The last eighteen months has marked a period of market shifting volatility in the Oil and Gas sector globally. Oil prices have remained low and unstable and organisations with exposure to the UKCS have been especially affected given the basin’s maturity and its relatively high cost base.
This has been a torrid time for the market as a whole but following the recent OPEC decision, there appears to be light at the end of the tunnel. With supply and demand seeking a gradual equilibrium, the oil price has recovered a little. Among some organisations there is a growing confidence that perhaps we have reached the trough – If we are poised for a recovery, this seems as good a time as any to take stock and examine what we’ve learnt from the experience and what organisations need to focus on to succeed in this new world.
Cost reduction and access to finance…. not the ‘be all and end all’
Since the start of the crisis, the prevailing trend in the market has been one of retrenchment. Most operators have significantly scaled back on their upstream CapEx spend and deferred projects globally. Many organisations have completely redefined their business model, trying to divest assets which their inherent cost base cannot make profitable and focusing on the projects where they can add value.
In addition, organisations have been looking to strip out costs from their ongoing operations both internally and externally through their supply chain.
In this vein, producers large and small have undertaken a serious examination of their third party contracting models, challenging their service providers to squeeze greater value out of existing contracts, scrutinising the services provided by third party providers against agreed service levels and challenging previously accepted out-of-contract costs or service deficiencies. In some cases operators have tried to completely renegotiate existing supply contracts.
This reassessment at the top has had a knock on effect throughout the supply chain and has had an acute impact on oil field service companies (OFS), who have responded by taking the tried and tested cost reduction measures: cutting CapEx and headcount, while minimising OpEx. Margins have been eroded and many OFS companies are still in financial distress. This is a problem for the whole industry not just the OFS sector. Without a thriving OFS sector and with the threat of key suppliers going to the wall, the sustainability of existing and future oilfield operations is called into question.
In the upstream market at least, large-scale financial restructuring has allowed companies to reduce leverage and improve liquidity as banks have continued to support struggling businesses where they see potential future upside. However, this has not been cheap and the ongoing funding costs may cripple those organisations that are not able to reform and adapt.
Continuing to cut costs, squeeze the supply chain or refinance cannot be the only levers that companies in the sector pull to remain competitive. Those companies that will thrive in the upturn will be those that are able to meet the challenges by redefining their business model, such as:
• focusing on innovation and R&D as a means to maximise future opportunities;
• looking at “Big Data” as a means to improve efficiency of operations whilst enhancing capability sets;
• ensuring future capability gaps are narrowed through effective use of partnerships, technology and outsourcing;
• minimising the complex nature of operations, optimising talent pools and capital deployment;
• targeted and focussed M&A which reduces complexity and differentiates the business; and
• working smarter through innovative solutions, use of consortia and intelligent demolition techniques to minimise the cost of decommissioning.
By adopting these ideas like these, whilst maintaining a sustainable cost reduction and cost management mindset, companies can position themselves well to be resilient at lower oil prices. Although prices may be rising, we may never return to $100/bbl but there is no reason why those players who are able to operate efficiently and profitably in the current environment, whilst investing sensibly for future growth, cannot emerge from the turmoil.
The M&A market has returned, with a twist
Another indication that there is an uptick in confidence, is the return of M&A activity in the sector. Generally, Q2 and Q3 2016 have seen M&A activity rebound sharply in the upstream sector but without a corresponding rise in OFS deals. However, there have been some changes, including:
• buyers increasingly grappling with purchasing assets out of administration or at least an increased risk that they won’t be able to rely on the contractual protections they obtain because the seller will not have the financial standing to meet their commitments.
• there has been renewed interest in the sector recently from PE and sovereign wealth funds, perhaps sensing that they may be able to acquire good assets at reduced prices. These (relatively) new market entrants are changing the landscape and make up of M&A transactions e.g. an increased use of PE style investment and finance structures and offtake/farm in arrangements as quasi finance structures and much more commercial arrangements being proposed around the thorny issue of decommissioning liabilities.
Only time will tell if the market sees the upturn in deal activity towards which recent deals have hinted. If the floodgates do open, buyers, sellers and their advisors need to be prepared for a changing marketplace and be poised to adapt to potentially changing market norms (at least while the period of low oil prices and instability remains).
Keith Bottomley is Solicitor in the Energy, Utilities, Mining and Infrastructure team in the Corporate practice at PwC.