Follow us

It has now been over two years since Total made its significant gas condensate discovery in the Brulpadda block, offshore Mossel Bay. The announcement led to much anticipation for the rapid development of an upstream petroleum industry in South Africa.

Recognising the need for a dedicated legislative framework for the oil and gas sector (which is currently governed by the long-standing, mining-focused Mineral and Petroleum Resources Development Act, 2002), in December 2019 the Government published a draft Upstream Petroleum Resources Development Bill (the Upstream Bill). Although the benefit of having dedicated, stand-alone legislation is undeniable, the draft Bill failed to deliver on a number of fronts (see our previous briefing on the Upstream Bill here). Since then, no updates to the Bill have been published (comments from the public were invited before 21 February 2020) and the text has not been submitted to Parliament.

In the meantime, a further discovery was made on the same block 11B/12B in November 2020. The geological potential of the region is becoming clearer and new entrants have farmed into a number of blocks over the past couple of years. The pressure is now mounting on the Government to press ahead with the legislative reforms.

Increasing M&A activity
While investors wait to see the Government's updated proposals for the sector, the country is seeing a growing number of 'farm-in' and 'area of mutual interest' transactions, as exploration companies position themselves across the most prospective acreage. These exploration-stage transactions are routine in the industry, but the peculiarities of the current legislative 'limbo', as well as a number of provisions of the Upstream Bill (if they become law in their current form), may present some additional complexities for would-be investors in South Africa's nascent upstream sector.

Carry obligations
All of the usual considerations for these types of transactions will apply. For instance, as the consideration for acquisition of the interest will ordinarily take the form of the purchaser assuming all or part of the seller's future costs on the block (rather than a cash payment at closing), particular care needs to be taken in drafting these 'carry' obligations, including the works (and corresponding work programmes and budgets) to which they relate, calculation of agreed carry caps, etc. This is a common area of dispute in farm-in agreements (FIAs).

The presence of a carried national oil company (NOC) will invariably complicate the carry mechanics under an FIA, notably as to how the parties' obligations to carry the NOC are reflected in the FIA carry. As is common in many jurisdictions, the Upstream Bill provides for the NOC, PetroSA in this case, to hold a carried interest in any exploration or production right, set at 20% in the Upstream Bill. However, the mechanics of the 20% carried interest are far from clear in the Upstream Bill, notably in relation to if and how exploration-stage carried costs are recoverable from future production. More fundamentally, the Upstream Bill is not clear at which level PetroSA is to hold its interest (in the exploration or production right directly or in the share capital of the titleholder).

BEE considerations
In addition to the PetroSA carried interest, every exploration and production right must have a minimum of 10% participating interest held by black persons.

Securing financing for equity investments into exploration projects is particularly challenging given that exploration activities are highly speculative, capital intensive and generate no immediate revenue. Exploration companies may therefore need to consider alternative funding mechanisms to introduce black economic empowerment (BEE) partners. By way of example, notional vendor loans are a fairly common financing mechanism in terms of which the BEE partner subscribes for shares in the exploration company for a nominal amount on the basis that any dividends accruing to it would be applied to reducing the balance of the notional loan, which is usually set at the market value of the shares. This method of financing allows the BEE partner to take full title in and to the shares without the need for an actual transfer of funds as would be the case with a traditional loan.

Taken together, the economic arrangements (between buyer and seller and among partners) are likely to be more complicated in the South African context.

Waiting longer to close
As in any sale and purchase agreement with a gap between signing and closing, the parties need to agree how to manage this interim period. There is always a natural tension regarding this period, where the purchaser is committed to acquiring but the transaction is not certain to complete. The need for government consent in oil and gas transactions means these provisions are standard practice in FIAs. However, the current context in South Africa means that parties can expect particularly lengthy interim periods, with some transactions taking in excess of a year to complete. During such a lengthy interim period, new work programmes and budgets will inevitably need to be developed and agreed and potentially key project decisions made (such as applications for licence renewals). Parties to the FIA will therefore need detailed provisions setting out how they will agree on any of those material decisions, particularly where those decisions will have an impact on carried obligations.

Transition to new legislation
As noted in our 2020 briefing, the transitional provisions in the proposed Upstream Bill are not clear, notably in relation to any pending applications and lodgements of rights and permits. This could create additional complications for transactions that are ongoing during the adoption of any new legislation, if the relevant agreements do not fully address all potential future scenarios. This could have a particular impact, for instance, on the applicability of the provisions relating to the State's carried interest.

South Africa has clear potential to develop a viable upstream sector and investors appear prepared to make the necessary investments. However, despite some signs of activity, including ongoing exploration and appraisal and new entrants into existing exploration blocks, the level of activity remains muted. It is clearly for the Government to make the next move in order to unlock the country's potential in this sector.


For more information, please contact Patrick Leyden and Paul Morton or your usual Herbert Smith Freehills contact:

Patrick Leyden photo

Patrick Leyden

Partner, Johannesburg

Patrick Leyden
Paul Morton photo

Paul Morton

Partner, Paris

Paul Morton

Related categories

Key contacts

Patrick Leyden photo

Patrick Leyden

Partner, Johannesburg

Patrick Leyden
Paul Morton photo

Paul Morton

Partner, Paris

Paul Morton
Patrick Leyden Paul Morton