Contractual relationships are an essential element of any business. However, the nature of the oil & gas industry is one that sees the sector dominated by contracts.
Companies can devote more attention to negotiating and entering into contracts than making sure those contracts achieve the agreed expectations and requirements. But without a proper understanding of the risks within their contract portfolio, companies run the risk of contractual non-compliance, as well as missing opportunities to gain better services from contract partners and identifying cost savings and revenue optimisation opportunities. Worse still, damage to reputation and relationships can occur when contract risks are not understood and managed.
Findings from the Group Contract Management Benchmark Report highlighted that ineffective control and management of contracts costs businesses $153billion per year in missed saving opportunities.
This serves to highlight why companies should be improving contractual controls and seeking to better understand and manage the contractual risks facing their organisation.
In the oil&gas sector context, there are several factors that contribute to the increase in contract risk:
Entry and expansion into emerging markets.
Global expansion into emerging markets has always carried with it traditional threats such as currency, operational, regulatory, language and cultural risk. A significant challenge lies in firms effectively managing outsourced business and supply chains in these markets. Increasingly, companies are held liable for the actions of agencies and contract partners used in outsourcing arrangements by regulatory bodies such as the SEC.
There have been several recent cases within the sector of companies facing heavy financial penalties under the Foreign Corrupt Practices Act (FCPA) for the actions of its agents abroad in passing bribes to government officials. Contract initiators therefore need to consider geopolitical and regulatory risks along with operational and business risks on a country-by-country basis when developing such agreements.
Joint ventures and sub-contracting relationships.
Joint ventures, alliances and partnerships are commonplace within the oil&gas industry as an efficient method to enter new markets, share technology or launch new products and services. These arrangements have a high potential to result in contractual issues and therefore require ongoing monitoring and assessment of performance metrics and compliance.
Merger and acquisition activity.
The merger with or acquisition of a company results in taking on the contracts of another organisation. Companies are therefore acquiring contracts over which they have had no prior knowledge, input into negotiating, monitoring or control over.
Patents, copyrights and trademarks and subsequent licensing of intellectual property.
To fully exploit newly developed technology, companies are licensing the intellectual property to a host of partners rather than developing the production and sales infrastructure internally. However, monitoring and collecting the associated payments can be difficult and expensive. Companies rely on the licensee’s processes and reporting, but have limited ability to monitor the completeness and accuracy of these reports. By effectively monitoring intellectual property, companies can validate reported loyalties, identify unreported royalties and better manage inherent risks.
Most companies have strong internal controls around the initiation of contracts, but many of them do not always have a similar focus on the administration phase. The contact initiators are usually not the subsequent contract administrators. It is equally unlikely that there is a formal knowledge transition process between the initiators and the administrators. The potential knowledge gap between the initiators and administrators increases the likelihood of non-compliance.
An effective contract risk framework allows a company to identify and proactively address contract risk by prioritising those that are most important and aligning proper monitoring procedures to them. An assessment of risks within the contract portfolio begins with compiling an inventory of third-party contracts and evaluating the risks associated with the contracts.
Companies interested in managing risk assess their contract risk on three criteria: transactional accounting, operational and regulatory environmental risks.
Risks are evaluated according to their impact in monetary terms, through likelihood of occurrence or by other factors critical to the success of the company’s strategy.
Knowledge of potential risks enables an enhanced evaluation of the risks in a contract portfolio. An effective monitoring plan can then be put in place, which has several key advantages, including the identification of over and under-payments, enabling improvements to accounting systems, controls and governance procedures to be identified and implemented; promoting a deeper awareness of potential relationship deterioration, which allows you to trouble-shoot before contract dispute arises, and the identification of non-compliance with the terms of the contract.
To protect company and shareholder interests, companies need to be proactive in assessing their contract risks.
Companies should consider a periodic operational audit programme of the contract process, and assessment of key contracts identified via the contract risk assessment process.
By taking a proactive approach to contracts, companies help mitigate contractual risks while making improvements that will enhance the businesses through increasing value through increasing revenues or reducing costs.
Kristine Dickson is director of risk advisory services at Ernst & Young