SPE 102874

Pricing of Long-Term Oil Service Contracts and Financial Risk Management

E. Lyadina-Saville, SPE, Saville Solver Ltd.

Copyright 2006, Society of Petroleum Engineers

This paper was prepared for presentation at the 2006 SPE Annual Technical Conference and
Exhibition held in San Antonio, Texas, U.S.A., 2427 September 2006.
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Abstract
Pricing of long-term oil service contracts assumes projection
of many components of business environment into the future.
Since volatility of business, financial, and political factors
have recently dramatically increased, the intelligent
quantitative analysis of financial risks and their incorporation
into bid/offer price curves, became of primary importance.
In this paper, we describe a commercial model for pricing long
term contracts based on term-structure approach and
incorporating effects of various types of financial risk,
including interest rate risk, currency exchange risk, credit risk,
legislation risk etc. We present a generic model of a long-time
contract, and methodology of initial valuation of at-market
contract, and its re-valuation during the term of agreement.
The model is applicable to a broad range of strategic
marketing decisions, when effects of various types of financial
risks and the duration of the contract are taken into account.
We discuss how a long-term contract may act as a tool for
asset-liability management, creating a preferable risk exposure
profile, and for exchange of risks between parties in a
mutually beneficial manner, thus creating a win-win business
situations for both operator and service company.
Introduction
Long-term oil service contracts are an attractive component of
business portfolio for both oil service and operator company.
They represent a high volume business transaction and help
improve stability of cash flows for both partners. They allow
the personnel develop in-depth knowledge of the tools,
equipment and business practices of the partner-company.

However the pricing of long-term contracts necessarily

involves forecasting of business, financial, and oprational
factors. Due to increase in volatility of such factors,
incorporation of financial risks into a pricing model is
required.

Financial risk components

The price of any item exchanged on a market, including the

price of services provided, is determined by interplay of
supply and demand curves. With a short-time contract, the
current (spot) values of operation and service costs, albeit
dependent of a multitude of components, are generally known,
and the bidding procedure could finalize the current market
price of service.
With a long-term contract, future supply and demand volumes
are not known. However, factors that affect evolution of
supply and demand, and sources of financial risk, may be
identified and price uncertainties may be estimated. The main
sources of financial risks affecting long-term contracts are as
follows:

Commodity price risk. This is the risk of significant

change in the price of consumed and produced materials,
tools, third party services etc during the life of the
contract;
Labor costs risk. This is the risk of significant change in
the cost of services of human resources;
Interest rate risk. This is the main factor determining the
time value of money and consequently the price of the
contract in its term structure;
Currency exchange risk. This is the risk of change in
unexpected way of a
relative value of different
currencies, affecting multi-currency transactions, sales,
and purchases for global businesses;
Credit risk. This is the risk of default to service its
agreement by one of the counterparties to the contract;
Legislation risk. This is the risk of unexpected changes
in regulations, legal requirements and political situation,
affecting possibility or efficiency of operations.

SPE 102874

Generic model of long-term contract

A long-term contract may be represented as a series of forward

contracts with different expiration dates (Fig.1)
A long contract

CF

pay

CF

pay

CF

service

CF

In the case of interest rate risk and currency exchange risk, the
equation for initial pricing is given as follows:

CF

pay

service

CF

service

equals to a bundle of forward contracts:

CF

In developed commercial model, valuation of the long-term

contract and calculation of payments profile is based on termstructure approach. At the inception of the contract, the
value to both partners, an operator and service company, of atmarket contract based on current market terms is such that
neither side is required to compensate the other. At initiation,
at-market contract has zero net present value, NPV (ignoring
at this stage profit margins and transaction costs). For both
sides of the contract, the present value of the known
contractual future payments by operator must be equal to the
present value of expected service costs incurred by the service
company.

0 = NPV =
t =1

pay

CFt ,pay
A
(1 + z tA ) t

FX

AB
spot

E (CFt ,service
)
B

t =1

(1 + z tB ) t

Here:
1

CFt ,pay
A

CF
+

service

CF

pay

pre-agreed cash flow of contract payment by operator in

currency A in the year t;

CFt ,service
B
2

CF

service

variable future cash flow of service costs in currency B in

the year t;

E (.)

++

CF

pay

expected value;

AB
FX spot

m
1

CF

current (spot) exchange rate between currencies A and B;

service

Figure 1. A long-term contract as a series of forward contracts.

ztA
-

zero-coupon rate in currency A at time t;

ztB
-

zero-coupon rate in currency B at time t.

SPE 102874

The advantages of adopting the term structure methods for

pricing the contracts are that [1]:

it is a generally used method for calculating the fair

value of a set of cash flows;
it provides a robust pricing and risk management
framework within which contracts can be valued and
traded.

It should be noted that the value of constant payment in this

case is not a simple average of costs during the contract, but
determined by a precise analysis of term structure and time
discounts for estimated costs profile.

Pricing a contract
The pricing process proceeds in three steps:
1.
2.
3.

Estimate variable costs applicable to each future

settlement date on the contract;
Use the zero-coupon yield curve to calculate the present
value of the expected future costs under the contract;
Calculate the annuity rate that has the same present value
as determined in point 2 to give the payment side of the
contract.

Composition and value of the current (spot) costs of the

service are known to a service company analysts. Projections
of these components over the contract horizon are done by use
of the available data from the financial forward and futures
markets (for commodities, interest rates, currency exchange
rates etc) and by analysis of financial, economical and
operational data sources for other cost components, not traded
on the futures markets.
A dynamic implementation of the pricing model utilizes the
past and current financial data from variety of available data
bases for a process of informed decision making and builds the
best estimate of the price curve based on a chosen economical
criterion. In contrast to currently available methods,
econometric projections are based on the use of optimal
regularization technique for underlying mathematical problem
of extrapolation [2]. A simplified static implementation of the
model allows for use of default values of economical factors
or the values chosen by a company analyst. Practical operation
of the model is based on the bounded rationality principle
and assumes that a sensible amount of model sophistication
should be used to balance the costs of search for additional
information and its potential benefits.

Case study
Results of a synthetic case study with constant profile of
payments are given on Figures 2,3.
In this case, estimated expectations of service costs give a
variable, but generally increasing costs profile. The level of
payments does depend on the duration of contract and
projected costs.

Figure 2. Levels of constant payments for contracts of

different duration.

SPE 102874

The value of a seasoned contract

Initial valuation of the long-term contract to zero net present
value is a necessary step of finding fair value of payments
and initializing at-market (or par) contract. However, with
maturing of the contract, parameters of economical and
financial environment do change and may deviate from their
initial estimates. In this case, the contract becomes off-market
and may become an asset for one of the parties and liability for
another. Quantitative re-valuation of the contract during its life
gives an important indicator for asset/liability managers. It
also will be necessary in case of voluntary termination of the
contract, or default of one of the parties.

Figure 3. Value of constant payment as function of contract

duration.

The value of the seasoned contract is the price required to

hedge or replace the contract with current, at-market (or par)
contract. Methodology of valuation of a seasoned contract is
based on term structure approach.

Complex contracts
Cross-subsidy

Depending on the shape of expected costs term structure, the

current payments during the life of a contract may be higher or
lower than the current costs. Since in our case study the
payments are constant, but the costs are generally growing, the
operator is initially subsidizing the service company, with
compensation at later stages of the contract.

Quantitative valuation of long-term contracts is possible in

case of more complicated time structure of services provided.
The more common types of complex contracts are as follows:

Payment profile

Pre-agreed contract payments by operator at time t should not

necessarily be constant in time. They may be indexed by
applying a pre-agreed index, such as fixed or variable interest
rate, a commodity price (for example, oil price), an equity
index value, the operators stock price, or any other calculable
reference rate, to amount of principal payment. This allows an
operator and service company, on a mutual agreement, create
a scenario of cash flows, which fits their specific financial
liabilities and business situation. In this case, a long-term
contract may act as a financial instrument and as security for a
series of mutual loans, beneficial for both parties. However,
this is only possible, if accurate quantitative valuation of the
contract is performed at the onset, and accurate quantitative revaluation of the contract is possible at any stage of its life, and
which takes into account financial risk factors and exchange of
risks between parties.

amortizing contract - with amount of services reducing

over time;
deferred-start or forward contract - priced at the current
date, but coming into effect at the future date;
accreting contract contract with amount of services
growing over time, a package of an initial spot contract
and a series of deferred-start contracts;
rollercoaster contract combination of the accreting
contract and amortizing contract.

Such complex contracts may come to existence at various

stages of reservoir development. Valuation of complex
contracts with flat or indexed profile of payment may be made
using the same term structure approach.

Credit risk in contract

Long-term contracts create a counterparty exposure to credit

risk on the other party to the contract. It caused by possibility
of default by the service company to provide services or an
operator to perform operations.
For contract default to take place, two factors must be present
simultaneously:
1.
2.

The counterparty must experience financial distress

At the time of default, the contract represents liability, not
asset, for defaulting party.

SPE 102874

Credit risk depends on creditworthiness of partners and the

remaining term of the contract at the time of default. The
expected loss rate from the contract is the product of two
factors:
1.
2.

Probability of default
Expected loss, if default occurs.

Probability of default from a given counterparty is a likelihood

of a given credits becoming unable to service its agreement.
Probability of default may be statistically estimated from
history of defaults in the same market by the companies of the
same credit class.
Credit risk exposure is determined by the present value of
expected loss as distributed during the life of the contract. This
yields different credit risk premiums for partners of different
credit rating.

Legislation risk in contract

Legislation, political, and environmental risks in long-term
contracts are country/area specific. Exposure to such types of
risks may be evaluated by statistical analysis of the historical
experience of events, shocks, accidents etc in the same
geographical area or the same type of the economy. Since such
exposure depends on the remaining term of the contract, the
corresponding risk premium should be allocated to a party
with higher investment in the contract at its earlier stages.

Long-term contract as tool for asset-liability

management

Long-term service contracts as over-the-counter forward style

contracts, can be tailored to the specific goals of partners and
create new risk-reward characteristics that address specific
needs of different operators and service companies.
A long-term contract, if designed and priced accordingly, can
provide new ways to control and manage exposure to various
types of risks, modify various risks on assets and liabilities
and convert one type of exposure to another, for instance,
changing the currency or price risk on a commodity or asset.
In this way, a contract becomes a useful tool for creating a
preferable risk exposure profile, for asset-liability
management and for exchange of risks between parties in a
mutually beneficial manner.
In a certain sense, a long-term contract acts as a financial
derivative. It may be used as a risk-management tool and
provide tailored solutions to risk-management problems.
Mutual commitment of parties, based on mutually beneficial
structure of contract, helps ensure that a long-term contract
evolves from a source of financial uncertainty to a source of
financial stability. This creates a win-win business situation
[3] for both operator and service company.

Conclusion

Developed commercial model for long term contract pricing

contributes to company profit maximization by intelligent
analysis of available financial, economical, and operational
data and quantified financial risk assessment.

Acknowledgement
The author is grateful to Edinburgh Business School (HeriotWatt University) for their efforts in application of Financial
Risk Management to E&P and to Saville Solver Ltd (UK) for
permission to publish this paper.

References

1.

2.
3.

P.Moles, Financial Risk Management Managing

Financial Risks with the Derivatives Product Set. Pearson
Education, 2003, ISBN 0 73-63892-0
A.N.Tikhonov, V.Ya.Arsenin. Solutions of ill-posed
problems. 1977, ISBN 0-470-99124-0
J.P. van Driel, T. Pederson, Creating Value by Improving
the Operator/Nonoperator Partner Relationship, SPE
Paper 96983-MS, 2005