Contingent consideration: bridging the value gap in oil and gas transactions - International Law Office

Introduction
Technically and economically recoverable petroleum resources
Basic principle of contingent consideration
Drafting contingent consideration targets
Equity dilemma and business and asset management
Further transfer of assets by acquirer
Credit support for acquirer's obligations
Comment

Introduction

The valuation of oil and gas upstream assets is inherently uncertain, particularly in respect of undeveloped reserves. This is because a valuation of upstream assets must factor in many variables, such as:

• predictions of future flow rates and production levels;
• development programmes and costs;
• oil and gas price forecasts;
• the level of the reserves themselves;
• the emergence of competing fuels; and
• demand destruction or even market collapse.

In many M&A transactions, the valuations by acquirers and vendors tend to differ. This is particularly the case for oil and gas assets, where the disparity is exacerbated by the uncertainty of oil and gas asset valuations. The economic climate focuses further attention on the value gap, as investors generally have less appetite for risk; as a result, they may be unwilling to place an upfront value on a potential future upside that is considered uncertain at the time of concluding a deal. However, vendors naturally seek to achieve the highest value for their assets, including the value of all potential upsides. Therefore, one way to bridge the value gap is by employing a contingent consideration mechanism.

Technically and economically recoverable petroleum resources

The estimation of unproduced petroleum resource quantities is based on a project-based classification system which determines the likelihood of the resources being technically and economically recoverable. Unproduced petroleum resources are categorised - in ascending order of likely commercial recoverability - as prospective resources, contingent resources and reserves.

Prospective resources are potential resources with a chance of discovery based on trends, but for which further information (eg, seismic data) is required in order to determine and evaluate the prospect. When a discovery is made, the resources are recategorised as contingent resources. The contingent resources are appraised and a development plan may be created for them where the appraisal reveals an increased chance that the resources are commercially recoverable. When a decision to develop is made, the resources are recategorised as reserves and are developed in accordance with the relevant development plan. The next stage is production.

Within these categories, volumes of petroleum resources are further classified according to the level of certainty of being commercially recoverable. For example, in the case of reserves, volumes may be classified as 'possible' (P3), 'probable' (P2) and 'proven' (P1). In the case of P3 reserves, there is at least a 10% chance that certain volumes of petroleum resources will be commercially recoverable, rising to 50% for P2 reserves and 90% for P1 reserves. However, increasing probability of resources also means decreased absolute volumes of petroleum.

Basic principle of contingent consideration

Contingent consideration is an arrangement whereby at least part of the purchase price is calculated by reference to pre-agreed future performance indicators or events, with payment being dependent on the satisfaction thereof. In the case of oil and gas assets, where the value depends heavily on production levels and the development status of reserves, contingent consideration payments are generally triggered by a specific event, such as production or reserves reaching certain agreed levels or a reclassification of reserves to show that they are more likely to be commercially recoverable.

The use of a contingent consideration mechanism allows vendors to achieve better prices for assets which prove to be successful after completion, while acquirers pay more accurate prices for assets without taking unwanted equity risks.

However, the application of a contingent consideration mechanism in private oil and gas mergers and acquisitions raises a number of commercial and legal issues which acquirers and vendors should take into account in negotiating and drafting the legal documentation.

Drafting contingent consideration targets

Contingent consideration targets should be clearly defined in order to avoid future disputes about whether they have been reached. Where a contingent consideration target involves levels of reserves, the parties should make provision for the reserve levels to be certified by independent third-party experts. In addition, in order to avoid delays or debates as to the appointment of an expert, the parties may stipulate in advance a prescribed procedure for such appointment.

Vendors should avoid 'all or nothing' targets and seek to agree a number of incremental contingent consideration targets in order to mitigate the risk of a single target not being met. For example, the targets can be structured so that a contingent consideration payment becomes due and payable on proven reserves reaching Level X, with a further payment being due and payable when a higher Level Y is reached.

Where certain contingent consideration targets have been met but, subsequent to the relevant payment being made, certain volumes of petroleum are reclassified to a lower level of certainty, thereby bringing the volumes of petroleum below the relevant target, it is unlikely that vendors will agree to repay the contingent consideration. Therefore, in order to mitigate this risk, acquirers may seek to ensure that targets are maintained over a prescribed period before they are deemed to have been met.

Equity dilemma and business and asset management

Where a contingent consideration mechanism is used in the context of mergers or farm-ins (ie, arrangements where both parties become joint owners of an asset on completion), the vendor and the acquirer may have conflicting interests in respect of the assets, which may affect the management of the business. During the period in which a contingent consideration remains outstanding, the vendor's investment and management decisions will be aimed at reaching the pre-agreed targets in order to trigger the payments - an aim which may take priority over certain market considerations. The acquirer, on the other hand, will be driven by market realities. For example, in a market where the oil or gas price is low, it may prefer to delay investments in developing the relevant resources until the market conditions are more favourable. There may be other competing investment priorities which the acquirer may favour over investments that would potentially trigger contingent consideration payments.

Standard joint operating agreements or shareholders' agreements which deal with, among other things, the management of assets and the business generally stipulate that work programmes and budgets, a declaration of commerciality of discoveries and development decisions - all of which may affect the likelihood of reaching the agreed contingent consideration milestones - require unanimous approval; alternatively, they may be deemed majority decision matters that require the approval of both parties (or a majority of the parties, as appropriate). Accordingly, if the joint operating agreement or the shareholders' agreement makes no specific provisions on the process for making decisions that may affect the likelihood of reaching the agreed contingent consideration targets, the potentially conflicting interests of the parties may hinder the management and operation of the assets and the business.

Where possible, detailed management provisions covering the contingent consideration period should be discussed and agreed by the parties in advance in order to avoid post-completion conflicts and to give the vendor a fair chance to earn contingent consideration without being unduly fettered by the acquirer's investment interests. For example, the parties may agree on the required level of investment in the assets or business or steps that the parties should take in order to reach the agreed contingent consideration target.

This position can become even more difficult to manage where the acquirer is the sole owner of the assets on completion. The acquirer's management of the business or decision making, due to either market realities or investment priorities, may run contrary to the decisions that would bring the contingent consideration targets closer. In some cases, the acquirer may simply be aiming to avoid making contingent consideration payments. In traditional M&A transactions that do not include contingent consideration elements, vendors are generally not afforded rights to control an acquirer's management and investment decisions in relation to the assets or business after completion - and in most cases, they are keen to have a clean break on completion. However, in transactions with a contingent consideration element, vendors should negotiate and agree provisions dealing with management strategies to cover the contingent consideration period, thereby protecting their prospects of achieving and benefiting from the contingent consideration payments. This may be a difficult issue to negotiate, as an acquirer is likely to resist restrictions on its freedom to make strategic or investment decisions about assets that it owns, especially as such strategic or investment decisions are likely to be dependent on the realities of the oil or gas market at the time. Therefore, agreements on operational or management restrictions should strike a balance: they should allow the acquirer sufficient management and operational flexibility to make the right decisions at the relevant time, while protecting the vendor's opportunities to reap the rewards of any contingent consideration payments.

Further transfer of assets by acquirer

Vendors and acquirers should consider the relationship between an acquirer's obligation to pay contingent consideration and a right of transfer of all or part of the acquirer's rights and obligations in the assets or business. On such a transfer, what happens to an acquirer's obligation to pay any outstanding contingent consideration that becomes due and payable post-transfer?

Vendors may address this issue in a number of ways. For example, they may impose a specific lock-in period whereby an acquirer cannot transfer its rights or obligations in the assets or business, in order to allow what the parties deem to be sufficient time to meet the prescribed targets. The duration of the lock-in period is likely to be a negotiation point, as acquirers generally will not wish to be restricted from making investment decisions and disposing of assets for a long period.

Alternatively, vendors may agree to transfers by acquirers provided that the acquirer remains liable to pay any contingent consideration that may become due and payable after the transfer. A negotiation point is likely to arise: does the acquirer remain thus liable for a defined period after the transfer, or indefinitely? The longer an acquirer remains liable for any contingent consideration payment, the more it may be unwilling to accept certain restrictions on its management.

Another option is for the parties to agree that the acquirer may transfer the assets, provided that the acquirer pays all or part of the contingent consideration, notwithstanding that the relevant contingent consideration targets have not been met. This allows both parties a clean break and avoids residual obligations on the acquirer to make any post-transfer contingent consideration payments.

Restrictions on transfer or post-transfer payment obligations will make disposal of assets more complex and protracted. Acquirers should be mindful of this potential complexity when agreeing contingent consideration structures.

Credit support for acquirer's obligations

In uncertain markets, vendors should carefully consider their future ability to make contingent consideration payments once they are due and payable; where appropriate, the need for credit support arrangements should be discussed. This can be in the form of a parent company guarantee, payment of part or all of the contingent payment into an escrow account or other forms of credit support. This depends on the identity of the acquirer, its credit rating and the confidence the vendor has in the acquirer's ability to discharge its payment obligations when they are due and payable. Whatever form of credit support mechanism is selected, this will invariably add to the overall complexity of the transaction.

Comment

In the present economic climate, fewer M&A deals than usual are being completed in the energy sector. Taking reserves risks is not an attractive proposition for potential acquirers, but applying a contingent consideration mechanism may bridge the value gap and make a deal possible. The application of such mechanisms is not without its difficulties, but it has the potential to solve one of the important commercial challenges: ensuring that the price of the relevant assets is reflected against the inherent development risk in respect of those assets.

Some commentators suggest that applying the contingent consideration structure to upstream private M&A deals distorts the fair market value of the relevant asset. Vendors tend to argue that contingent consideration structures deflate the fair market value of assets - while acquirers tend to argue that they inflate it. This remains a complex question for the various players in the market as contingent consideration is increasingly used in oil and gas M&A deals. Whether or not a contingent consideration mechanism is an appropriate pricing mechanism is debatable, but in the current circumstances it is arguably a necessary evil.

For further information on this topic please contact Renad Haj Yahya or Trinh Chubbock at Ashurst by telephone (+44 20 7638 1111), fax (+44 20 7638 1112) or email (renad.hajyahya@ashurst.com or trinh.chubbock@ashurst.com).