Oil and Gas Companies Consider Alternatives to Lump Sum Bid Contracts

A recent discussion with my colleague Tim Cummins at IACCM suggests that an increasing number of oil and gas companies are exploring alternatives to traditional “lump sum bid” contracts, that are typically used for large oil and gas construction projects.  This is largely due to risk aversion and the unpredictable nature of new project environments, as well as the uncertain geographic terrain that lends itself to a time-and materials contract structure.

There are multiple categories with commercial models that include lump sum, time and materials and others, but construction projects such as new pipelines, preparation of new drilling sites, and others are the biggest ones.  This format places the bulk of the risk on suppliers/contractors.  In this case, they will include the project risk elements, and include a surcharge in their lump sum, which is generally in their favor.  However, it is a risky strategy.  

Alternatives to lump sum bid include:

1.)   Gain share or cost savings sharing mechanisms;

2.)   Alignment of contractual terms and conditions (i.e. indemnifications, liabilities, warranties, insurance, etc.) to reflect realistic risk scenarios [to optimize associated cost];

 Such alternative contracting models are more agile, as they can adapt when there is uncertainty over scope, goals, or achievability.  They may be outcome-based, performance based, or payment occurs based on results.

These various approaches have some overlaps and in particular they all point to the need for more collaborative governance and performance mechanisms. In some cases, they also need to recognize the overall value being generated and consider risk / reward allocations based on that potential. For example, if you can cut drilling time by half, but pay a 50% premium to the drilling company, does that make sense based on the overall economic benefit from faster production?

 Oil and gas companies need to give more thought to risk terms such as those described here and in strategic relationships, particularly in the current volatile market. But a more immediate and practical approach may be to balance them with terms that reduce the likelihood of negative events occurring – essentially through what we term ‘relational contracting’.  This in turn requires that attitudes to the role and value of the contracting process need to shift.  This is beginning to happen, but as we know, change takes time!