CHAPTER 8 MANAGING RISK IN OIL AND GAS ACQUISITIONS
| Jurisdiction | United States |
(May 2008)
MANAGING RISK IN OIL AND GAS ACQUISITIONS
Holme Roberts & Owen LLP
Denver, Colorado
Howard L. Boigon
Hogan & Hartson LLP
Denver, Colorado
Milam Randolph Pharo
St. Mary Land & Exploration Company
Denver, Colorado
I. Introduction
This paper and its attendant discussion is intended to present to both inside and outside counsel the broader context of risk management encountered in acquisition and divestiture work. Legal counsel is often asked to quickly draft a contract in a transaction without knowing the underlying economic assumptions and drivers that made the transaction desirable in the first place. This puts counsel in the exceptionally awkward position of either trying to draft a contract that ameliorates all risk known to that attorney, or expose himself to being second guessed after the fact when it comes to light that some issue that has caused a problem fell through the cracks.
Given that many lawyers whether in-house or not do not sit in the technical evaluation meetings or the bid discussion sessions, the predictable tendency of lawyers who are by nature risk averse is to try and cover everything they can think of, and fight to the death over every comma change and concept in reaching a signed contract. But as we are learning with the current mortgage financial fiasco, even for banks who purport to take no risk, and whose attorneys are often the most inflexible, the failure to understand the underlying risks affecting your client's business is, or can be, a prescription for disaster. So what is our role? The authors suggest that we need to understand our client's risks, provide contractual protections, perform sufficient due diligence to confirm that the risks we can contractually protect against have not occurred, and finally, if any such risks have arisen, assist in adjusting the value of the transaction to consistently pay for the transaction delivered and reasonably believed to exist by the buyer, rather than the one promoted.
II. Understanding and Confirming the Buyer's Economic Analysis
Before undertaking a discussion of specific risk factors to keep in mind while performing our contract drafting, due diligence, and, if necessary, price adjustment roles, we start with an admonition from a different profession, "First do no harm." There are often underlying value drivers in a transaction that do not show up on a bid sheet and unless you are a geoscientist or reservoir engineer extremely familiar with the fields and area affected by the transaction, you will not know where the unquantified value lies. You will not know that there is a budding play in a deeper interval and if you trade that away to satisfy a different contractual need you will have the opportunity to potentially lose more value than any contractual legal work will ever save. This is not a question of whether or not it is the lawyer's fault, but again if you are not in the meetings and do not truly know all of the drivers supporting this transaction, there are many risks. Merely having your landman client contact attend the negotiations with you may not solve this issue if that person works for a company that views a transaction as a bifurcated process, the first part being the determination of the bid, and the second being the consummation of the
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transaction. The failure to integrate these two processes creates a significant risk to the client that is rarely, if ever, considered; at least until it's too late.
A. Know the Risks Affecting the Transaction Economics
This portion of the paper will attempt to present many of the risks attendant to a typical oil and gas transaction whether asset based or an entity combination. Some of these issues can only be partially mitigated by contractual terms in today's marketplace as no seller of which we are aware is currently offering general warranty deeds with a guarantee of current and future well performance, particularly as to the undrilled wells. Nevertheless, what are the risks that must be routinely undertaken in the context of any oil and gas transaction?
1. Ownership
We will start with this not because it is necessarily the most important, but because it is the one with which lawyers and landmen are most familiar. Everyone wants confirmation that the seller owns the cost bearing interest it represents as well as the entitlement to the revenue stream represented. Intricate contract adjustment mechanisms have evolved with which most of us are familiar and are discussed in detail in other papers presented by this Foundation and others on what to do if there are discrepancies in the seller's ownership. These portions of the agreement are regularly debated and questions such as individual and basket thresholds for defect values abound, as well as whether the adjustment will be a straight ratio formula, or a rerunning of the engineering economics leaving all matters constant from the original bid process, only adjusting for the affected change in working interest and/or net revenue interest. On the risk side of this, bear in mind that when you succumb to the argument of a per-issue threshold, you can have a significant number of niggling problems that after a while begin to amount to something resembling real money, but that if you agree to a deductible, you as the buyer have decided to provide an insurance policy to the seller regarding the seller's own title. Thus, should defects exist as to the seller's ownership, the buyer must decide if its engineering economics can withstand paying the additional sum of the deductible for the properties in question.
a. Payout. A different risk issue regarding ownership is the economic impact of a well reaching payout and having the seller's ownership interest change at a time different than that assumed by the buyer in running its engineering economics. Often no mention is made in the allocated value exhibit as to the presumed date of payout and the contract drafted accordingly, and given how tardy almost all companies are at keeping track of the occurrence of payout (not to mention gas balancing) this payout date can be off not only by months, but occasionally by years. If you think a well still has millions of dollars to recoup before the seller's interest is cut in half by the occurrence of payout only to find that payout will occur in the next few weeks, you will have grossly overpaid for this property and likely have no adjustment avenue as the ownership numbers before and after payout are correctly stated.
b. Defect Adjustment Mechanism. The final matter submitted for consideration regarding ownership is whether or not a ratio adjustment mechanism truly works. Keeping in mind that a ratio can work for or against you in a value redetermination, these authors would submit that a more accurate value is determined by rerunning the engineering economics
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with the corrected ownership numbers leaving all other variables the same. This requires a certain amount of trust between the buyer and the seller which may not be present. The ratio concept presumes that the working interest and the net revenue interest defect occurs proportionately, but talk with a reservoir engineer, and you will learn that even in this most straightforward of circumstances the numbers don't always work out like that as to value, and should the working interests stay the same and the net revenue interest alone decrease, your economics will definitely be affected in a manner not reflected in a wholly accurate manner by applying a ratio to the allocated value.
Whether or not to become embroiled in these various issues other than simply worrying about confirmation of the seller's ownership interests is affected by a number of factors such as whether there are a handful of properties that drive the value of the transaction and thus a decision that negatively affects one or a few of these high value properties has a material impact on the transaction as a whole, or is value spread throughout many properties that have different ownership and thus a slight discrepancy here or there or a slight inaccuracy in the calculation of the value is unlikely to have any material impact on the transaction as a whole. Thus knowing the property value profile, the diversity of ownership, the likelihood of a material ownership discrepancy, and the impact of how the value of a title discrepancy is calculated must all be thought through and considered in the drafting of your transaction documents.
2. Volumes
Assuming the seller owns its represented interest in the properties, more value is embedded here and in the next section than likely anywhere else in the transaction, and there is very little counsel can do to protect it. A fundamental driver of value in the upstream sector is what volume of hydrocarbons will the existing and future wells produce. The ability of the buyer's technical team of engineers and geoscientists to parse this question with accuracy underpins the entire economic analysis of the transaction.
As we live in a discounted cash flow world, at least for public companies, you can possibly miss the EUR by a bit, and if the production life is long enough, this may skate through the value component, but remember you will miss those reserves someday nevertheless. However, if you misunderstand the decline curve or at what rate the production curve will go hyperbolic, you may well have an economic tragedy on your hands with regard to this particular transaction. Getting your financial return when you expect it is most often a function of production volumes and revenue and rate of return is dependent upon doing this in a timely or at least as predicted manner.
Protections that are available to manage this risk can arise in the context of no material diminution of production rates at the time of closing, representations...
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