M&A transaction risks can hamper growth

It might surprise some that Houston ranked second only to New York City for M&A deal value during the first nine months of 2011, according to the Houston Chronicle. To be sure, this was a notable achievement considering that US metropolitan areas such as Chicago and Boston have a significantly higher presence of venture capitalists, private equity firms, and hedge funds whose business models essentially consist of buying and selling companies.

But to those in E&P, Houston's emergence as a hotbed for M&A activity was far from unexpected. Since their primary assets (i.e., reserves) are a dwindling resource with a finite value, E&P companies are under constant pressure to acquire and exploit reserves or buy other E&P companies when they cannot replace reserves organically. Fortunately, their historically strong balance sheets and cash positions allowed them to make deals last year, even as many other industries and locales were forced to retrench.

Since reserves have a finite value, E&P companies must acquire and exploit reserves. (Images courtesy of Grant Thornton)

Understanding key transaction risks and negotiating and structuring the transaction to mitigate them are critical to a successful deal. After all, a single M&A transaction can alter a company's future significantly. The challenge is that most companies are operationally focused and typically do not have sufficient M&A experience at the executive level or the infrastructure needed to acquire and integrate companies effectively. With so many E&P company earnings and reserve restatements stemming from acquisitions in recent years, it is clear that the industry is not immune to this challenge.

With that in mind, it is a good idea for E&P executives to examine key transaction considerations that are unique to their companies and have the potential to negatively impact capital deployment and/or cash flows if not properly measured and factored in. Grant Thornton's Energy Transaction Advisory Services group helps companies assess E&P transaction risks. Executives should consider a number of essential items within these categories when conducting due diligence.

Transaction risk assessment

There are five overarching categories for assessing transaction risk. Reserve and production characteristics. Concerns here include:

• The impact of historical versus projected production volumes and volatility on cash flows;
• Concentration and diversification among geologic basins (e.g., percentage of oil versus gas, onshore versus offshore, and number of wells);
• The duration that proved undeveloped reserves (PUDs) have been on the books, the related drilling program to develop these PUDs, and whether there were significant changes to the drilling program;
• The reserve report, which is a critical report relied upon during E&P transactions and presents many risks and estimates that are important to consider, including risks related to whether the report was prepared internally or externally, projection sensitivities based on production and forecasted capital expenditures capex, and estimates generated by comparing the current NYMEX strip with the price deck used; and
• Historical asset impairment testing and related analyses.

Reinvestment. Concerns here include:

• The reserve life index – calculated by dividing proved developed producing reserves by annual production – that indicates the potential pressure of capital deployment;
• Comparison of the annual reserve replacement index, which indicates a company's ability to replace its annual production with indexes calculated by companies of similar sizes;
• Evaluating a company's ability to economically replace reserves, which involves looking at historical finding and development (F&D) costs based on dollar/boe;
• Calculating an undeveloped lease expiration waterfall, which identifies potential acreage and reserves at risk of being lost;
• Drilling and capex assumptions used in developing PUD projections;
• The reserve acquisition price/boe versus historical F&D costs; and
• The existence of commitments related to seismic acquisition, capex, drilling, or long-term take-or-pay contracts with commodity price caps or floors.

Operating and capital efficiency. Concerns here include:

• Operating efficiency as measured by the full-cycle cost and expressed as dollar/boe. The full-cycle cost is the average cash cost to produce each boe and the capital necessary to replace it – in other words, the sum of lease operating expenses plus general and administrative burden plus F&D costs; and
• Management's ability to maintain a strong liquidity position as measured by the ratio of capital spending to cash flows. Tax exposures. Concerns here include:
• Federal, state, and local income tax exposures;
• Sales and use tax, property tax, employment tax, escheat, or other applicable tax exposures; and
• Deferred tax assets/liabilities, net operating loss carry-forwards, the depletion deduction allowance, like-kind exchanges, and tax basis verification.

A single M&A transaction can alter a company’s future significantly.

Non-E&P operations. The major concern here is the potential for significant liabilities related to other businesses (e.g., midstream, distribution, or refining/marketing) with different risk profiles, such as an out-of-the- money trading book from aggressive marketing/trading activity or environmental liabilities from refineries and chemical plants.

In addition to looking at these items while conducting their due diligence, E&P companies should consider factors that fall outside these broader categories. Following are some of the questions clients should answer: Does the asset base, as currently leveraged, generate adequate return on capital invested? If not, what are the scenarios to optimize investment? What are the strategic synergies that can be created by the transaction under consideration, and how are they expected to impact the overall value chain? Are hedging programs in place to protect against commodity price exposures? Are there any joint venture or royalty issues, counterparty risks, or off-balance sheet financing contingencies?

The challenge, of course, is finding the best way to perform financial and operational due diligence in today's environment of limited or stretched corporate development budgets. Companies can build out their corporate development departments, engage experienced transaction advisory professionals to leverage their internal team, or elect to do both. Whatever approach a company takes with respect to due diligence, the rewards for conducting it will be clear: The company will not only make more informed decisions but also perform its fiduciary duties for its investors and lenders in an optimal way.