Lessons from the Gulf Spill: Do’s and Don’ts

We’re pleased to feature another post from Steven Kopits of Douglas-Westwood, this time on lessons to be learned from the BP oil disaster.

Lessons from the Gulf Spill: Do’s and Don’ts

by Steven R. Kopits

 

As the effects from the Macondo blow-out appear to be dissipating, it may be time for some preliminary lessons learned.

Do Focus on the Blow-out Preventer.
Many of us in the industry were shocked by the failure of the BOP, the failsafe device intended to prevent blow-outs like the one in the Gulf of Mexico. It was supposed to work, and it didn’t. Moreover, some excellent reporting from the New York Times indicates that BOP failures are more common than thought. Nevertheless, in the future, as in the past, the BOP must remain the focal point of spill prevention. BOP design and practice needs to be thoroughly reviewed and updated for safe and appropriate use in deep water. BP, as well as the other oil majors, can carry the cost, which would probably run into the low hundreds of millions of dollars. But it should be done, and Congress may have an interest in monitoring progress.

Do Capture the Lessons of BP’s Response.
In many ways, it is astounding that BP was able to get control of a rogue well in 5,000 feet of water in less than 90 days, given that no real contingency plans were in place at the time of the blow-out. These lessons should be recorded and institutionalized in the public record in the next three months. Let’s figure out what BP did wrong and what it did right after the blow-out, and make sure the industry has access to the knowledge. Congress may wish to monitor progress in this area.

Do Make Safety Records More Public.
Some believe BP’s corporate culture may be implicated in the accident, the result of a financially-driven management pressing field managers to take too much operating risk. In such a culture, the low-level safety personnel need to be able to push back on senior management. One method may be to compel more standardized, public disclosure of safety issues. This institutionalizes the whistleblower function; that is, rather than putting the safety manager in the position of whistleblower ‘ratting out’ his company, the safety report is by definition public. This is a tricky area, but one worth pursuing. Assign it to Cass Sunstein, Administrator of the White House Office of Information and Regulatory Affairs, and his team and see if they can make some progress on the topic.

Don’t Assume Whistleblower Legislation will Work.
It won’t. It’s not the Texas thing to do, and these topics are far too complex for a simplistic whistleblower approach. What do you want the whistleblower to say?: “Don’t you understand, they’re using only 5 spacers instead of 11! Don’t you understand what this means!? No, they won’t.

Do Send Field Managers to the ‘Rickover School’.
In an aggressive corporate culture seen in many oil majors, the ability of field managers to push back is critical. In such a situation, the most dangerous manager is one trying to dutifully comply with the mandates passed down from above. All field managers in the oil business (frankly, in the energy business) responsible for major at-risk activities, for example, the management of a refinery or an offshore drilling rig, need to know how to push back against management. The best I have ever met in this respect have been alumna of the nuclear fleet under Admiral Hyman Rickover. Rickover, considered the father of the US nuclear navy, left a legacy of technical achievements including the United States Navy’s continuing record of zero reactor accidents. A key component of this legacy was the empowerment of subordinate officers and enlisted personnel to resist the unreasonable requests of senior officers. I don’t know if this program is available commercially, but it wouldn’t be too difficult to set up a school. Attendance should be mandatory.

Don’t Permit Unlimited Liability.
In principle, companies should pay for the damage they cause. However, the potential damages are so great in the case of offshore drilling, that the small risk of a large spill may be enough to deter companies from the field. Over the past five years alone, more than 18,000 wells were drilled offshore, of which some 2,500 were in deep water (greater than 500 meters). And nothing remotely like this happened — the offshore oil & gas industry has in the last 22 years achieved an excellent safety record. Can oil companies absorb the risk of another accident? Of the thirteen oil companies producing oil and gas in the deepwater Gulf, seven qualify as supermajors, and six are smaller companies like Murphy Oil (market capitalization: $10 billion) and ATP (market cap: $0.6 bn). While the industry’s giants can handle the risk, the smaller companies would have been wiped out if they had caused the spill.

At least as important are equipment providers like Cameron (market cap: $10 bn), the manufacturer of the implicated BOP. If equipment and parts manufacturers are to have unlimited liability, then many may simply leave the US or stop serving the segment. Not all the parts that could fail are large. For example, the world’s largest floating production platform, BP’s Thunderhorse, nearly sank when a valve was inadvertently installed backward. Work on a valve was also implicated in the fire aboard the Piper Alpha platform in 1988. In this, the worst offshore oil incident ever in terms of human loss, 167 men died in the ensuing explosion and inferno. In both cases, the failure involved a small part and a relatively minor service error. Thus, not only large companies, but also the entire offshore component manufacturing and service sector could be affected by unlimited liability.

The oilfield services segment is a key exporter and competitive industry for the US. Consider: Douglas-Westwood analysis indicates that just four US companies — FMC, the Vetco Gray division of GE, Dril-Quip and the above-mentioned Cameron — will sell more than $3 bn of just subsea hardware this year to Brazil alone. Private equity firms have expressed concern to us about whether such companies can be financed in light of the Gulf accident. If liability is to be unlimited, then these companies may no longer be viable in the US. A manager of a major listed company providing equipment to the offshore segment told us last week that senior staff is moving en masse to Paris from Houston. Thus, unlimited liability may result in either an abandonment of the Gulf of Mexico or the relocation of companies’ headquarters to foreign jurisdictions, with minimal financial and legal exposure retained in the United States. The loss to the US economy could be much greater than the environmental cost of the Macondo blow-out.

So there’s a need to balance accountability with the health of the oil field services business. Liability needs to consider not only the damage inflicted, but also the ability of a given company to pay. For example, liability could be capped at 30-40% of a company’s book equity. Prior to the Macondo blow-out, BP’s book equity was about $100 billion; and Citi Investment Research suggests the total bill to BP will run just approximately $38 billion — about 38% of book value. In the case of BP, the ratio would seem to hold up.

In any event, the Obama administration should announce that it intends protect the overall health of the oil industry, even as it seeks to insure accountability for damages inflicted.

Mr. Kopits heads the New York office of Douglas-Westwood, energy business consultants. The views expressed are his own. Douglas-Westwood is the leading global consultancy in the commercial analysis of the offshore oil and gas services sector.

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24 thoughts on “Lessons from the Gulf Spill: Do’s and Don’ts

  1. Daniel Redondo

    Re: unlimited liability. If liability is capped, then the risks (and costs) associated with the spill are socialized, meaning U.S. taxpayers would bear some costs. If this is the means to keep businesses in the game, then a percentage of the profits ought to be socialized too. Yes, royalty payments already exist, but these are woefully low and aren’t directed to a cleanup fund. What do yo think about taking a % of the profits on all players and establishing a cleanup fund?

  2. Bob_in_MA

    Mr. Kopits heads the New York office of Douglas-Westwood, energy business consultants.
    So, Mr. Kopits believes that the companies that provide his salary shouldn’t have to pay the costs brought on by their activities. I’m shocked, shocked!
    If there are such a large number of wells that didn’t leak, the premium cost of insuring them should be small. And for the record, for it’s first 70 years Fannie Mae cost the taxpayers absolutely nothing. That was a very poor indicator of risk.
    And if you capped liability to the size of the company, just how long would it take until the drilling/operations were done exclusively by subcontractors?
    Capped liability doesn’t mean capped risks, it means transferring the costs of that risk to others.

  3. Steven Kopits

    You could have a clean-up fund. Fund it out to, say, $20 bn. But who will hold it? If it goes to the government, well, what does the government do with it? Will it be like Social Security, where the govt spends the funds and writes itself an IOU? Or will it be a large, de facto sovereign wealth fund? Or do the oil companies hold it? Would this be a giant private equity or hedge fund? Twenty-billion dollars wouldn’t make it the biggest fund in the country, but certainly top ten or so. Do we want oil companies in the hedge fund business?
    Also, keep in mind that oil companies pay substantial taxes. Here are a few selected numbers for some deepwater oil producers in the Gulf, and their taxes paid last year:
    BP: $8.4 bn
    Anadarko: $0.8 bn (when net income when negative)
    Chevron: $25.5 bn
    Exxon: $40 bn
    Conoco-Phillips: $8.3 bn
    The economic activity of these companies generates plenty of cash to pay for clean-ups over all.
    Finally, there’s the issue of capturing economic activity. Do you want Cameron to manufacture in the US, or Brazil? (The Brazilians could gut this industry if they actually were serious about it.) All those employees of the countless companies in Houston supporting the offshore oil sector could be replaced by Brazilians or Chinese over time. Do we want to cede one of our most competitive industries to third countries?
    To my mind, the focus has to be on prevention, not remediation. Do whatever you like, but the BOP has to work.

  4. mulp

    Yeah, the argument that no accident in the US means that drilling for oil proves there is no risk is rather absurd. A blowout from the Montara wellhead platform on August 21, 2009, and continued leaking until November 3, 2009 does not count when determining the safety of drilling in the ocean; the well was in shallow water. The Kab 101 platform accident October 23, 2007 in the Gulf of Mexico doesn’t count.
    The pollution of waters around the world by oil production are too numerous to list.
    The argument being made is essentially “we promise to pollute the waters of other nations but protect US waters. Or at least only affect a small number of poor people. Trust us.”

  5. Daniel Redondo

    Keep the cleanup fund separate from the government’s coffers. Give instructions to invest in the most secure/conservative manner.
    Your tax numbers are incorrect. For instance, Exxon Mobile most certainly did not pay $40 bn in taxes. See http://www.forbes.com/2010/04/01/ge-exxon-walmart-business-washington-corporate-taxes_2.html. It appears you are citing income, not taxes.
    If the BOP made by Cameron was faulty due to design, Cameron shortly will be out of business and the issue of relocation will be mute.
    Prevention is of extreme importance, but if the costs of cleanup are capped, it certainly provides an incentive to take risks.

  6. ReformerRay

    True – excess social security funds were used to avoid raising income taxes. Did not happen with FDIC funds. Imitate FDIC. Set up a fund to pay for cleanups, paid for by firms drilling in the ocean.

  7. bellanson

    capped liability is bad, way too many opportunities to turn that into privatized profits but socialized losses. can you spell Too Big To Fail.
    If risks are so low, then use mandatory liability insurance. Insurance companies are pretty good at pricing risk. The liability amount should be set high enough

  8. Rich Berger

    According to what I can find – http://dels.nas.edu/global/osb/Pollution-In-The-Ocean, the largest source of oil in the ocean is natural seepage, followed by leakage from cars, boats, etc (consumption of oil). Leakage during extraction is the smallest of the main sources.
    Do – Have a sense of proportion and realize that there are costs and benefits to every human activity.

  9. jay

    Wow. The writer did not even try to justify the liability cap. It is a bad idea because it is was the apparent justification.
    If there is so little risk as he claims, insurance will be fairly cheap and this wont be a problem for smaller companies. If there is a long history of smaller safety problems, competent insurers will charge higher rates for the companies who have a bad safety record….and voila the market works.

  10. Daniel Redondo

    Why are you including sales based taxes? These are transaction taxes paid for by the purchaser (consumer, retailer, whomever pays it) and passed on by Exxon. These are not paid for by Exxon out of its own pocket.

  11. Joseph

    Kopits: Finally, there’s the issue of capturing economic activity. Do you want Cameron to manufacture in the US, or Brazil? (The Brazilians could gut this industry if they actually were serious about it.) All those employees of the countless companies in Houston supporting the offshore oil sector could be replaced by Brazilians or Chinese over time. Do we want to cede one of our most competitive industries to third countries?
    Funny how so-called free-marketeers have no problem with government subsidies for the oil industry. Replace oil sector with textile sector in your paragraph above and tell me what you think.

  12. Fat Man

    “The best I have ever met in this respect have been alumna of the nuclear fleet under Admiral Hyman Rickover.”
    There have been no alumna of that program. It has alumni.

  13. RicardoZ

    My thoughts have been that had Bush been president during the spill there would have been much better and indepth reporting on the problems which would have probably given us more solutions. But more importantly in retrospect since the Gulf itself took care of 75% of the spill, his decisiveness in allowing berms and booms and skimmers, plus his consistent approval of dispersants would have more than taken care of the remaining 25%.
    Most of the problems with the spill were due to governmental infighting and indecisions. Politics – who gets credit – seemed to be the overriding consideration.

  14. Jeff

    As a general rule, you want liability to be borne by the people who are in a position to affect the risk. Some of the liability should be borne by the government since it alone has the power to mitigate some of the costs of a spill. A big unpopular foreign-owned company like BP is a juicy target for lawsuits, merited or not. Only the government can make and enforce rules to ensure that the resulting verdicts are fair.

  15. Buzzcut

    Don’t: come to any conclusions until a good amount of time has passed and we can see the true consequences of the blowout.
    We will have a much better feel for what the true environmental consequences of the blowout are in a year or two. It is clear that there was a lot of fear mongering during the massive leakage phase. The short term predictions did not come to pass, but we need to see what the longer range consequences are.
    Did the short range predictions fail because BP did a good job of skimming/ dispersing/ etc. or just luck? Again, perhaps time will allow such analysis to be done.

  16. jonathan

    If you’re going to make this argument about liability and you don’t address the moral hazard issues then you aren’t making a good argument. Several people have noted insurance. Your argument encourages companies, particularly those of smaller size, to operate in more risky ways. That is usually handled in private life by insurance because you only get lower premiums if you adequately manage your risks. Like many people, I’ve read reams about the oil spill and I continue to be astonished that industry people avoid thinking about the market solutions to the problem but prefer instead to make a pure “jobs” argument to avoid liability. If it’s safe, then prove it’s safe to insurers and then you don’t have to pay extremely high premiums. If the cost of premiums is high, then the industry can fund a reserve pool. These are all market solutions that don’t require “socialism,” meaning that you are asking me and the rest of America to socialize your risk just because you don’t want to carry it.

  17. Steven Kopits

    Some responses:
    Fat Man appears to be right. Back to basic Latin for me.
    As for liability issues: If there is to be unlimited liability, then some companies may chose not to sell product into the Gulf. In some segments, as few as three technology providers could bottle up the whole system, but it is probably fair to say that if 20 important vendors or other market participants decided not to serve the Gulf, you might close the whole thing, at least to future development.
    So, I am not opposed to liability. However, there is a cost-benefit equation here that bears some thought. How likely is unlimited liability to close the Gulf? For example, how likely is a company manufacturing components for the industry with, say, $100 million dollars of revenue, going to react? Can they afford $40 billion of insurance coverage? Or will they just accept unlimited liability as if nothing had happened? (And what of their investors?) Will these companies stop serving the market, or move their operations elsewhere? And if they do, what is the likely effect on operations in the Gulf? Will alternate sources of supply appear? From where? Do these increase or decrease risk?
    If these companies abandon the Gulf, are they important enough to materially affect operations in the Gulf? Could they effectively close it down? If they don’t, what is the likely economic cost? And if they do, is closing the Gulf and crippling the US offshore industry an acceptable cost to prevent the risk of another blow-out?
    To me, these are not trivial questions. Before I imposed unlimited liability, I would want to make sure I had a pretty good idea about the answers.
    As for blaming the accident on an administration: Personally, I don’t see this as primarily a political issue. It is could be argued that BOP regs should have been updated some time ago. But remember, a lot of companies are already using more advanced BOPs, and we’d had no major blow-outs since 1969. So, I think the daily operating reality is that, regardless of administration, BP is using that BOP on that day. It looks like we need double ram BOP’s with better control systems to reduce risk. But, then, who do you want to manufacture them? Maybe Cameron, a leading name in the industry? Or do we just retire all those drilling rigs in the Gulf using single ram BOPs or older control systems?
    And finally, Jonathan, yes, decreased liability may, in principle, create moral hazard. However, a 30-40% hit to book equity is more than disincentive enough to modify behavior, I would think. As a rule, this is not a careless industry–indeed, it’s reasonably safety obsessed. Everyone is aware that a backward-installed valve could sink a rig and that there is always risk of injury or fatality purely as a nature of the industry. And to have a critical part certified for use on a rig is a big deal. So I personally don’t think some limit on liability would result in a material deterioration in risk profiles.

  18. Dan Weber

    I didn’t follow the liability argument, and I think many commentors did not, either. I suspect some people are talking past each other.
    Companies should be able to provide complete compensation for their accidents. They can do this either by being really big, or having assets/insurance contracts held in trust unrelated to their activities.
    What we don’t want is for big companies to get out of the oil drilling business and leave it to only little companies, that can simply go bankrupt when an accident happens. I heard that the big companies got out of the oil shipping business after the Valdez but I don’t have a cite.
    (Assuming you don’t want deep-sea drilling to completely stop, which some people do. And although I disagree one has to admit they have a very good argument on their side right now.)

  19. Bob

    This post appears to be pretty ill informed on the legal and legislative issues on liability. First, the clean up costs are already unlimited, meaning that no liability limit has been imposed by legislation (few other industries benefit from politician provided liability caps), and if there is gross negligence, then Clean Water Act penalties can be $4300 per barrel. The only legislative discussion on liability is economic damages–fisherman who can’t fish, etc. A blowout like Macondo would bankrupt any company but a major without any change in long-standing law. They are all reevaluating risk because they overestimated or ignored their own risk management (remind you of any other sectors of the corporate world?). The most recent proposal on liability involves shared industry liability assessed by market share in the Gulf/US offshore waters (see Politico, etc.). Eliminates the small company concern without relying on taxpayer bailouts. Also, this odd anecdote about people relocating to Paris (Schlumberger??) because that somehow gets you out of “exposure”? Please. Halliburton has already relocated HQ to Dubai to pursue ME business. That doesnt stop anyone from suing their pants off in the US. No one is talking about sending executives to jail here, criminal environmental penalties in the case would still just be fines on the company, barring something really outrageous (malicious intent or something highly highly unlikely). I do not believe any such move to Paris has anything to do with liability. Maybe they are getting summoned back to get read the riot act on safety in light of recent events…

  20. Strat

    Kopits: You could have a clean-up fund. Fund it out to, say, $20 bn. But who will hold it? If it goes to the government, well, what does the government do with it? Will it be like Social Security, where the govt spends the funds and writes itself an IOU?

    Reformer Ray: True – excess social security funds were used to avoid raising income taxes.

    Daniel Redondo: Keep the cleanup fund separate from the government’s coffers. Give instructions to invest in the most secure/conservative manner.

    These comments are confused.
    The Social Security Trust Fund is invested in “special non-marketable securities of the U.S. Government on which a market rate of interest is credited.” (2010 Trustees’ Report).

    If you set up an oil cleanup trust fund and invest it primarily in U.S. treasuries, as Daniel Redondo implicitly suggests (secure/conservative), the result will be identical to what’s happening with the Social Security Trust Fund (i.e., the government will use the funds to finance current spending in lieu of current taxes, as Reformer Ray notes happened with the SS surplus). The difference is only cosmetic.

    There are probably reasonable arguments as to why such a fund should be kept out of government hands. Nobody has made one yet.

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