Due Diligence: Its Importance, Impact, and Improbabilities

Summary. Due diligence affects all participants in the petroleum industry: investors, bankers, brokers, engineers, accountants, the government, and the companies raising money, acquiring properties, or merging. While many articles about due diligence have been published in financial publications, little is available in the petroleum engineering literature, This paper outlines the importance and impact of due diligence with checklists and examples from my experience as a securities analyst, investment banker, evaluation engineer, and expert witness or adviser. Introduction Due diligence may be the most important function in any oil and gas transaction involving raising money, acquiring properties. or merging companies. Due diligence can "make or break" a transaction or cause it to be restructured. If it is not properly exercised, everyone loses. SPE established voluntary standards for reserve auditing in Dec. 1979. While reserve auditing can be a part of due diligence, the two processes are not the same. In fact. no legal or dictionary definition exists of due diligence as it is practiced today by reserve-evaluation engineers. One attorney told me: "In a sense, [due diligence] is an ‘art form.' It is what you envision it should be for the application you have planned." Another attorney said it was planned." Another attorney said it was "everything you checked and everything you should have checked." In the Financial Products Standards Board's 65-Page Products Standards Board's 65-Page Standards for Oil and Gas Investments, "due diligence" is mentioned only briefly three times and is not defined in the glossary. However, this book and the Financial Products Standards Board's 16-page Standards Products Standards Board's 16-page Standards for Public Oil and Gas Programs have the most complete checklists that I have found for the due diligence process, except that they do not cover the broader responsibilities of the oil- and gas-evaluation engineer. My recommendation for a definition of the due-diligence process is the systematic review and verification of the information contained in oil- and gas-reserve evaluation reports, prospectus, or other documents used by one or more of the parties involved in the sale of stock, bonds, or interests in a property, an acquisition, a merger, or a bank loan. Due diligence includes reporting these findings and any other factors that may affect the proposed transaction to the client. The purposes of this paper are to clarify the oil- and gas-evaluation engineer's role in the due-diligence process and to illustrate the major issues and hazards involved. Ref. 1 provides more detail. Due Diligence Process and the Evaluation Engineer The only auditing standards for oil and gas reserves are those promulgated by SPE in Dec. 1979. These standards do not cover such key areas as the impact of the economic limit on reserves, product pricing, report preparation and contents, taxes, operating preparation and contents, taxes, operating costs, investments, contracts, and price escalations. As an extension of the current SPE reserves definitions. the Soc. of Petroleum Evaluation Engineers published Petroleum Evaluation Engineers published Monograph I-Guidelines for Application of Definitions for Oil and Gas Reserves in Dec. 1988. This guideline covers many topics not included in the reserve-auditing standards that are critical to a due-diligence investigation. Both can and should be used as tools in a due-diligence portfolio and are available from SPE. To see how the evaluation engineer fits into the due-diligence process, let's first look at the normal due-diligence responsibilities of the investment banker for public oil and gas offerings and mergers and acquisitions. Investment bankers have a dual responsibility: to conduct, or hire independent third parties to conduct, a due-diligence parties to conduct, a due-diligence investigation and report on the company and to follow subsequent events to ensure that the company performs its functions properly after the offering. The various engineering. geological, or accounting professionals who should take part in the different phases of due diligence for oil- and gas-related offerings are included in the following investment-banker responsibilities:The evaluation engineer and accountant should assess the quality and experience of management and staff.The evaluation engineer and geologist should evaluate the previous record of the general partner on a pretax-cash on cash basis.The evaluation engineer should audit company reserves or reserves to be acquired.An evaluation engineer with a background in operations should assess the quality of operations.The evaluation engineer, geologist, accountant, and attorney should review the offering. JPT P. 1097