James Cook and Paul Teuten take a look at the North Sea oil and gas market
Even for an industry known for its volatility and cyclicality, the speed of developments over the last six months has taken many people in the oil and gas sector by surprise. Energy companies across the whole sector are facing substantial challenges caused by the current oil price environment.
What is already becoming clear is that there will be ‘winners’ and ‘losers’ as a result of the current turmoil. The question many companies, investors and other stakeholders are asking is ‘how can you limit the damage in the short term and go on to create value from the unique opportunities caused by the down cycle?’
Current market conditions
It is well understood that the cause of the rapid oil price decline was the imbalance in supply and demand caused principally by production growth from Russia, Iraq and the US, where shale production has created an opportunity for US energy independence; and Saudi Arabia’s unwillingness to be the swing producer in response to this production growth.
There are ongoing questions over the stability of the Middle East producers in the mid-term, with ongoing unrest between Saudi Arabia and Iran, together with the social upheaval in Libya, Syria, Yemen, Egypt, Tunisia, Nigeria and Somalia. This all points to significant risk to future supply.
Closer to home, companies operating in the UK continental shelf are some of the most vulnerable to lower oil prices. Whilst there are still 23 billion barrels of oil available to extract from the North Sea, the average costs of production have increased by 400 per cent in the last ten years. The cashflow cost to producers in 2014 was an aggregate cash loss of £5 billion, the biggest shortfall since the 1970s and an unsustainable trend. In addition, North Sea capex increased from £6 billion in 2009 to £16 billion in 2014, yet production continued to fall at ten per cent per annum over the period, highlighting the rising cost of bringing new production on-stream.
Capex and operating costs needed to reduce significantly in the North Sea and this would have been the case without the fall in oil prices. The expectation now is for capex to halve by the end of next year and we are already seeing production costs coming down. Producers are targeting a 40 per cent improvement in operating costs and the service companies we’ve been speaking to have all experienced rate reductions of between ten per cent and 40 per cent since the start of the year.
With its high costs and deep-water exploration, the North Sea was amongst the first to feel pricing pressure as producers started early to cancel or delay projects. This has continued in the new year with significant pressure being applied to the supply chain to reduce costs through contract negotiations. As these negotiations continue, there will inevitably be winners and losers. But this shake out was needed to bring the costs of operating in the region back to reality.
After the shock at the precipitous fall in oil prices and disbelief that they could remain so low, there is now an acceptance within the industry that oil prices, despite the recent uptick, will remain in the $60 to $70 per barrel range for the foreseeable future. This is the new normal by which all industry participants should be planning their future operations.
There is an expectation that these challenging market conditions will provoke substantial M&A activity in the sector. But with the exception of the Shell/BG deal, few large deals have been announced. There are several reasons for this: firstly the impact of reduced spend in the industry is only now hitting companies; actually 2014 was a pretty good year for many and it is only in these next quarters that the pain will really be felt. Secondly, there are few sellers – there are lots of buyers in the market but they are expecting to pay lower values; owners may need to get used to no longer being able to achieve double digit multiples for their assets but this reconciliation to the new normal is going to take time; and there is little panic amongst owners to have to sell now. But the expectation is that this will change over the course of this year and next and we expect to be busy after the summer.
The other influence on deal activity is the banks’ reaction; in the UK the lending banks are perceived by the industry to have had a knee jerk reaction to the uncertainty, with many having stepped away from committing to any more lending and being much more selective in regard to their interactions with clients. The feeling in Aberdeen is that there is a lack of understanding amongst the banks, not helped by the physical distance between them. Banks are feeling the pressure however, as alternative sources of funding start to take interest in North Sea assets.
The competition amongst buyers is anticipated to increase as long-term strategic players and PE houses with new dedicated energy funds compete for deals. We’ve also seen a continuing strong focus on technology in recent M&A transactions, as investors see this as a catalyst for improvements in efficiency, which will be the key to viability of certain fields.
Corporates looking to make strategic acquisitions will be in direct competition. Whilst there is huge investor interest and vast sums of money ready to be put to work in the sector, buyers are having trouble pulling the trigger on opportunities due to the risk of the unknown. In short, it’s going to take a while for everyone to adjust to the new environment before normal M&A activity resumes.
Coming back to the question of how to navigate through the storm and create value in this market, we consider that companies and investors need to be play a long term game – initially being defensive in the early stages of this cycle.
Key areas of focus should be:
- Liquidity issues and cost reduction to match demand. Companies should right size their business based on the current oil price environment, rather than the hope of price increases in 2015, and assume that revenue and margin pressure will persist.
- Treat customers as partners. Companies will be in a better position if they build stronger relationships with their best customers. We see service providers entering in to longer-term contracts and offering bundled services/ offerings to increase customer retention.
- Lender management. Leveraged businesses need to talk to lenders early and be realistic about how the business is likely to perform for the balance of the year. Don’t pretend that sales will increase when there is no chance of this happening. Banks should respect realism.
- Financial flexibility. Companies should look at alternative sources of capital rather than rely on existing lenders.
However, once a clear path to financial stability has been established, the market offers opportunity for those that are ready to go on the offensive. For those seeking to make smaller steps, there are a large number of very talented people that have been let go as a result of headcount reductions: this represents a huge opportunity to selectively make high quality additions. For the more ambitious, acquisitions across new geographies and service diversification to spread risk and increase opportunities will be attractive. Whilst large-scale consolidation in the market is definitely still on the cards as companies seek to take advantage of weakness in the sector, the race for assets is more likely to resemble a marathon than a sprint.
DUFF & PHELPS
James Cook and Paul Teuten are Managing Directors at Duff & Phelps. Duff & Phelps is the premier global valuation and corporate finance advisor with expertise in complex valuation, dispute and legal management consulting, M&A, restructuring, and compliance and regulatory consulting. The firm’s more than 2000 employees serve a diverse range of clients from offices around the world.
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Issue 125 October 2015