Capturing value in upstream oil & gas deals - KPMG · 2020-02-27 · When players in the upstream...

The key is planning for the industry’s complex integration challenges

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Successful value capture in upstream oil & gas deals

Methodology

The findings in this paper are based primarily on our on-the-ground experience in the upstream oil and gas industry. To validate our experience, we reached out to C-suite executives in U.S. upstream oil & gas companies. There are 82 independent upstream O&G companies with revenues over $100 million and executives from 12 of these formed our research panel and completed a detailed survey in late 2019. We thank them for their generous contributions. Due to the small sample size, the panel’s responses are directional. However, they confirm our own insights on how value is created or destroyed during the complex integration process required in these businesses.

1© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

When players in the upstream oil and gas industry pursue acquisitions, their focus is typically on gaining economies of scale, accessing new reserves or expanding geographically. In 2019, despite constrained energy prices, upstream asset deals continued at a strong pace, with transactions across a broad range of North American basins.1

If past experience in upstream deals holds, however, many of these transactions may fail to deliver expected returns. This will be because buyers did not focus early and intensely on post-deal integration. Four out of five O&G executives who participated in this research cited operational disruption and poor execution as the reasons for coming up short. The deals were smart; the execution was flawed.

The problem is seldom about integrating the assets – O&G companies are highly skilled at valuing reserves and producing assets, and incorporating them into their operations. Where upstream companies fail to capture value is in back-office integration, which is a common trap for acquirers across industries. But integration in O&G is far more complex, because of the special activities involved. The functions that drive back-office complexities include:

Introduction: The special challenges of oil & gas integrations

1 “U.S. oil and gas M&A activity maintains momentum in third quarter,” Oil & Gas Journal, Oct. 2, 2019

Based on insights from executives and our work with M&A clients in the industry, we find a strong correlation between upfront investment in integration planning and ultimate value realization. Once they have a deal in their sights, buyers have no time to lose. This is when disciplined and robust integration planning – with particular focus on how to combine IT and other technical functions – give acquirers their best shot at capturing synergies and realizing expected deal value. In this paper, we show C-suite executives and strategic planning staffs the potential value creators and destroyers in upstream O&G deals; how companies can realize anticipated value in a deal; and five steps companies can take to plan successful integrations.

— Land Operations & Administration

— Exploration and Appraisal

— Drilling & Completions

— Production Operations

— Oil and Gas Accounting


https://www.ogj.com/general-interest/economics-markets/article/14067858/us-oil-and-gas-ma-activity-maintains-momentum-in-third-quarter

How do uptream O&G companies capture value from M&A? According to executives on our panel, 44 percent of the value of a deal comes from incremental production (Exhibit 1). Executives cite a combination of other factors

as well, such as headcount synergies, leveraging the buyer’s advantages to improve the target’s performance, and optimization of various functions and activities as leading sources of value.

Value creators in upstream Oil & Gas deals

Exhibit 1 — Upstream Oil and Gas Deal Value Creators

Source: KPMG Upstream Oil & Gas Executive Panel.

5% 10% 15% 20% 25% 30% 35% 40% 45% 50%0%

44%Incremental production increases

22%Headcount synergies

12%Other strategic positioning

10%Operational efficiencies: IT, processes, governance

6%Midstream transport / optimization

4%Volume / purchasing power

2%Marketing / sales optimization


Buyers typically use historical data to gauge production value, but they can also look forward to significant increases if they have better recovery methods than the target company (and the opposite will be true if the seller is more advanced than the buyer or if unrealistic estimates were used to predict future production). The diligence

team has the opportunity to gain a clear understanding of the true potential for production increases or shortfalls. To reduce any disruptions in drilling and completion activities after the transaction, buyers can plan for the handover of drill schedules, process manuals, and permitting.

Production

Reducing overlapping headcount is a common source of synergy. In exploration & production (E&P), overlaps frequently arise in general management, finance, revenue and joint-venture accounting, IT, and other support functions. Headcount opportunities in field operations depend largely on the type and location of assets being

acquired. For example, redundancies are more likely if the buyer is acquiring assets in basins where it is already active. It is advisable to take the time to evaluate future growth plans across basins to determine if resources can be utilized elsewhere.

Headcount

Buyers can realize additional deal value if they have advantages that the seller lacks that can be used to improve performance of the target business. For example, a buyer might possess strategically useful water or water disposition rights, permitting, superior geological intelligence, or vertical integration of strategic goods or service providers. Likewise, a buyer might have key

relationships or control of raw materials, such as sand or other fracking materials, which could allow it to complete a well in the acquired business at a lower cost. Or the buyer could have lower-cost transportation and delivery arrangements than the target company, or intellectual property that can improve the performance of the acquired business.

Applying buyer advantages

A data analytics gap

Three out of four industry executives said data analytics is becoming a necessity in assessing potential deals. Yet more than half of the executives also said they do not use data analytics at all or “only somewhat.”

This validates our experience that there is significant opportunity to harness the power of modern data analytics tools and techniques for upstream O&G M&A. These companies have long used analytics to identify reserves and production opportunities, but the same techniques can also be used to identify sources of value in areas such as IT, finance, accounting, human resources, land operations & administration, sales & marketing, procurement/purchasing and supply chain.


Combining back-office operations of two organizations can generally lead to more efficient operations, but only if the integration is managed well. In the IT organization, applications can be rationalized and best practices from both entities utilized. A transaction can be used as an opportunity to upgrade to a cloud-based environment or implement other new technology. There is also potential value in streamlining processes in finance, accounting, human resources, land operations & administration, sales & marketing, procurement/purchasing, supply chain, and other support functions.

Capturing value from back-office operations depends on how the integration is managed. For example, it

is important to understand any cultural differences and develop an effective communication and change-management plan that heads off potential conflict. Successful execution also depends on setting up a governance structure to effectively manage the newly combined organization. In the process of establishing a new governance structure, companies can find opportunities to reduce management layers and redundant roles.

Here are three areas of operational efficiencies that are common opportunities in upstream O&G transactions:

Operational efficiencies

Value creation opportunities in these areas include filling unused capacity in existing pipelines and processing plants, negotiating volume pricing with third-party processors

and other service providers, and optimizing routes and renegotiating rates with truckers.

1 Midstream and transport optimization

As an E&P company grows, it has an opportunity to realize value through volume discounts. Discounts on pipe, mud, proppant, water services, and other inputs can amount

to tens or even hundreds of millions of dollars. Simple contract renegotiations can create additional value, even if volume discounts are limited.

2 Volume purchasing power

Often, the buyer can command a better price for the target’s output. For example, if the seller has relied on a third party for marketing and sales, the buyer can immediately recapture the upcharge. Or the buyer may have more favorable pricing terms through existing

relationships, which may now apply to the target’s output. The buyer can realize additional value if it has better systems or processes in marketing and sales, depending on where in the value chain the final sale takes place.

3 Marketing and Sales optimization


Value destroyers end up costing the buyer significantly more than anticipated. In our experience, value destruction, in its many forms, often begins with lack of planning or focus. The top three sources of value destruction,

according to executives we surveyed, are lack of execution, operational disruption, and commodity/financial risk (Exhibit 2). The lesson is that buyers have to plan carefully for how they will extract the value they expect.

Value destroyers in upstream oil and gas deals

Exhibit 2 — Upstream Oil and Gas Deal Value Destroyers

Source: KPMG Upstream Oil & Gas Executive Panel

5% 10% 15% 20% 25% 30% 35% 40% 45%0%

41%Lack of execution

39%Operational disruption

16%Commodity / financial risk

1%Employee turnover

1%Penalties from not meeting regulatory requirements

1%Brand dilution

1%Customer turnover


Like most acquirers, many upstream oil and gas companies focus primarily on getting the deal done and, only after the close, really get into the details of integration. When integration does not begin early with a thorough plan, however, companies often wind up taking reflexive and

even hasty actions to capture value and justify the deal. As pressure mounts to show results, companies may resort to top-down cuts and headcount reductions that undermine growth plans and work against the best long-term interests of the company.

Poor integration planning and execution

Confusion and misunderstanding during the merging of two organizations is a common risk. However, this outcome can be avoided if proper planning and communication are in place well ahead of the deal closing. In whole company acquisitions, disruption often arises from differing cultures or leadership styles. Where customers overlap, there may be disruption over primary points of contact, pricing, and even how to combine accounting methods and reporting cycles. In a carve-out situation,

confusion and disruption are common when transition services have not been properly identified or planned. If seller-retained employees are required to remain on the job to ensure operational continuity, complications and conflict may ensue. Taking the time to identify all transition services and clearly define the necessary processes and interactions between organizations can greatly reduce the potential for operational disruption (See “Transition service agreements”).

Operational disruption

Because the value of upstream companies or assets is predominately derived from a calculation of expected future production multiplied by an assumed oil or natural gas price, sudden and unexpected downward movement in price can lead to a significant loss of revenues. Of course, this risk can be hedged with a position in a futures

or forward contract, but is typically not 100 percent covered. Similarly, if financial leverage is used to acquire a company or asset, the effects of commodity price risk can also trigger certain elements of debt covenants or other instruments, which can aggravate the buyer’s financial position.

Commodity/financial risk

Upstream O&G deals are subject to regulatory requirements, which can be raised by environmental, energy, antitrust and other authorities and must be fulfilled

for the deal to proceed. Failure to plan for, manage, and track these regulatory requirements can lead to significant penalties.

Penalties for not meeting regulatory requirements


Transition service agreements

Many upstream O&G deals are asset deals or carve-outs from larger organizations. In these cases, the parent organization selling the asset often provides shared services for these business units or assets. Getting the right data, people, processes, technology, and contracts in place to properly run these business units is critical to realizing deal value.

Transition service agreements (TSAs) are often a necessary mechanism to have in place. They allow the buyer to properly stand up the capabilities to take over many front-, back- or middle-office functions. Differing systems, data structures, and processes often make it difficult to take on a carve-out operation without some level of transition service in place.

There are many pitfalls to avoid when dealing with transition services. For example, lack of proper governance planning for the TSA period can lead to service level variance, lack of issue resolution, general confusion, and operational disruption.

In addition to planning for the integration of various business functions, it is also critical to plan for any required transition services. We find that proper planning and having a governance structure in place for transition services can greatly reduce the risk of business disruption and enable value realization across the business.

2 2018 Retention Report: Truth & trends in turnover, Work Institute, 2018

According to research by the Work Institute, when an employee quits voluntarily, it costs the employer about one-third of the employee’s salary. The costs include recruiting and training a replacement, as well as lost productivity. The total cost for U.S. companies is estimated to be $600 billion per year.2 Deal activity has shown to increase the odds of higher turnover. Employee engagement tends to

drop during M&A and fall even more when employees perceive they will be directly affected. Employees need specialized skills for O&G roles. So it is critical to avoid losing high performing employees or people in critical roles. To retain talent, acquirers can communicate directly with valued employees. Sometimes companies offer retention bonuses to hold on to valuable talent.

Employee turnover

A dis-synergy occurs when there is an increase in cost or loss of revenue that is directly attributable to the deal. This can happen when the buyer and seller share a customer and the total customer spend now exceeds the customer’s rules against relying too much on one supplier.

Then the customer will move some of the business to another supplier. Brand dilution is another potential dis-synergy. Dilution can occur when the combination of two companies creates a new category that deviates from the orginal brand identity.

“Dis-synergies”


http://info.workinstitute.com/2018retentionreport

Upstream O&G companies do a fairly good job at integrating drilling and completion activities, as well as in finance and accounting—functions at which successful E&P companies generally excel. It is in other back-office

functions that upstream companies tend to fall short: land operations and administration, supply chain, HR, procurement/purchasing, sales and marketing, and IT (Exhibit 3).

How to realize value in upstream oil and gas deals

Exhibit 3 — Integration is most successful in finance and drilling

Source: KPMG Upstream Oil & Gas Executive Panel

Note: Respondents were asked to rate, on a scale of 1 to 5, how successful integration of various functions has been in their deals. The responses were averaged across all respondents and raised to the fourth power to show degree of separation.

Drilling & Completion

Culture

Land Operations &

Administration

Supply Chain

HR

Procurement / Purchasing

Sales & Marketing

IT

Less Successful More Successful

Finance & Accounting

Averaged results on a scale of 1 to 5; 1 being least successful and 5 being most successful in terms of how well companies integrated certain business functions

3.0 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9

Significant opportunity exists to increase deal value realization through better operational integration in these areas


In our experience, we find a strong correlation between a disciplined integration process and realizing deal value. This is further supported by the executives on our panel. When companies find success in integrating operations, they tend to see more overall deal success, as indicated by the linear regression model shown in (Exhibit 4). This finding, along with the finding that many O&G companies do not integrate operations well, suggests that there is significant value in upstream O&G deals that many buyers are not capturing.

Identifying expected synergies to justify a deal is fairly straightforward. These are generally top-down estimates of savings in purchasing, headcount, and other operational efficiencies. It is much more difficult to manage the integration to fully realize potential value. Companies that successfully realize deal value devote resources and time for planning the integration well before the deal closes. They also focus and prioritize integration efforts for the greatest impact.

This means having a team in place to manage the integration across the business. From exploration, drilling and completions, production operations, midstream, marketing, IT and other back office functions, having a clear understanding of the dependencies and impacts, driving the process, keeping people focused, and coordinating the synergy opportunities across the business is the best way to effectively realize deal value.

Note: The Deal Value Realization scale is the average for each respondent across on the question: “In your company’s three most recent deals, has the value met, exceeded or fallen short of expectations?” The Operational Integration Success scale is the average of responses to “How successful has your integration planning been in these areas?”

Exhibit 4 — Success in integration correlates with value capture

Operational Integration Success

Dea

l Val

ue

Rea

lizat

ion

4.0

3.5

3.0

2.5

2.01.5 2.0 2.5 3.0 3.5 4.0 4.5

Integration Success vs. Deal Value Realization


Five steps to successful integrationA successful integration is the result of thoughtful, thorough and early planning. By following the principles laid out in these five steps, upstream O&G leaders can greatly increase the odds of success.

1

Naturally, due diligence for upstream deals focuses on well, production, and financial data. However, buyers can also use the due diligence process to identify potential integration risks and get a jump on integration planning. It

pays to take the time to dig into IT and back office issues and develop insights about supply chain and commercial functions.

Use due diligence to plan integration

A smooth separation for a complex and ambitious carve-out

In 2019, a small E&P company partnered with a large private-equity firm to acquire a $2 billion carve-out business from a large US-based E&P company, a deal that would triple revenue and headcount. A Transition Service Agreement (TSA) was required to stand up the necessary processes and IT systems and hire the resources to run the business.

With a short timeline and limited resources, the company called on KPMG to help. Using our standard target operating model approach for the carve-outs, we helped with strategic planning for Day 1 and creation of the needed TSAs. Working with the client and other consulting firms, we helped design the future-state operating model across all functions, including people, processes, systems, data and other assets, as well as contracts and agreements. We assisted in a range of other activities, including setting up an IT PMO, running TSA exit workshops and developing project governance tools for the executive steering committee. The result was a successful Day 1 for a complex and highly ambitious transaction. The buyer had effective transition services that did not impact business operations and a rigorous plan for delivery of IT infrastructure, software applications and data transition readiness for the field.

If the company or asset is a carve-out from a larger organization, transition services will likely be required. Take the time to understand the actual entanglements with the

parent before the deal closes. Create a clear schedule of the required transition services, including service levels, duration, key contacts, pricing, and issue resolution.

Don’t skimp on transition services 2


How an integration management office found $5 million

A private-equity backed E&P company needed assistance integrating an offshore exploration and production company in a $2 billion deal with $25 million of expected cost savings. Prior integration planning efforts had fallen short of expectations, so four weeks before closing, the company called KPMG to review integration plans and propose improvements. We helped establish an integration management office (IMO), which drew up an integration roadmap with critical milestones, and prepared the Day 1 readiness plan, interim target operating models, communications plans, and a system for synergy estimation and tracking.

This disciplined approach helped the buyer identify $30 million in synergies – $5 million more than anticipated. In addition, the company got a standard set of integration tools and templates to be used in future deals. And, as a result of the IMO approach, the company achieved a smooth Day 1 transition.

Don’t take integration lightly. Get the CEO to re-iterate the importance of smooth integration to the entire organization, and spell out why a smooth integration is essential for delivering the value objectives of the deal.

Arrange for CEO, CFO, COO and other key executives to work with the steering committee and receive weekly or bi-weekly updates and make key decisions.

Get executives involved in integration 3

Have a Day 1 plan in place to take control of the newly acquired company or asset. In order to avoid disruption to operations and value destruction, it’s best to have signatories on bank accounts, delegation of authority, and

new reporting structures in place and clearly communicated to all relevant stakeholders on Day 1. Delaying this action could result in disruption to operations and value destruction.

Take control early4

Hit the ground running

Closing a deal feels like the finale, but it’s important to keep moving and not lose momentum. Indeed, by the time the deal closes, you may be behind where you need to be. The best way to hit the ground running is to organize

a team immediately after signing to begin Day 1 planning and design the overall integration program, including how to optimally capture synergies. That way, upon close, momentum will be in your favor.

5


How KPMG can helpKPMG is a leading provider of deal advisory services to the upstream O&G industry. KPMG member firms provides Tax, or Advisory services to 185 out of 228 energy companies on the Forbes Global 2000.

With our cross-functional approach – encompassing IT, HR, Operations, Tax, and Accounting – we can help you identify and realize value in an upstream oil & gas deal.

Source: Forbes Global 2000, August 2019.

We help conduct due diligence on all aspects of upstream deals, including well, production, and financial data; identifying potential integration risks; and anticipating IT, back office, supply chain and commercial integration issues.

Due diligence

We help buyers create plans for integration and value capture before close. This includes helping organize an integration team, designing the overall integration program, laying the foundation to capture synergies, anticipating cultural issues and managing key internal communications.

Deal integration planning

We can help create a clear schedule of required transition services, including service levels, duration, key contacts, pricing, and issue resolution.

Transition services

We can provide recommendations for post-closing actions to mitigate risks, capture cost savings or improve processes identified during our due diligence work.

100-Day Plan


About the authors

Casey Hinson is a Director in KPMG’s Strategy practice with over 10 years of experience in the Energy sector. On the M&A Services team, he specializes in integration planning and carve-out / separation planning, with significant experience in business performance improvement and transformation, and strategic planning.

Casey HinsonDirector, Strategy, KPMG LLP

Jay Teinert is a Principal in KPMG’s Strategy practice and the leader of the Energy practice for Deal Advisory and Strategy in North America. Jay has over 20 years of professional experience in both consulting and industry. He has led merger integration and divestment projects within the industry and as an external advisor.

Jay TeinertPrincipal, Strategy, KPMG LLP

We would like to thank our contributor:

Lance Baird Director, Strategy, KPMG LLP

Lance Baird is a Director in KPMG’s Strategy practice with over 18 years of experience in the Energy sector. On the M&A Services team, he specializes in integration planning and carve-out / separation planning. Lance held several progressive roles at a large oil and gas supermajor before joining KPMG in 2015.


The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.

The KPMG name and logo are registered trademarks or trademarks of KPMG International.

© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. DASD-2020-575

Some or all of the services described herein may not be permissible for KPMG audit clients and their affiliates or related entities.

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Related Thought Leadership from KPMG

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Delivering Long Term Value in E&P

Casey Hinson Director, Strategy KPMG LLP 811 Main Street Houston, TX 77002 713-518-2656 [email protected]

Jay Teinert Principal, Strategy KPMG LLP 2323 Ross Avenue Dallas, Tx 75201 214-840-8082 [email protected]

For more information, contact us:For more information, contact us:

Lance Baird Director, Strategy KPMG LLP 811 Main Street Houston, TX 77002 213-319-2785 [email protected]

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Capturing value in upstream oil & gas deals - KPMG · 2020-02-27 · When players in the upstream...

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