2008 began as a year of tremendous promise. Commodity prices were on a steep upward trajectory and showed no signs of slowing down, global economies were growing and there was an unbridled sense of optimism and that it really was different this time.
Activity levels in the North Sea were strong as producers were working furiously to bring projects online to capture the record prices, and caution was being thrown to the wind in terms of costs.
In order to capitalise on the success of the industry, private equity firms, flush with cash from recent fundraisings, were clamouring for exposure to the oil&gas sector.
Crowning all of this, the UK Government introduced an 80% increase in the capital gains tax rate, solidifying entrepreneurs’ thinking that now was the time to seriously consider selling their businesses. All this created one of the most active deal climates in recent memory.
Following this burst of activity, there was a natural slowdown as the year cruised into summer.
Few would have any idea of the speed and magnitude of the credit crunch that would proceed to batter first the inter-bank, then the lending, then the equity markets.
Storied names such as Lehman Brothers, Merrill Lynch and Wachovia would fall in the US, followed closely by troubles in the Royal Bank of Scotland, Halifax Bank of Scotland and Bradford & Bingley.
Emerging markets would be forced to turn to the International Monetary Fund to prop up their economies, and by the time Christmas had come, close to $1trillion would be spent in order to stave off collapse.
While the failures of the financial institutions were quite serious, the credit crunch began to penetrate other parts of the market.
As the lending market began to contract, private equity houses found that injecting debt into their transactions at the lofty levels witnessed before the beginning of April was no longer possible.
Increasing interest costs also began to hit their portfolio companies whose deals had been done in the preceding year, causing covenant cushions to contract and making already nervous lenders even more skittish.
With access to debt becoming increasingly difficult, some of the generalist PE houses that were starting to explore the oil&gas and oilfield services sectors began to shy away.
Even trade was not immune – corporations which had been sitting on swelling cash balances as a result of having lost some of the auctions in the beginning of the year suddenly switched their focus to conserving their cash for fear they might need it later on.
As the deal market continues to soften, more and more companies are finding their business models under threat and recognise the need to seek alternate arrangements to execute their plans.
The AIM market has begun to consolidate, with Wintershall bidding for Revus Energy and Granby Oil & Gas being acquired by Silverstone Energy.
There have also been a number of offers made as share prices have fallen, such as Salamander Energy’s bid for Serica Energy and Endeavour International’s offer for Ithaca Energy – bids that targets have rejected as opportunistic and not reflective of the true value of their assets.
In the wake of these spurned offers, target companies will find themselves under increasing pressure to deliver value to shareholders. As a result, some companies are being creative in their financing strategies, such as Ithaca Energy’s debt financing arrangement with Dyas (a subsidiary of a Dutch conglomerate).
Those that are able to survive through this kind of ingenuity will find they have been given a reprieve from more dire straits, but perhaps only temporarily.
Although the debt markets have become challenging in the short term, there is still strong support for the sector from both PE houses that are familiar with the space and the banks on a medium to longer-term basis.
Banks will shortly begin their capital allocation process for the coming year, and oil&gas will continue to feature prominently.
While margins will be higher, debt levels lower and credit committees tougher, companies will still find support for projects that are robustly designed and well thought out. Indeed, some PE houses have taken advantage of the current climate and have been able to secure deals regardless of access to bank funding.
One of the more notable examples of this was Lime Rock Partners’ participation in backing the ex-PSL management team to purchase Enermech on a fully underwritten equity-only basis.
Despite some optimism in certain quarters, the transaction landscape is still fraught with uncertainty.
There is considerable debate around the direction of oil-price movements, as well as the length of time they will stay at current levels. While a consensus exists that current prices are too low, given the supply and demand balance, it cannot be ignored that a global recession will continue to impact commodity prices.
This raises the issue of whether now is an appropriate time to consider exit options for businesses.
Are we near the bottom of the cycle and, therefore, too early to consider a sale, or is this simply a brief pause before the next leg down where companies will see even further value erosion?
This uncertainty will inevitably lead to pricing compression on transactions at both the listed and private levels, although the time lag for this remains to be seen.
As Charles Dickens once said, it was the best of times and it was the worst of times, but what is certain about the transaction market is that 2009 will be an interesting, if not volatile, year.
Alec Carstairs is an Ernst & Young oil&gas partner
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