The Sale and Purchase of a Marginal Upstream Interest — One Man's Meat is Another Man's Poison
At a time of falling oil prices it is natural for an oil company to want to examine its portfolio of upstream interests, to manage the development costs and opportunities which those interests represent, and to strategically consider whether any of those interests are marginal and not worth developing. This could, in turn, be a precursor to a decision by an oil company to sell a marginal interest to anybody willing to buy it, rather than to keep the interest and allow it to lie fallow.
This article considers the ways in which marginality is defined, how different oil companies have different perceptions as to what is and is not marginal, and how the categorisation of an upstream interest as marginal is reflected in the sale and purchase of such interest.
The meaning of “marginal”
“Marginal” is defined in the Oxford English Dictionary as “of or at the edge; not central; close to the limit, especially of profitability; barely adequate; unprovided for”. What actually makes an upstream interest marginal from an oil company’s perspective is a matter for debate. There is no obvious single answer that fits all situations.
In the simplest sense, an upstream interest will be marginal if the likely revenues to be earned from selling the petroleum produced from the interest appear to be equal to or only slightly greater than the costs which would be incurred in developing the interest to the point of production.
“Marginal” here in essence means “not profitable enough to want to bother with” from an oil company’s perspective. This will, however, be a very subjective test and the results will vary between different oil companies − for one oil company an upstream interest might be classified as marginal, whereas for another the same interest might not.
The time for the determination by an oil company of the marginality of an upstream interest is typically the point at which: (i) the acreage within the interest has been explored and appraised and is determined to have petroleum production potential; (ii) the interest has not yet moved into the development phase as a precursor to production; and (iii) an oil company is assessing the costs of development versus the likely revenues from the development.
At this point the true productive potential of the interest is a great unknown – an attempt to assess this potential determines the interest’s future economic viability to an oil company.
An oil company’s declaration of marginality in respect of an upstream interest will often also be arrived at after the periodic ranking of that interest within the entire portfolio of an oil company’s interests. Thus an interest might be regarded as not being marginal in isolation but could be declared as being marginal in comparison with other more attractive interests after a ranking exercise has been conducted.
There are certain variable factors which can make an upstream interest marginal or not. The more obvious of these are the impacts of rising development costs and of falling future petroleum prices, but certain other factors are also relevant when assessing marginality:
(i) perceptions of marginality will fluctuate over time according to an oil company’s particular economic situation, market and fiscal terms and the performance of the wider economy in which an oil company operates. When times are tough for an oil company and funds are required for other more-valued purposes, there could be a sudden classification of interests as marginal, as part of an oil company’s rationalisation programme in order to generate cash; and
(ii) oil companies will, from time to time, examine their portfolios in light of changing strategic outlooks. Certain interests could become undesirable, and ‘marginal’ is often the shorthand used to describe such interests as a justification for disposing of them. This is less obviously an economic decision.
In Nigeria, the Marginal Fields Licensing Round (launched in November 2013) attempted to codify the meaning of “marginal”. The accompanying guidelines indicate a marginal field as being one containing petroleum reserves which has lain undeveloped for a period of over 10 years and which is declared to be a marginal field by the President. This is really a fallow acreage development initiative however and, although the guidelines document some of the characteristics of what constitutes a “marginal” field (including fields with high gas and low oil reserves), the Round definition of what is and is not marginal remains subjective and lacks the benefit of an objective test.
The conclusions to draw from these various factors are:
(i) that there is no single, absolute and objective view of what “marginal” means because one oil company’s declaration of marginality in respect of an upstream interest may be met by a declaration from another oil company, with a different set of perspectives and expectations, that that same interest should not be treated as marginal;
(ii) that nothing remains stationary or inviolate over time; for a variety of reasons an upstream interest could suddenly drop below the line and become marginal, where hitherto it did not have that status. Marginal interests could always be generating themselves; and
(iii) that marginality is not always a purely economic decision.
Contracting for the sale of a marginal upstream interest
An oil company could make the internal decision to dispose of an upstream interest because it regards the interest as marginal and not worthy of continued effort or investment. An oil company, as the seller, will source a potential buyer and the buyer will appraise the seller’s interest. The buyer might determine that the interest is not marginal. Thus is born the potential seller/buyer relationship in respect of the transfer of the upstream interest.
When it comes to valuing the upstream interest, the base data which is applied by the seller and the buyer will be the same between both parties, as will be their respective quantifications of such data. Assessments of geological risk, estimates of recoverable reserves of petroleum, predictions of future petroleum prices and calculations of probable development costs will usually turn out to be quite similar, and the conversion of these factors into a single monetary value of the net future value of the interest will generally give a similar outcome. Crucially, it is what that outcome means to the seller and the buyer that indicates the divergence in their attitudes and expectations.
Assuming that an indicative price for the upstream interest can be agreed, the seller and the buyer will then embark on the negotiation of a sale and purchase agreement (“SPA”) for the conveyance of that interest. At this early stage, two paradoxes will soon become apparent in the negotiating positions which the seller and the buyer will adopt in closing out the terms of the SPA:
(i) the seller, keen to sell the upstream interest because of its perceived marginality, does not want the buyer to exploit that marginality as a reason for beating the seller down on the proposed sale price or other commercial terms. Therefore, to protect its position, the seller will insinuate that the interest is anything but marginal. The seller, inwardly so keen to sell the interest, adopts the posture of being a reluctant seller of a highly prized prospect; and
(ii) the buyer, keen to buy the upstream interest because it does not regard it as marginal (or, at least, because it regards the interest as less marginal than the seller does) must emphasise the marginality of the interest as a reason for beating the seller down on the proposed sale price or other commercial terms. The buyer, inwardly so keen to buy the interest, adopts the posture of being somewhat indifferent as to whether or not it buys the interest.
Thus we can end up with something of a danse macabre – the seller declares that the upstream interest is anything but marginal in order to improve the price and other commercial terms, and the buyer declares that the upstream interest is plainly marginal in order to drive down the price and other commercial terms. The seller and the buyer adopt opposing positions, which are contrary to their natural thinking, in order to progress the deal.
These contradictory positions will be reflected through several provisions of the SPA:
The purchase price
The agreed purchase price for the marginal interest will be the product of negotiation between the seller and the buyer, and will result from one of the biggest commercial challenges that the seller and buyer must overcome. The buyer will want as low a price as possible and the seller as high a price as possible, but this is a natural consequence of any sale and purchase arrangement and is not unique to the sale of a marginal interest. The manner in which payment of the purchase price is effected could, however, be subject to some particular negotiations.
The seller will start from the position that it should be receiving the full purchase price up front from the buyer. This is reflective of an upstream interest which, from the seller’s negotiation standpoint, has no uncertainty associated with it and is anything but marginal.
The buyer, in seeking to exploit its perception that the seller considers the interest to be marginal, could seek to implement a deferred consideration payment arrangement whereby an element of the purchase price payable by the buyer to the seller for the interest is made contingent upon a defined circumstance, such as the interest achieving defined levels of reserves certification, defined development programme costs being met or defined levels of petroleum production being achieved.
Deferred consideration, if it is accepted by the seller, is at least a partial admission of the marginality of the interest through recognition of the uncertainty which is inherent within it. If this form of payment structure is adopted the seller is, in reality, taking a punt on the interest proving to be more valuable after completion than it is perceived to be by the seller at the time the SPA is entered into.
In this way, deferred consideration can be used to bridge the gap between what the seller and the buyer actually consider the interest to be worth.
However, the seller, reluctant to admit any weakness associated with the interest, could instead insist on full payment of the purchase price for the interest by the buyer upon completion of the SPA, in a manner more obviously consistent with the disposal of a prime asset.
Arguments that the seller could employ to deter any proposal by the buyer for a deferred consideration structure may include:
(i) that the seller would have to impose post-completion obligations on the buyer to address the disparity between the buyer’s split objectives of exploiting the interest and increasing its profitability on the one hand, and preventing the trigger of the deferred consideration payment on the other; or
(ii) that it would require the buyer to put in place credit support to cover any deferred consideration payments that may become payable by the buyer to the seller post completion.
Whether or not these arguments are effective will depend on the respective bargaining positions of the seller and the buyer.
The seller will ordinarily be keen to limit the extent of the warranty protection which it offers to the buyer under an SPA, by offering a limited set of warranties, an extensive list of expressly un-warranted matters and rigid limitations on the buyer’s ability to make a claim (by reference to time and financial caps, the seller’s awareness and information that has been disclosed to the buyer during the course of the disclosure process). Whether or not the interest is deemed to be marginal from the seller’s perspective, the seller will want to ensure that it gives no warranty to the buyer relating to the physical condition of the interest, reserves and reservoir performance.
Where the seller is selling a prime asset, the seller will be particularly parsimonious in the warranty protection which it offers to the buyer in respect of the upstream interest, because it knows the buyer will be keen to buy on whatever terms it can and could accept less warranty protection.
In order to sweeten the deal for the sale of a marginal interest, however, the seller could be inclined to be more generous in the warranty protection which it gives the buyer. This, in part, is a reflection by the seller that the interest is marginal, but this is not something the seller would be happy to admit.
The buyer will always be looking to increase the warranty protection which is on offer from the seller, especially if it has only undertaken minimal due diligence of the interest. The warranties given by the seller to the buyer in relation to the interest may provide the buyer with a remedy against the seller if it transpires that any of them are untrue and, as a result, the buyer has paid too much for the interest and suffered a loss. They also enable the buyer to glean more about the interest as the seller will be obliged to disclose against the warranties.
This all helps to inform the buyer’s opinion of whether or not the interest is marginal. But the buyer could be ready to reduce its demands for warranty protection from the seller in order to secure the interest quickly.
The usual construction in the SPA is that the seller assumes responsibility for liabilities associated with the interest (including taxation liability and third-party claims) arising prior to an agreed economic date (the date on which the buyer has valued the interest) and the buyer assumes responsibility after that economic date, with crossindemnities between the parties where liabilities fail to follow this agreed allocation.
However, to enhance the prospects of selling a marginal interest, the seller could assume responsibility for certain liabilities even if they arise after the agreed economic date. This is contrary to the seller’s natural commercial instincts, but could be necessary if the seller’s bargaining power is weak.
Nonetheless, whether or not the seller perceives the interest as being marginal, the seller is strongly likely to resist agreeing to extend its liability for decommissioning and environmental liabilities beyond the agreed economic date in all circumstances, given the seller’s genuine concern that such liabilities could be attributed to the seller long after the sale and purchase process has completed.
The buyer will also seek indemnities from the seller in respect of specific risks that have been highlighted during the due diligence process, particularly in instances where the warranty protection offered by the seller to the buyer is compromised by the buyer’s awareness of such risks. Indemnity protection allows the buyer to recover on a pound-forpound basis if specific risks arise, but it is often limited to a percentage of the agreed purchase price. The buyer will argue that because the interest is marginal, it is already taking a big risk in acquiring the interest, and so the seller’s liability under the indemnities should not be restricted. Conversely, the seller will argue that because the interest is anything but marginal, the seller’s liability under the indemnities should be minimal, and so should be capped at a small fraction of the purchase price. Often the parties will meet each other halfway.
The marginality of an upstream interest is difficult to grasp. It can come and go over time, and even when it is admitted to by an oil company which is the interest owner, it is often then denied by that same oil company, acting as the seller, during the process for the sale of that interest. The buyer’s position can be equally contrarian. The buyer may be keen to buy the marginal upstream interest, but in the SPA it will press for the inclusion of commercial terms which are indicative of the acquisition of an unattractive proposition.
The sale process starts because the seller wants to sell an interest which it regards as marginal. The buyer does not share that view, because it would otherwise make little sense for the buyer to acquire an interest which it also regards as marginal. Yet in negotiating the SPA, the buyer applies commercial pressure to treat the interest as marginal and the seller underplays the interest’s marginality. To the untrained eye, this reversal of roles can be quite confusing. Yet, ultimately, in any successful sale and purchase process, there must be some mutuality of understanding and awareness between the seller and the buyer as to how they each perceive the “marginality” of the interest in order for a deal to be struck.