The seller and broker will likely give you access to a virtual data room, basically a massive electronic depository of critical data. Sometimes, you’ll have an exclusive arrangement where you’re the only evaluating party, sometimes you won’t. The seller will provide you with a lease operating statement, essentially a set of limited financial statements specific to the group of wells involved in the transaction.
In reality, the lease operating statement is something you should take with a grain of salt. Because as you’ll likely see, it will contain a disclaimer – sometimes several of them – stating the seller gave reliability the ol’ college try but, ultimately, must disclaim responsibility for the accuracy of the data.
Unfortunately, since the lease operating statement contains unaudited information, no third-party has tested or issued an opinion on it. That puts you in a bit of a bind since you’re relying on that critical information to steer your decision-making around the transaction.
Bring in the Reservoir Engineers
Since you shouldn’t take the lease operating statement as gospel, it’s essential to have a qualified in-house team or engage a third-party reservoir engineering firm to critically evaluate the production estimates from the VDR materials.
Since the whole point of your organization acquiring the asset is to produce future cash flow streams, you need to know if the acquisition model’s economic assumptions actually hold any water.
Prove-Out Historical Revenue and Expense Data
Before we move on from the lease operating statement, you’ll still need to prove-out revenue and expense data from the seller. For revenue, assuming you're operating under the same set of contracts as the seller, your revenue stream should generally follow historical economics after accounting for changes in production
However, your due diligence process should include a strong focus on proving out those historical revenue streams by tying everything back to the actual purchaser statements. This includes taking what the seller presented in the lease operating statement and aligning it with actual cash receipts to the company for the asset.
Likewise, it’s worth your time and effort to go through the historical expenses and look for anything that seems out of place or peculiar, any sudden changes, or items that don’t make any sense or are just flat-out sloppy. Any of these tell-tale signs could mean the accounting is messy elsewhere or the seller just stopped investing in field improvements and maintenance.
Also, look at the ad valorem taxes and make sure they are consistent with the statutory rates in the area you’re operating. The same goes for applicable insurance coverage costs or other expenses that are in your model but missing from the seller’s figures.
Understand Any Existing Commitments
Let’s use a hypothetical for a moment and assume your acquisition includes contracts that have been in place since Titanic ruled the box office. Chances are those contracts have gone through several different owners and contain several different amendments. As you might guess, tracing through those contracts is essential, and consume a fair amount of time.
Similarly, you need to fully understand any existing midstream contracts as well. To state the obvious, those contracts are crucial in knowing how much it will cost to get your volumes from the wellhead to the marketplace.
Since midstream companies have their own expenses like easement, leasehold, and equipment costs, they won’t build that infrastructure without some sort of commitment from the producer. That’s yet another contractual obligation that can shape your ultimate success with the transaction.
Expect to find minimum volume commitments to midstream providers that can trigger some especially punitive penalties if you don’t meet them. And that creates another problem – different economic factors can significantly affect the financial viability of certain volumes, even “minimum” ones. However, contracts with midstream companies could force you to commit to higher volumes than you would like.
Transition Services Agreement (TSA)
When you’re acquiring a large asset, it’s common to integrate a TSA into the purchase and sale agreement. The TSA states that the seller will continue to operate the asset and provide back-office services for a period of time while your team ramps up and you integrate the asset into your system.
Since plenty of things can go sideways in that interim period, it’s important that you not only have a well-worded TSA but also watch it like a hawk. Unfortunately, sellers can sometimes try to bill you for costs in excess of what the TSA states. And as many buyers have found out the hard way, it can become a significant reconciliation process to make sure the seller treats you appropriately under the agreement.
Therefore, you want to make sure that the agreement clearly identifies the scope of work and doesn’t speak in ambiguous terms. Like it or not, many sellers will take advantage of nonspecific language and the fact that they’re the ones with the upper hand since they control the cash. Just be sure to keep an eye on accounting periods vs. production/activity periods.
Smaller buyers are especially susceptible to these types of actions from larger sellers, who are essentially daring the buyer to take them to court. Thankfully, a well-negotiated TSA in your purchase agreement that’s as specific as possible can help mitigate this often-overlooked risk.
There’s more that goes into due diligence for a producing asset acquisition, but these insights, along with this accompanying oil and gas due diligence checklist, certainly provide you with an excellent place to start.
To read the full article from RealClear Energy , click here