BP likely to pay most of the bill for gulf oil spill

Drilling contractor Transocean Ltd. “and possibly the service companies” were “responsible for the human errors or equipment failures” that may have triggered the Macondo blowout Apr. 20 in the Gulf of Mexico, but BP PLC will be the one who pays for the oil spill response and damages, said analysts at Citi Investment Research & Analysis, a division of Citigroup Global Markets Inc.

Sam Fletcher
OGJ Senior Writer

HOUSTON, May 8 -- Drilling contractor Transocean Ltd. “and possibly the service companies” were “responsible for the human errors or equipment failures” that may have triggered the Macondo blowout Apr. 20 in the Gulf of Mexico, but BP PLC will be the one who pays for the oil spill response and damages, said analysts at Citi Investment Research & Analysis, a division of Citigroup Global Markets Inc.

That’s because in the typical contract for oil field services, the customer accepts liability for spills or damage to the reservoir and indemnifies the contractor.

On the other hand, analysts at FBR Capital Markets & Co. in Arlington, Va., said, “Based on the pieces of this puzzle we have been able to assemble so far, it appears to us as if the primary responsibility for the accident may not lie with any…of the service companies.”

Although there has been much talk of the blowout, its potential consequences, and possible cause—primarily centering on apparent failure of the blowout preventer (BOP)—few within the industry are yet ready to assign blame with so much about the tragedy still unknown. Transocean’s rig, Deepwater Horizon, sank Apr. 22. Missing and presumed dead are 11 people who were aboard the rig. BP was operator of the well with 65% ownership. Its partners include Anadarko Petroleum Corp. (25%) and Japan’s Mitsui & Co. Inc. (10%).

Reports filed with the US Minerals Management Service from the rig indicate the well was drilled to TD by mid-April. Subsequently, a tapered casing string was cemented in place with foamed cement by Halliburton Co.—“one technique that can be used to combat annular gas migration,” said FBR analysts. The rig’s BOPs were last tested Apr. 10, including function and pressure testing of the shear rams.

“What we do know” FBR analysts said “is that the reservoir was not successfully isolated with cement, that either the casing or the wellhead must have failed, and that the [BOP] was unable to seal the well. All of these three ‘events’ were seemingly necessary for the blowout to occur. Had any one of them not occurred, then the well would almost certainly have been contained.” They added, “Whether or not certain procedures used during the construction of the well contributed to the aforementioned ‘events’ remains uncertain.”

Four primary contractors—Transocean, Halliburton, Cameron International Corp., and Smith International Inc., the 60% partner in the M-I SWACO joint venture—provided personnel or equipment for drilling the Macondo well. “These companies have built strong reputations for safety over decades, and they now see their safety records blemished in ways that could impact future business,” said Citi Investment analysts.

Gulf of Mexico E&P stocks were down about 16% (median) the last week of April as concerns increased over incident’s aftermath. “While the Obama administration was quick to place full blame on BP, that did not prevent related companies Transocean, Halliburton, and Cameron from facing abrupt sell-offs during the week,” said analysts at Pritchard Capital Partners LCC in New Orleans.

Citi Investment analysts reported, “The shares of Halliburton, Cameron, and Transocean lost $5 billion in total market value. Shares of BP and Anadarko…also sold off on heavy volume as investors tried to sort out the liabilities and lasting impacts of the well blowout.”

That initial reaction by nervous investors was “highly overdone,” giving other investors the opportunity to buy shares “of some of the world’s most premier companies at significant discounts,” said Pritchard Capital Partners. “Simply put, we believe this is a ‘buy on the rumor, sell on the news’ story, particularly when $11.5 billion in market cap vanishes. We recommend investors accumulate Cameron, Halliburton, and even Transocean, despite current speculation surrounding the Deepwater Horizon tragedy. We believe they face limited liability surrounding the disaster, particularly when considering the value lost in each company’s shares” in the selloff that was “rampant speculation from investors looking to limit their positions due to the lack of clarity all three had provided the market,” they said.

Pritchard Capital said the US Coast Guard, under the provisions of the Oil Pollution Act of 1990, charged a Transocean subsidiary as responsible for an oil discharge in the gulf, but Transocean denied responsibility as the discharge is more than a mile undersea.

Mishap speculation
FBR Capital Markets analysts said, “It is clearly possible that the Cameron International [BOPs] were in good working order but may have possibly been hindered by a certain wellbore procedure, which we believe would typically be determined by the operator. We also believe that the initial cause of the blowout may not have been primarily related to cementing, but may have been due to casing collapse during a negative pressure test.”

They said, “Based upon multiple industry contacts, we now believe that the casing was undergoing a negative pressure test prior to the blowout occurring. This is a normal and necessary step after setting subsea casing strings. One industry participant we spoke with suspected that the 7-in. x 9-5/8-in. tapered casing string may have collapsed during this test, perhaps at or just below the tapered section, opening up a potential flow channel.” This remains unconfirmed as no one has been able to inspect the wreckage on the sea floor.

“Our current theory is that incomplete isolation by the cement allowed a buildup of annular pressure, which contributed to a casing collapse during a negative pressure test, after which the BOP was unable to seal the well due to an obstruction too thick for the BOP to crush or shear, such as a tool joint of drill pipe,” said FBR analysts.

In New Orleans, Pritchard Capital analysts speculated a pressure increase in the riser above the BOP led to the blowout and fire. “The BOP may not have been able to stop the initial fire, and onboard diesel fueled it further,” they said. “Keep in mind that over 70,000 gal of fluid is in the riser between the BOP and the rig floor. When the rig sank to the seafloor, the 5,000-ft riser’s rotational movement caused the BOP seals to break at the wellhead and the riser. The leak then intensified as the flow and pressure coming through break points forced the failures to open more, which is why the leak flow rate [continued] to increase. In other words, even if the shear rams did not fail, the leak would most likely still have intensified.”

Morgan Stanley & Co. Inc. New York, hosted a conference call with several industry experts to discuss “technical, legal, and political” ramifications of the blowout. Company officials said, “We brought together a 15-year Transocean veteran, an Oil Pollution Act litigation expert, a former US government career attorney with over 27 years experience dealing with ocean policy, our Capital Alpha political consultants, and Morgan Stanley equity research analysts. We focused on three key topics, including potential scenarios regarding how the accident occurred, legal and political fallout from the incident, and outlook for the companies involved,” particularly Halliburton, Transocean, Cameron, and Smith International.

“The Deepwater Horizon was known as a state-of-the-art unit with a highly professional and experienced crew and a long track record of exemplary safety. Halliburton had apparently completed cementing the final production casing string 20 hr prior to the explosion, and had performed tests that demonstrated the integrity of the final production casing string,” Morgan Stanley said. “Several reports agree that the next step would have been to seal off the well using cement plugs, a standard practice that would then allow BP to temporarily abandon the well and return at a later date. Whether Halliburton had installed the final cement plugs by the time of the explosion is where accounts of the incident diverge.”

With Halliburton completing and testing the casing, Pritchard Capital analysts said, “We believe this removes blame that Halliburton’s cementing job was faulty.” The firm is “one of the world’s premier deepwater service companies, acting as the cementing contractor on 64 deepwater floaters, or roughly 41% of all delivered rigs,” they said.

Halliburton maintains cement plugs had not been put in place. “This is in line with accounts from other industry contacts, who claim that the rig was still preparing for the final phase of sealing the well,” Morgan Stanley said. “It is possible that a loss of drilling fluids had occurred but was being obscured by an expanding gas bubble. If loss of pressure allowed hydrocarbons to escape up the drill pipe quickly without being noticed, the explosion would have caught the crew by surprise, which corresponds to survivors’ accounts.”

If the cement plugs had been installed, the blowout would indicate some problem that prevented the well from sealing properly. “Setting cement at these depths is a balancing act, requiring highly experienced engineers to calculate just the right mixture and density to address the unique challenges of that particular depth and terrain,” said Morgan Stanley. Contractual protection from liability may be weaker if the cementing was performed improperly, analysts said.

However, they noted, “If the well had not been plugged, then improper cementing could not have caused the blowout. If the well had been plugged, we believe that it would be nearly impossible to demonstrate [if] Halliburton had improperly performed the cementing because the explosion would have blasted the cement plug to bits and scattered its remains across miles at the bottom of the ocean.”

Halliburton said the foamed cement it used in cementing the production casing string was consistent with that used in similar applications. FBR analysts observed, “Foamed cement is certainly not a risky technique as some outside of the industry may believe, but our channel checks indicate that a flexible cement system, such as Halliburton's ElastiCem system, might have been a suitable alternative choice for this application. We do not know for certain whether the operator or Halliburton specified the final choice of cement system, but we believe the decision of which cement system to use ultimately rests with the operator, who is also typically involved in its selection.”

FBR added, “One of the common challenges with placing foamed cement is complete annular mud removal, which can leave a channel if not successfully achieved.” A cement bond log could have determined if a mud channel had formed in the pipe. “Our channel checks indicate that a logging crew was aboard the rig but was sent home roughly 10½ hr prior to the blowout. There would likely not have been enough time to both run a bond log and set a cement plug near TD during the 20-hr period between the primary job and the blowout,” said FBR analysts.

“The absence of a cement bond to the casing can reduce its collapse resistance by up to 60%. If the casing had been exposed to a buildup of annular pressure during the performance of a negative pressure test, it could potentially cause collapse if the differential pressure exceeded the casing's tolerance limits,” they said. “The other possible path through which the blowout could be flowing, but not our favorite theory, would be if the subsea wellhead failed to seal the annulus.”

An FBR official reported, “Our analysis shows a confluence of events outside the control of either Halliburton or Transocean may have contributed to the blowout. Given this analyst's former experience as a cementing engineer and the evidence available today, we can find no fault so far with anything Halliburton may have done and are thus more confident that the stock should gradually recover as investors gain a similar confidence.”

MI-SWACO handled the drilling fluids to equalize pressure down hole to prevent the release of hydrocarbons. “Like cementing, determining the correct mix for drilling fluids requires highly experienced, expert engineers to balance unique challenges of a particular assignment. While it is possible that an incorrect mixture for drilling fluids could have created problems leading to the blowout, our experts believe this is unlikely given that MI-SWACO’s engineers were highly experienced and it is fairly easy to test drilling fluids throughout the process to ensure they have the right density,” said Morgan Stanley.

However, FBR said there is “less clarity” about the operation of the Deepwater Horizon semisubmersible rig, and Transocean may face “a larger overhang of investor worry.”

Blowout preventer
The BOP generally is purchased while the rig is still being constructed, and usually comes with a short-term warranty. “Given that the Deepwater Horizon was built in 2001, the warranty is almost certainly no longer valid,” said Morgan Stanley. “The BOP is part of the rig, so the drilling contractor is responsible for regularly pressure testing and maintaining the unit, as well as replacing parts as needed.”

A drill-pipe tool joint, drill collars, “or other oversized obstruction” could have prevented closure of the BOP aboard Transocean’s rig. That’s what caused the Ixtoc blowout on June 3, 1979, in the Mexican side of the gulf. Workers were pulling the pipe from the hole to change the bit when that blowout occurred, and BOP shears were unable to sever the thick steel walls of the drill collars then in position within the BOP. That blowout resulted in what was then the biggest oil spill in history.

However, FBR analysts reported, “None of our channel checks indicated any knowledge or concern that the BOP failed to function as designed due to an obstruction too thick for the BOP to crush or shear, such as a tool joint of drill pipe.”

Morgan Stanley analysts said, “Our experts point out that the BOP may have been fully functional, but the initial explosion could have disabled the BOP’s controls and severed the electrical communications cable, in which case BOP failure would have been a consequence, rather than a cause, of the explosion.”

They added, “It is likely that the explosion killed everyone on the drill deck, which explains why nobody there tried to manually activate emergency shut-off systems. When hydrocarbons reached the surface, the massive explosion could have knocked out communications between the rig and BOP, preventing the remote emergency shut-off signal from triggering the BOP’s massive rams to slam the well shut.” In such an event, Morgan Stanley analysts said, “BOP failure would have been a consequence, rather than a cause, of the explosion.”

They said, “Clearly no one survived in key areas to manually activate BOPs or any other alarms or safety devices.”

Morgan Stanley analysts said, “The only scenario in which we could envision the BOP manufacturer being held liable is if it turns out there was a latent defect that had not been previously known. We believe this scenario is highly unlikely because the BOP had been tested repeatedly, and Cameron has a reputation for supplying high-quality BOPs.”

Cameron’s potential liability “is minimal” on the blowout preventer it made some 10 years ago as its original warranty has long since expired. Moreover, the BOP was tested weekly “and should have had a 5-year remanufacturer per code,” said Pritchard Capital analysts. In a pre-blowout conference call, Cameron said it had $500 million in liability protection. “But the lack of commentary and overall clarity from management, likely due to confidentiality agreement reasons, gave the market worry, sending shares down 20% at one point” on Apr. 29, the analysts said. Since Cameron is “one of the premier oil service companies,” they said, the disaster will not do long-lasting damage to the company’s reputation. “With roughly 5 million shares available for repurchase, we expect management will support the stock price at current levels,” they said.

In a recent filing with the Securities and Exchange Committee, Transocean said, “Our mobile offshore drilling fleet is considered one of the most modern and versatile fleets in the world.” At the end of March, the company owned, had part interests in, or operated 140 mobile offshore drilling units, including 46 ultradeepwater, deepwater, and harsh-environment semisubmersibles and drillships, 26 midwater floaters, 10 high-specification jack up rigs, 55 standard jack ups, and 3 other rigs, with another 3 ultradeepwater floaters under construction.

The Deepwater Horizon was operating under a contract that was to extend through September 2013. The backlog associated with that contract was about $590 million. The rig was insured for its replacement value at $560 million, subject to a deductible of $500,000 to $1.5 million. It sank Apr. 22, 2 days after an explosion and fire. On May 5, Transocean received a partial insurance payment of $401 million. Company officials said, “We carry insurance that covers wreck removal, if required, subject to certain limits and deductibles.”

Analysts report Transocean has a blanket policy of $1 billion with a $50 million deductible. Moreover, Raymond James analysts said, “While we do expect significant legal costs going forward, we still believe that the financial risk for Transocean is relatively manageable for the Deepwater Horizon accident. Keep in mind Transocean should have free cash flow of $3 billion in each of next 2 years.”

Morgan Stanley said, “Drilling contractors are particularly sensitive to three key clauses, and write contracts in such a way that liability lies with the oil company for pollution due to oil coming from the well (i.e. a blowout), reservoir damage, and loss of production.” The language of the contract typically specifies that the oil company will protect, indemnify, and defend the contractor in these cases.

As a result, the drilling contractor is responsible for fuel leaking from its rig but likely is contractually protected from any environmental liability resulting from a blowout.

Morgan Stanley concluded, “The operator and the other lease interest owners will absorb the lion’s share of the financial liability for the oil spill and any potential punitive damages.” The analysts added, “We expect the following outcome:

• Cameron and Smith to be fully absolved of liability.

• Transocean’s potential liability to be relatively small and well within insurance policy.

• Halliburton unlikely to be held responsible, as the company claims it had not plugged the well, and even if it had plugged the well it would be extraordinarily difficult to demonstrate flaws with the cement.

• Industry-wide implications to be a long term positive for equipment manufacturers and somewhat mixed for offshore drillers.

• Impact on shipping lanes in the gulf to trigger a congestion-like effect on tanker rates.

“BP's bill will be unknown for some time. The Obama Administration has repeatedly reiterated that BP is the responsible party for clean-up costs, including the government's expenditures for the Coast Guard and Louisiana National Guard. However, it is less certain how much liability the firm might have for economic loss by the gulf's industry, including aquaculture,” said FBR analysts.

Like the decades-long court battle over payments for the Exxon Valdez spill, litigation from the blowout will likely last for years. However, FBR analysts are more interested in “what, if any, punitive or preventative actions” the MMS will take against BP. “We expect significant fines and note that a moratorium on drilling or production is possible, although unless the investigation surfaces adverse information, it appears unlikely at this early stage,” they said.

Morgan Stanley sees potential government regulation of offshore exploration “as a positive” for the drilling equipment industry, “as drilling rigs may require more redundancy of equipment, as well as more frequent servicing and replacement of equipment.” They added, “On the drilling side, we expect established offshore drillers with the newest deepwater units to benefit as demand for their rigs is likely to increase.”

Contact Sam Fletcher at samf@ogjonline.com.

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