‘Caveat Emptor: let the buyer beware’ is one of the settled maxims that applies to any buyer who is bound by actual and constructive knowledge of any deficiency in any asset to be purchased. The historical application of Caveat Emptor gave rise to the need for the potential buyer to conduct due diligence and be satisfied with the outcome (i.e., the benefits and risks associated with the target assets) before committing to acquire such assets. This article will attempt to provide some points for consideration in any due diligence exercise for the purpose of upstream oil & gas assets acquisition under the production sharing contract (“PSC”) regime.
Main Objective of a Due Diligence Exercise
The main objective of conducting a due diligence is to ensure that the data gathered by the potential buyer is accurate, complete and satisfactory enough for the potential buyer to appreciate the risks and benefits of acquiring such oil & gas upstream asset. The risks and benefits ascertained from the due diligence process will influence on how the potential buyer will negotiate the sale and purchase agreement which includes seeking for better terms (including purchase price and its adjustments (if any), conditions precedent and the time to fulfil such conditions precedent, covenants pending completion, specific representation or warranties, indemnities and limitation of liabilities) to better safeguard the position of the potential buyer.
Methodology of Due Diligence
A standard due diligence process includes the review of all relevant documents provided in a data room, requesting for further information, evidence as well as written confirmations, liaising with, interviewing the seller’s or the target company’s relevant personnel/consultant, conducting relevant site visits, contacting relevant authorities or agencies as well as engaging third party experts to cover specific areas of the due diligence such as law and tax. The potential buyer should not be “penny wise, pound foolish” in utilising the necessary resources to formulate and execute the due diligence in accordance with industry practice to avoid the potential buyer falling into the risks of the unknown.
Ideally, due diligence should be conducted prior to the execution of the sale and purchase agreement and be subsequently updated prior to completion of the acquisition. However, there may be instances where the potential buyer and/or the seller is keen to execute the sale and purchase agreement before the detailed due diligence exercise is completed and in such a case, the potential buyer will have to insist on the satisfactory outcome of the due diligence exercise as one of the conditions precedents to complete the transaction.
Assets Acquisition or Share Sale
Just like in any typical acquisition, the potential buyer will have to assess whether the sale will involve acquisition of the business through the transfer or assignment of various individual components/assets of the business or the transfer of shares of a target company which owns such components/assets. If the seller is part of an established and mature oil & gas organisation, the potential buyer should expect that the sale will only involve the transfer of shares in a target company in which case verification must be made to ensure that the seller has good title to such shares free from encumbrances.
In an oil & gas upstream assets acquisition, it is critical for the potential buyer to review all material contracts in relation to the target assets (which would include PSC, Joint Operating Agreement, Crude/Oil/Gas/Condensate Sales Agreement, Pipeline Operating Agreement, Crude Oil/Gas/Condensate Pipeline Transportation Agreement, Floating Production Storage and Off-loading (FPSO) Agreement, Floating Storage and Off-loading Agreement (FSO) and other materials and services contracts) to ensure that the petroleum operations can continue efficiently post completion. This would include verifying whether such contracts are still in full force and effect, the expiry of such contracts and the commercial terms. Specifically, the need to ensure that the PSCs are still in full force stems from the principle that title to oil & gas upstream assets resides with the regulatory authority/owner of the petroleum resource awarding the respective PSCs. In addition, the potential buyer will have to consider the residual balance of petroleum reserves available to be produced during the remaining term of the PSCs to ensure that the acquisition would result in sufficient economic returns based on the initial investment and future expenditures.
Further, the potential buyer should investigate on whether there has been a default on the part of the target company or the counter-party in respect of any of the material contracts and the effect, consequences of such default to the petroleum operations including the rights of the non-defaulting party to terminate the respective contracts. As an example, the failure of the participating interest in spending a minimum sum for purpose of exploration may result in imposition of penalties and liquidation of guarantees which may have to borne by the potential buyer if there are no specific warranties or indemnities in the share sale agreement/asset sale agreement to cover such liability.
Change-of-control Requirements under the PSCs and the JOAs
It is common for PSCs and JOAs (and certain licences and permits) to have specific change-of-control restrictions which may include the requirement to procure consent from the relevant regulatory authority/owner of the petroleum resource and waiver of any rights of pre-emption or rights of first offer from the existing joint venture participating interests/partners. The resolution of these restrictions will typically be one of the conditions precedent in the sale and purchase agreement/asset sale agreement.
Although all petroleum companies have stringent guidelines on their responsibilities as reasonable and prudent operators, the nature of upstream petroleum operations will typically carry an inherent risk to the environment. Statistically, there is an occurrence of about 1.8 spills per year on average between 2010 and 2019 and 3.2 spills per year on average between the year 2000 and 2009. Despite the decreasing number of oil spill occurrence over the decades, such occurrence remains an on-going concern for upstream petroleum asset owners and regulators. Thus, many governmental and/or regulatory bodies have become more vigilant in protecting the environment by enacting, implementing and enforcing laws to that effect. The potential buyer and its advisors should always strive to investigate, assess and evaluate all risks and liabilities (whether actual or potential) associated with the environment including any cost impact to rectify damage to the environment or anticipated abandonment and decommissioning liabilities with the objective to prevent huge financial liabilities and implication.
Mandatory abandonment and decommissioning operations are now part of the environmental liabilities scenario and the future abandonment and decommissioning liabilities must be factored in the potential buyer’s economic/financial model. In some acquisition cases, abandonment and decommissioning costs will be one of the most important variables to be estimated by the potential buyer.
Litigation, Investigation/Regulatory Sanctions
In essence, the potential buyer will have to ensure that the seller and/or the target company has obtained and maintained all governmental permits, licences and the seller’s compliance ith all applicable laws in relation to the target assets/target company. Any non-compliance of such laws will result in potential or pending legal actions against the participating interest/target company which may have an impact on the petroleum operations post-completion of the acquisition. As part of the due diligence process, it is crucial for the potential buyer to seek all information and disclosure in regard to on-going litigation, official investigations or potential/threatened suits, actions, claims against the target company. This should also include any actual or threatened employment or labour dispute or claim that has been or yet to be initiated by the seller’s employees or other persons against the target company.
In any change of control of a business, it is inevitable for employees to be concerned on whether the policies and operating philosophies of the potential buyer will be acceptable to and embraced by the employees in contrast to the existing working conditions and the way of doing things. Knowing the exact working conditions and current policies of the target company will enable the potential buyer to make informed decisions on whether to maintain the existing practice or to introduce new approaches and policies taking into account of the impact of such decision on the morale of the employees.
Commercial & Financial Risks
The due diligence process should also extend to assess the risk of insolvency on the seller which may prevent or hinder the completion of the transaction in addition to the target company’s financial status, insolvency risk and existing and past liabilities including liabilities in relation to tax in the jurisdiction where the target company operates and the jurisdiction of where the target company is incorporated.
In addition, assessment will have to be conducted on the existing joint venture partners of the target company/participating interests to assess their overall capability and willingness to continue to fulfil their commitments under the PSCs and JOAs and their possible response to the proposed change in control of the target company.
A common commercial risk in an oil & gas assets acquisition would include the non-accuracy of data on the petroleum resource base including the sub-surface and the geological and geophysical data, records, maps, models based on due diligence conducted. Subsequent interpretation of such data and also field performance post-completion may result in the departure from the potential buyer’s initial anticipated economic benefits of the proposed acquisition derived from the potential buyer’s initial technical and commercial due diligence and analysis over such data. Where the potential buyer has a strong bargaining position, the buyer may wish to insist the seller to represent or warrant the accuracy of such data.
In addition, the potential buyer should undertake its best endeavours to inquire, investigate and inspect the physical assets and the records of operations and maintenance with the view to discover any material damage, destruction, deterioration or loss to the material assets for the petroleum operations including the conditions of existing wells. Further, the potential buyer should assess any other relevant events and surrounding circumstances (including change in government, the existence of international/regulatory sanctions, strikes, extreme weather and extreme shifts in the geopolitical relations involving governments having jurisdiction over parties to material contracts) that may impact the performance of petroleum operations of the target company.
Lastly, potential buyer should also make a prudent assessment on the impact of Covid-19 pandemic on its oil & gas business acquisition. International Energy Agency (IEA), in its 2021 market report, summarized that “global oil demand, still reeling from the effects of the pandemic, is unlikely to catch up with its pre-Covid trajectory.” The report noted that the demand in Asian countries will remain to increase strongly despite at slower pace than before. However, the demand of the same in OECD countries is forecasted not to return to pre-crisis levels.
In conclusion, the due diligence process should be conducted with the objective to discover as much information necessary for the potential buyer to execute the sale and purchase agreement and complete the acquisition of any upstream oil & gas asset or target company and the potential buyer must commit sufficient manpower and financial resources, including the engagement of professional advisers, to achieve its objective. An effective due diligence may provide the potential buyer with greater standing and bargaining position when it comes to negotiating the necessary terms and provisions to be captured in the sale and purchase agreement of the target assets/target company.
Based on our experience, we hold the view that irrespective of how extensive the due diligence exercise is conducted, there is no guarantee that such exercise will reveal everything there is to know in regard to the operations of the target company or the petroleum asset. As an example, for some reasons, the seller may not even be aware of the existence of a side letter amending the PSCs, which is a common practice in the upstream oil & gas industry. The potential buyer may also encounter difficult employees from within the target company or the seller which is evidenced by the deliberate withholding of material information preventing the potential buyer to make a fair assessment on the target company or petroleum asset. The potential buyer should always be attentive and prepared for any last-minute discovery by the potential buyer or disclosure given by the seller which could be revealed right before the ceremony for the signing of the sale and purchase agreement or completion of the transaction. Nevertheless, the importance of effective and proper conduct of the due diligence exercise prior to acquisition cannot be stressed or emphasized enough to allow the potential buyer to make informed decisions to either finalise a mutually acceptable deal with the seller or walk away from an unfair deal.
1 https://www.itopf.org/knowledge-resources/data-statistics/statistics/#:~:text=The%20total%20volume%20of%20oil,in%20the%20last%20five%20decades.(Spills of more than 700 tonnes)