New perceptions change risk planning

The oil and gas industry is still recovering from the greatest global financial shock in more than 75 years. The worldwide economy remains in a fragile state, and additional stress is anticipated because of slow job growth, continued deleveraging, and the uneven manner in which advanced and emerging market economies are weathering the financial storm.

Against this backdrop, the blowout of an exploratory deepwater oil and gas well in the Macondo prospect in the US Gulf of Mexico (GoM) on April 20, 2010, touched off an explosion and fire aboard the Deepwater Horizon drilling rig, killing 11 workers and resulting in the leaking of millions of barrels of oil.

The incident draws attention to the critical need to focus on risk management and to plan for the unexpected, regardless of how remote it might seem. In the wake of this disaster, the industry can expect renewed and expanded regulatory focus on safety and environmental risk preparedness and mitigation. The incident also will impact individual, corporate, financial, and legal risks.

There is a critical need to focus on risk management and to plan for the unexpected.

Policy and regulation
Uncertainties in the direction of energy policy have been prolonged, partly by the vague outcome of the Copenhagen climate conference in December 2009 and partly by the inability of the US to adopt a clear energy policy. These uncertainties have been exacerbated by the GoM oil spill. In all likelihood, some countries will increase safety precautions and inspections and may alter fiscal regimes to compensate for increased government regulatory costs and for the perceived increased risk of a deepwater incident. Rising costs will come from higher demands from regulators and the need for additional safety investments.

Specific key issues include whether or not acoustic triggers for blowout preventers will be required (they are currently required in Brazil and Norway, but not elsewhere), whether or not simultaneous relief wells will have to be drilled, and whether or not specific equipment/safety redundancies will have to be put in place. Additional governmental inspections and more stringent licensing requirements must be expected.

In the UK, regulators are reviewing deepwater procedures and have taken steps to double the number of annual drilling rig inspections by the Department of Energy and Climate Change. In Brazil, the National Petroleum Agency has announced a review of safety systems and contingency strategies in light of the Macondo spill given that the development of the prolific subsalt area in ultra-deep water at high pressures presents a new series of technical challenges, potential dangers, and environmental risks. In the US, a six-month moratorium on all deepwater drilling activity has been imposed, while the reason for the oil spill is investigated and new safety and environmental requirements are established.

Access to reserves
Gaining access to reserves at a reasonable cost will remain a challenge. The economic impact of the global recession on oil-producing nations has led several countries to look at their fiscal terms with a view to taking a greater share of revenue. Meanwhile, with oil prices rebounding, hopes for an easing of fiscal terms have generally been dashed.

Furthermore, the spill in the GoM will impact physical access to deepwater reserves. The long-term effect is not yet known. What is known is that the incident in the GoM will have major implications for US oil and gas operators and contractors. In the immediate term, the much heralded opening of the eastern GoM is not likely to occur any time soon, which will have a significant impact on reserves access in the US. In 2009, production from the GoM reached almost 1.6 MMbbl/d, accounting for almost 30% of the total US oil production. Of this production, more than 80% was developed from water depths greater than 650 ft (198 m).

In addition to existing US offshore fields, there are significant new reserves in deepwater and frontier areas offshore Brazil, West Africa, and Southeast Asia/Oceania, as well as the Arctic and Antarctic. Licenses to operate in some existing and new areas are likely to be under threat until confidence in deepwater operations is restored.

Gaining access to reserves at a reasonable cost will remain a challenge.

Costs and capital
If the world is on the cusp of economic growth, another risk to consider is project cost inflation. Resumption of increasing costs like those seen from 2002 to 2008 would be very damaging to the industry.

Results from Ernst & Young’s recently completed annual US E&P Benchmark Study found that production costs – which had reached unprecedented highs by mid-2008 – declined 22% in 2009. This is the first decrease the industry has seen in the five-year period studied.

Cost containment remains a challenge for new projects. Increased focus on technically, geographically, and geologically challenging reserves means higher absolute costs and greater risks. As production of these reserves grows, there will likely be an operational shift from cost reduction to cost containment, (i.e., cost stabilization).

For many companies, cost-efficiency strategies implemented in 2009 continue to improve cash flow. A concentrated effort will be required to maintain the benefits of those strategies. Given the most likely increase in costs due to anticipated new regulatory and environmental requirements, however, maintaining a stable cost structure may be nearly impossible.

Increased operational costs possibly could be offset by implementing enterprise resource planning solutions which can help identify opportunities to lower costs and create long-term efficiencies. In addition, the market is ripe for mergers and acquisitions. Considering realignment and consolidation opportunities (including divestment of assets to focus on core competencies and the selective outsourcing of services such as IT development and support) can create liquidity opportunities.

Operational, technological challenges
Operational and technical challenges have grown in recent years, mainly due to the increased focus on operating in challenging environments.

When organizations consider pursuing new offshore ventures, they need to update their risk assessment approach to take into account the lessons from the GoM oil spill. Technologically groundbreaking projects need to consider how to deal with a catastrophic or worst-case failure and whether there are clear action plans as well as the supporting technological capabilities to manage such a failure. There must be an increased focus on partner and contractor experience and expertise in the types of projects undertaken. Partner and contractor financial strength and ability to fund cleanup and liability costs in a worst-case scenario are also important.

Addressing every possible risk is impossible, but the industry needs to convince regulators and stakeholders that it is prepared for catastrophic events. One way to do this is to show risks have been considered and addressed in a thorough and holistic manner.

Risks can change quickly. As global risks continue to shift at a dramatic pace, companies must continuously evaluate their risk management processes to ensure that they are focused on the risks that matter. Preparing and planning for imminent risks and solutions to head them off will make it easier to weather the storm and deliver value to shareholders and consumers.

Note: The views expressed herein are those of the author and do not necessarily reflect the views of Ernst and Young LLP.