationships
in the Offshore Oil and Gas Industry”, (2005) 23 Journal of Energy & Natural Resources Law 1
at 7.
140 Chima, Christopher M, “Supply-Chain Management Issues in the Oil and Gas Industry”
(2011) 5 JBER.
141 Ghandi, Abbas and Lin, CY Cynthia, “Oil and Gas Service Contracts around the World: A
Review”, (2014) 3 Energy Strategy Rev 63.
142 De Graaff, Naná, “A Global Energy Network? The Expansion and Integration of Non‐triad
National Oil Companies”, (2011) 11 Global Networks 262.
 On the Contractual Risk Allocation in Oil and Gas Projects 185

party could be a passive one.143 However, under the oilfield service contracts,
the contracting parties always remain on one side of the transaction.144 The
parties could either be an oil company acting in the capacity of an operator
or an oilfield service company providing the services and equipment for the
operational work.145

Differences in bargaining positions can result in one party being dominant and
being able to impose terms and conditions in a non-negotiable manner.146 In
this regard, the party with the dominant position might have little sympathy
and less concern or perhaps be unwilling to recognise the other side’s position
and accept alternative clauses that might challenge their interest in the
industry.147 The operators will often conserve their own database of model form
of contracts and usually use them as a foundation in contract negotiations.148
However, during the contract negotiation process, there is a high possibility
of inequality in bargaining power between the operators and contractors. The
inequality of bargaining power happens when there is “imposition of will by
a dominant party on a party with inferior economic bargaining power, who
is being unfairly coerced into indemnifying the dominant party, stating that
the result will rest on the relative bargaining power of the parties”.149 Here,
the inferior party may well find that he is given no opportunity to negotiate
the one-sided set of terms prior to the conclusion of the contract, but that he
should “take it or leave it”.150 As a result, the conclusion of the contracts, the
contractor will end up with greater risk and liability. Thorpe argues that:
[a] contractor who wants this construction work is in difficult position. If
it thinks it is only credible contractor, either because of its special abilities
or else because the market is tight, it can decline to bid in the hope that the
operator will invite it to proceed by direct negotiation. But this is a high-risk
strategy, and if contractor’s assumptions about its favoured position are
incorrect the operator will proceed with the tender and award the contract
to another contractor. Otherwise the contractor will have to bid and will be
faced with difficult decisions on its contract exceptions. How far can it go in
proposing more balanced contract terms without the operator rejecting its

143 Harrigan, Kathryn Rudie, Managing for Joint Venture Success (Simon and Schuster, 1986),
p 48.
144 Finch, John H, “Transferring Exploration and Production Activities within the UK’s
Upstream Oil and Gas Industry: A Capabilities Perspective”, Change, Transformation and
Development (Springer 2003), p 97.
145 Ernst, David and Steinhubl, Andrew M  J, “Alliances in Upstream Oil and Gas”, [1997]
McKinsey Quarterly 144.
146 Pitkethly and Wilson, supra, n 136, p 29.
147 Hobbs, Brian and Andersen, Bjørn, “Different Alliance Relationships for Project Design and
Execution”, (2001) 19 Int J Project. Mgmt 465; Leis, Jorge, McCreery, John and Gay, Juan
Carlos, “National Oil Companies Reshape the Playing Field” (Bain Brief, 2012).
148 Franklin, supra, n 139, p 7.
149 Kinsella, N Stephen, “Oilfield Indemnity and ‘Separate Insurance’, Provisions in the Wake
of Getty Oil”, [1994] Tex Oil and Gas LJ 29.
150 Beale, H, “Unfair Contract Terms Act 1977”, [1978] Brit J Law & Soc 114 at 115.
186 The Law Review 2017

bid as non-compliant? If the contractor does bid with contract exceptions

and is invited in to negotiate them, it is likely to find that the operator is
absolutely wedded to the terms included with the tender. The operator will
insist that its standard terms are non-negotiable and that contractors must
bid on these one-sided terms or not at all.151

The biggest issue in oilfield service contracts is allocation of risk. It is also the
most contentious issue and takes up the greatest amount of time in contract
negotiations. In some oil gas projects, where the operator prepared the
contracts, the operator transfers considerably more risks to the contractor.152
It is important to note that the operator might be better able to sustain a large
loss on a particular project because the losses would average out in the long
run over several projects, whereas the contractor might go bankrupt if they
have to cover the losses.153 It is argued that the risks should be allocated fairly
between the operator and contractor. The typical reaction of the operators
is to insist on using their own proforma contract where they tend to regard
themselves as being in the driving seat and they will normally require their
own prevailing pro forma conditions to be used.154 On this matter, it has been
argued that:
[i]f the operator is challenged about the imbalanced of its terms and
conditions and the generous discreations conferred upon it, it usually
responds that it is a responsible company and will always deal reasonably
with its contractors. This may or may not be true. The problem is that these
warm words have no contractual or legal effect at all. They will not prevent
the operator from holding the contractor to the strict words of the contract
if it sees a commercial advantage in doing so. In reality, unless the operator
has received lots of low bids, it is impossible to avoid negotiation, and these
negotiations are often highly confrontational. Certainly there is less room
than with a joint venture agreement for a compromise solution that satisfies
all sides. The negotiation of a procurement contract is a tug-of-war, and
when the rope moves an inch towards one party it moves exactly an inch
away from the other.155

Despite the imbalance of contractual terms, the contractors might still sign
the contract in order to secure a job, even though they would be subject to

151 Thorpe, supra, n 138, p 282.

152 Osmundsen, Petter, Sørenes, Terje and Toft, Anders, “Offshore Oil Service Contracts New
Incentive Schemes to Promote Drilling Efficiency”, [2010] J Petro Sci Engin 220.
153 Beh, Hazel Glenn, “Allocating the Risk of the Unforeseen, Subsurface and Latent Conditions
in Construction Contracts: Is There Room for the Common Law?”, (1997) 21 Kan L Rev 115.
154 Moomjian, Cary  A, “Drilling Contract Historical Development and Future Trends
Post-Macondo: Reflections on a 35 Year Industry Career”, IADC/SPE Drilling Conference and
Exhibition on March 7, 2012 in San Diego, California, USA (Society of Petroleum Engineers
2012) http://www.drillingcontractor.org/wp-content/uploads/2012/04/Drilling-Contract-
Historical-Development-and-Future-Trends-Post-Macondo.pdf.
155 Thorpe, supra, n 138, p 282.
 On the Contractual Risk Allocation in Oil and Gas Projects 187

unacceptable levels of risk.156 In fact, some of the contractors risk double

jeopardy as any extraordinary risks will not be accepted by subcontractors
and will be passed down in the usual way from the operator to the contractor
but not then passed on in the subcontract.157 In this situation, the contractor
is exposed to both his own risk and his subcontractor’s risk.158 Generally,
operators’ statutory duties pertaining to the award of contracts give theoretical
power to the contracting community to ensure fair, open and competitive
tendering practices, however, only a brave contractor would legally challenge
an operator with whom he aspires to work in the future.159 This is a problem
“in so-called negotiated contracts if the stronger party chooses to dictate to
the other”.160 The stronger party may use his power by declining to enter into
any contract at all.161

However, it has been argued that a bargain is not unconscionable simply because
the parties possess unequal bargaining power; it is also not unconscionable if
there is inequality in outcomes regarding risk allocation to the weaker party,
however, it is important to emphasise that due to:
gross inequality of bargaining power, together with terms unreasonably
favourable to the stronger party, may confirm indications that the transaction
involved elements of deception or compulsion, or may show that the weaker
party had no meaningful choice, no real alternative, and hence did not in
fact assent or appear to assent to the unfair terms.162

3.3 Public policy

It is argued that the law should control contractual freedom in respect of

the risk allocation to prevent unfair practices, either by statutory control or
judicial control if the contracts are found to be against the public interest
because of their failure to protect and pose harm to society.163 In A Schroeder
Music Publishing Co Ltd v Macaulay,164 Lord Reid said that:
The public interest requires in the interests both of the public and of the
individual that everyone should be free so far as practicable to earn a livelihood
and to give public the fruits of his particular abilities. The main questions
to be considered is whether and how far the operation of the terms of this
agreement is likely to conflict with this objective … If contractual restrictions

156 Ibid.
157 Ibid.
158 Ibid.
159 Franklin, supra, n 139, p 6.
160 Beale, “Inequality of Bargaining Power”, supra, n 133.
161 Macaulay, Stewart, International Encyclopedia of Comparative Law (Mohr 1974), p 18.
162 Braucher, Robert, “The Unconscionable Contract or Term” (1969) 31 UPittLRev 337.
163 Waddams, Stephen M, “Unconscionability in Contracts”, (1976) 39 MLR 369; McKendrick,
supra, n 66, p 837.
164 [1974] 1 WLR 1308 at 1313, HL.
188 The Law Review 2017

appear to be unnecessary or to be reasonably capable of enforcement in an

oppressive manner, then they must be justified before they can be enforced
… I need not consider whether in any circumstances it would be possible to
justify such a one-sided agreement. It is sufficient to say that such evidence
as there is falls far short of justification.

However, it is unclear what public good or public interest means; it is equally

unclear what needs to be taken into consideration when deciding what public
good or public interest means in relation to special interests and special
groups.165 “That calls for proper consideration and fine balancing of all aspects
and views on a particular subject or issue in order to arrive at a decision or
policy which best captures the public good or interest”.166 Since there is no
exact definition of “public interest” and “the good of society”, it allows any
government and political institution to exercise flexibility in deciding the
best policy to strike a fair and reasonable balance to all competing interests
of that society or industry.167 Therefore, the decision made by a particular
government, as regards public interest, will be different from one society to
the other and from one industry to the other.

For example, some states in the US have an Oilfield Anti-Indemnity Act.

Louisiana, Texas, Wyoming and New Mexico all have such a law. The law
places some restrictions on oilfield service contracts in relation to certain
aspects of indemnity clauses. The main idea of the legislation is to prohibit
large operators from requiring contractors to indemnify them not only for the
contractor’s negligence, but also for any potential negligence of third parties,
including their own negligence. It is argued that this kind of indemnity might
injure the public welfare or interest, or is contrary to public decency, sound
policy, and good morals.

In a judicial context, the courts may feel compelled to intervene in the context
of a contractual relationship in order to apply what they deem to be necessary
as a matter of public policy.168 The position was summarised in the context
of the relationship between a person’s right to commit a civil wrong and to
be indemnified in respect of any loss that person may thereby have suffered,
leading to a recognition of the need to strike a balance between public policy
and the freedom of contract:
The court’s refusal to assert a right, even as against the person who has
committed the anti-social act, will depend not only on the nature of the
anti-social act but also on the nature of the right asserted. The court has to
weigh the gravity of the anti-social act and the intent to which it will be

165 Igiehon, Mark Osa “Law, Economics, Public Interest and the Theory of Regulatory Capture”,
(2004) 8 MJLS 2 at 13.
166 Ibid, p 18.
167 Ibid, p 12.
168 Roberts, Petroleum Contracts: English Law and Practice, supra, n 129, p 23.
 On the Contractual Risk Allocation in Oil and Gas Projects 189

encouraged by enforcing the right sought to be asserted against the social

harm which will be caused if the right is not enforced.169

The further discussion on public policy will be illustrated in Deepwater

Horizon case below.

3.4 Insurance

“A contract of insurance is one whereby one party (“the insurer”) promises

in return for a money consideration (“the premium”) to pay the other party
(the assured”) a sum of money or provide him with some corresponding
benefit, upon the occurrence of one or more specified events.”170 In Prudential
Insurance Co v Inland Revenue Commissioners,171 Channell J said that:
Where you insure a ship or a house you cannot insure that the ship shall
not be lost or the house burnt, but what you do insure is that a sum of
money shall be paid upon the happening of a certain event. That I think
is the first requirement in a contract of insurance. It must be a contract
whereby for some consideration, usually but not necessarily for periodical
payments called premiums, you secure to yourself some benefit, usually
but not necessarily the payment of a sum of money, upon the happening of
some event. Then the next thing that is necessary is that the event should
be one which involves some amount of uncertainty. There must be either
uncertainty whether the event will ever happen or not, or if the event is
one which must happen at some time there must be some uncertainty as
to the time at which it will happen. The remaining essential is that which
was referred to by the Attorney-General when he said the insurance must
be against something. A contract which would otherwise be a mere wager
may become an insurance by reason of the assured having an interest in
the subject matter—that is to say, the uncertain event which is necessary to
make the contract amount to an insurance must be an event which is prima
facie adverse to the interests of the assured. The insurance is to provide for
the payment of a sum of money to meet a loss or detriment which will or
may be suffered upon the happening of the event.

It is essential to note that an indemnity is the core concept of an insurance

obligation. This is because, in the event that an insured suffers loss, he shall
be fully indemnified by the insurer. On this point, Halsbury’s Laws of England
states that:
Most contracts of insurance belong to the general category of contracts of
indemnity in the sense that the insurer’s liability is limited to the actual loss
which is, in fact, proved. The happening of the event does not of itself entitle

169 Hardy v Motor Insurers’ Bureau [1964] 2 QB 745 per Diplock LJ.
170 MacGillivray and Parkington on Insurance Law, 8th edn (London: Sweet & Maxwell Ltd, 1988),
p 1.
171 [1904] 2 KB 658 at 663.
190 The Law Review 2017

the assured to payment of the sum stipulated in the policy; the event must,
in fact, result in a pecuniary loss to the assured, who then becomes entitled
to be indemnified subject to the limitations of his contract.172

Therefore, “[t]he ability of a party to make a recovery under a policy of

insurance in respect of loss of, or damage to, its facilities may help to underpin
the operation of whichever liability allocation model is selected”.173 The basic
idea underlying the allocation of liability is that insurance will be taken out
by each party to shield them from loss,174 where such obligation is normally
stated under an insurance clause in a contract.175 However, it is important to
note that a party’s right to recover under an indemnity clause does not cease
due to the existence of his claim to be indemnified under an insurance policy,
considering the fact that the obligation under the contractual indemnity is a
primary liability; whereas, the insurer’s duty of indemnity is only a secondary
one.

Usually, under the oil and gas contracts that use knock-for-knock indemnities,
the contracting parties are required to insure against their prospective liability176
since insurance generally reduces risk exposure.177 According to Peter Roberts:
A party may be more inclined to honour a mutual hold harmless regime and
not to try to overturn a limitation in the contract in favour of commencing an
action for the recovery of its losses where that party has made a successful
insurance recovery in respect of those losses. Furthermore, where a guilty
party pays model applies, a party which can make a successful insurance
recovery in respect of the loss or damage it has suffered may be less inclined
to bring an action against the guilty party for the recovery of its losses.
Where a mutual hold harmless model is underpinned by the commitment
of each party to arrange insurance in respect of the loss of, or damage to,
its facilities, the strict liability created by the mutual hold harmless model
may be modified partially by a commitment of a party to indemnify the
other in respect of the deductible component of the insurance coverage
which would otherwise fall to be borne by the party suffering the loss or
damage. This would therefore result in a hybrid liability allocation model,
where the base layer of mutual hold harmless is supplemented by a first
tranche of guilty party pays.178

In short, the knock-for-knock clauses would be meaningless and have no value

if the indemnitor has insufficient assets to back-up the indemnity.

172 Halsbury’s Laws of England, vol 25, 4th edn (London: Butterworths, 1983) para 3.
173 Ibid, para 345.
174 Bunni, Nael G, Risk and Insurance in Construction (London: Routledge, 2003), p 179.
175 Downie and McBratney, supra, n 58, p 17.
176 Stickley, Dennis, A Framework for Negotiating and Documenting Petroleum Industry Transactions
(CEPMLP, Dundee: 2006), p 157.
177 Moomjian, supra, n 154.
178 Roberts, Petroleum Contracts: English Law and Practice, supra, n 129, p 345.
 On the Contractual Risk Allocation in Oil and Gas Projects 191

Insurance provisions are one of the important features in oilfield service

contracts that specify the types of coverage and policy limits that have
to be maintained by the parties, for example the contractor is usually
obliged to purchase, inter alia, workers’ compensation, employer’s liability,
comprehensive general liability, property coverage and excess liability
coverage.179 Some jurisdictions have made it mandatory for the employers to
take out workers’ compensation insurance in order to protect employees who
are injured while they are in the line of duty.180 Commercial general liability
insurance is used to provide coverage for losses stemming from bodily injury,
property damage and so on.181 Oilfield service contracts rarely specify the
coverages which should be taken out by the operator, with the assumption
that operators will act prudently in obtaining insurance or otherwise has the
financial ability to absorb the risks it contractually assumes.182

However, it is important to note that the indemnitor is not able to insure

the risk for such losses in every event, for instance, in the event that the
indemnity provision allows the indemnitee to be held harmless for bodily
injury or property damage incurred as a result of the indemnitee’s own sole
negligence.183 The indemnitor under an enforceable indemnity provision of
this kind would bear the risk of uninsured loss.184 Therefore, the contractor
should be more diligent in assuming liability under indemnity clauses since
the contractor might not be protected by insurance for certain liabilities that
have been assumed under the hold harmless clause.185 For example, in respect
of a construction all risk policy, customarily it would be procured either by
the operators or contractors (at the operator’s cost) to protect the operator,
contractors and subcontractors for any construction risks.186 However, “it
is becoming a feature of construction projects that the operator is unable
or unwilling to procure project insurance in the market and proceeds to
absorb the risk on a self-insured basis”,187 which would leave the contractors
uninsured and exposed to risk.188 Conceptually, insurance is used as a risk

179 Moomjian, Cary A, “Contractual Insurance and Risk Allocation in the Offshore Drilling
Industry”, [1999] Drilling Contractor 26.
180 Andrew Stephenson, “Risk Allocation in Process Engineering Projects” (2003) 22 Australian
Resources & Energy LJ xliv; Gerald and Williams, supra, n 112).
181 Robert J Franco, “Insurance Coverage for Faulty Workmanship Claims Under Commercial
General Liability Policies” [1995] Tort & Ins.L.J. 786.
182 Moomjian, supra, n 179, p 26.
183 See “Contractual Risk Transfer”, in Construction Risk Management X.F.1 (International Risk
Management Institute Inc, 1st rep 1986).
184 Meyers, Robert L III and Perelman, Debra A, “Risk Allocation Through Indemnity
Obligations in Construction Contracts”, (1988) 40 SCL Rev 989.
185 Potamkin, Lawrence and Plotka, Norman L, “Indemnification against Tort Liability: The
‘Hold Harmless’ Clause, Its Interpretation and Effect upon Insurance”, [1944] U Pennsylvania
L Rev & American Law Reg 347.
186 Stephenson, Andrew, “Risk Allocation in Process Engineering Projects”, (2003) 22 Australian
Resources & Energy LJ xliv.
187 Franklin, supra, n 139.
188 Ibid.
192 The Law Review 2017

cushion by the indemnitor in assuming risks of an indemnity and it is in fact

an underlying engine rather than ancillary tool for risk management.189 Taking
out self-insurance in order to reduce transaction costs might be particularly
natural for super-majors; however, that would be barely acceptable to some
of the contractors, as they cannot afford self-insurance.190

3.5 The “guiding principles”

The oil and gas industry in the United Kingdom Continental Shelf (“UKCS”)
has taken steps to ensure “a competitive, fair marketplace, successful as far
as they go”,191 by issuing “a voluntary industry code of practice to set down
common ground between operators and contractors in the form of so-called
guiding principles” which operates as a primary guidance for contractual
negotiations between the parties.192 The term “guiding principles” may be
defined as documents, which describe themselves as codes of practice, codes
of conduct, guidance, standards, etc.193 It could be argued that the guiding
principles, as deployed by the industry, could help to resolve the problem of
imbalanced risk allocation, which is caused by the adjusted indemnity and
mutual hold harmless scheme. Franklin suggests that the guiding principles
which are referred to by operators and contractors in determining a reasonable
share of risk allocation should take into account the following:
Whether a risk is more readily managed or avoided by one party or the
other; whether any particular risk can more readily be insured by one
party, or indeed whether insurance is available exclusively to only one of
the parties; the scope and limits of contractor’s insurance which it carries
in the ordinary course of its business; the size and financial position of the
contractor; the value, location of performance and nature of the contract;
whether there are public policy reasons which operate against the exclusion
or limitation of certain liabilities.194

However, it has been argued that, “if these principles are applied to each
contract then a project involving the preparation, negotiation and execution
of several hundred contracts—as is not uncommon—would never get off
the ground”.195

4. Conclusion

Traditionally, the understanding of risk distribution is based on the common

law concepts of fault and negligence or breach of contract. However, contractual

189 Timur, supra, n 13, p 2.

190 Ibid; Lima, S L and Bednekoff, P A, “Temporal Variation in Danger Drives Antipredator
Behavior: The Predation Risk Allocation Hypothesis”, (1999) 153 Am Naturalist 649.
191 Franklin, supra, n 139, p 14.
192 Ibid, p 14.
193 Ferguson, R B, “The Legal Status of Non-Statutory Codes of Practice”, [1988] JBL12.
194 Ibid, p 8.
195 Ibid.
 On the Contractual Risk Allocation in Oil and Gas Projects 193

indemnities have modified the liability of the contracting parties in accordance

with the parties’ wishes, which is an example of the expression of the concept
of freedom of contract.

Moreover, since the nature and extent of risks tend to be project-specific

in today’s high-risk scenarios and multiparty complex projects, therefore,
adoption of tailor-made contract strategies is more desirable.196 In this regard,
some of the risks are not being covered by the insurance industry since those
risks are considered as operator’s risks. This situation will leave the contractors
uninsured, which in turn leaves them exposed to financial detriment if an
incident occurs. Even though in some jurisdictions, for example, the UKCS,
guiding principles have been issued as a means of imposing a fairer risk
allocation, the guiding principles only operate as self-regulation and are not
binding on the parties.

196 Rahman, M Motiar and Kumaraswamy, M M, “Risk Management Trends in the Construction
Industry: Moving towards Joint Risk Management”, (2002) 9 Engin Const & Architec Mgmt
131.