Established oil and gas investors have long been aware that in this market you need to take a ‘through-cycle’ strategy, managing the up cycle in the knowledge that tougher times are always on the horizon. The execution of the strategy in down cycle, organic or inorganic, can play a decisive role in determining the winners when the market recovers. And the market will recover.
So is now the time to invest? For the long-term, committed investor we believe so. While there may be some short-term downside ahead, the industry is in or around the trough. As US unconventional production continues to decline and petroleum demand expectations are revised upwards each month, the supply overhang will necessarily begin to unwind. The fundamentals of when remain in some doubt although based on current trends we anticipate 2H 2016. For those who believe in the cycle this is an obvious time to invest in the right opportunity.
Until now, there has been no shortage of potential buyers. Rather there has been an unwillingness on the part of sellers to accept conditions that discount the likelihood of a swift return to $90/bbl Brent. After more than a year of falling or depressed crude prices, there are signals that sellers are now becoming more realistic about their business valuations. After five quarters of reporting on declining profits, declining valuations, layoffs and cost-focused strategies, the mentality is beginning to shift.
On the upstream side this is expected to become increasingly material as hedges expire. The best placed firms are protected until Q4 2016 but a large proportion will have their production priced at market value much earlier. Some hedges are beginning to expire already. Worse for the shale producers in the US, the credit lines that have funded the boom are now much harder to come by. Producers in basins that previously attracted significant interest – Sandridge in the Mississippi Lime, or Goodrich in the TMS – now face interest payments of more than 20% or revenues. And they’re not alone.
Signs of distress are also apparent further down the supply chain. As equipment manufacturers of everything from wellheads to rigs work through their backlogs the pressure of stabilising profits increases. Even in the subsea equipment sector, characterised by substantial backlogs since Q1 2013, concern, cost-cutting and layoffs are growing.
Aside from a handful of major acquisition announcements, targeting BG Group, Baker Hughes and Cameron in the upstream and oilfield sectors, activity has remained generally depressed. More M&A activity is sure to follow, however. The potential for efficiency gains and risk balance within a larger, stronger, more integrated organisation will drive others to inorganic strategies. The old business models so exciting in early 2014 need to adapt. The potential of M&A activity to drive improvements in cost and delivery efficiency will be critical if distressed firms throughout the supply chain are able to survive or thrive during this extended down cycle.
Short-term underperformance will remain a concern for buyers – calling the bottom is as challenging as ever. But we know the market will correct. For investors with ‘through-cycle’ investment strategies now and the near future may be the time to invest.