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By STEVE TUCKEY, who has written on insurance issues for a decade for several national media outlets

American motorists paying $4 a gallon for gas can have some far reaching impact.

Abroad, Russia starts feeling its oats, assaulting its neighbors with brief invasions, while Iraq wracks up an impressive budget surplus and the U.S. goes deeper into the red paying for that country's freedom to savor its oil profits.

For the insurance industry, soaring oil prices have opened up exciting new areas of business in ways that might seem counterintuitive at first glance.

Overall, more exploration for oil that's increasingly difficult to extract will bring greater risks to insure in different ways. But with the thirst of the newly energized economies of India and China showing no signs of lessening, costly and risky measures are the only options.

Jim Pierce, Houston-based chairman for Marsh Global Marine and Energy, says that deep-sea drilling for oil at depths up to four miles is a 21st century phenomenon, with the giant independent oil companies such as ExxonMobil Corp. in the forefront. But he says, so far, major losses connected with deep-sea probing haven't occurred.

"To date there has never been an incident in deep-water drilling of either a major operational or pollution event," Pierce says.

Moreover, since the 1969 Union Oil Co. platform blowout on the Santa Barbara Coast which spilled 200,000 gallons of crude and killed thousands of marine mammals, fish and birds, there has never been a major pollution incident resulting from drilling offshore.

Today, 85 percent of U.S. coastal waters remain prohibited to offshore drilling. It's only the Western two-thirds of the Gulf of Mexico that's open to oil exploration. And that is where most of the oil thought to be available from deep sea drilling is located within the territorial jurisdiction of the U.S.

HAPPY JACK

In September 2006, Chevron announced along with Devon Energy and Norway's Statoil Company promising results from a mammoth field, deep beneath the Gulf of Mexico.

The find comes just as discussions of a so-called topping out of the world's oil supply takes on new urgency as the impact of the growth of India and China gains significance.

One huge oil reserve, even it could rival the 1968 discovery of Prudhoe Bay and increase U.S. reserves by up to 50 percent, will not turn around the world's tight energy markets, experts say, and won't bring the U.S. any closer to energy independence any time soon.

"But the capability to find and recover petroleum at extreme depths, temperatures and pressures as demonstrated by the Chevron team may indeed tip the balance of supply and demand in the long term," says Andrew Latham, a vice president of energy at the energy consultancy Wood Mackenzie in Edinburgh, Scotland.

Areas believed to have oil deposits beneath the ocean floor which could now be commercially recoverable include the North Sea off the coast of Britain, the Nile River Delta off the coast of Egypt and possibly coastal Brazil, Latham says.

The record-setting Chevron well, called Jack 2, sits 175 miles off of the coast of Louisiana and is more than five miles deep: A measurement which includes a mile of ocean depth. Modern seismic 3-D gear enabled the exploration team to know where to drill to have a chance to make their $100 million bet a successful one.

Pierce says the cost of this exploration is not so much the operational risk, although that is considerable in any kind of new exploration of this magnitude.

"The actual cost is what is astronomical, sometimes up to $500,000 a day just to have a rig on site," he says.

But here is where it gets interesting.

The majority of the oil companies taking the great risks, at least in the initial case of the Gulf find, are the Integrated Oil Companies who "take very large self-insured retentions and then buy pure catastrophe coverage from the commercial insurance marketplace."

Thus, any potential impact on new insurance premiums coming from the new risk is mitigated by the fact that the companies "leading the charge" are the larger ones taking more self-insured risk, Pierce says.

"But as deep-water technology becomes tried and tested we will see more of the larger independent exploration companies into that arena, there will be a more direct correlation between the perceived risk and the insurance market," Pierce says.

And that is where the segment of the market represented by Houston-based broker John Rathmell of Lockton comes into play. These mid to large-size independent drilling and exploration companies definitely use the commercial market place to cover their risk, and have placed higher and higher limits the more complex their projects become.

"From a practical perspective, there is much greater potential exposure because the cost of the well is multiples of those drilled on the shelf," Rathmell says. "If you lose one of those wells, the costs could be up to $150 million."

Nonetheless, deep-sea drilling rigs do have one advantage of being able to move out of the way of the same storm that might threaten an onshore facility. "On the shelf (at around 200 feet) they are in the mud and you can't move them," Rathmell says.

But despite the considerable operational risk of a blowout, the fact remains there have been very few recorded well-out-of-control events for deep-water wells for the nearly decade that they have been in operation.

"There is now a statistical base to draw some kind of exposure base model," Rathmell says, noting that the deep-sea drilling record is more impressive than the shelf drilling record.

The risk factor remains not so much the depth of the sea where you drill, but how deep you go into the earth's crust. "They are starting to test depths they have never ever gone to before in the actual earth," Rathmell says.

Underwriters are starting to realize that the design of the wells and the expertise of the crews have so much improved over the years that higher limits are possible to impose without breaking the bank of the insured. "The drilling units are so much better and there is an understanding how this has led to such a lack of problems," he says.

The cost of a $300 million to $500 million limit is a lot lower today than it might have been five years ago, Rathmell says. "The markets are recognizing the improvement in operations and the safety record."

Such a record has enabled some start-up enterprises drilling ultra deep wells to obtain insurance at relatively economic levels, "solely based on their ability to convince the insurance market directly that they are engineering these wells not to have a problem."

"The soft market has helped these new deep-water players going in to buy insurance," Rathmell says. "If they had come out three years ago after Katrina and Rita, it would have been hell."

But while the mid and large-cap enterprises in Rathmell's universe continue to plumb the depths of the seas, the giant multinationals are getting into the act, exploring promising new sites around the world.

And here is where another interesting factor comes into play that could be music to insurance company ears as they attempt to capitalize on the rush to develop new and harder to reach sources of fossil fuels.

RUSSIA, BRAZIL AND MEXICO

Pierce says that the big state-sponsored, what are known in the industry as National Oil Companies, from countries such as Russia, Brazil and Mexico control about 90 percent of the world's oil reserves.

This is important to keep in mind the next time you hear a politician bemoan the control "Big Oil" allegedly has over the amount of money we have to set aside to put gasoline in our cars, he says.

"The National Oil Companies are achieving more and more self-sufficiency, and are looking for more labor and are driving projects that historically used to rely on independent companies," Pierce says.

More importantly for the insurance industry, there is more insurance coming into the marketplace from the National Oil Companies. "So because of this transfer from this shift from the IOC's to the NOC's there is more risk entering the commercial insurance marketplace than under the old paradigm," Pierce says. The big IOC's such as ExxonMobil and BP still play a critical role and more often than not end up partnering with the NOCs on projects throughout the globe.

Where you really see new risk entering the commercial marketplace from the NOC's is on the project side, involving construction of refineries and other major facilities. "So it is basically more of an onshore trend more than offshore," Pierce says.

At first glance, National Oil Companies with the ultimate backing of their governments looking to rely more and more on the commercial marketplace might seem puzzling. And Pierce finds the trend "intellectually stimulating" as the brokers play an important role in placing the risk.

"As the NOCs strive to gain sophistication in their risk management techniques, they are very willing to listen and partner with risk management firms to learn from us, and have us help them adopt new techniques that the IOC's might be bringing in house," Pierce says.

As for any new insurance premiums rising from more traditional offshore drilling of depths of around 500 feet, it might be too soon to start budgeting those dollars. Political impediments in the U.S. are still strong, and have been in effect since 1990 in the aftermath of the Exxon Valdez incident, a spill that occurred from a ruptured tanker.

"If you think about it in the last 30 years, all the major oil catastrophes have come from shipping," Pierce says. "They have not come from drilling."

Rathmell agrees that any drilling in shallow waters stemming from the current political and economic climate will have an impact on the market. "But that is going to take years to play out so it is not even worth talking about," he says.

While a new round of traditional offshore drilling will of course bring new business, Pierce says the insurance industry is comfortable enough with the environmental soundness of the current technology and its 30-year safety record that it can probably handle it quite comfortably.

"The issue is a political issue," he says. "It is not a rational risk issue."

The deep water reserves, with all their inherent risk and danger, remain the greatest resource to avoid the so-called topping off syndrome fears of earlier in the decade.

"Underwriters are aware of the tremendous values at risk in deep water drilling as potential for catastrophic loss," Pierce says. "No one is operating in an information vacuum."

In the Armageddon scenario, Pierce says, you are drilling in 20,000 feet of water and your blowout preventer on the sea floor fails. "And you have four miles of water between your rig on the surface and the failing equipment on the sea floor. Also, your secondary and tertiary choke valves all fail so you don't have an ability to stem the flow of oil," he says. "It could be an operating malfunction, but this has never happened."

Oil drillers, of course, are not the only energy companies taking on new risks as prices skyrocket.

The Dallas area-based J-W Operating Company over the past year has expanded its natural gas exploration operations by about 50 percent as it attempts to cash in on alternatives to oil and coal.

Risk Manager Tom Duncan says commodity risk, plummeting prices once all the operations are in place and running, remains his greatest concern.

Price hedging therefore becomes the main tool for J-W as their world grows with the sale of futures contracts to withstand any possible price declines in the foreseeable future.

Banks are increasingly forcing companies such as J-W to adopt sophisticated enterprise risk management techniques before they will part with any of their money, Duncan says.

"Banks want to know that they are well protected and to that extent you try and look at things in a more sophisticated way, not just merely operational risk but also economic risk as well," Duncan says.

October 15, 2008

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