New supplemental collateral requirements could severely damage independent Gulf of Mexico drillers, producers – Part 2

On Sept. 12, 2016, the federal government initiated big changes to its bonding requirements for the financial liability for decommissioning oil and gas assets on the U.S. outer continental shelf (OCS).

The new requirements are game-changing, according to some experts who predict that the new requirements will drastically cut production from the OCS, send many OCS operators into bankruptcy and will cause a virtual end to the aftermarket for OCS leases.

The Department of Interior’s Bureau of Ocean Energy Management (BOEM) is requiring cash, supplemental bonding and/or other collateral of all the operators and leaseholders on the OCS, with opportunities for companies who can pass a rigorous financial screen proving they have the financial wherewithal to self-insure.

Last week’s significant rule change came in the form of a Notice to Lessees and Operators—known in the industry as an “NTL.” The NTL in question is called “NTL 2016-N01 – ‘Requiring Additional Security’.” The new NTL discontinues the prior supplemental bonding rules that were set by NTL 2008-N07. NTLs are a mechanism that BOEM uses to modify rules on the fly, without going through arduous rulemaking procedures required by the Administrative Procedures Act.

NTL 2016-N01: Risk sharing and waivers are gone

Experts Predict Trouble Ahead for Gulf of Mexico Oil & Gas Operators

The decades-old old practice of issuing waivers to OCS operators partnering in a lease with financially strong co-lessees or co-owners who could cover the decom costs has been replaced under the new rules of NTL 2016-N01 by a self-insurance requirement that requires a rigorous demonstration of every partner’s financial strength.

“You are responsible for ensuring that all obligations, including decommissioning and abandonment, are satisfied for every lease, right-of-way and right-of-use-and-easement in which you have an ownership interest,” the new NTL reads.

These new security requirements for operators and leaseholders involved in both shallow and deepwater oil and gas operations on federal OCS leases use a recently updated cost structure for decommissioning. Costs used to calculate decom liability for leases will go from largely 1990s-era pricing to today’s price levels.

As BOEM reviews each company’s OCS leaseholds applying the new cost structure, it will make a determination as to how much additional security is required of operators and leaseholders.

BOEM will notify operators to pay cash, prove their ability to self-insure each lease, ROW or RUE in which they have an interest up to a maximum of 10% of a company’s tangible net worth (lowered from the previous level of 50%), or submit a tailored plan of compliance that meets BOEM’s prescribed format and timeline.

Acceptable forms of additional security

In the new NTL, BOEM outlines the acceptable forms of security as:

  • Surety bonds
  • Pledge of U.S. Treasury Securities
  • Tailored Financial Plan –  Abandonment Accounts, Third-Party Guarantees, another form of security approved by the regional director, a combination of security methods in this section

Operators have 30 days to dispute any aspect of the regional director’s proposed amount of additional security in writing and request a meeting with BOEM concerning the dispute. After meetings and negotiations are over, BOEM will issue an order to provide additional security or provide a tailored plan (applies to jointly owned leases/assets).

“After you receive an order to provide additional security, with or without a preceding proposal and meeting, you must provide the additional security required for your sole liability properties within 60 days of receipt of the order,” the NTL says.  “You must also provide the remainder of the additional security required (i.e. that additional security required on properties other than sole liability properties) within 120 days… .”

“If BOEM cannot approve your tailored plan within 180 days of its submission, BOEM may require you to provide the full amount of the required additional security within 30 days of the date on which this 180-day period ends,” the NTL says.

To gain a perspective on the effects this new supplemental security requirement could have on the operators and lessees in the OCS, with a focus on the NTL’s effect on operators and leaseholders in the Gulf of Mexico, Oil & Gas 360® spoke with two long-time experts in the field of oil and gas leasing, drilling, production and the related regulations governing the industry.

Experts predict trouble ahead for Gulf of Mexico Oil and Gas Operators

Robert Thibault, Haynes and Boone

Robert Thibault is an attorney with Haynes and Boone who represents energy companies involved in technical energy disputes including work with the relevant administrative and regulatory environment. Thibault was a senior attorney for Texaco Inc., representing Texaco in complex litigation, arbitration and mediation, before federal and state courts of all levels and before administrative agencies, including the Bureau of Ocean Energy Management, Regulation and Enforcement, formerly the Minerals Management Service of the Department of Interior, the Federal Energy Regulatory Commission (FERC) and the Texas Railroad Commission. Thibault has a J.D. from the University of Texas at Austin School of Law.

Experts Predict Trouble Ahead for Gulf of Mexico Oil & Gas Operators

Eric Smith, Tulane Energy Institute

Eric Smith is Professor of Practice at the A.B. Freeman School of Business at Tulane University and Associate Director of the Tulane Energy Institute. In addition to twelve years of full time academic/advisory experience, he has thirty six years of operational experience in the downstream petrochemical industry and in the offshore drilling and construction sectors. Smith has a degree in chemical engineering from Georgia Tech and an MBA from Tulane University.

Exclusive Interview with Robert Thibault and Eric Smith

OAG 360:  When you look at the new supplemental bonding requirements required by the Bureau of Ocean Energy Management (BOEM) that the agency issued in NTL 2016-N01, who is going to be impacted by these changes?

Robert Thibault:  The simple answer is everyone.  The most immediate and obvious impact will be on mid-sized and small lessees and operators who will have to deal with the demand to post, in a very short time, security that covers vastly increased dollar amounts of liabilities.  In the end though, everyone is going to face less-obvious, but extremely important and powerful impacts – including the largest industry players and the federal government and U.S. taxpayers.

Eric Smith:  There is a hidden cloud over everyone’s head in this new bonding regime. There is a risk of reducing the size of federal offshore production. By driving existing players out of the business, shutting in existing production and by decimating the aftermarket buyers—the companies who would otherwise extend the productive life of mature leases by acquiring them and continuing to produce from the assets.

OAG 360:  How will the government’s new financial requirements impact the oil and gas companies today who are operating platforms, bidding for federal OCS leases, acquiring drilling blocks and infrastructure from other oil and gas companies, and the companies that are drilling and producing oil and gas from federal leases on the U.S. outer continental shelf today?

RT:  Every aspect of life for an independent is governed by the current economic environment of low commodity prices and the ongoing bank lending base redeterminations.

It comes down to mid-size independents who have sufficient financial strength to qualify for self-insurance and those who cannot.  Those who can’t qualify to self-insure will have the hardest time meeting the BOEM’s new bonding/security demands. It will likely be beyond the reach of some of these players.

We have to understand that the bonding industry has dramatically changed to the point where it is even questionable as a source of security.  Those players with the financial staying capacity will present what the BOEM calls “tailored plans” that BOEM deems acceptable as an alternative to outright bonding.  The successful plans will likely require coordination with other financial players.

ES:  As a simple economic fact, there is not sufficient capacity in the entire bonding industry to issue the bonds needed to cover the current cumulative P&A and Decommissioning liabilities that BOEM has estimated at $40 billion. Added to that, only bonding companies that have been approved and certified by the U.S. Treasury Department are acceptable to issue bonds to BOEM, and the number of certified bonding companies willing to work in the oil and gas sector has substantially decreased to a literal handful.

The overall impact of these structural issues is that companies currently offering bonding services are largely requiring virtually 100% cash collateral for the face value of the bond. That is to say that a $1,000,000 bond now requires $1,000,000 in cash or cash equivalent collateral. As an alternative, companies can post the required cash collateral immediately or, depending on the goodwill of the government, gradually increase the collateral pool until the total amount required has been provided.

OAG 360:  How will the new higher collateral requirements affect the largest offshore players—the majors and supermajors?

RT:  While we can presume that the supermajors and the majors will easily qualify for self-insurance, they will need to go through the filing process and the public disclosures that may entail.  More substantively, public companies of every size need to confirm the adequacy and accuracy of their corporate and SEC filings. some of them will be impacted by the immediate need to make good on the plugging and abandoning and decommissioning costs on legacy properties that are now being held by operators who are not going to survive the bonding demands and whose assets, after the predictable bankruptcies, do not cover these costs.

ES:  Supermajors and majors will be impacted by the constriction in the aftermarket when the pool of smaller company buyers shrinks. There will be fewer potential buyers with less financial resources available for their offered prices.  Thus, in the end, it may be the supermajors and majors who face the steepest re-alignment of their current economic models. The so called legacy liabilities of the majors may actually be reduced as the new collateral demands on independents take effect.   However, a more likely result is that legacy liability will remain as a “last ditch” source of funding for P&A liabilities, particularly those incurred by now bankrupt independents.

OAG 360:  Will the new requirements in any way affect the oilfield service companies who service platforms and support the E&P activity in the Gulf of Mexico?

ES:  Let’s not kid ourselves, the most immediate impact will be that every incremental dollar taken to satisfy the bonding will come directly from operations budgets supporting investment to drill new exploratory wells or to further develop and maintain existing production – all work done primarily by the service companies.   Without a doubt, the decrease in drilling and production activity will remove work from the service companies.  Sure, there will be some amount of positive offset for those companies who actually do the decommissioning work itself – plugging and abandoning wells, removing and dismantling platforms and reconditioning the subsea topography – if and when the companies actually engage in the work, as opposed to merely providing bonding for it.

RT:  The degree of offset to the loss of drilling and production work will be dependent on how creative the tailored plans will be in engaging in actual immediate decommissioning work that offsets the immediate loss of work from drilling new wells and developing on-going production. It’s not clear that any funds contributed to a tailored plan will actually be available to pay for partial P&A expenses.  For example, many operators are now spending money on existing wells long before an entire production platform is physically removed.

ES:  There will be a triple negative effect.  First, every dollar taken to satisfy new bonding requirements will come directly from operations budgets.  Second, this new bonding regime will simply drive many current players out of the business. There will be very few willing buyers to take on and continue production at these leases. The result will be that some, perhaps the majority, of these currently producing leases will be permanently shut-in resulting in a shortfall in the “take” payable to the federal government.  Third, there will be a very real contraction of the aftermarket of buyers for OCS properties.

The Federal government and U.S. taxpayers will face a significant loss of income from these existing national resources.

RT:  The entire economic model for the OCS, especially the Gulf of Mexico, is based on a vibrant aftermarket for the acquisition properties that no longer fit the economic metrics for the first and second-in-line owners.

I agree with Eric that this contraction of the pool of potential buyers will be the hidden whammy that reduces Gulf output as properties become uneconomic and abandoned long before they would have, were it not for the new financial security demands of this new NTL.

OAG 360:  If a company or a group buys a lease block in the Gulf OCS from a prior owner, how does the liability flow as far as the new rules for paying the government its decommissioning security for the operations in that block?

RT:  As this NTL is presently structured, the BOEM will only look to the present leaseholder for financial security for the plugging and abandoning and decommissioning liabilities attributed to its leases.  An interesting point is that there is an absolute requirement in every federally approved assignment where the seller agrees to keep full financial liability for all P&A and decommissioning costs for every well and facility on the lease at the time it sells.

ES:  The final bulwark preventing U.S. taxpayers ever paying for plugging and abandoning or decommissioning costs has been the ability of the federal agencies to go up the chain of title to find leaseholders who have the funds to actually pay for any deficiencies not covered by current lessees or their bonding companies.

OAG 360:  How do you see this playing out –BOEM taking its new, updated decom cost structure and doing a financial assessment for each lessee and operator using its five criteria, then the notification process to operators and leaseholders demanding more collateral—in your view, what does the timeline for this process look like?

RT:  BOEM and BSEE have expanded their staffs to handle this work, but we should expect an uneven progression that impacts different companies at different times.  While there is some talk about the agencies trying to follow a phased schedule, there is nothing that prevents them from dealing with any company as they see fit, particularly regarding the so called “tailored plans.”

Even where a schedule is followed, we can all presume that the largest players will probably qualify for self-insurance, with smaller companies coming up to bat that much quicker.

ES:  Some sources believe that the involved agencies may actually start with the weakest operators in order to head off perceived taxpayer liability sooner rather than later.

OAG 360:  The stated goal of BOEM’s supplemental security requirement initiative is to protect the taxpayer from risk on the uncollateralized decommissioning liability on the OCS oil and gas production.  Do we know what is the dollar amount of decommissioning liability that has been paid by taxpayers during the past seven or eight decades of offshore drilling in the Gulf of Mexico? 

ES:  From my experience going back many years, there have been only a very few  instances where the U.S. taxpayers have actually paid any plugging and abandoning or decommissioning costs in the OCS. Recent OCS bankruptcies have resulted in called bonds and payments by sureties who provided bonding support for existing leases. More common have been payments to the government due to contingency payments of legacy obligations.

OAG 360:  If a company with federal OCS leases in the Gulf of Mexico, for example, falls below the financial capacity, projected strength, business stability or reliability thresholds set by BOEM—triggering a higher collateral demand under NTL 2016-N01—if the company is unable to meet the collateral demand, at that point what happens? 

In other words, if the additional security is not able to be provided in the required time frame by the lessee or operators and a tailored plan submitted to BOEM is deemed to be insufficient, what happens next?

RT:  The regulations clearly provide BOEM and BSEE the power to take a number of actions, including immediately shutting in operations, ordering the immediate plugging and abandoning of wells and decommissioning of platforms for which the preliminary notices have been given for the requisite time period, and taking steps to implement notices for future plugging and abandoning and decommissioning work on wells, platforms and facilities that have been idle the requisite time.

It’s up to BOEM and BSEE whether and when to actually start implementing these powers as to any particular situation.

ES:  I would add that each bankruptcy will accelerate aggregate production declines and subsequent calls for restitution while further diminishing the available pool of bonding liquidity.

OAG 360:  For smaller companies that are presently trying to survive the oil price downturn, protect or strengthen their balance sheets, and continue working in the Gulf, how and where do you see the capital coming from to meet the government’s new OCS decommissioning security requirements—if you’re barely keeping your head above water now due to reduced sales volumes from the commodities price downturn, and you are fighting to de-lever your balance sheet, etc., where can a smaller company turn to come up with the capital or security to meet BOEM’s new requirements?

ES:  There are real headwinds as far as finding capital sources.  It is doubtful as an economic reality that the bonding industry can satisfy the new cumulative need and this is only heightened by the requirement of Treasury Department approval and certification.

For example, it might be possible to add bonding capability from the London market, one of the few foreign sources of surety bonds, but that will require the U.S. Treasury to add these large companies, such as Prudential, to their approved Treasury list.

Likewise, the current economic headwinds and the redetermination by traditional lenders that are reducing their outright lending to the oil and gas sector raises questions as to this other traditional segment as a source for new guarantees and standby letters of credit.

RT:  Even simple asset sales, which is traditionally the last resort for cash generation, will face resistance – if nothing else than from much lower purchase prices that will reflect fully the fact that new buyers will need to face the same increased bonding requirements faced by the sellers.

Any viable solutions will involve existing financial players who are willing to participate in a new tailored plan before these players take on the long term risk associated with guaranteeing P&A performance.

OAG 360:   What can companies do to get in front of the situation, to try to address these changes, to be ready before the demand notices hit their mail boxes?

RT:  The companies with financial staying power will turn to presenting tailored plans that BOEM deems acceptable as an alternative to outright bonding.  These tailored plans will provide some flexibility, but they will need to be meaningful and will take some careful, hard and creative work.

For example, we are working with one of our large banking clients to create a viable financial vehicle that taps into the real equity that can support these actual plugging, abandoning and decommissioning liabilities.

ES: It is likely that any acceptable tailored plan will drain working capital out of already depleted balance sheets, reducing operators’ ability to attract new capital for either exploratory drilling or even complete development of existing leases.

OAG 360:  What do you believe the U.S. OCS drilling industry is going to look like in 2020?  2025? Who will be there to buy leases and blocks from the majors when they want to sell them?

RT:  From a lawyer’s perspective, I suspect the deep offshore portion of the market will look similar to today, where ultra-majors, majors and major independents continue to aggressively look for elephant fields – as their available CapEx allows under any given price structure.

The shallow water segment and industry players below this initial level of well financed activities will start to look substantially different as there will be fewer financially capable buyers available and their buy-in prices and timing will be affected by security requirements both from the agencies and potentially the sellers themselves.

I suspect that there will be many fewer ‘lower rung’ buyers who were the traditional clients for fully exploiting mature properties.  I also expect that the Federal agencies will move more quickly than they have historically to close out, decommission and remove idle iron.

ES:  I believe that the ultimate result will be that more wells will be abandoned as uneconomic earlier in their productive life. I specifically believe that shallow water, gas prone sections of the U.S. Gulf of Mexico will bear the brunt of this government-induced culling of offshore production.

EDITOR’S NOTE: This is the second in a series of feature articles concerning the challenges heading to the offshore drilling industry as a result of new supplemental collateral requirements on lessees and operators on the U.S. outer continental shelf.  Read the original story here.

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