In the last six months, the offshore drilling industry in the Gulf of Mexico has been affected by a national regulatory policy that has vacillated between: (1) initially favoring new drilling in the eastern Gulf; (2) ordering a moratorium on all deep water drilling based on safety concerns in response to the blowout on the Deepwater Horizon drilling rig (the "Original Moratorium"); (3) imposing a second moratorium based on a stronger statement of environmental concern shortly after a court found that the Original Moratorium was likely "arbitrary and capricious" (the "Second Moratorium," collectively the "Moratoria"); and (4) beginning the development of new offshore drilling regulations to be enforced by the newly created Department of Interior's Bureau of Ocean Energy Management, Regulation and Enforcement ("BOEMRE").

While to date only a few drilling rigs have been re-deployed away from the Gulf to other international areas of activity, there is concern that the Moratoria and upcoming regulatory changes could cause drilling companies to decide to move more rigs out of the Gulf. Drilling industry sources have expressed fear that the new government regulations under discussion (the "New Rules") will have a fundamentally adverse impact on the industry. For example, in a July 22, 2010 press release, the National Ocean Industries Association ("NOIA"), an offshore drilling industry trade association, warned:

Many in the current administration and Congressional leadership have indicated that it is perfectly acceptable to reduce the number of oil and gas exploration companies to those judged to be big enough to pay . . . The move to drastically increase the amount of financial responsibility necessary to bid on leases and to make an unlimited liability cap will, without a doubt, result in many companies being no longer able to stay in business. The result is more and more jobs lost and less energy produced at home.

This article describes strategies that a company in the offshore drilling industry (the "industry") can use to survive the fundamental changes caused by these changing government policies. This survival process includes: (1) understanding the structure and extent of the offshore drilling industry in the Gulf of Mexico and its long-term importance to the United States; (2) understanding how long the Moratoria will continue and whether court action is likely to shorten them; (3) developing a plan to conserve cash and other resources to survive during the Moratoria; (4) understanding the New Rules and what they will mean for future business operations and net revenue; (5) considering how, if necessary, to modify a company's capital structure to meet projected new levels of net revenue; and (6) determining whether a sale or merger transaction is an appropriate strategy in the new regulatory environment.

I. The Industry
A study published in July 2010 by IHS Global Insight concludes that U.S. offshore oil and gas operations, primarily in the Gulf of Mexico, produced about 30 percent of U.S. oil and 10 percent of U.S. natural gas in 2009. Of this, over 50 percent comes from deepwater drilling projects. The industry has a huge economic impact throughout the Gulf of Mexico region, employing over 380,000 people and generating over $70 billion of economic value in 2009, according to IHS. This is a vital national resource that cannot easily be abandoned when a sufficient supply of alternative fuels is not available to replace these hydrocarbons, and acquiring them overseas puts the United States at greater risk of conflict over energy resources in a world in which national oil companies are asserting greater control over their country's oil and gas.

Independent (non-major) oil companies act as operators on more than half of the wells drilled in the Gulf. Currently shallow water drilling and production is dominated by independent exploration and production companies ("independents") who do not need to find huge reserves to justify a drilling program. But even in deepwater projects with their higher capital requirements and potentially larger finds, the participation of independents in many deals enables many more wells to be drilled, permitting major oil companies to spread risk over a larger number of projects, thus expanding significantly the amount of drilling activity that occurs.

The IHS study expresses concern that the New Rules will make it more difficult for independents to continue, much less expand, the level of drilling activities, thus reducing the amount of work available in the Gulf for drilling companies and providers of related services. The concern is that tightening of safety regulations, related requirements for additional capital investment in safety technology, and additional bond and insurance costs might make it prohibitive for all but the largest independents to act as operators in the Gulf. If this is true, it will reduce the level of drilling and reduce net revenues for other independents and their vendors and suppliers. While larger drilling companies might be able to respond by deploying their rigs elsewhere around the world, smaller drilling companies that have focused on the Gulf will have difficulty doing so, as will many of their equipment and service providers.

II.The Two Moratoria and Related Lawsuits
On May 30, 2010, the U.S. Department of Interior's Minerals Management Service (the "MMS"), now known as BOEMRE, issued the Original Moratorium barring the issuance of new permits for deepwater drilling for six months; a similar Second Moratorium was issued in July. Two pending lawsuits have challenged the Moratoria and a preliminary injunction has been issued staying enforcement of the Original Moratorium, but the Moratoria will likely expire by their own terms on November 30, 2010, before plaintiffs' claims are finally resolved through the appeals process. The next scheduled hearing in either suit was set for September 22, 2010 (after the press deadline for this article).

A. The Hornbeck Lawsuit
On June 7, 2010 Hornbeck Offshore Services, LLC and other industry participants filed a complaint in a federal district court in Louisiana alleging that the Original Moratorium was "arbitrary and capricious and an abuse of discretion" and seeking an injunction staying its enforcement. On June 22, the district court issued an Order preliminarily enjoining the Original Moratorium, finding that it was likely "arbitrary and capricious" because: (1) it was not supported by factual data; (2) it was overly broad; (3) it did not balance competing interests; and (4) its enforcement would cause irreparable injury through the loss of jobs and consequent harm to the economy.

The next day, the MMS and other government agencies appealed the district court's Order and sought a stay pending the appeal. On July 8, 2010, the Fifth Circuit denied the government's request for a stay. On July 12, 2010, the BOEMRE rescinded the Original Moratorium and issued a Second Moratorium that imposed the same bans and suspensions and purported to include additional evidentiary support. Simultaneously, the government filed a Motion to Dismiss in the district court and a Motion to Vacate in the circuit court, both arguing that the Hornbeck suit is now moot.

On August 16, 2010, the Fifth Circuit asked the district court to consider: (1) whether BOEMRE has authority to rescind the Original Moratorium, (2) whether the evidence supporting the Second Moratorium was available for the First Moratorium, and (3) the differences between the two Moratoria. Although the district court has responded to the Fifth Circuit's request, the Fifth Circuit, as of September 13, has not scheduled oral arguments on the Government's appeal of the preliminary injunction of its Original Moratorium.

B. The Ensco Lawsuit
On July 20, 2010, Ensco Offshore Company ("Ensco") filed an amended complaint against the Government before the same Louisiana federal district court challenging the Original Moratorium and the Second Moratorium under many of the same theories asserted by Hornbeck. The Ensco suit also challenges new shallow and deepwater drilling and permit requirements imposed by BOEMRE that have essentially shut down all deepwater drilling operations in the Gulf. Ensco and the government filed cross-motions for summary judgment. Oral argument on the motions was scheduled for September 22, 2010.

C. The De Facto Moratoria
There is a substantial likelihood that neither the Hornbeck Lawsuit nor the Ensco Lawsuit will have reached a final order vacating the Moratoria before they expire by their own terms on November 30, 2010. Meanwhile, the BOEMRE is reported to have substantially reduced its pace in granting new drilling permits and has proposed that some spill response plans satisfy newly imposed requirements.

III. The New Rules

A. What Will the New Rules Be?
One result of these lawsuits is the creation of a climate pressuring the government to end the Moratoria and promulgate the New Rules by November 30, 2010. It is difficult to know with precision what New Rules BOEMRE will propose. It has available to it a number of sources for advice. For example, there is the May 27, 2010 Safety Report that formed the basis for the Original Moratorium (this is the report that was purportedly based on the work of a number of listed experts who later claimed their conclusions were misrepresented). In addition, BOEMRE has been in consultation with a group from the Natural Academy of Engineering that has focused on standardizing technology and practices for (1) blowout prevention, (2) well operations and (3) other safety systems.

NOIA and the American Petroleum Institute have issued two reports dated September 3, 2010 (the " industry Reports") setting forth the industry's recommendations concerning the New Rules. It is not possible to know whether these recommendations will be followed.

Perhaps the best insight into BOEMRE's thinking are Notices to Lessees 2010 No. 5 and No. 6 published in June 2010. These notices reiterate a requirement for more detailed checking and certification of (1) blow out preventers; (2) all procedures concerning well operations; (3) safety procedures; and (4) training of personnel to deal with emergencies. Company CEO's are required to certify compliance with all rules in these four areas. Moreover, these notices list a number of additional things that must be done based on recommendations made by the May 27 Safety Report.

B. What Impact Will the New Rules Have?
The New Rules are likely to increase capital costs for new safety equipment and increase operating expense by requiring more expensive methods of operating, larger bonds and more expensive insurance based on higher liability limits. They will likely result in larger capital requirements and reduced net earnings after expenses. The extent of these economic impacts will be clearer as we approach the November 30, 2010 expiration of the Moratoria and the likely promulgation of the New Rules. Numerous experts will offer their insight as drafts of the New Rules are released and they are ultimately promulgated.

IV. Stand-Alone Restructure

A. Short-Term Survival of the Moratoria
The short term goal for companies in the industry is to survive until the Moratoria expire. This could require a stringent program of cash conservation. Because it may be difficult and expensive to obtain a new loan or raise new equity financing during the Moratoria, the most likely available source for any needed additional cash would be the sale of assets. However, the current situation has made valuation of assets particularly challenging; moreover, it is important that a company sell only those assets that are ancillary to its future core operations. There are numerous financial restructuring experts who can help with programs to conserve cash, identify core assets, and assist in valuing and marketing non-core assets.

B. Long-Term Restructure To Survive Under the New Rules
It will be important to quickly appreciate the effect of the New Rules on capital expenditures and operating expense, and their impact on net revenue available to service debt. The same financial restructuring advisors who can help with survival during the Moratoria can undertake this analysis and assist in any necessary restructuring negotiations with lenders and other capital suppliers.

In the last several years, many secured lenders have been willing to negotiate to lower current debt service payments and extend maturities. And many unsecured bondholders have been willing to negotiate the conversion of debt to equity. There are numerous capital providers willing to lend and make equity investments in restructuring situations. Restructuring negotiations involving these same three elements have often occurred outside of bankruptcy courts and resulted in many successful stand-alone restructurings.

If these negotiations fail, the Bankruptcy Code permits stretching out secured debt payments, converting unsecured debt to equity, making new loans with "priming" first priority liens and making new equity investments upon exit from bankruptcy.

Often, the essential questions for the viability of a stand-alone plan of reorganization, whether in bankruptcy or out, are (1) can a feasible plan be shown that merely stretches out secured debt and converts some, or all, unsecured debt to equity; or (2) will it be necessary to obtain additional restructure/exit financing; and (3) is restructure/exit financing available for the company at an acceptable price?

V. Transactions By Sale or Merger
If new capital cannot be attracted to a stand-alone restructuring of a company, it is often an indication that a restructuring plan is not feasible. In that situation, it might be useful to consider the sale of the company or its assets. Although these sales can be done outside of bankruptcy, some purchasers favor buying assets from a Chapter 11 estate because the purchased assets can be acquired free and clear of claims by creditors of the seller. Some purchasers care so much about this clean, unencumbered title that, to obtain it, they are willing to go through the cumbersome process of being a "stalking horse" bidder at a bankruptcy auction, entitled to a break up fee if they lose.

A catalyst for a sale transaction might be that one or more companies have decided to act as accumulators or consolidators to achieve a larger size which may be beneficial under the New Rules. However, that larger size can also be achieved by a "roll up" merger of a number of smaller companies into a merged company able to function better in this new market. This could be accomplished in two ways. First, a number of companies might recognize the need for a merger and do so in an out of court transaction. It would, of course, greatly facilitate this approach if a capital provider were willing to put new capital into the new combined entity. Second, if a number of smaller companies are forced into Chapter 11 cases by the Moratoria and the New Rules, they might participate in such a merger as they exit bankruptcy. Again, this process would be greatly facilitated if capital providers were willing to invest new capital as bankruptcy exit financing.

The analysis described above could apply not only to independents but also to drilling companies and all types of industry-related equipment and service providers. Some industry companies in each of these categories may be better able to survive the Moratoria and New Rules either by stand-alone reorganizations or by horizontal or vertical consolidations through sale or merger.

VI. Conclusion
How does a company in the industry survive the Moratoria and New Rules? Accept the fact that cash must be conserved to survive as long as the Moratoria are in effect. Come to grips early with the impact the New Rules will have on operations, insurance, risk management, capital requirements and net revenues.

If nothing further needs to be done, great! If capital structures need to be adjusted to fit projected new lower net revenue streams, negotiate consensual restructure deals promptly.

If needed restructuring is not possible on a stand-alone basis, look for a purchaser or merger partner sooner rather than later. Staying agile in the face of this uncertain, rapidly changing environment will be essential and the chances of survival much greater for those who act early.

Zack A. Clement is a partner and R. Andrew Black is senior counsel in the Bankruptcy and Insolvency Practice Group of Fulbright & Jaworski L.L.P.