To ensure companies meet their obligations to plug oil and gas wells and reclaim drilling sites, Colorado regulations require oil and gas operators to provide a surety bond in the amount of $10,000 or $20,000 for individual wells, depending on well depth.  Alternatively, an operator can provide a single $100,000 “blanket” bond to cover an unlimited number of active wells (Colorado requires individual bonds for “excess inactive” wells).

Blanket bonds provide a volume discount on financial assurance for large operators.  At the same time, they decrease the average bond amount per well and increase the odds that available bond amounts will be inadequate to pay for necessary cleanups on multiple sites.

For example, as we noted in PetroShare gets the Oil and Colorado, the hole, prior to filing bankruptcy PetroShare had a $100,000 blanket bond (plus another $200,000 in individual bonds for “excess inactive” wells) covering 89 wells in Colorado that we estimate, based on the depth of the wells, will cost nearly $16 million to plug.

Blanket bonds are a moral hazard because they contribute to systemic risk for state oilfield regulators, by incentivizing the accumulation of unsecured marginal and inactive wells that will eventually become orphaned.

Systemic risk in oilfield regulation unfolds in three phases – accumulation, materialization, and spreading.  Blanket bonds are a powerful engine for the accumulation of potential liability for states in the event that oil and gas operators fail to fully reclaim wells and return lands to their original condition when production ceases.  Here’s how:

• By allowing a low per well bond amount, blanket bonds encourage more drilling, adding to the inventory of wells that eventually must be plugged.
• Rather than plugging and reclaiming old wells as they drill new ones, the original operators who profit most from the well defer these end-of-life costs in several ways.
• First, they sell late-life “stripper” wells to smaller companies. Even though closure costs for stripper wells often exceed their production value, Colorado allows blanket bonds for these wells, too.
• Another way to defer plugging is to put unproductive wells in permanent “excess inactive” status.  Bond amounts for these wells are higher, but still far below what it will cost to plug them.
• Finally, companies can simply present inactive wells as active.  Colorado operators can game the system to maintain “active” status for unproductive wells by selling past production from leasehold tank inventory or by “swabbing” the well to extract and sell a small amount of fluid product each year.  This both defers plugging costs and avoids individual bonding requirements for inactive wells.
• By providing oil companies with the equivalent of free unsecured credit on closure costs for a period of time that can far exceed a well’s useful life, blanket bonds both overvalue oilfield assets and understate liabilities, allowing risk to accumulate in financial instruments backed by loans to the oil and gas industry. Ultimately, private lenders and state regulators may have to compete for a finite pool of industry resources to satisfy financial and environmental obligations.

The accumulation of off-balance sheet liability for oil and gas producing states is apparent.  As we reported in Billion Dollar Orphans, Colorado has 60,000 unplugged oil and gas wells.  Only 20 percent of these wells produce more than marginal quantities of oil and gas.  Half are stripper wells.  Ten percent have not produced in the past two years.  Another 20 percent are injection and other types of non-production wells.  We estimate it will cost $7 billion to plug all of these wells, excluding reclamation costs.  Yet, to secure these obligations, Colorado holds a mere $160 million in individual and blanket bonds.  That’s just two percent of estimated plugging costs.

The mounting risk seems likely to materialize as a result of climate change and the transition to a low carbon economy.  As fossil fuel economics deteriorate, it will become increasingly obvious to regulators, investors and lenders that the oil and gas industry will be unable to pay its environmental and social debts.

It is not difficult to foresee a mass orphanage scenario in which new drilling stops, lower prices, lower production and rapid decline curves render existing wells unprofitable, and the industry does not have the resources to plug and reclaim millions of unplugged inactive wells.  If this happens, blanket bonds will be largely to blame.

To help states avoid this mass orphanage scenario, we are launching a new online database that will enable people to see the full extent of company’s onshore oilfield plugging obligations in states around the U.S.  To launch this new online tool, we will host an upcoming webinar.  For more information or to sign up for the webinar click here.