Global investment in oil&gas continued throughout the downturn, with 2009 investment back near 2007 levels following a record 2008, according IHS Herold data (see story on Page3).
Despite this, production from the UK Continental Shelf (UKCS) has declined throughout the era of cheap and plentiful finance since 2000.
This raises the question: who will invest in the long-term development of the UKCS? And why would they do it?
There is a simple answer to the first question. Data clearly suggests that total income far outstrips the operating expense, capital expenditure and tax demands on the sector.
Therefore, in theory, the UKCS could be self-funding, with profits from production being ploughed back into exploration and development, and little external requirement for finance.
The reality is far more complex. The UKCS is competing in a global oil&gas market for investment (particularly for equity). UK producers may not be UK explorers. An investor whose expertise lies in exploration is likely to prefer to invest their cash in exploration worldwide than to invest in the entire oil&gas cycle in a single region.
In addition finance providers – be they private equity, public markets, bond holders or banks – have quite different investment criteria, and most do not wish to be involved across the entire lifecycle of field development, and funding UKCS activity gets complicated.
While the capital market for exploration finance is primarily supplied by equity, producing assets are attractive to debt providers, who can invest against more predictable cash flows.
This means that different sections of the market have very different financing requirements. In production, funding comes chiefly from reinvestment of cash flows. The principal requirements to create an attractive investment climate here are fiscal stability, fostering shared infrastructure and managing abandonment costs sensibly.
At the development level, project-specific debt is potentially available. A functioning debt market and a stable fiscal regime make investment possible.
In exploration, equity is often the only source of funding; the considerations for investment include high potential returns, to be increased by low costs and taxes.
Finally, a liquid market for transactions is a requirement to attract investment into the sector, particularly at the exploration stage. Finance providers tend to crystallise the returns on their investments through merger and acquisition activity, rather than, say, investing for a project lifecycle and waiting for the cash flows from production to come in years after initial investment in an exploration prospect.
Happily, the equity market is improving, and IPOs (initial public offerings) are back on the agenda.
Funding in the public markets evaporated during 2008-09. There were no new issues on the Alternative Investment Market (AIM) from mid-2008 until early-2010.
However, this year, IPOs of oil&gas companies are back. This follows a recent strong run for secondary issues, which has enabled already listed businesses to recapitalise, and looking at the pipeline, going public is increasingly an option for presently unlisted businesses.
The landmark transaction to date this year is the plan announced by Petrofac and Lundin to spin off and float their North Sea assets in a deal reportedly worth $1-1.5billion.
In a constrained market, however, capital is not readily available to all companies. Focus areas include those with near-term returns such as exist in the North Sea. But speculative exploration or capital-intensive projects requiring a high oil price in order to be economic are less likely to receive investment, at least in the public markets.
The debt market is reopening, too.
The availability of debt finance is improving as UK banks get back on their feet and are being urged to provide liquidity. It should be said that the focus in banking remains, nevertheless, on de-leveraging, shorter-loan terms, higher pricing and tighter covenants, and there is less competition among debt providers.
But it is certainly the case that debt funding is available for good projects that are profitable at sensible projected oil prices.
Transactions are the key to continued investment, but who is buying, and why?
Merger and acquisition activity will encourage continued investment in the UKCS over the long term as sellers crystallise gains and buyers invest to breathe new life into their acquisitions.
Four chief categories of buyer in the UKCS will be prominent: private equity, smaller independents, European utilities and Japanese trading houses.
All are likely to increase their investment in the UKCS in the short to medium term.
Private-equity investors made a cautious return to the oil&gas market in late-2009. In December, RIT Capital Partners pledged £121million to North Sea start-up Agora Oil & Gas.
The previous September saw the acquisition by Fairfield Energy of two UK North Sea blocks from BP, Enterprise Oil and Mobil. Fairfield is backed by a syndicate of PE investors led by Warburg Pincus.
There is also a handful of heavyweight management teams which see value in the North Sea. A number of well regarded private-equity firms are known to be interested in backing them, identifying opportunities in untapped or neglected assets, new technologies, and a liquid market of future investors to provide an exit.
Listed independents have, for some years, represented a significant investor class in North Sea assets as the majors have divested marginal and end-of-life fields, and smaller players with specific expertise and a lower cost base have bought in, taking advantage of easy access to finance in the years to 2008.
Many formerly acquisitive listed independents survived the period of severely limited access to capital but are now focusing on optimising existing assets. Investors have shown faith in refinancing these listed companies: secondary fundraising in each quarter has progressively increased since the lows experienced in the final quarter of 2008.
Utilities now represent a major buyer class. Europe is a net gas importer and utilities are particularly interested in investing in North Sea gas assets to secure supplies and reduce price volatility following supply shocks in recent years.
Connected to this is the fact that gas storage capacity (of which the North Sea infrastructure is a potential source) is now taking on a strategic significance.
The landmark transaction in this category in 2009 was, of course, Centrica’s £1.3billion acquisition of Venture Production. RWE (which owns the UK’s NPower) has also been active, acquiring a majority stake in the Breagh development.
Fourthly, a number of Japanese trading houses have cash to spend and wish to invest upstream in order to expand and bolster their trading operations. These buyers are often interested in taking a minority stake, which is a differentiator in certain transaction processes.
Production in the UKCS may have declined over the last decade, but there is increasing appetite for investment in UK oil&gas.
Fiscal stability, increased debt availability, a range of strong transaction rationales and investors from several quarters competing to secure UKCS assets at different stages in the oilfield lifecycle will all play a role in the long-term development of the UKCS.
Alec Carstairs is head of oil&gas at Ernst & Young in Scotland
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