Energy Sector Alert Series: Five Essentials for Managing Deal Risk

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.

¹ This alert focuses on asset-based deals. Other deal structures, like stock purchases, may raise additional issues warranting further strategic consideration.

² Alaska Stat. § 38.05.850

³ See Investment Treaty News, Foreign investment contracts in the oil & gas sector: A survey of environmentally relevant clauses (2011).