David Patton

Locke Lord Bissell & Liddell LLP

The domestic oil and gas business is changing and many independents who have historically built their companies by exploring for and finding new oil and gas deposits are now looking to purchase existing producing assets. Others want to sell their own assets to provide new exploration capital. This is a side of the business that may be new for many traditional E&P companies, and in particular, for many geoscientists and engineers who are or will be involved in evaluating these transactions. The geoscientists and engineers need to be aware of both the process and the potential pitfalls.

Every sale of oil and gas assets should start with an executive summary that provides answers to fundamental questions essential to the parties’ decision of whether or not to move on to the next phase of the purchase. Some of the basic questions include an analysis of the parties. Is there one buyer and one seller or are there multiple parties on either side of the transaction? Is there a public company involved? The financial strength of both parties must be considered to assess the risk of non-performance.

The executive summary should include general information about the assets. For example, the location of the assets has many implications. Are the properties producing? Whether the leases are primarily private, state, Federal or Indian should be determined. Does the seller own less than 100%? Are fee minerals included? What gathering systems, pipelines, plants and other improvements are included within the assets? Are material  contracts involved? Does seismic data come with the deal? What assets are excluded and why? It is important to know whether the seller is the operator and if the buyer is likely become the operator. What is the history of ownership?

A seller’s reserve report is a good starting point to serve as a baseline for buyer’s own comparative analysis of production, including, the number of producing wells being purchased, the volume of production, the age of wells, operating costs, the potential for future development and current market factors. If a high value is to be placed upon proved undeveloped wells, probable wells or other potential future wells, it is important to know how those potential sites are to be described and valued in the purchase agreement. Does the seller have the authority to sell or is the sale contingent upon further approvals, such as board of director approval. Are the properties affected by preferential rights to purchase or required consents?

A buyer should take into account seller’s proposed concept of liability retention by seller and liability assumption by buyer. This ranges from an “our watch/your watch” except for title and environmental to buyer’s assumption of all liabilities for all time periods except for a limited indemnity restricted by time, subject matter or value.

Most sales begin with a data room. The data room process is critical to buyer’s decision of whether or not to make an offer and at what price. The seller’s reserve report, backed up by the buyer’s own analysis, is the foundation.  Necessary information includes (i) reserve evaluation, (ii) production history, (iii) working and net revenue interest, (iv) lease operating expenses, and (v) expected capital expenditures. Lease and contract terms should also be determined. Surface use restrictions should be researched. What gathering systems, pipelines and plants will be acquired?  If seismic or other technical data is to be included with the assets, assess all licensing issues.

The Purchase and Sale Agreement (“PSA”) is the next phase of the transaction. The purchase price is the most important single deal point. If an offer is relatively higher than others, the seller will more likely make accommodations in the PSA. There are many issues that are subject to negotiation. For starters, is a deposit required and if so how much? Will an escrow agent hold the funds? Will the purchase price bear interest.

One of the most important elements of the PSA is the agreement of the parties as to the allocated values of the properties. In its simplest terms, the aggregate sum of the allocated values for the properties to be sold equals the purchase price. Allocated values are used to make purchase price adjustments and may be used for tax treatment.

The scope of assumed obligations and retained obligations is an important issue. The assumption by buyer of certain obligations is understandable and expected in the custom of the industry. But there are limits. The PSA should be clear about what seller or buyer each will be responsible after the closing. The extent of the warranty typically extended by a seller of oil and gas properties is a special warranty in which buyer is protected by seller from those claiming “by, through or under seller, but not otherwise.” Under a special warranty seller does not warrant title to be “good and marketable” but only that if seller ever had title, seller did not encumber it. A buyer might ask for a broader “general” warranty that assures that seller will defend title against all claimants, but the current custom in the industry is that only a special warranty be given.

The parties must come to agreement on realistic time schedules for the various phases of the transaction, including (i) due diligence period, (ii) notices of and responses to title defects, title benefits and environmental defects, (iii) cure period and dispute resolution period for defects, (iii) closing date, (iv) final settlement date, (v) survival of representations and warranties, and (vi) the drop dead/termination date.

Even if an assignment will only provide a special warranty, there is a much higher standard for determining title defects. The title and environmental standards should be expressly defined in the PSA. In the current market, sellers have been able to insist that title and environmental defects should not affect the purchase price unless a certain level of economic impact is achieved at both the individual property and aggregate property levels. Customary remedies for title and environmental defects include some variation of the following (i) reduce the purchase price by the amount of the defect and include the property in the sale, (ii) exclude the property from the sale and reduce the purchase price by the allocated value of the affected property, (iii) exclude the property from the sale and reduce the purchase price by the allocated value of the affected property, but allow seller the opportunity to cure the defect within a certain time period and put the property to buyer for its allocated value, or (iv) include the property in the sale without a reduction in the purchase price and agree to cure post-closing, (v) include the property in the sale and seller indemnifies buyer.

The PSA should address financial terms, including (i) title defect and title benefit thresholds and deductibles, (ii) environmental defect thresholds and deductibles, (iii) casualty loss treatment, (iv) termination rights upon certain purchase price adjustment levels, (v) expenses and overhead charges during interim period, (vi) level of authority for interim operations without buyer’s consent, (vii) price for gas imbalances, (viii) exclusion of liability for punitive, special or consequential damages, (ix) indemnity thresholds, deductibles and caps, and (x) general limits or caps on liability of seller or buyer.

Every PSA contains express representations by the parties. The representations often include the following subjects (i) status of organization, (ii) authority to enter purchase agreement, (ii) planned future commitments, (iii) prepayment and take or pay obligations, (iv) litigation and claims, (v) governmental permits and consents, (vi) broker’s fees, (vii) imbalances; (viii) preferential rights and consents, (ix) compliance with law, (x)compliance with leases and contracts, (xi) payment of taxes, (xii) bankruptcy, (xiii) calls of production, etc. An important consideration is to what extent the representations of the parties will survive closing. The seller will want its representations to end as early as it can negotiate and a buyer will want enough time to discover if there is a breach of a representation.

The PSA should express the agreement of the parties with respect to interim operations prior to closing and actions to be taken after closing. Some of the covenants of the seller that might be included are (i) operate as prudent operator, (ii) comply with law and contracts, (iii) not encumber assets, (iv) maintain insurance, (v) provide access to assets, (vi) not resign as operator, (vii) release all mortgages prior to closing, (viii) deliver assets and records upon closing, and (viii) cooperate with final settlement and allocation of monies. 

The PSA should address what happens if there is an act of God, terrorist action, fire, explosion, earthquake, volcanic eruption, wind storm or other casualty after the purchase agreement is signed but before closing? The same question also applies to condemnation, eminent domain or other taking.

The indemnity provisions of a PSA are difficult provisions upon which to reach agreement. There is a long laundry list that changes from deal to deal, but often includes losses arising from (i) misrepresentations, (ii) breach of covenants, (iii) ownership and operation of the properties, and (iv) payment of royalties. Indemnities can flow both directions.

There are certain standard termination provisions that are customarily present in any purchase agreement. Among them are (i) the right to mutually agree to terminate, (ii) the right of either party to terminate if the other party remains in breach, (iii) the right of one or both parties to terminate if the purchase price is adjusted by more than a certain amount, or (iv) the passage of a date certain with no closing having occurred. The PSA must establish remedies for breach. The starting point in most sellers’ forms of purchase agreement is that seller is only required to return buyer’s deposit as the buyer’s sole remedy for a seller’s breach—not much of remedy. If the deal fails to close as a result of buyer’s breach, sellers usually keep the deposit as liquidated damages.  One alternative is for the buyer to receive not only a return of its deposit but also be entitled to other remedies at law.

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