Three Reasons BOEM’s Updated Financial Assurance and Risk Management Requirements Are Unenforceable

by BakerHostetler
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Part One

The Interior Department’s Bureau of Ocean Energy Management (BOEM) has finally issued its promised Notice to Lessees (NTL) No. 2016-N01, “Requiring Additional Security,” which supersedes NTL No. 2008-N07, “Supplemental Bond Procedures.” The new NTL, with multiple linked attachments, becomes effective Sept. 12, 2016. The new NTL largely concerns a lessee’s ability to carry out its obligation to decommission wells, platforms and pipelines on oil and gas leases in all regions of the Outer Continental Shelf (OCS). Lessees are already assessing how these new requirements will impact their OCS operations.

In many respects, the new NTL mirrors the Proposed Guidance advertised by the BOEM on Sept. 22, 2015.[1] Despite inviting comment from stakeholders, the final guidelines fail to take into account several of the fundamental concerns expressed in comments submitted by companies and trade groups directly affected by the financial assurance requirements. As a result, the new NTL is subject to challenge on at least three bases.

First, the NTL’s linked attachments conflict with the regulations. Second, by ignoring asset retirement obligations (ARO), which are already included in a company’s audited financial statements, BOEM effectively double-counts the costs of removal by subtracting its own estimates of removal liability from a tangible net worth already reduced by AROs. Third, the 10 percent cap on self-insurance is a rule adopted outside of a proper rulemaking. Over the coming weeks we will explore each of these reasons in turn.

If the new NTL were found to be unlawful, the superseded Supplemental Bond Procedures in NTL No. 2008-N07 would not be automatically resurrected. At a minimum, it too violated the regulations in its disregard of the treatment of AROs in audited financial statements, contrary to 30 C.F.R. § 556.901(d)(1)(i), 81 Fed. Reg. 18112, 18170 (March 30, 2016).

Reason Number One: The guidance contains language inconsistent with the regulations.

In one key respect, the new NTL appears as if it were written by two “committees” prohibited from communicating with one another. One committee, drafting the text of the NTL, recognizes that BOEM, before requiring a supplemental bond from a lessee, has the burden of showing that the lessee lacks the financial capacity to perform its obligations under its OCS lease. The other committee, drafting the linked attachments, takes for granted that no one has the required capacity, making the only relevant question how big the supplemental bond must be. Lessees who are meeting with BOEM to discuss their financial capacity need to be mindful of the agency’s inconsistent messaging. And lessees must be aware that the second message is unlawful.

The regulations applicable to leases[2] require BOEM to ask two questions: First, does a lessee have the financial ability to carry out its present and future lease and regulatory obligations? 30 C.F.R. § 556.901(d). And second, if the answer is no, how much additional security must be provided? 30 C.F.R. § 556.901(e). BOEM recognizes this two-step process in the NTL No. 2016-N01: “[T]he Regional Director will evaluate your financial ability to carry out your present and future obligations annually to determine whether you must provide additional security and, if so, how much additional security you must provide”; and “[i]f the BOEM Regional Director determines that the financial ability of any lessee or grantee for any lease, ROW, or RUE is not sufficient to assure performance of its lease, ROW, or RUE obligations, he or she may require the lessees or ROW and RUE owners to provide and maintain additional security” (NTL page 2, I. and II. [emphasis added]).

What happens if the answer is “Yes, a lessee has the financial ability to meet its financial obligations”? Pursuant to the regulations, this would be the end of the analysis. A company that meets the five criteria set forth in 30 C.F.R. § 556.901(d)(1) should not have to provide any additional security.

Despite its apparent recognition of the two-step process, the new NTL’s incorporated attachments contradict this position. “This NTL discontinues the policies under NTL No. 2008-N07, whereby if BOEM determined that one or more co-lessees or co-owners had sufficient financial strength and reliability, it was not necessary to provide additional security.” (NTL page 1, Introduction.) Or, as stated more explicitly in its summary of key changes to the NTL, “[l]essees will no longer be granted waivers, but may be eligible for self-insurance to meet some or all of their supplemental bond obligations.” See http://www.boem.gov/Risk-Management/.

So, BOEM’s position appears to be that every company must provide supplemental financial assurance – it’s just a matter of finding the right mix of self-insurance (if a company qualifies) and bonding through a tailored financial plan. But this is not merely a change in policy. It is contrary to the regulations. BOEM is not permitted by its regulations to assume that a company lacks adequate financial capacity; it must first affirmatively find the lessee does not.

Consider the following scenario: A major exploration and production company (Major) holds a 50 percent interest in a lease. The remaining 50 percent interest is split equally among three independent exploration and production companies. Major can demonstrate that it meets the NTL’s thresholds for financial health:

  • It exceeds the minimum thresholds for six of the nine financial capacity ratios set forth in the NTL.[3]
  • Its existing OCS lease production and proven reserves calculated using the PV-10 method are “significantly in excess” of its financial obligations.
  • It has been operating in the OCS for more than five years.
  • It has an S&P rating of BBB+ (an “investment grade” rating according to BOEM).[4]
  • It has a satisfactory record of compliance.

If BOEM properly applies the regulations, then Major should not be required to provide any additional financial assurance because the answer to the first question set forth in the regulations – “whether lessee has the financial ability to carry out your present and future obligations” – is answered in the affirmative.

What if the scenario is modified to concern a new lease issued to Major, as the 100 percent interest holder on a “sole liability property” – those leases for which there are no co-lessees and no prior interest holders? BOEM’s guidance specifies that the agency will set a minimum credit rating below which BOEM would not allow the use of self-insurance on sole liability properties. See http://www.boem.gov/Reliability/. That minimum S&P credit rating is A-. http://www.boem.gov/Risk-Management/. Again, Major should not be required to provide any supplemental financial assurance for that property because it has met the five standards in 30 C.F.R. § 556.901(d)(1) for demonstrating financial ability to meet obligations. But will BOEM nevertheless require Major to provide a bond for the sole liability property because its credit rating is lower than A-?  The answer is unclear.

Under either of these scenarios, BOEM’s demand that Major provide supplemental financial assurance is unlawful.

[1] For additional background on BOEM’s financial assurance requirements, please see October 5, 2015, Shale Blog post and May 9, 2016, Shale blog post.

[2] The regulations governing Pipelines and Pipeline Rights-of-Way and Rights-of-Use and Easement, 30 C.F.R. §§ 550.1011(a)(2) and 550.166(b), respectively, are less robust than the regulations governing leases and do not contain the same two-step process for determining when additional security is required.

[3] It is unclear from the NTL and the “Financial Capacity” webpage what the minimum number of ratios a company must satisfy is in order to be deemed to have capacity substantially in excess of existing and anticipated lease obligations. The Financial-Ratios webpage identifies the number that has to be met in order to qualify for self-insurance, but the calculation of the self-insurance amount should not occur until after BOEM has made a determination of financial ability. The guidelines are silent on the threshold BOEM will apply in performing the first step in its analysis. See http://www.boem.gov/Financial-Ratios/ (“For self-insurance purposes, BOEM is setting a minimum number of benchmarks that a company must exceed … in order to be considered eligible for some measure of self-insurance. BOEM is setting the minimum number of financial ratios for which a company needs to exceed the benchmark at 5 out of 9.”); http://www.boem.gov/Benchmark-for-Each-Ratio/ (“BOEM will utilize the nine ratios listed in the NTL as a part of the process for evaluating financial capacity. […] If a company passes at least 5 out of 9 ratios, self-insurance, expressed as a percentage of the company’s tangible net worth, may be granted, up to a maximum of 10%, depending on consideration of the other four criteria.”).

[4] Again, it is unclear from the NTL and the “Reliability” webpage what the minimum credit rating is that a company must have in order to be deemed to have the financial ability to carry out its obligations. The NTL does not identify a minimum rating. And the “Reliability” webpage indicates that BOEM “will use the reliability criterion in two separate ways. First, BOEM will adjust the percentage of self-insurance allowed for any lessee based upon its credit rating. Second, BOEM will set a minimum credit rating below which BOEM would not allow the use of self-insurance on ‘sole liability properties’ as defined in the NTL.” See http://www.boem.gov/Reliability/.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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