What You Didn’t Consider About the Oil and Gas Due Diligence Process

What You Didn’t Consider About the Oil and Gas Due Diligence Process

Combining two companies can be complex, especially in the oil and gas industry. You aren’t just buying a customer base, the products, and physical equipment sitting in a warehouse — you’re purchasing the rights and titles necessary to produce. More than other industries, you have to confirm you’re getting what you’re paying for, which is why you must have a proper due diligence process in place to ensure success and mitigate risk.

To help your firm prepare for a potential purchase, we want to help you examine six essentials:

  • Why your next merger and acquisition needs due diligence
  • Why oil and gas companies need it
  • What businesses often forget 
  • The goals for proper due diligence
  • How a selling company can prepare 
  • How a purchasing company can prepare

Why is Due Diligence Important During a Merger & Acquisition?

An open exchange of information is crucial to the success of any deal. When it comes to due diligence, it’s the first time the buyer has detailed access to the information the seller shared in their virtual data room during the bidding process. It’s the first in-depth opportunity to analyze information about the value of the potential asset. 

In other words, it helps you see that you’re getting what you’re paying for.

For an oil and gas company, due diligence provides insight into the titles and leases for the various properties, wells, and tracts of land used by the seller. The selling company puts forth data that says, “I own this, I want to sell it, and someone wants to buy it.” 

Due diligence can help buyers know when to back out of a deal, complete with several critical defects:

  • The seller’s terms on the leasehold aren’t as reported
  • Deductibles aren’t met in terms of the value of issue and loss
  • The seller doesn’t own the declared acreage
  • The seller doesn’t own the declared wells
  • Lease terms are shorter than originally stated 
  • Clouds on the title create concerns about ownership claims 
  • The seller owes people more money than originally stated

While no one issue stops a deal, the buyer must determine the internal threshold that will cause them to back away from the merger.

Ultimately, due diligence for the buyer is about telling the seller, “Prove that you own it.” The buyer begins the process from the perspective of “I want to prove you don’t own it,” with the intent of punching holes in their claim. If the buyer can’t punch holes, the seller owns the property, and the sale can move forward.

What Makes Due Diligence Extra Important for Oil and Gas Companies?

As stated earlier, oil and gas mergers and acquisitions are complex. Any asset or piece of data can impact the value of the investment. Such assets can have billions of dollars in long-term value, so both buyers and sellers must consider increased risks such as:

  • Quantifying the number of barrels left in the ground
  • Any impact on royalty owners
  • The continued royalty and revenue payments, joint interest billing, working interest, and more
  • Accounting for other party’s payments

Additionally, the oil and gas industry has changed to be more focused on returns. Most companies buy those properties and assets with a significant amount in loan value. The buyer must be able to back up and collateralize that loan with what they’re paying for it, as the bank requires it.

Due diligence proves you have the collateral for the loan you’re pursuing. Without a thorough process, the purchaser can’t prove to its lenders and investors they will generate the asset’s expected return.

What Do Most Oil and Gas Companies Forget with This Process?

Too many firms forget that they aren’t just acquiring an asset you own. They’re accepting a responsibility to act as a prudent operator. Thus, they need the data to function correctly.

However, people often don’t get the correct data. It should go beyond just actual fact-finding and ensuring the seller owns what they say they own. The buyer needs the full range of data points, and they need it to be good data. Without it, the merged company can’t fully function after the acquisition is finished.

Moreover, proper due diligence when acquiring an asset isn’t cheap, but oil and gas companies try to cheap out on it. They either don’t have the right resources for proper due diligence, or the selling company hasn’t updated/maintained their data when selling. Creating data from scratch is costly if the selling data was terrible, but the company will also go off the rails without accurate information.

What Should Your Goals Be When Acquiring an Oil and Gas Asset?

In our experience, both the seller and buyer should pay attention to four critical elements: 

  1. Confirm the actual value of the asset in its current state without future projections
  2. Create a clear plan for integrating that asset within the identified timeframe
  3. Focus on material, not immaterial, items that could change the long-term value of an asset
  4. Determine a firm defect threshold for what should stop a deal, including what is an actual defect and what truly impacts the sale and quality of an asset
  5. Specify who will be in charge of what and when after the acquisition is complete

How Should the Seller Prepare for Due Diligence?

The seller should put their company in the best possible situation to be sold, including assets, leases, finances, equipment, and more. But preparing for proper due diligence requires a few extra steps:

  • Determine precisely what you think the value of an asset should be
  • Know which wells are valuable
  • Know what to expect from defect threshold or deductible
  • Talk to the engineers to determine valuable wells
  • Take your independent look at your assets so that you can identify problems from the buyer’s perspective
  • Pull and evaluate ALL your data sets before you go to market

Ultimately, your company doesn’t have to be perfect, but it has to be in a good position to sell. Not only must you preserve the value before you go to sell so your buyer can’t punch holes in your lease, but you must also be prepared for questions from the buyer. 

How Should the Buyer Prepare for Due Diligence?

When you’re the person spending the money to acquire the asset, it comes down to having a clear plan for getting the seller’s information into your systems of record. Such steps include:

  • Have the right resources to perform due diligence in the timeline allotted by the contract
  • Clean up the seller’s data on both sides before integrating it into yours
  • Use your allocation value spreadsheets
  • Work the data from the top down to ensure you’re getting the full acquisition
  • Communicate with sellers about data formats to streamline the process

While this might seem counter-intuitive, you should limit your research to the essentials of your defect threshold. Due diligence isn’t cheap. If you can’t find defects, then move forward. But if a deal doesn’t meet your threshold, you will waste money, especially if you can’t get out of the deal or impact your purchase price. 

Don’t force what you can’t change. Due diligence should be about putting your company in the right frame of mind to complete a transaction that delivers a positive impact for both companies and your respective investors.

Use Due Diligence to Improve Your Oil and Gas Transactions

Both sides of a merger and acquisition want the process to be successful so everyone can reap the financial benefits. That means absolute transparency about the essential elements of the deal—and for oil and gas companies, that means the property and the data. Proper due diligence provides the necessary tools and clear communication that buyers and sellers need throughout the purchase process.

If your business desires expert guidance the next time you’re acquiring a crucial asset for the future of your business, talk to EAG 1Source today. We have experience at all levels of the oil and gas industry, especially when assessing IT concerns and advising senior leadership on the right course of action.

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