Innovation Disincentives in Industry Service Agreements

By Jim Cormack and Lowy Gunnewiek

Originally published on February 22, 2018.

Typical Industry Service Agreements have slowly evolved over time. Balancing the numerous business decision variables involved between oil and gas industry operators and their service providers, these agreements focused on short-term cost control along with risk management and allocation. We argue that current contracting practices actually increase future costs because opportunities for improvement and cost reduction are dis-incentivised and thus overlooked.

The relative maturity and broad application of these fairly standardized agreements has built up an inertia that inhibits change. In the current oil and gas price environment, change is required because of the importance of managing all costs. This focus is necessary, but under the umbrella of Industry Service Agreements, opportunities for innovative improvements, and thus longer-term cost reductions are being held back by these types of standardized agreements that were developed when the requirement to innovate had a different priority.

At EnerNEXT, we believe that it is imperative to recognize the long-term costs to industry resulting from a near-term focus on institutional risk aversion and short-term cost certainty. A non-comprehensive view of contracting strategies limits innovation from taking place at a time when innovation is needed to achieve tomorrow’s needed cost competitiveness. This is especially true in high production cost regions such as the Western Canadian Sedimentary basin, and further emphasized by the emergence of plentiful supplies of oil and gas in jurisdictions with lower operating costs.

The issues and decision criteria explored in our November 21, 2017 Commentary have wide ranging application for Risk Management generally, but we explore only issues specific to energy Industry Service Agreements. That is, standard service and supply agreements that include sophisticated commercial risk allocation mechanisms such as “Knock Provisions” and “Operator Cost Recovery Provisions”. These types of provisions provide contracting parties with near term cost certainty, insurance efficiency and short-term risk predictability.

While recognizing the value of these types of provisions, they generally fail to adequately incent innovation and continuous improvement. This is problematic at a time when high operating costs are presenting significant challenges for long-term business sustainability and in the competition for global investment capital. We argue that current contracting practices actually increase future costs because opportunities for improvement and cost reduction are dis-incentivised and thus overlooked.

Generally, the decision-making process taken between industry operators and service providers will naturally consider the generic and high-level process steps of defining the problem, specifying what is to be accomplished, identifying limiting factors, and developing potential alternatives. The decision-making process will then also introduce typical business variables that in their simplest form consist of: capital cost, finance, risk, insurance, markets, reserves, production, technology options, skill sets, etc. Over time and with the introduction of cost pressures and increased complexity in how these variables are considered, opportunities for innovation have been stymied. This is in part because of an evolved and entrenched perspective of “this is how we do it” mindset in the oil and gas industry.

In short, the benefits of including Knock Provisions and Operator Cost Recovery Provisions in Industry Service Agreements are focused on near term cost certainty, insurance savings and clarity of which party bears the costs of risk. These variables have come to dominate agreements without due consideration of their long-term impact on the industry. Inadvertently, legal counsel has negatively contributed to future cost competitiveness by introducing structural inefficiencies into the procurement process of services and operating arrangements.

A good working definition of innovation is “An idea that has a practical and valued application and improves upon what we have done before”. To innovate requires curiosity, desire, intellect, creativity, courage, tenacity, and the lack of fear to fail. Most importantly, getting the context right is key. It is also important to create an environment such that if an innovative idea is going to fail, it should be based on lack of merit, not because people and processes get in the way.

At EnerNEXT, we support the idea that innovation and continuous improvement processes can be included in Industry Service Agreements in an “improvement covenant” in two general ways, such as: (i) “test process improvement” methodology that targets a continuous annual improvement in service level performance; and (ii) a contractual requirement that the service provider bring forward a number of ideas each year to improve services, technology and/or save money. The innovations generated through such improvement covenants must lead to cost reductions, and so improvement covenants are generally supported by “gainsharing” clauses. Gainsharing clauses are a system of management used to increase the profitability of all parties by motivating stakeholders to work smarter, use resources more efficiently and eliminate waste. Clauses pertaining to intellectual property (IP) generated from this kind of work will also need to be included, and can also be structured to motivate innovation.

In summary, Industry Service Agreements need to innovate and take a step back from their historical focus on the concise allocation of the responsibility for risk events. Requirements and incentives for long-term cost innovation between the contracting parties must be encouraged and rewarded for the long-term health of the industry.

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