Contract errors can be costly

Researchers expected the data to show an even distribution of net gains and losses in acreage from title defects. Instead, the research team was surprised to discover that twice as many title defects resulted in a net loss rather than a net gain in acreage. And the net loss was considerable.

In one case, a company that cleansed its records prior to divestiture discovered a net loss in acreage of 19% after having its records cleansed more thoroughly by an outside firm.

In another instance, even after a company that performed customary due diligence still realized a net loss in acreage of 4.6%. With more than 300 oil and gas lease deals a year in the US averaging $100 million per deal, a loss in acreage of just 4.6% represents a loss of over $1.3 billion annually.

Buyers stand to lose even more after closing the deal when they invest in exploration and drilling. As Sam McNeil, managing director of River Capital Partners in Charlotte, NC, points out, "The acreage is a major concern when wells are drilled on faulty leases. For example, if you look three to five years in the future, after a company has drilled six deep wells from a pad and invested $30 million to $70 million only to discover later that the lease was faulty, that would conceivably put millions of dollars at risk."

THE STATUS QUO

This problem is ubiquitous in the oil and gas industry. In its analysis of 145 public transactions, the University of Utah research team revealed a lack of organization, transparency, and accountability across the board. Of the 145 transactions, 48 had a different closing price compared to the announced price. One out of every three leases had measurable errors, and customary due diligence uncovered only the most obvious errors. The industry has come to accept these uncertainties in transactions as part of the status quo because land record errors are too difficult, costly, and time consuming to uncover.

The perception in the industry is that a standard loss of 4% to 10% is acceptable, but with a $1.45 billion deal on the table, that equates to a potential loss of $58 million to $145 million on a single transaction.

PAINFUL LESSONS

Stories of losses in oil and gas land lease deals due to title defects and other undetected land record errors are not hard to come by. One company purchased what it had thought included a $6 million asset. The seller had given the buyer a limited number of days to perform its due diligence. After the due diligence period expired, the buyer discovered a depth restriction that rendered the asset worthless. Unfortunately, the discovery came too late. The buyer was forced to absorb the cost.

In a deal closed 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 outstanding issues, including Southwestern's waiver of any future claims related to title defects.

We see another example in 2008 when BP (NYSE:BP) purchased $1.75 billion worth of assets from Chesapeake. The acquisition included 90,000 acres in the Arkoma Basin Woodford shale in Oklahoma. After closing, BP found $116 million in title defects. Unfortunately the threshold was capped at $35 million. The defects led to multiple disputes between BP America and Chesapeake costing them millions in attorney's fees.

EXPLORING THE ROOT CAUSE

Leases are dynamic instruments. Part of the problem with land records is that people in the industry treat them as though they are static documents. The average oil and gas lease has changed hands five times. As with buying and selling any real property, oil and gas leases can be bought, sold, or transferred in part or as a whole. They can be broken down into infinite combinations. Each lease could have unique terms and may be amended or encumbered over time.

With each new transaction, leases and contracts could be split or combined. Often times, however, the documentation is either duplicated or misplaced. Managing documentation dating back decades can cause many issues. Buyers and sellers maintaining accurate records, verifying information and recording or resolving discrepancies can cost billions. Because of the potential errors in title records, very few title companies are willing to issue title policies on the ownership and validity of the chain of title.

In addition, over the course of time, contracts expire, leases expire, Pugh clauses take hold, and obscure provisions are triggered without the company's knowledge. A company may not actually own what they thought they did once the deal is on the market.

THE DIFFICULTY IN VALIDATING LAND RECORDS

Land departments often lack the personnel, expertise, and technology to carefully examine land documents and address errors in the customary time allotted for due diligence. One company cited in the University of Utah study was given only 23 days to complete its due diligence on a nearly $1.45 billion bundle of leases. Compounding the problem is that land records are often in the form of paper documents. Those that have been scanned and digitized are typically stored as images, the contents of which are unsearchable. Like paper documents, they must be manually examined and read very closely by highly skilled professionals who are trained to recognize the types of errors and omissions that commonly result in lost acreage. Enterprise land systems capture only the critical data needed for year-end acreage reporting, rental payments, and tracking major obligations. Considerable fieldwork is required to confirm the seller's ownership of the assets prior to a divestiture.

Errors of omission are particularly difficult to detect, because analysis must uncover what is not there. Uncovering missing records and missing data requires a deeper level of examination than most land managers and even most outside firms are equipped to perform.

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, a company lost a substantial amount of net acreage due to title defects.

A BETTER WAY

Imagine being able to convert all land records to digital, searchable documents and subject them to deep analytics capable of detecting not only errors but also omissions. Imagine having the process, personnel, and technology in place to reduce land record errors to undetectable levels. As a buyer, you would know more than the seller does about its own land records and rights. As a seller, you could guarantee or warrant that your land documents contained no detectable errors, thus preempting any buyer demand for a discount.

Imagine also the convenience of having these digital land records stored securely in a virtual data room, where sellers could easily share the records with prospective buyers to facilitate the due diligence and bidding processes.

Fortunately, there already is a better way. The technology, personnel, and disciplined processes are already in place and tailored to handle the high volume and complexities inherent in oil and gas land lease contracts. There are companies that provide this service for you.

REALIZING ADDITIONAL BENEFITS

Having your land records and well files digitized, organized, and searchable delivers additional benefits. The volume and pace of development in the industry demands that companies be able to respond quickly to opportunities made available by developing technologies. Re-evaluating these assets is a data-driven process requiring quick access to well data. Decisions based on lost or misplaced documentation or land record errors can lead to costly mistakes, delays, and disagreements.

When the time comes to divest land assets, a digital warehouse also enables you to share your land records and related documentation with prospective buyers without having to copy and ship paper documents. You simply provide the prospective buyer with a username and password to log in to the warehouse and obtain the files they need.

WEIGHING THE COSTS

Having land records digitized and using cutting-edge analytics to data-mine the assets and having those records available to support due diligence and the bidding process certainly costs money. However, the cost is considerably less than the average loss from a land deal gone wrong, and the benefits are considerable. Typically, this work is one-tenth the cost of what a company stands to lose by not having its records digitized and cleansed. In addition, after your land records are digitized and organized in a land-specific data warehouse, the cost of building and managing a conventional data room is eliminated. This also eliminates the cost of the time and money one spends on searching, copying, and shipping paper documents when the need arises.

"Everyone in the industry knows there are errors, but putting it in perspective shows there's a lot of missing money," said McNeil. Companies reluctant to spend a small percentage of what's become the standard loss as a result of title defects 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 a member of the board of trustees of Keystone College in La Plume, Pa.