Small independent E&Ps operating in the Gulf of Mexico’s Outer Continental Shelf are struggling to find their sea legs as they cope with volatile commodity prices, and new regulations regarding decommissioning of offshore facilities could take them out at the knees. The Notice to Lessees (NTL), “NTL 2016-NO1, Requiring Additional Security,” was released by the Bureau of Ocean Energy Management (BOEM) in September. It was crafted to protect U.S. taxpayers from any financial burden arising from offshore operators’ potential inability to fund the decommissioning of offshore oil and gas platforms, subsea wells and associated assets—but exposes operators to more stringent financial requirements than ever before.
Some E&Ps say the bonding requirements are prohibitive. Fieldwood Energy LLC, Talos Energy LLC, Energy XXI and Arena Energy LP formed Gulf Energy Alliance, a coalition aimed at supporting policies that protect, assist and encourage the offshore industry. The coalition is working with regulators on the subject of the NTL.
This new rule, effective as of September 2016, could put offshore operators out of commission themselves, as companies are now required to guarantee 100% of future decommissioning costs for oil and gas properties in which they have a working interest, through surety bonds or other forms of collateral.
“The financial bonding requirements, the regulations—all that comes at a cost,” said Jim Wicklund, managing director, Credit Suisse. Over the past four years, activity in the Gulf has dropped by more than 90% in shallow water, he added. “We’ve never had spending down for more than two years in a row in the industry, ever,” but in offshore, “this will be the third year.”
Despite the drop in activity and rigs, the last few years provided amenable bonding conditions to E&Ps. Under the former policies, “if BOEM determined that one or more co-lessees or co-owners had sufficient financial strength and reliability, it was not necessary to provide additional security,” the BOEM reported in September. E&P companies were exempt from the supplemental bonding requirements as long as their tangible net worth exceeded $65 million and was twice the amount of their estimated Plugging & Abandonment (P&A) liabilities, according to the Opportune report, “A Cost-Benefit Analysis of the BOEM NTL on OCS Bonding.”
Overall, this swift elimination of exemptions has left operators, consultants and analysts reeling. The BOEM and Bureau of Safety and Environmental Enforcement (BSEE), which is responsible for generating the liability assessments, maintain that this measure will safeguard taxpayers, but operators continue to question the degree of risk. Is this P&A paranoia, a minor overreaction or a practical response?
“There’s always some risk; you can never eliminate the risk completely,” said Josh Sherman, partner at Opportune and one of the writers of the firm’s report on decommissioning. Yet “over 80 years of offshore operations and drilling in the Gulf, there has been only one case in which the taxpayer has arguably had to pay for P&A liabilities,” and that liability was paid out of future revenues from those assets. “It didn’t come out of the taxpayer’s pocket.”
How big could the problem be?
According to IHS Markit’s “Offshore Decommissioning Study Report,” the Gulf of Mexico ranks as the largest region in the world when it comes to the number of platforms decommissioned, with approximately 4,000 plugged and abandoned so far. It currently has more than 5,000 oil and gas structures in place. Historical costs for decommissioning facilities in the area “have been in the $500,000 to $4 million range for shallow-water structures.”
Opportune pegs the net present value of the liability of all OCS leases’ P&A costs at roughly $23.8 billion, and $589 million has already been posted in bonds. Majors and large independents (companies with more than $4 billion in net worth, in Opportune’s study) are part of the current or previous chain-of-title in almost every case. “Uncovered properties,” in which they are not included in the chain-of-title, only make up $1.4 billion—meaning that the uncovered risk to the taxpayer is $829 million.
The NTL demands that small independents obtain supplemental bonding to the tune of $2.2 billion, the report said, an untenable amount. “My view is that it takes the small independents from the hospital to hospice,” Sherman said.
The metrics the BSEE implements to calculate decommissioning costs have been routinely called into question due to their lack of consistency. While individual E&Ps now provide their internal costs of decommissioning to the BSEE, “the estimated costs of decommissioning that BSEE has started to release do not reflect reality,” said Randall Luthi, president of the National Ocean Industries Association (NOIA). In some cases, operators claimed the BSEE came up with costs that were two to three times greater than what the operators calculated, Sherman said. How can the P&A costs go up, he asked, when rig costs have decreased since 2014 by 50%?
In part, the inflated calculations could result from the government contracting out the decommissioning work, but that is unlikely to account for the total increase.
“I’m sure that will continue to be a knife fight,” Wicklund said. “The industry will argue that the metrics aren’t practical, and the government will continue to say that’s the way they’re calculating it until someone shows them a better way.”
The BOEM has acknowledged challenges in obtaining the most up to date and accurate decommissioning data from the Bureau of Safety and Environmental Enforcement (BSEE). This data—the cost of decommissioning wells and offshore rigs—is what determines what E&Ps are actually liable for. Due to disputed decommissioning costs and very slow turnaround times to document any changes that are agreed upon, BOEM and E&P companies have concerns about “BOEM’s ability to obtain valid data from BSEE’s data system.” BOEM has also acknowledged that its methodology to judge the “financial strength” of lessees, which it uses to determine how much each E&P company is allowed to self-insure rather than post cash or obtain other financial assurances, is not perfect. “These regulators have never had to judge the financial strength of E&P companies in the past.” said Ryan Scott, senior policy director, HBW Resources LLC, a consulting firm.
Moreover, the BOEM is requiring all decommissioning liabilities to be “financially assured” through cash, bonds, etc., within a year. In other words, BOEM is preparing as if all of the platforms, subsea wells and related assets currently in the Gulf would be decommissioned all at once, immediately, a situation which is “extremely unlikely to come to fruition,” according to Jack Belcher, executive vice president, HBW Resources. Realistically, it could be decades before decommissioning occurs. “A lot of it depends on where you are in the process,” Luthi said. “If this is the first well drilled in what is likely to be a multi-well field development, it could be 40 to 50 years before decommissioning commences.”
While the BOEM promotes the NTL as a device to keep taxpayers safe from the ramifications of offshore E&P bankruptcies, it “could potentially cause the very thing that it’s trying to hedge against,” said Belcher.
A sure thing?
The NTL may provoke restructurings, with individual companies facing varying levels of risk. “The biggest determinant depends on the strength of the company’s balance sheet,” Belcher said. Surety bonds aren’t a sure thing for all.
Only some potential customers have access to capital. “Could [surety companies] provide the bonding? The answer is yes,” Wicklund said. “Are they willing to?”
Analysts at Opportune found that “third-party insurers and recent industry examples” indicate that the surety bond market lacks the capacity to absorb the additional bonding requirements, according to the report. Very few small independents possess the investment-grade credit rating, or any credit rating, to qualify for a bond, Sherman said. “There’s additional collateral that the company will have to put up to get those bonds,” Sherman elaborated. “That additional collateral is about 1%-3% of the actual bond cost.
“One side-point is that many of the wholly-owned subsidiaries of the majors don’t have a stand-alone credit rating or audited financial statements and, thus, can’t qualify for self-insurance,” Sherman said. Consequently, some majors and large independents have to post collateral as well, “further reducing returns in a strained economic and operating environment.”
However, at a recent offshore financial workshop co-hosted by NOIA, “the surety companies were very confident that they had sufficient capacity for adequate coverage,” Luthi said. “The E&P companies themselves are not completely convinced of that at this time.”
Some alternatives exist for the small independent operator, but again, there’s the question of access. More than $107 billion of private equity has been raised over the last couple of years specifically for the oil and gas industry, Wicklund pointed out. “If the returns were high enough, private equity would be a source of capital.” Offshore poses a challenge, though, as the costs of drilling and production have risen to rival the costs of oil sands in Canada, he said.
There are several levers for individual companies to consider aside from private equity backers or firms, Sherman said. These include whether the company has liquidity available in its borrowing base, whether the bond market has the appetite to purchase second-lien debt, and whether current secured lenders are willing to convert some of that debt into equity.
Some small independents find themselves in a precarious position due to this “game-changer,” Belcher said. The NTL “functions as an attack that directly limits companies’ ability to produce,” threatening their very existence.
Finding a fit
There is one shred of hope for E&Ps treading water. One aspect of the NTL could potentially allow for exemptions. BOEM is open to companies and regulators cooperating to create “a tailored plan to meet your additional security requirement,” the NTL states. But the offshore industry isn’t jumping for joy just yet.
“This is one of the positives of the NTL,” Luthi said. But uncertainty prevails. “What we don’t know is how these are working because it’s still relatively new in the process. Most companies that have submitted their plans are still awaiting approval.”
Wicklund is cautious as well. “So far, the regulators haven’t adhered to that really at all in terms of the deep water,” Wicklund said. “I don’t get any indication that if they haven’t done it before, that they’re going to start doing it now because it’s a shallower or different customer base.”
The effects of this tailored plan triage remain to be seen, but Sherman anticipates that it will take more than one company’s success to turn the tide. He referenced one company at a recent workshop said the BOEM disagreed with them over the decommissioning cost estimate. The ultimate outcome of the conversation, according to the operator, was that, “You’re only one company. If everyone feels the same way, we’ll revise it.”
If the NTL remains in effect, and individual companies’ tailored plans aren’t approved, small independent offshore operators could be in crisis. In that case, “we estimate $2 billion of capital that small independents will not be able to ever deploy to drill wells,” he said. Wicklund foresees a hole in the production cycle in three to four years.
That hole the NTL dug will have far-reaching consequences. “This may still be a solution looking for a problem,” as Luthi put it, and implementation of the NTL as written will not only diminish future production; it will reduce future U.S. royalty revenue. According to the Opportune report, their most probable outcome scenario estimates that “approximately $9 billion of future OCS development…will not occur over the next 10 years as a result of the NTL.” In addition, a total of $4.6 billion will be lost in royalties, and “total and direct costs of the NTL to the taxpayer are estimated to be approximately $14.6 billion.”
The U.S. taxpayer may not be at real risk, but small independent operators in the OCS certainly are, if the NTL holds and operators must come up with more capital.