Strategy of reserves acquisition There are many broad

Strategy of reserves acquisition There are many broad strategic approaches used by oil and gas companies but there are just five basic strategies which a company can adopt: spread activities both geographically and technologically in an effort to ensure that failure in one or more areas is compensated for by success in another (no speciality strategy); confine activities to one geographical area to maximise experience and minimise costs (geographical strategy); 1

confine activities to one or more technological capability (for example, deepwater engineering) to make the best use of company technical strengths (technological strategy); confine activities to ventures with low front-end cost and add value to projects with technical innovation (low cost strategy); confine activities to ventures that have a specified risk level such as high risk and high reward (perceived) or low risk but more modest expected rewards (risk strategy). 2

Specific strategies include: concentrating efforts in one region; a typical strategy of a number ofcompanies in the North Sea such as the former Goal Petroleum before it was taken over by Talisman; concentrating efforts in one country; many Canadian and US oil companies have never ventured outside of North America; concentrating efforts on one sedimentary basin; similarly, US and Canadian companies may explore and develop solely in their local sedimentary basin in their local state where they have had proven success; some companies prefer to concentrate on either oil or gas. Many companies actively avoid gas ventures while others, perhaps with their own gas transmission system, avoid oil; 3

Specific strategies include(continued): some companies concentrate on either deep or shallow offshore waters to take account of their technical strengths and acreage availability, for example Petrobras exploring the deep waters offshore Brazil; some companies concentrate on deep reservoirs, to take account of long experience in drilling deep wells; companies may opt only for exploration ventures that require smaller initial investments but have higher risk either because of a perception that these will ultimately prove most profitable or because of financial constraints. Hunt Oil and Triton Oil, both of Dallas, have followed such high risk and high reward strategies; companies may concentrate on the lower risks but lower rewards of proven basins, usually with higher front-end costs, perhaps driven by experience or conservatism; 4

Phase1OriginalVenture Phase2 Competition Phase 3 (mature) Once the discoveries of Phase 1 companies and successful Phase 2 companies come on stream, the area enters Phase 3. It is a mature sedimentary basin or a mature geological play within that basin. The technical challenge has changed. There are still opportunities to be had but these rely less on luck and more on specific technical specialities and negotiating skills. The competition is intense, companies with particular skills or experience in the specific opportunity are better placed for success. It is in Phase 3 where every opportunity is highly sought after but, unlike in Phase 2, because of longer experience in the area, risks are likely to be more carefully gauged and understood. The traditional geological plays of the North Sea are typical Phase 3 opportunities. 5

Phase 4 (depleting) After years of production from a proven area, opportunities for new exploration and development become restricted. In Phase 4 engineering skills come to the fore, for example, redeveloping old fields using enhanced recovery methods and using innovative production techniques to make small fields economic. Many of the oldest production areas in the world are in this phase of development, including the onshore areas of Sumatra and Java in Indonesia and much of the US. Many of the relatively new opportunities in Russia, Kazakhstan and Azerbaijan would also be in this category but for western oil companies' lack of experience of working there. 6

WHAT ARE THE OPTIONS? During Phase 1, opportunities for direct negotiation with governments may exist. During Phase 2, entry is confined largely to bidding in acreage releases or licensing rounds. During Phase 3, licensing rounds continue and more and more farm-in opportunities (discussed below) come available. In Phase 4, farm-in opportunities dominate with new exploration acreage becoming scarce. Direct purchase of existing fields and of production will also normally become a possibility in Phase 3 and Phase 4 activities. Each of these options has its own special characteristics. 7

Licences and contracts with governments In most countries mineral rights are vested in the state. Oil industry operations can be carried out only under licences or contracts granted by governments. Petroleum agreements with governments take many forms and are usually based on the legislative regime in the country concerned, in combination with direct negotiation of certain terms (see Table 1.1). There are three normal forms of agreement: licences (including leases, permits and concessions); contracts (especially production sharing contracts); a complex amalgam of the above. 8

In all cases operations are carried out under the supervision of the government authorities. The critical economic point for a company to appreciate is that the value of its potential production must be sufficient to provide a rate of return on its investment to justify the substantial risks. In countries with little history of oil and gas exploration and production and those with high geological and commercial risks, the agreement and its tax terms may be negotiable. For example, governments may include incentives, such as tax breaks for marginal fields, to encourage investment. 9

Petroleum agreements with governments 10

Direct negotiation The advantage of direct negotiation of an agreement is that, early on in an exploration phase, a government is particularly keen to see companies come in and exploit any opportunity that it has defined and, with little competition, the company has good control over the terms. The disadvantage is that both the company and government will be unaware of the true risks. The early stages of exploration in numerous oil-rich countries saw inequitable terms negotiated by oil companies with colonial or inexperienced governments such as in Indonesia and, before nationalisation, in the Middle East. Few such opportunities remain in the world except in areas with particularly severe cоnditions (climatic,..). 11

Bidding Once competition for acreage begins then tax terms become fixed for everyone. Acreage is made available in tranches (a licensing round) whereby a government will select an area or areas and divide them into a number of blocks of a certain size. Large blocks are usually made available in relatively unexplored areas while smaller ones are available in proven lower risk areas (such as the North Sea). Companies may also be given the opportunity to nominate acreage they would like to see included in a licensing round. They then make sealed bids for the block or blocks they want after evaluating any available data. These data have been collected by previous licensees in this and adjacent areas and are provided by the government (subject to the terms of the agreement with the oil company which collected them) for review at a cost. 12

Most forms of agreement (licences and production sharing) are awarded on the basis of work commitments comprising a fixed number of wells to be drilled (perhaps to a stipulated depth or target reservoir) and a fixed number of kilometres of seismic data to be acquired; these commitments being accomplished over a fixed period of time (usually three to five years). The agreement may also include cash bonuses to be paid such as bonuses on signature of contract, bonuses for training government employees and sliding scale bonuses at different levels of ultimate production. Where there is competition costs go up. 13

Investment at risk The work commitments are therefore the main considerations when bidding for a block since they are the 'investment at risk'. The aim is generally to minimise the work commitment and all other extraneous payments required by the government while maximising the time over which this commitment is made. In a competitive environment there is little room for negotiation. Of course there are many other considerations to be taken into account in applying for acreage, besides work commitment and, of course, geological potential. These include the ability of the company to manage operations, the oil or gas export route if exploration is successful, the stability of the government, the financing available and the ultimate economic return from the project. The risk inherent in an exploration project is the biggest unknown of all and the importance of understanding risk cannot be stressed too much. Minimising the 'investment at risk' should be the key consideration in bidding and in subsequent negotiations with governments. 14

Farm-ins A farm-in is a way in which a company can acquire acreage from other companies ; in areas in which they are interested but failed to obtain in licensing rounds or by other direct methods. Acquisitions are negotiated on the same basis as with governments - by committing to work. A company that negotiates a farm-in is called a farminee. Conversely, a farm-out gives an opportunity for a company to divest itself of acreage that does not fit its strategy or for a variety of other reasons, discussed below. 15

Farm-ins usually involve a work commitment - rather than a cash payment - by the farminee, such as paying for a well or seismic programme in return for an interest in the licence. Farm-in opportunities usually involve exploration or higher risk appraisal wells, a premium payment (two times the work cost for a percentage interest plus actual sunk costs is a typical standard, but it depends on the quality of the acreage) and sometimes include the operatorship. If there is more than one partner in a licence then farm-ins may be offered by the whole group with the farminee taking a portion of each of their interests in return for payment of outstanding work commitments. Alternatively, farms-ins may be offered by a single company in a group, in which case partnership agreements often include rights to match the terms of a farm-in by current partners. If this option is not exercised it is certainly worth considering why this is so. 16

Reason for farm-in opportunities There are many triggers which might cause a company to decide to farm out a portion of its interest in an exploration area which in themselves point to the quality of the acreage that may be available: the company or group wants to get rid of what it perceives to be a poor asset, perhaps because it does not form part of its overall strategy but more likely because it is high risk. This is the most common reason for farm-in opportunities; the company or group wants to raise money to pay for work commitments or to drill wells that are not commitments. It may want to spread the risk or may simply be a shoestring outfit that genuinely cannot raise capital; 17

the company may want to relinquish operatorship of a licence because it believes the challenge to be beyond its in-house expertise. Small companies, for example, may be happy to operate seismic programmes but not to drill wells, particularly offshore, because of a lack of qualified ersonnel; the company may want a second opinion - comfort that its venture is indeed a good one. In this case a smaller company will attempt to farm out to a larger one and the operatorship will be an issue; many small companies use farm-outs as their overall company strategy. They acquire acreage cheaply, usually in areas that are not mainstream, attempt to add value to the acreage by doing some basic technical work and acquiring some seismic data, and then farm it out to pay for the big cost items such as drilling. 18

Purchase of exploration packages Companies sell assets, usually in a packaged deal, for many different reasons. Obviously some are identical to those for farm-ins but sales may also be required for more deep-seated financial reasons and it remains important to understand first why these assets are available. The triggers for a company to sell are: the acreage is not part of the strategy - begging the question of why was it acquired in the first place; an asset has entered a new phase of activity, such as appraisal or development, which is not a part of a company's strategy or suitable finance is not available; 19

there is a demand for cash for another venture that takes priority – perhaps a new field development; change of focus - the company initially acquired the acreage on the basis of certain criteria which have since changed because of other circumstances such as change of management, oil price declines or competing interests; the whole company is up for sale, it is leaving the exploration industry; the exploration acreage has poor perceived prospectivity. 20

Purchase of production If a company has spare capital and low production rates, perhaps with interests in the downstream oil industry, a common approach to making a more self-sufficient company is to purchase producing oil or gas. It has often been said that purchasing production is cheaper than actually exploring for new oil, because of the reduced risk, but this purely depends on the company. If it has a good focused exploration department with a well thought out strategy then the risks of exploration failure should balance the premium that needs to be paid on the producing interests. 21

Both the buyer and seller need to be happy with the deal and, since oil in the ground is easier to value once reserves are fairly well-known and facilities are all in place, there must be a strong reason for paying that premium. For this reason purchase of production is usually carried out only under special circumstances such as the need for a supply to refineries or for tax and other fiscal reasons. A good example was the sale by BP of production units in the North Sea Forties field. This was a tax-driven sale of assets that were worth more to the buyer than the seller as taxable income could be used to offset exploration costs elsewhere. BP, with its high North Sea production levels, was already using its full tax concession. 22

Purchase of complete portfolios Occasionally a company will radically change direction and put all its assets in an area up for sale. This happened several times in the North Sea during the mid- and late 1980s after the oil price decline led many of the multifunctional companies (publishers, builders and others) which had invested in exploration and production departments during the days of high oil prices to decide to get out. The selling company will normally set up a data room with or without the help of consultants where interested parties may inspect the well and seismic data specific to each area available. 23

Usually such sales are highly sought after, at least at the evaluation stage, because some good assets may be included among the dross and the opportunity to review data over areas that may adjoin your own is always welcomed. Decisions on what to purchase depend on prospectivity, remaining reserves and production rates and relative development and production costs. The challenge is to find the good assets, value them and to bid correctly. Almost invariably after a competitive sale there is a feeling that the successful purchaser has over-bid to acquire the asset, with the technical and economic evaluation taking second place to so-called intuition. 24

Asset swaps Asset swaps occur when two companies, usually holding certain exploration assets, rarely production assets, decide that each other's block would be of more worth to their own portfolio. A typical case might be where a discovery well locates a field that partly underlies a neighbouring licence in which the operator of the discovery does not have an interest. To avoid the complexities of unitising the field (i.e. subdividing the recoverable oil by technical evaluation of the amounts lying in each area), which is fraught with uncertainty, it may be swapped for another undeveloped discovery the operator may hold in another area which may be of more use to the other party. In practice the company wishing to acquire a licence or licences will offer an unwanted asset that it believes the other may want in return. If the other company agrees there will be bargaining - the approached company is in a stronger bargaining position - and, if consummated, the swap should automatically increase the value of the swapped assets for both parties because they fit better into the overall strategy of each. An exchange is thus an excellent way of increasing the worth of assets without actually spending any capital. The problem is a matter of finding the right match. 25

Asset swaps are becoming much more common and are increasingly being completed in the North Sea as the area becomes more mature, good acreage is hard to find and companies have fixed views on their future strategy. The beauty of swapping assets is that no money changes hands, pre-emption rights are avoided and, if the exchange is equitable, both companies see an increase in the value of their assets. It is up to the technical staff to come up with the perfect match. As basins mature throughout the world, asset swaps are set to become more common outside the UK with inter-country as well as intra-country swaps. Unfortunately, besides a possible slight improvement in technical know-how being applied to some of the swapped assets, for example Statoil's swapped acquisition of part of the Hibernia Field offshore Newfoundland, there is no real improvement in their underlying value - there may be no more oil resulting from the blocks because of the swap. 26

Company takeovers and mergers The purpose of a company takeover is more complex than simply a desire to acquire additional exploration and production acreage as part of an overall acquisition strategy. However, in practice, if the two companies involved are solely exploration and production companies within the oil industry, the increase in asset base is essentially the only positive outcome for a company embarking on a takeover strategy - apart from short-term financial machinations. Similarly, the merger of two companies, although designed to enhance the whole by capitalising on the strengths of both, in practice merely leads to a larger company with higher overheads. 27

Unless considerable rationalisation occurs after the merger or takeover, which inevitably means personnel redundancies, among other things, the takeover or merger scenario does nothing for a company's exploration and production assets. The acquisitive company may have adopted such a strategy to add value to its and the acquired company's assets, but it is the people in the company that the value of these assets really depends upon. Since takeovers and mergers lead to a reduction in total staff, a takeover strategy is not good for the bottom line - the discovery and production of oil. Nevertheless, takeovers and mergers do occur with some regularity in the oil industry, normally after periods of rapidly changing, particularly reducing, oil prices when investment capital is also fluctuating in availability. 28

Conclusion A company can adopt one or more of five basic strategies. These are summarised as: no speciality, geographical speciality, technological speciality, low cost speciality, risk speciality. There are many subsets of these strategies which should match the specific strengths of the company adopting them. 29

Company strategy is dependent not only on type but also on timing. There are four phases in the exploration and development of a new oil or gas province. These are summarised as: original venture, competitive, mature, depleting. 30

A number of options are open to an oil or gas company to acquire reserves. They include: direct negotiation with governments, farm-ins, purchase of exploration assets, purchase of production, company takeovers/mergers. These vary in quality depending on the timing and the reason for the availability of the asset. 31