Due Diligence—Risk Costs of Asset Ownership

In this column, we occasionally highlight applications of risk assessment that are perhaps less apparent to some.  Since risk permeates almost all industrial endeavors, it is not surprising that risk understanding is or should be an essential part of many types of decision-making.  We have already covered risk assessment in incident investigation and as a means of conflict resolution.  With the recent uptick in M&A (mergers and acquisitions) in the US, this is a good time to examine the role of risk in due diligence.

Pipeline systems are assets.  Their value stems from their ability to generate revenue for the owners.  Each pipe joint, tank, compressor, pump, valve, and fitting contributes to the revenue generation.  Each also carries a cost of ownership.

Asset acquisition is common in the hydrocarbon industry.  But too often, insufficient attempts are made to fully quantify the implications of acquiring an asset.  To be sure, key economic values such as the income generation, the maintenance costs, the replacement capital costs, and others are known and presumably drive the purchase decision.

Many, however, don’t recognize that risk too can be quantified.  An industrial asset normally generates some amount of risk.  This should not be ignored during acquisition contemplations.  The risk aspect could rise to the level of being the sole determinant of whether the acquisition should proceed—overriding other economic considerations.

Case Study

A relatively new gathering system was to be acquired as part of a package of oil and gas producing assets. As a pipeline system that was potentially coming under new ownership, current and future producing field volumes and operating expenses were estimated by the acquiring company as part of their due diligence.  However, the expense estimates did not include a quantification of risk.  In the evaluator’s notes, there was only a cryptic sentence or two advising that some leaks have been experienced.

It was only after the acquisition was completed that the new owners discovered that internal corrosion leaks were being experienced on pipelines that were only two years old.  These leaks occurred even though the pipelines were transporting generally non-corrosive hydrocarbon mixtures and maintenance cleaning was occurring regularly.  Subsequent investigations determined that an unusually aggressive form of microbial activity was causing unprecedented degradation rates.

A formal risk assessment on the field’s pipelines was eventually performed.  The results were compared to other assets owned by the operator.  The risk assessment showed that the new acquisition had increased the acquiring company’s annual pipeline risk by 12%, even though the new pipelines added only 2% to the company’s pipeline mileage.  So, although the acquisition’s assets were virtually brand new, they carried more risk than the company’s 40+ year old assets.  This was due to the special integrity threat from internal corrosion, the proximity of the new assets to sensitive receptors, and some higher pressures and volumes associated with the new systems.  The 12% increase in risk was estimated to add tens of thousands of dollars to the company’s annual operating costs.

Whether or not this information would have proved to be a ‘deal breaker’, had it been known prior to the acquisition, was not reported.  However, most would agree that this knowledge would have certainly influenced the purchase negotiations.

The reality is that acquisitions are frequently negotiated very quickly and secretively.  There is often little time or patience for detailed due diligence, especially for more technical issues such as regulatory or risk implications.  Nonetheless, answers to some general risk questions can be the difference between ‘good’ and ‘bad’ deals.  Fortunately, such answers can be obtained quickly when proper risk assessment techniques are employed.

Having full risk knowledge allows more complete understanding of the role of the new asset in a company’s collection of facilities.  The successful manager will take a portfolio view of his assets.  There are costs of ownership that must be weighed against revenue generation.  Each asset should generate revenue in excess of its total cost of ownership, including the incremental risk to which the portfolio becomes exposed when new assets are added.  More on this in an upcoming column.