Commercial Due Diligence: it is more important than that you think!
Due diligence is vital for a successful transaction in any industry because the due diligence findings are a direct input into the valuation. Understandably, most emphasis is put on technical, legal and financial due diligence because of their impact on the valuation. But I would like to argue that commercial due diligence (particularly in oil and gas transactions) has its mark to make on the value and success of a transaction. If you want to get my tips/best practices on how to do commercial due diligence for an oil and gas transaction – keep on reading!
Why Commercial Due Diligence?
I have worked as a Business Developer in the oil industry for more than 25 years and participated in many due diligence exercises and that has demonstrated to me that commercial due diligence should have a more prominent place in the overall valuation of a transaction.
The reason, in my opinion, why Commercial due diligence is often an ’afterthought’ is because Commercial due diligence deals with the more intangible aspects of a transaction. It is often hard to put a monetary value to the issues found in Commercial due diligence but they can have an impact on the valuation and success of a transaction nonetheless!
Commercial due diligence has 2 elements to it which I will discuss in detail below:
Inputs into the economics: Identification of key commercial issues in agreements and contracts that could have a significant/material impact on the transaction.
Non-technical issues that can have a strategic impact, not only on the transaction itself but also on how the asset can be operated in the future.
Where to Start Commercial Due Diligence?
One should always start reading the information memorandum (IM) to get an overall view of what is on offer, but a good place to start the commercial due diligence is the Joint Operating Agreement (JOA) because it governs a lot of commercial issues. In a future blog I will go into detail and give more tips on what is important from a commercial point of view in a JOA, but if you want a checklist of important commercial issues, please click here.
Other good sources of commercial information are Transportation Agreements, Service and Operating Agreements, TPOSA (Transportation, Production, Operation and Service agreements) Production Sharing Contracts, Licences, in-country Petroleum Law, Oil/Gas Sales Agreements.
Besides knowledge of the commercial aspects of the agreements, the person who is doing the commercial due diligence should also have a good understanding of the Buyer’s (growth) strategy to be able to comment how the transaction fits within that strategy
Over my years doing commercial due diligence I came across the following items and their issues. I am sharing these 15 tips with you so you don’t have to re-invent the wheel when you are doing your commercial due diligence
Inputs into the economics
Oil or Gas Sales
How are the produced hydrocarbons sold? Spot or long-term sales agreement? Is the price of crude linked to a benchmark (like Brent, WTI, Dubai)? Are any premium or discount to be applied? How is the premium/discount calculated? What are the lifting arrangements? Is the price of natural gas linked to a benchmark such as NBP or Henry Hub?
2. Tariffs in oil and gas transportation and service agreements
Tariffs are often indexed; this means that you need to find the data that is used to calculate the indexation factor of the tariff. Economic indicators such as PPI (producers price index) or RPI (retail price index) of a country are often used as indexation factor. The indexation factor is calculated as the ratio of the chosen indicator in year x over the indicator in year 1. These indicators can be found on websites of a country’s Statistical Service or of the OECD.
3. Area rentals
Area rentals can be found in the licence agreement, the in-country Petroleum Law or production sharing contract (PSC). These are often mentioned in the Information Memorandum (IM), but is always good practice to double-check and to check whether they are indexed or if they will be regularly reviewed (i.e. increased) by the government.
4. (Outstanding) work commitments
A company sometimes has to commit itself to a certain level of work to be granted a licence or PSC. This can range from doing a desktop-review of geological reports to committing to run a certain amount of 3D seismic or drilling (several) wells. The amount of work committed to and amount of work yet to be completed has to be taken into account in the valuation together with the remaining time left to fulfill these commitments: you need to check whether there is enough time left on the licence to finish all the commitments agreed to. If there is not enough time left, an extension will have to be negotiated with the government.
5. (Outstanding) bonus and royalty payments
I have seen PSCs with impressive bonus payments which had to be paid when certain milestones were reached. In sought-after regions these payments can be significant so they can have a big impact on the valuation.
6. Seismic survey and rig contracts
Don’t forget to review the seismic and rig contracts that are in place, because these might have provisions in which certain rights are not automatically transferred from the Seller to the Buyer (e.g. the Buyer has to re-negotiate terms to get access to a Seller’s seismic survey, beneficial rig rates are not transferable from the Seller to the Buyer).
Strategic, non-technical issues
7. Possible deal structures
The Commercial due diligence person should act as a spider in a web and collect information from all the disciplines that are contributing to the valuation. With that information, she can think through possible deal structures, report the advantages and disadvantages of each and recommend the best option.
8. AMI (Areas of Mutual Interest)
Are any areas excluded from the transaction as because the Seller has an agreement with another party?
Area of Mutual Interest agreement is often seen in the oil and gas industry between companies interested in joint or group participating in oil and gas activities within a designated acreage considered by the co-venturers to be of common interest. (source)
9. Preferential rights of existing co-venturers: pre-emption, right of first refusal
With pre-emption it is important to have a view if the other co-ventures are likely to pre-empt the transaction. Why bother to make an offer (with all its effort, costs and use of resources) if the deal is going to be pre-empted anyway? Furthermore, the pre-emption process can significantly extend the time between signing and closing, so it is important to get pre-emption waivers from the co-venturers early on in the period between signing and closing.
10. Change of control/assignment provisions
Change of control provision are important in corporate deals. Some PSCs I have seen require government approval when there is a change of control at one of the parties to the PSC. This means that the government has the opportunity to make additional demands to Buyer or make (unfavourable) changes the PSC in exchange for its approval.
11. Voting rights in OCM
I have seen voting right provisions in old North Sea JOAs in which ‘2 or more parties’ have to agree to something: this was fine in the time when there were many parties in a JV but when there are only 2 parties in the JV this means that unanimity is required on all decisions and can sometimes be problematic!
An operations committee provides review, guidance and oversight for the overall operations of a corporation or business. As members of management, committee members develop insight into the business operations in order to suggest strategic business directions and business policy implementation.(source)
12. Competitive advantages (or disadvantages) over other prospective Buyers
Can we realize value where our competitors can’t? What can we do better than our competitors to improve the value of the opportunity? But also think about the reverse as well: can our competitors see value, where we can’t? How do we mitigate this? How do we account for this in our valuation?
13. Opportunities for bolt-on acquisitions
Do the other JV partners want to sell as well at the same terms and conditions? Are nearby assets for sale?
14. Synergies and 3rd party business
Does the acquisition give access to or improve the Buyer’s position within an export network? (I will be writing a future post on synergies, so watch this space!)
15. Remaining PSC/licence duration
Is there enough time remaining on the licence to capture its value? Will the block become fallow soon? Are there any upcoming mandatory relinquishments? What is the process to extend a licence, is it lengthy?
Don’t worry that you will come across each of these 15 topics the next time you’ll be doing Commercial due diligence, but I wanted to give you a list with all the topics that I have come across so you won’t forget (an important) one. Furthermore, I hope that this blog shows that Commercial due diligence shouldn’t be an afterthought in the due diligence process. Each item can have an impact on the valuation and success of a transaction.
At Salève Energy Partners we have a lot of experience on Strategy, Business Development and Commercial issues in the oil and gas industry and if you want to know more about Salève Energy Partners and how we can be of assistance, please have a look at our website www.saleve-energy.com/expertise or contact us at firstname.lastname@example.org . And don’t forget to download the JOA checklist or the Commercial due diligence checklist!
Be sure to bookmark this post and pin it so you can refer back to it in the future!
Patricia Zegers-de-Beyl has worked in the oil industry for more than 27 years, gaining experience in business development, strategy and commercial aspects of the industry. As a seasoned Business Developer with an Engineering mindset she is passionate about applying and sharing her experience, knowledge and skills through Salève Energy Partners. Patricia has worked for several European oil companies and on projects across the globe and outside the office she enjoys doodling and building with Lego.
Patricia holds a Master’s in Petroleum Engineering from the Delft University of Technology and an MBA from The Open University.