June 2010

The Macondo, Gulf of Mexico, Oil Spill

Insurance Implications

© 2010 Risk Management Solutions, Inc. 2

THE 2010 MACONDO OIL SPILL

Between February and early April 2010, the Macondo well was drilled to 18,000 ft (5,486 m) in 5,000 ft (1,524 m) of water in block 252 Mississippi Canyon (MC252). Located 50 mi (81 km) off the coast of Venice, Louisiana, the well was drilled from Transocean‘s ultra deepwater, semi-submersible mobile Deepwater Horizon rig. BP was the field operator, having a 65% share in the field, with Anadarko Petroleum, a leader in deepwater drilling, having a 25% share, and Mitsui Oil Exploration having a 10% share. The well was successful in locating a major oil reservoir, and at the conclusion of the drilling operation, the well casing was to be installed and field sealed with a cement plug—to be reopened later from a production platform. The Deepwater Horizon drilling rig was ready to be moved to a new location.

The cementing of the well was completed by the contractor Halliburton in the early morning hours of April 20. Throughout the day, the heavy drilling muds were being replaced with sea water and the pressure in the well was tested for any problems in the cementing. On this final day, there appear to have been indications of some flow into the well; however, exactly what caused the catastrophic failure of the cement cap remains unclear. At 9:45 p.m. local time, a large blowout of methane gas traveled up the drilling pipe. The gas ignited on the platform, leading to an explosion and fire that quickly grew out of control (Figure 1). There were 126 workers on the platform at the time—11 of whom were killed. After burning for a day, the platform sank, rupturing the drilling column that connected the platform with the sea bed.

Figure 1: Fighting the fire on the Deepwater Horizon drilling platform on April 21, 2010 (Source: U.S. Coast Guard)

Both at the time of the initial gas blowout, and subsequently through the intervention of BP engineers using remotely controlled underwater vehicles, the outflow failed to be intercepted by the 450-ton 49-ft (15-m) tall seafloor blowout preventer (BOP), designed to rapidly shut off the flow of oil or gas by squeezing, crushing, or shearing the pipe.1 Early speculation around these failures has focused on insufficient battery power, failure of the hydraulic systems, and excessive thickness of the well casings.

1 In an emergency, it should have proved possible to operate the BOP from a number of different points on the platform. The BOP was also intended to shut down automatically, if all contact with the platform was severed. There were also attempts to operate t he BOP through the intervention of a subsea vehicle at the seafloor.

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After the sinking of the platform on April 22, and collapse of the riser pipe, it was discovered that large quantities of crude oil and gas were escaping through the ruptured drill stem and two openings in the BOP close to the seafloor. For weeks following the platform‘s explosion, there was controversy about the magnitude of this flow, initially estimated at 5,000 barrels per day. On May 21, 2010, Admiral Thad Allen, the National Incident Commander for the Deepwater Horizon Response team, formally established the Flow Rate Technical Group (FRTG), a mul ti-agency federal effort to validate the amount of oil flowing into the Gulf of Mexico from the damaged pipes2. On May 27, the FRTG announced that the best estimate of flow was between 12,000 and 19,000 barrels per day. On June 9, the team raised this esti mate to between 20,000 and 25,000 barrels, and on June 10, 2010, an estimated 25,000 to 30,000 barrels per day were flowing into the Gulf—about half of which was being collected. Five days later, the estimates were again raised to 35,000-60,000 barrels per day.3 It is not clear whether this uptick reflects only improved estimation methods or also higher flow rates after the removal of the riser at the start of June.

Attempts at Containment

On May 7, 2010, BP placed a 98-ton steel dome over the principal source of discharge, with the intention of funneling the oil to a pipe for surface collection. However, this procedure failed when the dome became clogged with gas hydrate crystals. Then, on June 3, after cutting the riser with remotely controlled shears, a cap was successfully placed over the severed riser, allowing an estimated 14,000 barrels of crude oil per day to be collected at a surface recovery ship. The recovery rate increased and was claimed to be 30,000 barrels per day on June 18. By the end of June, BP stated its plans to fit a new cap with a riser reaching to within 300 ft (91 m) of the sea surface that could be disconnected in the event of an advancing hurricane. With the new containment measures, the capacity of captured oil is intended to be between 40,000 and 53,000 barrels per day by the end of June and 60,000 to 80,000 barrels per day by mid-July.3 However, these plans are contingent on operations not being significantly disrupted by an advancing hurricane , when all the surface facilities would need to be removed for at least a few days, and the oil would once again flow into the sea.

Based on a 35,000-60,000 barrel per day estimate of the release—that may have been lower before the riser was cut—and taking into account the amount understood to have been collected over the first sixty days since the original sinking of the platform on April 22, 2010, the volume of crude oil released into the Gulf of Mexico has been between 1.6 and 3.2 million barrels.

Hurricane-SIick Interaction

By early June, the slick covered a surface area of 9,460 mi2 (24,500 km2), washing ashore along the outer barrier

islands of southern Louisiana and toward the coast of Alabama (Figure 2(a)). One feature of the Macondo slick that had

been identified in a controlled release of crude oil and gas in deep water off Norway (Johansen et al., 2003), is that a

slick formed through deep release of oil is much more emulsified than would be the case for a shallow release. There

were also reports of plumes of oil droplets in colloidal suspension at depth in the Gulf of Mexico. Through the summer of

2010, the Macondo slick is expected to remain in a clockwise gyre in the Northeast Gulf. The gyre is in process of

separating from the Loop Current, which runs between the Caribbean and the southern tip of Florida. It therefore seems

unlikely that significant quantities of the oil spill will pass toward southern Florida or into the Atlantic Ocean, as has been

speculated. Oil at the surface is expected to evaporate and weather into tar clumps which will eventually, over a period

of months, sink to the seafloor, become consumed by bacteria, or become deposited on beaches. The oil-consuming

microbial activity in the waters of the Gulf is high because of the large number and flow rate of natural subsea oil seeps.

2 For more information on the FRTG, see http://www.deepwaterhorizonresponse.com/posted/2931/FRTG_Fact_Sheet_5_26_1.559427.pdf . 3 http://www.deepwaterhorizonresponse.com/go/doc/2931/661583/

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Also, the oil in this region tends to be a light crude, with lower tar content. The coastline affected by the oil coincides

with the Gulf of Mexico Dead Zone, a region in which levels of fertilizer and other nutrients brought down the Mississippi

River have made the Gulf of Mexico‘s waters in the vicinity of the delta almost devoid of oxygen and hence of life (Figure

2(b)). As a result, the impact of the oil on primary marine productivity in the coastal zone is much lower than would have

been the case on other coastlines. The Dead Zone fluctuates in area up to 8,108 mi2 (21,000 km2)—a similar extent to

that of the oil slick. However, the adjacent coastal salt marshes and barrier islands have active ecosystems.

(a)

(b)

Figure 2: (a) Oil slick in the Gulf of Mexico as seen from space on June 12, 2010 (Source: NASA); (b) the Dead Zone in the Gulf of Mexico; red zone indicates the least oxygenated water (Source: http://www.gulfhypoxia.net/News/images/stephanieclarkmap.jpg)

At the start of what is expected to be an active hurricane season, there has been much speculation as to how hurricanes might affect the oil slick, or the oil slick hurricanes. Basic theories about hurricane–slick interaction would suggest that the slick could impede a hurricane by slowing evaporation and the storm could be strengthened by oil trapping and absorbing heat. According to NOAA, the oil slick isn't likely to have a significant influence on a storm either way, because the slick is spread out and patchy and the area of ocean evaporation that feeds a hurricane is far more extensive than the principal extent of highest surface winds (NOAA, 2010). High winds and waves are expected to weather and break up the oil, speeding the biodegradation process. However, a hurricane in the Gulf could also transport oil to additional sections of coastline.

Analysis by RMS suggests that in an average year (i.e., assuming medium-term activity rates in the RMS® U.S. Hurricane Model), there is a 10% probability that a hurricane wind field will pass through the current ex tent of the slick, and about a 4% probability that this would be an intense Category 3-5 hurricane with a significant storm surge and the potential to carry tar deposits far inland. Given all the indications concerning the elevated activity now expected through the 2010 hurricane season, these probabilities are 13% for a hurricane wind field passing through the slick and 7% for an intense Category 3-5 event. However, any hurricane in the vicinity of the slick has the potential to bring waves that break protective booms and allow the oil to be displaced into coastal salt marshes and beaches abo ve the tide line. RMS analysis also indicates an approximately 16% chance that a tropical storm or hurricane will pass within 100 miles of the Macondo well before the end of July, rising to more than 40% by the end of August, requiring precautionary evacuation of the replacement drilling platform and surface oil recovery vessels.

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Historical Perspective

Assuming the relief well interception is successful by mid-August 2010, the volume of unrecovered oil spilled from Macondo will be comparable to the total oil released from the previous worst oil spill in the southern Gulf of Mexico, which persisted from June 1979 to March 1980. The Ixtoc I well, drilled by Mexico's government-owned oil company, Petróleos Mexicanos or Pemex, in 150 ft (46 m) of water in the Gulf of Campeche, suffered a blowout after a loss of drilling fluid, leading to a fire that similarly caused the destruction of the semi-submersible drilling platform. An estimated 30,000 barrels of oil was released each day, eventually reduced by pumping heavy mud and metal debris into the well but not finally brought under control until the reservoir had been re-drilled nine months later in March 1980. The total Ixtoc I spill was estimated at 3.3 million barrels of crude (Schmidt Etkin, 2009), with 71,500 barrels of oil impacting 162 mi (266 km) of Texas beaches and requiring over 10,000 cubic yards of oil soaked beach sand to be removed. Pemex spent $100 million cleaning up the oil, but was able to avoid additional liability for business interruption and environmental damage by claiming sovereign immunity.

Hurricane Henri, a Category 1 hurricane, passed just north of the main portion of the Ixtoc I oil spill in September 1979, but did not show any intensity changes that can be attributed to the slick. The wind and waves diluted the thick surface oil concentration into a thick "mousse.― About 90% of the deposited oil was scoured off beaches, washed into estuaries, or swept back out into the Gulf of Mexico. In August 1980, the oil sediment mats were then washed into coastal lagoons by the surge and waves from Hurricane Allen, a Category 3 storm at landfall, but a Category 5 storm thirty-six hours before landfall in the Gulf of Mexico.

More recently, in 2005, hurricanes Katrina and Rita caused a series of spills from platforms and pipelines, totaling about 16,000 barrels (MMS, 2010). If one additionally considers spills on land, this estimate increases significantly. For example, Hurricane Katrina caused a series of spills from tanks, pipelines, and production platforms, totaling more than 250,000 barrels of crude and refined oil products around the coasts of southern Louisiana (Pine, 2006). The background level of oil pollution naturally seeping into the Gulf of Mexico from the seafloor is estimated to be 560,000 to 1,400,000 barrels per year (1,534 to 3,835 barrels per day) (Schmidt Etkin, 2009).

Offshore Platform Modeling

The RMS® Offshore Platform Model provides a tool for estimating losses to offshore exposure due to hurricane events in the Gulf of Mexico. Losses are calculated for physical damage to multiple classes of platforms and rigs, for operators extra expense (OEE) and loss of production/loss of hire coverages. OEE typically refers to a group of coverages obtained by the well operator, including control of well, making well safe, cost of re-drill, and plug and abandon. OEE losses are a significant driver of risk to the offshore energy industry in the Gulf of Mexico, contributing nearly a third of the average annual loss as estimated by the RMS model.

It is important to differentiate offshore exposure in terms of water depth, as this will often dictate the types of damage and loss in a hurricane. For example, deepwater wells such as Macondo are considered to be at minimal hurricane risk and historically have not suffered any loss during a hurricane event, due to safety precaut ions taken in advance of a storm. As part of evacuation procedures, the drilling or production riser is disconnected from the wellhead and the BOPand safety valves on the blowout preventer are closed. In shallower waters, hurricane damage to wells typicallyoccurs when the associate platform or rig is severely damaged or collapses. According to the 2010 RMS®

Platform Industry Exposure Database, 90% of the Gulf's over 10,000 active wells are located in shallow water. For a Offshore

shallow water well, there is a small possibility that a hurricane could also cause a loss of control of a high-production

well, leading to a major oil spill.

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IMPLICATIONS FOR LIABILITY COVERAGE

Determination of Responsibility and Costs

The platform explosion and ensuing oil spill likely resulted from a chain of failures in procedures, maintenance, supervision, and testing during the close-out of the Macondo well.4 While determination of specific corporate responsibility for the elements of failure in this chain will be subject to ongoing investigation—and litigation—failures in the cementation process and quality controls, the supervision and monitoring of the well, and in the maintenance of the blowout preventer (BOP) are expected to be the primary contributing factors. In eighteen of the 39 well blowouts surveyed by the federal government‘s Minerals Management Service (MMS)5 from 1992-2006, cementing was found to be the ultimate cause of the blowout (Izon et al., 2007).

Early accusations laid by the U.S. Congress are that BP took shortcuts in the available procedures to manage the wel l. Some mitigation could come from the fact these procedures appear to have been signed off by the MMS.6 However, ―government preemption‖ is not a principle that guarantees to shield BP from the charge of gross negligence. As BP has been assigned the role of responsible party, it will be up to BP to win the legal arguments that other parties to the spill should share its losses. However, other parties may also receive their own third party lawsuits.

The total cost of the Macondo oil spill will include multiple categories of loss:

Management and clean-up of the spill

Claims by businesses, principally in the beach tourism and fishing industries, for loss of revenues resulting from the spill

Claims and lawsuits relating to personal injury or death in the explosion, fire, and sinking of the Deepwater Horizon platform

Environmental and natural resources claims for damage from the spill—from conservationists, fishermen, and states

Health claims from those exposed to the oil or dispersants and other chemicals employed in the clean-up of the spill7

Product liability lawsuits related to equipment failures on the platform, subsea, or related to the containment of the spill

Lawsuits filed relating to lost revenues for royalties, leases, or taxes from government entities

Shareholders and securities lawsuits concerning mismanagement before and after the loss of Deepwater Horizon rig, leading to the dramatic reductions in share valuations that followed the spill8

Fines or other penalties

The first of these categories—management and clean-up—will be a function of the duration over which oil continues to pour from the well head, as well as the degree to which oil residues are displaced inland, as could follow a hurricane. As

4 One view of the chain of events leading to the well failure was laid out by Henry A. Waxman, the chair of the Committee on Energy and Commerce of the U.S. House of Representatives, and is available at: http://energycommerce.house.gov/documents/20100614/Hayward.BP.2010.6.14.pdf . 5 On June 18, 2010, the Minerals Management Service (MMS) was officially renamed the Bureau of Ocean Energy Management, Regulation, and Enforcement (BOEMRE). 6 See http://energycommerce.house.gov/documents/20100614/Hayward.BP.2010.6.14.pdf . 7 The spraying of chemicals to remove oil from rocks after the Exxon Valdez spill of 1989 was claim ed to have led to widespread health problems (see http://www.prwatch.org/node/9147). 8 These could lead to claims on Directors and Officers (D&O) policies held by these companies.

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authorized by the Oil Pollution Act (OPA) of 1990, the Oil Spill Liability Trust Fund (OSLTF) is available to pay the costs of the federal response to an oil pollution incident, and to compensate claims for damage and removal. The law requires that these costs are recovered from the polluter. BP and Transocean have been named as responsible parties, although all claims are currently being processed centrally through BP. The OPA requires the full costs of an oil spill be recoverable, including clean-up costs, lost profits, destroyed property, and lost tax revenues. It also caps these economic damages at $75 million. However, the OPA does not limit liability if the incident was caused by gross negligence, willful misconduct, or in violation of federal safety, construction, o r operating regulations. U.S. Senate Democrats have made several attempts to pass legislation through the U.S. Congress to raise the cap from $75 million to $10 billion, or eliminate the cap altogether. It remains unclear, and probably subject to subsequent legal challenge, whether this increase could be imposed retroactively. On May 16, 2010, BP Chief Tony Hayward acknowledged that claims related to the spill will exceed the $75 million limit and agreed to pay legitimate claims and not seek reimbursement from the OSLTF. Transocean, the owner of Deepwater Horizon, filed papers in a Houston court on May 20, 2010, seeking to limit its legal liability to $27 million under the Limitations of Liability Act of 1851, as applies to a foreign based company vessel. Transocean relocated its headquarters from Texas to Zug, Switzerland, in 2008.

The loss of revenues among affected businesses will depend on where the oil slick moves along the coastline and onshore, as well as how quickly it dissipates. There is, for example, relatively little sandy beach coastline, and the associated tourism activity, in Louisiana but much more in Alabama and Florida, could be impacted. On June 16, BP agreed to establish a $20 billion escrow fund to compensate victims of the Macondo oil spill.9 This account will be funded over several years and does not represent a cap on the company‘s liabilities . Payments from the $20 billion escrow fund will be managed by Kenneth Feinberg, who handled the compensation fund for victims of the September 11, 2001 attacks and who is currently the ‗pay czar‘ tasked by the President with approving top salaries in companies in

receipt of federal bailout assistance following the 2008-2009 credit crunch. On June 19, BP stated it had received 64,000 claims and the average time from filing a claim to checks being issued is four days for individuals and seven days for "more complex business claims that have provided supporting documentation.‖ The company said a 1,000-member claim team is working in 33 field offices in Louisiana, Mississippi, Alabama, and Florida. Paying 31,000 claims for $104 million so far, BI claims currently being refunded by BP most likely include significant claims inflation, with the current intense political climate likely encouraging exaggeration and fraud. However, once the spill has been contained, claims are likely to be scrutinized in more detail than is currently possible. BP has also been told to contribute at least $100 million to compensate individuals and companies suffering downtime as a result of a moratorium on deepwater drilling. However, on June 22, 2010, the six-month moratorium was overthrown by a federal judge in New Orleans as causing undue hardship to the local economy; the White House has said this judgment will immediately be appealed.

Who Will Pay?

Three organizations were responsible for components associated with the failure of the uncontrolled well: BP, Halliburton, and Transocean. It seems unlikely that any of them will escape some responsibility for the spill . However, the share of costs each will be required to bear will be determined by a whole range of factors including: their relative responsibilities identified in independent inquiries, their contractual agreements limiting liability, the relevant marine law, and the workings of the OPA. Lawsuits may also be filed against the manufacturer of the BOP, Cameron International, for some responsibility in the blowout. However, unless it can be shown there was some fundamental defect in the design of the blowout preventer, given that the equipment was almost ten years old and maintained by Transocean, Cameron may be able to resist this extension.

Under normal circumstances, costs would be expected to fall proportionately to Anadarko Petroleum, which had a 25% share in the Macondo Field, and Mitsui Oil Exploration, which had a 10% share. A bill of $20 billion to BP would 9 http://www.bp.com/genericarticle.do?categoryId=2012968&contentId=7062966

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therefore imply costs of $7.5 billion to Anadarko and $3 billion to MOE. However, while BP generated $239 billion of revenue in 2009, Anadarko only generated $9 billion. On June 18, the chief executive of Anadarko Petroleum, Jim Hackett attempted to distance the company from responsibility for the costs of the spill, stating: ―The mounting evidence clearly

demonstrates that this tragedy was preventable and the direct result of BP‘s reckless decisions and actions….BP is responsible to its co-owners for damages caused by its gross negligence or willful misconduct.‖ Also, MOE has said that it has given up its interest in oil from the well. However, BP is likely to sue both Anadarko and MOE to pay their shares—in one of a number of large, long-running lawsuits that will determine the ultimate allocation of costs.

In the event of a major hurricane storm surge leaving tar residues on privately-owned property or land, homeowners insurance would not cover oil damage, as these policies exclude pollution and damage to the land on which a property is situated. Also, it has been argued that the raw, natural crude oil spilling into the ocean may not qualify as a pollutant .10 National Flood Insurance Program (NFIP) policies for residential and residential condominium association do not contain pollution exclusions for property damage due to floodwaters, although there is no coverage for costs of testing or monitoring pollution unless required by law or ordinance. There is typically a $10,000 limit on pollution damage for non-residential policies. NFIP policies cover removal of debris, although debris is assumed to be building materials damaged due to floodwaters, rather than any residual tar deposit. Property owners could separately sue, or file a class action lawsuit, against BP for land contamination. For commercial flood policies, the removal of oil debris would be an additional element in clean-up costs after a storm surge flood, as was the case in Hurricane Katrina.

For business activities interrupted by the oil spill, these businesses would not claim oil spill damage on their hurricane insurance coverages if their business was also interrupted by a hurricane. Insurers providing coverage may also try to recover some of the paid claims by suing BP and others, if additional costs are related to pollution.

Liability Insurance Coverage

In terms of available liability insurance coverage, BP, the field operator with a 65% share of the prospect, was self-insured. However, Anadarko Petroleum has admitted an operators extra expense (OEE) (i.e., control of well) coverage of $177.5 million with a $15 million deductible; and Mitsui Oil Exploration (70% owned by Mitsui Co Ltd, 20% by the Japanese government and 10% by independent investors), has OEE coverage of $45 million. Both partners with BP will most likely be unable to prevent the costs associated with the oil spill being distributed in proportion to their share of the prospect, even though agents of the U.S. government are currently assuming that BP has the sole responsibility in paying for the consequences of the spill.

Transocean, owner of the Macondo well and drilling operations, has $560 million in coverage for the platform and access to $140 million to cover wreck removal, as well as $950 million in limits for liability (with a $700 million limit for an offshore loss). The well cementer, Halliburton, has $600 million of general liability coverage. Cameron International, manufacturer of the blowout preventer, has $500 million of general liability coverage. As a result, there is total available insurance of approximately $3 billion, with around $2 billion of that reflecting liability coverage (Table 1).

The lawsuits likely to play out over several years will determine how much of this coverage becomes exhausted. Legal arguments to access the coverage held by Halliburton and Transocean will undoubtedly transpire. Transocean is likely to resist these claims strongly, arguing its limit of liability under maritime law, and Halliburton is currently insisting that the contractual terms of its agreement with BP absolve it of liability. Cameron International has the strongest case to argue against liability. Therefore the total insurance costs, are likely to fall between $1 billion and $3 billion.

10 http://www.insurancerate.com/will-home-insurance-absorb-costs-of-oil-spill-damage.php

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Table 1: Insurance coverage of companies involved in the Macondo oil spill, including operators extra expense (OEE) coverage and general liability coverage

Company Available Insurance Coverage

(in $US)

BP $0

Anadarko Petroleum $177.5 million

Mitsui Oil Exploration $45 million

Transocean $700 plus $950 million (general liability)

Halliburton $600 million

Cameron International $500 million

TOTAL ~$3 billion

BP self-insured its risks through a captive insurer, Jupiter Insurance Ltd., with $6 billion in capital, but no reinsurance protection. Jupiter‘s per occurrence limit on physical damage and business interruption is $700 million and unlikely to cover environmental and third party liability. BP Shipping has $1 billion in marine liability pollution coverage through mutual insurance associations.11

Offshore oil platforms are the most complex and difficult commercial risks to underwrite. Different types of liability coverage may apply, including:

Comprehensive general liability that provides coverage for claims as a result of bodily injury or property damage to a third party

Environmental/pollution liability that provides coverage for bodily injury, property damage, and clean-up costs resulting from a pollution incident from an insured site

Workers compensation/employers liability that provides coverage for claims arising from injury or death of employees while at work

Operators extra expense (OEE) and energy exploration and development (EED 8/86) are two standard insurance coverages available to owners and operators of wells. Excess liability insurance that covers all legal liabilities of an offshore energy facility operator can be purchased as an additional layer of coverage in excess of the OEE policy. There is no standard limit for seepage and pollution coverage under the OEE contract, although the payout will be capped by the combined single limit. Typically, payments under OEE/EED are a proportioned hierarchically, with claims first paid for control of wells, then re-drilling costs, with any remaining portion of the limit assigned for seepage and pollution.

Although both OEE and EED policies are similar, EED has more restrictive wording on what is covered and the limit of liability of the underwriters. Care, custody, and control, related to insured‘s liability for third-party equipment, are typically part of an OEE endorsement. However, EED 8/86 often excludes drilling or work-over rigs coverage. It also excludes indemnity and liability for any claims ―caused, in whole or in part, if the insured did not exercise due care and diligence in the conduct of all operations in accordance with regulations, requirements, and normal and customary practices in the industry,‖ as well as utilize all safety practices and equipment considered prudent.

11 http://www.iii.org/presentations/the-deepwater-horizon-disaster-insurance-market-impacts.html

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Implications for Future Liability of Energy Companies

The 2010 Gulf of Mexico oil spill will have a significant and long-lasting impact on offshore energy insurance availability, rates, and coverages. The contract terms of both OEE and EED policies will likely be revised. Moody‘s has estimated that property rates are already 15-25% higher for rigs operating in shallow water and about 50% higher for deepwater rigs, but these are initial reactions in a market that will be transformed by the occurrence of this event and the way in which the losses from it will exceed all previous industry expectations.

However, even more than the direct costs, the way the event has headlined the U.S. political agenda for more than a month will itself have long-term consequences. In particular, the more punitive the situation is being made for BP now, the more difficult it will be to conduct offshore deep drilling in the future. In forcing BP to set up an escrow account of $20 billion to manage potential future claims, and in demanding BP compensate workers laid off as a result of the government-imposed moratorium in deepwater drilling, the U.S. government is also pressing extralegal remedies that will raise the assessed political risk around future natural and manmade U.S. catastrophes, when retroactive legislation might be applied to extend the contractual terms or limits of insurance coverage.

U.S. Senator Jeff Sessions (Republican-Alabama) is currently co-sponsoring a bill that would raise the liability for oil-related economic damages to a figure equal to the company‘s profits the previous year, or $150 million, whichever is

higher. For BP, this is approximately $20 billion. Republicans argue that smaller companies would get the insurance they need to drill; without insurance, they can‘t get financing, and without financing, they cannot operate. Based on the experience of the Macondo oil spill and the extreme attention that the spill has acquired, it will not be politically tenable to cap oil pollution liability in this way, as there would always be political pressure to break the cap and make the operator liable for all the extra costs of containment, pollution clean-up, and business interruption. Therefore, going forward, companies involved in deepwater drilling will need to plan for liabilities in which the Macondo spill becomes a de facto probable maximum loss. Current global insurance capacity for an individual operators extra expense coverage has been assessed at only $1.5 billion, which includes the costs associated with well control and well re-drilling, before liability costs of any spill itself are added. Only by significant increases in the cost of deepwater liability coverage could there be a major expansion in capacity to $5 billion or more (backed by the major reinsurers), but even that figure will likely be insufficient.

Given the absence of sufficient insurance capacity to provide $10 billion in liability coverage, future deepwater drilling could only be pursued by the largest oil corporations with sufficient resources to self-insure. As the liability costs seem likely to make deepwater drilling unaffordable for smaller independents like Anadarko, a wave of merger and acquisition activity among the smaller oil exploration companies is now anticipated.12 However, the political rebuke and reputation damage suffered by BP could lead major corporations to purchase smaller exploration companies and preserve their identity in order to pursue ‖arm‘s length‖ deepwater oil prospecting.

The political impact of the Macondo spill also has important implications for questions of liability following other industrial accidents in which there is currently a pre-agreed cap on the liability costs assumed to an original operator. The most obvious parallel is the nuclear industry, where there is a $10 billion cap on assumed liabilities (established in the 1957 Price-Anderson Act)13 reflecting a mix of pooled and private insurance and government compensation. The Macondo spill will likely prompt deepwater drilling operations to take on an elevated safety and regulatory culture, as has been developed within the nuclear industry

12 http://www.petroleum-economist.com/default.asp?Page=14&PUB=279&SID=726115&ISS=25630 13 Private operators of nuclear power plants need to be aware that, in the event of a major release of radiation, their implicit liabilities could become unlimited and ruinous, regardless of the pre-agreed liability cap.

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RMS Modeling Capabilities for Liability Insurance Coverages

RMS has been working since 2006 in the development of liability risk pricing and accumulation models. The Macondo oil spill highlights a number of ways in which probabilistic risk modeling can be applied in the offshore industry, and by insurers and reinsurers covering the liability arising from offshore assets.

The calcula t ion of technical r isk costs for uncontrol led releases f rom offshore dri l l ing

The current methodologies employed within the oil industry for calculating the potential impacts of an uncontrolled release have proved inadequate. A better understanding of the potential risk costs could have dramatically changed the calculation of the benefits of alternative, more expensive risk management options during the completion and closure of the Macondo well. Going forward, for all offshore drilling prospects, it will be important to perform probabilistic analyses of alternative sizes and durations of releases to evaluate realistic risk costs of a release, if only so that oil explorers can measure the risk-adjusted financial benefits of their well management procedures.

There is no historical evidence that blowout probabilities are any higher for deepwater wells than for shallow water ones (see Izon et al., 2007). However, as first identified in a study thirty years ago (Webb, 1981), as a preliminary to initiating deepwater drilling: ―The wholesale transfer of underwater inspection, maintenance, and repair techniques away from divers to various alternatives is required. Further, the consequence of the limitations of these alternative techniques demand that underwater inspection, maintenance, and repair be a major consideration during the initial design of deepwater production systems‖. The Macondo blowout has proved the significance of these insights; there is much greater difficulty in managing and closing off a deepwater well as compared to a shallow well, and, therefore the potential for much longer uncontrolled flows. It is also clear that the technologies required to manage an incident in deep water had not been advanced in tandem with the move to drill in deep water. Therefore, while a shallow well might be in closer proximity to the coast, a deepwater well can be expected to create longer -lasting and therefore much larger spills, significantly adding to the ultimate costs.

The costs of any spill are strongly affected by location. There will be significantly higher potential costs for locations with high-value coastal properties, large tourism industries, or thriving fisheries. Costs will also be significantly higher in a litigious society, such as the U.S. The U.S. coastlines with the highest densities of coastal commercial activities (principally from tourism and fisheries) are in Southern California and Florida. The expected annualized risk costs developed from the stochastic modeling of blowout probabilities, duration and volume of release (including impacts on business interruption and clean-up) may be several tens of millions of dollars for a deepwater well in U.S. waters. RMS has the capabilities to explore how expected losses of potential spills could be calculated probabilistically and also related back to the risk cost for the original well.

Managing clash among l iabi l i t y contracts

The Macondo oil spill has highlighted the potential for separate liability insurance policies, written for entities impacted by the same underlying event to be subject to clash—in what is, in effect, a ―liability catastrophe‖ or L-Cat. The correlation of policy losses from the Macondo spill extends not only across the different partners in the prospect, but across the equipment manufacturers, service companies, drilling platform owners, and operators of the well. As part of its liability risk modeling agenda, RMS has been developing systems for tracking the inherent correlations that exist among sets of individual liability policies, and looking at the potential impact in the same underlying event—as with the Macondo spill. Identifying these potential correlations is a critical component of effective portfolio management.

However, as also highlighted by the Macondo spill, a massive liability clash event has a major impact on the value of the companies exposed to the liabilities. The share values of all the companies potentially impacted by the Macondo oil spill , including BP, Anadarko, Mitsui, Transocean, Halliburton, and Cameron, have all been subject to falls of 40% or more, wiping off more than $100 billion in their collective values. This overall reduction in value highlights how insurers with liability books need to manage, holistically, the correlations that exist across their insurance and investment portfolios.

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REFERENCES

Izon, D. et al. (2007). Absence of fatalities in blowouts encouraging in MMS study of OCS incidents 1992 -2006. Drilling

Contractor, July/August 2007, 84-90. Retrieved from http://drillingcontractor.org/dcpi/dc-julyaug07/DC_July07_MMSBlowouts.pdf.

Johansen, O. et al. (2003). DeepSpill - Field study of a simulated oil and gas blowout in deep water. Spill Science &

Technology Bulletin, 8(5-6), 433-443.

MMS (2010). OCR-Related Incidents: Spills - Statistics and Summaries 1996-2011. Minerals Management Service. Retrieved from http://www.mms.gov/incidents/spills1996-2011.htm.

NOAA (2010). NOAA’s Oil Spill Response: Hurricanes and the Oil Spill. National Oceanic and Atmospheric Administration. Retrieved from http://www.nhc.noaa.gov/pdf/hurricanes_oil_factsheet.pdf.

Pine, J.C. (2006). Hurricane Katrina and Oil Spills: Impact on Coastal and Ocean Environments. Oceanography, 19(2), 37-39.

Schmidt Etkin, D. (2009). Analysis of U.S. Oil Spillage, (API Publication 356). Washington, D.C.: American Petroleum Institute. Retrieved from http://www.api.org/ehs/water/spills/upload/356-Final.pdf.

Webb, G.D. (1981). Inspection and repair of oil and gas production installations in deep water . Ocean Management, 7(1-4), 313-326.

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ACKNOWLEDGEMENTS

Author: Robert Muir-Wood

Contributors: Abigail Baca, Auguste Boissonnade, Ben Fox, Patricia Grossi, Ryan Irvine, Raj Vojjala, Lisa Ward

Editor: Shelly Ericksen Special thanks to Bob Reville of RAND Corporation for his review and comments.

About RMS

Risk Management Solutions is the world‘s leading provider of products and services for catastrophe risk management.

More than 400 leading insurers, reinsurers, trading companies, and other financial institutions rely on RMS models to quantify, manage, and transfer risk. Founded at Stanford University in 1988, RMS serves clients today from offices in the U.S., Bermuda, the U.K., France, Switzerland, India, China, and Japan. For more information, visit our website at www.rms.com.