?There is a popular expression across many regions that is an adaptation of a Mark Twain observation: “If you don’t like the weather here today, just wait and it will change.” So it goes within the ever-changing energy industry, and 2009 will prove the statement infallible.

Take a look into the current U.S. economy: a crisis in the subprime mortgage arena, pessimism on Wall Street, catastrophic losses due to hurricanes Gustav and Ike, a new administration in the White House, and a commercial credit crisis that is possibly as bad as anything this country has seen in the past 60 years. The seas have certainly changed since mid-2008 when Nymex crude oil was being traded at more than $140 per barrel and natural gas was at more than $12 per million Btu.

All of this is complicating buyers’ and sellers’ ability to price E&P properties. Before making purchase or sell decisions, asset-owners would be wise to consider a broader range of risks, from legacy pollution exposure to third-party credit risk.

Today, an acquisition or divestiture may be the most important strategic move a company will make. The key is to find a way to understand all of the risks associated with buying and selling, how to properly evaluate those risks, and how to efficiently and effectively mitigate the risks. It is also important to understand what tools exist to address these risks.

Evaluating risk

Conducting proper due diligence for acquisitions and divestitures can be a cumbersome task, particularly when it comes to evaluating risk. An operator can be exposed in many different scenarios, and many of these scenarios are easily overlooked. The first step in evaluating the risk associated with a prospect is to review contractual risk. Carefully consider the language of the purchase-and-sale agreement, and understand the allocation of liabilities. If liability can be contractually transferred or at least reduced, then fewer risk-transfer mechanisms are required, and a more efficient risk-management program can be created.

The second step in performing due diligence for a potential acquisition is to assess operational risk. Assessing operational risk includes asking the proper questions, which will vary depending on the type of acquisition.

When considering a corporate transaction, there are hundreds of quantitative issues to be worked through, ranging from commodity-price forecasts to current salaries, but there are other, more qualitative, issues that tend to be overlooked.

What is the history of these properties? Are there pending litigation or outstanding insurance claims? If a claim is still pending, who will receive the proceeds after the transaction has been completed? Is there any long-term insurance such as a pollution legal liability policy associated with any assets? When looking at a distressed company, ask the status of its directors and officers liability insurance and how widely held the company is. There are additional questions to answer when considering an asset purchase. What contracts will be inherited and what indemnification obligations will result from those contracts? Will assets be purchased on an “as is/where is” basis? This is often the case when dealing with majors.

Have there been any environmental or legacy issues associated with the asset? If dealing with distressed assets, these issues must often be resolved in very short order. All of these questions are asked to identify risks that cannot normally be found on a balance sheet or reserve report.

In addition to contractual and operational risks, third-party credit risks should be considered. Credit risk has become one of the most important factors to examine when acquiring a package of wells. Operators must be able to identify who is receiving their product and assess the credit risk associated with those entities to ensure that certain revenue targets are met.

Counterparty risk, as it relates to insurance carriers, has also become a concern in the current economic and credit situation. It would behoove operators to know the financial status and rating of the carrier that holds the exposure. Be aware of a carriers’ ability to pay any significant claim in its entirety with speed and efficiency. It is just as important as reviewing the solvency and liquidity of banking, hedging and marketing relationships. This reality has been made obvious by recent well-publicized financial issues encountered by some domestic insurers.

Surety is fast becoming a hurdle for most operators that are looking to expand their asset base. The surety market has hardened significantly, and more collateral is typically being required to secure the necessary bonds. Operators would be best served to investigate the collateralization and pricing of surety. If surety is unavailable, operators need to plan on putting up letters of credit to take the place of surety, which can have a significant impact on cash flow.

Mitigating risk

After identifying as many exposures as possible and determining the organization’s risk tolerance, determine what risks your company can retain, reduce or transfer through commercially available insurance. What is the proper way to mitigate or transfer this risk?

Start by understanding the indemnities that are present in the contracts that are being signed and inherited. This is crucial because, unlike insurance-policy wording and limits which may be altered from year to year, these contractual provisions can last indefinitely. Know the language that is in the purchase-and-sale agreements, joint-operating agreements and the Exhibit D that is associated with each property. Reviewing this language can be very tedious but can provide an enormous benefit to operators that understand the impact on operations.

When acquiring a company or inheriting personnel with an asset purchase, know the safety record of that organization or department. What type of employees will be inherited? Seasoned oilfield workers or inexperienced employees? Develop internal safety and loss-control procedures, which can be implemented at every level of the operation.

This will reduce exposure to property-loss and personal-injury claims. Consider adding a dedicated health, safety and environmental (HSE) position to the operation team of newly acquired wells or facilities. Someone who has a history and familiarity with the assets would be an excellent candidate for the new role.

Insurance can play a vital role in A&D decisions. Insurance is typically considered a necessary evil or a four-letter word that is used to only fulfill contractual obligations, but it can be a very efficient and reliable financial tool in transferring unavoidable risk.

One of the most crucial actions an operator can take to reduce exposure when evaluating deals is to make sure the insurance program mirrors operations. Liability and property coverages must fulfill all contracts—existing and inherited. If contractual insurance limits are not met and proper severability language is not present in the contract, the operator may be found in breach of contract, which could void the entire agreement in the event of litigation.

In addition, operators should review older contracts to make sure that limits are still applicable to today’s market. Fifteen years ago, $3 million in control of well or operators’ extra-expense coverage was a significant limit; in today’s pricing environment, this coverage is sub-standard for most wells. Nonoperators participating in deals should regularly review insurance provisions to see what is being offered in operating agreements. In short, a risk-management program should be tailored to all A&D activity.

In addition to standard oil-patch liability and property coverages, pollution legal liability, or PLL, is an insurance product that can be of enormous benefit in acquiring and divesting assets. Pollution and environmental exposures are a huge concern to any operator, especially as they pertain to longer-lived oil assets. Pollution legal liability coverage can be put in place for a certain group of assets and will cover the operator up to the specified limit for unknown—and to a degree known—pollution issues. This would effectively protect an organization from responsibility for any environmental impact that was done previous to its operations and going forward for a specific amount of time.

This policy can sometimes be transferred with a defined group of assets, which may help to increase the value of an asset that a company is trying to divest. This tool may also bring a buyer to the table that normally would not look at a certain type of well package, such as a major or super-independent. Buyers may procure this policy to add some predictability to a newly purchased package or may simply ask that the previous operator/seller purchase it on their behalf.

The policy may allow a better valuation of the asset and can typically be put in place with a Phase I or II environmental study. It can add certainty to projects that could result in future costs for clean-up as well as other monetary damages. In addition, there are also several maritime and onshore specialty products that may assist in adding value to a company or group of assets intended to be bought or sold. As credit risk is identified in the buyer or seller’s oil and gas operations and mitigation of the risk is not possible, it is important to note that there are commercial insurance products available to help insulate against credit risk. Do not immediately withdraw from the evaluation process if potential acquisitions are tied to a facility or end-user that is identified as a financial or credit risk. There may be a reasonable solution available through insuring your third-party credit risk.

Meanwhile, contingent business interruption, or CBI, coverage can give the buyer a decent measure of protection if revenue from the assets is highly dependent on a third-party processing facility. When evaluating a group of wells or a lease purchase, look for bottleneck situations in which an entire group of producing or potential well locations may filter into only one production or processing facility.

It may be determined that the revenue exposure associated with a possible facility shut-down would be too great, but do not abandon the evaluation without first considering CBI coverage.

Conclusion

Today’s economic environment is constantly changing the stage upon which oil and gas mergers and acquisitions unfold. Although the stage is shifting, one familiar feature is that players each face a large amount of risk that needs to be understood, evaluated and mitigated before any merger or acquisition takes place.

Following these steps will allow an organization to protect shareholder value and be competitive in any market.

Brian Hudler and Phil Lukefahr are energy-risk specialists with EnRisk in Fort Worth, focusing on upstream and midstream risk management.

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