Pitfalls in the oil patch

Oct. 21, 2017
Key considerations for private equity investments in upstream joint ventures

Key considerations for private equity investments in upstream joint ventures


IN THE MARRIAGE OF HEAVEN AND HELL, poet William Blake wrote that "[t]he road of excess leads to the palace of wisdom." Following a period of strong oil prices and abundant sources of capital during the last commodity cycle, the downturn has left oil and gas producers searching for viable sources of capital. Some producers have sought out joint ventures with private equity investors as a means to acquire, finance, and develop oil and gas assets in the upstream space. While joint ventures can be a solution for both parties, investing in upstream joint ventures involves a unique set of risks and issues for private equity investors that may catch even seasoned investors off-guard. This article addresses three focus areas for private equity investors contemplating an upstream joint venture in the current market environment: (1) the counterparty, (2) market access, and (3) the exit. Taking the time to understand these areas will help lead the investor towards the upstream joint venture "palace of wisdom."

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Focus on the counterparty

In successful joint ventures, the counterparties rely on each other for success. In upstream joint ventures, private equity investors may find themselves relying significantly more on their counterparties than they do in other industries. For this reason, investors should focus on finding the right producer counterparty when mulling over an upstream opportunity, in particular, by addressing control and operation of the properties, producer bankruptcy risk, and potential transferability issues. For ease of reference, in this article we sometimes refer to an experienced operator/producer as the "producer" and a private equity investor as the "investor."

Control and operation

Private equity investors are used to having significant control over their investments. In joint ventures, these controls show up in the form of affirmative control rights (such as the ability to force a sale or replace a manager) or negative control or veto rights (such as the ability to prevent certain corporate actions).

This traditional control model is harder to implement in the upstream space. From the outset, there is an information asymmetry between the producer and the investor. The upstream space requires a unique mix of geophysical, engineering, environmental, finance and land management expertise that can give the producer more leverage in the initial negotiations, and frequently results in investors relying heavily on the producer throughout the life of the joint venture. Such reliance means that the investor, even if it may negotiate for certain contractual controls, may not have as much actual control as it is used to.

This is compounded by the structure of upstream joint ventures. Joint ventures in the upstream space are predominately structured as asset transactions (mainly because oil and gas assets are easily divisible), with the investor and the producer counterparty each directly owning a portion of the hydrocarbon assets. With each party holding its own direct interest in the assets, normally the parties select the producer to act as the "operator" of the jointly-held assets, and negotiate a joint operating agreement to define the rights and obligations of the parties with respect to those assets.

The industry-standard AAPL Form 610 Model Form Operating Agreement (the Model Form) is customarily the starting point for these negotiations. While the Model Form has many benefits, it also contains several operator-friendly provisions that can result in less control for a non-operator party (here, the investor). For example, removing underperforming operators is a challenging process to execute under the best of scenarios, but becomes even more challenging under the terms of the Model Form. Non-operators are limited to removing the "operator" entity "for cause." In practice, this has been a very high bar for removal. Even in a scenario in which a non-operating party owns a majority interest in a contract area, and therefore might expect that it could replace the operator at any time for any reason, the terms of the Model Form will not allow for the replacement of the operator by interest ownership alone.

As another example, the Model Form provides an operator more control than a non-operator party in the pace of development of the assets and in the acquisition of new properties within the relevant geographic area. While an investor may initially be content to allow the producer to control these operational-type activities, changes to the producer's financial capabilities, changes to commodity prices and changes to competitive forces within the relevant geographic area may result in the producer and the investor having different views on, and different abilities to execute on, these activities. Investors face both contractual and practical restrictions related to the pace of development and the acquisition of new properties, and will want to address these concerns in the joint venture documentation.

Bankruptcy risk

In addition to operatorship issues, investors should scrutinize the creditworthiness of their producer counterparty, and whether and how the venture should be unwound in the event the producer becomes bankrupt. Investors should understand the potential risk that the hydrocarbon assets that they hold directly or have a right to receive may be re-classified as property of the bankrupt producer counterparty's estate, as well as the risk that the contractual rights that the investor has bargained for may be suspended during the bankruptcy process and/or rejected completely by the bankrupt producer counterparty as it emerges from bankruptcy. Like most of the risks discussed in this article, these risks can be addressed and mitigated, but are crucial to address up front.


Investors should reflect on whether and when to permit their producer counterparties to sell and transfer their interests in the jointly-owned assets (and operatorship) to a third party. Because investors often rely heavily on their producer counterparties, investors ordinarily will want to make sure the producers are prevented from (or at least limited in) transferring their interests (and operatorship) to third parties without the investor's agreement. This is particularly true during the development period, when the producer's expertise is especially key to the success of the venture.

Focus on market access

Once a prospect is successful and hydrocarbons are flowing, the venture may find that its market access is constrained by limited existing pipeline resources or burdensome gathering agreements. The investor should examine whether there is a viable midstream option for transporting hydrocarbon production to market. A venture that results in a substantial increase in production in an area may require a separate midstream buildout, either by the joint venture parties or a third-party midstream gatherer. Such buildouts are usually expensive and potentially distracting to upstream ventures.

If there is an existing viable midstream option, investors should diligence potential costs. Sometimes, undeveloped assets are already dedicated to a midstream provider. Especially in well-developed plays like the Permian, STACK/SCOOP and Appalachia, existing gathering agreements may constrain or limit take-away options or make the access available only on expensive non-market terms, placing more strains on owner cash flows.

The relationship between upstream producers and midstream gatherers has been put to the test during the downturn. Gathering fees from fixed pricing in midstream contracts were once viewed as regular, expected and almost annuity-like revenue source by midstream gatherers. These fees have become less certain as they have resulted in significant financial burdens on upstream producers in a low-price environment. In many cases, upstream producers have approached their midstream gatherer counterparties seeking relief. Some midstream gatherers have agreed to adjust pricing. Some have not. In extremis, some upstream producers have attempted to use the bankruptcy process to rid themselves of burdensome midstream dedications, with mixed results. In one much publicized example, the bankruptcy court in the Sabine case (Sabine Oil and Gas Corp. v. HPIP Gonzales Holdings LLC (In re Sabine Oil & Gas Corp.), 547 B.R. 66 (Bankr. S.D.N.Y. 2016)) determined that a midstream dedication did not run with the land, and as such, could be rejected by the upstream producer debtor, a result that brought into question the treatment of midstream contracts that many thought would survive bankruptcy.

Interestingly, the low-price environment and other dynamics have in some cases resulted in more-favorable deal terms for some upstream producers in negotiations with midstream gatherers, especially in hot plays like the Permian. Midstream gatherers are paying premiums to upstream producers to be able to transport their production, sometimes in the form of cash and/or equity. In June 2017, several news outlets reported a transaction between a midstream gatherer and an upstream provider in which the midstream party agreed to pay the upstream producer a significant cash amount up front and to carry the producer on a significant portion of its capital expenditures in connection with the construction of a gathering system and processing plant that will be used in the transportation of the producer's future production. It will be interesting to see if this trend continues.

It is important for investors to understand the landscape surrounding access to market for the venture, which can vary greatly depending on the location of the assets.

Focus on the exit

Finally, investors should focus on the eventual exit of their joint venture investment. Private equity investors generally have relatively short-term investment strategies, and expect to have flexibility in their ability to exit the investment when it makes financial sense for them to do so. Aside from the usual joint venture exit challenges that arise from the fact that each joint venture involves parties that may have different intentions for the investment, exiting a joint venture in the upstream space can be challenging.

Investors will want to retain flexibility over the timing of their exit, whether during the initial development phase or the later operational phase. Practically, it may be more difficult to exit during the development phase. Because producers typically want more control over the development of their assets than a financial investor, the investor looking to exit during the development stage may find their potential buyers limited to a subset of other private equity or financial buyers, rather than the full suite of financial and strategic acquirers who may be interested in the deal at other stages of its lifecycle. In addition, producers can be much more sensitive to transfers by an investor during the development phase, as a new party may not have the same views as the producer regarding the build out and development of the venture.

One unique aspect of joint ventures in the upstream space is that, as mentioned previously, producer counterparties are generally chosen to operate the jointly-owned assets. But on exit, savvy investors understand that potential buyers will put a premium on being able to take over the operatorship of the properties, and will want to focus on how to capture that premium when the non-operator investor looks to exit its investment. Such a right may be more palatable to a producer during the operational phase when the development has been substantially completed than it may be during the development phase.


As private equity investors consider moving into or expanding their exposure to upstream oil and gas joint ventures, they should ensure they understand the full suite of risks and issues involved, including those addressed in this article. Assessing counterparty risks, market access and the desired exit outcomes can increase the investor's odds for finding an upstream joint venture "palace of wisdom."


Marc Rose is a partner and Jeremy Pettit is an associate in Sidley Austin LLP's private equity and energy transactional practice located in the firm's Dallas, Texas office. Rose and Pettit represent private equity funds and energy companies in mergers and acquisitions, joint ventures and investments.

This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content therein does not reflect the views of the firm.