A $40 billion time-bomb threatening the Gulf

Hundreds of stakeholders in the Gulf of Mexico oil and gas sector huddled in a Louisiana movie theater on a late August morning to hear about a USD 40bn problem.

This problem had been slow to develop over the last two decades, but a new set of regulations taking effect on 12 September threaten to accelerate its impact across the entire offshore energy industry – from Big Oil to the wildcatters who issued billions of new debt to fund rapid expansion plans.

The Bureau of Ocean Energy Management (BOEM), the government agency that oversees leasing of drilling rights in the Gulf, invited guests to the AMC Elmwood Palace, a standalone venue that sits across from a Kmart and next to a Popeyes in the suburbs of New Orleans. The purpose of the meeting was to outline the overhaul of the rules governing who has to pay for plugging and abandonment (P&A) – the expensive process of shutting down oil wells and dismantling the massive steel platforms associated with oil production on the US Gulf coast.

P&A may sound like a benign line item. But it’s a highly problematic balance sheet byproduct of a decades-long oil rush that, when combined with crashing oil prices, has left operators, taxpayers, and the environment at risk for disaster.

During the boom years, the cost to eventually tear down multiplying offshore structures was hardly top of mind. Light-touch regulation meant that most companies didn’t have to set any money aside to fund P&A, and the regulatory agencies had vastly underestimated how expensive deep-water drilling had become.

But now, after feverish planning that began in 2013 regulators are poised to ensure that the true cost of decommissioning is balanced against a company’s ability to pay. However, this change is set to take effect at a time of unprecedented financial strain for the sector.

Earlier this year, government officials estimated the cost to dismantle all the platforms in the Gulf had reached at least USD 40bn. Putting the figure in context, officials also noted that operators have just USD 3bn of collateral to pay for it.

“What the government is asking companies to do they should have done 15 years ago,” said Robert Byrd, a recently retired 35-year-veteran of the industry whose experience includes planning and executing offshore platform decommissioning projects and cost estimating for those projects.

The vast majority of companies previously operated under a waiver, allowing them to skip setting aside any collateral to pay for future P&A costs. These included relative upstarts like Energy XXI, W&T Offshore and Fieldwood Energy that had grown rapidly in the shallower shelf region of the Gulf by acquiring drilling rights offloaded by multinational corporations.

Starting this week, however, the P&A payment process will be turned on its head as every single offshore operator will soon be on the hook for the total cost to decommission each oil well, pipeline and platform on any lease they have a stake in.

“For a lot of the small and mid-sized energy companies operating on offshore federal leases, it's a potential game-changer,” said Omer F. “Rick” Kuebel III, a New Orleans-based lawyer in the energy practice of Locke Lord LLP.

Most attendees at the recent BOEM informational event were already aware of the imminent changes, though others are just starting to come to terms with the havoc that new regulatory requirements could wreak on more vulnerable players in the industry.

“Some people there were realizing the scope of this and the amount of work involved…there was just a lot of concern over how the implementation is going to work,” said Scott Sewell, a broker of surety bonds – used as collateral to fund P&A expenses.

Companies facing the most immediate pressure are those with sole ownership of a lease or pipeline who cannot lean on co-lessees to stump up the collateral. These properties represent roughly USD 2.2bn of additional decommissioning costs and are considered the highest risk by BOEM, which has given their owners until 13 January 2017 to find the money, according to BOEM data and a Debtwire Investigations Team analysis.

“BOEM will work with all lessees to develop an approach that works best for the government and for each company,” BOEM spokesman Caryl Fagot wrote in a statement to Debtwire. “One goal of this effort is to increase the options available to the industry for mitigating their financial risks. It is the responsibility of BOEM to ensure that the government and taxpayers do not have to pay for decommissioning costs.”


An interactive map of total uncollateralized decommissioning liability for active leases in the Gulf of Mexico, color-coded by total cost

Representatives from Energy XXI and Fieldwood Energy declined to comment on the situation, while W&T Offshore did not respond to requests for comment.

IDLE IRON

The distress gripping many of the companies in the energy sector today only compounds the problem. Cash-strapped companies have been delaying the start of the decommissioning process and actively skirting spending money on plugging and abandonment.

Despite a law stating that unprofitable wells must be plugged and platforms dismantled five years after they have reached the end of their useful lives, vague legal definitions and loopholes have allowed idle structures to rust in the ocean for decades.

If a company claims there is some “future utility” in a well they can put off the expensive plugging process indefinitely, several sources noted. Many operators have simply shut the valves on thousands of oil wells that are too costly to run rather than begin P&A – a potentially dangerous practice as the pressure from natural gas can build up over time, according to Byrd.

Companies also have an inordinate amount of idle platforms, including some toppled by hurricanes decades earlier, which the regulators are simply not aware of, noted three sources familiar with the process.

Sources note that while the number of shut-in wells has increased throughout the last 18 months of depressed commodity prices, decommissioning activity has decreased during the same period.

Only 64 structures including platforms and pipelines have been removed year-to-date, compared with 145 in 2015, according to Debtwire analysis of BOEM data. There were in excess of 200 removals per year for the years 2010 to 2014, data show.

Making matters worse, company estimates for the P&A and decommissioning costs can be wildly off compared with what regulators require.

Not only is the government now requiring collateral from companies who were previously exempt, it has also exponentially increased the decommissioning estimates, further impacting the amount of financial assurance required, said Paul J. Goodwine, a lawyer with the Houston law firm of Looper Goodwine.

“Over the past three years, the amount needed to cover decommissioning has ballooned as the regulators have systematically updated their assessments,” Goodwine added.

Indeed, there is no prescribed methodology for estimating P&A costs, explained Gary Siems, vice president of decommissioning at Montco Oilfield Contractors. While a shallow water well can typically cost between USD 350,000 and USD 500,000 to plug and abandon, the estimated cost of taking down a shallow water (less than 300 feet water depth) platform can range from USD 250,000 to USD 4m depending on the type, complexity and water depth, according to estimates provided by Montco.

Those industry averages, company estimates, and regulator estimates also don’t account for issues that can come up during the P&A process that can run costs up to ten times more than the original estimate, sources noted.


Interactive map of every standing structure in the Gulf of Mexico, color-coded by age

PRESSURE BUILDS

The vast build-up of uncovered P&A liabilities started with BOEM’s predecessor, the Minerals Management Service (MMS). For decades, companies that passed a rudimentary financial test based on their net worth were spared from setting aside any supplemental bonds to fund P&A liabilities.

But as a scathing December 2015 report by the US Government Accountability Office (GAO) pointed out, this backward-looking financial metric said little about a company’s ability to cover future decommissioning.

Meanwhile, when a waived energy company sold the operating rights on their leases, the buyer was also protected from having to raise additional collateral, no matter how financially risky they were. As operating rights passed through multiple hands and partitioned into increasingly smaller units, the regulators soon found themselves unable to keep track of who owned what.

“Under the old regulations, everybody could ride the coattails on supermajors like Chevron and you didn’t have to put up any bonds,” said Gustaf Johansson, director of projects at Montco. “That door has slammed shut. I can promise you that.”

After the Deepwater Horizon oil spill in April 2010, the MMS was split into three separate agencies to respectively oversee revenue collection, approve drilling permits and safeguard the environment. While the break-up was meant to streamline regulatory functions, responsibility for P&A bonding was now split between two of the new entities. BOEM hands out leases while the Bureau of Safety and Environmental Enforcement (BSEE) is charged with estimating decommissioning costs.

But a lack of actual cost data meant that BSEE relied on financial models from the 1990s to project P&A liabilities. Its internal database system calculated the cost to plug a deep-sea well at USD 100,000 versus the agency’s own estimate of around USD 21m per well. Cost estimates can also rise dramatically when oil rigs are damaged by storms, up to 15 times more than an undamaged structure, according to the GAO report.

“Until this last set of rule changes, the providing of cost data was voluntary by the operators and we've only in the last few years begun to realize how damned expensive these deep water decommissioning projects are,” Byrd said.

Top 25 operators by uncollateralized liability ($m)

ON THE HOOK

Corporate strategies for how to fund the gap between the old and new regulatory regimes are few. Now, only the most financially secure companies with the best credit ratings can waive a portion of their bonding requirements up to 10% of their tangible net worth, known as self-insurance. The rest will have to issue surety bonds or pledge proceeds from US Treasury bills to the regulators.

The clock starts on 14 November when BOEM begins mailing out order letters with the agency’s additional bonding requirements. For leases that have more than one company with a stake in the operating rights, it falls to a single nominated company, known as the designated operator, to negotiate with other stakeholders and raise the extra collateral by 14 March 2017.

With many of the oil and gas companies grappling with falling credit ratings and existing debt trading at deep discounts, the weakest Gulf operators could struggle to meet the onerous new requirements.

“The state of the oil industry is so poor financially today that there will simply be too many companies that are not able to get the type of bonding the government is asking for,” said Byrd.

At the New Orleans movie theater event, Chevron deep-water land manager Keith Couvillion stood up to talk about how the financial burden could be spread across the mess of interlocking partnerships that make up drilling rights in the Gulf.

With the 21st slide of a now publicly available PowerPoint presentation projected on the cinema screen, Couvillion posed the question that no-one in the audience likely wanted to ask – what happens to an operator that can’t afford to post its share of collateral with its co-owners?

BOEM’s response to that query is blunt. If it doesn’t receive 100% coverage for each lease then it would impose fines, shut-down production or start canceling leases altogether.

For the riskiest companies, another option is quickly becoming the only one, hammer out a private long-range plan with BOEM. At least one event attendee only went to the presentation to discretely lobby the regulators, hoping to cut the best deal possible. Many in the audience kept quiet during the Q&A, worried that any question specific to their situation might tip off competitors to potential negotiations with BOEM, according to one observer.

Operators that once enjoyed a waiver under the previous regime now face the prospect of raising capital at a time when their credit ratings are at all-time lows.

For example, BOEM ordered the previously-exempt W&T Offshore to provide USD 260m in additional security, of which at least USD 34m is tied to leases and pipelines where W&T is the sole owner, according to the company’s public filings and BOEM data as of 30 August.

The company is in talks with the agency to reduce its P&A liability, according to filings, arguing that the decommissioning estimates are too high. Finding an insurance company to underwrite a surety bond of any size will be near impossible without having to pledge substantial amounts of cash as collateral.

“W&T is between a rock and a hard place,” said Lance Gurley, Managing Director at financial advisory firm Blackhill Partners, which specializes in oil and gas restructurings. “Their ability to continue to operate is only as sufficient as their negotiations with the regulators, and they have one hand tied behind their back given their cash flow challenges. The company has absolutely no leverage. When you have the regulator who is in the position to make a commercial decision, it’s always an uphill battle.”

A LIT FUSE

As distress in the energy space continues to claim victims in bankruptcy court at a frenetic pace, investors and advisors are closely watching for clues on how increased bonding requirements will be dealt with. More than 150 oil and gas companies have filed for bankruptcy over the last 18 months, according to Debtwire data.


Bankruptcy filings in the oil and gas sector since the crash of crude oil prices in late 2014

One thing is for sure, energy companies looking to restructure their debt will now have to clear a space at the table for Department of Justice lawyers, who are actively involved in several cases where P&A obligations have become a sticking point for the reorganization.

As one of the most indebted operators in the Gulf, Energy XXI (EXXI) poses a major risk to taxpayers given its potential USD 1.2bn decommissioning liabilities, according to government data as of 30 August.

BOEM singled out the company more than a year ago, and in April 2015 sent a letter asking for at least USD 1bn of additional financial assurances. Issuing a bond underwritten by a surety company to satisfy the obligation was an expensive option at the time, if it was an option at all.

Unlike other types of insurance where the policy provider can hedge against risk by charging higher premiums, surety bonds are designed never to be called. If a bond issuer cannot meet the obligation that its bond is tied to – in this case decommissioning an oil rig – then the surety company must pay the full amount. This binary outcome for the surety translates to a rigorous due diligence process.

"For companies at risk of a restructuring, the concern is not a higher premium, “said Robert J. Duke, General Counsel of The Surety & Fidelity Association of America. “The primary concern is whether the restructured company will have difficulty getting the bond in the first place."

Unable to come up with the necessary cash, the now bankrupt Energy XXI is privately negotiating a tailored plan with BOEM. That plan however, threatens to significantly influence the level of payouts for investors who thought they were first in line for repayment of their bankruptcy claims, said three sources familiar with the case. These so-called senior secured creditors may now have to play second fiddle to the government, who is demanding that P&A costs are covered first. Negotiations over the plan also threaten to derail the company’s exit from bankruptcy as EXXI will be forced to prove that it can meet its P&A obligations to the government before being permitted to operate, the sources noted.

“These lease obligations to the government come first and for senior secured creditors, that’s not a message they’re used to receiving,” Kuebel said.

As the EXXI bankruptcy case progresses over the next few months, offshore operators and investors alike will look to it for answers to just where the USD 37bn for P&A will come from, whether innovative solutions arise or it comes at a cost to those investors backing the companies.

After decades of relentless drilling, regulators have hit the pause button and the industry is forced to take a look back at the trail it has left behind.

"This may be the most critical issue for these companies to resolve,” said Locke Lord’s Kuebel. “The industry knows it and is dealing with it. But the financial markets may not understand it yet."

By Alex Plough and Marion Halftermeyer with additional reporting by Alexander Gladstone