Oil and Gas Property Acquisition
Authors: Wilson Wallace W. 
Published: December 2007

During the last 10 years, there has been increasing emphasis placed on the acquisition of producing properties by outright purchase. This trend is a result of the depressed condition of the petroleum industry, the impact of taxes and the increasing costs of replacing reserves through exploration and development. Procedures are outlined whereby this activity may be organized on a more systematic basis by operators who contemplate this approach to expansion and growth. Methods of financing the purchase of properties are reviewed, with emphasis placed on current problems created by the increased demand for desirable properties.

Introduction

During the last 10 years, the oil industry has witnessed accelerated activity in buying and selling producing properties, transactions which range in size from individual leases to the assets of entire companies. There are those who view this with alarm, believing it to be a trend toward the elimination of the independent operator. Others see it as merely a logical outgrowth of current economic conditions and the realities of our present tax laws. There is little need to underscore the current depressed status of the petroleum industry and the many problems this has created. World-wide imbalance of supply and demand during a period of increasing costs has sharply reduced cash flow and profits. Consolidation of operating units and elimination of less profitable investments have occurred throughout most companies, large and small. It is an economic fact of life that the independent producer can neither expand nor maintain his competitive position unless he offsets most of his income-tax liability with profitable drilling. Many independents now find this difficult or impossible to accomplish because of reduced cash flow resulting from low allowables. The alternatives are gradual liquidation or a capital gain sale of assets. On the other hand, many petroleum economists are satisfied that reserves in the ground can be replaced at lower incremental cost by outright purchase than by exploratory drilling. Whether this generally is true is not so important as the fact that many companies are acting on this premise. It is interesting here to note that the economic circumstances which create a supply of properties for sale have brought about a demand for properties to buy.

The ABC Transaction

The critical ingredient is a feasible method of financing--not only to supply the substantial amounts of money required, but also one which does not in itself create additional tax problems for the seller or the buyer. The approach which has been used in nearly all transactions of any size is the so-called ABC or reserved production payment method, which will be discussed in more detail. In essence, the purchaser supplies equity cash amounting to only a small part of the total consideration. The balance is provided by the sale of a production payment to a third party, with outside financing from banks or other sources. The loan is retired out of income to the production payment, which does not represent taxable income to the purchaser. The advantages of this procedure to the buyer, compared with a straight cash purchase, often are very substantial. In a straight cash deal, the buyer must retire the entire investment out of after-tax income; with ABC financing, he has a much smaller net investment and no tax liability for the income which finances most of the total consideration. His average return is increased correspondingly, and the over-all rate of return or "leverage" usually is several times greater. For a stated average return on investment, the availability of ABC financing usually results in a substantially higher total consideration to the seller than the buyer could afford to pay with a straight cash purchase. This, of course, has not escaped the attention of operators who have properties for sale. Asking prices for desirable production have increased sharply, especially during the last five years. Most sellers now ask for -- and receive -- prices which include substantial values for undeveloped reserves, future waterflood possibilities and other "plus" factors which would not have been considered previously. Increased prices also are indicative of the fact that the demand for high-quality production now exceeds the available supply, with more companies and groups competing. A trend toward competitive bidding has started which seems certain to be followed hereafter in the larger deals. Many companies actively seeking production to buy have created special departments whose sole purpose is to locate and negotiate for properties.