M&As versus JVs

Choosing the right strategy for your company

Fabio Solimene, LL.M, ENI Saipem S.p.A., Milan

Oil and Gas transactions play a very important role in the general takeovers landscape. According to a recent study from PLS Inc. and Derrick Petroleum Services, global M&A oil and gas upstream deal activity for the second quarter of 2013 totalled $24.9 billion in 141 separate transactions with deal values disclosed. This is up 19% if compared to the first quarter of the same year (which totalled $20.9 billion in 117 deals) and down 12% in comparison with the second quarter of 2012 (which totalled $28.4 billion in 173 deals).

In the first-half of 2013, the deal value has been equal to $45.8 billion. According to the above report, "This represents the lowest six-month period since at least 2007 while the first-half 2013 deal count (258 deals) is second only to the first half of 2009 (184 deals for $65 billion)."

The setback can be attributed to the general economic crisis and, in particular, to the European debt crisis which created a general slowdown in European economies and generated fears that weakness could infect other Western countries, dampening energy demand and creating, according to a Deloitte M&A study in midyear 2013, "uncertainty that affects everyone who is looking to commit large amounts of money to M&A activity."

There is no doubt that the need to reduce costs and maximize profits constitutes a main goal of any takeover. However, further drivers specifically related to oil and gas transitions may include the following:

the exploitation of new opportunities that would not be possible without merging with a company operating at a certain level of the chain (e.g. extraction) or in a certain geographical market (e.g. emerging markets);
the compensation of individual reciprocal strengths and weaknesses;
the will to share the economic risks of exploitation of oil assets;
the acquisition of new intellectual and human capital, know-how and new technologies, without bearing the relevant costs; and
the increase of the company's share market value.

It has to be noted that M&As in the oil and gas sector also bring high perils related to the risks of breach of competition rules. In particular, such transitions may result in:

the elimination or drastic reduction of competition;
the attribution of a substantial market power to the merged entity allowing it to raise oil prices, by reducing output unilaterally; and
the tendency of the remaining market players to (voluntarily or involuntarily) coordinate their pricing and output decisions in order to survive.

For these reasons, M&As in the petroleum sector are closely scrutinized by the various national and international competition authorities which may take steps in order to resize the relevant outcomes in term of restraint to competition. A famous case is the Standard Oil Co. of New Jersey v. United States where the US Supreme Court, having found the company guilty of having de facto monopolized the petroleum industry through a long convoluted series of anti-competitive actions – so that, by 1906 it controlled more than 75 % of US oil production – ordered that Standard Oil be divided into several competing firms.

In addition to the above, it should be noted that a large percentage of takeovers in the oil sector fail in a relatively short period of time due to several reasons, such as:

the acquiring company overpays the acquired asset in the urge for expansion, without doing a complete due diligence activity;
the merging companies fail to integrate with each other due to a number of factors, such as the lack of flexibility and the inefficiency as to the management of integration issues; and
the managers of the merging companies put their personal interest – mostly of an economic nature – before the interests of their companies.

Joint ventures in the oil and gas sector are often in the form of joint operating agreements (JOAs), which may be deemed as having the same role of partnership agreements or memoranda and articles of association in a company but with the advantage of keeping the relevant shareholders (in this case, the co-venturers) formally separated and autonomous from each other. However JOAs represent a form of JVs which is already advanced whereas before that stage the parties may decide – or in some cases be forced – to enter into some other specifically-designed types of JV agreements such as:

Area of Mutual Interest (AMI) Agreements, used in the oil and gas industry by independent companies intending to jointly undertake projects in a particular phase of field development within a designated acreage – the so called area of mutual interest or AMI – with the aim identify the AMI and provide the rules to be applied within the area. It has to be underlined that by entering into this type of agreements the parties do not commit themselves to a specific program of operations.
Joint Bidding (Application) Agreements, with which the parties aim at making a joint application for licenses in order to increase the chance of success and set the provisions regarding the respective rights and obligations in relation to such application.
Joint Study Agreements, i.e. agreements by which operators decide to share their individual studies or cooperate in undertaking new ones.
Joint Planning Agreements, which are pre-unitization agreements where the parties agree joint rules for the development of the operation.
Joint Data Agreements, setting the rules regarding the exchange and acquisition of data between the co-venturers.
Joint Drilling Agreements, which can be further divided into: (i) Joint Well Agreements, executed in case two oil companies, which have carried out exploration and appraisal work on two adjacent blocks, realize that there may be a reservoir underlining both blocks and decide that the further activities shall be conducted on a co-operative basis and that the drilling shall be carried out by one of them (generally the operator of the block where the well is located) and that the relevant costs will be shared between them; (ii) Third Party Well Logging Agreements, used when two oil companies - one of which is still at the exploration phase - work on two blocks, one of which underlines the other, and decide that one party could provide the other information from its well, using the other company's logging equipment.
Joint Selling Agreements, whereby the parties agree to jointly sell the products of their activities.

Undoubtedly, all the above forms of JVs present a set of advantages rendering them particularly attractive. For companies may profit from JVs in order to solve the following issues:

The costs for financing large oil and gas projects might be so high that a single company (even a major one) may not in a position to bear them alone.
Large-scale exploration and production projects carry high risks (inter alia of political nature), which the venturers may want to share in order to avoid full exposure.
The joining of assets may allow the JV to develop a market leading position.
JV agreements usually contain termination and exit clauses allowing the parties split the JV upon occurrence of some triggering events, such as in case of: (i) deadlock (i.e. the impasse created in case of disagreement between the venturers); (ii) breach of the JV agreement by one of the parties (e.g. in case of default of one of the co-venturers); and (iii) change of control (i.e. in case the legal entity controlling a venturer changes and other venturers do not want continue the JV with the new subject).

Also JVs, like M&As, can raise competition concerns and can expose the co-venturers to both criminal sanctions and civil damages. This is particularly true as to:

Joint Bidding (Application) Agreements as they may directly affect the competition balances in the bidding procedures (see for e.g. the case U.S. v. Gunnison Energy Corporation);
Area of Mutual Interest (AMI) Agreements, as they usually contain clauses allowing the parties to bid for assets in the AMI only through the consortium.
Joint Selling Agreements, as they could: (i) facilitate co-ordination of behaviors of the parties, also through the exchange of sensitive information; (ii) affect price competition due to the fact that the parties could agree on the prices for the products and services to be sold; (iii) limit the range of products or services that the parties can offer; and (iv) result in a exclusion of smaller players following the high power acquired by the selling group (see for e.g. the so called GFU case).

An obvious observation is that, when companies do not (or cannot) engage in M&As – e.g., when a company decides to undertake the entirety of the oil project and deal directly with the resource holder – but is willing to share the activities related to the exploration and/or production of oil and gas (or any other activity related to their businesses), there is no other choice than entering into an ad hoc JV agreement, specifically designed for the industry.

Moreover, from a general standpoint, it is easy to note that the two macroscopic differences between M&As and JVs are to be found in the level and the time of the parties' commitment.

As a consequence, the fact that M&As are generally perceived as more effective than JVs is counterbalanced by the fact that a wrong merger or a wrong acquisition is more likely to create higher losses – in particular, in terms of economic outcome – than a wrong JV. This aspects, combined with the fact that, according to recent studies, the success of mergers over time remains particularly low, should have an important impact in the choice between M&As and JVs.

Given the above, we can say that, when dealing with M&As and JVs in the oil industry, a number of factors should to be taken into consideration:

JVs may be the only way to operate in a certain state, e.g. when host governments prefer (or impose) that international oil companies operate by means of a JV with the national oil company.
An acquisition may not be feasible due to the particular structure of the desired target assets which may be hard to disentangle from non-desired ones. In these cases, JVs are the only way to benefit of such assets.
Oil and gas assets are generally costly to operate and require specific skills and expertise the acquiring party may not dispose of. In this case, a JV would allow a company to exploit the sought assets without having to incur in the relevant costs of acquisition and exploitation.
An M&A transaction would necessarily involve the acquisition of the target's employees. However, in some cases, the process of integration between the employees of the acquiring company and those of the target may not be easy due to cultural differences between the two (in particular when the companies are located in different countries). In JVs, instead, employees remain part of their company and do not have to forcibly integrate.
M&As in the petroleum industry may carry a certain level of difficulty as to the assessment of target's value when: (i) the acquiring company does not operate in the industry (e.g. in conglomerate mergers); or (ii) does not have enough information about the target company or its assets (e.g. when the target is located in a country where access to information is not easy). This issue loses sensible strength in JVs since the co-venturers do not acquire any liability from each other but only share liabilities related to the JV.
In some countries, foreign acquisitions of oil assets are completely forbidden or too strictly regulated so that a JV may be the only way to enter the market.

As shown above, when dealing with takeovers in the oil and gas industry, the players should take into consideration a number of fundamental factors to guide their decision as to which form of deal to engage in. Which factor prevails will depend largely on the specific kind of transaction and on contingent factors. It is the role of the respective counsels to highlight and explain such factors to their clients in order for them to reach a decision.

About the author

Fabio Solimene is an Italian admitted lawyer and trained US mediator currently employed as legal counsel at ENI Saipem S.p.A. where he is part of the Overseas Litigation Department. He specializes in international arbitration and mediation, commercial litigation and business law, including mergers and acquisitions and international commercial transactions, with a particular emphasis on oil and gas-related matters. Solimene holds an LL.M. in oil and gas law gained at the University of Reading (UK).