PETROLEUM

ECONOMICS
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Oil and Gas Property Acquisition

WAllACE W. WILSON CONTINENTAL ILLINOIS NATIONAL BANK & TRUST CO.

MEMBER AIME CHICAGO, ILL.

Abstract It is interesting here to note that the economic circum-

stances which create a supply of properties for sale have
During the last 10 years, there has been increasing brought about a demand for properties to buy.
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 The ABC Transaction
and the increasing costs of replacing reserves through ex-
ploration and development. Procedures are outlined where- The critical ingredient is a feasible method of financing
by this activity may be organized on a more systematic - not only to supply the substantial amounts of money
basis by operators who contemplate this approach to ex- required, but also one which does not in itself create ad-
pansion and growth. Methods of financing the purchase of ditional tax problems for the seller or the buyer. The
properties are reviewed, with emphasis placed on current approach which has been used in nearly all transacti?ns
problems created by the increased demand for desirable of any size is the so-called ABC or reserved productI~n
properties. 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
Introduction
is provided by the sale of a production payment to a third
During the last 10 years, the oil industry has witnessed party, with outside financing from banks or other .sources.
accelerated activity in buying and selling producing prop- The loan is retired out of income to the productIOn pay-
erties, transactions which range in size from individual ment, which does not represent taxable income to the
leases to the assets of entire companies. There are those purchas~r. The advantages of this procedure to the buyer,

who view this with alarm, believing it to be a trend toward compared with a straight cash purchase, often are v~ry
the elimination of the independent operator. Others see substantial. In a straight cash deal, the buyer must retIre
it as merely a logical outgrowth of current economic con- the entire investment out of after-tax income; with ABC
ditions and the realities of our present tax laws. financing, he has a much smaller net investment and no
tax liability for the income which finances most of the
There is little need to underscore the current depressed
total consideration. His average return is increased cor-
status of the petroleum industry and the many problems
respondingly, and the over-all rate of return or "leverage"
this has created. World-wide imbalance of supply and de-
usually is several times greater. For a stated average return
mand during a period of increasing costs has sharply re-
on investment, the availability of ABC financing usually
duced cash flow and profits. Consolidation of operating
results in a substantially higher total consideration to the
units and elimination of less profitable investments have
seller than the buyer could afford to pay with a straight
occurred throughout most companies, large and small.
cash purchase. This, of course, has not escaped the atten-
It is an economic fact of life that the independent pro- tion of operators who have properties for sale. Asking
ducer can neither expand nor maintain his competitive prices for desirable production have increased sharply,
position unless he offsets most of his income-tax liability especially during the last five years. Most sellers now ask
with profitable drilling. Many independents now find this for - and receive - prices which include substantial
difficult or impossible to accomplish because of reduced values for undeveloped reserves, future waterflood possibil-
cash flow resulting from low allowables. The alternatives ities and other "plus" factors which would not have been
are gradual liquidation or a capital gain sale of assets. On considered previously. Increased prices also are indicative
the other hand, many petroleum economists are satisfied of the fact that the demand for high-quality production now
that reserves in the ground can be replaced at lower in- exceeds the available supply, with more companies and
cremental cost by outright purchase than by exploratory groups competing. A trend toward competitive bidding has
drilling. Whether this generally is true is not so important started which seems certain to be followed hereafter in the
as the fact that many companies are acting on this premise. larger deals.
Original manuscript rectived in Society of Petroleum Engineers office Many companies actively seeking production to buy
.Jan. 14, 1961. Revised manuscript received April 14. 1961. Paper pr~­ have created special departments whose sole purpose is to
,ented at 9lst Annual Meeting of AIME. Feb. 26-March 2. 1961, In
St. Louis. locate and negotiate for properties. Some also provide
SPE 3
JUNE, 1961 527
special training to their cngineers, geologists and landmen, with other operators or the acquisition of other interests
in order that they can recognize any special situation to consolidate ownership. Analysis of future secondary
which might result in a profitable acquisition. A number recovery possibilities will disclose where properties or
of new companies and groups of investors have been or- interests might be acquired to facilitate those operations
ganized for the specific purpose of achieving growth or to simplify the formation of units.
through property acquisition, and some of them have been After a decision has been made to attempt to buy pro-
remarkably successful. The seller of choice production no duction in an area, a preliminary analysis should be made
longer needs to seek out a buyer; now it is the buyer who of the producing fields to determine which would be of
must find the deal before some other group is aware of its specific interest. A number of factors will need to be con-
existence. sidered, including: (1) average reserves, allowable rates,
It seems appropriate here to ask what should be the market outlets, possibilities for additional development or
basic objectives of any aggressive program of property secondary recovery, and other factors which will affect
acquisition. Other than the obvious profit motive, there future income; (2) special operating problems and the ex-
appear to be only two logical goals which would justify this perience of present manpower to handle them effectively;
activity - long-range growth and reduction of incremental and (3) the extent of ownership by independents. Most of
costs. There seems to be little point, for example, for a this information can be determined by reviewing ownership
producer whose entire operations are in the Permian Basin maps, allowable schedules, scout data, commercially avail-
to spend money and time attempting to buy small interests able well logs and production records, and published
in Illinois or California. Similarly, a small company which reference data.
has neither adequate working capital nor a large operating There is no assurance that any of the analytical work
staff should not attempt to compete for a $100 million just outlined will turn up useful leads about properties
deal. A company whose current production averages 25 which can be purchased. It always is possible to approach
B/D/well at an average direct lifting cost of 40¢/gross bbl individual operators with an offer to buy for a stipulated
should not dilute its averages by acquiring high-cost strip- price per unit of reserves, based on a report by a mutually
per production unless there is some compelling reason for acceptable consultant and further subject to financing. This
doing so. These examples are not uncommon, and they em- approach usually is unsatisfactory because the offer is not
phasize the point that some companies do not have a long- definite enough to secure an option for enough time to
range program to which their acquisition program is work out the transaction. Usually it will be more ad-
geared. To many prospective purchasers the only consid- vantageous to find out, in advance of any contact, whether
eration is whether a deal can be financed, not whether it any of the operators in the field might be receptive to an
fits in with or improves the average quality of their cur- offer.
rent operations. Aggressive, widespread activity in search of
production to buy is a time-consuming and expensive opera- Factors Causing Forced Sales
tion, requiring specialized engineering and legal talent. It
A review of a large number of oil and gas property
also has the effect of driving up prices for desirable produc-
transactions which have occurred during the last five years
tion, often beyond the point where a reasonable profit can
discloses a limited number of circumstances, or combina-
be realized.
tions of circumstances, which induced the owners to sell.
Brief summaries follow.
Information Required for Program Analysis
1. Estate Problems--The death of a principal created
There are many practical difficulties in designing an estate tax liabilities requiring partial or total liquidation.
effective program of property acquisition, but a logical 2. Retirement-The owner was of advanced age and sold
starting point is a complete analysis of the company's out to create an estate for his heirs.
current operations. This study should provide at least the 3. Dispute Between Co-owners-This has resulted in
following information for each operating district or area. dissolution of partnerships or small corporations, which
1. Current utilization of present administrative, technical resulted in liquidation.
and field personnel to determine where and to what extent 4. Investor Groups-Groups of investors made capital
additional operations can be added for maximum efficiency. gains sales after their properties were fully developed or
2. Proved developed reserves and direct operating and paid out to avoid high individual income taxes on their
administrative expenses, both current and future. production.
3. A tabulation of uneconomic or marginal properties, 5. Excessive Overhead - Stockholders or co-owners
their potential value for secondary recovery operation and forced a sale of assets to displace high cost or ineffective
recommendations for their retention or disposal. management.
4. Available undeveloped acreage, both proved and 6. Debt Liquidation-Properties were sold to provide
wildcat, and the cost and expected timing of future drilling. funds to payoff debts.
5. A list of joint-interest leases, including the various 7. Consolidation-Properties isolated from major opera-
owners of the working interest and an analysis of the ad- tions, or operated minority interests, were sold to reduce
ditional cost of profit resulting from diversified ownership. operating or overhead expense.
A survey of this type will disclose areas where opera- 8. Working Capital-Owner sold some properties to
tions should be expanded or curtailed, along with other generate funds needed for the development of others, or
valuable information on operating efficiency, quality and to provide working capital for other purposes.
longevity of reserves, and future development possibilities. 9. Inadequate Market-Company was unable to develop
Management then can pinpoint areas where additional adequate market through trade-outs of crude or did not
production should be acquired for maximum effective use want to wait for future gas outlet.
of manpower and reduction of average costs. Detailed in- 10. Loss of Growth Potential-Company was in gradual
formation on marginal operations, splinter interests and liquidation due to inactive management, reduced cash flow,
isolated properties will suggest possibilities for trade-outs inadequate financing, or other circumstances.

528 JOt:RXAL OF PETROLEU~l TECH~OLOGY

 11. No Interest in Secondary Recovery Operations- assumes no other liability. His share of the total income
Corripany had properties susceptible to water flooding, but is offset substantially by expenses, and he normally pays
lacked technical personnel, capital, or interest in developing little or no income tax during the life of the production
them. payment. C has purchased the production payment for
12. Impact oj Regulations-Partial or total liquidation $1,200,000 and receives 85 per cent of the runs until this
followed adverse ruling of state or Federal regulatory amount is recouped with interest, solely out of the produc-
agency. Company sold properties to avoid future regulatory tion from the property. If C is a tax-exempt charity, the
problems. cost-depletion allowances are unimportant, and a profit
13. Tax Losses-Company with a substantial tax loss, equal to the "spread" between the effective and the bank
which it could not take advantage of in future operations, interest rates is realized. In the case of a taxable entity,
sold out to another company which could give some effect however, the normal method of accounting for cost deple-
to it in the purchase price. tion and the write-off of interest expense to the lender can
create losses during part of the life of a production pay-
Knowledge of any of these circumstances, or combina- ment. These losses then may be used to offset other in-
tions of circumstances, may help pave the way to an ad- come, a feature which often makes ownership of produc-
vantageous purchase in an area of interest. tion payments very attractive.
It always is desirable to be able to make an offer to There are many variations of the transaction just out-
purchase on a basis which is within the limits of available lined, depending in each case upon the applicable circum-
financing. The cost of a complete engineering report may stances. There is the ACB approach, for example, wherein
not justify securing a firm loan commitment in advance of A sells to C for cash, and C conveys to B after reserving
making an offer. Sometimes this problem can be minimized the production payment. He then uses the retained produc-
through the use of a preliminary report prepared by the tion payment as security to borrow the balance of the
engineers of the purchasing company. In most illiitances, consideration paid to A. This arrangement is very useful
sufficient data are available from published information, where it is desirable to aggregate a number of individual
records of regulatory agencies and other sources to make interests under one conveyance.
reasonably complete evaluations. With a report of this
type, the bank can indicate the probable range of financing Most commercial banks which engage in oil and gas
which can be expected, subject to confirmation by a com- financing are prepared to make loans secured by mortgages
plete report at a later date. on production payments and assignments of runs dedicated
to their liquidation. There are significant differences be-
Assuming that a transaction develops as a result of tween this type of transaction and conventional borrowing,
negotiations, the final step is to arrange for a firm loan
however, since in the former case the bank must look
commitment. It is assumed that the seller wants a com- solely to dedicated runs for repayment. For this reason,
plete cash settlement, although many purchases are ar-
the bank must be completely satisfied with the capacity of
ranged with partial payment in stock, reversionary rights
the property to produce the necessary income and with the
and other non-cash considerations. It also is assumed that ability of the operator to manage the property effectively.
the buyer wishes to acquire the proJ:'lerty through the re- The conveyance from A to B and the assignment of the
served production payment (ABC) method of financing.
production payment to C must provide that B will operate
the property in accordance with sound oilfield practice and
Example ABC Transaction will take such steps as are reasonably necessary to protect
As a typical ABC transaction, suppose that A, the seller, the rights of C. In the event of willful neglect or malprac-
has a property which he wishes to sell to B for a total con- tice, C or his assigns has the right to take over and operate
sideration of $1,500,000. A conveys the property to B for the property and to be reimbursed out of all of the runs for
$300,000 cash, but he reserves for himself a production his expenses, with interest.
payment of $1,200,000 plus an amount equal to interest Bank policies with respect to production payment loans
at 6Y<1 per cent computed monthly on the outstanding are about the same as for other types of oil and gas credit.
balance, payable out of 85 per cent of the runs from the It must be recognized, however, that the collateral value
property, free and clear of all costs and taxes. Simultane- of a production payment is limited to that which can be
ously with the conveyance to B, A sells the production pay- ascribed to the runs assigned. The bank will assure itself
ment to C for $1,200,000, who finances the purchase with that the loan can be retired out of the assignment within
a bank loan of $1,200,000 plus interest at 6 per cent, se- a reasonable period of time and that the residual value after
cured by a mortgage on the production payment and the payout is adequate incentive to assure competent operation.
assignment of runs. At this point, A has divested himself Payouts cause a serious problem because of generally low
of his entire interest in the property and has $1,500,000 allowables. Many transactions which were financed on the
in cash, out of which he pays the applicable capital gains basis of allowables in effect five years ago will have payouts
tax. B owns the property, subject to the terms of the pro- much longer than desirable. Forecasts of future allow abies
duction payment. During the life of the production payment based on gradual improvement in demand offer some en-
B receives 15 per cent of the runs, out of which he pays couragement, without which it would be difficult to justify
all of the operating costs. C owns the production payment, a number of transactions made in the last two years.
for which he paid $1,200,000, and will receive a maximum The degree of leverage, or average annual return, limits
of that amount plus the interest factor. After liquidation the amount of equity capital which a company can afford
of the production payment, B owns the entire residue of to invest, especially when there is no substantial recoupment
the property. for periods of five years or more. As a result, pressure often
The entire transaction, of course, is worked out care- is exerted on banks to extend themselves beyond a com-
fully in advance. The dedication of runs is based on esti- fortable position, based on developed reserves and current
mates of future revenue and expenses and is designed to income. Undeveloped secondary reserves, to which pur-
cover substantially all direct costs of operation during the chase prices commonly have been assigned in recent
payout period. B covenants to develop and operate the transactions, present an additional complication. A sound
property in a prudent and workmanlike manner, but he bank loan should be supported by income from which it

JUNE, 1961 529

is to be repaid and by marketable collateral which can be all of their oil and gas properties and, also, have created
sold in the event of default. Undeveloped secondary re- a demand for such properties by others. The widespread
serves do not fit in either category. In effect, if a bank use of production payment financing and increased demand
were to assign collateral value to such reserves it merely for quality production have driven up prices substantially.
is reducing its coverage on the balance of the security. Many companies are increasing their efforts to acquire
producing properties, but some appear to have no syste-
Long-Term Financing matic program for this activity. A desirable plan would
be to purchase only those properties which provide long-
Some transactions which include long-lived oil and gas range growth and reduce average incremental costs. To
reserves require financing for longer terms than banks can design such a program, it first is necessary to make a com-
provide. In cases of this type, the production payment loan plete analysis of the company's current operations and
may be divided between a bank and sources of long-term then to seek out additional properties which provide the
financing such as insurance companies, pension trusts, or desired objectives. Most transactions of this type are
endowment funds. This usually is accomplished by selling financed by the reserved production payment or ABC
two production payments - one payable out of most of method, which has advantages both to the buyer and the
the assignment, and the other designed essentially to pay seller. Adequate financing of this type is available from
interest only until the first is retired and, thereafter, out of commercial banks and from various sources of long-term
the total assignment. Most long-term lending institutions
require some additional consideration in the form of higher
funds. ***
interest than bank rates, a share of the remaining net
profits, or both. An interesting form of additional consid-
eration which some long-term lenders require is a deferred
interest factor. For example, interest in addition to the WALLACE W. WILSON is vice-presi-
normal rate on the outstanding balance of their loan wiIl be dent in the Oil and Public Utilities
computed monthly at 2 or 3 per cent, and this amount will Div. of Continental Illinois National
accrue. At the payout of the loan, the total of this accrued Bank, Chicago. Before joining the
interest is repaid out of some pre-arranged percentage of bank as a petroleum engineer in
the runs. March, 1956, he was chief of reserves
and evaluations and chief reservoir en-
gineer with Continental Oil Co. From
Summary
1947 to 1950, he was assistant pro-
Current economic conditions in the petroleum industry fessor of petroleum engineering at
have made it desirable for some operators to sell part or The U. of Texas.

530 JOURNAL OF PETROLEUM TECHNOLOGY