Negotiating offshore construction contracts4 March 2025

The Shipbuilding Contract

For a commercial vessel, the contract for its construction (a “shipbuilding contract”) is between the shipyard (as “builder”) and client (as “buyer”) – often through a special purpose company incorporated by its parent (as beneficial shipowner) to hold title in the vessel following delivery.

The principal terms of a shipbuilding contract are reasonably well understood – there are even standard forms such as those produced by the Shipbuilders’ Association of Japan (SAJ Form) or Association of Western European Shipbuilders (AWES Form) – though parties can negotiate whatever terms they see fit.

Similar arrangements (and terms) to those of a shipbuilding contract are also used to build certain offshore units such as drilling rigs, offshore supply vessels (OSVs) and accommodation units. However, a project for the construction of a large-scale floating asset, such as a FPSO or FLNG, requires quite different terms to a shipbuilding contract.

The EPCIC Contract

In FPSO or FLNG construction projects, the seller (as “contractor”) is not a shipyard but a large offshore contractor with the skill and expertise to take full responsibility for the engineering, procurement, construction, installation and commissioning (EPCIC) of the relevant unit under the terms of a bespoke contract (an “EPCIC contract”). The buyer will not be an affiliate of a shipowner but likely an affiliate of a national or international oil company (as “company”) purchasing the asset for deployment and utilisation on a particular oil or gas field.

For a large-scale EPCIC project, the contractor will sub-contract much of the work and co-ordinate and manage the various work streams with sub-contractors up to project completion. Notably, the contractor is likely to sub-contract construction of the unit’s hull and manufacturing of the topside production modules and mooring system to separate sub-contractors. It is thus relatively common for the hull to be built at a separate yard and jurisdiction from the mooring system and topside modules, requiring transportation (to a different jurisdiction) for integration. Whilst maintaining full responsibility, the contractor contracts directly with a shipyard to integrate topsides, mooring system and all other materials into the hull before delivering a fully installed and commissioned unit to the company.

Contract Price

One of the key commercial differences between building a standardised commercial vessel (such as an LNG carrier) and an FPSO or FLNG is price. In today’s market, a newbuild LNG carrier’s contract price is roughly US$280m. However, an FPSO’s (not including any sub-sea architecture such as risers and umbilicals) can exceed US$5bn. The sheer difference in value of such assets has a direct effect on how the relevant construction contracts of each class of asset are structured.

Refund Guarantee

In shipbuilding contracts, it is standard practice for the buyer to pay the builder a significant portion of the contract price (commonly 50%-70%) in advance of the vessel’s delivery. This ensures the builder has less exposure to the buyer in the event of the latter’s payment default and helps finance its own related construction costs.

The buyer will want to ensure that if it has the right to terminate the shipbuilding contract prior to delivery for breach by the builder (and subsequently exercises such right), the builder will repay any contract price instalments the buyer has paid in advance. This will necessitate the provision by the builder of a refund guarantee pursuant to which an independent third party (usually a bank incorporated within the same jurisdiction) will guarantee its obligations to repay any such advance instalments. Even given the figures referred to above in respect of a technologically advanced asset such as an LNG carrier, the actual amounts guaranteed under a refund guarantee are usually manageable by commercial banks.

This is not the case for an FPSO or FLNG unit, where it is simply not commercially viable for a contractor to obtain a refund guarantee in an amount equivalent to even 50% of the contract price.

Transfer of Title

In most shipbuilding contracts, title in the relevant vessel/unit remains with the builder until it is built. Upon delivery under the shipbuilding contract (and simultaneously with payment of the amount of the contract price due on delivery), title in the vessel passes to the buyer. The refund guarantor’s (being the bank issuing the refund guarantee) obligations then automatically expire as, upon delivery, the buyer has no lingering right to terminate the shipbuilding contract and demand a refund of any instalments paid in advance.

In EPCIC contracts, where it is not generally possible for the contractor to procure a refund guarantee to secure the refund of any pre-delivery instalments, title in the asset is transferred from contractor to company progressively during the construction process.

Progressive Transfer

Under an EPCIC contract, the contractor still requires the company to pay some of the contract price in advance of the unit’s delivery. Generally, the advance payments the company must pay will reflect a proportion of the value of works completed (against which title will be transferred).

To differentiate an EPCIC contract from a shipbuilding contract for the purposes of the Sale of Goods Act (under which the latter is recognised as being a contract for the sale of goods where title does not pass until completion), the former must include clear and precise terms regarding what property is being transferred (on a progressive basis) by contractor to company and when.

An EPCIC contract may include a provision that title to materials constituting work pass to the company upon the earlier of (i) identification of such materials to the extent they apply to the work and (ii) the relevant payment being made by the company. For larger, more valuable items (e.g. hull and topside modules), express provision should be included as to where and when title in them is intended to pass. To the extent necessary, an agreed mechanism for the transfer of title in such items should be agreed within the EPCIC contract, with any registration requirements giving legal effect to such transfer also incorporated. It is essential for parties to have clarity as to who has title in materials at any given point during the construction process.

Whilst a mechanism for a progressive transfer in title is the only feasible option to address the aforementioned issues regarding the construction of an asset of the value of an FPSO or FLNG, it provides its own challenges.

Underlying Challenges

If a contractor raises its own funds to cover a unit’s construction costs, it may be obliged to grant security over the relevant materials to its financiers, making it unable to pass legal title on to the company. Even if title can be transferred to the company on a progressive basis during construction, it is possible such transfer may give rise to an unfavourable tax position due to the application of a sales tax that would otherwise have qualified for an export exemption had title remained with the contractor (or its subcontractor).

Where title in certain materials cannot be transferred during construction, whether because the contractor’s financing arrangements prohibit it or there is a commercial element (such as a tax cost) preventing parties from agreeing to such a transfer, the contractor may have to grant a security interest over such materials in the company’s favour. Such security may take the form of a ship’s mortgage over the hull, chattel mortgage over the topside modules and/or assignment of contractor’s rights (together with a full step-in right for the company) under certain key sub-contracts.

As EPCIC contracts are carefully negotiated to address all elements of the work required to ensure the relevant unit can operate as required at its designated site, the value of the materials if they were to be sold independently of the project (should the company terminate the contract) is likely to be significantly less than the actual cost the company paid the contractor for them as part of the contract price. Therefore, the main purpose for the contractor in obtaining a progressive transfer of title in such materials (or security interest over them) is not so the company can re-sell them to recover the amount of any advance payments already paid should it terminate the contract, but to allow it to obtain possession of them to “take-over” the project on termination.

Up to the point of termination, the contractor (or sub-contractor) will likely have possession of the materials as it will have needed them to perform its obligations under the EPCIC contract (i.e. complete and deliver the unit). Therefore, and notwithstanding that title will have passed and/or security over such material granted, the company still needs physical possession of the materials to maintain the project. This requires it to enforce it rights in the various jurisdictions where these are located. Local law advice should be sought not only when the EPCIC contract is being negotiated to ensure suitable provisions are included for the registration of title and/or granting of security, but also before any action is taken by company to enforce such rights.

Passing of Risk

Transfer of title and of risk are two separate concepts.

Under a shipbuilding contract, risk in the vessel passes simultaneously with title. Under an EPCIC contract, the company generally requires the contractor bear the risk of loss and damage of the unit up until the time works have been completed – and insure such risk accordingly.

Leasing Arrangements

Where a buyer purchases a vessel under a shipbuilding contract, it will usually look to recover capital expenditure via the vessel’s employment, whether through charter hire or freight.

In an EPCIC contract, the contractor builds the asset for the company (similar to builder and buyer under a shipbuilding contract), with the latter paying the former the contract price and incurring the unit’s capital cost. Ultimately, it is the company (on its and any co-venturers behalf) that will look to recover capital expenditure through the income received from its utilisation of the unit.

Given the contractor’s intimate knowledge of the unit, the company may contract with it to operate and maintain the unit on its (and its co-venturers’) behalf following delivery against the payment of a service fee.

Units such as FPSOs and FLNGs can also be leased or chartered by contractor to company (with the former retaining title in the unit). Under a leasing arrangement, the contractor remains responsible for the engineering, procurement, construction, installation and commissioning of the unit – as well as its operation and maintenance whilst deployed at the designated field. The contractor will have incurred the capital cost of the unit’s construction – which it will wish to recover from the company as part of the daily hire payable under the lease.

There will always be complex issues to examine when considering the most appropriate structure to build and operate an FPSO or FLNG unit – i.e. whether the company should lease or directly own it. Unfortunately, unlike a shipbuilding contract where any one of a number of standard industry forms can be used, due to the specific nature of a large scale EPCIC project for a floating offshore unit and the multi-jurisdictional issues that can arise, there is (as yet) no one size (or contractual form) of EPCIC contract to fit all. There is clearly an element of risk in these projects (given their sheer capital cost) that cannot be removed solely by negotiating contractual terms alone. Therefore, sector players are inevitably large credit-worthy companies with balance sheets to match their obligations and successfully complete these projects.