Game-Changer: Can a $40 Billion Spill Transform an Industry?

Charles Fournier, a Senior Consultant for FTI  Consulting and a graduate of The George Washington University Law School, recently answered this question in an article for FTI’s quarterly newsletter.

Mr. Fournier received his J.D. from GW Law in 2007 and is currently based out of Abu Dhabi in the UAE.

Here is a condensed copy of the article:

“In the end, the focal issue may be the management of risk: even with robust efforts to prevent oil-related incidents, they can and will happen—at which point the crucial question is how to cope with the consequences.”-Deepwater Horizon Oil Spill: Selected Issues for Congress, CRS Report R41262, July 30, 2010

The details of the Deepwater Horizon spill are now well known. The Macondo well was drilled in the spring of 2010, fifty miles off the coast of Venice, Louisiana. BP was the field operator with a 65% share in the field; Transocean’s ultra deepwater, semi-submersible mobile Deepwater Horizon rig handled drilling, to a depth of 18,000 ft (5,486 m) in 5,000 ft (1,524 m) of water; cementing the well was Halliburton’s job.

On April 20, a large blowout of methane gas traveled up the drilling pipe and ignited on the platform, the fire went out of control, and the 450-ton 49-ft (15-m) tall seafloor blowout preventer (BOP) failed to intercept the flow. We also know the immediate physical consequences of that blowout: Deepwater Horizon now lies on its side, 5000 feet down, and 4.9 million barrels of oil spilled into the Gulf of Mexico before the well could be capped. News coverage stressed the broader consequences of the spill for Gulf fishing and tourism and marine and wildlife habitats. The U.S. government demanded that BP shoulder all financial consequences—cleanup costs may top $40 billion—and went on to threaten fines of up to $21 billion, a ban on new offshore permits, and a de facto moratorium on deepwater drilling. BP’s commitment to pay cleanup costs may shield it from negative PR consequences or even lawsuits. But what consequences will BP’s massive pledge of resources to the resolution of the Deepwater Horizon crisis have for deepwater drilling and the industry as a whole?

The 2010 Gulf oil spill and BP’s response to that spill changes the game of deepwater drilling, creating a quantifiable worst-case scenario that insurance companies can now use to re-calibrate their risk assessment models. The insurance framework imposed by the Oil Pollution Act threatens to collapse under the weight of financial pressure now facing deep water operators. As a result, the industry may perhaps be looking at higher insurance premiums, major consolidations, commercial wars, and protracted lawsuits. Anticipating and preparing for these changes may be essential to the survival of IOCs, SOCs, and Independents.

The end of (Relatively) cheap insurance ?
The Macondo oil spill blows the cap off estimated financial responsibility limits created under the 1990 Oil Pollution Act (OPA). The OPA’s system of so-called “financial responsibility laws” and compulsory liability insurance requires the lease holder of a covered offshore facility (COF) to demonstrate a minimum amount of oil spill financial responsibility (OSFR)—previously estimated at $1.5 billion for spill cleanup costs plus $75 million for the capped consequential or
economic damage. From an insurance-premium perspective, the cap on consequential damages is now moot. BP’s decision to pursue remedies beyond the $75 million cap reveals liability capping as a failed solution: there will always be political pressure to break the cap and make the operator liable for all costs of containment, pollution cleanup, and business interruption—especially since there is now precedent for doing just that.

Some leading insurance companies3 in the oil and gas market say they would be unable to offer adequate insurance protection for offshore operations under the threat of such liability.4 Even beyond enormous potential cleanup costs, extralegal remedies being pursued by the U.S. government—forcing BP to set up an escrow account of $20 billion to manage potential future claims, requiring BP to compensate workers laid off as a result of a government-imposed moratorium on deepwater drilling—may also increase the assessed political risk around future natural and manmade catastrophes… The offshore energy insurance market has a current finite capacity for liability insurance, including overage for offshore oil pollution spills in U.S. waters, somewhere in the range of $1.25 billion to $1.5 billion. Expansion in capacity to $5 billion or more (backed by the major reinsurers)—a figure likely to be insufficient, given the massive scope of BP’s forecasted liabilities—will come at the cost of significant increases in premiums for deepwater liability coverage. Energy underwriting rates were down 10-15% before the disaster, but recent reports indicate premiums for insuring deepwater operations have gone up by 25-30% and for deepwater drilling by 100% or more.

Changes in the insurance market may not hurt the largest deepwater operators, who can selfinsure,
and use that self-insurance to demonstrate OSFR, but smaller operators do not have the selfinsurance option…Small and mid-sized oil companies cannot self-insure even at much lower levels of liability, and they usually demonstrate OSFR by means of an insurance certificate (other options for OSFR include surety bonds, guarantees, letters of credit, and self-insurance, but the insurance certificate is the most common choice for smaller operators). Without available and affordable insurance products, these smaller companies will be pushed out of deepwater drilling.

Regulatory impasse ?
Operators in the Gulf of Mexico fall under the jurisdiction of the U.S. Oil Pollution Act of 1990 (OPA). U.S. regulatory response (or lack thereof) to the crisis will affect the Gulf’s deepwater operators directly, and as precedent may spill over to influence North Sea deepwater drilling as well. Under OPA, a responsible party (RP) is liable for all removal, cleanup and containment damages. Consequential economic or environmental damages are capped at $75 million, not adjusted for inflation, with the Oil Spill Liability Trust Fund overing the excess, up to a per-incident cap of $1 billion. Since the OSLTF is capped at 2.7 billion, a single catastrophic oil spill could easily wipe it out…

Alternatives to the OSLTF that might help operators would be politically unpopular, and are unlikely to emerge. To keep insurance affordable for smaller operators, the liability cap could be lowered. Regulatory changes might support the creation of an alternative source of insurance capacity via “reinsurance sidecars,” catastrophe bonds, or derivative financial instruments that securitize insurance risk. These risk financing options could in theory provide the added capital needed in the insurance marketplace to cover higher liability and associated OSFR limits, although oil-spill-prone insurance-backed securities may have little appeal after the splash caused by similar products called to mortgage-backed securities.

A third alternative would involve more regulation and a nationalized insurance program on the model of the National Flood Insurance Program (NFIP), which fixes rates for flood insurance purchased from private insurance companies by homeowners and renters living in communities that follow prescribed floodplain management standards. While some of these changes might have beneficial consequences for IOCs, none is likely to emerge from a Congress that greeted BP’s leaking well with a flood of bills designed to widen and tighten the existing regulatory framework.

Legislation that would significantly tighten regulation on industry is perhaps equally unlikely in a newly divided Congress, but deepwater operators are not in circumstances where “no news is good news.” Even if Congress does not increase the cap on consequential damages under OPA… it is possible that deepwater drilling operations will move to an elevated safety and regulatory culture like that developed within the nuclear industry. In the meantime, operators still face unlimited responsibility for removal, cleanup, and containment of accidental spills; they are still legally required to demonstrate OSFR; and the old $1.5 billion estimate for spill cleanup operative for OFSR has been blown away by the 2010 spill.

IOCs’ win , Independents ’ loss ?
“There is no more easy oil, and the subsea industry is critical to unlocking more oil to meet world supply.” (Tom Botts, Shell Europe’s vice president of exploration, Subsea 2008 Conference.)

BP’s great loss won’t mean the end of deepwater operations in the Gulf of Mexico; only the players will be different. The U.S. Energy Information Service (EIA) estimates that in the near term, most new U.S. oil production will be in the deep waters of the Gulf of Mexico. As BP Chief Executive Bob Dudley emphasized in the aftermath of the spill, deep-water drilling is needed to meet a forecasted 40 percent increase in energy consumption by 2030. But the certainty of higher insurance premiums, coupled with the uncertainty of any U.S. government action to contain deepwater operators’ cleanup liability or limit exposure to increased insurance costs, may precipitate far-reaching changes in the industry…

As growth opportunities for older IOCs are increasingly concentrated in high risk sectors (new frontiers, mega projects, and unstable regimes), we must recognize a new risk paradigm, even for large IOCs. The Deepwater Horizon spill will inevitably result in insurance premiums high enough to drive smaller players out of the deepwater fields. We are likely to see industry consolidation as smaller companies merge to reach the critical mass needed to self-insure or amass the capital and technological know-how to compete with oil field service companies for the now prevalent service agreements. They will also have to fend off the offensive of new well-funded and locally well connected baby IOCs like Kuwait Energy.

Finally, the legal fallout from the Macondo spill suggests that any company continuing involvement in deepwater operations should expect to go forward under the shadow of probable litigation. BP is currently facing potential claims from businesses (beach tourism, fishing) for loss of revenue; claims and lawsuits related to personal injury or death in the explosion, fire, and sinking of the Deepwater Horizon platform; environmental and natural resources claims for damage from the spill; health claims from those exposed to oil or to chemicals used in cleanup; and securities lawsuits. There may also be product liability lawsuits deriving from equipment failures on the platform, subsea, or related to spill containment. Further litigation will likely emerge with shareholders and state governments over lost revenues for royalties, leases, or taxes, and finally between operating partners, as OPA imposes joint, several, and strict liability and their limited insurance coverage (barely more than $3 billion when pooled together) is dwarfed by the liabilities amassed by BP.

The immediate consequences of the Deepwater Horizon blowout have been contained: the well is capped, physical cleanup is underway. But the effects of the disaster are likely to spread over the industry for some time to come.

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