CHAPTER 4 DUE DILIGENCE IN THE CONTEXT OF THE INTERNATIONAL OIL AND GAS DEAL

• Jurisdiction: United States

Due Diligence in Oil & Gas and Mining Transactions
(Sept 2018)
CHAPTER 4
DUE DILIGENCE IN THE CONTEXT OF THE INTERNATIONAL OIL AND GAS DEAL
Robert Brant
McCarthy Tetrault LLP
London, U.K.
Niki Gill
McCarthy Tetrault LLP
Calgary, AB

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ROBERT BRANT is the Managing Partner of McCarthy Tétrault's London, England office (where he has been based for the last 20 years) and a member of its Business Law Group. He is an experienced corporate/commercial lawyer, focusing his practice on international mergers, acquisitions and divestitures, and international securities offerings. Mr. Brant regularly advises a wide range of international companies in connection with European M&A and corporate finance transactions (including new stock exchange listings) as well as significant commercial contracts. Mr. Brant's experience extends to a number of different sectors with a focus on energy and mining in Europe and Africa. Clients which Mr. Brant has represented include Canaccord Genuity, Canadian Overseas Petroleum, EnCana, First Quantum Minerals, GMP FirstEnergy, Heritage Oil, Scotiabank, TransCanada PipeLines and RBC Capital Markets. Mr. Brant is recognized by Chambers Global as a leading practitioner in Corporate/M&A (Canada and UK). He received his LLB from Osgoode Hall Law School in Toronto and his BA (Economics) from Western University. He qualified as an English solicitor in 1999 and was called to the Ontario bar in 1993. He is the past President of the Canada-UK Chamber of Commerce.

NIKI GILL is an associate in the Business Law Group in McCarthy Tétrault's Calgary, Alberta office. She maintains a general corporate and securities practice that includes corporate finance and mergers and acquisitions, with a specific focus on oil and gas transactions. After receiving a Bachelor of Arts degree from the University of Alberta, Ms. Gill received her JD from the University of Calgary in 2017 and was called to the Alberta bar in 2018.

Cross-border deals can give rise to a myriad of issues and a great deal of risk. Managing risk is best served by conducting a thorough due diligence prior to any cross-border transaction. A thorough title due diligence can help to ensure that an international venture or acquisition has a firm foundation upon which a return on investment can be secured. Due diligence should also include familiarity with the types of production sharing contracts in use in the desired jurisdiction and the benefits and detriments of typical clauses and provisions within them. Finally, corruption risk can be mitigated by ensuring practices are conducted in alignment with domestic and foreign legislation.

1. Title Due Diligence

Conducting a title due diligence helps ensure that the chain of title exists as represented by the seller, whether a private seller or a government entity. When dealing with a foreign government, care is taken to ensure that title to the land in question or the lease being offered has not previously been leased or licensed to another person or entity and that the lease, license or property in question can validly be transferred from one entity to another. Title due diligence plays a vital role at each phase of a deal and can occur even after the deal has closed to confirm warranties.¹

Oil and gas title due diligence can be limited by time and financial constraints, or by the nature of the deal.² Property involved in oil and gas transactions can be extensive and complex and is often subject to various other leases, fee ownership and other rights. Given these constraints, parties to cross-border transactions often make representations and warranties or give other assurances regarding title to decrease the amount of due diligence they need to undertake. While serving the interests of time, such arrangements hinge on the transparency of the parties and adequacy of reporting processes. Third party rights to an encumbered property or asset can have an adverse effect on profitability and can impact operations.³ Highly burdened land and property can augment investment risk and lead to difficulties in obtaining financing as lenders experience a lack of assurance in a borrower's ability to support the loan.

A significant aspect of oil and gas due diligence is identification of defects in title and identifying whether and how they can be remedied or cured. To do so, an examination of the title focuses on the owner of the asset, whether the asset is subject to a split estate, and what rights each holder of rights in the asset is entitled to pursuant to the rights granted. Rights of possession, first refusal, sale or development granted to third parties can give rise to multiple mineral development on the same lands and can affect the ultimate value of an oil and gas property.⁴ Copies of any previous title opinions, copies of ownership or land reports can be requested to fulfill due diligence requirements and ensure that an asset is not encumbered by third party rights in a way that will have an adverse impact on future profitability.

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Conditions unique to oil and gas due diligence include identification of boundaries regarding potential for drilling and spacing, and integration of oil and gas rights with surface rights. Title due diligence in oil and gas will need to identify and locate land formations in order to asses any depth limitations. Evaluation of a reserve is conducted utilizing technical expertise in tandem with financial analysis of costs and expenses. Due diligence exercises in oil and gas also consider the royalty regime in the host country and any additional permitting that might be required for drilling or exploration activities.

Traditionally in Canada, purchasers in energy deals assume the risk of environmental liabilities upon purchase, as long as there is no misrepresentation of such liabilities by the seller. International purchasers may not face similar considerations in other countries and can be an additional cost of business. The costs of environmental remediation or abandonment and how those costs will be distributed between a buyer and seller can delay closing or create unanticipated risks for one party.⁵

Consequences of failure to conduct a thorough due diligence in regards to title can range from additional costs in the future, post-dating the close of the deal, reduced profitability of an acquired asset, or even the failure of a deal to reach completion. Cross-border litigation that can be avoided by conducting a due diligence often involves jurisdictional questions and conflicts of laws issues, making such litigation difficult to commence and see through. These pitfalls can be reduced by use of representations and warranties and a due diligence exercise that makes use of all available reports, title opinions and documents, and consideration of all domestic legislation and regulations.

2. Variation in Production Sharing Contracts

Production sharing contracts ("PSCs") are entered into by private companies ("PCs") and host government entities ("HGEs") and are geared towards a split of profits between the two parties upon the discovery, extraction and ultimately, the sale of oil and gas. PSCs balance the need for financial reward and the mitigation of risk for the PC and ensure a return on resource exploitation and extraction for the HGE. PSCs can be executed directly with a foreign government or can be executed with a government-owned company instead. In either case, the type of contract is dependent on the level of risk and reward assumed by each party. This risk allocation forms the basis for the type of contract entered into by participating entities.

HGEs seeking broader benefits from their hydrocarbon resources have recognized the value of participation in the extraction and exploitation of natural reserves. Where previously, HGEs maintained a preference for issuing licenses or concessions, recent trends have seen the development of PSCs as a model for resource development. HGEs are enabled to share in a greater degree of a share of production and fruits of the extraction process while maintaining control over how and when resources are developed. HGEs are better able to ensure sustainable development that incorporate environmental protection measures and can reroute profits of exploitation back to adversely affected regions and populations.

Under PSCs, PCs are typically given the right to explore for and produce hydrocarbons and are often under obligations to conduct certain exploratory activities in respect of the rights granted. Upon discovery, a company is obligated to enter into a development plan with the host government and conduct any production in accordance with such agreement, the terms of the

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existing production sharing contract and any applicable law.⁶ The PC is the lawful owner of a portion of the production and can fluctuate their prices in response to commodity prices and production level.⁷ If a PC's exploration efforts do not result in a discovery of commercially producible amounts of hydrocarbons, the PC is not reimbursed for expenses of exploration. If production is possible, production is split between the HGE and the PC according to formulae specified in the PSC.

While the risk is allocated primarily to the company under a PSC, the entitlement to profits present a potential reward for the risk taken by the PC. In return for a greater share and certainty in the result and...