Mikal E. Belicove, member of the Board of Trustees at Keystone College. Pa.
Most people would never consider buying a car without a clean title or a house without title insurance, but in the 350 billion dollar a year U.S. oil and gas industry, buyers and sellers routinely sign off on contracts that contain title defects representing tens of millions of dollars. The assumption is that the net gains and losses in acreage will even out. But according to new research out of the University of Utah, that assumption is as costly as it is wrong.
The November 2014 study from the David Eccles School of Business at The University of Utah — Title Clean-Up Analysis (by K. Bown, M. Dixon, J. Ingebritson and K. Rodriguez) — analyzed approximately 5,600 leases and deeds from two fairly large lease deals with dozens of predecessors. The four-person research team expected the data to show that the net gains and losses in acreage from title defects would even out. What they discovered instead is that title defects are two times more likely to result in a net loss than in a net gain in acreage. In their analysis of 145 additional public transactions, the team revealed a lack of organization, transparency, and accountability across the industry. Of those 145 transactions, 48 listed both the original announced price and the price at closing. Of those 48, one-half (23) had a different price at closing.
Deals in which a company performed customary maintenance of land records, title defects resulted in a net loss in acreage of 19.9 percent, according to the study. In the 350 billion dollar a year U.S. oil and gas industry, that represents nearly $70 billion annually.
Good for the seller, right? Well, not always. Savvy buyers anticipate these potential losses and use them to negotiate price reductions. Sellers, also aware of the rampant title defects in oil and gas leases, reluctantly accept millions of dollars less in exchange for a release from any future obligations.
“Whether you’re buying or selling oil and gas leases, it pays to be the smartest one in the room,” says Tom Agnew, CEO & Co-founder of EquityMetrix — a Dallas, Texas-based firm specializing in land data management and revenue recovery, and the firm that sponsored the study. When the time comes to close a deal, however, buyers and sellers often rely on conjecture rather than fact regarding the accuracy of the documentation.
Case in point. In late-December of 2014, Chesapeake Energy Corp. (NYSE: CHK) sold its oil and gas assets in West Virginia and southwest Pennsylvania to Southwestern Energy Co. (NYSE: SWN) for $4.975 billion, $400 million less than the $5.375 billion deal announced in October. According to Chesapeake, the $400 million adjustment was to settle various matters, including Southwestern’s waiver of any future claims related to title defects.
Transactions like this show vetting a lease is incredibly difficult. Although the Statute of Frauds requires states and counties document Mineral Rights (including oil and gas rights), documentation varies according to state and county. The required legal documentation is often incredibly complex, containing not only the names of the owners and a legal description of the property, but also the number of wells allowed, depth restrictions, Pugh clauses, preferential rights, types of minerals the Lessee is allowed to recover, descriptions of easements and roads to and from wells, and so forth.
Further complicating the task of vetting oil and gas leases is the fact that leases and rights can be bought, sold, transferred in part or whole, or broken down and assembled into infinite combinations. With each new transaction, the lease and its rights can be split or combined. The chain of title can reach back centuries, and documentation is often duplicated or misplaced.
“Those involved in acquisitions and divestitures rarely have the time, technology, and personnel to track down title defects,” said Agnew. Traditional lease brokers and consulting firms can remove some of this uncertainty from oil and gas lease deals, but as the University of Utah study showed, even after customary due diligence by a reputable firm, a company still stands to lose a substantial amount of net acreage due to title defects. In an average transaction of $100 million, a relatively small loss of 4.6 percent represents $4.6 million.
“A company should be able to spend a fraction of what it stands to lose from title defects to have everything properly vetted prior to closing,” says Agnew, whose firm employs a team of 100 professionals who all follow a disciplined process that centers on deep proprietary analytics.
Agnew tells a story of a client who could have avoided a bad case of buyer’s remorse. The buyer purchased what it had thought included a $6 million asset. The seller had given the buyer a certain amount of time to discover any title defects. After the time expired, the buyer discovered that the seller never owned the asset; the lease contract included a depth restriction that rendered the asset worthless. Too late. The buyer had to eat the $6 million loss.
“Had the buyer come to us first,” Agnew says, “they could have found the defect within the due diligence period and $6 million off the price.”
Many companies reluctant to spend a small percentage to clean up their records would be wise to consider the significantly higher costs of not doing so.
About The Author: Mikal E. Belicove is an Entrepreneur Magazine columnist and contributing writer and a member of the Board of Trustees at Keystone College (La Plume, Pa.). For more information, visit www.MikalBelicove.com.