Climate Change and Trends in Global Finance

On December 12, French President Emmanuel Macron, joined by President of the World Bank Group, Jim Yong Kim and the Secretary-General of the United Nations, António Guterres, hosted the One Planet Summit highlighting public and private finance in support of climate action. The summit’s focus centered on addressing the fight against climate change and ensuring that climate issues are central to the finance sector.

The summit’s most notable event was perhaps the announcement that insurance giant Axa would be dumping investments in and ending insurance for controversial U.S. oil pipelines, quadrupling its divestment from coal businesses, and increasing its green investments fivefold by 2020. Axa’s plans echo those of BNP Paribas, who, in mid-October, announced that it would terminate business with companies whose principal activities involve exploration, distribution, marketing, or trading of oil and gas from shale or oil sands. The bank also ceased financing projects that are primarily involved in the transportation or export of oil and gas. These moves themselves follow controversy over the Dakota Access pipeline in the U.S. from mid-March that resulted in ING’s $2.5 billion divestment in the loan that financed the pipeline.

These measures prefigure what might be a more conspicuous trend of large institutional investors moving more rapidly away from fossil fuel investments and into green investments. In mid-December, the World Bank said it would end all financial support for oil and gas exploration by 2019. Around the same time, New York Governor Andrew Cuomo revealed a plan for the state’s common retirement fund, with over $200 billion in assets, to cease all new investments in entities with significant fossil-fuel related activities and to completely decarbonize its portfolio. Recently, HSBC pledged $100 billion to be spent on sustainable finance and investment over the next eight years in an effort to address climate change. Additionally, JP Morgan Chase committed $200 billion to similar clean-minded investments, Macquarie acquired the UK’s Green Investment Bank, and Deutsche Bank and Credit Agricole both made exits from coal lending. As the landscape of global finance shifts, it will be important to monitor how funds, banks, and insurers address the issues related to climate change.

 

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The UK 14th Onshore Oil and Gas Licensing Round

Andrews Kurth

At the end of July 2014, the UK government published application criteria and terms for the 14th onshore oil and gas licensing round. This will be key to the aspirations of would-be shale gas developers in the UK. Onshore licences are available in areas including the Bowland Shale in the north of England (where the British Geological Society estimates a potential gas-in-place resource of 1,329 trillion cubic feet (tcf) alone) and the Midland Valley in Scotland.

Applications for new licences under the 14th round can be made until 2:00 p.m. 28 October 2014. This is the first round of onshore licensing in the UK for six years, and the resultant final licence awards are expected to be announced in the next 12 to 18 months. The level of interest expressed in these new licences will be a good barometer of how the industry regards the steps which the UK government has been taking to promote the growth of shale gas in the UK.

Additionally, new model clauses for onshore licences have been issued in the Petroleum Licensing (Exploration and Production) (Landward Areas) Regulations 2014, which came into force on 17 July 2014. These model clauses are intended to promote unconventional oil and gas exploration and production and include several new provisions which are aimed at affording greater flexibility to licensees – these provisions relate to “drill or drop” elections, the term of the licence (with revised focus on extensions and retention areas) and splitting horizontal layers on surrenders.

The new model clauses recognise the different attributes of shale gas exploration and production programmes and that shale gas deposits typically have a much wider geographic footprint when compared to conventional oil and gas resources. Whilst greater flexibility is given to licensees under the new model clauses, there are also tighter controls over proposed project activities and timescales, with the intention of accelerating the outturns of planned exploration and production plans. 

The new model clauses are also intended to promote the findings of the recent Wood Review relating to maximising economic recovery.

There is also a new requirement for a detailed Environmental Awareness Statement (“EAS”) to be submitted with licence applications. The EAS is intended to demonstrate a licence applicant’s understanding of the environmental sensitivities relevant to the area proposed to be licensed. This requirement is intended to promote a successful interface with ecological sensitivities.

The UK government has taken a number of other steps to promote shale gas development in the UK, including introducing localised fiscal incentives to support the development of shale gas exploration pads. However, significant other issues still remain to be addressed by would-be shale gas developers, including obtaining planning permission to drill and hydraulically fracture test wells and managing often vociferous local public opposition to shale gas development. We have previously considered how UK onshore shale gas developments might be structured (see Notes From The Field – Issues 3 and 6).

Many challenges still lie ahead. Oil & Gas UK, the trade association that represents the interests of the UK’s offshore oil and gas industry, has given a cautious welcome to these new developments:

“There are a number of synergies between the offshore oil and gas industry and the onshore sector. Many of the techniques and some of the services required to recover land based unconventional shale gas already exist in the offshore oil and gas sector and should be readily transferable. There is scope for making these learnings and expertise from the offshore sector quickly transferable to operators developing onshore oil and gas resources. The new Oil and Gas Authority, which will govern both onshore and offshore industries, should ensure consistency of approach wherever applicable.”

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Texas Supreme Court Clarifies Royalty Calculations For Enhanced Oil Recovery

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In French v. Occidental Permian, Ltd., the Texas Supreme Court clarified royalty calculations for enhanced oil recovery.  The Court:

  1. Rejected a royalty owners’ claim that royalties on casinghead gas should be determined as if the injected carbon dioxide (CO2) was not present
  2. Held that, under the applicable leases and Unitization Agreement, the costs of removing CO2 from the gas were post-production expenses that royalty owners must share with the working interest owner

In the opinion, the Court emphasized the importance of efficient production of oil and gas and the prevention of waste.

Background

The Plaintiffs-Appellants, Marcia Fuller French and others (“French”), were lessors on two different oil and gas leases.  Both lease royalty provisions provided that the casinghead gas royalty was net of post-production expenses, but not production expenses.  The Defendant-Appellee, Occidental Permian Ltd. (“Oxy”) owned a working interest.  The parties had entered into a Unitization Agreement to allow secondary recovery operations.

Oxy began injecting wells on these leases with CO2 in 2001 in order boost oil production when waterflooding became less effective.  As a result, the wells produced natural gas that was about 85% CO2.  Although Oxy could reinject the entire casinghead gas stream, Oxy had the gas treated off site to remove the CO2.   It sold the resulting gas and had the extracted CO2 sent back to the well to be reinjected.  Oxy paid royalties on the gas after it was treated and deducted the treatment costs from French’s royalties.

French sued arguing that, except for the removal of contaminants and the extraction of NGL, the costs of processing the casinghead gas (including transportation costs) were production costs that should be borne solely by Oxy.  Conversely, Oxy argued the CO2 removal was necessary to render the gas stream marketable.  At trial, the Court agreed with French and awarded her $10,074,262.33 in underpaid royalties and entered a declaratory judgment defining Oxy’s ongoing royalty obligations.  The court of appeals reversed with a focus on the damages calculations, but did not reach a decision on whether the cost of separating the CO2 from the casinghead gas was a production expense.

Supreme Court’s Decision

The Court examined the parties’ agreements noting that French consented to the injection of extraneous substances into the oil reservoir and gave Oxy the right and discretion to decide whether to reinject or process the casinghead gas.  The Court further pointed out the Agreement provided that the royalty owners agreed to forego royalties on any unitized substances used in the recovery process.  The Court found that French benefited from that decision and therefore must share in the cost of the CO2 removal.  The question then became whether the CO2 processing was a production or post-production cost.

French argued that the CO2 separation was akin to the removal of water from oil, which Oxy treated as a production cost.  The Court, however, found that oil and water are “immiscible” and separation of the two is a relatively simple process, unlike CO2 and gas separation, which requires special technology.  Water separation is necessary for reinjection into the reservoir and to make the oil marketable.  Conversely, CO2 separation is not necessary for continued production of oil.  The Court then noted that Oxy was not required to reinject the casinghead gas.  Therefore, based on the parties’ agreements, “French, having given Oxy the right and discretion to decide whether to reinject or process the casinghead gas, and having benefited from that decision, must share in the cost of the CO2removal.”  Id. at 7.

Conclusion

The Court indirectly emphasized efficient production of oil and gas and prevention of waste.  The gas processing was economically beneficial to both French and Oxy.  The CO2 separation increased the value of the stream to both Oxy and French by allowing sale of the extracted NGLs and allowing reinjection of more than 10% of the gas produced directly back into the field.  Because French received the benefit of Oxy’s decision, it had to share in the cost.

This opinion is an important reminder to carefully negotiate and agree to terms in all agreements.  It is a further reminder to proceed in an efficient and economic manner.

EU Sanctions And The International Oil And Gas Industry

Andrews Kurth

The international oil and gas industry is continuously tasked with adapting to an ever evolving sanction-regulated environment. The level of sanction activity and implementation in recent years has been unprecedented, partly as a result of the political events which gave rise to the Arab Spring and the opposition to Iran’s nuclear programme. The recent crisis in the Ukraine, and associated sanctions against Russia, have sparked further debate around the need for effective, targeted punitive measures and the consequences they may have for Europe.

This article considers the EU’s sanction regime, explores the effect it has on international oil and gas companies and addresses the short-comings of the EU’s decentralised system.

What are sanctions?

Sanctions are political policy instruments used to encourage jurisdictions acting in contravention of international law to adopt standards supported by the wider global community. They impose measures designed to cause damage to the targeted government, non-state entity or individual (“Target”) in order to force it to undertake, or prevent it from undertaking, certain behaviour. They may inhibit the Target from accessing foreign markets for trade or deny it from pursuing financial and other forms of commerce. The professed ultimate objective of a sanction is to preserve or restore global peace and security.

What is the source of EU sanctions?

The UN Security Council imposes sanctions through Security Council resolutions which are binding on the EU. The EU implements all sanctions imposed by the UN Security Council through legislation enacted by the European Council. The process typically results in a European Council regulation which has direct effect in EU member states’ separate legal systems, creating rights and obligations for those subject to them, and overrides national law. Additionally, the EU may decide to impose self-directed sanctions or restrictive measures which go further than a UN Security Council resolution in circumstances in which the EU deems such action to be necessary.

Why do EU sanctions affect international oil and gas companies?

Over the past two decades, the EU has engaged in an active use of restrictive measures in the form of economic and financial sanctions, embargoes and restrictions on admission to a country. Economic and financial sanctions typically take the form of asset-freeze measures which involve the use of funds and economic resources by Targets or persons acting for and on behalf of Targets, and the provision of funds and economic resources to designated Targets. Embargoes may prohibit trade in certain goods, and activities relating to such trade, with Targets (including the flow of arms and military equipment). Visa or travel bans can be imposed preventing certain persons from entering the EU or transit through the territory of EU member states. These sanction measures are part of the EU’s strategy to support the specific objectives of the Common Foreign and Security Policy.

At the time of writing, the EU has announced asset freezes and travel bans against around twenty individuals in Russia and the Ukraine. Companies conducting their business in the oil and gas sector should be particularly vigilant to ensure they act in compliance with EU sanctions, as Ukrainian and Russian entities and individuals who operate in this industry may increasingly become sanction targets.

US sanctions are questionable under international law because they apply extra-territorially to third state parties involved in business activities with the Target. Unlike the US, the EU has refrained from adopting legislation with extra-territorial effect. However, the EU’s recent sanctions against Iran displayed a greater resemblance to those levied by the US than had previously been the case. For example, sanctions were imposed prohibiting the provision of key resources to various parts of the Iranian oil and gas industry, as well as the provision of financial services to that sector. As a result of EU financial sanctions most, if not all, banks and other financial institutions have declined from conducting any business relations with the Iranian regime.

It is clear that EU sanctions are wide reaching and their scope has a significant impact on business activities. They will apply to international oil and gas companies in the following situations:

  • within EU territory, including its airspace;
  • on board of aircrafts or vessels under the jurisdiction of an EU member state;
  • to EU nationals, whether or not they are in the EU;
  • to companies and organisations incorporated under the law of a member state, whether or not they are in the EU (this captures branches of EU companies in non-EU countries); and
  • to any business done in whole or in part within the EU.

The corporate behaviour, performance and conduct of international companies are powerful channels through which the objectives of sanctions against Targets are achieved. Since an international oil and gas company has little option but to observe EU sanctions to the extent such company falls within the EU’s jurisdiction, these restrictive measures are likely to play a big part in a company’s commercial decision making processes.

Why are EU sanctions difficult to manage?

A principal reason why EU sanctions are difficult for international oil and gas companies based in various EU member states to manage largely stems from the fact that the European Union lacks a centralised licensing body. Instead, the responsibility for implementing and enforcing EU sanctions is delegated to the relevant competent authorities of the EU member states. The potential for variance and discrepancy is rife in a system where there are twenty-eight EU member states, each with their individual national resource constraints and self-centred policy objectives.

Typically, the competent authorities of EU member states are responsible for:

  • granting exemptions and licences;
  • establishing penalties for sanction violations;
  • coordinating with financial institutions; and
  • reporting upon the implementation of sanctions to the European Commission.

There have been calls for a central EU licensing body which would produce a single licensing and exemption policy for EU member states. Although EU guidelines on sanctions and best practices for the effective implementation of restrictive measures go some way to plug the gap, arguably a more comprehensive regime for implementing sanctions is required to provide a better level of certainty to international businesses operating in the realms of the EU.

Managing the risks

International oil and gas companies have always had to function in politically active climates. As sanctions initiated by multilateral organisations such as the UN and EU become more fashionable, so too does the exposure to political risk that these companies will face. Given the considerable levels of investment that can only be recouped over extended periods of time, and in accordance with pre-determined contractual apportionments, international oil and gas companies need to be able to recognise, assess and manage these political risks effectively.

Oil and gas companies can relieve the risks imposed on them by sanctions through political lobbying, taking pre-emptive measures and by reacting quickly to sanctions once they are implemented. Commercial negotiations will need to focus on the allocation of risk as a result of one party’s failure to perform or withdrawal from the contract on the grounds of applicable sanctions.

International oil and gas companies need to be proactive and consider both the legal solutions and pre-cure safeguards. Time and effort should be spent focusing on drafting and negotiating the relevant contractual documentation, following a careful risk assessment, instead of deferring to dispute resolution provisions. For instance, careful construction of force majeure provisions can allocate each party’s obligations in the circumstance where an event outside of a party’s control causes contractual performance to become impossible. Thus, whilst conventional force majeure clauses relating to physical events afford relief to an affected party from its liabilities under the contract, oil and gas companies should consider expanding such contractual provisions to cover sanctions and other restrictive measures imposed on them by the UN and EU.

To avoid falling foul of existing EU sanctions, oil and gas companies should also consider putting in place comprehensive compliance procedures and systems to implement applicable sanction regimes. Penalties for breach of sanctions can be severe; a person guilty of a sanction-related offence may be liable on conviction to imprisonment and/or a fine. Falling foul of sanctions also means that a transaction can immediately become unlawful.

Conclusion

In view of the economic significance of the EU, the application of economic financial sanctions can be a powerful tool. But like a chain is no stronger than its weakest link, the effectiveness and success of the EU’s sanction regime depends on all EU member states applying, implementing and enforcing EU sanctions in a consistent manner.

The current EU sanction regime warrants a fully integrated approach which would undoubtedly benefit its policy objectives and move some way to reducing the unduly high economic cost that international oil and gas companies face when operating their businesses in the EU.

In voicing the sentiments of Henry Kissinger: “No foreign policy – no matter how ingenious – has any chance of success if it is born in the minds of a few and carried in the hearts of none”, perhaps now, in the dawn of the recent events which have taken place in the EU’s backyard in the Ukraine and Russia, the EU should further global security measures by tightening its ranks and implementing a more centralised, and better monitored, sanction regime.

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The President’s Methane Reduction Strategy – Here’s What Energy Companies Need to Know

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President Obama recently released a Strategy to Reduce Methane Emissions (Strategy) that sets forth a multi-pronged plan for reducing methane emissions both domestically and globally.  Domestically, the plan is to focus on four sources of methane—the oil and gas sector, coal mines, agriculture and landfills—and to pursue a mix of regulatory actions with respect to those sources.  Energy companies now have the opportunity to help influence exactly what those actions will be.

For the oil and gas sector, the Strategy indicates that the federal government will focus primarily on encouraging voluntary efforts to reduce methane emissions—such as bolstering the existing Natural Gas STAR Program and promoting new technologies.  But the Strategy also identifies two areas of potential mandatory requirements.  First, later this year, the Bureau of Land Management (BLM) will issue a draft rule on minimizing venting and flaring on public lands.  Regulated parties will have the opportunity to submit comments after the proposed rule is released.  Second, the Strategy confirms that the Environmental Protection Agency (EPA) will decide this fall whether to propose any mandatory methane control requirements on oil and gas production companies.  Consistent with that announcement, on April 15, 2014, EPA released five technical whitepapers discussing methane emissions from the oil and gas production process.  The agency is soliciting comments on those whitepapers—they are due by June 16, 2014.

For coal mines, the Strategy indicates that BLM will soon be seeking public input on developing a program to capture and sell methane from coal mines on public lands.  The Strategy further indicates that EPA will continue promoting voluntary methane capture efforts.

For landfills, the Strategy calls for public input on whether EPA should update its regulations for existing solid waste landfills, indicates that EPA will be proposing new regulations for future landfills, and indicates that EPA will continue to support the development of voluntary landfill gas-to-energy projects.

For agriculture, the Strategy does not suggest any new regulatory requirements.  Instead, it indicates that EPA and the Department of Energy will work to promote voluntary methane control efforts and that those agencies will place special emphasis on promoting biogas—starting with the release of a “Biogas Roadmap” in June 2014.

In addition to these sector-specific approaches, the Strategy emphasizes the need for improved methane measurement and modeling techniques, both domestically and globally.  All of the topics covered by the Strategy are ones about which regulated parties may want to submit comments—to EPA, BLM and/or the Office of Management and Budget.

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Caveat Emptor: Due Diligence of the United Kingdom Continental Shelf Oil and Gas Assets

Andrews Kurth

 

This article explores the due diligence of United Kingdom continental shelf (“UKCS”) oil and gas assets from a buyer’s perspective. Good management, organisation, communication, clarity and common sense are the key to a successful due diligence exercise. The scope of the due diligence review will depend on a number of factors, including whether the buyer has any knowledge of or a current participating interest in the target asset, whether the asset is in the exploration or production phase or is an operated asset, the size of the deal and any cost and time restraints. Whether a buyer requires a red flag due diligence report or a comprehensive report on the asset, care must be taken to ensure that no stone is left unturned during the course of the review. Failure to do so may result in undesirable consequences.

Preparation

Before embarking on an extensive review of the documentation provided by the seller, the buyer should seek to determine the scope of the due diligence exercise at the outset to prevent it from becoming a moving target which may lead to inefficiencies and unexpected cost implications. Sometimes the prospective buyer will investigate the asset with a view to purchase. More often than not, due diligence of the asset will amount to no more than a tyre-kicking exercise. The intention of the prospective buyer will therefore ultimately colour the scope of the due diligence undertaken.

As well as considering the information memorandum prepared by the seller (if any), it is also useful for the buyer to geographically place the asset by consulting a map of theUKCS licence interests and blocks. Such preparations will enable the buyer to better piece together the documentation provided in respect of the target asset and request any missing information from the seller.

Data Room

Whether the seller furnishes the buyer with a virtual or a physical data room, the buyer must keep an accurate record of the documents that have been disclosed. If a virtual data room is employed, the buyer must ensure that it is notified when new documents have been provided and, if documents are supplied in soft or hard copy outside of the virtual data room arrangement, details should be kept of these by the buyer as well. This is all essential because all disclosure will later form part of the sale and purchase arrangements between the buyer and seller.

Data rooms for asset disposals typically include legal, financial, technical, commercial and operational documents. One of the first tasks that a buyer should undertake is to review the data room index, if one has been provided, and allocate documents to the various specialists for review; careful coordination is paramount to ensure that all bases are covered. If no index has been supplied, one should be requested from the seller and, if such index is not forthcoming, it is recommended that the buyer compiles an index so that it can keep a running record.

Depending on the scale of the exercise and number of people employed to assist, the coordinator of the due diligence exercise should ensure that team members effectively communicate with each other. Typically, virtual data rooms limit access rights to a small pool of permitted entrants, so responsibilities should be allocated between professionals at an early stage. Data rooms are often poorly organised so it is important that the coordinator is made aware of documents which have been filed out of place in order for them to be allocated to the correct team members for review. This way, no document will be overlooked.

Title Verification

A UKCS asset is typically represented by a licence, a joint study and bidding agreement (“JSBA”) or joint operating agreement (“JOA”) and, in some cases, a working interest assignment. Assets may also be subject to a unitisation and unit operating agreement (“UUOA”), transportation, processing and petroleum sales agreements and other material project contracts.

One of the key objectives of the buyer’s due diligence is to determine whether the seller actually holds an interest in the asset. Often an asset will be described inconsistently in the documentation by which it is governed and may not correspond accurately with the information held by the Department of Energy and Climate Change (“DECC”). This is especially true of those assets historically operated under a JOA which has been subsequently sub-divided to apply to multiple blocks within a licence, or those assets with an alias which has stuck over the passage of time. It is therefore very important that both parties are agreed on the correct identity of the asset being bought and sold from the outset.

Similarly, infrastructure assets are frequently referred to under a variety of guises and are often complex in nature. For instance, the Sullom Voe Terminal, which is one of the largest oil terminals in Europe, handles production from more than twelve oil fields in the east Shetland Basin and approximately twenty different companies presently hold interests in the terminal. This, combined with the fact that it has been 35 years since first oil arrived at the Sullom Voe Terminal, means that tracing title to this infrastructure asset is likely to be a knotty and time-consuming exercise.

Although DECC holds data on all offshore licences, this should by no means act as a substitute for mechanically tracing title to an asset, however tempting this may be. Many UKCS assets date back over 40 years and so tracing title back to their inception can be a lengthy process. The buyer must therefore decide whether it wants to undertake or commission such work, or whether it can take comfort from tracing title back through only a limited number of transfers and seek a full title guarantee from the seller. Extensive title representations and warranties may reduce the scope of title due diligence but often they will be qualified by the information, or lack thereof, disclosed to the buyer in the data room and so are not a reliable remedy if there is a title defect.

There may be some merit in tracing title of each material contract back to the date on which it became effective in order to determine whether or not it is relevant to the transaction. Sometimes contracts in the data room will have been entered into by parties which are neither the seller nor its predecessors in title and, in other cases, may not be relevant to the target asset at all. In these circumstances, and depending on the purchaser’s view of the asset, it may be more efficient to determine which contracts are required to be assigned or novated at the due diligence stage rather than when the parties are seeking to complete the deal.

An additional complication is that a company which was originally the holder of an interest in an asset may have changed its name since it was first registered at Companies House. The buyer should therefore consult the change of name register held by Companies House at the start of the due diligence exercise and take note of any previous names. This will enable the buyer to piece together information relating to the asset more easily.

Title to assets, excluding infrastructure, is evidenced by the relevant licence, JSBA or JOA and, if applicable, UUOA. Typically, a transfer of a participating interest will be evidenced by a JSBA or JOA deed of novation, and if applicable a UUOA deed of novation, which will provide for the transfer of the relevant participating interest from the seller to the buyer. Conversely, not every transfer of a participating interest will be evidenced by a licence assignment. An example of this is where the buyer and seller are already party to the JOA and/or UUOA. If neither the buyer nor the seller is joining or leaving the licence, and the parties are simply adjusting their participating interests under the JOA and/or UUOA, a licence assignment will not be required. In the same way, where a licence governs multiple blocks and the buyer has an interest in another block covered by the licence and the seller is also remaining on the licence, either because it has an interest in another block covered by the licence or because it is only selling part of its interest to the buyer in the relevant block, when the buyer acquires the interest in the relevant block, a licence assignment will not be required.

There is often a question asked as to whether working interest assignments are required to show a complete chain of title to an asset. A working interest assignment evidences the transfer of the beneficial interest in the asset. The more prevalent view is that this type of assignment is no longer necessary to perfect title, especially where there is a JSBA, JOA or UUOA already in place. Its purpose, being a document on which stamp duty was levied, is now obsolete. Although, buyers and sellers still frequently include the working interest assignment in their suite of completion documents by means of convention, it is not obligatory to enter into this assignment to complete an asset transfer. Due to the disproportionate amount of time and energy that buyers and sellers may spend in hunting for non-existent working interest assignments to evidence a complete chain of title, the better view may be to exclude the working interest assignment from the scope of the title due diligence exercise.

Assignment

Pre-emption rights and consent provisions are principal deal-structure considerations and should therefore be given top priority when conducting the due diligence exercise. Their consequences may prevent the proposed deal from going ahead, increase the cost of the transaction if co-venturers are permitted to withhold their consent on the grounds of financial incapability unless some form of financial security is provided by the buyer and/or cause the deal to be restructured as a share sale. It will therefore be important to review the assignment provisions of all the material contracts, and particularly any JSBAs, JOAs and UUOAs, to identify such obstacles at the earliest possible stage.

If an asset is governed by both a JOA and UUOA, care needs to be taken in order to determine whether the pre-emption and/or consent provisions in one or both agreements apply. Often the UUOA will expressly state that the provisions in the UUOA supersede the provisions in the JOA to the extent that they conflict. In this case, the assignment provisions in the UUOA will override the assignment provisions in the JOA in respect of the area covered by the JOA which forms part of the unit area. Any remaining area that is solely governed by the JOA will be subject to the JOA pre-emption and consent provisions. If it is not clear from the documentation whether the provisions in the UUOA or JOA will prevail, the better approach for a buyer to take may be to err on the side of caution; in other words, to apply the more onerous pre-emption and/or consent provisions to the whole of the asset transfer or consider restructuring the transaction as a share sale.

Material Contracts

The scope of the due diligence review of material contracts is likely to be determined by the materiality threshold proposed by the buyer with respect to contract value. The buyer should review all material contracts in order to ascertain whether the seller has the necessary rights under such contracts and identify potential liabilities, risks and onerous provisions that affect the valuation of the asset or, worse still, could prevent the deal.

It is important that the correct selling entity holds an interest in the relevant material contract and any inconsistencies should be highlighted to the buyer so that the seller can arrange for any necessary inter-group transfers in good time if required. The buyer should also be vigilant to any poison pills that kill the contracts in the event of a change of party or change of control.

If time, cost and scope permit, it can be invaluable to prepare full and accurate contract summaries of all material contracts. The simplest and most efficient way of doing this is to table contract summary templates for the various categories of contract. For instance, there could be separate templates for licences; JSBAs, JOAs and UUOAs; petroleum sales agreements; transportation and processing arrangements; and sundry agreements, if applicable. Templates are useful aides to those reviewing the asset documentation. Firstly, they ensure that all members of the team focus and report on every provision of the contract within the scope of the due diligence exercise. Secondly, and especially for large scale due diligence reviews, they are important for the purposes of consistency and efficiency. The buyer’s due diligence report should be informative, concise, on point and appear to have been written by one person. Full, tailored contract summaries help to achieve this purpose.

Contract summaries also serve a bigger purpose. If after the due diligence exercise the buyer decides to enter into a sale and purchase agreement with the seller and proceed to completion, the closing documents will include deeds of assignment and novation for the various material contracts. Complete contract summaries make the task of deducing which material contracts will need to be assigned or novated easier. They also make for a more efficient process as they prevent the buyer from having to re-locate each document in the data room and re-review their provisions.

If the asset is producing or has an approved field development plan, the buyer should expect to see material contracts in the data room relating to petroleum sales agreements and lifting, transportation and processing arrangements. Particularly in respect of some of the older UKCS assets, it is not always clear whether a document is historical or not. Typically, the buyer will exclude historical construction, tie-in commissioning and joint development agreements from its due diligence scope and place less emphasis on reviewing pipeline crossing and proximity agreements, unless it has a particular interest in the provisions of such documents.

It is likely that the data room will include some material contracts which are governed by the laws of another country or state. Depending on the importance of such contracts, the buyer should consider whether to seek advice from local counsel. In addition, in the course of due diligence for an asset acquisition, it is likely that there will be property and tax related documentation and these should be reviewed by specialists in those fields. It may also be necessary to examine the proposed transaction from a competition perspective and so the need for competition lawyers should be considered at an early stage.

During the due diligence exercise, the buyer should be aware of any information which evidences that the seller has been acting in breach of contract or is in breach of its licence obligations. Any current or anticipated claims from third parties or on-going litigation will be of particular interest to the buyer and should be noted. The buyer should also be alerted to whether any contractual provisions will be breached by the acquisition of the target asset if they are ignored by the buyer. For instance, often under seismic data contracts data must be returned or a supplemental fee paid if the identity of the purchasing company alters.

On completion of a transaction, the buyer will want all material contracts to be novated to it from the seller, unless the transaction is structured as a share sale. In some circumstances this may not be possible if third-party consents remain outstanding and so the seller and buyer should use their reasonable endeavours to obtain such consents post completion. Typically, this approach is only taken in respect of those contracts of limited value or importance. The seller will agree to hold such contracts as trustee and agent of the buyer and the buyer will agree to perform such contracts on the seller’s behalf and indemnify the seller against any costs or liabilities it incurs in respect of such arrangement. This split completion approach is not always possible in respect of those agreements which are contractually linked to others or to the transfer of the participating interest. The buyer should therefore bear in mind any linkage provisions that it uncovers in its due diligence exercise.

Decommissioning

The buyer will be keen to discover whether a field-wide decommissioning security agreement is in place for the target asset or whether the JSBA, JOA and/or UUOA include decommissioning security provisions. Where decommissioning security provisions exist, the buyer should consider the type and amount of security required, the credit rating of such security, whether the asset is in the run-down period and/or how the trigger date is calculated. Depending on the terms of the transaction and whether a section 29 notice has been served on the seller before the asset is transferred to the buyer, the buyer may need to provide security for decommissioning under the sale and purchase agreement to the seller as well. Decommissioning arrangements will be a fundamental consideration to the buyer’s valuation of the asset and will therefore always require financial and/or actuarial input.

Encumbrances

The buyer should conduct a charges search at Companies House in order to determine whether the seller should arrange for any outstanding encumbrances over the asset to be released as part of the transaction. The buyer should also be concerned with any third-party royalties over the seller’s interest in the asset. Any royalty payments on production in respect of all petroleum won and saved will have an impact on the financial value of the target asset and so the buyer should factor the existence of these into its valuation.

Likewise, details of any outstanding cash calls, sole risk activity or carried interests may also be important considerations for the buyer and their existence may result in an adjustment of the price the buyer is prepared to pay for the asset.

Questions and Answers

The question and answer process is central to the due diligence exercise and is an important string to the buyer’s bow. By asking the seller questions, the buyer can better understand the seller’s asset from the responses provided and seek to address any holes or limitations in the data room documents. A classic example of the curious incident of the dog that didn’t bark in the night is the unknown existence of an area of mutual interest agreement which, in the most draconian of circumstances, may prevent a buyer from completing its transaction with the seller, or may prevent the buyer from applying for and/or acquiring an interest in another particular licence area post completion of its transaction with the seller.

If draft contracts have been included in the data room the buyer should ask the seller to confirm whether final versions have been executed and, where documents which have been provided during the due diligence exercise refer to others which have not, the buyer should request these missing documents from the seller. The buyer should maintain an accurate list of questions that have been submitted to the seller and the responses received. Sometimes questions will be answered unsatisfactorily and it is therefore important for the buyer to re-phrase or pursue answers to the originals.

The buyer may also choose to contact DECC with questions on an unnamed basis during the due diligence exercise if there appears to be an inconsistency between the asset data held by DECC and the documentation provided by the seller in the data room. In doing so, the buyer must be careful not to breach any provisions contained in any confidentiality or non-disclosure agreement that has been entered into between the buyer and seller in respect of the transaction.

Conclusion

The buyer conducts due diligence so that it can properly evaluate the risks and benefits to it in acquiring a particular asset, re-negotiate the price that it is prepared to pay for the asset, and decide whether or not to go ahead with the purchase. The due diligence report should identify and quantify issues found and propose solutions for the buyer to consider. Depending on the concerns identified, traditional contractual protections in the sale and purchase agreement may be insufficient and, consequently, the buyer may decide to walk away from the deal. The importance of the due diligence exercise is therefore paramount.

Article by:

Rebecca Downes

Of:

Andrews Kurth LLP