RAISING THE STAKES:

RISK ALLOCATION IN THE OFFSHORE PETROLEUM INDUSTRY FOLLOWING THE MONTARA AND DEEPWATER HORIZON OIL SPILLS BY MICHAEL FILIPPICH
I INTRODUCTION On the 21st of August 2009 a blowout at the Montara oilfield off the Northwest coast of Australia resulted in an uncontrolled release of oil and gas into the Timor Sea that lasted for 10 weeks. All 69 crew members onboard were safely evacuated. During an attempt to plug the well a fire broke out causing major damage to the drill rig and wellhead platform. Less than a year later, a more significant blowout occurred on the BP operated Deepwater Horizon drill rig in the Gulf of Mexico killing 11 crew members and destroying the rig. Approximately 4 million barrels of oil flowed from the damaged wellhead into the Gulf resulting in the largest oil spill in history.

The findings from these two incidents will have far reaching implications for the Australian offshore petroleum industry. The Montara Commission of Inquiry was

established by the Federal Government to investigate the underlying cause of the Montara oil spill and the adequacy of the regulatory regime governing offshore petroleum activities in Commonwealth waters. The Commissions final report contained 100

findings and 105 recommendations. Many of the recommendations regarding the restructuring of the offshore petroleum regulators are already being implemented. The Government has also entered into consultation with industry on a number of other recommendations relating to offshore health and safety, environmental liability and the introduction of a civil penalty regime.

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This paper will focus on two recommendations in particular that have the potential to significantly alter the risk allocation between Titleholders, operators and offshore contractors. The first is the recommendation to introduce legislation making contractors involved in the installation of well barriers liable for the performance of those barriers. The second recommendation relates to the implementation of a polluter pays scheme to cover the emergency response, monitoring and clean up costs of an environmental incident.

II KEY FINDINGS AND REGULATORY CHANGES The principle cause of the Montara oil spill was largely uncontested and was due to the failure of a cement casing shoe used as the primary well control barrier.1 This failure was compounded by the fact that only one of the two pressure containing caps used as a secondary well control barrier was installed. The circumstances leading to the blowout on the Deepwater Horizon drill rig were significantly more complex however the primary cause could also be linked to the failure of a cement primary barrier and multiple secondary barriers. The underlying cause of both incidents was a systematic failure in risk management from the companies involved and a lack of oversight from the government departments charged with monitoring and regulating them.

Montara Commission of Inquiry, Report of the Montara Commission of Inquiry (2010).

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In order to address the lack of regulatory oversight the Montara Commission of Inquiry recommended that a single national regulator be established for offshore petroleum activities. The proposal for a national regulator was first raised in the

Productivity Commission Report into the Regulatory Burden on the Upstream Petroleum Sector in 2009. At the time of the Montara incident, Commonwealth waters were

managed by a Joint Authority (JA) comprised of the responsible Commonwealth Minister and the relevant State or Territory Minister. Day to day regulation of offshore petroleum operations was vested in the Designated Authority (DA) which was invariably a government department acting as the delegate for the responsible State or Territory Minister. The National Offshore Petroleum Safety Authority (NOPSA) was responsible for regulating occupational health and safety offshore. Structural integrity issues and Well Operation Management Plans were regulated by the Designated Authority.

The Montara Commission of Inquiry recommended that responsibility for well integrity be moved to the National Offshore Petroleum Safety Authority to achieve a more integrated, rigorous and independent approach. Consolidating the multiple DAs across different jurisdictions would enable them to share expertise and reduce inconsistencies in the application of regulatory requirements. The inquiry also raised concerns about whether the DAs combined role as title administrator, regulator, policy maker and promoter of industry could create a conflict of interest.2

Ibid.

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On 30th of May 2011 the Offshore Petroleum and Greenhouse Gas Storage Amendment (National Regulator) Bill 2011 (Cth) was introduced to Parliament to create two new regulatory bodies that will replace the Designated Authorities of the States and Territories. Under the Bill, NOPSA will be expanded into the National Offshore

Petroleum Safety and Environmental Management Agency (NOPSEMA) and will be responsible for facility and well integrity issues, environmental management and occupational health and safety. A new body called the National Offshore Petroleum Titles Administrator (NOPTA) will be created to oversee titles administration, approval and regulation of transfers and dealings and the keeping of the registers of petroleum and greenhouse gas titles. No change to the Joint Authority arrangement was proposed by the Bill. Similar changes were made to the United States Minerals Management Service (MMS) after the Deepwater Horizon incident. The MMS was responsible for regulatory oversight of the offshore petroleum industry, environmental protection, promoting development and energy independence and revenue collection. The role of the MMS to promote offshore drilling and revenue generation was often in sharp tension with its mandate of ensuring safe drilling and environmental practices. In the words of one official, balancing the mixed policy objectives of the MMS was like trying to mix oil and water.3 The MMS has now been reorganized into three independent entities, the Bureau of Ocean Energy Management, Bureau of Safety and Environmental Enforcement and the Office of Natural Resources and Revenue.

National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling, Deep Water: The Gulf Oil Disaster and the Future of Offshore Drilling (2011).

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III LEGISLATING AGAINST CONTRACTORS Governments worldwide have so far focused on closing the regulatory gaps that allowed the Montara and Deepwater Horizon incidents to occur. Addressing the

systematic failures in risk management that caused the blowouts in the first place will require extensive consultation with industry. The last two decades have seen significant changes in the way wells are drilled offshore. Oil companies now outsource almost every aspect of well construction to specialist contractors. For example, in the case of the Montara blowout, PTTEP Australasia was the operator and holder of the production license for the Montara oilfield. PTTEPs engineers were responsible for designing the wells and supervising the construction. The wells were drilled by Singapore based company Atlas who owned and operated the drill rig. The cementing of the primary barrier that failed was performed by oilfield services company Halliburton and the testing of well barriers was subcontracted to Schlumberger.

It is clear from these arrangements that many of the critical functions related to well integrity are not performed by the Titleholder. Section 569 of the Offshore

Petroleum and Greenhouse Gas Storage Act 2006 (Cth) requires Titleholders to carryout operations in a proper and workmanlike manner and in accordance with good oilfield practice. The Titleholder is held accountable for any work performed by its

subcontractors and must ensure that they also comply with the requirements of the Act. Problems arise due to the fact that the relationship between the Titleholder and subcontractor is purely contractual. It is unclear what recourse (if any) the Government would have against a negligent sub-contractor in the event that the Titleholder became

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insolvent. The extent of a contractors liability for an offshore incident is defined under its contract with the Titleholder and not the relevant legislation. The Montara Commission of Inquiry recommended that legislation be introduced: ....to ensure that contractors who are involved in barrier installation (such as cementing companies) have a direct interest in the performance of works to a proper standard. In particular, consideration should be given to (i) preventing contractors from avoiding the economic consequences of negligent installation of barriers; and/or (ii) imposing specific legislative standards of workmanship on contractors with respect to well control (similar to those which presently apply to licensees).4 The implementation of this proposal would result in a significant change to the standard risk allocation between a Titleholder and its offshore contractors. The complex nature of offshore petroleum operations exposes Titleholders and contractors to a significant risk of liability arising from the actions of other parties. To manage these risks companies enter into contracts with reciprocal or mutual indemnities that provide that each company indemnifies the other against claims arising out of personal injury, death, property loss or damage and environmental pollution suffered by the other party irrespective of the cause and where the fault lies.5

Under standard form contracts such as the AIPN Well Services Contract (2002), the Titleholder indemnifies the contractor group against any claims arising from a well blowout, damage to the subsurface including the reservoir and any pollution released below the surface of the water.6 The contractor group indemnifies the Titleholder against losses to its personnel and property and any claims arising from pollution above the

Montara Commission of Inquiry, above n1. Andrew Thompson, Service contract liability after Deepwater Horizon Minter Ellison Lawyers http://www.minterellison.com/public/connect/Internet/Home/Legal%2BInsights/Articles/AER3_1011%2BService%2Bcontract%2Bliability/ at 13 June 2011. 6 Ibid.
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surface of the water caused by its equipment. This risk allocation reflects the fact that the Titleholder is ultimately responsible for the subsurface engineering and design of the wells and each contractor is responsible for its own equipment. The Titleholder also stands to receive the greatest reward from the enterprise and should therefore take on the most risk.

The cost incurred by a Titleholder due to a well blowout can be significant. BP has transferred approximately $20 Billion US dollars to an escrow account to cover liabilities arising from the Deepwater Horizon oil spill. Given the potential damage to the company and its balance sheet, a Titleholder will often seek to allocate more risk to contractors performing critical functions. Specialist services such as the cementing of well barriers require proprietary equipment, materials and techniques. The Titleholder will therefore need to rely on the contractors skill and expertise for this component of the work. In these situations the Titleholder will normally narrow the scope of the reciprocal indemnities to exclude cases of gross negligence or willful misconduct by the contractor. The term gross negligence does not have a settled Common Law meaning. From cases both in Australia and overseas it would appear that gross negligence sets a standard that is substantially greater in magnitude and more culpable than ordinary negligence. 7 Gross negligence includes, at the very least, a serious disregard for obvious risk but does not require conduct to be willful or intentional. The definition of gross negligence as

Gavin Witcombe, Did you knowwhat gross negligence is? Clayton Utz http://www.claytonutz.com/publications/newsletters/projects_insights/20060816/did_you_know--_what_gross_negligence_is.page at 13 June 2011.

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applied to the offshore petroleum industry is a key factor in many of the legal claims between BP and the service contractors involved in the Deepwater Horizon oil spill. It is unclear whether the US courts will take into consideration the frontier nature of the deepwater drilling industry when deciding the threshold of what constitutes gross negligence or whether they will adopt the position of the English courts in Independent Broadcasting Authority v EMI Electronics Ltd 8 that the law requires even pioneers to be prudent.

The current practice of assigning liabilities through contracts and taking into consideration cases where it can be demonstrated that the contractor has been grossly negligent would appear to be the most appropriate method of managing risk offshore. Introducing legislation to prescribe liabilities between the Titleholder and its contractors would be problematic for a number of reasons. Firstly, the current arrangement of reciprocal indemnities requires parties to only insure against the risk of damage to their own staff and property and not the risk of damage to the entire facility. Altering this risk allocation would require companies to take out expensive and overlapping insurance premiums which would drive up the cost of doing business offshore and prevent smaller contractors and operators from entering the industry.9 The potential cost of the risk allocated also needs to reflect the value of the task performed and the financial capacity of the company taking on that risk. For example a company performing a $2 million dollar cementing operation on a well is unlikely to be willing to take on the risk of a $10 billion dollar well blowout in the event that its cement fails. Taking a fault based

8 9

(1980) 14 BLR 9. Thompson, above n5.

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approach to assigning liabilities would also be difficult due to the complex interaction of systems on a drill rig. This would likely lead to costly and time consuming litigation to determine the engineering causes of an incident and the relative contribution of each contractor to the overall failure of the system.

Instead of the Government introducing legislation to prescribe liabilities offshore, it is proposed that the Titleholder should be required to demonstrate to the regulator that they have performed due diligence on their contractors to ensure they have the necessary expertise, insurance and financial capacity to fulfill their obligations under the contract. Any liabilities not assigned to the contractor should be covered by the Titleholders insurance premiums. This would give the Titleholder and contractor the freedom to negotiate a risk allocation that best reflects the work to be performed without any Government intervention. In the event of an incident, the Government will be able to recover costs against the Titleholder in accordance with the Act who will in turn be able to claim damages from their contractors under the terms of the contract and their insurance premiums.

The second component of the Montara Commissions recommendation on contractors was to introduce legislative standards of workmanship for activities related to well control. This proposal is problematic as the Titleholder is ultimately responsible for the well design and installation of barriers and not the contractor performing the work. The introduction of legislative standards for contractors is also inconsistent with the Governments objective based approach to offshore regulation. A more prescriptive regime has the potential to shift the burden of responsibility from the Titleholder to the

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Government and stifle innovation. Under the current objective based regime the onus is placed on the Titleholder to ensure and demonstrate to the regulators that the risk of an incident occurring has been reduced to as low as reasonably practicable (ALARP).10 This allows sufficient flexibility in operational matters to accommodate the specific requirements of individual projects and avoids the lowest common denominator approach to regulation that often occurs in prescriptive regimes.

IV THE POLLUTER PAYS PRINCIPLE Another important finding of the Montara Commission of Inquiry was that the Offshore Petroleum and Greenhouse Gas Storage Act 2006 (Cth) and the Environmental Protection and Biodiversity Conservation Act 1999 (Cth) are deficient in a number of areas relating to environmental incidents offshore. There is currently no legislative requirement to recover costs incurred from an offshore oil spill under the National Plan and the extent of a companys liability for cleanup costs is also unclear.11 The maximum penalty for an oil spill in a Commonwealth Marine Area under the EPBC is 2100 penalty units or $231,000 which is disproportionately low compared to the economic and environmental consequences of an oil spill.12 The criteria for environmental monitoring are also unclear and are often determined by the companies involved and not the environmental regulator.

Australian Government, Final Government Response to the Report of the Montara Commission of Inquiry (2011). 11 Montara Commission of Inquiry, above n 1. 12 Sophie Osbourne, Environment Matters: The Montara Spill new regulatory powers, new liability risks Blake Dawson http://www.blakedawson.com/Templates/Publications/x_article_content_page.aspx?id=56753 at 13 June 2011.

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To address these deficiencies the Montara Commission of Inquiry has recommended a number of amendments be made to the OPGGSA and EPBC. It was proposed that the EPBC be updated to enable Government bodies to determine the monitoring and remediation required once an oil spill occurs rather than leaving this to the company responsible. The Government also plans to conduct a detailed review of the existing civil penalty regime to determine if it needs to be expanded or whether the existing penalties relating to well integrity should be substantially increased so as to act as an effective deterrent. Under the US Clean Water Act13 the Environmental Protection Agency is able to seek civil penalties of up to $1100 per barrel of oil spilled in US Federal waters. If the EPA is able to prove that the company which caused the spill acted willfully or negligently the fine is increased to $4300 per barrel.

The Government also plans to investigate the implementation of a polluter pays scheme to cover the costs associated with the clean up, monitoring and emergency response of an environmental incident offshore. Industry has already indicated that it

supports this policy in principle but that the final structure will need careful consideration due to the complex and critical nature of the issue.14 The polluter pays principle has the potential to expose offshore Titleholders to significant and ongoing liabilities for environmental incidents. The BP Deepwater Horizon well blowout has effectively set the liability threshold for a major oil spill at $20 Billion USD. Companies will need cost

33 U.S.C. 1251 (1977) Australian Petroleum Production and Exploration Association Ltd. (APPEA), Submission to the Draft Government Response to the Report of the Montara Commission of Inquiry Australian Government Department of Resources, Energy and Tourism http://www.ret.gov.au/Department/responses/montara/cwlth-response/submissions/Pages/Submissions.aspx at 13 June 2011.
14

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effective ways to allocate the risk of these liabilities in order to continue operating under a polluter pays scheme.

One method of managing this risk is through insurance. A number of insurance products exist to enable companies to reduce their exposure to the financial costs associated with a well blowout. Environmental or pollution liability insurance provides coverage for bodily injury, property damage and clean up costs resulting from a pollution event at a particular site. Operators can also purchase well control or extra expense insurance to cover the cost of regaining control of a well in the event of a blowout or any legal costs arising from the loss of a drill rig. Unfortunately these insurance policies are typically capped at a fixed amount which is well below the potential liability arising from a major incident. The insurance industry has recently testified to the US Congress that it would be difficult to provide coverage in excess of $10 billion USD per incident. 15 The cost of this insurance would also be prohibitively expensive and would most likely push smaller players out of the offshore industry leaving only a small group of energy SuperMajors and National Oil Companies that are large enough to self insure.

One option for reducing the financial burden on Titleholders of a polluter pays scheme is for Australia to establish an Oil Spill Liability Trust Fund similar to the one created in the US by the Oil Pollution Act16. In the US all responsible parties including the lessee of an offshore facility are strictly liable for removal costs and certain damages

Robert P Hartwig, The Deepwater Horizon Disaster: Insurance Market Impacts Insurance Information Institute http://www.iii.org/presentations/the-deepwater-horizon-disaster-insurance-market-impacts.html at 13 June 2011. 16 33 U.S.C. 2701-2761 (1990)

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arising from an oil spill.

Removal costs include the cost of recovering damaged

equipment or pipelines or retrieving a sunken rig. The licensees liability for removal costs is unlimited and each facility is required to maintain evidence of financial responsibility of at least $150 million USD. Compensable damages are defined in the Act and include oil spill cleanup costs. These costs are capped at $75 million dollars per facility. The cap does not apply in cases of gross negligence, willful misconduct, a violation of an applicable regulation or acts of war and does not limit the amount of civil or criminal penalties that might be imposed under the US Clean Water Act17.

Costs in excess of $75 million dollars are paid out of an Oil Spill Liability Trust Fund which derives a majority of its revenue from a 5 cent per barrel tax collected from the oil industry on petroleum produced in or imported to the US. The fund can pay out up to $1 billion dollars per incident and can be used for costs not directly covered by the responsible party. The policy justification for an Oil Spill Liability Trust Fund is that it ensures that adequate funds are available to clean up an environmental incident without placing a significant insurance or financial burden on offshore Titleholders or exposing the Government and tax payers to the risk of a company defaulting on its obligations. Titleholders only need to obtain insurance up to the liability cap as any additional costs are covered by the fund. This increases the number of companies financially capable of engaging in offshore exploration and production which in turn maximizes resource recovery and helps drive competition through increased participation.

17

33 U.S.C. 1251 (1977)

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Any plans to establish an Oil Spill Liability Fund in Australia would need to carefully consider the maximum amount payable per incident and the limit of the liability cap. Most offshore oil and gas operations in Australia are in remote locations far from populated areas. An offshore oil spill in Australia is less likely to impact coastlines or local communities to the same extent as a spill in the Gulf of Mexico. There is however the potential for a spill to affect the coastlines and fisheries of neighbouring countries such as Indonesia or East Timor. The maximum cost of an incident in Australia is unlikely to be as high as $20 billion dollars but could still be in the billions particularly if international claims are made against the company.

In the wake of the Deepwater Horizon incident, law makers in the US have raised concerns that the existing liability cap is set too low to act as an effective deterrent. Although BP waived the liability cap and elected to cover all costs associated with the spill themselves, there is no guarantee that future operators will do the same.18 Raising the cap to $500 Million or even $1 Billion would serve as a powerful incentive for offshore Titleholders to maximise prevention and minimise risk. It would also promote investment in technology to improve safety, emergency response and clean up operations. Legislative efforts by Congress to raise the liability cap have been put on hold until they can assess the impact of these changes on small independent operators.

The reasons for BP waiving the cap were not made clear however it is likely that a number of legal and political factors contributed to this decision. As the largest oil producer in the Gulf of Mexico, BP risked significant losses if its licenses were cancelled by the Government. It was also likely that BPs ability to invoke the cap would have been challenged in the courts on the basis that the event was the result of their gross negligence and willful misconduct. Waiving the cap was also a positive move from a public and government relations perspective and showed that the company was prepared to take responsibility for the incident.

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Any decision in Australia on where to set the liability cap should find a balance between ensuring that oil companies bear the social costs of their actions and that the financial burden of a polluter pays scheme does not drive competent independent oil companies out of the industry. The overlap between the liability cap and any expansion of the civil penalty regime should also be considered. The financial responsibility

requirements for an offshore Titleholder should reflect the liability cap to ensure that companies dont go bankrupt before compensating the Government and other affected parties. Consultation with the insurance industry is also important to ensure that

Titleholders can obtain adequate coverage up to the amount where the liability cap comes into effect. Options for consolidating coverage between Titleholders or establishing a mutual insurance pool should also be investigated as a way of lowering the overall cost of insurance and reducing the financial burden on smaller independents.

V CONCLUSION Petroleum exploration and production in offshore waters has always been a high risk activity. In order for the offshore petroleum industry to maintain its social licence to operate it must put the safety of workers and the environment above all else.19 The separate investigations into the Montara and Deepwater Horizon oil spills concluded that both incidents were preventable and were caused by systematic failures in risk management that placed in doubt the safety culture of the entire industry.20 Resolving these shortcomings will not be achieved by legislative changes alone. Making

contractors liable under the OPGGSA for well integrity is not commercially viable and
19 20

Australian Government, above n 9. National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling, above n 3.

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will have a detrimental effect on the offshore services industry. A more practical solution would be to leave the risk allocation to the parties of the contract and require Titleholders to perform comprehensive due diligence on their contractors. The Australian

Governments commitment to establishing a polluter pays scheme for environmental incidents offshore is an important step towards making Titleholders financially responsible for their actions. It is essential that the scheme is developed in close

consultation with industry and doesnt act as a financial barrier that prevents small competent operators from participating in the industry. The creation of an Oil Spill Liability Trust Fund should also be investigated as a way of limiting the financial burden on Titleholders.

Rising oil prices and advances in drilling technology will continue to push petroleum exploration and production into riskier and more challenging environments. The Montara and Deepwater Horizon incidents were an important wake up call to both offshore operators and the governments that regulate them. Regulations will need to

keep pace with new industry developments without stifling innovation or significantly altering the risk allocation between the parties offshore. So long as risks are identified and costs effectively managed the offshore petroleum industry will continue to supply the worlds growing energy needs for many years to come.

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BIBLIOGRAPHY
1. Articles / Books / Reports Australian Government, Regulation Impact Statement Government Response to the Report of the Montara Commission of Inquiry (2011). Australian Government, Final Government Response to the Report of the Montara Commission of Inquiry (2011). Montara Commission of Inquiry, Report of the Montara Commission of Inquiry (2010). National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling, Deep Water: The Gulf Oil Disaster and the Future of Offshore Drilling (2011).

2. Case Law Independent Broadcasting Authority v EMI Electronics Ltd, (1980) 14 BLR 9.

3. Legislation Clean Water Act, 33 U.S.C. 1251 (1977) Environmental Protection and Biodiversity Conservation Act 1999 (Cth) Explanatory Memorandum, Offshore Petroleum and Greenhouse Gas Storage Amendment (National Regulator) Bill 2011 (Cth). Offshore Petroleum and Greenhouse Gas Storage Act 2006 (Cth) Offshore Petroleum and Greenhouse Gas Storage Amendment (National Regulator) Bill 2011 (Cth). Oil Pollution Act, 33 U.S.C. 2701-2761 (1990)

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4. Other Sources Andrew Thompson, Service contract liability after Deepwater Horizon Minter Ellison http://www.minterellison.com/public/connect/Internet/Home/Legal%2BInsights/Articles/ALawyers ER3_1011%2BService%2Bcontract%2Bliability/ at 13 June 2011. Australian Petroleum Production and Exploration Association Ltd. (APPEA), Submission to the Draft Government Response to the Report of the Montara Commission of Inquiry Australian Government Department of Resources, Energy and Tourism
http://www.ret.gov.au/Department/responses/montara/cwlth-response/submissions/Pages/Submissions.aspx

at 13 June 2011. ExxonMobil Australia, Response to the Draft Government Response to the Report of the Montara Commission of Inquiry Australian Government Department of Resources, Energy and Tourism
http://www.ret.gov.au/Department/responses/montara/cwlth-response/submissions/Pages/Submissions.aspx

at 13 June 2011. Gavin Witcombe, Did you knowwhat gross negligence is? Clayton Utz
http://www.claytonutz.com/publications/newsletters/projects_insights/20060816/did_you_know--_what_gross_negligence_is.page at 13 June 2011.

Government of Western Australia Department of Mines and Petroleum, Montara Commission of Inquiry Response from the Western Australian Department of Mines and Petroleum Australian Government Department of Resources, Energy and Tourism
http://www.ret.gov.au/Department/responses/montara/cwlth-response/submissions/Pages/Submissions.aspx

at 13 June 2011. Robert P Hartwig, The Deepwater Horizon Disaster: Insurance Market Impacts Insurance Information Institute http://www.iii.org/presentations/the-deepwater-horizon-disasterinsurance-market-impacts.html at 13 June 2011. Sophie Osbourne, Environment Matters: The Montara Spill new regulatory powers, new liability risks Blake Dawson
http://www.blakedawson.com/Templates/Publications/x_article_content_page.aspx?id=56753

at 13 June 2011. Tony van Merwyk, The Montara Report: What it means for offshore operators and Titleholders Freehills http://www.freehills.com.au/6834.aspx at 13 June 2011.

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