CHAPTER 6 12 COMMONLY OVERLOOKED, UNDERAPPRECIATED AND|OR SCREWED UP TRANSITION ISSUES THAT CAN RUIN YOUR WHOLE DAY (OR DEAL)
| Jurisdiction | United States |
(May 2006)
12 COMMONLY OVERLOOKED, UNDERAPPRECIATED AND/OR SCREWED UP TRANSITION ISSUES THAT CAN RUIN YOUR WHOLE DAY (OR DEAL)
Linda Featherstone
EnCana Oil & Gas (USA) Inc.
Dallas, Texas
C. BARRY OSBORNE
Barry Osborne is Associate General Counsel for the Mid-Continent Business Unit of EnCana Oil & Gas (USA) Inc. in Dallas, Texas. He was admitted in 1986. Education: University of Texas at Austin, B.S.; University of Texas at Austin, J.D.
LINDA FEATHERSTONE
Linda Featherstone has 30 years of Land experience in the Mid-Continent and Rockies areas with expertise in lease negotiations, field land work, division order preparation, lease analyst work and due diligence. Linda is currently Group Lead of Land Administration for the Mid Continent Business Unit of EnCana Oil & Gas (USA), Inc. and directs a staff of 25 people for the East Texas, Fort Worth and Permian Basins. She is responsible for division orders, lease data management, land mapping and records management.
Linda received her Bachelor of Science in Education Degree from the University of North Texas in 1979. She is a Certified Professional Landman and is a member of the AAPL and the Dallas Association of Petroleum Landmen.
In the acquisitions area, with more and more emphasis and value being placed on undeveloped reserves, now more than ever the ability to hit the ground running after an acquisition closes is critical. The ability to immediately deploy an active development program is often integral to the economic projections upon which the purchase price was based. Even if the production and reserves come in as anticipated, a delay of just a few months can drastically impair the economics of a deal, and the loss of acreage that may result from such unforeseen delays can be devastating.
The following is a list of twelve common problems that arise during transition. Many of these problems must be identified during the diligence phase, or even the evaluation phase of the acquisition to properly remedy; however, the one thing common to all of them is that the team responsible for transitioning and executing on the new assets often end up holding the bag. That being said, this is certainly not an exhaustive list. Every practitioner who has worked a deal, big or small, likely has his or her own list, along with a war story to go along with it.
1. Detail your drilling commitments.
Know how many rigs you need running in order to hold the leases you are buying. Don't get caught with a drilling commitment in a lease that you cannot obtain the rigs for or that you do not have the budget to fulfill. Under most purchase and sale agreements, drilling commitments that cannot be reasonably fulfilled are not title defects even if you catch them during diligence.
For years, acquisitions primarily involved the buying of proved developed producing reserves and proved developed non-producing reserves. During that era of acquisitions, acreage was not the primary driver of value. Many companies have now entered the era of the resource play. In a resource play, proved developed reserves are not the primary driver of value, but rather future drilling opportunities and the drilling inventory that the acreage component of the acquisition represents. "Undeveloped reserve potential" is paramount for such companies.
Unfortunately, the traditional purchase and sale agreement, as well as the acquisition sequence model of: 1) opportunity recognition; to 2) data room and evaluation; to 3) bidding; to 4) purchase and sale agreement; to 5) due diligence; to 6) closing; to 7) transition, was primarily designed for acquisitions that were geared toward proved developed producing and proved developed non-producing reserves. Acreage was largely unvalued or
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undervalued upside potential. This paradigm is often not the case anymore, particularly in resource play acquisitions, yet the model has not changed. Consequently, in these types of acquisitions, while the engineering and diligence on the proved reserves piece of the acquisition may be on target, a deal can unravel during transition and execution due to unforeseen problems with the acreage that do not involve matters that are covered in traditional land due diligence and, even if they are discovered, do not constitute title defects under the traditional purchase and sale agreement giving rise to a purchase price adjustment.
The following is a common definition of "title defect" taken out of a purchase and sale agreement, followed by a common seller's representation regarding maintenance of leases from the same purchase and sale agreement:
"Title Defect" means any condition other than a Permitted Encumbrance that now or in the future: (A) reduces Seller's Net Revenue Interest in any of the Leases to less than the amount as shown on Schedule 3.4(b) of each Lease; (B) increases Seller's Working Interest as set forth on Schedule 3.4(b) for each Lease (other than increases that would result in the Net Revenue Interest in such Lease or Well being proportionately increased); or (C) imposes, on any of the Leases any lien, charge, encumbrance, claim, easement, servitude, right, burden or defect that is not a Permitted Encumbrance hereunder. It is expressly understood that Permitted Encumbrances do not constitute Title Defects.
All Leases are in full force and effect and are maintained by their terms. Accurate and timely payment of delay rentals have been made to maintain in force an defect all Leases within the primary term on which drilling operations were not timely commenced. All other Leases are validly preserved beyond the primary term by production in paying quantities or the accurate and timely payment of shut-in royalty payments or otherwise. Except as set forth on Schedule 3.6, all rentals, royalties, overriding royalty interests and other payments due under each of the Leases have been timely and accurately paid, except amounts that are being held in suspense as a result of title issues in circumstances that do no provide any third party a right to terminate any such Lease.
Nowhere in either the customary definition of title defect or in the customary seller's representation regarding lease maintenance is there provision for lease clauses that impose requirements that are impossible to perform in order to maintain the lease.
I don't know that the overall acquisition model is going to change anytime soon, but in the meantime there may be a couple of language changes that can be folded into a purchase and sale agreement to help mitigate certain types of lease maintenance issues that are not currently covered by the customary purchase and sale agreement provisions. Outlined below is some suggested language to add to a "title defect" definition, as well as a seller's rep regarding lease maintenance that could serve to give the acquirer an avenue for adjustment should certain non-traditional type of lease maintenance problems arise. The limitation, of course, is that this type of lease maintenance issue must be discovered during the diligence process for an adjustment to occur. Maintenance issues that are not identified
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during diligence and that do not materialize until after closing will require much more creative solutions.
For the definition of "title defect," consider adding the following language. There are of course as many variations of this language as there are drafters; however, the concept captured here is intended to act as a genesis of a thought process. I have used the language previously quoted above as a starting point for the definition.
For purposes of this provision, "burdens" shall include any provision in a Lease or other instrument granting oil and/or gas rights that requires commencement of drilling or other operations that cannot be fulfilled by the exercise of reasonable diligence prior to the expiration of the Lease or other such instrument granting oil and/or gas rights.
An alternative would be to include a new definition of "burdens" to the definitions section of the purchase and sale agreement. The result should be the same.
To the seller's representations and warranties section of the purchase and sale agreement, consider adding the following language:
No Lease is subject to any outstanding drilling requirements or other obligations necessary to maintain such Lease or to otherwise extend the primary term or any secondary term of such Lease that cannot be fulfilled through the exercise of reasonable diligence.
Granted, these types of provisions are going to be difficult to negotiate into the customary form of purchase and sale agreement. What constitutes "reasonable diligence" is certainly to open to interpretation and there may be a better phrase with a more easily captured definition. Nonetheless, this type of provision is worth the negotiating effort. Remember, there was a time when indemnity provisions that extended to the period of the seller's operatorship prior to closing were considered to be tough trades. Now such provisions are commonplace.
2. Scrutinize your shut-ins.
Leases can typically only be held by wells that have been completed and are capable of commercial production. Be sure your seller has not drilled wells to total depth, shut them in before completion, and tendered a shut-in payment thinking that was enough to hold the lease. A drilled well alone is not sufficient to hold a lease with a shut-in payment under the terms of most leases. Unfortunately, this is not an item that is commonly scrubbed down thoroughly in diligence.
As alluded to, a condition precedent to most shut-in royalty clauses is that a well first be capable of producing in paying quantities before a lease can be extended by tendering a shut-in royalty payment. The Texas Supreme Court defined the phrase "capable of production in paying quantities" in Anadarko Petroleum v. Phillip Thompson,...
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