Until recently, the vast majority of oil and gas joint ventures and strategic alliances had been in exploration, as companies joined to share the risk and diversify their prospect portfolios. That is changing as companies begin to enter into new types of transactions not just to spread their risk, but rather to accomplish a myriad of other goals that often relate to areas previously thought of as their "core competencies." While each of these transactions has its own genesis and companies entering into these have their own unique strategies, there are some general perceptions that have led to the consideration and execution of these transactions. One is the perception that oil and gas price increases can not be counted on to result in improved performance, since any reasonable analysis of oil and gas price history shows that reducing costs and achieving reserve and production growth will be necessary to survive and grow in the future.

Another overall dynamic is the convergence between natural gas production and downstream uses of gas that is occurring not only in the U.S., but around the world. This is creating interest in upstream natural gas investments by both power and gas utilities as well as project developers.

As more and more gas is found in areas around the world that have no existing pipeline systems and demand, producers are being required to develop downstream assets and markets to be able to justify the reserve development. Power development is needed in many areas and LNG or anhydrous ammonia facilities also represent potential uses of gas that can be developed. Joint ventures are the preferred method of sharing the risks and profits from these areas.

These JVs or alliances also re-flect a growing re-cognition that downstream-integrated investment structures will reduce pricing volatility effects. If you consider all commodities, as well as energy, it is apparent that the pure producers do not dominate the major commodity businesses, but rather the integrated companies, whether energy, metals, agricultural products, etc., dominate. Being subject to pure commodity pricing volatility significantly increases risks, making financing either sometimes unavailable or more expensive, and restricts access to some capital markets. Chart 1 shows that many of these project teams include partners that bring access to price hedging in some form. Most financiers today remember the late 1970s and early 1980s where unrealistic pricing euphoria in forecasts that never materialized led to lots of red ink and huge write-offs. As they have re-entered the energy financing market, they have little desire to take the pricing risk that led to past problems. Thus, many now require that price hedging be a part of the deal through either fixed price offtake agreements or with financial products sometimes available in the markets. In fact, many of the financiers have affiliated entities that provide these types of instruments.

While volatile, crude oil prices have shown considerably less volatility than natural gas. Yet the tightly integrated structure of the major oils has served them well over decades in reducing the effects of price volatility. One only needs to look at the relative sizes and capital costs of pure producers and refiners (who have volatility risk at both ends of the supply chain) as compared to the tightly integrated major oils. Even the international government owned production companies have integrated downstream to some extent due to oil pricing volatility, which is less that half of the volatility of natural gas. When the volatility of natural gas is considered in relatively well developed markets and the lack of pricing available in undeveloped countries where new gas reserves are being found, it is easy to understand the reluctance of financiers to take the price risk they took in the past.

With the recent devaluation of currencies seen in SE Asia, it should make both project developers and financiers begin to take a harder look at the currency risk that they may be taking. In the future, many of these ventures will include partners that are brought into the JV/alliance to provide some level of hedging of the currency risk. This brings up a key point in the formation of JVs and strategic alliances ­ which is that one of their major requirements should be to allocate risks to those best able to either eliminate, manage or absorb them.

There have been numerous JVs in the gas marketing area in the U.S. These are partially driven by the continuing squeeze on marketing margins that resulted in the situation where the marketing costs for many gas producers exceeded the margin that could be realized above simply selling gas at published indexes. On the other hand, the marketers are being driven to increase throughput so that the significant fixed costs can be spread over larger volumes.

Some producers found that they could earn equity in these marketing operations in re-turn for long term reserve and production dedication. For even those producers that looked at investing in the downstream gas value added chain, JVs made sense to some since they did not have the market and logistical expertise in-house to fully develop and manage the opportunities. The strong convergence between the gas and power industries in the U.S. has led to an increasing number of JVs, alliances and mergers. These will continue and grow over the period as power transmission, distribution and markets are opened up. One need only look at the merger between Enron and Portland General and the venture between Vastar Gas Marketing and the Southern Company to see the trend for the future. For natural gas producers that, based on the integrated oils' success over time, want to either reduce pricing volatility or participate in the evolving downstream opportunities in natural gas and power, JVs and strategic alliances should be given serious consideration, particularly in foreign areas. Eventually these ventures will go beyond simply marketing arrangements. As we have seen in the natural gas industry, wholesale marketing quickly becomes very competitive and margins are driven down to the point that many marketers make little net margin. The opportunities for profits come from either ownership of assets or arbitrage of either assets or spread pricing opportunities. The table above shows the convergence between gas and power as indicated by the fact that the largest power marketing companies are predominantly companies that were initially gas marketers.

Another type of JV/alliance being seen today that is relatively new is the production combinations covering all or certain geographically concentrated oil and gas properties. These represent a departure from past practice where most producers felt that operations were a "core process," not to be lightly relinquished. These make sound economic sense based on cost and overhead reduction due to economies of scale and reduced time spent by management. However, they can also be an integral part of a company's exit strategy from an area or region. As companies begin to reduce U.S. exploration, more management and technical time and expertise, as well as capital, will be focused internationally where large reserve finds, particularly oil, are more possible. These production area JVs/alliances can be thought of as "cash cows" that will provide the future capital to support exploration in other areas. One cornerstone of a cash cow strategy is to cut as many costs as possible and these JVs/alliances should be able to do that. Also, their formation and structure can facilitate quick sales/divestitures, when owners perceive a favorable market.

For any individual joint venture or strategic alliance, the basic drivers can be classified into one of two broad categories ­ either strategic or financial. The most common strategic reasons are:

• New market entry ­ either product or geography
• Leverage of "niche" expertise
• Create critical mass for survival and success
• Create a better asset mix based on strategy
• Create access to or buy expertise and/or technology
• Integrate further into the value added service chain
• Improve competitive positioning
• The primary financial drivers to these transactions are:
• Spread and allocate the risk to those better able to handle specific risks
• Create hedging benefits from an integrated structure
• Accounting and tax implications
• Enhanced financing options
• Cost reduction and economies of scale

 

Some of the more popular specific investment JVs are for the following types of projects:

• Power plant development
• LNG project development
• Conventional reserve exploration and development
• Production of oil and gas in basins and areas where the parties have limited new investment plans
• Downstream oil refining, marketing, specialty products, etc.
• Pipelines, gathering and processing facilities

 

Unfortunately, many of these JVs and strategic alliances will fail if history is any guide. Often times the perceived benefits of a "deal" are so attractive that the required planning process is either incomplete or potential problem areas are either ignored or assumed to be able to be handled at some time after formation.

There are some important requirements for success that should be considered, which are:

• The parties should have a common vision
• In addition to a common vision, there should be a common strategy
• There should be a strong mutuality of interests
• All parties should contribute and share in the success or risk
• There should be a clearly defined decision making process
• Risks should be clearly allocated to the parties that can best manage any risk
• There should be sufficient capital available
• All major terms should be spelled out and not left to future negotiations
• Transfer pricing of products or services to the venture should be clearly defined as to the methodology to be used
• Effective and quick dispute resolution should be agreed to

 

There are several planning considerations that are important to evaluating and structuring a transaction, which are:

• Target investment dynamics and intricacies
• Strong management support
• Fit with the overall corporate business plan
• Build vs. buy alternatives
• Funding, original and ongoing
• Conflicts created ­ internal or external
• Structure of transaction (tax, liability, accounting, and control)
• Operations and liaison effects
• Duration and exit strategies (do you need a prenuptial agreement?)

 

As an editorial point on exit strategies, in the euphoria of putting together a JVs or strategic alliance, exit strategies and conditions are often overlooked or inadequately treated. This can cause numerous and lengthy trips to the court house and far too frequently the company wanting out has to buy their way out at costs that were not anticipated. While in the negotiation or formation stage, no one likes to think about what might happen in the event of failure of one of these complex ventures. Yet there is nothing any more frustrating than having to suffer long lead times and large costs to extricate your company from a failed venture.

Once the business planning process and strategy has been developed, the problem remains to find the right partner. This can often be an extensive search that involves using industry contacts and reviews of track records and reputations. There should be a strong screening process established (kind of like dating around to find the right mate). It is seldom that a "perfect" partner will be found and consequently priorities should be established to make sure that critical success factors are met.

Generally, prior to final agreement on a JV or strategic alliance, due diligence to some degree will be required. Management needs to ensure that the due diligence process is thorough and not limited by the desire to get the deal done. In my career, I have been on all sides of these types of transactions. Unfortunately, as a consulting service provider that includes due diligence for clients, too often the client drive to a deal is so strong that the message to us in due diligence is to look, but don't find any deal killers. This most often occurs when due diligence is delayed until after the terms are set and only very limited time is allocated for due diligence.

In summary, there are many good strategic and financial reasons to consider and enter into JVs and strategic alliances in today's complex and changing energy industry. However, putting them together in a way that will add to the chance of success requires careful planning and execution. Concentration on details and consideration of exit strategies and effects, while time consuming and distasteful in the heady period of putting the transaction together, will save time, money and frustration later on when things inevitably don't go as well as planned.