In this eight-week alert series, we are providing a broad look at current and emerging issues facing the energy sector. Attorneys from across the firm will discuss issues ranging from environmental disclosures and risk management in business transactions to insolvency, compliance programs and intellectual property. Please click here to read all of our recent publications.
Oil prices have fallen below $30 per barrel for the first time
in more than a decade. This trend, along with the shale gas boom,
evolving regulatory constraints, and a growing focus on renewables,
have made one thing clear: the oil and gas industry is getting a
makeover.
While these developments are subjecting many companies to financial
distress, the current market is creating opportunity for
others—including investors who are new to the space. Crucial
to each forthcoming transaction is a thoughtfully crafted,
well-implemented diligence program. From the real estate and
environmental perspectives, such a program should confirm asset
valuation, identify risks, and provide a basis for estimating
contingent or future financial obligations.
Based on recent developments, here are five things to consider in
shaping a diligence program at the front end of a
transaction.
1. Assets
In oil and gas deals, assets may include real estate; property
rights; production, extraction, processing, and distribution
facilities and equipment; and operations (and rights to future
operations) at multiple locations.1
Sellers should precisely identify the assets that are included in
(and excluded from) the transaction, and buyers should confirm
their understanding. This is especially important for deals
involving innovative energy technologies. For example, the Federal
Court of Claims recently decided a case centered on whether gas
conditioning equipment is an integral component of a fuel cell
power plant, and therefore part of specified "energy
property." (The court held that it was. RP1 Fuel Cell, LLC
v. United States, 120 Fed. Cl. 288 (2015).)
Buyers should confirm the seller's rights, title, and interest
in the target assets and identify any limitations on the
transferability of assets, such as required third-party consents or
approvals. This process may include a review of deeds, leases,
licenses, contracts, and joint venture agreements, and an analysis
of land title records.
While the universe of assets can change after a letter of intent is
signed, last-minute surprises can sink a deal, and litigation can
result if the parties do not have a meeting of the minds. Careful
drafting helps to avoid potential gaps, overlaps, or conflicts
between included and excluded assets.
2. Contingent Assets
Target assets may include future development, production, or
extraction rights. Respecting the size of the deal, buyers
generally should do a "deep dive" on the estimated costs
to exercise future rights and sellers should be prepared to share
information about those rights. This may involve a high level of
technical expertise, so buyers and sellers often benefit from
engaging experts to help evaluate those assets.
Underlying agreements and transactional documents sometimes tie
future development rights to project-related milestones or timely
development. Buyers should confirm that no such future development
rights have lapsed. And buyers should consider whether hedging or
other arrangements, which may have been used to reduce exposure to
decreases in oil prices, have expired or will expire, involve a
risk of default by counterparties, or contain terms that may limit
coverage due to market conditions.
Buyers also should assess whether the exercise of contingent future
rights will be met with public support or face opposition.
Opposition can be a forerunner of litigation, which may delay or
prevent the realization of contingent benefits.
3. Regulatory Review
On February 18, 2016, the US Environmental Protection Agency (EPA)
announced its national enforcement initiatives for the next three
years. EPA reaffirmed its focus on ensuring that energy extraction
activities comply with environmental laws. The highly regulated
nature of the energy sector complicates the diligence process.
Parties should be mindful of looming regulatory changes—such
as endangered species listings or revisions to pipeline safety
rules—that could create new liabilities and obligations or
affect development rights.
Oil and gas projects often require federal, state, and local
permits. Asset location is key to determining the applicable legal
framework. For example:
- projects on federal land or requiring federal permits may be
subject to the National Environmental Policy Act (NEPA) and certain
requirements of the Endangered Species Act;
- projects on the Outer Continental Shelf are regulated by the
Bureau of Ocean Energy Management and Bureau of Safety and
Environmental Enforcement;
- projects on Alaska's North Slope may require tundra travel
permits;2 and
- international projects may be subject to production sharing agreements with a wide array of environmental provisions.3
Regulatory review is a critical part of the diligence process
and is necessary to identify government approvals or consents that
may be required to close the deal or to enable the buyer to operate
post-closing. Responsibility for permit transfers incident to the
transaction should be expressly allocated between buyers and
sellers. For example, in a recent transaction involving the sale of
petroleum assets, the buyer assumed responsibility for perfecting
all required permit transfers with the seller's cooperation.
Buyers should be especially vigilant about permit transfers
requiring formal administrative action, particularly where
operations may be controversial. Formal administrative action often
creates openings for opposition.
4. Liabilities and Obligations
Upstream, midstream, and downstream oil and gas assets present
different environmental risks, some of which cut across sectors.
For example:
- within the upstream sector, potential environmental liabilities
may result from spills, leaks, ruptures, and discharges;
- midstream assets also may raise such risks, as well as unique
issues under the jurisdiction of the US Department of
Transportation Pipeline and Hazardous Materials Safety
Administration (which regulates the transportation of oil and
hazardous materials) and the Federal Energy Regulatory Commission
(which regulates the operation and must approve the sale of certain
transmission facilities); and
- downstream assets can pose other environmental issues, such as claims related to releases from underground storage tanks (USTs), air emissions mandates and control requirements, or the use of methyl tertiary butyl ether (MTBE).
Buyers should evaluate the environmental status of former and
existing assets to assess cleanup obligations, restoration
commitments, retirement obligations (including well plugging and
abandonment and tank removals), and potential exposure to natural
resource damages claims. Restoration and retirement obligations may
be found in permits, joint venture agreements, and related contract
documents. Buyers also should evaluate permits and regulatory
obligations to identify unsatisfied permit criteria and confirm
compliance status.
Sellers should anticipate buyers' desire to evaluate
environmental risk and regulatory compliance and to identify
unsatisfied obligations, and should be prepared to share key
documents with buyers. A proactive approach can save time and add
efficiency. For example, in deals involving sites with ongoing
remediation, sellers successfully have facilitated price
negotiations with prospective purchasers by retaining an
environmental contractor to estimate the cost to close those sites,
and sharing that information with prospective purchasers early
on.
5. Diligence Output
Information collected during the diligence process should be
measured against business expectations. When diligence reveals new
information, buyers should assess the materiality of the
information and consider shaping a plan to factor it into the deal.
Experienced consultants and legal advisors can help place
information into context.
There are a range of legal tools and contractual provisions (e.g.,
covenants, guarantees, indemnities, and releases) that can be used
to manage risks identified in the diligence process. For example,
if new information relates to an unanticipated remedial obligation,
the buyer and seller can negotiate a cost to complete the
remediation, and adjust the purchase price with the buyer
performing the work post-closing. If, on the other hand, the seller
prefers to or must retain responsibility to complete the
remediation, then a portion of the sales proceeds can be placed in
escrow as security for future performance, and the seller can
perform the work pursuant to an access agreement that defines
cleanup levels. If the parties cannot agree on who will bear
certain risks, environmental insurance may be available to bridge
the gap.
Conclusion
A variety of factors are increasing the pressure on the oil and gas
industry. As companies innovate and reposition themselves, the deal
environment may present some eye-opening opportunities. A tailored
diligence strategy is crucial, and parties should identify key
consultants and advisors as early in the transactional process as
possible. Such an approach will help buyers and sellers realize
business goals and avoid dashed expectations.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.