It's time to make offshore operations great again
During the presidential campaign, the current administration promised to "Drain the Swamp" - shorthand for cutting federal bureaucracy. Candidate, now President, Trump also promised to be more friendly to the traditional energy industry and has nominated cabinet members, undergoing confirmation hearings at the time of this writing, who give every indication of at least understanding the traditional energy industry and its significance to the country. Certainly his January pronouncements on the Keystone and Dakota pipeline are encouraging.
In its waning months, the outgoing administration unleashed a tidal wave of federal regulations, much of which is aimed at energy. For the offshore segment of the energy industry, part of that effort is an announced intention to change the way that the Bureau of Energy Management (BOEM) will calculate the amount of third-party bonding it will require as a condition of allowing companies operating in waters over the Outer Continental Shelf (OCS) to continue to own and operate their leases, platforms, pipelines and rights of way, easements and rights of use agreements. A good place to start draining the regulatory swamp might be this new procedure.
"Rulemaking" by federal agencies normally starts with a Notice of Proposed Rulemaking, which is published in the Federal Register, inviting "comments," and then holding public hearings if necessary. However, where agencies such as BOEM want to "clarify" their rules, they have wide latitude to do so. On September 12, 2016, BOEM issued NTL No. 2016-N01, "Requiring Additional Security." That NTL provides that:
- Lessees will no longer be granted waivers, but may be eligible for self-insurance to meet some or all of their supplemental bond obligations.
- Lessees may be eligible for self-insurance regardless of their net worth. Waivers were available for those with a decommissioning liability up to 50% of their net worth, but self-insurance will not exceed 10% of tangible net worth.
- BOEM will no longer waive bonds automatically based on the combined financial strength and reliability of co-lessees or operating rights holders, but will permit lessees qualifying for self-insurance to share it with co-lessees and operating rights holders.
- The minimum credit rating that a party must have to be allowed to apply its self-insurance to sole liability properties will be A3 (Moody's) or A - (Standard and Poor's).
- There will be a phase-in period to comply with these revised financial assurance requirements. We are implementing a strategy of dealing with the highest-risk properties first (e.g. sole liability properties as defined in the NTL), and we are working with industry to prioritize their properties.
- BOEM may consider alternative forms of financial assurance to provide additional flexibility for lessees to meet their additional security requirements. This will allow companies to create a tailored financial assurance plan that best meets their needs while ensuring their OCS liabilities are adequately covered.
Then, in December 2016, BOEM issued Orders to Provide Additional Security for sole liability properties, i.e., properties for which there were no other working interest owners or predecessors in title (Sole Liability Orders). This focused on an area of regulatory concern because if that owner/operator failed after having commenced operations and without sufficient bonding, there would be no other party to look to for remediation.
On January 6, 2017, BOEM announced a six-month delay or extension in the application of the new NTL-2016 standards. This was followed on February 17, 2017, by a notice that the Sole Liability Orders were being withdrawn.
At least one commentator described NTL-2016 as a "regulatory solution looking for a problem." The perceived problem is a $40 billion unfunded liability to perform plugging, abandonment, and decommissioning work in the Gulf of Mexico (GOM) once oil and gas production from existing leases is finished. Several trade groups have jointly filed a Freedom of Information (FOIA) request to see what data BOEM relied on in its estimate. To date, no final response has been issued, but BOEM has blamed its lack of response on the Bureau of Safety and Environmental Enforcement (BSEE) in its preliminary response to the FOIA requests. The bitter irony here is that until a few years ago, BOEM and BSEE didn't exist, having been created (along with Office of Natural Resources Revenue) post Macondo out of the Minerals Management Services, which on paper at least appeared conflicted. Additionally, a coalition of offshore energy companies has been working with BOEM to discuss and perhaps refine its approach.
As best as anyone can tell, the $40 billion amount appears to be sourced in a US Government Accountability Office (GAO) report. In December 2015, the GAO issued a report titled "Actions Needed to Better Protect Against Billions of Dollars in Federal Exposure to Decommissioning Liabilities." That report stated in summary:
As of October 2015, for an estimated $38.2 billion in decommissioning liabilities in the Gulf, Interior officials identified about $2.3 billion in liabilities that may not be covered by financial assurances. However, these officials were unable to determine the extent to which these data were valid due to limitations with Interior's data system, among other things. Of the remaining $35.9 billion in decommissioning liabilities, Interior held or required about $2.9 billion in bonds and other financial assurances, and had foregone requiring about $33.0 billion in bonds for the remaining liabilities.
In other words, the GAO was pointing out that BOEM's policy of waiving bonding requirements for large, financially stable companies operating in the GOM left it exposed for the "unfunded" portion of future expenditures. The result was NTL-2016.
And here's why it has been described as a solution looking for a problem: Despite all the recent bankruptcies of offshore operators, the government has not had to spend any of its (i.e., our) money to perform plugging and abandonment (P&A) or decommissioning work. The reasons are explained below, but keep that fact in mind as you think about the effect that NTL2016 and the increased bonding requirements have had, and will have, on the industry.
To be clear, the NTL will not affect the majors in any significant way. Companies with sufficient equity and market capitalization may self-insure or be granted "limited" waivers, subject to redetermination. But the NTL will affect independent oil and gas companies. Significantly, negatively, and here's the worst part, without a real benefit to the government, the environment, the industry, or the consumer. There are a number of things wrong with the NTL.
For starters, the GAO report itself shows that the vast majority of the unfunded liability is attributable to companies that BOEM has determined to be financially sound, even in the depth of the last oil market crash. Next, the data supplied to the GAO by BOEM may not rest on sound empirical data. That data appears to have been based on decommissioning costs calculated when oil was at a much higher price and service providers priced their services less attractively than the current market. If so, then the cost of those services would be significantly overstated. And third, BSEE freely acknowledges that in recent years it has not had to come out of pocket to actually perform P&A or decommissioning work. That's because it almost always has co-interest owners or predecessors in title to look to, or bonds. That raises a bankruptcy related issue, discussed below.
Even before NTL-2016, BOEM was rightly concerned about the viability of operators in the GOM. Because of plummeting oil and gas prices, BOEM redetermined the amount of bonding it would require from existing operators in the Gulf. Based on then recent price drops and fresh reserve reports, BOEM issued a number of notices to individual lessees seeking, in some instances, hundreds of millions of dollars of additional bonding and a short timeline in which to post the increased security. The increased bonding requirements can cause a cascade of defaults under a company's loan agreements driving it into bankruptcy.
Here are just a few examples of companies that filed Chapter 11 or launched major restructurings soon after being hit with redetermination letters. In April 2015, Energy XXI Ltd. (EXXI) received letters from BOEM notifying certain of its subsidiaries that they no longer qualified as exempt from bonding and would need to post (cumulatively) $1 billion in additional bonds. Six months later, BOEM notified EXXI that additional bonds, over and above the $1B previously requested, would be needed. In June 2015, EXXI sold off one of the fields giving rise to part of the $1 billion additional liability, posted some additional bonding, and began discussions with BOEM to address the still substantial shortfall. In early 2016, EXXI entered into a "Long Term Plan" with BOEM to address that shortfall. On April 14, 2016, EXXI entered into a Restructure Support Agreement (RSA) with its major creditor groups and then filed Chapter 11 the same day. NTL-2016 was issued in July, further complicating EXXI's efforts. Nonetheless, EXXI's Plan or Reorganization was confirmed and its exit from bankruptcy occurred in December 2016, and adopted the Long Term Plan entered into with BOEM in February of last year, subject to increase or change pursuant to the Department of Interior's discretion, including any NTL's issued by BOEM.
Similarly, Stone Energy was notified by BOEM in March 2016 that it would require additional bonding for Stone to maintain its GOM leases. In late March 2016, representatives of Stone met with representatives of the Bureau of Ocean Energy Management (BOEM) and proposed a tailored plan for financial assurances relating to abandonment obligations, whereby it proposed posting incremental surety bonds. In May 2016, in recognition of the tailored plan and ongoing restructuring efforts, BOEM rescinded its demand for additional bonding, subject to ongoing review.
While it was in discussions with BOEM, Stone's banks notified it in April 2016 that its borrowing base had been redetermined (presumably based on fresh reserve reports) and that Stone's liquidity would be reduced by $200 million. Restructuring efforts began in earnest. Stone spent most of 2016 in an unsuccessful attempt to sell its Marcellus and Utica assets and a successful effort to negotiate an RSA with its bondholders. Ultimately, it filed Chapter 11 to implement the RSA and filed a prepacked plan of reorganization, which included a sale of the non-core assets that it had marketed earlier.
W&T Offshore Inc. was notified by BOEM in December 2015 that it was no longer exempt under BOEM guidelines. In the first quarter on 2016, W&T received several orders from BOEM directing it to post security for its obligations in an amount in excess of $260 million. W&T appealed and received several extensions of the deadlines set by BOEM. During those extensions it entered into discussions with BOEM about the terms of a tailored plan as had EXXI and Stone, and such plan remains under discussion.
Thus, in all three cases, BOEM and the operators have been able to work, or are working, cooperatively. In at least one case, the operator had to file numerous administrative appeals seeking "stays of execution." It is that scenario that worries industry.
BOEM is right to be concerned about weak operators in the Gulf for a variety of reasons. But precipitous commodity price fluctuations causing major dislocation in the markets will only be compounded by sudden demands for increased bonding. Where such demands themselves trigger liquidity based covenant defaults under loan agreements or trust indentures, a "flat spin" or death spiral can be caused inadvertently. Energy lenders understand that regardless of the terms of their security documents, they will not have access to the proceeds of their collateral or the collateral itself without provisions being made for remediation. Those situations can and should be avoided at all costs, and cooperation is the key. As shown by the case studies just discussed, even before NTL 2016, BOEM showed reasonable restraint and was able to work out "tailored plans" as a reasonable compromise. But the NTL, as written, doesn't require such cooperation, leaving operators to the tender mercies of the administrative appellate process.
The bigger problem is what happens when an operator or producer facing increased bonding and a host of other financial problems files for Chapter 11, or Chapter 7 liquidation, and ends up abandoning its leases. The "abandonment" scenario occurs where the risk adjusted present value of the leases, net of bonding requirements, makes the property economically unviable. This is much more common problem for small onshore leases, but it does happen in the Gulf. In fact, two notable Houston cases, ATP Oil & Gas Corp. and Black Elk Energy Offshore Operations LLC, saw OCS leases that had been producing even in the bankruptcy cases shut in, sales of some or all of the leases not materialize, ultimately followed by lease terminations by BOEM, and unfunded P&A obligations.
In both cases, operator bonding was woefully short. In both cases, BOEM exerted significant influence. Yet, in both cases, environmental obligations are being met, and the government hasn't expended one thin dime because it demanded that coowners and predecessors in title step up to do the work. BOEM was within its rights to make those demands. But it rewarded the debtors, and punished the responsible owners, through its conduct in the bankruptcy case. So while the gist of this article is for fewer regulations, here's a suggestion for an additional regulation, and an explanation of why it's needed:
Require BOEM to assign its administrative claim in bankruptcy cases to responsible parties who fund or perform the debtor's P&A and decommissioning obligations.
This is necessary because while the law is clear that the government has the highest priority administrative expense claim under the bankruptcy code for amounts relating to enforcing health and safety requirements, there is no such statutory provision granting the same high priority claim to responsible parties who undertake, willingly or not, the decommissioning obligations. There is some case law which should be read to provide that treatment, but at least one influential court has held to the contrary. However, looking primarily to tax cases, there is stronger case law allowing for assignment of a governmental priority claim against the debtor to another creditor which undertakes such tax obligations by agreement with the relevant governmental agency. Of course, the easier fix would be to clarify the statute. But since Congress likes dealing with bankruptcy problems nearly as much as oil company credit departments do, no one should hold their breath waiting for that to happen. Instead, the suggestion is for the creation of a simple and common sense rule that if the government calls on a party to undertake an obligation for which the government would have an administrative expense priority, and that party does the work or pays for the work to be done, it should receive an assignment of the priority claim that the government would have had if the government had expended the money. Service providers would argue for the status quo and would say that predecessors should be liable they sell to weak buyers and that giving those sellers a priority claim would unfairly penalize the vendors.
One final note. While the President is looking for inefficiencies and overlap, he may come across the regulatory morass governing the offshore business. In 2009, i.e., pre-Macondo, the American Petroleum Institute (API) estimated that there were 27 "principal" statutory authorities that apply directly to OCS oil and gas operations, and that there were 88 CFR parts implementing these statutory authorities. It also estimated that that there were 24 "significant" approvals and permits applicable to OCS oil and gas operations. Additionally, API noted that its study did not include broad-based regulations applicable to all commercial enterprises, nor did it count federal statutes or regulations concerning the Coastal Zone generally.
Finally, API's study focused only on federal regulations, and cautioned about the existence of "various state-related approvals." In other words, there were a bunch of other laws, rules, regs, and permits that might trip you up, in addition to the major ones. And that was eight years ago, again pre-Macondo. Another commentator estimated that there were at least a dozen federal agencies that had jurisdiction or review authority over OCS operations, and that too was before Macondo.
The purpose of this article is not to detract from the important work that BOEM, BSEE, the Coast Guard and other federal agencies do. In fact, BOEM's prompt, thorough, and candid responses to my informal requests for information were enormously helpful in rounding out the research necessary for this article. Same goes for API and members of one of the industry groups. But anyone who has worked in business, or represented businesses (and I've done both), knows that too much supervision of workers and processes leads to inefficiencies and confusion.
It will take people smarter than this opinionated lawyer to thresh the regulatory wheat from the chaff, but it must be done. At least some of those smarter people are already at work. One industry group is working cooperatively with BSEE to suggest streamlined procedures. That same group is noodling the possibility of an industry coalition to actually fund and carry out emergency plugging, abandoning and decommissioning activities in those relatively rare circumstances where the operator fails and there are no solvent co-owners or predecessors in title.
There are many other good ideas which are being explored and others to be explored. Those ideas will simplify procedures, improve the US' already good safety and environmental record and make offshore operations more efficient. In short, it's time to make offshore operations great again.