Drilling Contracts and Insurance
This section provides an overview and discussion of the contractual and insurance options for the drilling phase of a geothermal project and the most appropriate route for the AECC site. As the majority of the cost of a deep geothermal project is the drilling phase, the contractual structure needs to be robust and the most suitable for the project. As geothermal developers are often small with limited balance sheets, the terms of the contract, particularly with regards to additional cost liability, must be favourable to the developer ("Operator" in contractual terms). The definition and distinction between geological and technical risk and, above all, the allocation of that risk between the drilling Contractor and the geothermal Operator is key to delivering a successful project. There are many examples of projects that have failed, even in the UK, due to a lack of clarity on the contractual obligations when aspects of the drilling do not go according to plan. If the Operator does not have sufficient cash reserves or is not effectively insured, the project will fail.
A typical drilling operational structure for a deep well is outlined in Figure 21. The potential variations to this structure will be discussed in subsequent sections.
Figure 21: Typical deep drilling operational structure
Within the European drilling sector there are two principal types of contract for drilling geothermal wells:
- Turnkey or so termed 'Engineering, Procurement, Construction' (EPC) contract
- Day Rate Contract
Shallow (<1,000m) geothermal projects and water wells have traditionally been drilled under a Turnkey Contract. This means that a drilling contractor delivers a completed well for an agreed price. The drilling contractor therefore takes on all of the drilling risk. As geothermal heat projects were often undertaken by building developers or local municipalities with little geothermal experience, the Turnkey contract allowed the Operator to pass on all technical risk and responsibility to the Contractor until completion and handover of the project.
However, as drilling becomes deeper and more complicated (particularly with directional drilling and hydrocarbon risks) Turnkey contracts become less common. Instead, Day Rate contracts are used. Under a day rate contract, the drilling contractor provides personnel with specialist drilling engineering expertise and the Operator provides personnel responsible for the coordination and management of the project. It is effectively a time and materials contract.
Geothermal projects with deep drilling and deviated wells require higher performance drilling rigs and greater deep drilling expertise. This has resulted in contractors from the oil & gas sector being used for the project due to their deep drilling experience. Many contractors from the oil & gas exploration sector now see the drilling of geothermal wells as a very attractive market and regularly compete on an international scale for contracts. In general, their contractual experience has been based on day rate contracts, that transfer much more of the risk to the Operator. This is acceptable in the oil and gas industry, where Operators typically have substantial balance sheets and an in-house team of drilling and reservoir experts. This is generally not the case for geothermal Operators that often need to arrange sufficient insurance cover (where available) to pay for any unexpected changes to the drilling programme and hire a team of specialist consultants. Both of these types of contracts are explored in more detail in the subsequent sections.
The single well system planned for the AECC has been designed to be a simple drilling operation (a vertical well with no deviation) and standard casing diameters/ cementing. It is not designed to operate under pressure and does not need a bespoke cementing design. The preference is therefore to proceed with Turnkey or EPC contracts that allocate risk to the driller and mean that the well can be completed for a fixed price. This is something that we have been exploring in detail with drilling and construction contractors as part of other projects we are developing.
Due to the higher level of risk borne by the Contractor, the cost of a Turnkey contract can be higher than that initially quoted for a day-rate contract. The amount of the additional cost is also dependent on the assumed responsibilities and technical complexity of the drilling program. Where sub-contracted services are required the contractor will typically include a handling fee. From our experience this value typically lies between 10% and 15%.
Although these contracts are 'fixed price' technically intensive and therefore costly problems during drilling (e.g. equipment loss & damage and drill fluid loss) can lead Contractors to claim costs as issues relating to geological conditions, which, depending on the wording of the contract, may be borne by the Operator or Contractor. The proving/disproving of these types of claims is commonly the responsibility of the Operator and therefore the wording of the contract needs to be precise and agreed by all parties prior to commencement of drilling.
Under a Turnkey contract, a drilling contractor normally seeks to complete the well quickly (and problem free) as the contract will typically include a deadline for completion of the works.
Day Rate Contracts
A day rate contract can be split into two categories:
- Day rate contract without a main contractor
- Day rate contract with a main contractor
For both types of contract, the time management (and subsequent total cost) is controlled by the Operator, who also carries the down-hole risk. The Contractors are often incentivised (through bonus payment schemes) to provide services more efficiently to avoid an excessive number of days and therefore cost, being allocated to drilling. The possibility of negotiating an incentivised contract will depend on the complexity of the well and the prior knowledge of the geological conditions.
Day Rate Contract without a Main Contractor - Multiple Contracts
Under a day rate contract (without a main contractor) the drilling contractor's responsibility is reduced to the operation of the drilling rig and the provision of suitably qualified personnel.
The drilling contractor would typically operate under instruction from the Operator with coordination of the delivery from the Operator appointed supervisory team (or Company Men).
The drilling risk in this case is exclusively borne by the Operator and therefore the contractor is not required to add any risk related supplements. Further, any handling surcharges for service and delivery are avoided as the contracts between the service companies and the Operator are direct. Figure 22 and Figure 23 below provide an overview of the contract and project management structure for a day rate contract model without a main contractor.
This type of structure is typical for an oil and gas well where trained personnel can be provided by the oil and gas company to design the well and monitor/ interpret all aspects of the drilling operation. Further, the oil and gas company will have standardised contracts for all of the sub-contracting entities involved. For a geothermal well, the Operator will need to locate and employ suitably qualified staff prior to tendering a contract as well as employing these staff throughout the drilling operation. The geothermal Operator will also need to develop all of the contracts for the project using experienced oil and gas lawyers. This process can add significant time to the development of a project.
Figure 22: Contract Structure under a day rate without Main Contractor
Figure 23: Project Management/Communication Structure under day rate without Main Contractor
Day Rate (with Main Contractor) - Single Contracts
Under a day rate contract with a main contractor, the drilling contractor is responsible for all materials and delivery including sub-contractors (under a single contract). The main contractor will also typically include some supplementary costs in their pricing depending on the assumed risk and include a handling charge for subcontractors, which is normally between 10% and 15%. Apart from an increased cost for the well with the application of the handling charges, the individual subcontractors of the main contractor will often look to the Operator for supervision and coordination of the services provided by these subcontractors. Figure 24 and Figure 25 below provide an overview of the contract and project management structure for a day rate contract model with a main contractor. The Operator will still need to find and employ a planning/ supervisory team and will still 'own' the technical and geological risk.
Figure 24: Contract Structure of Day Rate with Main Contractor
Figure 25: Project Management/Communication Structure under day rate with main contractor
Both Turnkey and Day-Rate contractual structures offer potential benefits and problems for geothermal contractors wishing to develop projects in Scotland. A Turnkey approach can offer security of a fixed price but is likely to be expensive for complex, directional drilling in an essentially unknown geological environment. A day-rate contract on the other hand may suffer from cost over-runs that cannot be met from a small geothermal contractor and will require a highly experienced team to be hired by the geothermal contractor for the duration of the project along with experienced lawyers to handle the multiple contractual agreements. Prior to developing a project it is important that a geothermal developer understands how they intend to contractually manage a deep well in Scotland. If an appropriate contractual structure is not developed in advance of the drilling programme then a project may fail due to either litigation or, as is more common with geothermal projects, insufficient funds to complete the project due to cost over-runs falling on to the geothermal Operator.
For the single well system, we have designed the well to be as simple as possible to drill and install. Further, as the well does not require hire flow rates or operational pressures, the project is less prone to geological risk. It has always been our aim to roll out the DGSW systems in a similar way to water wells or piling projects under an Engineering Procurement Construction (EPC) contract. As such, we have been in discussion with a number of large scale contractors across Europe that are willing to operator under an EPC contract to deliver single vertical wells at a fixed cost. In particular, we have developed a relationship with Zublin (owned by Strabag (£20bn turnover)) who have experience of drilling and delivering projects across Europe. The EPC contracts have been adapted from those used by Arup in large scale construction projects throughout Europe and we believe that this approach offers the most sensible solution to the delivery of a deep geothermal single well at the AECC site for a fixed cost.
The following table (Table 5) provides an overview of the advantages and disadvantages of the different contract options discussed is this report.
Table 5: Overview of advantages and disadvantages of the different contract options
|Turnkey / EPC||Day rate without Main Contractor||Day rate with Main Contractor|
|History||Principally Geothermal||Principally Oil & Gas||Principally Geothermal|
|Fixed delivery price||Yes||No||No|
|Technical Responsibility||With drilling contractor||With Operator||With Operator (except coordination)|
|Suitability to water wells/ standard construction||Yes||Yes but contractual complexity adds cost||Yes|
|Suitability to complex directional drilling in 'unknown' geological environments||No||Yes but needs strong supervisory and legal team supplied by Operator||Yes but needs strong supervisory team from Operator|
|Suitability to small contractor||Yes||No. Additional staffing required||No. Additional staffing required|
|Geological Risk||Borne by Operator||Borne by Operator||Borne by Operator|
|Technical Risk||Borne by drilling contractor||Borne by Operator||Borne by Operator (except coordination)|
|Cost over-run||Borne by drilling contractor||Borne by Operator||Borne by Operator (except coordination)|
This section provides an overview of potential insurance mechanisms that can be used to insure the drilling phase of a geothermal project. There are four areas of a project that need to be considered:
- General Liability Insurance
- Exploration Insurance (Well Performance Risk Insurance)
- Construction All Risk Insurance (CAR)
- Lost In Hole Insurance (LiH)
The general liability policy concerns the legal liability in respect of property damage and personal injury to a 3rd party. The level of liability will depend on the local jurisdiction and legislation. In our experience on other single well projects, general liability coverage is typically available on a stand-alone basis for a project but can also be incorporated into the overall general liability policy of the Operator. A level of £10m (aggregate basis) is normally regarded as being a sufficient limit for a geothermal project. As a geothermal developer, GEL currently has this level of cover in place and it is a fairly standard insurance product in the UK.
It should be noted that if a geothermal project is located in a mining area, specific insurance requirements will probably need to be put in place. This should be discussed with the local mining authority where appropriate. In some cases mining law may provide a strict liability, where no negligence or willful intent needs to be proved for the project to be considered liable. Such strict liability would usually be excluded from common liability insurances. The pricing of a policy to cover this type of liability will vary substantially with different limits, scope of coverage and level of excess.
Exploration insurance (well performance risk insurance)
Exploration insurance covers the potential risk of the well not performing. In the context of a geothermal project the policy would cover an unsuccessful well in terms of the production flow rate, the temperature, the draw down in the well and thermal capacity.
In recent years, due to substantial losses, all insurers have stepped out of this market for low enthalpy geothermal projects in Western Europe. Across Europe, some Government backed policies are in place - most notably in France. There is no such Government backed risk insurance scheme in the UK. Therefore, in Scotland, an Operator will have to take on this risk with no insurance mechanism to re-coup costs. This is important when considering deep geothermal wells that require high flow rates in unproven geological formations. Without insurance mechanisms, we believe that private funding is unlikely ever to be involved in the drilling stages for these types of wells.
Construction all risk insurance
Construction All Risk Insurance typically covers the cost of any unforeseen property damage to the well during construction due to geological and technical risks. For example, well instability, stuck drill string (in an unsuccessful fishing attempt) and collapsed casings. The insurance should cover all expenses (e.g. labour, day rates of the rig, energy, cement, casings, etc.) incurred to bring the well back to the same standard as prior to the incident occurring.
Due to a large number of claims over the past decade across Europe, a significant number of commercial insurers have also stepped out of this market. As a result, underwriting capacity is limited depending on the location. Each project typically has to qualify for such coverage by providing evidence of a risk mitigating well design.
Where available, a typical excess for this type of insurance is in the range of £250,000 - £500,000 per loss. It is expected that the premium rate on the insured limit will be in the range of 4 - 7 % of the total cost of the well. The more expensive the well, the more expensive the insurance and Operators should bear this in mind when considering deep deviated wells in Scotland. The construction risk cover can be split into geological risks and technical risks:
The geological risks are defined as geological conditions, which have the potential to pose issues and therefore require additional remediation measures. These issues can result in, but are not limited to, delays, variations to design and damage to material and equipment. Such examples of covered issues are as follows:
- Total loss of drilling fluid resulting in complex control measures
- Differential sticking leading to (in the worst case) the drill string being stuck in hole
- Abnormal pressure formations leading to the collapse of the well and the requirement to drill a sidetrack well
- In well hydrocarbons requiring additional oil and gas control measures
The technical risks are defined as problems resulting from material, equipment and machinery issues, which typically require additional measures to be implemented, resulting in delays, variations to design and damage to equipment. Such examples of covered issues are as follows:
- Material failure due to mechanical and thermal stresses leading to pipe/liner rupture or breakage and drill rods becoming jammed in the well
- Damage to the well due to a service contractor
- Human error
Both geological risk and technical risk need to be very well defined and clear levels of responsibility allocated prior to awarding a drilling contract.
Lost in Hole Insurance
Lost in hole insurance covers the loss or damage of material and equipment underground and includes all associated material replacement costs.
If the drilling equipment is rented from a service company, the respective rental and lease contract will normally stipulate a liability to replace or indemnify lost and damaged subsurface equipment as new, irrespective of how worn the equipment was at the time that the incident occurred. This liability is typically transferred in its entirety through a rental contract from the drilling contractor (who rents the equipment) to the Operator.
The value of a new bottom hole assembly (BHA) consisting of a Rotary Steerable System (RSS), Measure while Drilling system (MWD) and other components can easily exceed £1 million. In the case of a LiH incident, fishing costs for attempts to retrieve the equipment back to the surface (which includes; specific fishing equipment, labour cost and travel expenses) will be incurred.
The excess for this type of policy is normally between 20-30% of the insured costs. Such coverage is generally still available in the market. The insurance premium is likely to vary between 5 - 15% of the total equipment cost although it will also depend on the complexity of the well design, the insured limits and the experience of the drilling contractor and company man.
The table (table 6) below summarises the potential insurance mechanisms that will be available for deep geothermal projects in the UK. In addition an indication of the typical premium rate and excess is included.
Table 6: Summary of insurance mechanisms for a deep geothermal well
|Insurance Type||Coverage||Typical Premium Rate||Typical Deductibles|
|General Liability||Third Party Property Damage Third Party Liability||The premium and excess for general liability in the UK will be subject to the insurer and the relationship between the insurer and the Operator.|
|Exploration||Unsuccessful Well||Exploration risk insurance is not available in the UK whether through a commercial insurer of State backed scheme. If the well does not perform as expected then the Operator is financially at risk.|
|Construction All Risk||Unforeseen damage through: o Geological Risks o Technical Risks||4 - 7 % of total well costs per well||£250 000 - £500,000 depending on well construction and design|
|Lost in Hole||Loss and Damage of material underground||5 - 15% of the max. drill string costs per well (£0.5m - £2m)||25 -30% of cost|
As discussed in the previous section on contracts, the deep geothermal single well has been designed to be a relatively straightforward drilling operation. As such, the well(s) will be drilled under EPC contracts. This allocates the Lost in Hole risk and the construction risk to the contractor. As Operator, we therefore do not need to add Construction Risk or Lost in Hole insurance costs to the project, resulting in further cost savings. For general liability as an Operator, we already have cover in place to £10m for the development of single vertical wells.
For other types of wells, particularly deviated deep wells, the construction risk insurance and lost in hole cover are likely to be passed to the Operator. This will increase the cost of the project due to the required insurance premiums.
Email: Johann MacDougall
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