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The race for survival in the oil and gas industry, closing to an end

As oil prices are close to the lows of the last three decades and the number of mergers and acquisitions is decreasing, 2015 may be considered the year needed by the oil and gas industry in order to accept new realities that will be valid for a long time. The next step, prompted by unprecedented financial pressures and by the need to restructure the business models the companies must align to, makes many of the actors in the field to be on the edge in the race to stay on the market. The oil and gas industry is thus ready to be one of the areas with great potential for business in terms of mergers and acquisitions deals in 2016.

The fall in oil prices that began in the second half of 2014 was a phenomenon that should have triggered a frenzy of deals in the mergers and acquisitions field for companies in the oil and gas industry. But things went backwards! In the first quarter of 2015, when oil prices were close to the lows of the past three decades, and was obviously in full race of falling, was recorded the lowest level of transactions in the past about three years.

According to statistics from the report “Oil & Gas Mergers and Acquisitions Report - Year-end 2015,” published by Deloitte earlier this year, in the first three months of last year only 74 transactions were recorded; the number of deals showed a certain recovery in Q2 and Q3, but then fell again in the last quarter of the year, so that 2015 as a whole ended with 379 transactions. It was a significant lower number than in the previous year, 2015 being the worst year in this regard, after the peak in 2012. In fact, looking further behind, according to the same Deloitte report, the total number of registered mergers and acquisitions 2015 was even lower than the one recorded during the great financial crisis of 2007-2008 (see the chart ‘A locked market’).

Delayed bankruptcies

Analysts explain this paradox, given the discrepancy between the oil price and the number of transactions and acquisitions on the market, by the existence of a specific general context. Thus, they say, the fall in oil prices occurred against a background marked by the resumption of economic recovery in the US in particular and by the stabilization of the economic situation in Europe - the second largest economic bloc globally. This has fuelled the expectations of price recovery. Concomitantly, as consequence of the low interest rates for years in a row, the actors on this market continued to have access to low-cost funding which allowed them to postpone the moment of internalising the losses arising from the fall in oil prices. On the other hand, the unexpected strength of the actors was supported by the fact that the technological advance also allowed them a continuous adjustment of production costs. This explains, for example, why the US ‘shale’ industry came through longer and

A locked marketbetter than expected, given the negative effects of the falling prices. This is therefore the context before the collapse of oil prices in H2 of 2014! A collapse that, even if it did not take the market by surprise, has placed potential buyers and sellers in ‘stand-by’, waiting for stabilization, due to the its speed and scale. Although the number of potential sellers increased, buyers became more reluctant to assuming risks, as any asset purchased ‘cheap’ might prove later that could have been bought even cheaper . Meanwhile, on the selling side, the same unknowns made the sellers consider whether this negative context on the oil market is really the worst time to sell - which led them to focus more on restructuring operations in order to obtain a better cost control and especially to obtain additional financing.

The effect of cheap money

One can therefore speak of buyers’ reaction of ‘withdrawal’ from the markets, which could be considered one of the defining elements of reducing the number of mergers and acquisitions worldwide. On the other hand, for vendors the cheap and plentiful money have artificially kept alive many of the companies that normally would have had to leave the ring (which would have increased the number of M&A transactions).

This phenomenon - which is one explanation for the resilience of the industry in 2015 (as measured by the low number of M&A transactions, disproportionately small in relation to the extent of the oil prices collapse) - originated in 2006-2007, when the prospect of oil price increases started a true chain reaction for investments in this field; the first signs of the ‘exuberance’ in this area (rational or irrational, this is a different discussion) surfaced after 2008-2009, when a major inflection of international financial flows occurred worldwide, meaning that money began to head towards the oil and gas industry in disproportionate share against other areas. Therefore, according to the “Oil and Debt” report published mid last year by BIS (Bank for International Settlements, institution headquartered in Basel, Switzerland, which acts as central bank for national central banks) during 2006-2014 the value of debts contracted by issuing bonds by the oil and gas companies exceeded the amount of loans taken through the same type of instruments by the companies in all the other sectors.

At the end of 2014 this led to total debts of the companies in the oil and gas industry (as bank loans, bonds, etc.) of more than USD 2,500 billion; the ‘exuberance’ was revealed not only by the value itself but also by its growth rate from one year to another. During 2006-2014 the amount of debt contracted by oil and gas companies through bond issues had a growth rate of 15% per year (from USD 455 billion in 2006 to USD 1,400 billion in 2014). Concomitantly, the industry had borrowed heavily from the banks: the amount of bank loans contracted at industry level also increased at a high pace of about 13%, from USD 600 billion to USD 1,600 billion. “Two things happened: we had high oil prices while the central banks had a very relaxed monetary policy,” said Spencer Dale, BP chief economist, quoted by Financial Times in mid-April 2016 explaining the phenomenon. “It was a mix that has boosted and supported the industry,” he added.

That was “a classic bubble example,” stated Philip Verleger, one of the economists specialized in energy, quoted by the same British publication, also in mid-April 2016, talking about the phenomenon which led the global oil and gas industry to the current situation. “It was a race of irrational investments, fuelled by the expectation that prices will continue to grow,” Verleger added, in trend with the existing general opinion among analysts.

The FED and oil

“The companies that borrowed money when prices were high will go through a difficult period,” Verleger pointed out on same occasion, even though they succeeded for some time, aided by a favourable context, to postpone a painful final. An ending that cannot be delayed, as the costs due for this phenomenon of debt increase, of assumed liabilities, over several years, is harder to roll over. Out of the industry’s total debts, which according to BIS were of about USD 2,500 billion at the end of 2014, no less than USD 550 billion were loans and bonds due in the next five years; about USD 300 billion are due by the end of 2017 (USD 72 billion had to be rolled in 2015, USD 85 billion are due in 2016 and USD 129 billion are due in 2017). In such context, the FED decision to hike the key interest by the end of last year is the first of the elements that bring recognition to a painful reality. In December 2015, the US Federal Reserve Bank increased its key interest rate by 0.25 percentage points for the first time since 2006. Since similar decisions are expected in the next period (although in the first months of 2016 FED has twice postponed another increase), the step taken by FED is a first impulse in a process meant to end the mechanism by which some of the players in the oil and gas industry have delayed the restructuring required by the fall in oil prices, by rolling the debts.

The moment of acknowledging the issue is all the more difficult to avoid as, over the trend of more ‘expensive’ money (which will complicate financing and/or refinancing old debts) overlaps a battle for market share between large producers, a battle fiercer than ever . The best example of this is the failure of the meeting in Doha in mid-April 2016; a meeting that, despite having modest goals (the draft resolution and discussions were focused only on the idea of freezing crude oil production until October at January level) was a failure because of a dispute between Iran and Saudi Arabia - the two biggest rivals in the Middle East. “Iran will not give up under any circumstances its historical output share,” said at that time the Iranian Oil Minister, Bijan Mandar, expressing Iran’s firm positioning on a market where it wants to take advantage of the partial lifting of international sanctions - after the entry into force of the nuclear deal by mid-January - in order to increase output and exports and to regain its market share.

The drivers of paradigm change

At individual level, it is said that the first step in solving a problem someone has is recognizing the existence of the matter; extrapolated to the oil and gas industry, it can be said that 2015 was the year when it needed to internalize and to recognize that it is facing a systemic difficulty. This is what John England, Vice-president in charge with the oil and gas sector in the United States with the consulting company Deloitte, says in a report published in early 2016. “The industry has gone through all the five phases of pain caused by the fall in oil prices and is now in the phase of acceptance; the companies are forced to accept that they will be in this situation for a long time and that businesses should be developed in agreement with this state of affairs.” This process, which explains why and how the managers have postponed radical decisions (and the number and value of transactions on the market in 2015 were significantly below the 2014 level), is very close to the final chapter, as John England explains. Therefore in 2016 lies ahead a paradigm shift, as there are many prerequisites needed for a revival of M&A transactions on the market. Jason Rosychuk, oil and gas specialist with the consulting company Pinset Masons, claims the same. Following a survey conducted among managers in the American oil and gas industry in early February 2016, he concluded that they expect an increase of M&A transactions in the next 12 months, amid unprecedented tensions in the field. From his perspective, the phenomenon of acute financial problems is just one of the engines of the expected changes; he claims the opportunity some companies have to expand their business to new areas is very important. “Technology is one of the key trends, as oil and gas industry practically turns into a high-tech industry that pushes companies to buy new technologies such as, for example, those in the ‘shale’ field,” Rosychuk says.

Evolution of oil pricesHis perspective on the evolution of M&A businesses is shared by the specialists of the consulting company Wood Mackenzie, who, in a report released earlier this year, were saying: “We expect 2015 to be the year of minimums for the M&A transactions. Uncertainties about the price trends have maintained and have amplified the differences between sellers and buyers, leading to reduced activity in this area since October 2014. But after 14 months of resistance to change, doing nothing is less and less a valid option.”

According to Wood Mackenzie analysts, the building up of financial pressures will increase the number of potential sellers, because the balance sheets will worsen unless rebalance comes by asset sales. And this may happen given that funding options will be more limited, while companies face the need to restructure their debts. The shareholders will be less interested in capital influxes than they were, for example, in Q1 2015, when the expectations for a quick rebound in prices were still high. Thus, the number of vulnerable players will grow. If large companies or those owned by the states may be able to hold to the low prices for several years, in the lower echelons the options are virtually nonexistent, making the assets sale a necessity.

Wood Mackenzie analysts believe that the large players will look carefully for asset acquisition that provide strategic advantages on long term, while smaller players – which have sound balance sheets, will not hesitate too long to take advantage of the competitors’ problems. In addition, this ‘game’ is increasingly tempting to ‘opportunists’ and the money in stand-by is at levels higher than ever. According to surveys conducted in the United States by a consulting house specialized in this field - Preng & Associates, more than USD 80 billion are currently in the accounts of private equity funds, pending investment opportunities.

Oil price, an unknown

In this context, a rebound of oil prices could be one of the reasons for resumption of the M&A transactions market, Wood Mackenzie analysts say, who expect oil to reach the level of USD 65 per barrel in the last quarter of this year. Oil price volatility remains an obstacle in completing any agreements between sellers and buyers, Wood Mackenzie experts emphasize, arguing that its stabilization is the key to unlocking the transactions (see the graph ‘Evolution of oil prices’). Moreover, the dependence of the industry managers’ appetite for carrying out transactions is revealed by other studies as well. One of the latest analysis on this subject - a survey conducted by the American publication “Oil & Gas 360” (a publication owned by Enercom Inc., one of the consulting companies that provides niche services for the sector) in early February 2016, shows that 44% of company representatives in the industry would be interested to purchase assets if the oil would stabilize at around USD 30 per barrel, while 30% of respondents would not conduct any transaction of purchase or sale in such a scenario. This result may suggest that there still are a significant number of companies that continue to operate following the pattern of recent years, but that the share of those who are considering possible strategic acquisitions is quite significant.

On the other hand, the interest of buyers seems not to be focused on very large transactions. 40% of respondents stated that for the next 12-18 months, they will focus on transactions with values ranging between USD 100-500 million; 60% of participants to the survey expect businesses to take place rather in the oil industry’s ancillary services.

Conclusions and outlook

The combination given by the falling prices and the rising costs of loans in recent years, plus a peak in payments in 2016 and 2017 and the prospect of higher financing costs as a result of the FED increased key interest rate is therefore likely to further increase the already existing pressures on the companies in the oil and gas industry. Pressures which sooner or later will cause sellers to take the final decision, because the low price of oil leads, among others, to eroding the assets value with which the companies have guaranteed the loans; hence, every review of the collaterals decreases the assets value, while significantly reducing the amount of the funding lines - and thus the companies’ ability to borrow money.

Concomitantly, the decline in oil prices has reduced the revenues and the companies’ profitability, and the downward trend of ratings - determinant in taking new loans - significantly increase the existing tensions on financing the industry. This context makes that a large part of the actors in the oil and gas industry is already in the final stage of the race to remain on the market. And the end of the race is only a matter of time.

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