"You have a great chance here, but bear in mind, you can lose it all if you're not careful…This is…the way that this works."

– Daniel Plainview in There Will Be Blood

The Oscar-winning There Will Be Blood portrays the often brutal frontiers of the early oil industry in the U.S. The protagonist is Daniel Plainview, a loathsome but financially successful prospector. Although the story is fiction, the unfortunate reality is that individuals in the energy industry today can be just as ruthless as those portrayed in the film.

Often, risks in the oil patch are overlooked or ignored in favor of potentially

"hitting the big one." A vigorous due diligence program aids in identifying and minimizing risks before an investment is made. Sometimes a bad deal can be spotted before due diligence even begins. Investors should be particularly wary of unsolicited or "limited" opportunities, and promises of extraordinary returns.

Due diligence allows buyers and sellers to better understand promoters, managers and staff; deal valuation; pre-closing steps; post-closing expectations; and when to walk away. The fundamentals can be categorized as reputational, organizational, environmental and technical.

The process is dynamic and the areas of inquiry are often interrelated. Ultimately, the amount of due diligence undertaken at any level should be proportionate to the investment and the risks involved. These often change as parties progress towards a definitive agreement.

First off, a prudent investor should define his or her objectives and have an appropriate advisory team in place. Advisors such as engineers, landmen, attorneys and accountants are recommended, but they too should be vetted. Reputable consultants and advisors should acknowledge their limitations.

Early development of a due diligence checklist, with designated responsibilities and timelines, is also advisable. Ultimately, you and your team should be several steps ahead of the other side in the proposed transaction before showing any meaningful expression of interest.

Reputation

Reputational due diligence is simply another way of getting to know your prospective business associates. Although principals would be expected to disclose their professional experiences, these can be omitted, overstated or simply false. A preliminary background check may be sufficient to verify what is being represented; in other instances, a more detailed investigation may be warranted.

You may wish to obtain references, confirm professional affiliations and review public records. This is not always a simple process. For example, investment vehicles in oil and gas often fail, and the underlying entities may have been sued or sought bankruptcy protection. The true track record of key personnel is not always readily apparent. A request for disclosure of all current and recent management or ownership interests may be necessary. Further review could reveal countless skeletons in the closet.

With international transactions and parties, the stakes can be much higher. In the U.S., the Department of the Treasury's Office of Foreign Asset Control (OFAC) oversees and enforces sanctions against certain individuals and countries posing a threat to national security. OFAC maintains a list of "Specially Designated Nationals" including terrorists, drug traffickers and others whose assets are blocked and with whom transactions involving the U.S. are generally prohibited. You may need to cross-check this list to minimize the risk that you are doing business with objectionable characters.

The U.S. Foreign Corrupt Practices Act (FCPA) and other legislation can also present complications, including the threat of criminal liability. In recent years, alleged violations of the FCPA have plagued the energy sector. The newly enacted U.K. Bribery Act is expected to offer even greater challenges to the industry. You may need to require proof of specific anticorruption policies and procedures, and a clean history of compliance.

Ensuring the personal integrity of people involved in your deal is the primary goal of reputational due diligence. Irregularities discovered here should be resolved before proceeding further. No matter how good a deal may look, questionable people can ruin it. And, should your investment turn bad, proof of proper reputational due diligence can even serve as a defense against civil or criminal liability.

Organizational review

Oil and gas investments are often structured through business organizations. Organizational due diligence can verify the existence and good standing of entities in the deal, and ensure necessary approvals are in place.

To avoid opening a Pandora's box of professional fees, an investor can limit the review to confirm what is being represented. For example, leases, probate records, operating agreements, farm-out agreements, division orders, name changes, assignments and countless other matters may affect the interests being offered. Some may be relevant, others completely irrelevant . Once the scope has been narrowed, the inquiry is usually conducted on two fronts: public and internal records.

The public records review should begin with proof of qualifications to do business. These ordinarily include certificates of an entity's existence and good standing, and could include regulatory filings indicating necessary permits and approvals are in place.

Deed records are often key. The importance of title examination in certain oil and gas transactions cannot be overstated. Although it is part of the due diligence process, it is not discussed in any detail here, as it is a topic unto itself. Seek the advice of a professional specializing in title opinions for offerings involving ownership interests in property. Ultimately, how far you cast your dragnet in the public records should be determined by what is being offered and what is discovered elsewhere, particularly in internal records.

The scope of an internal records review is a point of negotiation and can be limited by a number of factors. Planning by all parties can help ease the process and ensure expectations are met. Protected virtual data rooms are becoming the norm in many transactions. You may wish to evaluate for metadata in the documentation you receive. Regardless of how documentation is shared, however, the fundamentals remain largely the same.

In exploratory ventures, meaningful documentation may not exist to support the proposed investment. In these instances, pay particular attention to projections and their underlying assumptions. What geotechnical and other data has been developed and by whom? What arrangements have been made with contractors? Are equipment and infrastructure even available in the area?

Raw data for each prospect should be provided regardless, and should include, at a minimum, prospect name and location; target reservoir and depth; controlled acreage; working and net revenue interests; well costs, including dry hole and completion costs; and estimated reserves.

Remember that despite advances in technology, some opportunities may not be supported by much more than speculation. An investment in undeveloped or underdeveloped areas can prove lucrative, but investors should be particularly cautious.

For existing production, the internal records review should include planned and actual results; accounting policies and procedures; accounts receivable; accounts payable; aging of accounts; and tax positions.

Financing history can also be important, as your money may be allocated in unexpected ways or, worse, you could be unknowingly drawn into a cash-strapped venture with no real means for a return. Off-balance-sheet financing arrangements may not always be disclosed, either out of ignorance or intent to deceive. Specialized oil and gas accountants should be consulted to determine if any financial irregularities exist. Generally accepted accounting principles (GAAP) should be followed.

Operating agreements also may require special attention, since they often provide for preferential rights and maintenance of uniform interests. Your review can reveal who holds those rights, what they are, when they might be exercised and whether they will be exercised.

Environmental concerns

Environmental due diligence should not be discounted in today's political and legal environment. These risks can be significant, and the potential for direct or successor claims can turn an otherwise ordinary investment into an albatross of liability.

In addition to records review, physical examination can provide a better understanding of historical use, the existence, condition and integrity of equipment, and possible disputes. Environmental assessments can detect problems before you invest, offer solutions and, perhaps most important, provide an estimate of remediation costs.

Environmental issues can certainly arise despite due diligence. For example, hydraulic fracturing, currently a beleaguered process, remains widely used. It consumes some 35 billion gallons of water each year in the U.S. alone, according to various reports. In Western states, where water resources are often limited due to drought or other conditions, the process may not be available without securing significant water rights. Investors may wish to determine if those rights have been secured and, if so, by whom.

Another issue related to hydraulic fracturing is waste-fluid disposal. Are disposal wells available nearby, or will trucks be needed to haul fluids long distances? What is the regulatory landscape in your area? Is it stable, or are there outside pressures that could impact future operations?

In addition to water issues, noise, air quality and "line of sight" concerns can result in imposition of measures such as sound barriers and vapor-recovery systems, or can shut down operations entirely. A well-regulated industry is important, but certain actions may not be reasonably anticipated, adding costs. Environmental issues can result in significant adjustments to deal terms or cause a property to be excluded from consideration entirely. In these situations, a premium may be placed on technical due diligence.

Technical issues

If the team behind an opportunity has the technical ability to make the deal work, shortcomings elsewhere may be of less concern. For producing properties, reviewing well or operation files can help verify technical abilities and results. These files could include daily drilling reports; production and completion reports; authorization for expenditures (AFEs); spacing orders; communitization agreements and approvals; unitization agreements and approvals; pooling agreements; and permits.

Even if you have had prior dealings with management and staff behind a deal, you may wish to consider deal-specific "competency" evaluations. These include reviewing contingency planning and ways to minimize cost overruns, all of which can be quite complex. Geotechnical data, in-house engineering capabilities, reserve analysis, drilling operations and independent reports of operations, including dry holes, can all be critical pieces of information.

The technical data should ultimately support the economic data and be readily available. If not, you may have a problem. Just as you should ensure that financial records are maintained in accordance with GAAP, you should confirm that technical data and assumptions adhere to industry standards.

Technical complications arise for even the most seasoned professionals, and the consequences can be significant. Cross check your technical findings with your physical inspection reports and records review, particularly for obligations that may be terminating or arising near or after your anticipated closing.

In the end, due diligence is a means to risk assessment and cure. Risks in the oil patch can be considerable, and cures elusive. Due diligence should inform investors of risks as fully as possible and help ensure that investments are well placed. Remember that issues of low probability can have high consequences. This is…the way that this works.

Justin W. R. Renshaw is a Houston-based attorney with Vorys, Sater, Seymour and Pease LLP, primarily representing interests in energy, transportation and industrial matters. He has assisted large companies, start-ups, and individuals with a variety of onshore and offshore energy issues in the U.S. and abroad.