The basics of underwriting energy bonds


Energy bonds are required for many different projects.  Maybe your customer needs to plug a well or perhaps they need restore land to its previous state after installing solar panels.  Whatever the obligation, there’s a lot that goes into underwriting energy bonds and you need to make sure you are working with an underwriter that has experience and expertise in this sector. 

Energy Overview

Energy sources can be classified as nonrenewable, renewable, or secondary energy. Most of the United States energy comes from nonrenewable energy sources which include natural gas, coal, petroleum, propane, and uranium. Renewable energy sources comprise solar, wind, hydropower, geothermal, and biomass energy. Secondary energy sources are made by using another source of energy, such as electricity and hydrogen, are in a usable form that can be easily stored, moved, and delivered.

Energy companies in the oil and gas industry can be categorized based on their operations. There are three segments of the energy value chain. Integrated energy companies operate across all these segments.

  1. Upstream companies, which participate in the exploration and production (E&P) of oil and gas
  2. Midstream companies, which are responsible for processing and transporting extracted hydrocarbons through pipelines
  3. Downstream companies, which refine and distribute the petroleum and gas products to retail outlets and end customers, and in some cases are the retailers themselves.

Energy use can be classified into five sectors:

  1. Transportation – uses energy through vehicles, such as trucks, trains, aircrafts, and boats to transport people or goods
  2. Industrial – includes equipment and facilities that are used for manufacturing, mining, agriculture, and construction
  3. Residential – energy used in homes and apartments
  4. Commercial – includes energy used in offices, stores, schools, hospitals, hotels, warehouses, restaurants, and places of worship
  5. Electrical power – gets it energy from primary sources and is mostly generated for the purpose of selling to the other four sectors

The performance of energy companies is driven by supply and demand. The dynamics of supply and demand then affect energy commodity prices. Factors that can affect demand for energy include the economy, consumer preferences, technology, and government policies. These factors can drive demand higher or lower for one energy source while having the opposite effect on another source. The supply of energy sources can be affected by the actions of the Organization of the Petroleum Exporting Countries (OPEC) or various political events.

Common Energy Bond Obligations

Oil & Gas Well Plugging Bonds

Oil and gas well plugging bonds are typically required by law prior to commencing drilling operations. These bonds guarantee compliance with applicable statutes or regulations, including the principal’s obligation to cause the well to be properly plugged and abandoned when it becomes dry or no longer productive. Well plugging bonds are usually issued to government agencies responsible for the regulation of natural resources, whether at the city, county, or state level.  

Many of these bonds contain a cancellation provision, but agents and customers should know that this only releases the surety from any go-forward liability. Hence, with this type of obligation the surety requires a release from the obligee. In the bond form, there is typically maximum penal sum language, limiting the surety’s maximum potential liability.

Decommissioning Bonds

Similar to well plugging bonds, decommissioning bonds guarantee the removal of equipment –such as offshore platforms, wind turbines or solar panels – and the restoration of land to its pre-existing state. The bond amount is determined by several factors, typically the decommissioning and restoration costs. In order to underwrite these bond requests, the surety will typically review cost estimates and decommissioning plans.

Decommissioning bonds are typically requested by a landowner, municipality, state, or federal government when developers of an energy system are granted rights to operate on private or public land. The bond provides recourse to the government, taxpayers, and/or landowners should the principal fail to properly decommission the facility once it is no longer active. Agents and principals should be aware that given the long-term duration, the surety prefers an annually renewable or cancellable bond form, but full release typically requires replacement with an alternate form of security.

Reclamation and Closure / Post-Closure Bonds

Reclamation or closure/post-closure bonds cover environmental obligations to restore land to its original state after commercial use or cover environmental remediation in the event corrective action is required due to contamination or release of hazardous materials into the environment. These bonds typically are provided to various regulatory agencies at the state or federal level, including the EPA, and guarantee that work is performed or funding for said work is established at the site in accordance with the approved plans.

Particularly due to the complexity and hazardous nature of the work, along with the potential duration, these bonds are considered higher risk to the surety. Typically, the bond forms are statutory and dictated by the governing agency, but follow similar formats which allow for cancellation, but only if the surety is replaced within a certain amount of time from cancellation.

Underwriters will typically review site-specific documents, such as closure/post-closure or remediation plans, along with the engineer’s cost estimates. Sureties typically prefer to bond sites with active operations.

Performance Bonds

Energy companies may have construction and service/performance-based contracts for various projects. This can include Guaranteed Energy Savings Contracts between a qualified provider and a building owner to reduce the energy and operating costs of a building or group of buildings by a specified amount. This is done by implementing facility upgrades or energy conservation measures (ECMs) that result in energy savings. This is often required by schools and other governing bodies.  

In order to underwrite these obligations, the surety will request underlying contract and supporting documents, including engineering estimates, from your customers. The surety will often consider duration of the work, liquidated damages, warranties, and other terms of the obligation. If the obligee requires specific bond forms, the surety would review the terms in the bond relative to the terms of the underlying contract as well.

The surety bond for this work would typically not cover performance or efficiency guarantees beyond initial construction. If the contract requires performance or efficiency guarantees, as the surety, the preference is opting to bond those separately on an annual form or have them excluded from the bond altogether.

License and Permit Bonds

There are a variety of license and permit obligations applicable to energy companies, namely right-of-way and excess weight bonds. These bonds are usually cancellable with 30 days’ notice. 

Certain energy companies will also be required to post fuel tax or fuel dealer bonds, depending on the nature and location of their operations. These bonds guarantee that fuel sellers operating within a state will pay the state government taxes, penalties, and interest owed and are required for fuel owners as long as their license it active. Fuel tax and dealer bonds forms are state specific and are typically cancellable. It is important to always review the underlying agreement to determine whether the bond has any tail exposure. Tax bonds might be cancelable, but the surety is not necessarily released from the exposure until an audit is completed and the release is granted. 

Court Bonds

Energy companies sometimes have court bond needs, such as injunction, appeal, condemnation and cost bonds. The company can either be the plaintiff or defendant. Companies that build pipelines or conduct drilling may see a need for frequent condemnation, cost and injunction bonds. The bond form should include maximum penal sum language to limit the surety’s maximum potential liability. For appeal bonds in particular, underlying court documents, such as the judgment, will be reviewed by the underwriter.

Customs Bonds

Entities that import goods into the United States or engage in import-related operations typically require a customs bond. These bonds guarantee payment of required duties, taxes and fees to Customs; proper filing of required paperwork; and compliance with applicable regulations. Examples of customs bonds include importer or broker bonds and drawback payment refund bonds.

These bonds can be issued to cover a single transaction, or on a continuous basis to cover all transactions by the principal while the bond is in force. Customs bonds are cancellable but can include tail liability after cancellation, as the surety remains liable for duties incurred during the period the bond was in force. Agents and principals should be aware that as a result, sureties may take steps, such as holding collateral, to monitor or mitigate ongoing liability until the point when all underlying entries have been liquidated.

Utility Deposit Bonds

Utility deposit bonds are financial guarantee obligations to the utility company. When entering into an agreement for utility services, the utility company will agree to accept a bond in lieu of a cash deposit securing future payments under the service agreement. These bonds should be cancellable by the surety upon advanced written notice.

Market Considerations

Economic and legal factors play a significant role in the industry, and thus in underwriting energy bonds.

General Economic Conditions

The energy market is sensitive to many factors, including commodity pricing, inventory levels, government policy, and weather.

A commodity is any homogenous good used in commerce and traded on an exchange. Examples of commodities are natural gas, precious metals, electricity, grain, etc. Commodity pricing relies heavily on supply and demand patterns, and anticipation of future pricing and speculation. Commodity prices rise with inflation.

Oil inventory levels, or crude oil stockpiles, are reserves of unrefined petroleum measured by the number of barrels. These stockpiles are used to adjust for supply and demand and the inventory levels are impacted by OPEC directives, tax policy, and other factors. Higher inventory levels correlate with lower oil prices and natural gas inventory is affected similarly. Higher inventory levels imply weaker demand for natural gas.

Government policies affect taxes, tariffs, interest rates, and regulation, all of which in turn impact pricing. The Energy Policy Act addresses energy production in the U.S., and this can change with the political party in power.    

Weather also plays an important role in energy pricing as the seasonal cycle indicates that demand for energy increase during peak winter and summer weather, for both heating and cooling, respectively. Natural disasters, depending on the severity of their damage, can affect plant operations and potentially reduce supply. On extreme levels, they can cause outages, which will then cause shutdowns or slower production.

Lastly, it is important to note that the energy market cycle shows that prices rise and fall over the course of four to eight years on average.    

Legal Challenges

In recent decades, there has been a shift towards expanding environmental protections. In particular, the energy sector has become the focus of this reinforced effort. Worldwide efforts to reduce environmental risk has forced energy companies to reevaluate their operations. The United Nations’ Paris Agreement is one example of this movement which was ratified in 2016 with a purpose to keep global temperatures from rising further. One way to implement this is by curbing carbon emissions. Most companies formed sustainable, low-carbon operations moving forward. However, certain companies, especially those in the coal business, faced lower demand and losses as a result. Despite the U.S. slowly leaving the Paris Agreement, energy companies will need to continue to incorporate climate change actions into their future operations.

In addition to overall climate change awareness, there are also environmental obstacles applicable to specific projects. Pipeline companies face frequent litigation from homeowners living in close proximity to the construction, and pipeline opposers. These legal battles can be costly and result in construction delays.

In summary, energy is a complex sector which requires expert underwriting.  As previously stated, agents should only work with sureties and underwriters who have experience in this industry and who are keeping current with regulations.  Agents are also encouraged to stay abreast of legislative changes.  Together sureties and brokers can be come trusted advisors to our energy customers.