Contractors expenditure

Before looking at how the contractor can make money from a contract, his expenses should be understood. These costs can be broken down into 11 groups.

1.

Interest payments on rig

2.

Insurance cost of rig

3.

Repair and maintenance

4.

Catering

5.

Personnel

6.

Training

7.

Administration

8.

Marketing

9.

Capital replacement

10.

Inventory

11.

Contingency

If the contractor can, by manipulating the contract, get the operator to assist in any of the above expenses, then the contractor's profitability will increase. This concept must be fully understood by the operator to ensure that he is aware that what seems a small concession by the operator, could increase the contractor's profitability considerably. When bargaining you must know what your 'chips' are worth.

1. Interest payment on rig

Most drilling contractors borrow money from banks to buy rigs. The banks will set an interest rate for repayment. The drilling contract has no influence over this and therefore this cost centre can not be affected by contract manipulation.

2. Insurance cost of rig

The rig owners must insure their rig. The rates of insurance vary very little from block to block in a given area, therefore there is no room for manoeuvring in this cost centre.

3. Repair and maintenance

The drilling contractor bears all of these costs. If he can reduce them then his profitability will increase. Any clause or condition that the contractor can insert into the drilling contract which allows him to spend less money on repair and maintenance will increase his profitability.

Clauses which appear regularly in contracts such as '30 minutes per day oiling and greasing time' are allowing the contractor a cost-free facility to repair equipment on the operator's time. How many operator owned rigs need 30 minutes per day oiling and greasing? The drilling operation is by its very nature intermittent, hence allowing periodic lubrication daily.

Other clauses, which greatly increase the contractor's profitability, are those where the operator pays for certain spare parts. An example of this would be if the operator paid for all rubber goods in the BOP stack. This action would be taken by the operator in an attempt to ensure no scrimping on the quality of BOP equipment. An unscrupulous contractor can, however, keep his entire fleet of rigs supplied with BOP rubber goods from this one contract. This can be prevented in several ways. Auditing rubber goods consumption over a period of years or comparing it with the operator's own rigs can quickly highlight any misuse of the contract intention. Another way would be to put a cash limit on purchasing in a given period. However, this in itself could be counter productive to the contract intention. Contrast clauses should never be open-ended, since the temptation can prove too great for some to resist exploiting them.

It is much neater to built all these miscellaneous charges into the basic day rate and have severe penalty clases {such as zero rate) as soon as shoddy maintenance standards make themselves felt.

4. Catering

Most contracts include catering for the contractor's crews. Contractors can increase their profitability by reducing catering costs. An army marches on its stomach and drill crews are not a lot different.

Within the contract, it must be clearly shown what the standards of catering will be. If a third party caterer is being used, the payment details should be included to illustrate what the contractor's intended expenditure will be. There must be a mechanism whereby the operator can insist on a good standard of catering from the contractor at zero additional cost to the operator.

Contractors are allowed to charge catering costs to the operator for the operator's staff over and above a stipulated number {normally six or so). This figure can be a profit centre for contractors. During production testing, for example, the operator could have 20 or 30 extra staff on board and a nightly charge would be made by the contractor to accommodate them. A few extra dollars per head which slipped by at the contract reading stage could add up to a considerable sum by the end of the year.

5. Personnel

To operate the rig, the contractor needs onshore and offshore personnel. Good staff do not come cheaply and the personnel costs represent a major proportion of the contractor's expenditure. His costs can be reduced by two means: employing fewer people, or employing the same number of people but paying them less.

It is therefore in the contractor's interest to bid for a contract with minimum personnel, in the hope that additional personnel can be charged for outside the basic rig contract. It is furthermore not in the contractor's interest to disclose the rates that he is paying on or offshore staff, or to be held to certain levels. It is also not in the contractor's interest to be held to using his own staff rather than independent labour pool staff.

6. Training

It is usually incumbent upon the contractor to ensure that his staff have the appropriate certification for their positions. Unless the drilling contract stipulates differently, then that is where the training effort might stop. Clearly, training is an expense for the contractor and if he can get out of spending any extra money on it he can improve his profitability. If the contractor can get the oil company to train his staff at the oil company's expense then this again improves the contractor's profitability.

7. Administration

The cost of administering a drilling rig is considerable. To the operator, a smooth contractor administration is required to support an efficient rig. However, any excess administration will be paid for in the day rate directly or indirectly by the rig crews receiving less of the salaries pot.

It was noticeable that as the 'cold wind' blew through the drilling industry in 1986/87, many administrations survived, whilst the offshore crews bore the brunt of the economic cuts. Most contractors would like to disguise the cost of administration by quoting a total salary cost but it is not necessarily in the operator's interest to allow them to do so.

8. Marketing

These costs cover publicity, publications, services and the salesmen that contractors use to market their rigs. These costs can be quite high and consequently longer term contracts are attractive to contractors as they reduce the marketing effort and therefore cost. It must be realised that as with all costs incurred by the contractor, the operator pays for them in the end.

9. Capital replacement

Rigs tend to be written down over the years and, if the drilling contractor intends to stay in the market, he must plan to purchase new rigs ultimately to replace the old ones. To purchase rigs, the contractor needs capital and capital is accumulated over the years from other rig contracts,

10. Inventory

All spare parts that a contractor has sitting on the shelf, either on the rig, or at his yard, cost him money. Clearly, carrying a $0.5 m inventory on a rig is cheaper to a contractor then carrying a $1 m inventory. The skill in the equation is ensuring that sufficient parts are carried to cope with servicing and breakdowns, whilst still maintaining a minimum stock level. As far as possible, the contractor will try to minimise the inventory that he has to carry.

11. Contingency

Contingency costs cover such items as unexpected major equipment failure or redundancy payments for crews. Any concession that the operator makes, which reduce contingency costs, adds to the potential profitability of the contract for the contractor.

3.2 Contractor's income

In every aspect of the contract that the oil company pays out, the contractor can make a profit. Most rig comparisons refer only to the day rate, as if it were the only payment involved. In fact, many payments can be paid by the operator and each of these must be finely tuned to ensure that no exploitation is taking place. Payment can be divided up into 12 forms, as follows:

  1. Mobilisation fee
  2. Day rate
  3. Charge for additional personnel
  4. Charge for additional equipment
  5. Built in repair time
  6. Handling charges
  7. Escalation charges
  8. Charges for replacing damaged equipment
  9. Charges for consumables
  10. Charges for accommodating additional OPCO personnel
  11. Charges for OPCO modifications
  12. Demobilisation fee

As can be seen from the above list, whilst the day rate is the major cost centre, the drilling contractor still has a lot of ways of extracting additional income from the unwary operator.

Now we will look in more detail at the sources of income that a drilling contractor enjoys.

1. Mobilisation fee 12. Demobilisation fee

What exactly are we paying for? In practice, it is a fee to cover the extra charge facing the contractor to move a rig or start up or lay off a rig. The contractor faces real costs for this, so a payment of some sort is required, either directly as mob/demob payment, or indirectly as an additional day rate payment.

On land wells, the mobilisation fee covers the time until the rig is ready to spud. On offshore wells, this is not always the case. Semi-contracts, for example, will often pay a mobilisation fee and then standby rate until the rig is towed to location and moored up.

During certain periods, bad weather can be expected {October is usually very bad in the North Sea) and anchor handling problems can be expected. It is up to the operator to decide how much responsibility he wishes to take for the downtime so incurred. The most effective means of limiting this responsibility is to pay a mobilisation fee which takes the rig from its original location until the rig is ballasted down and moored at its new location. Any delays are then to the contractor's cost.

The operator must protect his interests and try to fix costs at every stage possible to maintain tight fiscal control on the well.

2. Day rate

In life you only get what you pay for. The day rate is unavoidable, however, we must determine what each rig's day rate involves, to establish value for money. If the well only requires 10 ra stacks then 10 m rigs will offer much better value on the day rate than 15 m rigs. A 15 m system costs much more to buy and maintain, therefore will cost more on a day rate than an equivalent 10 m system. Ifboth types of rig are being offered at the same price then, either one is charging too much, or the other is charging too little and scrimping on other features.

Included in the day rate is the repair and maintenance and inventory. Documentation supporting the systems in place must be studied to determine the professionalism of the contractor when comparing options.

3. Charge of additional personnel

The basic contract should include all the personnel for the normal work load. Additional personnel should only be paid for at market rates. It does not take long to determine what market rates are and this must be done. The contract must stipulate the procedure whereby additional personnel can be requested and supplied and the terms under which this will happen.

4. Charge of additional equipment

As far as possible, this cost should be avoided by building into the equipment list all equipment needed for normal operations. It is much easier to compare bids if all contractors are quoting exactly the same equipment list. Again, only market rates should be payable for additional equipment and a formula established to ensure that this will be done in practice.

5. Built in repair time

Putting the rig on standby rate for excessive downtime is no threat to a drilling contractor. In practice, the standby rates are only a few per cent cheaper than the operating rate. It is much more effective to have a contract whereby the contractor is allowed a few hours of repair at operating rate, after which the rig goes on zero rate. Clauses such as this allow the rig staff to get the support that they require from their base management.

6. Handling charges

If the operator asks the contractor to arrange or purchase something, then it is only fair that the contractor makes a handling charge. Usually, this is in the form of a markup, typically 5-10 per cent. In practice, sometimes there is a scale of charge and this represents the best approach. A suitable scale charge would be:

up to £100 000/month - 10 per cent, or anything over £100 000/month - no extra charge.

In this way, the contractor receives a fair handling charge, although the operator's ultimate liability is restricted and controlled.

7. Escalation charges

These are best avoided, if possible, as they are fairly complicated to administer in practice. Typically, they are related to the RPI or a projected inflation rate. A flat rate is a much better deal all round and does not keep the accountants up all night.

8. Charges for replacing damaged equipment

If the operator's programme has damaged some of the contractor's equipment then it is only right that the operator should compensate the contractor. The operator must protect himself from sharp practices here and he can do so by laying down clearly in the contract, the terms under which payment will be made. For charges for replacing damaged equipment the following are required:

  1. Invoice showing purchase date and price.
  2. Maintenance records.
  3. Inspection records.

Failure to supply these will mean that no payment will be made. Payment will be made as follows depending on age of equipment:

0-6 months new price

6-12 months 80 per cent of new price

1-2 years 50 per cent of new price

2-3 years 25 per cent of new price thereafter zero payment

The damaged equipment will become the property of the operator after payment is made. Clauses such as the foregoing make it clear to both sides what charges are allowed. This means that the contract is easy to administer.

9. Charge for consumables

It is better to build all consumables into the normal day rate as they tend to be open-ended charges.

10. Charges for accommodating additional OPCO personnel

These charges should not be inflated and as before, the market rates should be established and laid out in the contract draft.

11. Charges for OPCO modifications

If the operator wishes to modify the contractor's rig or equipment then he must pay for it. In the contract, the terms under which modifications could be carried out must be clearly stated. Two outside engineering companies should be approved by both sides, as alternatives to the drilling contractor's in-house expertise, to provide services for OPCO modification. If only the drilling contractor is allowed to modify his rig then the operator faces a monopoly and has no bargaining power at all. If the work goes out to tender then the operator can establish the market rate for the work and use this to control costs.

3.3 Negotiating contract terms

RULES FOR NEGOTIATION

  1. Know what the contractor wants
  2. Know what you are prepared to pay
  3. Know what the contractor is prepared to take
  4. Play down the contractor's strengths
  5. Accentuate the contractor's weaknesses
  6. Exploit but never humiliate the contractor

In the previous sections we have looked at the ways in which a drilling contractor makes money and spends money. Knowing this information gives the operator insight into the contractor's affairs. Further specific information should be established prior

3.3.1 What suitable rigs are available?

This can be established by subscribing to specialist journals which list available rigs, or by consulting the contract drilling companies directly.

Quite often rigs are working for other operators on a fixed number of well plus option deal. Most contractors will bid these rigs as potentially available, but the option clause could prevent them from meeting your deadlines. A phonecall to the operator concerned could eliminate some of the doubt surrounding possible option jack-up. Clearly a rig which is definitely available is more attractive than one which is potentially available. A list should be made of the available rigs that could do the

3.3.2 What alternative work is available for these rigs?

This is slightly more difficult than determining which rigs are available. A news collection service, either formalised, or informal, should be used to gather information

Service companies usually have a good idea about what is going on and can provide useful information about other operators' intentions. Talking to other operators at operators' meetings can provide more details of their plans.

To negotiate with contractors, you must know what alternatives are available to the contractor. If he has a lot of alternatives, then it will be more difficult to strike a

3.3.3 What are market forces?

This is even more difficult to predict, but an attempt must be made to quantify the prevailing forces. Market forces can make themselves felt in many ways, some of which are outlined below.

Fashions change and rigs come into and or out of favour. There is a current trend in the North Sea towards using jack-ups, especially large ones in areas which were traditionally semi country. If there is a large demand for jack-ups, then their prices will go up. If you are drilling in an area which could use either type in a strengthening jack-up market, then a better deal could be struck for a semi than a normal market would permit.

There is a finite number of rigs worldwide. If a new area opens up to drilling, rigs must be brought from other areas to do the work. This can lead to shortage of rigs in the original area. This criterion can be thought of as a global extension of the alternative work scenario. It is necessary to know what is happening globally to negotiate successfully. If a new area is opening up in six months time, the contractor may favour a six-month contract at a bargain price.

Certainly the contractor tries at all times to predict the future markets as best he can. To move a rig from one area to another area costs money. There are towing charges and the rig earns no money during the move. Consequently, the contractor must see a greater potential revenue from the new area compared with the old area just to break even financially.

The easiest way to determine regional distribution is to subscribe to a dedicated specialist journal which keeps its readers up-to-date on developments. Third party service companies usually have good data bases on this information and should be consulted on an informal basis.

3.3.4 What are individual contractor's priorities?

To understand this, the motivation of the drilling contractor should be investigated. What is the contractor's intention? If he is in expansionist mode, then he may be very interested to cut his profit margins to secure regular work to fund his expansionist programme. If there is uncertainty about the future for the contractor, he may put his rigs on the market for sale. In this case, he will not be looking for longer term contracts.

Does the contractor wish to penetrate a new market? Does he, for example, have a reputation for running jack-nps but wish to get into semi drilling. In this case, he will probably subsidise the operation to get the first few jobs in the new market. To neglect the contractor's priorities is naive and expensive for the operator.

3.4 Summary

Answering the foregoing questions gives us an overview of the situation which it is vital to have prior to beginning negotiations. If at all possible, negotiation should be avoided, as it is time consuming and costly. We have seen in section 3. how the contractor makes and spends his money. To have influence in these matters, the contract that the operator issues must be specific and definite in order to reduce negotiated items to a minimum. To effect this we will look at the conventional day rate contract and how out theories can be applied in practice.

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