BOEM Bonding: What You Need to Know About New Financial Assurance Requirements Proposed for Offshore Oil and Gas Drilling
The Biden administration has proposed changes regarding when oil, gas, and sulfur lessees and certain other parties operating in the offshore Outer Continental Shelf must post additional bonds or other “supplemental financial assurance” (“Supplemental FA”) related to their operations. The proposed rule tracks some parts of a rule originally proposed by the Trump administration in 2020 and would do away with the current 5-point test for determining whether Supplement FA is required in favor of a simplified test based on the credit rating of the lessee or interest holder. The Bureau of Ocean Energy Management (“BOEM”) expects the proposed rule to increase both the number of lessees that must post Supplemental FA and the amount of Supplemental FA required.
For certain entities looking to develop oil, gas or sulfur projects in offshore areas or to obtain a right-of-use and easement either for state or federal projects, this proposed rule would require Supplemental FA if their credit rating failed to meet certain investment grade benchmarks, or if the valuation of the “proved” oil, and gas reserves did not “exceed three times the estimated cost of the decommissioning associated with . . . those reserves.” However, the proposed rule omits a concept proposed by the Trump administration whereby no Supplemental FA would be required where a “predecessor lessee,” which is also jointly and severally liable for decommissioning costs, has satisfied the investment grade criteria. In addition to the new requirements, the proposed rule would provide suppliers of financial assurance some explicit protections so they are not exposed to the same requirements as current and former lessees.
Those interested in recommending changes to the proposal or indicating their support have until August 28, 2023, to do so through the public comment process.
Why is Supplemental FA necessary?
The purpose of this proposed rulemaking is to reduce the risk that taxpayers would have to fund the decommissioning of wells and other infrastructure associated with offshore oil, gas or sulfur development. BOEM notes that more than 30 corporate bankruptcies have occurred involving offshore oil and gas lessees with unbonded decommissioning liabilities since 2009. In BOEM’s eyes, this fact demonstrates that the public is at some risk of potential responsibility for decommissioning liabilities, “especially during periods of low oil and gas prices.” The total value of the decommissioning liabilities associated with these bankruptcies was quite significant, in the range of $7.5 billion.
BOEM itself notes, however, that the “actual financial risk” was “significantly less than the total offshore decommissioning liability associated with offshore corporate bankruptcies.” The reason for this is that other private parties remain responsible for decommissioning costs. In fact, BOEM notes that “co-lessees and predecessors retain pre-existing obligations to fund or perform decommissioning.” Moreover, the “bankrupt company’s assets were often sold to financially stronger buyers who assumed those liabilities.” Indeed, BOEM concedes that most of these leases “were ultimately sold or retained by the companies reorganized under chapter 11.” However, there are assets for which a bankrupt party is the only liable party on the lease. As a result of this risk, the “[Bureau of Safety and Environmental Enforcement (“BSEE”)] 2023 budget request included $30 million in order to address this uncovered infrastructure.” These obligations likely stemmed from periods before any financial assurance was required at all, but BOEM is not forthcoming on that point.
If the proposed rule is enacted, BOEM estimates that the aggregate amount of Supplemental FA required under this proposal for decommissioning activities would increase by an estimated $9.2 billion over current levels, providing additional security that the decommissioning costs would not become the government’s liability, but also increasing burdens on the companies that must provide the Supplemental FA.
What does the BOEM proposal require?
The proposed rule would retire the current process of determining whether a lessee is required to post Supplemental FA, which involves weighing these five factors: the lessee’s financial capacity, projected financial strength, business stability, record of compliance with existing rules and regulations, and reliability (the “5-Point Test”).
Instead, BOEM proposes to look only at the credit rating of the lessee and, where applicable, the ratio of the value of proved oil and gas reserves on to the lease to the estimated decommissioning liability associated with the reserves. BOEM has proposed a BBB- (S&P) or a Baa3 (Moody’s) credit rating threshold. For entities that are not rated by the major credit rating agencies, BOEM proposes using an “equivalent proxy credit rating.”
Offshore operators are required to post a base bond to cover their lease and regulatory obligations. These bonds range from $50,000 for a lease-specific bond with no approved operational activity to $3 million for an area-wide bond that includes a development production plan. Under the proposed rule, a lessee with an investment grade credit rating would not be required to post any Supplemental FA beyond this base bond. Further, where there are multiple co-lessees on a lease, if any one co-lessee meets the credit rating threshold, none of the other co-lessees would be required to post Supplemental FA. For any lease on which all lessees are rated below the required rating, BOEM would next look to the value of the lease’s proved oil and gas reserves relative to lease decommissioning obligations associated with the production of those reserves. For any such lease, if a lease has proved reserves with a value of at least three times that of the estimated decommissioning cost, no Supplemental FA would be required.
The proposed rule also changes how BOEM calculates the required Supplemental FA. Currently, BOEM uses a single algorithm-based deterministic estimate to determine the amount of Supplemental FA required. In 2020, BSEE updated its Technical Information Management System with the latest industry-reported decommissioning costs. BOEM now proposes to use this information in conjunction with a probabilistic factor to determine the new amount of Supplemental FA required for a given lease. The probabilistic factor was tailored to “have a seventy percent likelihood of covering the full cost of decommissioning a facility.” This is a statistical concept, so the expectation is that the figure will be correct 70 percent of the time. The figure will “exceed the actual decommissioning value of many facilities” and would be insufficient in other cases. Probabilistic scenarios of 50 percent (“P50”) and 90 percent (“P90”) were also developed, but BOEM is currently proposing the 70 percent (“P70”) approach. P70 is estimated to result in a 30 percent increase in total Supplemental FA, or an additional $9.6 billion in total Supplemental FA. The changes in the proposed rule would be phased-in over a period of three years.
What are the implications for industry?
The simplification of the test for Supplemental FA would improve the predictability of determining whether Supplemental FA would be needed. Indeed, both the Trump and Biden administrations appear to agree that the existing 5-Point Test is not a useful indicator of an entity’s ability to fulfill decommissioning obligations. Dispensing with the 5-Point Test would reduce the programmatic effort needed to make the determination of when Supplemental FA should be required. However, the proposed rule will create its own challenges for entities that are not rated by the major agencies. In that situation, BOEM proposes using an “equivalent proxy credit rating.” It is unclear from the proposed rule how BOEM will carry out this process, or the implications on entities subject to such a proxy rating. BOEM has stated that any entities seeking a proxy rating would have to provide audited financial statements and that it would use a “commercially available credit model.” This kind of lessee information has been used in the past to determine an entity’s financial capacity under the 5-Point Test but was not a determinative factor in determining whether Supplemental FA was required.
The proposal will provide additional clarity for lessees by providing a straightforward benchmark, but the proposed rule is expected to increase the number of lessees that must post Supplemental FA, and it would also increase the amount of Supplemental FA required. Smaller oil, gas and sulfur producing entities, that do not have the credit rating needed to avoid a Supplemental FA requirement and are producing at smaller properties, are most likely to feel negative impacts from this proposal. Their means of avoiding this obligation comes down to finding a co-lessee or co-owner that meets the credit rating test in order to avoid the Supplemental FA requirement, or only pursuing larger properties, where the valuation of the assets is large enough to avoid the requirement. In practical terms, this new obligation would create another financial hurdle to entities pursuing opportunities of this nature. This could further compound in the secondary market for operating assets. Leaner operators will have a bigger hurdle to cross when pursuing marginally economic wells from other operators. However, this may be offset somewhat by the perception of reduced risk on the part of the selling entity, which would expect less risk of decommissioning liability falling back on it as a predecessor.
Inevitably, requirements like this will almost certainly suppress competition and limit the ability of smaller entities to pursue these opportunities. Moreover, this proposed rule would add significant costs to the production of oil, gas or sulfur from offshore leases. No one would dispute that there are benefits to the taxpayer where there is no viable predecessor entity that meets the applicable test. But in situations where viable responsible entities do exist, it is hard to see any real benefit to the environment, BOEM’s program or the taxpayer from requiring Supplemental FA in this fashion. BOEM points to the bankruptcy of several companies in 2009 as a motivating justification for the proposed rule, but, as it has acknowledged, there was little risk to the taxpayer, even then, because the majority of the assets were acquired by other operators which assumed the liabilities. In addition, if the plugging and abandonment obligations had triggered, the existing bonding requirements would have covered some or all of the costs, with co-lessees and prior lessees responsible for the remainder.
In fact, the proposal states only that requiring Supplemental FA where a predecessor meets the credit rating “strengthens” the bonding program. The proposal makes no effort to assess the impact of requiring Supplemental FA in this context and thus reflects no effort to balance the benefits from the additional costs against the impacts from requiring Supplemental FA where there is no real risk of default. In that regard, this aspect of the rulemaking seems to add to the growing list of rulemakings proposed or issued by the Biden administration that add to the costs of producing, importing and using fossil fuels without appropriately weighing the impacts.
The revision of the program away from the 5-Point Test is also significant. While subjective, the test furnished regulators with a way to assess whether smaller entities were likely to fulfill their obligations to perform their decommissioning obligations. The proposed rulemaking rightly critiques these factors as not necessarily financial in nature, but the qualities being analyzed were suitable for answering the question of whether the proposed lessee or operator could reasonably be expected for fulfill its obligations under the lease, including those relating to decommissioning. And while the current 5-Point Test does not provide some lessees and other parties with clarity about whether Supplemental FA requirements might be required, it offers a more holistic approach to the determination than the proposed rule.
The proposed rule may change before it is finalized as part of the rulemaking process. Participating in the public comment period is your opportunity to influence that process and provides an opportunity both to help BOEM correct issues with the proposal, and to voice support for positive parts of the proposal. The public can comment on any aspect of the proposal, but BOEM has specifically solicited feedback from operators and other interested parties on:
- the 3-to-1 ratio for asset economic viability to decommissioning costs and whether that is an appropriate metric and threshold;
- how the elimination of the 5-Point Test may create a disincentive to comply with regulations;
- the costs and benefits of setting the Supplemental FA requirements based on each of the P50, P70, and P90 decommissioning liability levels, and how P90 would affect smaller entities;
- the costs and benefits of otherwise considering predecessor lessees or grantees in determining the level of required Supplemental FA;
- the appropriateness of relying on the S&P Global’s Credit Analytics credit model, or other similar, widely accepted credit rating models to generate proxy credit ratings and the appropriateness of this approach of relying on lessee and grant holder credit ratings, including whether BOEM has proposed an appropriate credit rating threshold of BBB-, and if not, what threshold or set of thresholds would best protect taxpayer interests while not imposing undue burdens on industry; and
- whether financial assurance should be required of all companies, regardless of credit rating, and the impacts such a requirement might have on investment and on potential taxpayer liabilities on the outer continental shelf.
Regardless of how the proposed rule might affect your operations, voicing concerns or support for the different parts of the proposed rule is critical for the rulemaking process and important to determining the specific requirements in any final rule. Vinson & Elkins is available to provide more in-depth information about the proposed rule, the implications on your operations, and steps you can take now to mitigate exposure to its future ramifications, should the proposed rule be finalized. V&E also has broad experience guiding interested parties through the notice and comment period, best positioning your concerns for consideration and potential future judicial action. The comment period closes on August 28, 2023.
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.