Permian Consolidation Piques Interest in Drill-to-earn Opportunities
Drill-to-earn arrangements have been utilized in the Permian for years in the forms of joint ventures, farm-outs and other customizable agreements.
Austin Lee and Jay Harper, Bracewell LLP
The current roster of players in the Permian Basin stands in stark contrast to what it was at the peak of the shale revolution. During the last year and a half alone, the basin has seen a consolidation trend accelerate, evidenced by the acquisition of several large E&Ps that had been pillars of the Permian landscape for years.
This leaves a handful of power players controlling larger amounts of the production and delineated inventory. With that brings the need for acquiring companies to rework drill schedules and inventory stacks, as well as raise money to pay off acquisition debt. Selling portions of newly expanded asset bases is one way to do that and, given the large number of experienced management teams seeking foundational assets for new companies, buyers are excited to acquire assets that are no longer a priority for their current owners.
Jay Harper. (Source: Bracewell)
Amidst this consolidation, Permian operators have increased drilling activity in formations beyond the Bone Spring, Spraberry and Wolfcamp—most notably the Woodford and Barnett formations. While it comes with some level of risk, interest in these less-developed formations has increased dramatically, in many cases creating unanticipated pockets of value within the newly expanded asset bases resulting from large-scale acquisitions.
In this environment, we have seen an increased interest in drill-to-earn transactions which offer participants a flexible and capital-efficient way to trade on these assets.
Drill-to-earn agreements
Drill-to-earn agreements have been utilized in the Permian for years. Whether styled as a joint venture, farm-out agreement, development agreement or under some other moniker, these highly customizable arrangements allow a party willing to spend drilling dollars to earn interests in acreage or specific depths that the other party does not plan on developing. Earning requirements can be structured to account for both the drilling party’s capital constraints and/or the need to maintain leases or depths that are subject to lease expiry or a continuous development clause.
The amount of interest earned as compared to that retained by the non-drilling party, as well as the split of economics from the development under these arrangements, can be structured to address party’s specific goals.
In some situations, the non-drilling party wants to retain an override to maintain upside from acreage it would never have drilled. In others, the non-drilling party will retain a non-operated working interest to keep barrels of production on its books. In most cases the retained working interest will be “carried” in some form by the drilling party, which not only offloads the risk of exploration to the drilling party but allows the non-drilling party to maintain upside without associated production costs.
Capital advantages
Drill-to-earn arrangements convey just as many benefits to the drilling party. The consolidation of the Permian has made obtaining interest through traditional acquisitions difficult and costly. Drill-to-earn arrangements may avoid expensive up-front acquisition costs and allow a party to earn in-demand interest directly through the expenditure of development dollars.
When a drilling party acquires a foundational asset through one of these arrangements, they are typically spending “equity” dollars up front, as they most likely do not have a production base to lever up. In these situations, a drill-to-earn arrangement can provide an efficient way to spend those equity dollars with a quicker path to cash flow generation.
It can also accelerate the development of a production base on which the company can obtain more traditional (less expensive) bank financing. The efficiency and flexibility in tailoring these arrangements to align with a drilling party’s initial capital position are key reasons why many management teams are targeting drill-to-earn arrangements to attract investors and capital sponsors.
By leveraging its operational track record to get access to one of these transactions, a management team can also get a leg up in the fundraising process as investors typically prefer investing in a team with line of sight to an asset rather than the blind pool capital commitments employed in the early stages of the shale revolution.
Drill-to-earn as A&D
Drill-to-earn arrangements are a form of asset acquisition at their core. They present the same “asset level” issues encountered in normal asset acquisitions. Applicable consents and preferential purchase rights will need to be addressed.
The drilling party may also become subject to any midstream or produced water arrangements that are binding on the earned acreage under dedications. Where the interest being earned is limited to specific depths, the parties will need to be mindful of both existing operations and the needs (or requirements) to develop other depths within that same acreage. This may require the parties to obtain additional agreements to secure adequate surface and subsurface rights or agreements for the shared use of facilities serving wells both on and off the earned acreage.
Where the parties each maintain a working interest in the earned acreage, they must establish a regime of governance for future development of the relevant assets, usually through an agreed form of joint operating agreement. Restrictions on the ability to transfer one’s interest in the acreage and/or areas of mutual interest are common mechanisms used to incentivize development and maintain alignment for development of the earned acreage and the surrounding area.
Finally, parties to a drill-to-earn agreement must be mindful of, and account for, the tax implications associated with these arrangements. A tax partnership between the parties is often necessary to properly allocate tax attributes, such as intangible drilling costs, to the parties based on the share of the development costs they are bearing.
The future of drill-to-earn
Consolidation has washed over the Permian and is showing no signs of slowing down. The resulting needs to rationalize portions of expanding asset bases, coupled with the emerging value proposition that some of the less developed formations now represent, has piqued interest in drill-to-earn opportunities throughout the basin.
The future will tell if this trend continues and to what level these versatile arrangements will be utilized in the Permian landscape going forward.
