As industry evolves, risk management programs must too

Emerging liabilities associated with fracturing, road use, storm damage among new considerations

By Kevin Sisk, Aon Risk Solutions

As the energy industry develops and deploys new technologies to meet the challenges of supplying the world’s energy needs, the effectiveness of the industry’s risk management programs must also evolve. Although some companies in the industry have made few changes to their risk management philosophy and structure in the past 30 years, others have actively sought to manage their risk as operations have changed.

It is important for energy companies to continually look at the emerging risks and liabilities associated with onshore and offshore drilling, as well as consider when to evaluate their effectiveness in handling these exposures as part of their risk management program.

A study conducted in Denton, Texas, determined that each fracturing site requires approximately 364 trips to haul water. These trucks can be heavy when fully loaded, weighing as much as 100,000 lbs, and may be traveling in rural locations over low-volume roads.

For most contractors, this represents a significant increase in vehicle activity over prior years when operations were not so fracturing intensive, leading to increased vehicle safety concerns.

Some states have claimed that the trucking activity from fracturing damages the foundations of roads, while many industry participants believe they are simply being asked to pay for deferred maintenance. Many industry participants have resorted to documenting their operations and the conditions of the roads being used before, during and after drilling.

During fracturing operations, it’s not uncommon for up to US $25 million worth of equipment to be on site, while equipment needed for deeper wells can easily exceed US $50 million. With the close proximity of onsite equipment and the heightened exposure to fire and explosion, some contractors are seeking to modify traditionally accepted indemnity allocations and place additional responsibility on the operator for the equipment. This can create additional concerns for the operator, as the operator’s insurance policies may exclude coverage for damage to property of others in the operator’s care, custody or control (CCC).

The preamble of the IADC Daywork Drilling Contract states:

“For purposes hereof; the term ‘Daywork’ or ‘Daywork Basis’ means Contractor shall furnish equipment, labor, and perform services as herein provided, for a specified sum per day under the direction, supervision and control of Operator (inclusive of any employee, agent, consultant or subcontractor engaged by Operator to direct drilling operations).”

Some insurance carriers hold the opinion that this clause, combined with preparing the location and having a company representative onsite, fits squarely into the standard general liability exclusion for property in the care, custody or control of the insured and would thus eliminate coverage.

Because CCC coverage in a control of well policy is typically limited to lower amounts – US $1 million to US $5 million most commonly – and that coverage for drilling or workover rigs may be excluded, some operators have sought to change this preamble and delete language referring to the operator’s control of drilling operations.

A strategic approach to designing the insurance program to address this potential issue should also be considered.

Pipeline Operations Exposure

As the industry continues its successful production of domestic shale plays, gathering and intrastate transmission lines have proliferated, particularly in urban areas.  While many in the industry understand the risk of pipeline operations, the potential catastrophic exposure of an explosion in populated locations can often times be underestimated.

In September 2010, there was a large explosion in a suburb of San Francisco, Calif. that serves as an example of the potential impact of an explosion in an urban area.  Eight people were killed, and another 58 were injured, while 38 homes were destroyed and an additional 120 homes were damaged.  Several homes continued to burn after the gas main had been closed.   It was estimated that the operator of the pipeline could be facing US $1.7 billion in costs from the explosion, wiping out all profits for the company over the last decade.

Since many Exploration and Production (E&P) companies have a broad source of revenue from a large geographical spread of wells, business interruption, or accidental loss of revenue, is often not seen as a major exposure.  However, many companies fail to recognize their increasing dependency on certain infrastructure that may be owned or operated by others, particularly pipelines and gas processing facilities plants.  These have the potential to become significant bottlenecks that can threaten a material portion of a company’s revenue from any one region.  This is commonly referred to in the risk management community as a “contingent business interruption” exposure, because it is contingent upon damage to someone else’s property.  While it is possible to insure against this type of loss, it is frequently overlooked  or undervalued in the process.  A deep understanding of this potential exposure is critical when designing an effective risk management program.

Some opponents of fracturing claim there is a direct link between fracturing and increased seismic activity and damage around well sites. A recent report requested by the US Congress and performed by the National Research Council (NRC) concludes that although a very small amount of the hundreds of thousands of energy development sites in the US have caused seismic activity at levels that are noticed by the general public, seismic activity caused by or likely related to energy development has been measured and felt in 13 states. These states are: Alabama, Arkansas, California, Colorado, Illinois, Louisiana, Mississippi, Nebraska, Nevada, New Mexico, Ohio, Oklahoma and Texas.

The NRC added that the process of carbon capture and storage posed a relatively higher risk than hydraulic fracturing or injection of wastewater.

While the actual link to inducing earthquakes can be debated, the cost to defend lawsuits, especially those involving expert witnesses and professional opinions, can be significant. Many liability insurance carriers look to exclude claims for property damage or bodily injury caused by subsidence, or for pollution events that may have been preceded by a subsurface event. A liability policy with these types of exclusions may not cover damages for these types of claims and may exclude the cost of defense.

Windstorm

Most offshore energy operations have become familiar with the significant changes in the insurance market since the windstorm events of 2005 and 2008.  Windstorm continues to be a sticking point in the insurance market with high retentions and premiums, although conditions are improving. More sophisticated companies have embraced dynamic financial modeling analytics to help develop the most efficient risk financing structure and long-term strategy. Many have also considered or formed captive insurance companies for a more formalized approach to financing of the wind risk premiums.

Removal of Wreck/Debris

One area that has not been addressed with the same level of attention as other offshore exposures is removal of wreck.  Because of the significant claims for the removal of damage after the 2005 hurricanes, operators and contractors are still struggling with the allocations of this risk in offshore drilling contracts. For example, consider the provisions below from one offshore drilling contractor working for three operators:

• Operator is responsible for removal of debris, including contractor’s items, to the extent that proceeds from contractor’s insurance do not respond.

• Operator is responsible for its removal of debris. Contractor is responsible for its wreck removal to the extent required by law or reasonably required by operator.

• Contractor is responsible for removal of debris of contractor’s items. Operator is responsible for removal of debris of operator’s items.

Given the different positions taken now by many contractors and operators, the subject of removal of wreck liability requires considerably more risk management attention than it has in the past. The insurance policies also have to be carefully crafted through many layers of coverage to respond properly in the event of claim.

Until Macondo in April 2010, energy underwriters had perhaps undervalued the risk of operational loss while focusing on the more obvious risk of windstorm. However, Macondo changed their perspective about the potential scale of damages and costs. The insurance market has gone through another round of changes in light of Macondo, including a notable reduction in capacity available, rate increases and the scaling of liability insurance limits to match the ownership interest of the E&P company in the well.

Underwriters are also questioning how much mitigation of risk is afforded under contractual indemnity structures, considering the complex litigation typically associated with larger claims.

In May 2010, Syracuse, N.Y., newspaper The Post-Standard posted an article on its website about Don Siegel, a hydrogeology professor at Syracuse University. Dr Siegel thought he had presented credible scientific evidence in a Dewitt, N.Y., public forum proving the benefits of drilling for natural gas in New York would far outweigh any negatives.

Then, a member in the audience of more than 75 people stood up and stated, “With all due respect, Dr Siegel, it’s not about the science.”

Controversy over whether fracturing causes contamination of private water wells and public drinking water aquifers rages on, and sometimes logic is not part of the debate.

Heightened awareness of potential liabilities has come through the media and from controversial documentaries, such as “Gasland.” However, differences in the admissibility of scientific opinions between various states can substantially affect industry exposure to toxic tort cases. Changes in peer-reviewed scientific studies may change this landscape.

Additionally, there is an inability of some waste facilities to adequately treat wastewater. These facilities might not be able to adequately remove radioactive materials or certain chemicals, including bromide, which is a salt. Some scientists believe the bromide can react with the chlorine disinfectants used by drinking water systems to kill microbe, which can create trihalomethanes, a potential carcinogen.

However, sources other than fracturing wastewater can cause elevated trihalomethane levels as well, including abandoned coal mines and other industrial sources. Yet, many companies have begun recycling wastewater to help avoid potential future exposure from the joint and several liability that can be part of an environmental lawsuit.

Other environmental exposures may arise from air pollution. For example, methane has been cited by environmentalists as the second most abundant greenhouse gas behind carbon dioxide. Some believe that the upstream industry may one day be subjected to similar liabilities and emissions monitoring requirements that the downstream energy industry faces.  For example, consider the following studies commonly cited by environmentalists.

Colorado

A 2008 Colorado analysis by the Colorado Department of Public Health concluded that emissions from oil and gas operations exceeded emissions for the rest of the state.

Wyoming

In 2009, Wyoming failed to meet federal health standards for air pollution for the first time in state history. The Wyoming Department of Environmental Quality blames the oil and gas sector.  Additionally, The New York Times reported that Sublette County, Wyo., had higher levels of ozone than those recorded in Houston and Los Angeles.

Texas

A 2009 Southern Methodist University study concluded that emissions from the oil and gas sector in the Dallas-Fort Worth area exceeded emissions from motor vehicles.

The potential for new governmental regulations can also increase the risk that industry participants may face.  The Energy Policy Act of 2005 specifically excluded fracturing from EPA authority unless diesel is used as a component of fracturing fluid. However, the Fracturing Responsibility and Awareness of Chemicals Act (FRAC Act) would repeal the fracturing exemption to the Safe Water Drinking Act.

The Bringing Reductions to Energy’s Airborne Toxic Health Effects Act, or BREATHE Act, is considered a sister bill to the FRAC Act. It would close exemptions in the National Emission Standards for Hazardous Air Pollutants and the hydrogen sulfide exemption, and it would prompt the industry to deploy the best-available emissions control technology.

So many ask – “Does our insurance cover this?”

Unfortunately, the way the insurance industry has historically offered coverage can create problems for the relatively new operations of fracturing. Changes to commonly used insurance policy language often takes time with insurance underwriters, which can be compounded by needing additional regulatory approval for admitted wordings in various states. Often, the result is the use of policy language that has not necessarily been designed nor updated to keep pace with today’s fracturing exposures.

For example, the standard pollution insurance coverage purchased today is by endorsement to a general liability policy and provided on a sudden and accidental basis, which means the insured must have discovered the escape of a pollution event within a certain time frame. The discovery time frame generally ranges from three days to 30 days, while the subsequent reporting requirement may vary from 14 days to more than 90 days following the pollution event. Gradual pollution type claims (i.e., those outside of these time frames) are typically excluded.

While the time reporting element is an important criteria to consider when evaluating pollution insurance, the scope of coverage being granted is of critical importance as well. Even for sudden and accidental pollution releases within the covered time frame, some carriers will still look to exclude clean up costs, while others may offer coverage to some degree. Pollution from waste sites is commonly excluded by many carriers, and the policy would need to be specifically endorsed to give back coverage for pollution emanating from waste disposal wells.

Ongoing monitoring costs following a claim are commonly not covered, and many carriers providing sudden and accidental coverage will not cover civil fines and penalties.

Many companies have added a stand-alone pollution liability policy as part of their casualty program. These policies can be designed to cover any combination of new or pre-existing pollution that occur both onsite and offsite. Not only is gradual coverage often included, but coverage for defense, investigation and future monitoring costs is typically included as well. Optional coverages can be included for non-owned disposal sites, waste transportation risks, business interruption and civil fines and penalties.

Fines and penalties are another area of concern for both onshore and offshore operations, especially since the basic sudden and accidental pollution endorsements offered by most insurance companies do not typically provide this coverage.

For example, consider the following recent onshore fines of two shale operators:

• December 2010 – EPA claiming authority under the Safe Drinking Water Act, issued Emergency Restraining Order against one producer, alleging that they caused or contributed to contamination of the Trinity Aquifer. The case was dropped after the operator strongly disputed having fault and subsequently agreed to monitor groundwater around the alleged contamination.

• December 2010 – Pennsylvania Department of Environmental Protection dropped plans to build a 12.5-mile waterline from Montrose to Dimock Township in exchange for a natural gas producer agreeing to pay US $4.1 million to residents affected by methane contamination attributed to faulty natural gas wells.

And for offshore participants, Macondo served as a stark reminder of not only the risks faced in deepwater but also the potential fines and penalties.

In addition to the billions of dollars Macondo participants have already paid as part of claims and settlements, potential civil fines and penalties arising from the accident still remain outstanding.  Some examples of the various governmental statutes and agencies that have been noted in public SEC filings as potentially applying to alleged Macondo participants include:

• Oil Pollution Act;

• National Pollution Funds Center a division of the US Coast Guard, is charged with administering the Oil Spill Liability Trust Fund;

• Department of Justice;

• Clean Water Act;

• Clean Air Act;

• Endangered Species Act;

• Migratory Bird Treaty Act;

•Comprehensive Environmental
Response Compensation and Liability Act;

• Emergency Planning and Community Right-to-Know Act; and

• Louisiana Department of Environmental Quality, Louisiana Oil Spill Prevention and Response Act.

Also, the Attorney Generals of the five Gulf Coast states of Alabama, Florida, Louisiana, Mississippi and Texas are part of the debate as to whether state laws should be superseded by various federal laws and statutes.

Recent media reports have focused on potential liabilities associated with one of these acts – the Clean Water Act.  The fines are based on the number of barrels of oil spilled, which is subject to debate between the US government and the parties involved. However, the ultimate fine is likely to be significant regardless of the final number.

In June 2012, The Wall Street Journal reported that civil fines for violating the Clean Water Act could range from US $5.4 billion to US $21 billion, plus up to an additional US $28 billion in criminal fines if the US successfully alleges criminal violations of the Clean Water Act or other laws. Compared with the US $20 billion claims fund settlement set aside for victims of the spill, these fines may cast a large shadow over the ultimate costs of this tragic accident.

Coverage for civil fines is available with certain markets, while criminal penalties are typically excluded. These exclusions differ by market and should be reviewed with a risk management advisor to identify the best alternatives available.

Like the energy industry, the insurance markets have been reminded of the potentially catastrophic exposures associated with onshore and offshore exploration. While companies face challenges to address the changing risk environment in the oil and gas industry, new risk management tools and resources are being developed. Now, perhaps more than ever, companies should be actively working to analyze the changing insurance market climate and differentiate their risk to underwriters to effectively design a successful risk management program.

*Editor’s note: This analysis represents solely the opinions of the author, not of Drilling Contractor nor the International Association of Drilling Contractors.