As we approach the midway point of the second quarter of 2016, the appetite of potential buyers for oil and gas properties has remained healthy even as commodity prices continue to languish near decade-plus lows. Since the price of oil plunged during the fourth quarter of 2014, we have seen a surge of dry powder being injected into the industry (whe­ther through the capital markets or investments by private equity funds) followed by a protracted period where the bid-ask spread between would-be buyers and sellers has remained too large to generate significant deal activity.

It appears that the “lower for longer” mindset has now taken over and has prompted companies to take increasingly defensive positions on the liquidity front. Some of the fortunate are accessing the capital markets while other companies have been drawing down whatever capacity they have under their existing credit facilities.

Further, many companies are feeling squeezed by their latest borrowing base redetermination as price decks now are significantly lower than in the fall of 2015, and nearly all of the above-market hedges that were buoying up companies’ cash positions have rolled off.

Unless commodity prices change course significantly, the need for cash, whether driven by the desire to protect properties with material unproven value from foreclosure, avoid workout or simply maintain the balance sheet, will likely force companies to sell assets as the only remaining (voluntary) source of liquidity.

Another catalyst that many suspect could drive asset sales is the potential increase in the willingness of banks to sell existing loan positions to more aggressive parties (such as hedge funds) at less than par value. To date, many banks have been hesitant to do this, but if some of the bankruptcies that are currently working their way through the system result in major losses for secured lenders, it could result in some of this paper changing hands. As a consequence, the equity owners of these companies may opt for asset sales as the alternative to contributing additional funds to prevent a workout or foreclosure situation.

With the potential for greater deal activity on the rise, this article will outline some of the trends, issues and associated risks that buyers are likely to encounter in the present environment.

Who and what is out there?

The most likely seller in this market will be an industry player that has to sell noncore acreage or monetize long-term inventory in order to satisfy the types of liquidity needs noted above. To date there have not been a lot of assets entering the market from struggling portfolio companies, but if credit-oriented issues do arise, there could be some deals available for assets that are not consolidated into other companies within the same portfolio.

As for potential buyers, the majority of the appetite for assets is coming from private equity-backed players seeking to pursue an “acquire-and-exploit” strategy or to purchase nonoperated assets in well-understood plays. Finally, there is some interest from the few industry players with (relatively) healthy balance sheets, but this interest is mainly focused on opportunistic purchases within their core acreage positions.

While marketed deals are ubiquitous in nearly every basin, there has also been an increase in packages resulting from bankruptcies and restructurings as well as in unsolicited bids by buyers seeking to purchase long-term inventory that operators may prefer to monetize.

Transaction trends

Despite the reluctance of companies to divest, once a company is put in a position where it is forced to liquidate and has found a price it is willing to accept, sellers are often willing to trade a lot away to get those deals done.

Many of the transaction themes that have presented themselves during this downturn are not surprising. Sellers are pitting potential buyers against each other to try to find a purchase price they can accept without having to expand the level of post-closing responsibility they are retaining. Additionally, sellers want deal certainty and want to execute and close transactions quickly once they have an acceptable purchase price.

Buyers, on the other hand, are concerned about issues presented by purchasing properties from distressed sellers. These include the execution and market risks associated with buying assets in, or ahead of, a bankruptcy process, the availability of credit support to cover post-closing obligations and being able to understand the full range of potential obligations and liabilities associated with purchasing assets in a distressed environment. Also, buyers are taking a closer look at the valuations they place on properties in order to line those valuations up with future development plans that, in many cases, can only support longer laterals.

Insolvent sellers

Early in the bid process, a buyer should make a thorough assessment of the financial health and solvency profile of its potential seller in order to confirm the appropriateness of its bid and assess what protections will need to be included in the deal documents.

Where bankruptcy seems likely, buyers have to weigh the trade-offs associated with pursuing a transaction prior to the bankruptcy process. Purchasing assets in a 363 Sale from an entity in bankruptcy offers many advantages such as “cleansing” the assets of many liens and encumbrances, minimizing exposure to successor liability for the assets in question and avoiding any risk of claims that the sale was a fraudulent transfer.

That said, the bankruptcy process is cumbersome, lengthy and can result in added costs (such as specialized advisors and greater logistical costs). It can also subject the buyer to competitive bids while the process drags on. Even if a buyer is able to become a “stalking horse” (typically entitled to a breakup fee if the transaction doesn’t go through), getting to that point is often a competitive process as well. Thus, many buyers feel that they can get a better deal if they are able to preempt the bankruptcy process and avoid the delays, additional costs, exposure to price risk and competitive bidding that come with it.

In cutting a deal with a seller that is a “bank­ruptcy risk,” there are several concerns that should be front of mind for buyers. If the buyer is a creditor of the seller and the receipt of the assets is determined to pay off an existing debt, then the there is a risk that the transaction could be challenged as a preference of the buyer over other creditors. Additionally, particularly in an unmarketed transaction, if the buyer cannot substantiate that it is paying “reasonable equivalent value” for the assets, and the transaction occurs within two years before the seller files for bankruptcy, then the transaction could be challenged as a fraudulent transfer.

While specialists should be employed to address insolvency risks, there are some general precautions that buyers can take to protect themselves in these circumstances. First, buyers should identify and eliminate conflicts of interests that could serve as the basis for a claim to challenge the transaction. Additionally, buyers should document the method by which they valued the properties and the negotiation process in order to substantiate that the transaction was done at arm’s length. Also, it may be appropriate to get a fairness opinion to substantiate the purchase price.

Credit support

Given the insolvency risks noted above, buyers have been loath to accept related-party guarantees as a backstop for a seller’s post-closing obligations. Rather, buyers have frequently insisted on having a portion of the purchase price retained in escrow for a period of time to support these post-closing obligations. Many times the amount of this “hold-back” will be based on the amount of the deposit the buyer is asked to put up at signing (i.e., instead of the seller receiving the deposit at closing, the deposit remains in escrow to support the seller’s post- closing obligations). The retention periods for hold-backs typically range from six to 18 months post-closing. Depending on the seller and the assets in question, buyers have been able to negotiate having additional amounts (beyond the deposit) added to the hold-back escrow at closing in order to provide additional post-closing security.

Obviously, having a hold-back runs counter to the needs of many sellers to quickly deploy the cash received from a transaction. Unfortunately, this need, coupled with the insolvency risk of many sellers, is precisely the reason that buyers are digging in so firmly to make sure there is some source of funds against which they can exercise their remedies post-closing. To date, many transactions have resulted in the seller ultimately agreeing to a hold-back, but the amount and retention period for that hold-back will be a heavily-negotiated point and will vary significantly from deal to deal.

Deal certainty

As prices remain volatile and equity sponsors continue to wait for a bottom, sellers have growing concerns about whether their buyers will show up to the closing table. Further, as the need for cash intensifies, once sellers have capitulated and accepted a lower-than-expected price, they want to close the transaction as quickly as possible and are pushing harder than ever to ensure that their buyer has little room to walk away from the deal after signing.

In this market, there has been an increase in sellers pushing to structure transactions in a “sign and close” format. While this structure only makes sense (for a buyer) in limited circumstances, it may require additional protections to einsure the buyer is not left exposed if substantial defects or breaches of representations are identified after closing. If a buyer (and often its financial sponsor) can get comfortable using this structure, it can be a feature that positively differentiates its bid from other buyers bidding on the same assets.

The majority of deals follow the more traditional delayed-closing structure. Under these structures, today’s sellers are asking for larger deposits from their chosen buyers as the deposit will serve as the seller’s principal remedy in the situation where a buyer attempts to avoid closing outside of the permitted termination rights contained in the agreement. Buyers are often able to mitigate the effects of requests for larger deposits (and arrive at a more reasonable number) by insisting that the deposit be maintained in escrow to become all or part of the hold-back as noted above.

Additionally, the scope of permitted termination rights and the conditions on the parties’ obligation to close have gained increased attention. For instance, with respect to termination rights for title and environmental defects, we have seen increased levels of negotiation regarding not only the threshold level at which these rights are triggered, but also with respect to the amount of control each party has over what is counted towards those thresholds, either of which can tip the scales on whether the buyer has a meaningful ability to get out of the deal if excessive defects are discovered.

Asset-level default concerns

Given that many asset packages will involve at least some jointly owned assets, purchasing properties in a distressed environment requires that a buyer assess much more than whether its seller remains financially viable and whether it is meeting its obligations under the leases and contracts that comprise the asset package. In most situations, buyers are becoming working interest partners with other parties that own interests in the assets and must also assess whether those parties are solvent and are meeting their obligations.

buyer should ensure they have the opportunity to conduct meaningful due diligence with respect to the leases and contracts involved in order to understand what upcoming obligations it will be subject to after closing. Are there development obligations that were not budgeted into its bid? Is the third-party operator paying its contractors? Are there carry payments or penalties that have been triggered (or are impossible to avoid due to pre-closing levels of activity)? Also, there should be increased scrutiny with respect to whether the seller (or a third-party operator) has complied with environmental obligations and plugging and abandonment requirements.

In areas where drilling is still taking place, there has been an uptick in the amount of defaults by nonoperating interest owners who have failed to pay joint interest billings. Often in these situations, operators have delayed exercising their right to deem these parties as nonparticipating parties under applicable operating agreements in hopes that they will eventually contribute their share of cash to the proposed operations. Buyers attempting to purchase nonoperated interests should seek to obtain appropriate protections to cover any losses from deemed nonparticipations that cannot be identified prior to closing but which result from pre-closing activities.

Often, addressing these asset-level issues that are (or should be anticipated to be) discovered during the buyer’s due diligence involves expanding the seller’s representations and warranties as well as putting in place a more stringent set of operational covenants to address specific concerns. Since, subject to certain qualifiers and dollar limitations, a seller’s compliance with its representations, warranties and covenants typically serves as both a condition to closing and the source of an indemnity claim post-closing, these provisions can provide the buyer both a way to get out of the deal and, if the deal closes, a post-closing remedy depending on when these issues are discovered.

New values for today’s economics

Finally, for packages focused on unconventional development, buyers are being forced to adjust the method they use to value acreage in order to account for the economic realities of the present market. Given that a certain length lateral will be required to justify development under most current price forecasts, buyers are frequently pricing deals on a net location basis rather than on a net acreage basis. This requires buyers to more closely examine the layout of the acreage position being offered to identify stranded acreage or “holes” that could prevent them from drilling the wells that are dictated by the requirements of their development plans.

Given that most of the buyer’s title diligence will come after execution of a purchase and sale agreement, it is important for title defect mechanics to be adjusted to capture the impacts of any value leakage that results from a defect in the title to one tract rendering surrounding tracts uneconomic. Thus it is important for buyers to clearly communicate with the seller early in the process that its bid is based on certain assumptions regarding lateral length and number of locations so that these mechanics can be addressed in the negotiation of the definitive deal documents.

Conclusion

While the current downturn has created a number of issues that will impact buyers as they move forward with asset purchases, buyers should be cautiously optimistic that there will be tremendous opportunities in the months ahead. Many deals should get done, but buyers that are able to address these risks in upcoming transactions will be in the best position to realize the true value of these opportunities.

James (J.J.) McAnelly is a partner in the Houston office of Bracewell LLP and a co-head of the oil and gas practice group. Jason G. Cohen is a partner focused on corporate financial restructuring. Austin T. Lee is an associate in the oil and gas practice group in Bracewell's Houston office.

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