Contractual indemnity in Oil and Gas Contracts
The Oil and Gas industry is a peculiar one. “Several aspects of the industry, e.g., the capital-intensive nature of the industry, market price volatility, geographic scope of assets and operations, the high-risk nature of exploration and exploitation of natural resources, technology requirements, environmental concerns, downstream brand promotion and protection issues, political sensitivities, scale and diversity of employee base, etc. give rise to particularly high levels of legal risk for international Oil and Gas companies”1.
In reality, “it is probably only possible to achieve absolute safety if, as a society; we do not undertake hazardous activities. However, we know that the application of technology brings great benefits to us as a society. The skill comes in exploiting potentially hazardous technology while minimising the risks – accepting it is not possible to totally eliminate the risks”2.
The ultimate aim of any operator of an Oil and Gas installation is to maximise profits by quick and efficient exploration of hydrocarbons with minimal or no interruption by way of accidents. Apart from being a lengthy process, determining liability and awarding cost to injured parties3 is usually a huge burden considering that the industry is characterised by sub-contracting. Risk will be managed and controlled when the risk has been explicitly allocated to one or more parties4. Money spent on taking out several insurance policies is considered an additional expense, with the incentive to use contracts to modify a common law approach to risk management becoming even more attractive.
The purpose of a contractual indemnity is to amend the common law position5. The modification of the common law approach to allocation of risks, by Oil and Gas contracts, have sometimes been criticised as the imposition of will by a dominant party on a party with inferior “economic bargaining power”, who is being “unfairly” “coerced” into indemnifying the dominant party6.
This paper intends to consider the “ standard industry practice” of using contracts as a vehicle for modifying a common law approach to allocation of risk, considering that the accelerated pace of change in the Oil and Gas industry makes it one of the world’s most challenging and complex industries in which to understand, draft and negotiate contracts7.
The Common Law Approach to Allocation of Risk
In the absence of a specific agreement, the general law relating to contract and tort/delict provide for risk allocation under the common law. Liability flows from breach of duty or fault, with the operative word being “negligence”. Subject to considerations such as remoteness of damage, frustration of contract, etc, the party in breach is obliged to compensate the non-breaching party thereby mitigating the loss. Under this system, though exceptions may be made towards shifting the burden of losses when a person is compelled to pay damages occasioned by the negligence of another, he can only be indemnified by the negligent party when no participatory fault exists.
Though not exclusive to Oil and Gas, one contracting practice which the industry has developed to manage and regulate its physical risks, is the indemnity clause8. An indemnity is an agreement whereby one party agrees to secure another against an anticipated loss or damage by making payment to the party having benefit of the indemnified party in the event that that indemnified party suffered a loss for which the indemnifier agreed to secure him9.
There exists two types of indemnities: the simple indemnity and the Mutual indemnity. The simple indemnity is a “one way traffic” with the burden falling on the indemnifying party to cover the indemnified in the event that the indemnified suffers loss for which he had been secured by the indemnifying party. On the other hand, the Mutual indemnity, commonly referred to as the “knock for knock” indemnity, is circular in nature. Here both parties indemnify each other; the only difference is that the security is in relation to different but related species of loss. “Under the Mutual indemnity regime, each party to the contract agrees to take responsibility for, and to indemnify the other against, injury and loss to its own personnel and property and its own ‘consequential losses’ (by this, the parties generally mean loss of profit and other economic losses). These cross-indemnities are usually intended to be effective even if the losses arose due to the negligence, breach of statutory duty or breach of contract of the party receiving the benefit of the indemnity”10.
Relevance of Indemnity Clauses in Oil and Gas Contracts
Every business venture possesses both un-foreseeable and anticipated risks accompanying their actualisation. However, Oil and Gas investments generally are very capital-intensive, often making these risks more than just a passing interest11. Parties want to make sure that they accurately reflect their intention in the contract in preparedness for any eventuality; the ability to shift liability via contractual provisions is important for oilfield participants, especially when the other alternative is fault- based indemnities.
From a legal perspective, indemnity clauses are among the most important clauses in any contract. This is especially relevant for contracts in the Oil and Gas industry where potential liabilities are enormous12. Considering the capital- intensive nature of the industry and with the realisation that several parties are involved in Oil and Gas transactions at the same time, it makes economic sense to allocate risk to the party best able to manage a particular type of loss, rather than result to a fault – based allocation of risk13.
As noted earlier, the main aim of any operator of Oil and Gas installation is the quick and efficient exploitation of hydrocarbons towards maximisation of profit. Fault-based indemnities are often enforced through expensive and time-consuming litigation to determine liability and responsibility which, in turn, can lead to increased legal costs14.
In addition, with insurance premiums on the steady increase, money spent on taking out several insurance policies is considered an additional expense15. During production on an Oil and Gas platform there are usually 20 or more representatives of companies on board. If all parties were required to carry out insurance against the remote but potentially catastrophic risk that might be prone to installation and personnel, the cost involved would not only be prohibitively expensive for smaller contractors, it would also be an inefficient use of financial resources16.
Oil and Gas Contracts Emanating from the UK Offshore Oil and Gas Industry; the Interpretation of Indemnity Clauses by the Courts
However possible it is to “contract around” the common law, in the absence of explicit language to that effect, the expensive and time-consuming process of litigation to determine liability and responsibility which the industry despises so much becomes inevitable.
“It is well established that indemnity will not lie in respect of loss due to a person’s own negligence or that of his servants unless adequate and clear words are used or unless the indemnity could have no reasonable meaning or application unless so applied…17”
The classic three- part test case dealing with the duty of a court in relation to indemnity provisions is summarised by Lord Morton of Henryton whilst delivering the judgment of the board of the Privy Council in the case Canada Steamship Lines Ltd v R18:
- w here a clause contains language which expressly exempts a person in whose favour it is made from the consequence of the negligence of his own servants, then effect must be given to such a provision;
- where there is no express reference to negligence, a court must consider whether the words in their ordinary meaning are wide enough to cover the negligence of his own servants;
- w here the words used are wide enough for the above purposes then the court must consider whether there is another head of damage on which to base the claim other than negligence.
Following the Piper Alpha incident, which was the worst in the history of the offshore industry, the efficacy of the indemnity clause and the importance of a contract communicating the true intentions of the parties were examined in detail. Among the cases featuring prominently was the Caledonia North Sea Ltd v London Bridge Engineering Ltd19 and the EE Caledonia Ltd v. Orbit Valve Co20.
Caledonia North Sea Ltd v London Bridge Engineering Ltd
Having been indicted by the committee set up to investigate the causes of the Piper Alpha accident, the operator settled the dependants of the victims and then raised actions against those contractors that were the employers of the victims and sought to enforce contractual indemnities in respect of the death and injury of the contractors’ personnel.
After a detailed perusal of the relevant clause (15.1(c)), the court held that the wordings of the indemnity clause in the contract was clear and unambiguous to the extent that in as much as such injury, death, damage, loss or destruction was not caused by the sole negligence of the operator, the contractors were liable to indemnify the operator.
EE Caledonia Ltd v. Orbit Valve Co
This case concerned a very similar set of factual circumstances and provides a useful counterpoint to the London Bridge case in terms of contractual drafting21.
The court, after a careful perusal of the indemnity clause, dismissed the operator’s claim. It held that the indemnity clause was to be construed according to established principles of construction, including the principle that a party would not be relieved of the consequences of its own negligence without the use of clear words showing that it was the parties’ intention. Although the words used in the contract between the operator and the contractor were potentially wide enough to cover liability arising from negligence, there was no express provision to this effect and, accordingly, the indemnity clause could not be so construed.
As a general principle of law, the failure of an indemnity provision to reflect the express negligence rule can undermine the validity of the indemnity22. Critics of this contractual instrument adopted by the industry to allocate risk have opined that, in practice, poor drafting can, notwithstanding the imposition of non-fault- based indemnities, also lead to protracted litigation23.
The Oil and Gas industry is a capital- intensive one. Most transactions run into hundred millions of dollars, with quite an amount of parties (operator, contractors and employees) working together all with the same target, profit. While some of the parties might be multinational oil companies, others might be “one man businesses”.
The volatility of the substances around which the industry operates suggests that risk is a factor which needs to be anticipated as well as allocated among the parties best equipped to handle it. The option of taking out several insurance policies for each party is not practicable. Not only will it be prohibitively expensive for smaller contractors, it would also be an inefficient use of financial resources.
Applying a common law approach to the allocation of risk is not only a lengthy process, in terms of determining liability and awarding cost to injured parties, but also a time-consuming enterprise; a luxury the Oil and Gas industry cannot afford.
Critics have found the imputation of indemnities into Oil and Gas contracts as unfair and potentially dangerous for parties to use contracts as a vehicle for modifying the common law’s approach to allocation of risk. They argue that it is as the 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. They further argue that, i n practice, it is difficult to get the balance right and a particular type of loss or poor drafting can, notwithstanding the imposition of non-fault- based indemnities, lead to protracted litigation coupled with the fact that it is virtually impossible to completely avoid a fault-based system of risk allocation.
In quantifying likelihood of loss or less-than- expected returns, parties who presume that they are most likely to be affected if “ the pendulum swings the wrong way” have the option of taking out a separate insurance policy to mitigate loss. Furthermore, recourse to litigation is a fundamental right of any party and cannot be deprived by contract. However, explicitly drafted and worded agreements minimise the occurrence of protracted litigation if the litigant is fully aware that he will also bear the cost of litigation in the event that he is unsuccessful.
The Piper Alfa incident, has thrown light on the importance of indemnity clauses in contracts emanating from the UK offshore Oil and Gas industry. Both the London Bridge case and the Orbit Valve have demonstrated parties intend the true meanings of their agreements as indicated by the wordings of their contracts. The law is not built on sentiments; neither will it be an instrument with which parties can negate from their responsibilities as “unfair” as it may seem. Rewards accompany risks and, in the event that events go wrong, the true intentions of parties as construed from the wordings of their contract should be given effect.
Paterson, J. and Gordon, G. Oil and Gas Law – Current Practice and Emerging Trends, Dundee Press (2007).
Caledonia North Sea Ltd v London Bridge Engineering Ltd  UKHL 32;  1 Lloyd’s Rep 562, 563, HL.
EE Caledonia Ltd v. Orbit Valve Co.  1 All ER 174;  1 WLR 1515, CA.
Canada Steamship Lines Ltd v. R  1Lloyds Rep
Walters v. Whessoe Ltd and Shell Refining Co. Ltd  CA (Civil Division) 6 Build LR 23
Hearn, B. ‘Allocating and Managing Procurement Risks’ (The Canadian Institute’s Legal & Business Guide to Public Procurement 2004) available at < <www.mcmillan.ca/Upload/Publication/allocating%20and%20managing%20
procurement%20risks%2… > accessed 10 December 2008
Hewitt, T. ‘Who is to Blame? Allocating Liability in Upstream Project Contracts’ available at <www.herbertsmith.com/Publications/Upstreamprojectscontracts.htm> accessed 10 December 2008
Kinsella, S. ‘Oilfield Indemnity and “Separate Insurance” Provisions in the Wake of Getty Oil’ available at <www.kinsellalaw.com/publications/kinsella_oilfield_indemnity.pdf> accessed 10 December 2008
Lovells International, ‘Oil and Gas Industry Legal Risk Comparative Analysis’ (November 2005) available at <www.acc.com/resource/v6674> accessed 10 December 2008
Macattram, G. ‘How can the indemnity clause expand or limit the responsibility for liability of the parties in international oil and gas contracts?’ available at <www.dundee.ac.uk/cepmlp/car/html/CAR10_ARTICLE2.PDF > accessed 10 December 2008
Wilkinson, P. ‘Safety Cases: Success or Failure?’ (Australian National University Publication, May 2002) available at < ohs.anu.edu.au/publications/pdf/seminar_paper_2.pdf> accessed 10 December 2008
‘Case study ‘Oil and Gas Exploration and Production’ available at <www.realoptionsvaluation.com/pdf/Case_Study_Oil_and_Gas_Exploration_and_Production.pdf > accessed 10 December 2008
‘Drafting Oil and Gas Industry Contracts’ available at <www.falconbury.co.uk/public/course/oil-and-gas-contracts > accessed 10 December 2008.
1Lovells International, ‘Oil and Gas Industry Legal Risk Comparative Analysis’ ( November 2005) available at www.acc.com/resource/v6674 accessed 10 December 2008
2Wilkinson, P. ‘Safety Cases: Success or Failure?’ (Australian National University Publication, May 2002) available at < ohs.anu.edu.au/publications/pdf/seminar_paper_2.pdf > accessed 10 December 2008
3Loss of property and production also contemplated in the term “injury”
4Van Staveren, M. ”Uncertainty and Ground Conditions: A Risk Management Approach – Google Books Result’ ( Technology & Engineering 2006) available at < books.google.co.uk/books?isbn=0750669586 > accessed 10 December 2008
5Macattram, G. ‘How can the indemnity clause expand or limit the responsibility for liability of the parties in international oil and gas contracts?’ available at www.dundee.ac.uk/cepmlp/car/html/CAR10_ARTICLE2.PDF accessed 10 December 2008
6Kinsella, S ‘Oilfield Indemnity and “Separate Insurance” Provisions in the Wake of Getty Oil’ available at www.kinsellalaw.com/publications/kinsella_oilfield_indemnity.pdf accessed 10 December 2008
7‘Drafting Oil and Gas Industry Contracts’ available at www.falconbury.co.uk/public/course/oil-and-gas-contracts accessed 10 December 2008
8Indemnification lies in the heart of the law of marine and fire insurance. For more details see Gordon, G. ‘ Risk Allocation In Oil and Gas Contracts’ in Paterson, J. and Gordon, G. Oil and Gas Law – Current Practice and Emerging Trends , ibid, p.336
9Available at http://www.lectlaw.com/def/i027.htm accessed 10 December 2008
10Hewitt, T. ‘Who is to Blame? Allocating Liability in Upstream Project Contracts’ available at www.herbertsmith.com/Publications/Upstreamprojectscontracts.htm accessed 10 December 2008
11Case study ‘Oil and Gas Exploration and Production’ available at www.realoptionsvaluation.com/pdf/Case_Study_Oil_and_Gas_Exploration_and_Production.pdf> accessed 10 December 2008
12Macattram, G. ‘How can the indemnity clause expand or limit the responsibility for liability of the parties in international oil and gas contracts?’ ibid.
13Hearn, B. ‘Allocating and Managing Procurement Risks’ (The Canadian Institute’s Legal & Business Guide to Public Procurement 2004) available at <www.mcmillan.ca/Upload/Publication/allocating%20and%20managing%20procurement%20risks%2; accesses 10 December 2008
14Macattram, G. ‘How can the indemnity clause expand or limit the responsibility for liability of the parties in international oil and gas contracts?’ ibid
15“insurance premiums have risen to such an extent that there have been significant efforts to reallocate risks through other methods such as self-insurance and contractual indemnity provisions.”
16Gordon, G. ‘Risk Allocation In Oil and Gas Contracts’ in Paterson, J. and Gordon, G. Oil and Gas Law – Current Practice and Emerging Trends p. 336 also see By Toby Hewitt, Who is to Blame? Allocating Liability in Upstream Project Contracts. ibid
17The judgment of Sellers LJ in Walters v. Whessoe Ltd and Shell Refining Co. Ltd  CA (Civil Division) 6 Build LR 23
18Canada Steamship Lines Ltd v. R  1Lloyds Rep
19 UKHL 32;  1 Lloyd’s Rep 562, 563, HL.
20 1 All ER 174;  1 WLR 1515, CA.
21Hewitt, T. ‘Who is to Blame? Allocating Liability in Upstream Project Contracts’ ibid
22Macattram, G. ‘How can the indemnity clause expand or limit the responsibility for liability of the parties in international oil and gas contracts?’ ibid