July 25 2011 Oil and gas decommissioning: present problems, future solutions Ashurst LLP | Energy & Natural Resources - United Kingdom Energy & Natural Resources Decommissioning - a burden for industryLegislationProblemsSolutionsCommentDecommissioning security and costs have become key factors in oil and gas development, financing and asset trade in the more mature oil and gas basins around the world. They present a particular problem in the UK oil and gas industry, especially in the North Sea. This update considers the state of the industry on the continental shelf and outlines the legal framework for decommissioning in the United Kingdom, together with the problems that it has caused and some of the solutions that have been proposed.Decommissioning - a burden for industryFor over a decade, the main industry trend on the UK continental shelf has been a move away from larger multinationals that hold a portfolio of producing assets with long reserve tails. In their place, smaller independent companies have emerged with limited or even single-asset portfolios and rapidly maturing fields. The government has actively supported this shift.The government and industry stakeholders are concerned that some of the smaller players may not exist when the time comes to meet their decommissioning obligations. The consequences of the insolvency of Tuscan Energy in 2005 focused minds on the need to require companies with an interest in installations on the continental shelf to provide security for their decommissioning liabilities. Alongside its partner, Acorn Oil & Gas, Tuscan Energy was redeveloping the Ardmore (previously Argyll) field when it became insolvent and nearly left the UK taxpayer liable to pay its decommissioning costs.The UK continental shelf contains more than 500 oil and gas installations, 10,000 kilometres of pipeline and 10,000 wells, together representing estimated decommissioning costs of at least £25 billion. Decommissioning is taking place more slowly than was envisaged in the 1990s, as higher oil prices have meant that ageing equipment has remained in commission far beyond its originally intended shelf life. However, the effect has been to postpone the impact of an enormous burden for the industry over a period in which cost estimates have increased steeply.Legislation Primary legislation The decommissioning of UK oil and gas assets is primarily governed by Part IV of the Petroleum Act 1998 - this implemented OSPAR Decision 98/3, which was influenced by the Brent Spar platform controversy in 1995.(1) The act requires licensees to pay for offshore installations to be properly decommissioned; in most cases (including for all structures weighing less than 10,000 tonnes) it effectively mandates complete removal from the seabed.The Department for the Environment and Climate Change is responsible for ensuring compliance with the act. It has powers under Section 29 to issue notices to a wide range of parties that are associated with offshore installations on the UK continental shelf. Such notice requires the receiving parties to submit, on the department's request, a decommissioning programme for the installation that covers estimated costs, an environmental impact assessment and ongoing monitoring, while also tying in with related consent procedures under other applicable laws.OSPAR requires that re-use options be considered for platforms - for example, the Brent Spar itself and the Maureen platform were reused as quays in Norway. Other options include using platforms as wind turbine foundations. The use of rigs to form reefs - to develop sport fishing, as in the Gulf of Mexico - is prohibited by the 1992 OSPAR Convention. In theory, the department can serve notices under Section 29 on a wide range of parties in respect of an installation: not only the current licensees and operator, but also any other party that owns an interest in an installation. (The term 'interest' is not defined, but the qualification "other than as security for a loan" gives comfort to lenders.) Notices may be served on associated companies - broadly, 50% direct or indirect affiliates of companies which are liable to service of a Section 29 notice. Moreover, Section 34 of the act extends the right to issue a Section 29 notice to any party that, at any time since the first Section 29 notice for the installation was issued, would have been liable to service of such a notice; this provision catches former licensees. Thus, the net can be cast widely.Once the decommissioning programme is approved - following a departmental review of the details, including cost estimates - the Section 29 notice holders are legally obliged to implement it. As they are jointly and severally liable, any one of them can be liable for 100% of the costs; this is the position anyway under Clauses 19 and 31 of the current model licence, but the relevant joint operating agreement will apportion liabilities between joint venture partners in previously agreed proportions. If the notice holders fail to implement the programme, the department may theoretically carry out the work and invoice them.The department used to require a plan when production on a field began to decline, but at least three years before the forecast cessation of production. As today's fields are typically smaller, the department tends to require that a plan be in place at the time of approval of a final development plan.Under Section 31(5), the department has the power to withdraw Section 29 notices (eg, on ex-licensees that have sold their interest), subject to service of a Section 29 notice on any incoming licensee and consultation with other existing licensees. However, it can reissue notices that are withdrawn in this way. Thus, the risk of incurring (or reincurring) liability can never be extinguished. In other jurisdictions, there is automatic irrevocable release of liability for a party that transfers its interest in an asset.The Energy Act 2008 adjusted the Petroleum Act in two ways. First, it clarified that the department can ask for decommissioning security at any time. Previously, the department would normally serve the first Section 29 notices for a particular field within six months of commencement of production, but not before. Second, the Energy Act ensures that in the event of insolvency, security provided under decommissioning arrangements is ring-fenced from creditors of the party that provided it.The legal regime appears strict, but the politically unacceptable alternative leaves a significant risk of costs falling on the taxpayer. The department wants at least one major player potentially 'on the hook' for each field in case smaller licensees become insolvent. As a result, joint venture partners or vendors must assure themselves that smaller joint venture partners or buyers will be able to pay their proportion of decommissioning costs.Departmental guidelinesThe department published its Guidance Notes on the Decommissioning of Offshore Oil and Gas Installations and Pipelines in 2000. It has regularly updated them, most recently in 2006, 2010 and 2011. The guidelines try to provide as much flexibility as possible to licensees while remaining within the tight legislative constraints of the act: Section 3 provides guidance on the process of issuing Section 29 notices. For big fields, years may pass between service of a notice and an agreement on a decommissioning plan, whereas on new small-field developments, the department may seek an agreement before granting approval of the final development plan. The department has indicated that it regards the use of Section 34 to require security from a party that has ostensibly divested its interest in a field as a measure of last resort, although it is not legally bound to this position. Section 4 recognises that security is constraining M&A activity on the UK continental shelf, but does not accept that the government should provide a remedy. The alternative is that the department (and, ultimately, the taxpayer) could be liable for the failure of oil companies - an outcome which the department effectively states is politically unacceptable. Annex F includes details of the risk assessment methodology used by the department to decide whether to require security from a particular licensee. The department will look at both the company's and its group's share of decommissioning costs for both the specific installation and its other assets across the UK continental shelf, in each case considering the cost against net worth. Companies are then ranked by class (from Class I to Class VI), depending on the results, with increasingly stringent policies applied to each class. Annex G provides guidance in the context of decommissioning security agreements. Although the department will not usually be a party to a decommissioning security agreement, the existence of such an agreement can facilitate withdrawal of a Section 29 notice on a departed licensee if the department considers that adequate security for decommissioning costs is in place. Where only one licensee remains, the department will usually require the last departing licensee to remain a party to the decommissioning security agreement in order to police compliance. ProblemsDecommissioning liability is affecting investment in the UK continental shelf. New entrants, which tend to be smaller players, are deterred from trading or have their debt capacity constrained by the size of the decommissioning security provision required.New, smaller players often seek to exploit older fields profitably by keeping overheads low and using new drilling techniques; their business model can be undermined if much of their debt capacity is tied up with decommissioning security.Many regard the legal regime as excessive, considering the negative effect for industry to outweigh the likely sum of decommissioning costs on which (then-current) licensees will default. A relatively new body, Decom North Sea, has been formed to assist industry by facilitating cooperation between firms and promoting expertise. Three issues in particular raise concerns.Double security Vendors, venture partners or the government may want any given company to provide security, which can create conflicts or obligations to provide two (or even three) sets of security for the same decommissioning liability. This can be a substantial balance-sheet liability, particularly for smaller players, and may restrict both their borrowing capacity and moneys available for other developments or acquisitions.Double security may be an issue when a vendor demands security on the sale of an installation, even if it has been released from a Section 29 notice (due to the risk of the department reinstating the notice), or where the department demands security from a licensee on concluding its financial standing is insufficient, in each case where such security is in addition to that already required by existing licensees.The vendor double security risk cannot be easily extinguished; once off the licence, the vendor no longer has the right to wither a defaulter and take the latter's percentage interest in the field. Therefore, a vendor may require security at 150% of the estimated decommissioning costs even though the actual cost to the security provider, after taking tax relief into account, may be one-third or even less. The departmental double security risk cannot be eliminated either, as the department will not fetter its discretion to require separate security under the Petroleum Act.High or inaccurate estimates of future costs The operator's cost estimates are usually used with the operator's discount rate to determine the amount of security that must be posted at a particular time. As the decommissioning date is never definite (and is often secret, as it is price-sensitive information), the only certainty is uncertainty. The date may be affected by the changing price of oil and gas, improved recovery methods, extended use of the infrastructure (eg, the tie-back of new fields to existing platforms) and the possibility of new uses for a field, such as gas extraction or carbon dioxide storage. Uncertainty is also increased by the fact that most UK continental shelf structures are custom-built for specific conditions, so that decommissioning solutions vary widely. These factors make it difficult for industry contractors to prepare for the performance of the work (ie, for the supply chain to respond to demand), thus adding to the problems in delivering cost-effective decommissioning.Debt finance issues Smaller players are usually required to post letters of credit in respect of their decommissioning liabilities; such letters of credit must be from a bank with a sufficiently high credit rating, as a smaller market participant's own credit rating will be too low to satisfy vendors, joint venture partners or the department that a licencee's credit or a parent company guarantee is reliable. Issuing letters of credit is becoming increasingly risky for these companies and their banks, as the fields being covered are more mature or smaller; therefore, the letters of credit are likely to be capable of being called within a shorter timeframe and the size of letters of credit is increasing in line with estimated abandonment costs. These costs are typically redetermined annually. If a cost estimate increases, banks may be asked to post a letter of credit which is greater than that for which they have approval. Partial or possible solutions include: ensuring that the borrower can persuade its vendor or venture partners to assume liability for increased costs (or at least in the amount of the letter of credit to be posted by the borrower); structuring the borrowing base facility (which is the form of facility that smaller players are likely to use to raise debt) in a way that allows the amount of the letter of credit to be increased - possibly with accelerated repayment of loans - or reduced, depending on the annual redetermination; or agreeing not to reassess costs for a longer period. There are even concerns that lenders may become subject to decommissioning liabilities: on enforcement of security (rather than on the taking of security); if they have control of a borrower or are otherwise associated with it by virtue of the controls that they have under the covenant package in a facility agreement, or by the taking of equity in the borrower group; or if a royalty or similar interest gives the lender a sufficient (economic) interest in an installation. In the case of a sufficient (economic) interest, it may be possible to mitigate the impact if the lender has an interest on an income stream from a portfolio of assets rather than a single installation. The relevant intention behind the Petroleum Act seems to be to impose liability on any party that receives profits generated by an installation - an economic interest is arguably the key. The Department for Trade and Industry, a forerunner of the Department for the Environment and Climate Change, would sometimes issue comfort letters to lenders, confirming that it would not call on them. Such comfort letters are no longer used, although the department reportedly gave lenders some form of comfort in relation to the sale of Oilexco's UK subsidiary to Premier Oil after the former's insolvency. Lenders are generally comfortable because the UK oil and gas industry would be thrown into turmoil if the department called on a bank to pay decommissioning costs.Where the department is party to a decommissioning security agreement, it requires credit ratings for a letter of credit provider of AA (Standard & Poor's) or Aa2 (Moody's), which is higher than the ratings usually required in industry decommissioning security agreements (ie, AA- (Standard & Poor's) or Aa3 (Moody's)). This creates a risk that a letter of credit may need to be reissued by a different provider, as the department could theoretically insist on becoming a party to a decommissioning security agreement at any time. In addition, the downgrading of many banks since the Lehman collapse has reduced the pool of eligible lenders to which borrowers can turn.There is also a foreign exchange risk. Revenues, particularly for oil, are likely to be in US dollars, which is therefore the typical base currency in a borrower's facility agreement. However, decommissioning costs and therefore the letter of credit are likely to be in sterling. A letter of credit is periodically revalued under the facility agreement if it is not issued in the base currency.SolutionsDecommissioning security agreementsOil & Gas UK decommissioning security agreement and related documentsOil & Gas UK, the industry body for the UK offshore oil and gas industry, published a template decommissioning security agreement in 2006, in response to widespread calls and after a lengthy industry-wide consultation and drafting process. The template functions as a flexible standalone agreement. It is often negotiated along with the joint operating agreement before the department approves the final development plan for a new field, or on the next transfer of an interest in the relevant licence for an existing development. The primary aims of the template are to: mitigate the risk of a party incurring double security issues; allow a uniform approach to the question of acceptable security; and reduce negotiation costs and lost management time. In theory, standardising and clarifying decommissioning risk helps to facilitate dealings in UK continental shelf assets. The template provides for an independent person to act as a security trustee, holding security on trust for the purpose of paying for decommissioning. Decommissioning security can be contributed to the trust in cash (although this is rare in practice), or by parent company guarantee, standby letter of credit, performance bond or insurance product (although this last option remains undeveloped).A decommissioning security agreement is frequently the key document that governs decommissioning liabilities between relevant parties. Joint operating agreements rarely contain satisfactory provisions where smaller players are involved. In practice, parties to a joint operating agreement (and possibly previous licensees) will often execute a decommissioning agreement - not to be confused with a decommissioning security agreement - that regulates liabilities between them and sets out when and how to agree a plan with the department. In effect, a decommissioning security agreement may sit under a decommissioning agreement or similar arrangement.Departmental requirements for decommissioning security agreements The department has its own requirements for decommissioning security agreements, although it is unclear whether it will always insist on them, either where the department is a party to a decommissioning security agreement or where the department is merely taking the existence of a decommissioning security agreement into account when deciding whether security for a particular field is adequate. The department does not officially accept parent company guarantees as decommissioning security. Annex G of the guidelines gives a number of reasons for this, including that: enforcement can be difficult if the parent is not based in England; accepting parent company guarantees from English parents only might breach EU law; and in situations where the department might need to call on the parent company guarantee, the entire parent group may well be in financial difficulty. However, if a licensee is itself substantial, the department may not require security (ie, a parent company guarantee) from it.The department will usually be prepared to withdraw a transferring licensee's Section 29 notice if it is satisfied with the decommissioning security agreement for a particular field.Formula and cost methodology The template contains a formula which, when satisfied, triggers a requirement to post security. The formula compares the net present value of pre-tax allowance forecast decommissioning costs, usually multiplied by a risk factor, with the net present value of post-tax net cash flow expected from the remaining reserves in the field. The risk factor (or 'Y factor') is almost always 150%, although this is not mentioned in the guidelines. When the requirement is triggered, all security must be posted (or, at a minimum, the difference between the cost figure (multiplied by the risk factor) and the income figure). In any case, use of the formula should ensure that as production declines to cessation, the decommissioning security agreement becomes fully funded.Using pre-tax costs and post-tax revenues is a conservative approach. Arguments in its favour include the fact that: payments into trust funds are not generally allowable for tax purposes (although the cost of letters of credit and bonds should be); decommissioning costs are allowable for tax purposes only when incurred, at which point allowances may have changed; each licensee's tax position will vary, whereas the operator must take a neutral position; allowances may not actually be recoverable; and Annex G of the guidelines states that costs should be assessed before tax. Arguments against that approach include that expenditure should be wholly deductible for corporation tax purposes; a permitted carry-back period applies to taxable losses that are linked to decommissioning expenditure. Companies doubtless bear this advantage in mind when setting decommissioning timetables.Decommissioning security agreements do not always contain a risk factor. However, the department is not comfortable with arrangements without a risk factor where the extent of decommissioning costs is uncertain. As such an agreement comes in at the development plan stage, the risk factor is often a de facto mandatory element. The agreement may provide for the risk factor element to drop out (perhaps with the department's consent) as soon as the decommissioning plan reaches a sufficient level of certainty, although this would typically happen much later in the project and might therefore be of little value.Cost assumptions in decommissioning security agreements are usually based on the operator's estimates, including a discount rate. However, there is recourse to an independent expert in the event of a dispute. Appendix 5 to the template includes much detail on cost methodology to reduce the scope for disputes and enable the expert to do his or her job. This methodology should prove important in making cost estimates more consistent and comparable across the UK continental shelf.To date, decommissioned facilities on the UK continental shelf have primarily been small structures, in shallower waters, which are either unsuitable or not cost effective for an extension of working life. As a result, there are few precedents on which the estimate of costs required as a schedule to the template can be based. The wide variety in installations and water conditions around the continental shelf means that cost estimates vary widely.Oil and Gas UK guidance The template is accompanied by the Oil & Gas UK Guidance Notes. These guidelines contain a useful discussion of the mitigation of double security risks through a decommissioning security agreement. An installation vendor can become a so-called 'second-tier participant', regardless of whether its Section 29 notice has been withdrawn, so that it is a party to the decommissioning security agreement and can enforce it without being obliged to post security. There is even provision for third-tier participants - notwithstanding that they are not party to the template - to have limited rights under the Contracts (Rights of Third Parties) Act 1999, in a disaster scenario where they are liable for decommissioning costs.Evaluating the templateThe template has been a success, as far as it goes. It has been widely adopted, saving negotiation time and costs, and the use of its standard cost methodology will benefit the whole UK continental shelf industry. It is frequently used in transactions as an advanced starting point, with amendments to make it consistent with the corresponding parts of the joint operating agreement (eg, cross-provisions for default, transfer and withdrawal, and general consistency with the expert and boilerplate provisions and general timings of activities). The template is also widely used to negotiate the form of letters of credit, performance bonds and parent company guarantees.The template may be significantly amended: to enable it to take the form of a supplemental deed to the joint operating agreement, rather than a standalone document, or to amend the joint operating agreement to remove its decommissioning provisions, thereby avoiding overlap and inconsistency; and where the parties later decide to recut a field as a storage facility and have it relicensed as such, because the creation of the storage reservoir affects the full implementation of the originally envisaged decommissioning plan. Such a storage decision tends to be made only at the end of field life, whereas a decommissioning security agreement is usually agreed at the development plan stage. Therefore, in some cases the agreement may need to be future-proofed to cater for a switch to gas storage (or even carbon dioxide injection). Other solutions Although there is no single solution that would reduce or eliminate the risk of decommissioning liability affecting trading and development on the UK continental shelf, several ideas have been floated, in addition to widespread take-up of the template and its cost methodology: Licensees usually obtain corporation tax relief to offset against decommissioning costs; thus, a proportion of such costs can be offset in practice. Relief can be up to 75% for installations in fields on which petroleum revenue tax is paid, or up to 50% for other installations. The recent tax rises to 81% and 62%, respectively, were accompanied by restriction on the amount of relief available for decommissioning costs, which excluded the same marginal tax rises. However, after a set time previous owners of an installation lose the right to claim relief (assuming that the department had ever required them to pay costs). An extension of the rules could result in industry players becoming more relaxed on the level of security required from incoming licensees. Oil & Gas UK frequently lobbies the department on this point, but has had little success so far. This is probably the biggest partial solution, as clarity could reduce - by at least half - the security demanded by vendors if they are confident that they can claim tax relief in the event of a disaster. The government could turn to previous owners to recover decommissioning costs in reverse chronological order, allowing distant previous owners a degree of confidence as to the risk of being made liable, and could claim for decommissioning costs only on an after-tax basis. However, neither of these measures is likely to be adopted in the United Kingdom soon. Vendors could sell their interest in a field to a small player while retaining liability for decommissioning; the vendor would realise increased consideration at the date of sale and would free up management time. A handful of such arrangements have been implemented on the UK continental shelf. Nevertheless, some players are reluctant to enter into such an arrangement again, fearing the loss of control over a serious liability for which they are ultimately responsible. The fallout from the Macondo well disaster will increase such reservations. Independent companies could cooperate to decommission several structures at once to save costs. Such campaign decommissioning would be similar to the practice of hiring a rig for different drilling campaigns. However, the difficulties in knowing when a particular structure will be taken down makes this option difficult to implement in practice, despite support from Decom North Sea. The use of a sinking fund would require all licensees to pay cash periodically throughout the life of the field in order to cover eventual decommissioning costs, so that letters of credit or other security would not be required. Unfortunately, under this system there is no eligibility for tax relief until decommissioning costs are incurred; Oil & Gas UK is lobbying the government on this point. Although a tax exemption for decommissioning projects has been discussed, it is yet to materialise. In any case, using cash in this way is unattractive and the plan is unlikely to take hold. CommentNotwithstanding the tough legislative framework for decommissioning in the United Kingdom, asset development is continuing at high levels - at present it is hampered more by headline tax rates than by the prospect of decommissioning costs. Such development is encouraged by high oil and gas prices and, in part, by the fact that the template enables some participants to take a less conservative stance on the risk of incurring liability for decommissioning costs. A combination of partial solutions may enable sufficient UK continental shelf activity to ensure that the amount of oil and gas left in the ground is kept to a minimum. However, the government and industry players will have to do more in future to ensure that decommissioning does not become a decisive factor in the development or enhancement of oil and gas assets in the UK continental shelf. Although the UK approach is politically attractive, other governments should be wary of copying it. For further information on this topic please contact Nicholas Ross-McCall at Ashurst LLP by telephone (+44 20 7638 1111), fax (+44 20 7638 1112) or email ([email protected]).Endnotes(1) Other international, regional and national legislation also applies, but is beyond the scope of this update.