Bridging the gap: Innovative structures supporting Oil & Gas deals
March 03, 2017
Over the last year, the Oil & Gas sector has seen an increase in the number of deals with a contingent pricing mechanism. In other words, transactions where there is an additional future payment from buyer to seller if certain specific criteria are met, such as Exxon Mobil’s acquisition of InterOil which features additional consideration linked to the volume of resource at the Elk-Antelope field in Papua New Guinea. This is not a new thing, of course – deals like this have been done for years in one form or another - but the recent increase in deals with a contingent element may well be indicative of a trend that has been expected for some time.
Put simply, contingency-based deals help bridge the gap between what buyers are prepared to pay, and sellers want to achieve. In the current environment, with a low and unclear future oil price, buyers are wary of overpaying, while sellers are anxious about potentially selling at the bottom of the market and accepting too little. Contingent deal structures give both sides the reassurance they need to do the deals they want. And with the oil price stabilising, and a greater consensus that the sector is going to have to live with ‘lower for longer’, the volume of activity with an element of contingent based consideration appears to be growing and is likely to rise further.
Clearly, anything that unlocks the current road blocks in the market and gets activity moving is a positive development. But both buyers and sellers need to be careful – not only to ensure they get a good deal, but also to avoid potential issues when the final price is determined.
Most of these deals fall generally into one of two contingent mechanisms: those based on the future level of commodity prices and those linked to the size of recoverable reserves. As shown below the range of contingent payments can be quite large, whilst some are harder to quantify contractually than others. It’s easy to define the level of oil price, and easy to see if that criterion has been met. On the other hand, estimated volumes of ‘recoverable reserves’ are more subjective, and provision needs to be made for independent verification. So our first piece of advice is focus on the definitions. The devil, as they say, is in the detail, so time spent upfront can help to prevent lengthy and expensive disputes at a later stage.
The second piece of advice is understand the tax consequences. For buyers, postponing some of the consideration until a later date may make sense from a cash-flow perspective, but it is important that this doesn’t trigger a tax liability that may not reflect the true commercial position. And the same is true, the other way round, for sellers. Don’t incur a tax charge now on money you may never see.
And finally, be prepared to communicate. The markets and other stakeholders like transactions that reduce risk, and these mechanisms can help to achieve this. On the other hand, every deal is unique, with different mechanisms, different risk profiles, and different assets involved, which makes it a challenge for analysts to determine whether a specific transaction is a ‘good deal’ for both parties and also can make it difficult to assess or calculate the fair value of any transaction. Likewise, the contingent element makes it harder to forecast longer-term cash flows, which makes assessing any future funding requirements more unpredictable.
So to sum up, contingent consideration mechanisms are getting the market moving, and making deals happen. That’s a good thing. Just make sure you do your homework.
Analysis of ratio of contingent payment to base consideration (Jan-14 to Dec-16)
|
Contingent consideration ratios |
|||
|
Mechanism |
Minimum ratio |
Average ratio |
Maximum ratio |
|
Reserves/ Resources |
0.02x |
1.11x |
4.18x |
|
Oil Price |
0.07x |
0.28x |
0.75x |
|
Hybrid |
0.19x |
0.67x |
1.50x |
Note 1: Number of deals with the relevant contingent mechanisms for deals over $10m
Source: 1Derrick
