It’s only natural for an oil and gas company to have trust issues when it comes to producing asset acquisitions. In fact, it’s downright healthy. You have a business to protect, not to mention stakeholders looking over your shoulder and monitoring your decision-making.
That’s what makes due diligence such a critical piece of the asset acquisition puzzle. Ideally, it should be restraining enough to prevent you from making bad deals, but not so restrictive that it stops you from making the right ones. And as you might already know, finding that balance can be tricky.
But that’s why Embark exists – to guide you through the typically murky process by lending you our collective decades of experience and expertise within the oil and gas industry. And since we’re very much the type that walks the talk, we’re going to discuss some key best practices we use during our oil and gas transaction engagements, along with a handy checklist you can use as your own. So let’s get started because you have some sparkling acquisitions waiting for you.
Before We Begin…
Whether you’re a newish company just getting your E&P feet wet or a veteran business moving away from greenfield projects and toward producing assets, you may find yourself walking into uncharted territory for you and your team. And that’s usually not a comfortable position to be in for finance leadership.
In other words, you might feel like a stranger in a strange land, but that’s okay. While we’re going to keep things fairly high-level with these insights and our accompanying checklist, you’ll walk away in a much better position to achieve your company’s cash flow dreams. Just remember, aside from the financial aspect of the transaction, you’ll have legal, land, and environmental due diligence as well, focusing on items like:
- Environmental assessments
- Land and title issues
- Intellectual property
- Physical inspection of equipment
Granted, many deals aren’t purely asset-driven or lease-driven, sometimes skirting the border between the two. But if you’re new to the producing asset component of the equation or just want to become more familiar with the financial side of it, we assure you that you’re in the right place. And as always, if you have further questions about the following oil and gas due diligence tips, we encourage you to reach out to our team.
Enter the Virtual Data Room (VDR) Prepared
The data room has come a long way in recent years. Chances are, you won’t be walking into a cozy conference room with boxes of documents sitting on a sensible, old-fashioned wooden table. Instead, the seller and broker will likely give you access to a VDR, basically a massive electronic depository of critical data, including:
- Land information
- Financial statements
- Legal information
- Contracts associated with the transaction
- Well performance information
Sometimes, you’ll have an exclusive arrangement where you’re the only evaluating party, sometimes you won’t. Whatever the circumstances, be prepared to roll your sleeves up and dig in because there’s due diligence gold in them thar virtual hills. It’s just a matter of knowing where to look and having the right set of eyes doing the perusing.
Take the Lease Operating Statement With a Grain of Salt
During your foray into the VDR, 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 theory, such a document should be chock full of relevant and useful data regarding the asset. Note, however, our purposeful use of the term in theory.
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.
Sounds a bit off-putting, borderline sketchy, right? 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.
So if you shouldn’t take the lease operating statement as gospel, what can you do to cover your financial backside and ensure you’re making a wise decision? That extremely pertinent question provides us with a smooth segue into our next few due diligence best practices.
Bring in the Reservoir Engineers
We’ll admit that reservoir engineering isn’t exactly our strong suit. Or our suit at all. But even though geological studies and engineering exercises are outside the purview of most financial experts, we understand how crucial a role they play in your oil and gas due diligence.
Thus, whether you have a qualified in-house team or need to engage a third-party reservoir engineering firm, it’s absolutely critical that you use a competent group to either prove or dispel the production estimates from the VDR materials.
Now, keep in mind, we’re not saying that all sellers are trying to pull a fast one on you. However, it’s obviously in your best interest to make sure you’re kicking every possible tire on the producing asset.
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. Or oil, natural gas, and natural gas liquids, in this case. Simply put, if the oil and gas properties don’t produce at satisfactory levels to make the transaction advantageous for you, then you’re left with two choices:
- Walk away from the transaction and consider yourself lucky that you didn’t sign on the dotted line, or
- Renegotiate the purchase price to a point where the lower production still makes financial sense for you
Either way, bringing in experienced reservoir engineers for a critical evaluation of the projected future production is essential.
Prove-Out Historical Revenue and Expense Data
Not to belabor the trust issue but, before we move on from the lease operating statement, we’d be remiss if we didn’t mention the 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 (See Reservoir Engineering).
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 sloppy 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. Thorough due diligence will help you avoid any surprises down the road, from sloppy accounting and unreliable revenue and cost estimates, to a field in disrepair and local bylaw issues.
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 while it isn’t necessarily challenging, it can certainly 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.
Long story short, unless you want to become a case study on what to avoid in A&D (acquisitions and divestitures) transactions, it’s imperative that you understand any existing commitments involved in the deal. If you don’t, bad things can and do happen to even the best-intentioned E&P folk.
A Solid Transition Services Agreement (TSA) Is Your BFF
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. At a pretty penny, of course.
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.
A Final Word Regarding Corporate Acquisitions
Lastly, while we don’t want to get too far into the weeds regarding corporate acquisitions, it’s important to remember they include an extra set of concerns that an asset acquisition does not. It goes without saying that acquiring a company entails an awful lot more than a group of producing properties.
Thus, if you’re staring a corporate acquisition in the face, know that there’s a more intense legal diligence required. Likewise, the transaction could involve things like compensation and pension plans, employee benefits, redundant systems licenses, ERPs, contractual obligations and relationships with software providers, and a whole host of other financial items.
Long story short, with a corporate acquisition, you’re acquiring an entire entity and everything that involves, including a significantly greater level of risk.
Want More Insights? There a Checklist For That
There’s obviously a whole lot more that goes into due diligence for a producing asset acquisition, but these insights, along with our accompanying oil and gas due diligence checklist, certainly provide you with an excellent place to start. In our checklist, you’ll find additional insights on a variety of topics, including:
- Review of preliminary settlement statement
- Detailed review of final settlement statement
- Asset level diligence
- Limited scope corporate financial due diligence
Of course, it always helps to err on the side of caution when it comes to something as complex as a major asset acquisition. That said, from the beginning of your due diligence to the preliminary and final settlement statements, Embark’s expertise in the oil and gas industry is your expertise. And the best news of all – we’re just a short contact form away.