The Aftermath of Deepwater Horizon

The Deepwater Horizon incident is a seminal event for the offshore oil and gas industry. The ramifications will be felt by exploration and production companies, oilfield services companies and oilfield equipment manufacturers, both in the United States and around the world, for years to come in the form of a more difficult political environment, a more complex and intrusive regulatory regime, more stringent industry operating standards and practices and, possibly, a revised view of operational risk. In the near term, the financial consequences of the recently announced deepwater drilling moratorium, as well as regulatory delays and uncertainty with respect to other offshore activities, could result in significant liquidity issues that potentially could spread across the sector.

Directors and senior management of companies involved in the offshore oil and gas industry should examine the potential near- and long-term effects on their companies of the fallout from the Deepwater Horizon incident, including the deepwater drilling moratorium, to determine how to address and, if possible, mitigate potential adverse consequences. Directors and senior management also should reexamine the company’s overall risk profile in light of these developments. In considering whether to conduct a risk review, directors and officers should be cognizant of the potential for significant governmental scrutiny, particularly in the current political environment, of alleged lapses in risk oversight. Because of the potential significance and multiple facets of this review (encompassing operational, financial, contractual, legal, fiduciary, disclosure and potential liquidity/solvency issues, among others), companies should consider enlisting the assistance of outside advisers, including legal counsel and financial advisors experienced in these matters, as well as accountants and communications firms, as appropriate.

This memorandum highlights key issues for directors and senior management of companies involved in the offshore oil and gas industry to consider as they prepare to respond to the challenges that are certain to arise from the Deepwater Horizon incident.

1. Business Plan

A prompt review of the company’s current business/operating plan may be in order. Any such review should take into account the deepwater drilling moratorium, including the prospect of its extension and of curtailed drilling activity if and when it is
lifted, and other current developments. Some of the questions to consider include:

• How do these developments affect our business plan?
• Have we conducted a “stress test” of the business plan against downside scenarios, including potential extension of the drilling moratorium?
• What capital expenditures in the company’s existing plan are “essential,” and what expenditures can be deferred or eliminated?

2. Terms of Material Contracts Affecting Rights and Liabilities

The Deepwater Horizon incident underscores the high degree of risk inherent in oil and gas exploration and production activities, particularly offshore activities. The terms of the contracts under which a company provides or procures goods or services commonly provide for the allocation of various of these risks between the contracting parties. These contractual terms often include force majeure provisions, cost sharing or reimbursement provisions, liability caps, releases and indemnification. The scope and implications of these provisions potentially can have a significant impact on a company’s overall risk profile. Questions to consider in this regard include:

• What rights/obligations of the company under its material contracts are suspended due to a force majeure event?
• Insofar as force majeure typically does not suspend the obligation to make payments, are significant payment obligations of the company otherwise suspended in the event of nonperformance by the counterparty, even if such nonperformance is excused?
• What are the liability caps/limitations and indemnification rights in favor of the company, its suppliers, and its customers under its material contracts?
• If the company is a non-operator, what are the company’s obligations/liabilities with respect to the operator’s mistakes or liabilities? Is that limited in the case of only gross negligence or some other high standard?
• If the company is an operator, what are the company’s obligations/liabilities with respect to catastrophic events?
• What are the effects of the drilling moratorium and potential extended regulatory delays on the company’s rights under its offshore leases, farm out and farm in agreements, and operating agreements and on the drawdown periods under its credit agreements?

3. Liquidity

As part of the business plan review, close attention should be paid to the company’s short- and long-term liquidity and capital positions and requirements. The analysis needs to take into account rights of the company and parties with which it contracts to declare force majeure (or the lack of such rights), and the company’s contractual liability/indemnification position, where applicable. It also may be prudent to review the company’s debt, hedging, production, purchase, sales, transportation and other material agreements to identify and assess potential covenant compliance issues or triggers of another party’s rights to terminate or require collateral; e.g., covenant defaults, cross defaults and accelerations, collateral calls, put rights and joint venture governance rights. Appropriate questions may include:

• How will our liquidity position be affected?
• How will the liquidity position of key customers, suppliers, partners and critical infrastructure providers be affected?
• What are the company’s contingency plans for alternative sources of capital and liquidity?
• What potential compliance issues does the company face under debt covenants and other agreements?
• What steps can and should be taken to mitigate the consequences of these issues?

4. Regulatory Responses

Although the full regulatory response to the Deepwater Horizon incident is not yet known, one thing is certain — companies in the offshore oil and gas industry will face a vastly different regulatory landscape. These responses likely will not be limited to U.S. waters, as other countries can be expected to react as well. At this early stage, questions about process and preparedness may be the most relevant. For example:

• Does the company have a process in place to monitor potential regulatory developments, both domestically and internationally?
• Does the company have mechanisms in place for communicating its thoughts and concerns regarding regulatory matters to the appropriate regulatory personnel and other relevant entities?
• Is the company positioned to address the recently announced safety and CEO certification requirements applicable to shallow water drilling?
• Is potential regulatory reaction to perceived lack of coordination and communication among various service providers in the field likely to affect the company?
• What are the company’s contingency response plans to address potential regulatory developments, and are they being monitored and revised in real time as regulatory responses become clearer?
• Will bonding levels change and, if so, with what potential impact on the company?

5. Product and Service Impact: Impairment/Obsolescence

As evidenced by the Notice to Lessees and Operators focusing on safety measures that was issued by the U.S. Department of the Interior on June 8 (NTL No. 2010-N05), the new regulatory and operating paradigm for deepwater drilling will involve greater redundancy, more rigid performance and safety standards, and stricter monitoring and testing requirements. A company’s future competitive position in the industry may well depend on its ability to modify its product and service offerings to address the new paradigm. The first step is identifying potential strengths and weaknesses.

• Are any of the company’s key product or service lines at risk of becoming impaired or
  obsolete under potential or anticipated new regulatory or operating standards?
• What changes to the company’s existing products or services are likely to be required to meet more stringent regulatory or industry standards?
• How is the company reevaluating its research and development activities/budget in light of the current situation? [1]

6. Insurance

Insurance is an important component of a company’s risk policy and profile. The effect of the Deepwater Horizon incident on the company’s insurance program should be evaluated, and appropriate adjustments to the insurance program or, where applicable, operations, should be made. Questions could include:

• What is the company’s business interruption insurance coverage, and how does it apply to the current situation?
• How will this incident affect the cost and availability of casualty and liability insurance for offshore activities?
• How will this incident affect the financial stability of relevant insurance carriers?
• Might the sufficiency or availability of insurance coverage be affected by the convergence of offshore activity-related claims with the predictions of a more active Atlantic hurricane season this year?

7. Unsolicited Takeover Activity

Many companies in the offshore oil and gas sector have seen a sharp decline in their equity market valuations as a result of the ongoing fallout from the Deepwater Horizon incident. Although some parties may be deterred by the uncertain environment, this presents a classic risk situation for an opportunistic takeover attempt in which a bidder seeks to take advantage of the value gap due to the Deepwater Horizon valuation impact with an apparent “high premium” or “risk takeout” offer. In this environment, it is important that directors review thoroughly their companies’ structural and governance vulnerability to unsolicited takeover activity or large scale market accumulations and take steps to maximize the ability of the board to act in the best interests of shareholders on a timely basis. Advance preparation can be crucial. Possible questions include:

• What is the company’s structural vulnerability to various types of hostile activity?
• Are there changes that could be adopted to improve the company’s structural or governance profile?
• Who is potentially interested in making an acquisition overture? What aspects of the company’s business would be attractive to them?
• What are the key valuation issues affecting the company?
• How should directors and officers respond to contacts or inquiries?
• How should the company respond to contacts or inquiries? [2]

8. Disclosure

Consideration should be given to potential disclosure obligations that may apply to the company with respect to the effects of the Deepwater Horizon incident. These obligations may arise under SEC reporting requirements, including for periodic reporting (e.g., annual and quarterly reports) and certain Form 8-K reporting requirements, under stock exchange rules or under the duty of candor imposed by applicable state law. In certain circumstances, this could include an obligation to correct prior statements. Possible questions include:

• Does the company have any current disclosure obligations; e.g., need to update its earnings guidance or make any corrective disclosures?
• Should the company include any discussion of the effects of the Deepwater Horizon incident (e.g., the deepwater drilling moratorium or the potential effect of the incident on important customers or suppliers) in the MD&A section of the next Form 10-Q?
• Should the company include additional risk factor disclosure in any offering documents or in its Form 10-K?
• Are there changes that should be made to the company’s forward-looking statement “safe harbor” language?

In sum, the aftermath of Deepwater Horizon incident presents significant and unusual risks for many companies in the sector. Directors and senior management need to be vigilant and proactive in identifying and responding to these risks. In this regard, the foregoing reflects certain key areas to be assessed by directors and senior management of companies in the offshore oil and gas industry, whether exploration and production companies, oilfield service companies or oilfield equipment manufacturers. It may be prudent for these companies to establish a task force, comprised of appropriate internal personnel and outside advisors, to review and monitor these and other company-specific areas of potential risk, to report to senior management and the board regularly regarding its ongoing assessment and to make recommendations as to appropriate responses by the company.

Endnotes

[1] The flip side of risk is opportunity. Whether viewed as risk mitigation or competitive opportunity, companies should consider what existing or potential products or services might be in (greater) demand as the industry responds to the post-Deepwater Horizon environment.
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[2] For some companies, the fallout from the Deepwater Horizon incident may present acquisition opportunities that would not otherwise have been possible. In this regard, directors and senior officers of such companies may want to ask:

• What opportunities might the current environment present for the company?
• What initiatives might others take and how would they affect our competitive position?
• Are there benefits and risks of being a first mover?
• What is the company’s capacity to undertake a significant strategic acquisition from a financial, integration and management standpoint?

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