ACQUISITION OF OIL & GAS ASSETS ABROAD Energy is the lifeline of every economy.

It is the prime carter of economic growth. Availability of energy with required quality of supply is one of the keys to sustainable development. It has a direct impact and influence on the quality of services in the fields of education, health, food and security. Oil and gas forms a small but significant part of the energy sector. Of all other sources of energy, hydrocarbons are the most critical and will continue to be so in the foreseeable future. Its level of utilization directly asserts the level of economic development. Emerging economies are expected to drive energy usage to still higher levels. For countries like India, access to affordable energy is critical to the economic growth of the nation and enhanced standards of living of its population. The Integrated Energy Policy of the Planning Commission defines Energy Security asunder: We are energy secure when we can supply lifeline energy to all our citizens irrespective of their ability to pay for it as well as meet their effective demand for safe and convenient energy to satisfy their various needs at competitive prices, at all times and with a prescribed confidence level considering shocks and disruptions that can be reasonably expected.1 Therefore, it is safe to infer that the chief emphasis of energy security policy of India focuses mainly on meeting the energy needs of all citizens and the ability to provide it to all citizens disregarding their capacity to pay. Securing energy sources is of strategic importance. Majority of the established hydrocarbon resources in the world are confined to and controlled by few countries, whereas the demand is world-wide. The concerns related to assured supply are threats of supply disruptions, terrorism, and instability in exporting nations, nationalist backlash, geo-political rivalries, speculative trading and business cartels. Recent global developments like economic downturn of 2008-09 and geo-political unrests in Middle-East countries have once again demonstrated the vulnerability of worlds crude oil prices and the resultant impact on economic growth of countries. The proven oil reserves worldwide at the end of 2009 were approximately 1333 billion barrels. The main concentration of oil is in Middle-East Asia followed by South and Central America. Additionally North American region accounts for significant portions of oil reserves because of large oil sands deposits. The Middle-East accounts for major share of worlds gas reserves, followed by Europe and Eurasia. Russia and CIS countries are the most prolific gas suppliers contributing to Europe and Eurasia region.

1 Report of the Working Group on Petroleum and Natural Gas Sector for the 12th Five Year Plan (2012- 17), Government of India, Ministry of Petroleum and Natural Gas, November 2011, full text available on

http://www.indiaenvironmentportal.org.in/files/file/wgreport.pdf (Last visited on 24th November, 2012)

Energy security remains a concern for India as the country faces challenges in meetings its energy needs. The country depends on imports to meet more than 75% of its hydrocarbon energy requirements. The growth in domestic oil and gas production is not commensurate with the growing consumption of petroleum products in the fast developing economy like India. The 12th Five Year Plan aims at overcoming the shortfall in availability of oil and gas in the country. The Plan purposes to expedite the exploration activities in the non-producing areas of Indian sedimentary basins; induct key technologies to improve processing techniques in seismic surveys and intensify exploration activities in existing as well as new fields. The consumption and production rate of oil and gas by India is shown as under in Table 1.1. And 1.2 respectively.

Table 1.1. Indias Crude Oil Consumption2

2 United States Energy Information Administration, available on

www.eia.gov (Last visited on 17th June, 2013)

Table 1.2. Indias Crude Oil Production3

In order to supplement domestic availability of Crude Oil and Gas, there has been substantial effort on acquisition of assets abroad. Oil PSUs, namely, ONGC Videsh Limited (OVL), Oil India Limited (OIL), GAIL, Indian Oil Corporation Limited (IOCL), Bharat petroleum Corporation Limited (BPCL) and Hindustan Petroleum Corporation Limited (HPCL) have
3 Ibid

invested Rs. 59, 108 crore (i.e. US$ 13 billion) up to 31.03.2011 on acquisition of assets mainly oil production assets viz. Sakhalin, Russia, GNOP and Block 5A in Sudan, Imperial Energy in Russia, Block BC-10 in Brazil, Block 06.1 in Vietnam, AFPC Syria and MECL Columbia. OVL has produced Oil and Oil Equivalent Gas (O + OEG) to 8.802 MMT, 8.776 MMT, 8.870 MMT and 9.448 MMT during 2007-08 to 2010-11. Production from overseas oil and gas blocks presently contributes about 10.5% of domestic production of India. The share of overseas production vis--vis indigenous production in given below in Table 1.3: Table 1.3 Overseas Production vis--vis Domestic Production4
Year Total Domestic (MMTOE) Overseas Production of OVL (MMTOE) Overseas Production as % of Domestic 2007-08 66.53 8.8 2008-09 66.35 8.78 2009-10 81.01 8.87 2010-11 89.9 9.45 2011-12 89.85 9.00

13.23%

13.23%

10.95%

10.51%

10.02%

The Ministry of Petroleum and Natural Gas is engaged in oil diplomacy through negotiations with Governments of other nations, Inter-Governmental Commissions, Joint Working Groups and region-specific events like the India-Africa Hydrocarbon Conference. Indian oil PSUs are being constantly encouraged to adopt a global vision in their pursuit of raw materials and raw material-producing assets abroad, and to pursue acquisition of oil and gas assets overseas. At present, Indias oil companies are undertaking the act of acquisition of assets in more than twenty countries including Vietnam, Russia, Sudan, Myanmar, Iraq, Iran, Egypt, Syria, Cuba, Brazil, Kazakhstan, Gabon, Colombia, Nigeria Sao Tome Principe, Trinidad and Tobago, Nigeria, Venezuela, Oman, Yemen, Australia and Timor-Leste. The total investment by oil PSUs overseas is Rs. 64, 832 crore which includes two pipeline projects in Sudan and Myanmar. OVLs purchase of Imperial Energy is the largest acquisition of a foreign company by oil PSU. They produced 9.4 million tons of oil and oil equivalent gas in 2010-11 (which is equal to 22% of domestic oil production) from its assets in Sudan, Vietnam, Venezuela, Russia, Syria and Colombia. By 2020, OVL is expected to exceed an annual production level of 20 MMTOE. It is often mulled over whether India should acquire oil and gas assets abroad or just import crude oil. Assessing the current scenario, OVL has purchased 8.4% of the giant Kashagan oil field in Kazakhstan for US$ 5 billion. Located in the north Caspian Sea, this is the world's largest oil discovery since 1968, with reserves estimated to be as high as 30 billion barrels. With crude

4 Supra at 1

prices at US$100 per barrel, OVL will recover the full value of its investment in a little more than six years. If prices fall, it will take longer. The deal is for 25 years.5 Viewed this way, it looks like a great investment in a high-cost crude market. In 2009, OVL made a disastrous US$2billion deal to buy Russia's Imperial Energy, and quickly found that output from its wells had dropped sharply. The asset in Kazakhstan is unlikely to suffer the same fate. It might be impossible to transport the oil physically to India, but that does not matter. OVL's stake ensures that 8.4% of Kashagan output can be swapped with any other seller worldwide. Though OVL has assets in over a dozen countries, it has to be considered whether it makes sense to buy into oil projects or whether to save the cash and buy oil on spot and negotiated rates from global suppliers. China prefers to acquire assets; Japan opts to buy oil, instead. India does both. It is pointless to pose this question to OVL, because its mandate is to acquire and operate oil and gas properties overseas. The government and our energy policymakers must enunciate the benefits of acquiring energy assets over simply buying the product in the market. Without a clear cost-benefit analysis, this debate cannot be settled. In the past, the government has talked about energy security as the principal driving force behind overseas acquisitions. But that is facile: Japan's experience shows that functional oil markets offer security, with some reserves thrown in. And oil markets functioned even during the two Gulf wars. However, for OVL and ONGC, there is one huge positive factor in the deal. It has helped turn a lot of the cash pile that the state-owned company was sitting on into a concrete asset that the government cannot take away in the form of oil subsidies or special dividends. And that is a pretty compelling reason to buy. Acquisition of oil and gas assets requires environmental exploitation. With growing concerns for environment and climate changes across the globe, certain measures and precautions are taken up so that environment is not made a scapegoat for economic development. This report throws light on the environmental, political, economic and other risks that Indian companies face while undertaking the trade of acquisition of oil and gas abroad and also examines the measures that have often been adopted to deal with the risks.

NECESSITY TO ACQUIRE OIL AND GAS ASSETS The Indian sub-continent has been undergoing an accelerated growth in the recent past. In spite of the global economic slowdown, the average growth rate of Indias gross domestic product (GDP) during the period 2006-09, was about 8.6 per cent. The corresponding average growth
5 Economic Times Bureau, 28th November, 2012

rates of net national income and personal disposable income were 14.5 per cent and 14.7 per cent, respectively. Indias per capita energy consumption is 383 Kg of Oil Equivalent (KGOE) as against the world average of 1,737 KGOE, which indicates a significant potential for growth in the demand for energy. As per the Integrated Energy Policy of the Planning Commission, Government of India, Indias energy need is expected to grow four-fold from 433 Million Tones of Oil Equivalent (MTOE) to around 1,856 MTOE by 2032. However, India depends largely on imports with over 75% of oil and 16% of gas consumption being imported. The Government of India is keen to increase the per capita consumption of energy to raise living standard of country. Higher economic growth is driving income growth, which in turn is driving up industrial investment and fuel consumption. In general, demand exceeds supply and there is a broad-based energy shortage, which is either met by imports or remains unmet. Oil and gas merger and acquisition value and count is shown below in the graphical representation:
Table 1.4. Oil and Gas Merger & Acquisition Deals by Value and Count
6

OVL

ONGC Videsh Limited (OVL) is a wholly owned subsidiary of Oil and Natural Gas Corporation Limited (ONGC), the flagship national oil company of India. Its primary business is to prospect for oil and gas acreages abroad including acquisition of oil and gas fields, exploration, development, production, transportation and export of oil and gas. OVLs international oil and gas operations produced 8.753 MMT of O+OEG in 2011-12 as against 0.253 MMT of O+OEG in 2002-03. Their overseas cumulative investment has crossed US$ 10 billion and they currently own assets in CIS & far-east, Middle-East, Africa and Latin America. RISKS Risks Associated With Types of Oil and Gas Assets In addition to the buyer's economic analysis of the acquisition, the buyer's acquisition team also
6 Deloitte Oil and Gas Merger and Acquisitions Report, Mid Year 2012

needs to be aware of the types of operational and other risks associated with different types of oil and gas assets that could make them more expensive or difficult to operate or that could require unanticipated cleanup or remediation costs. a. Oil and Gas Properties: Surface Waters or Shallow Aquifers A major risk related to both oil and gas properties are the risk of spills of petroleum, condensate or contaminated pit fluids into surface waters, underground aquifers and soil. Such spills could come from pipelines, tank batteries or drilling and production pits into soils or surface waters or through well casing leaks into underground aquifers. While good oil field practice and compliance with applicable laws and regulations should protect against these risks, properties that are close to surface waters such as streams or reservoirs will have a higher risk that a spill or leak could reach the waterways. Such an event would involve significant risks of spill cleanup costs, penalties for violations of Federal and State water pollution acts and increased regulatory scrutiny. b. Natural Gas Properties Natural gas properties have a unique set of risks due to certain components in the natural gas stream, the potential impacts on air quality of certain equipment used in the production and transportation of natural gas, and the fact that natural gas requires significant pipeline and midstream infrastructure to get the natural gas to market. c. Environmental Risks While natural gas properties are generally thought of as less environmentally risky than oil properties because they don't have the spill risks of oil properties, gas properties have their own set of environmental risks. For example, coal bed methane properties will typically require dewatering in the initial production stage which will require significant water disposal facilities. The cost of construction and maintaining such facilities can be quite substantial. Sour gas wells with significant amounts of hydrogen sulfide (H2S) will require special processing, and if the H2S levels are high enough such wells may require significant safety precautions. Perhaps the most significant environmental risk arises from the air quality issues involving compressors and storage tanks for natural gas condensate. In certain producing areas close to urban centers where air pollution levels are of concern, as they are in the Wattenberg Field northeast of Denver, condensate tanks may be subject to significant air emission controls. Because of the Wattenberg Field's proximity to the Denver metropolitan area, the CDPHE focused on the contribution of emissions of volatile organic compounds (VOC's) from condensate tanks to ozone pollution problems in Denver. While the industry's own studies disputed the impact of condensate tanks on Denver's air quality, in December 2006 the Colorado Air Quality Control Commission mandated significant new emission controls on VOC emissions from condensate tanks in the Wattenberg area These new emission controls resulted in millions of dollars of expenditures for new emission control equipment by operators in the Wattenberg area, as well as additional recordkeeping and reporting requirements. In addition to state agency enforcement, the Environmental Protection Agency and U.S. Department of Justice also have been active in Clean Air Act enforcement proceedings against

natural gas facilities of oil and gas operators. For example, in May 2007, Kerr-McGee Corp. settled an enforcement proceeding brought by EPA and DOJ involving compression facilities and storage tanks in the Denver Julesberg Basin of Colorado and the Uinta Basin of Utah. In addition to paying a $200,000 fine, Kerr-McGee agreed to spend $18,000,000 on new emission controls on storage tanks, compressor engines, and dehydrators, as well as to implement a number of other measures to reduce air emissions. d. Marketing While the price of both oil and natural gas are volatile, and both commodities are subject to sometimes significant variances between NYMEX prices and local area prices due to pipeline access and other sometimes unexplained factors, natural gas has been subject to considerably greater price volatility due to the difference in natural gas demand between summer and the winter heating season. The use of hedging strategies by producers has been fairly effective in reducing much of the volatility risk. In addition, unlike oil which can be marketed by truck no matter where wells are located, the marketing of natural gas is subject to a large number of variables such as proximity and access to space on transmission lines, access to gathering facilities, and whether the make up of the gas stream requires processing to remove natural gas liquids, carbon dioxide, H2S or other impurities in order to meet transmission line standards. Accordingly, the value of natural gas properties is based not only on the productive capacity of the wells but also on these other processing and transportation factors that can materially affect the ultimate net price that the working interest owners receive. An acquisition of natural gas properties thus requires that significant and thorough attention be paid by the due diligence team to the transportation and marketing circumstances of those properties. e. Royalty Risks Above, the issue of unpaid or improperly paid royalties is an issue of significant risk for the Buyer in an oil and gas transaction. Royalty issues are of much greater significance on natural gas properties because they have been subject to a substantial amount of litigation over the past 15 years concerning the treatment for royalty purposes of costs incurred after the wellhead for dehydration, compression, treatment, transportation and marketing (post production costs). The treatment of the post production cost issue varies from state to state and has been the subject of numerous legal articles and programs. On a particular acquisition this issue could be determined by the terms of the oil and gas leases involved (which may be the case if the issue of post production is adequately addressed in the leases) or it could be determined by the law of the state if not addressed in the leases. In any event, because sellers typically attempt to obtain a cut off of past liabilities for all matters, including royalty payments, as part of the purchase agreement negotiations, this is an area depending on the state in question which could have a material effect on the risk of the acquisition and requires thorough due diligence investigation. The proper payment of natural gas royalties on federal and Indian oil and gas leases under the Minerals Management Service regulations has also been the subject of extensive litigation over issues such as the scope of the lessee's obligation to put production into marketable condition at

no cost to the government and the use by lessees of marketing affiliates, so royalty issues on federal and Indian natural gas properties also require careful review. Due to the prevalence of post production cost litigation, most producing states have enacted check stub reporting statutes which require producers to report various deductions against the landowner's royalty and which often may contain significant penalties for non-compliance. Because of the penalties many of the lawsuits on royalty claims have also included claims for failure to comply with the check stub reporting requirements. RISKS ASSOCIATED WITH FINANCING AN ACQUISITION After having considered the items of the buyer's economic analysis that need protection, the risks to be considered from the transaction structure and the risks of the particular types of assets involved, the acquisition team also needs to consider the plans for financing the acquisition, whether immediately at closing or at some future point through a securities offering or other securities transaction. While financing plans for the acquisition do not directly affect the economic performance of the properties or lead to greater operating or cleanup risk, there are a few points that the acquisition team should consider. a. Acquisition Financing If the acquisition is to be financed at closing with a bank credit facility, the acquisition team should be sure to coordinate the entire loan process from the very beginning with the purchase agreement negotiation and due diligence process. Time periods between purchase agreement signing and closing in today's hot property market are commonly no more than 30 days. Accordingly, the acquisition team must know what the lender's title requirements, approval process and security documentation timeline will be, and it must ensure that the purchase agreement title and defect procedure allows for compliance with those requirements. More importantly, the acquisition team must be sure that the results of the buyer's due diligence reviews are promptly communicated to the lender and its counsel so that the entire title and other due diligence process under the purchase agreement can proceed with the lender's knowledge and concurrence. If the buyer and the lender have financed a number of acquisitions together this should not be much of an issue, but if it is a new relationship it is imperative that the acquisition team understands the lender's views on title defects and other due diligence adjustments. Otherwise, the buyer is at risk that it may reach agreements on purchase price adjustments arising from defects, only to find at closing that its lender has a different view of the impact of those defects on its collateral. b. Securities Offerings The acquisition team also needs to consider, if it is known, whether the properties being acquired are likely to be included in a future securities offering by the buyer, such as an IPO for a public company or as an asset contributed by the sponsor general partner in the formation of a master limited partnership. First, the provisions of the SEC's Regulation S-X, covering the requirements for financial

statements to be included in registration statements, may require that financial statements be prepared for the properties included in the acquisition as if they were a separate company and that such statements be reviewed by the issuer's audit firm. This requirement could arise if the size of the acquisition would cause it to be a significant subsidiary of the issuer. Creating such separate financial statements without a prior agreement from the seller to assist the process could be quite expensive and time consuming. If this requirement is at all likely to occur in the future, the acquisition team will be well advised to add to the purchase agreement a provision by which the seller agrees to make such information available and to agree to execute such customary representation letters to the issuer's audit firm as may be necessary to satisfy these requirements. Second, federal securities laws and regulations, including Regulation S-K, require the disclosure in a securities offering of material legal proceedings and claims for damages. If the properties being acquired were slated for inclusion in a securities offering by the buyer, the acquisition team would need to carefully consider whether any problems that were uncovered during the due diligence process would be significant enough given the size of the acquisition and its relation to the size of the issuer to require disclosure in the later securities offering. The acquisition team should keep that possibility in mind and consult with securities counsel as it decides how to resolve any sizable due diligence issues in the acquisition of the assets. DUE DILIGENCE CONSIDERATIONS Having covered some of the issues affecting a buyer's economic analysis, the transaction structure and various risks related to types of assets, we turn to the due diligence process and how it can be used to mitigate risk. Given the compressed time periods so common today, this process should begin well before the purchase agreement stage. a. Local Area Knowledge As we have discussed at various points earlier in this paper, many of the risks surrounding an oil and gas acquisition may relate to the impact of regulatory changes and agency enforcement attitude on future development activities planned by the buyer on the newly acquired properties and on which its bid is based. If the buyer is already operating in the area of the acquisition properties, it presumably will have the experience to know if its timing assumptions for development square with the current and likely future regulatory regime. If the acquisition team itself does not have that local knowledge, then it should make sure that its assumptions are appropriate by checking with the appropriate government affairs personnel in the company. The authors understand the concern about spending too much time on due diligence when a transaction is still at the data room or bid stage, but we would suggest that at least on a transaction where significant value is being placed on the ability to conduct future development, that such local knowledge investigations should be conducted in some fashion as part of the bid preparation process. b. Information Review Assuming you have drafted a contract containing many of the provisions we have recognized in

the prior discussion, you still have to discover whether or not the various representations, warranties, covenants, title, environmental condition, contracts and other rights to be transferred are as set forth in the transaction documents. While this review has to be done to the buyer's reasonable satisfaction, there may also be other parties to satisfy such as a lender or other financial partner, and you must be clear with one another as to the depth and completeness to which this due diligence review will be conducted. Qualified and effective due diligence providers are just like all other service providers. They seem to be in short supply and high demand. The cost of these services is another drain on your transaction economic analysis but given the size of many transactions today, probably not a significant factor. Of much greater concern is whether or not the due diligence team can be assembled, deployed, and able to complete their work in what is often a very attenuated timeframe. It is not unusual for records to reside in more than one office, and there are likely to be multiple counties where the properties are located causing a number of logistic issues. Of passing note, we have seen many companies attempt to require the prospective buyer to hold their bids open for as long as 30 days (an absolutely mortifying risk in a volatile commodity price market) and yet be expected to do their due diligence review of a significant number of properties in two weeks or less. It is submitted that both of these items are an opportunity for a disaster on the part of a buyer. The best advice we can offer is that you consider these issues, and formulate a bid proposal accordingly. But make no mistake, a party can make itself a more attractive bidder if it is willing to take the risk that undiscovered problems exist and it will merely figure out a way to resolve them when and if they occur. Obviously, this is quite difficult to quantify, and yet can materially move the economic results of your transaction. SELLER DUE DILIGENCE Most of our due diligence discussion has focused on the buyer's attempts to secure the deal he based his bid on. It will be obvious to the experienced acquisition hand, however, that the seller also has due diligence that needs to be conducted before a property package is put up for sale. This due diligence is much more than simply preparing property descriptions and lists of material contracts. The seller's goal in a property sale is to walk away from the properties after closing with no ongoing liabilities, or at least as few as possible. To achieve that goal it is important for the divestiture team to identify and disclose all outstanding issues that might be relevant to the value of the package. It is only through disclosure and a discussion of issues either at the data room stage or during negotiation of the purchase agreement that the buyer and seller can reach a business agreement by which the buyer will assume the risk on outstanding issues. Depending on the size of the seller it is important for the divestiture team to be sure that it has obtained the appropriate information from the land, gas marketing, legal and operations areas of the seller to allow for that needed disclosure. This process requires effort and follow-up to be effective, especially in situations where the divestiture team is located at the company headquarters and has to obtain the information from regional offices around the country. The process is made even more difficult by the fact that many asset sale packages are the lower value properties acquired by the Seller in a recent acquisition; these are often properties about which

the seller may have very little detailed information. Along with this information gathering process, the operational groups of the seller also need to be made aware of the pending property sale, so that they will continually advise the divestiture team of new developments and not enter into new contracts or extensions of old ones which might adversely affect the value of the properties to potential buyers.

PURCHASEAGREEMENT CONSIDERATIONS The oil and gas legal literature contains a wealth of RMMLF Special Institutes and other papers dealing with the proper drafting and negotiation of purchase agreements for oil and gas assets. Given the quantity and high quality of the available legal scholarship, this paper will not attempt to deal with purchase agreement issues that have been covered in detail with such excellence. We commend the reader to the papers and programs referred to in footnotes 1 through 11 of Part III A. above. Part II of this paper has already touched on a number of purchase agreement provisions, but in addition, there are a few purchase agreement provisions that are directly relevant to the allocation of risk in oil and gas transaction and that are appropriate for discussion in this section. a. Use of Special Conditions To most oil and gas transactional lawyers the conditions precedent section of the purchase agreement is part of the boilerplate. It normally provides that no litigation has been filed to prohibit the closing and that the representations and warranties of the parties are true in all material respects. If, however, there are particular elements of the buyer's economic analysis that must be confirmed and in place to protect the buyer's evaluation, the existence of these elements can be put into the agreement as one of the buyer's conditions precedent. Examples might be the waiver of a preferential right on a particularly valuable property, the vote in advance by other working interest owners to approve takeover of operations by the buyer, or government approval of a particular development plan that is crucial to the buyer's economics. b. Earn-outs and Contingent Payments In times before today's competitive property market when oil and gas asset deals were based primarily on the discounted value of proved producing reserves, it was customary for the purchase price to be paid only in cash at closing. As discussed in Part II above, in today's property market a buyer will not be successful in a competitive bid process unless it gives some value to proved undeveloped reserves and perhaps even to probable and possible reserves. Sellers today of course still want all cash at closing, but this has the effect of placing all the risk on the buyer to pay upfront for all those reserves that may take years to bring on line. While it is still relatively rare, one way to shift some of this risk to the seller is for the buyer to propose a contingent payment of some form, whether as just an additional payment in cash as production targets are met, or as a production payment or net profits interest. Such contingent payments might give the buyer the ability to pay a higher nominal price for the deal by having the seller share in the risk of when the additional production comes on line. Earn outs are very common in

non-oil and gas sectors of the merger and acquisitions market, and exploring such types of payments in oil and gas deals is something that buyers should give more consideration.