CHAPTER 3 THE PURCHASE AND SALE AGREEMENT -- THE BUYER'S VIEW
| Jurisdiction | United States |
(May 2006)
THE PURCHASE AND SALE AGREEMENT -- THE BUYER'S VIEW
St. Mary Land & Exploration Company
Denver, Colorado
MILAM RANDOLPH PHARO
Milam Randolph Pharo is Vice President -- Land & Legal at St. Mary Land & Exploration Co. in Denver, Colorado. He earned his B.A. at the University of Texas at Austin and his J.D. at Southern Methodist University. He was admitted to practice in 1977.
INTRODUCTION
The goal of the Buyer in preparing the purchase and sale agreement and attendant transaction documents is to preserve the value perceived by the Buyer at the time of making its proposal. This being said, there are risks that must necessarily be born by the Buyer. Notwithstanding that there are risks that a Buyer should be willing to take, it rarely should move to the extreme desired by most Sellers who have come to believe that they should be paid the offer price whether or not they possess the totality of the interests they represented to sell, and further, without regard to the often unquantifiable liabilities to which the properties may be subject. Thus, the Buyer must strive to achieve a contract that properly allocates the risks attendant to purchasing the properties to ensure that the Buyer does not pay full value for something less than the Buyer sought to acquire.
A seldom discussed component of Buyer achieving the goal of perceived value preservation is that the Buyer must know and preserve the perceptions of value held by the Buyer's internal technical staff. While this may or may not be directly written into the contract, as it may or may not affect the items of value perceived by the Seller for which the Seller seeks compensation, these items are nevertheless crucial to the Buyer obtaining the value it seeks to obtain by engaging in the transaction. These understandings must be achieved by the Buyer's representatives prior to entering into the purchase and sale agreement negotiations, or Buyer runs the risk of losing that serendipity value that makes the transaction desirable.
The thrust of this paper is to identify and discuss those issues which can destroy value for the Buyer. This paper will not seek to move stepwise through the individual elements of a purchase and sale agreement in the same manner as paper one inasmuch as that paper's authors did an outstanding job of not only going through the elements of a purchase and sale agreement but articulating a number of the issues faced by Sellers and Buyers with regard to each portion of the agreement. Where this author believes the Buyer's position needed greater detail than that given in paper one, you will find those reactions in the redline reactions set forth in paper three.
I. Risks Appropriately Assumed By Buyer.
A. Commodity Prices. Every Buyer must make its own decision regarding how it wants to run its acquisition economics. An obvious crucial element of this calculation is the commodity price both current and into the future that the Buyer will use in evaluating the value of the properties. There are numerous approaches that a Buyer can take with regard to pricing assumptions. Many use a three-year NYMEX strip which can be hedged or
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protected with other derivative instruments but even this straight-forward approach has other options. Given the life of the properties, one will need to decide whether or not the price at the end of three years will be escalated, held flat, or dropped back to a lower level and escalated from there. This is a matter on which every participant in our industry must make its own decisions, and although there is often no right answer at the time the bid is prepared, there will absolutely be an accounting of the decisions that were made. Nevertheless, this is outside of Sellers control (assuming no fixed price contracts that have extended duration), and is a risk the Buyer must analyze for itself.
B. Risk Factors Affecting Undeveloped Reserves. Inclusion of undeveloped reserves is a fact of life in any successful bid. Those reserves which have always fit in the proved category such as proved developed non-producing (PDNP) and proved undeveloped (PUD) have always been a factor in a Buyer's evaluation, although I can remember the time when all that was recited in an allocated values schedule were proved developed producing (PDP), and the discount rate was somewhere approximating 15%. Now however, successful bids frequently must go to 3P reserves which include proved, probable, and possible. Three factors greatly affect the value properly attributable to any reserves other than PDP reserves. These are the likelihood of success generally expressed as a risk percentage, the timing when those reserves will be brought on assuming success, and the costs that will be incurred in moving those reserves from one category to another.
PDNP or behind pipe reserves are rarely viewed as having a material risk in the fact of their existence. These have principally been identified on logs and are behind casing. The timing and costs of gaining access to those reserves can significantly impact their value. Will you have to wait until the PDP reserves currently existing in that wellbore are produced before you move up the hole to capture these, or will a rate acceleration well be appropriate? The same is not true for probable and possible reserves. Probable reserves can pose a very daunting challenge in that you may feel as confident of their existence as any PUD location, but they fall outside the definition of what constitutes a PUD and thus what can be booked for SEC purposes. If you can convert them into PUD locations fast enough, they can be booked and will add significant value, but if you are wrong or simply cannot gain access to this change in classification in a timely manner, the Buyer may find itself having to report excessive finding costs against its proved reserves which can have a materially negative effect in the marketplace. Nevertheless, these are decisions which the Buyer must make based on its own analysis because while a Seller will want you to believe that there are vast untapped opportunities in the property package, there will be no representation regarding the quality or quantity of reserves the Buyer is going to acquire.
C. Geology. Inextricably interwoven in the identification and risking of locations is the Buyer's geoscience evaluation of the Seller's properties. In today's sophisticated divestiture market, any potential Buyer will be presented with a glowing sales document touting the undeveloped potential of the sale properties. The Buyer's ability to make its own geologic and/or geophysical determinations is crucial to a proper evaluation, and ultimately this determination lies within the Buyer's control and area of responsibility. Where the Seller may become involved here is access to data, files, maps, and interpretations that are within Seller's possession or control. After all, it won't matter however slick or persuasive the Seller's presentation of development opportunities is, or even what the materials
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suggest (barring fraud) there will be no representation by the Seller sufficient to rectify poor geoscience decision making on the part of the Buyer.
D. Engineering. This is another area where the Buyer must have the ability to do its own independent evaluation of the materials presented by the Seller. The next few statements necessarily assume that the Seller accurately presents the performance of the existing wells and their attendant costs. The Buyer is going to take reservoir performance risks. The ability to accurately analyze and assess the performance of the material wells, whether currently producing or to be drilled in the future, is absolutely fundamental to the Buyer's ability to conduct a successful acquisition program. While there is some due diligence that can be done to confirm the engineering analysis performed by Buyer, in the customary circumstances, this engineering analysis is completed during the course of bid preparation. Consequently, decline curve analysis in the attendant economic analysis must be done by the Buyer.
II. Risks the Buyer Should Avoid or Mitigate.
Without demeaning the importance of most every provision in the purchase and sale agreement, many are generally not particularly controversial or difficult, and Buyer and Seller will come to terms. Generally speaking, the description of the assets to be conveyed, accounting procedures, Buyer's representations, and miscellaneous terms are straightforward and consistent from transaction to transaction. Most commonly, the parties' energy will be spent on the Seller's representations, the Seller's covenants, title and environmental defect procedures, and indemnification procedures. It is in these issues that the Buyer can lose significant value in the transaction, and for that reason, the balance of this paper will primarily focus on these matters. For this reason these matters and their related issues drive the negotiation process. As important as these issues can become, it is difficult to decide which is more remarkable, that Sellers will advocate so vigorously for agreements that in effect request that they be paid for assets that they do not own or that have material impairments, or that so many Buyers so readily accept these types of agreements. Notwithstanding the recognition that rare things are rare and common things are common, we should never lose sight when acting as a Buyer of the amount of value that can be lost through a poorly negotiated or understood purchase and sale agreement.
A. Seller's Representations. Rather than attempt to go through each representation that a Buyer might desire to add, I have saved this for paper number three wherein I have attempted to redline the proposed purchase and sale agreement submitted by Seller in an effort to achieve a mutually satisfactory...
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