Analysis: Gulf Drilling Costs, Regulations Likely to Rise

The Macondo oil spill in the U.S. Gulf of Mexico has set the stage for dramatic changes to the deepwater exploration industry, with future costs of drilling and operating in the Gulf expected to rise considerably, according to a white paper released by New York-based Grant Thornton LLP.

While certain cost increases can be attributed to natural market forces, such as insurance and capital providers repricing the risk of drilling and operating in deepwater, other costs increases will result from significant changes in regulatory policy, which are currently being discussed by Congress, according the study, The Implications of the Oil Spill on Deepwater Exploration and Production.

The repricing of risk in conjunction with proposed regulatory changes will have drastic long-term implications for exploration and production (E&P) companies.

Moody's Investors Service, for instance, has estimated that premiums for insuring offshore drilling rigs are likely to mushroom as much as 50%, resulting in higher day rates on drilling rigs for deepwater E&P companies, threatening the survival of exploration businesses without adequate capital resources. As a result, larger and more well-established energy companies will gain the upper hand in the Gulf, which accounts for 19% of U.S. crude oil reserves and 15% of total U.S. oil and gas reserves.

"As all of the costs associated with operating in the Gulf continue to rise, deepwater drilling will increasingly become the province of only the largest, most well-capitalized companies," said Rob Moore, a Director in Grant Thornton LLP's corporate advisory and restructuring (CARS) practice and co-author of the study.

As smaller independent oil and gas companies without critical mass and strong financial resources will have difficulty absorbing the higher drilling and operating costs of a post-oil spill environment, a wave of merger and acquisition activity across the E&P industry will likely result that will leave deepwater Gulf drilling concentrated among a handful of large energy companies as smaller players get absorbed through strategic purchases or wind down their operations.

"Additionally, asset divestitures by businesses under financial duress will create new transaction opportunities for both strategic and financial acquirers interested in capitalizing on acquisition opportunities," the study found.

While final regulations will not be signed into law for some time, several proposals have already been announced. One provision that has garnered much support is the Senate Environment and Public Works Committee's proposed removal of the current $75 million federal cap on economic liability from an oil spill. Previous proposals sought to raise the cap to $10 billion; however, with the costs of the BP oil spill steadily rising, policymakers are now seeking to impose unlimited liability.

Raymond James analyst Pavel Molchanov recently estimated that combined criminal and civil legal costs would reach nearly $63 billion. While BP may be able to shoulder these costs, such massive penalties could overwhelm other companies in the event of a similar spill.

Other proposals include increasing the civil and criminal penalties for an oil spill, requiring greater redundancy in drilling safety equipment, hiring additional federal inspectors, and imposing stricter requirements for deepwater drilling permits.

One piece of legislation proposed is a new provision in the CLEAR Act, a wide-ranging drilling reform bill recently approved by the House Natural Resources Committee. The CLEAR Act, an amendment to the Outer Continental Shelf Lands Act, raises civil penalties from $20,000 per day to $75,000 or even $150,000 per day and raises the maximum criminal penalties from $100,000 to $10 million for a violation. Changes to the penalty structure are being discussed in Congress, and steep increases are likely to be seen across the board as prosecutors look at every possible civil and criminal charge that can be raised against BP.

Laws requiring greater redundancy in drilling safety equipment also will raise costs, such as two blowout preventers on a well instead of one. For example, the estimated current cost of one blowout preventer is $40 million, or 10 percent of the total cost of an offshore drilling well. These costs could conceivably be too much for smaller companies to cover. The cost of a single blowout preventer is likely to rise, as legislation is being debated to require testing of fail-safe devices. The additional testing costs would be added to the blowout preventer.

The federal government's closer oversight of inspections and its stricter requirements for obtaining permits will undoubtedly raise drilling costs, the report found. Greater involvement from inspectors may mean not only additional costs, but also drilling delays, which can increase rig fees.

While U.S policymakers may feel that stringent regulatory changes are needed to satisfy the public's appetite for swift revenge on the energy industry, "policymakers need a balanced outlook in proposed legislation for drilling regulations," said Loretta Cross, managing partner of Grant Thornton LLP's CARS practice and co-author of the white paper.

The study noted that heavy dependence on foreign oil could ultimately have national security implications and leave the U.S. economy increasingly vulnerable to pricing power by Organization of Petroleum Exporting Countries. According to IHS Herold, deepwater Gulf discoveries were expected to add 900 Mb/d in oil production and nearly 6 Bcf/d of gas production by 2020, showing the importance of the Gulf to the U.S. policy goal of reducing reliance on foreign oil. Lawmakers should also take into account the infrequent nature of oil spills and offering economic incentive for self-regulation.


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