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Drilling & W
Incentives for Drilling Contractors
ell T
a report by
echnology
Petter Osmundsen
Professor of Petroleum Economics, and Head, Section of Petroleum Economics,
Department of Industrial Economics and Risk Management, University of Stavanger
Oil operations on the Norwegian Continental Shelf (NCS) – as in other contractors and oil service companies in the direction of a high pace
petroleum provinces – are characterised today by a shortage of rigs and (higher rate in the next contract) or a low pace (lower rate or lack of
very high rig rates. In addition, a disturbing decline in drilling efficiency employment after the contract has ended). Today, the latter applies.
can be observed. This has prompted the use of incentive mechanisms
in rig and oil service contracts. It has been argued that incentives in the Rig Hire – Evaluation Criteria and Compensation Format
drilling sector are unbalanced in that contractors have been rewarded Typical evaluation criteria for the hire of floating units include, in no
for uptime but hardly at all for efficiency. A number of petroleum particular order, expertise, financial strength, day rates, ability to
resources are time-critical in that their recovery depends on the use of complete on time, compliance with regulations on the NCS,
existing infrastructure, and irreversible losses may be incurred. operational efficiency and achievements, HSE system and culture and
However, there is a counter-argument: drilling fast is less important high-pressure, high-temperature (HPHT) expertise and experience.
than drilling correctly, and incentives tied to drilling speed can reduce
reservoir drainage and thereby resource utilisation. It is not only a We can see that price (day rates) is only one of many evaluation
question of drilling fast, but also of drilling correctly. A trade-off may parameters. The oil industry provides perhaps the foremost example of an
need to be made here, at least in parts of the well path. Challenges industry where opting for the lowest price does not necessarily represent
related to health, safety and the environment (HSE) can also arise. the best economics. Lifetime costs are what count, and the income side
Another source of concern is that additional incentives can have the must always be taken into account. Choosing a contractor without the
effect of driving up costs on top of already high rates. The question is necessary expertise could have unimaginable financial consequences – in
whether new incentives will primarily encourage a reallocation of the the form of damage to the reservoir, for instance. In addition come HSE
best equipment and expertise. considerations. So, tough technical and organisational standards are set
for contractors, and pre-qualification is carried out.
This article reviews some topical issues related to the drilling
contracts on the NCS. For a more extensive discussion, see Oil companies are subject to the European Economic Area’s
Osmundsen et al.
1
The focus in this article is on the relationship procurement directive, which aims to ensure competition for
between contract design and drilling efficiency, primarily on mobile assignments. However, the directive does not prevent criteria other than
units. This article examines rig contracts; oil service contracts are price from being used, provided that bidders are made aware of this in
analysed in Osmundsen et al.
2
A key element in the work on rigs and the invitation to tender. This facility is used;
3
however, the procurement
drilling has been the study of existing rig contracts on the NCS. The directive and the growing focus on avoiding corruption are placing
article also draws on a number of meetings and conversations with demands on the ability to audit contract awards. In this context, price is
key specialists in oil companies, rig contractors, oil service enterprises a more transparent criterion for distinguishing between contractors than
and the Norwegian Petroleum Directorate. various qualitative performance criteria, and can therefore represent a
safe decision base for procurement personnel in oil companies.
Incentive Structures for Drilling Contractors Therefore, the danger is that insufficient weight will be given to quality,
In discussions on compensation formats, incentives are often treated and that this will hinder innovation and lead to poorer decisions in an
as synonymous with various forms of bonus system. This is much too overall economic perspective (sub-optimisation). Conversations with
narrow; the financial incentive structure for a rig contractor includes contractors and oil companies have given us conflicting signals in this
the following elements: area. To be competitive in the long term, contractors must display
• evaluation criteria for awarding the drilling assignment;
Petter Osmundsen is a Professor of Petroleum
• compensation format and incentives in the current contract; and
Economics and Head of the Section of Petroleum
• remuneration in the next contract.
Economics in the Department of Industrial Economics
and Risk Management at the University of Stavanger.
He also holds an adjunct position at the Norwegian
The principal focus of attention for the management of a rig School of Economics and Business Administration
contractor is to secure employment for its units. Evaluation criteria for
(NHH) in Bergen. His research focuses are contract
theory, incentive design, tax design and market analysis
awarding rig assignments therefore function as an implicit incentive
applied to the petroleum sector. Professor Osmundsen’s
scheme. Since historical figures for drilling efficiency are utilised when previous positions include Research Fellow at the Massachusetts Institute of Technology
awarding rig contracts, strong implicit incentives are attached to this
(MIT), Associate Professor at the NHH and Research Manager at the NHH-affiliated
Institute for Research in Economics and Business Administration (SNF). He holds a PhD
parameter, even though they are not explicitly included in the rig
from the NHH.
contract’s compensation format. Furthermore, the remuneration
E:
Petter.Osmundsen@uis.no
agreed for the next contract will represent incentives for rig
© TOUCH BRIEFINGS 2009
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