OPERATOR AND CONTRACTOR BENEFIT FROM INCENTIVE CONTRACTS

Bethany Brandon
Eastman Christensen
Houston

With incentive contracts, drilling and service contractors assume greater responsibility for operations. That helps them to align their goals more closely with those of the operator.

This achieves a more equitable division of the risks. Many operators and contractors believe this is a more appropriate approach to contracting drilling services.

As they assume manageable responsibility, each party also has opportunities for greater reward.

Innovations in cooperation can create a "win-win" situation. In a win-win contract all parties benefit from the new relationships between operator, contractor, and service company.

The win-win situation can only be achieved by allowing the contracting parties to become much more closely involved in drilling operations. This is the primary motivation behind development of more productive contracting strategies.

INCENTIVE CONTRACTS

A contract with incentives is one way for the drilling contractor to take on a greater share of responsibility for operations while also gaining the potential for correspondingly greater rewards. Essentially, this represents a transition from the detailed instructions of a day rate or footage contract to a type of contract that specifies results.

Three types of common drilling contracts show the mechanics of this transition:

The day rate with bonus contract simply rewards performance improvements.
The performance incentive contract ties the amount of reward to assumption of responsibility and risk.
The lump sum or turnkey contract assigns all responsibility and reward to the contracting party.

The turnkey contract is the most extreme form of performance incentive.

All three contracts are designed to motivate the contractor to drill more efficiently by rewarding performance improvements. Ordinarily, these performance improvements would reduce the time required to drill a well and thus, reduce the amount paid to the contractor on a standard day rate basis.

In July 1991, the Independent Petroleum Association of America's cost committee reported that use of turnkey contracts increased 337% from 1984 to 1989. Footage rate and day rate contracts dropped correspondingly during the same period.

There is a transition away from giving detailed instructions to a contractor on a day rate contract and from contracting for specific footage to be drilled.

Performance incentive contracts provide a means of gradually transferring increasing responsibility to the contractor, facilitating the transition to the results-oriented contract.

Use of incentive contracts also provides for rapid introduction of technical developments, expanding the opportunity for contractors to obtain additional rewards. During this transition phase, integration of various service contracts is a logical means of simplifying the bidding process for drilling-related services.

BONUS CONTRACT

The first type of contract, day rate with bonus, requires no modification to the established day rate contract format. Instead, it merely includes payment of a per day bonus for drilling performance that is faster than the estimated time. Because drilling faster reduces the total number of drilling days, the amount paid under the day rate contract is actually reduced. To compensate for this, the bonus amount is awarded as a share of the savings.

The day rate with bonus format is readily adaptable to development drilling. This contract does not lend itself well to exploration drilling because the uncertainties of exploration make it more difficult to estimate the time and, consequently, to establish the day rate for an exploration well.

In such cases, the day rate with bonus contract can be modified to provide incremental bonus payments as performance continues to improve with respect to predetermined depth vs. time curves. As performance improves, the bonus increases proportionally.

Under the day rate with bonus contract, the risk remains primarily with the operator. The operator retains the same exposure found in a standard day rate contract.

TURNKEY CONTRACT

At the opposite extreme is the turnkey contract. Because of its structure, the turnkey contract assigns all risk to the contractor, who is paid a lump sum for a delivered product (the well). Under the conventional turnkey drilling contract, the operator contracts for a complete job rather than individually contracting for each service.

This gives the contractor direct responsibility for all drilling-related services. These services often include directional drilling, downhole engineering, drilling fluids and mud engineering, survey and data collection, and drilling equipment rental.

The contractor may be faced with pricing items with which he is unfamiliar or has little experience.

Turnkey arrangements require that the drilling contractor possess extensive expertise to manage the inherent risks, maintain a high level of management commitment, and have the necessary engineering and financial resources.

PERFORMANCE CONTRACT

The performance incentive contract is a more appropriate contract structured to combine both lump sum and day rate formats.

The flexibility of a performance incentive contract allows for a more gradual assumption of increased responsibility and risk by the drilling or service contractor.

This type of contract addresses the critical issue of how to equitably transfer assignment of risk; this is central to the successful transition from standard day rate contracts to incentive-based contracts.

For example, the various drilling-related operations can be assigned on a case-by-case basis to either the incentive rate, under which the contractor assumes risk, or the day rate, which places the risk with the operator. The performance element of the contract can be adjusted to accommodate all possibilities between day rate and lump sum.

To implement the performance incentive contract, the "carrot and stick" approach is used. The carrot is provided by an incentive to earn a share of the total savings from improvements in drilling efficiency. The earned share of the savings results in total compensation in excess of the base rate, measured as a factor of the base rate (e.g., base rate x 1.10 = total compensation).

On the other hand, the stick is provided by the potential lost revenue or penalty if performance does not equal minimum expectations.

A performance incentive contract also may include a breakdown clause which allows for payment of only a percentage of the day rate for stipulated time lost to a breakdown. A similar reduction in day rate can be included for any remedial work required to put the well back at the same depth and condition following a breakdown.

INTEGRATION OF SERVICES

Drilling contractors may have sufficient capacity to undertake responsibility for obtaining and overseeing equipment and logistics under terms of a performance incentive contract; but in most cases, downhole drilling and other technical skills must be obtained from other sources.

Many service contractors have developed these specialized skills to very sophisticated levels and can provide them on incentive contracts.

For both the operator and the drilling contractor, the integration of services simplifies project management. This concept can be applied as a subcontract arrangement with the drilling contractor or in conjunction with existing contracts.

Under traditional forms of contract, the operator must provide many specialized well services--the performance of which directly affects any potential bonus for the drilling contractor. An integrated team provides a coordinated supply of these critical services, reducing administrative and logistical demands. However, the integrated team is penalized for any substandard performance, eliminating that service burden from the drilling contractor.

The integrated approach ensures close coordination with the drilling contractor and operating engineers during planning and daily well operations. Because the integrated group coordinates the project as a single source for drilling services, it uses a "total well" approach to well planning, engineering, and rig site operations.

For example, a horizontal well in Fayette County, Tex., was drilled recently under a performance incentive contract.

Baker Hughes Inc. integrated all facets of directional planning, drilling, drilling fluids, bits, and data acquisition into one service.

Through planning with the operator, the team defined a target curve of 850 hr, or 35 days, to drill a horizontal well to a total depth of 8,934 ft. That included 13 days to drill the horizontal section.

The team provided steerable drilling systems, advanced technology journal bearing bits, polycrystalline diamond compact bits, and a drilling fluids program. At the end of the project, the integrated engineering services team achieved all objectives and completed the well in only 642.5 hr, or 27 days.

The time savings over the plan resulted in a bonus for both the drilling contractor and the team.

By creating a situation of shared risks and rewards, the performance incentive contract ensured that all parties had the same objectives. The common goals brought better cooperation and closer coordination between contracting parties, and that resulted in a well drilled in less time.