Addressing the Unique Risk: Strong Financial Due Diligence Mandatory in Volatile Upstream Acquisitio
AS THIS ISSUE of Oil & Gas Financial Journal goes to press, the E&P acquisition market appears poised for a comeback. While many upstream companies are facing increasingly difficult decisions involving financial restructurings, distressed financings, and potential bankruptcies, there are strong indications that the E&P market is positioned for a period of increased transactions, particularly during the second half of 2016. Financial conditions for upstream E&P companies have been largely strained entering 2016 for many reasons affecting the industry overall, including reduced liquidity from:
- expiring financial hedges,
- increasingly leveraged balance sheets,
- shrinking borrowing bases on debt facilities, and
- depressed commodity prices.
The need for strong and effective buy-side financial due diligence has perhaps never been greater as margins for errors in negotiated transactions have narrowed in lock-step with operating margins. The use of seller indemnities to limit risk offers less comfort in an industry where, for many participants, survival is uncertain. An orderly and regimented approach to due diligence is critical to validate assumptions underlying NPV calculations and protect ROI.
EFFECTIVE DUE DILIGENCE STARTS WITH AN EFFECTIVE PSAMany of the advantages afforded by effective due diligence originate with crafting a fair and equitable purchase and sale agreement (PSA). Generally, the PSA has customary provisions for increases and decreases to the purchase price based upon findings identified during two critical periods-the first being from the date of execution of the PSA to the initial closing and funding, and the second being from the date of initial closing and funding through the date of final settlement. The initial period is typically up to two months; the latter period, up to six months following closing.
Typical financial adjustments to the purchase price between the buyer and seller will generally include:
- cut-off of revenues and expenses of the properties to the effective date;
- environmental and title defects;
- merchantable hydrocarbon inventories as of the effective date; and
- amounts held in revenue suspense by seller as of the closing date, net of escheatable balances.
With the exception of environmental defects reviewed by engineering personnel, the financial due diligence team should be deeply focused on verifying all other financial adjustments to the purchase price. In our experience, financial findings (reductions to the purchase price) resulting from this area of due diligence routinely exceed the costs involved.
CORROBORATING ACQUISITION VALUATIONS THROUGH CASH FLOW VERIFICATIONAside from providing cash savings to the buyer via identifying adjustments to the purchase price, one of the most critical values brought by the financial due diligence team is ensuring net cash flows and production volumes generated from the subject properties correspond to the buyer's economic assumptions.
For all properties included in the transaction, the due diligence team should compare the net revenues and production volumes generated during the interim period (from effective date through closing date) to those projected in the buyer's acquisition valuation model. The causes of significant variations in volumes and cash flows should be investigated with seller personnel.
Although all properties are evaluated for significant variations, it is customary that detailed analysis to the independent third-party purchaser remittance advices and state production reporting is performed for all properties representing the top 80% of allocated values.
Findings from revenue due diligence can have financial consequence, particularly if considerable purchase-price value has been allocated to specific proved developed producing properties that later are determined to be shut-in, or where there has been an unexpected decline or cessation of production.
Such findings might even suggest misrepresentations by the seller that result in other legal implications favorable to the buyer. Once again, this is a critical area of focus by the financial due diligence team.
Analysis of expenditures focuses on lease operating expense (LOE) levels reported by significant property in the lease operating statements. The due diligence team should obtain sufficient history of LOE by property by month to enable meaningful analysis of operating metrics (rates per barrel of oil equivalent or thousand cubic feet of gas equivalent) to determine if they are reasonable, given present operating conditions.
Current expense run rates should be evaluated relative to anticipated rates in the buyer's acquisition valuation model to more closely fine-tune expected net cash flows and, ultimately, projected rates of return on the investment. Financial due diligence primarily helps lock down expense rates by property. However, most financial adjustments related to operating expenses generally result from proper cut-off as of the effective date.
IDENTIFYING RISKS TO FUTURE VALUEA fundamental goal of financial due diligence is to achieve a clear understanding of the risks assumed in the purchase, including any existing commitments and contingencies. Hopefully, any undisclosed risks identified in the performance of financial due diligence will result in some form of concession by the seller, whether it be as provided for within the PSA or through subsequent agreement.
Generally, to get a good understanding of binding obligations and commitments, the due diligence team should review most of the critical contracts pertaining to the operations and product sales arrangements for the properties. These agreements will include, but are not limited to, joint operating agreements, gas balancing agreements, product sales and marketing contracts, processing agreements and transportation agreements.
These agreements are typically read and briefed for buyer retention, and identified problem areas are communicated to the buyer. It is also important to determine which contracts are assignable or assumable and which ones require consent for assignment. The buyer may very well not want to assume all contracts if financial terms are not as favorable as can be achieved through alternative means.
While the legal team will generally sort out the assignability of contracts, it is important for the financial due diligence team to be able to identify financial risks and commitments embedded in assumed contracts and the potential impact on future financial results. Some examples include minimum volume commitments, contract escalations, and contractual commitments for expenditure. The due diligence team should assess the circumstances that trigger or accelerate financial obligations, the probabilities that such circumstances will occur and any actions that could be taken to minimize or avoid negative impacts.
One topic worthy of mention is the assumption of obligations related to existing gas balancing positions on the properties. Through decades of working financial due diligence on acquisitions, experience has demonstrated that companies in the upstream E&P sector do not always do a good job of maintaining current gas imbalance positions on their properties. Sometimes the PSA provides for the full assumption by the buyer of existing gas balancing positions, while other times there is a financial adjustment stated in terms of price per thousand cubic feet of gas for any variations from represented gas balancing positions by property. This latter situation is ideal for financial adjustments favorable to the buyer.
Additionally, the due diligence team should assess production imbalances for potential impact to future cash flows. Examples of issues that should be addressed include:
- make up provisions included in gas balancing agreements, if they exist;
- the sufficiency of remaining reserves to settle balances out of future production;
- cash-out provisions and mechanisms included in gas balancing agreements; and
- credit-worthiness of over-produced parties.
EFFECTIVE INTEGRATION EFFORTS SAVE TIME AND MONEYArguably, the greatest value provided by the financial due diligence team is the transfer of knowledge from the seller to the buyer as the sale is completed and the buyer assumes operations. Although the review of the closing and final settlement statements and the pursuit of cash recoveries generally garner the most attention during the due diligence phase, the acquisition will seldom be successful if a smooth integration of the operations and reporting responsibilities of the properties does not occur.
The due diligence team should interview seller representatives to fully understand these matters and devote considerable time and energy to documenting the seller's monthly processes and procedures. Critical focus areas include:
- state, federal, and tribal regulatory reporting;
- royalty distributions;
- severance tax and state production reporting;
- allocation groups and methodologies;
- product-marketing arrangements; and
- transportation and processing arrangements.
In closing, current market conditions coupled with recent trends in negotiated upstream E&P deals have resulted in buyers assuming more of the historical risks associated with acquired properties than ever before. With royalty litigation on the rise, more sellers are attempting to be indemnified for all royalty amounts payable to third parties attributable to production from the assets prior to the effective date. Moreover, in today's market, indemnifications from sellers cannot always be relied upon to mitigate assumed risks.
It is more important than ever for buyers to accurately identify, assess, and properly value the risks assumed in an acquisition on the front end in order to ensure attractive returns on investment. Buy-side financial due diligence is extremely important in mitigating risk in the upstream E&P acquisition arena. With expectations running high among A&D firms that the E&P transaction market is returning during 2016, strong due diligence will play a critical role in the success of acquisitions, specifically in terms of monetizing transaction savings, assessing acquisition risks, and securing effective integration of financial and operational responsibilities.