A two-track energy business
There’s a growing divide between big firms and smaller players in the oil and gas sector, and nowhere is that gap more evident than in access to finance
In May, China’s state-owned Sinopec joined a growing list of major oil and gas firms looking to take advantage of the easing credit markets and super-low interest rates to issue debt to fund capital expenditure plans.
Sinopec sold $3 billion of debt in its first dollar-denominated bond sale in more than 15 years, attracting orders totalling more than $19bn, at interest rates that credit analysts termed fair. Moody's Investors Service, which rated the bonds Aa3, said the proceeds of the issuance would be used for general corporate purposes in regard to Sinopec's overseas businesses and to fund its overseas expansion plans. So far this year, Sinopec has acquired a one-third stake in five of Devon Energy’s shale oil and gas fields for $2.44bn, and a 30% stake in the Brazilian unit of Portuguese oil company Galp Energia for $5.16bn.
With this deal, Sinopec became the fifth Chinese energy company to sell dollar bonds in 2012 following a record amount of debt issued by Asian borrowers in April, which included a $2.5bn issue from Indonesia's state oil-and-gas firm PT Pertamina; according to Dealogic, dollar-denominated debt issuance out of Asia, excluding Japan, in the first four months of 2012 totalled $56.4bn, significantly above the $39.5bn issued in the same period last year.
What this issuance demonstrates, say analysts, is that cash flow-rich companies like those involved in the energy industry – in this case, buoyed by high oil prices (the average price of a barrel of Brent crude in the first three months of the year was $119, or 12% more than a year ago) – have found enough depth in investor demand and confidence for this to be a sustainable market, despite the mounting sovereign debt crisis in the Eurozone. And bankers say the pipeline of bond deals remains strong.
In May, Ernst & Young released the results of its Global Capital Confidence Barometer, in which it found that 87% of the oil and gas companies that responded view credit availability as stable or improving, with many of these companies taking advantage of the improved credit conditions and favourable interest rate environment to reduce their cost of capital. E&Y said 71% of executives surveyed expect their debt/capital ratio to decrease or remain constant over the next 12 months, while 49% of respondents expect to use debt to finance deals, up from 30% six months ago.
“High levels of liquidity among yield-focused investors have created favourable conditions for corporate debt markets,” notes Andy Brogan, E&Y’s global oil and gas transaction advisory leader. “Companies are no longer looking only to reduce the cost of finance. Now that interest rates have been at historic lows for some time, those benefits have already largely been achieved. Instead, companies are seeking to optimise their capital structures and reduce their overall cost of capital, through rebalancing debt and equity levels, increasing debt maturities, or shifting short-term bank lines of credit to other forms of debt finance, such as private placements.”
That growing level of confidence in the industry has been in evidence since the start of the year. In January, the Economist Intelligence Unit (EIU) issued its annual barometer of the oil and gas industry, Big Spenders: the outlook for the oil and gas industry in 2012, which showed that of the nearly 200 oil and gas executives asked for their views about industry trends over the next 12 months, the share that described themselves as either highly or somewhat confident about the next 12 months had risen from 76% the previous year to 82% this year. And that increased optimism was poised to feed through into capital spending increases. “According to our survey, nearly two-thirds (63%) of respondents are planning to invest either somewhat or substantially more over the next 12 months, whereas in last year's survey that figure was just 49%,” noted the EIU.
Within that survey, however, was revealed what is being called the emergence of a “two-track” industry. While just 23% of executives surveyed cited limited access to capital and finance as a worry, those surveyed represent firms ranging in size from less than $500m in revenue (76 executives) to more than $500m, and it was the former group that drove up this issue to fourth place of worries from seventh place the previous year.
Thus, there is developing a situation where national and international oil companies (NOCs and IOCs), generating huge amounts of cash and enjoying ready access to financing, are on the hunt for junior oil and gas companies, whose lack of access to financing is forcing them to look to consolidation to meet their capital expenditure plans. In the first quarter, the percentage of funds raised by junior AIM-listed companies dropped to just below 20% of the total amount raised by AIM-listed companies, which compares with just under 40% of the total these juniors raised in the third quarter of 2011.
“The big companies are not capital constrained, they’re more likely to be opportunity constrained, and so the logical thing is for smaller companies to get bought by big companies and the catalyst that’s driving that is the lack of finance for these smaller companies," says Jon Clark, UK oil & gas transactions leader at E&Y.
E&Y's latest Oil and Gas Eye report, which provides quarterly analysis on activity driving the junior energy companies listed on London's AIM market, shows that in the first quarter there was an increase in M&A driven by a lack of access for these smaller outfits to development financing.
“It’s counter-intuitive, but a lot of this activity has been driven by challenges in accessing capital, which has then made companies vulnerable to takeovers,” says Clark.
During the first quarter, Premier Oil and Ophir Energy completed their acquisitions of EnCore Oil and Dominion Petroleum respectively. In addition, there were three offers made for other companies in the quarter. In February, East Africa-focused Cove Energy received a proposed offer from Shell to acquire the company in a cash deal that valued Cove Energy at £992m ($1.5bn). Two days later, state-owned Thai firm PTT Exploration and Production made a higher proposed cash offer of £1.119bn for Cove. Then in March, Total announced it had made a possible cash offer to acquire Wessex Exploration for 10 pence a share, though this was rejected by management and in early April Total withdrew its offer. Finally, in March, Ithaca Energy announced that it had received a confidential, non-binding proposal to acquire the company. Ithaca added that it had also received unsolicited interest from a number of third parties.
This is happening at a particularly bad time for juniors involved in the unconventional segment in the US, where greater costs associated with more capital-extensive plays are being borne just at a time when there is a looming credit crunch in the sector.
Dr Ruud Weijermars of Alboran Energy Strategy Consultants says the oversupply of natural gas on the North American market, and subsequent drop in prices to 10-year lows of under $2 per million British thermal units, is due to the easy and cheap credit that has been made available to shale-gas independents, which allowed them to keep drilling even when the business case to do so didn't exist. Now these funding sources are drying up.
This situation is exemplified by the travails of Chesapeake Energy, the US’ largest independent gas explorer, which is reeling as its debt levels soar and financing alternatives dry up. On 15 May, credit rating agency Standard & Poor’s pushed Chesapeake further into junk territory by downgrading it a notch to BB-, saying the company faces major uncertainties in these prevailing adverse business, financial and economic conditions.
“The risk profile of the shale gas business has simply become too high for any further debt and equity financing to be feasible,” argues Weijermars, calculating that the funding gap faced by the 20 major US shale-gas producers alone amounts to about $30 billion for 2012.
As such, Bruce Edgelow, vice president of the energy group at ATB Financial, expects to see a greater number of juniors succumb to high debt, while others will bet the company's future on the success of a few high-risk wells.
“Executives will need to manage risk appropriately in terms of effective deployment of capital as well as hedging commodity price fluctuations. They will also need to plan for potential higher interest costs on debt and manage those costs through a stand-alone interest-rate hedging programme,” he says.
Edgelow notes that all this comes just as access to capital for juniors is becoming more vital than it has been in the past, because these firms have begun to transition from drilling moderately priced vertical wells to drilling much more capital-intensive resource plays. For example, in 2000 the cost to drill and complete one well in Pembina was about $330,000, Edgelow says. But by 2010, this cost had ballooned to about $2.75m due to horizontal drilling and more complex completion techniques. And this trend is expected to continue as resource plays become increasingly dominant and as larger budgets, bigger capital bases and higher production become more commonplace.
“We expect consolidation to occur as a result of the critical mass needed to meet these increased capital requirements,” says Edgelow. “Liquidity-challenged small producers may be attractive targets for larger, well-capitalised companies looking to expand their asset bases.”
He adds: “Junior oil and gas companies will still be very active in this space in five years, however there will likely be fewer of them as a result of consolidation and incrementally higher entry costs.” Edgelow points out that the $10m “starter kit” a junior needed a few years ago will not be enough to meet the capital needs going forward, but instead may require $100m or more to sustain an adequate capital programme for one to two years.
Principal among those would-be consolidators will be the Chinese NOCs, which have been beefing up their war chests in anticipation of just such opportunities opening up.
“The NOCs will accelerate investments in North American unconventionals,” says Roger Diwan, a consultant for Guggenheim Securities. “The opportunity to acquire new technical skills in exchange for capital investment is a strong pull for the [Chinese] NOCs that are seeking expertise to bring back to domestic basins and to gain a strategic position in new basins with significant future production potential. Canada and the US will become NOC focus regions for Sinopec and CNOOC (China National Offshore Oil Corporation).
Beijing estimates the country's coal-bed methane (CBM) reserves could be as high as 36.8 trillion cubic metres (cm), which compares with China's proven gas reserves of just 2.8 trillion cm. To get that out, analysts say, will require sophisticated mining techniques including fracturing vertical and horizontal wells, U-shaped wells and cluster wells, adapted to meet local formations.
Debt has been the primary source of financing in the oil and gas sector, and the popularity of debt as a funding source is on the rise. In E&Y's Global Capital Confidence Barometer, 49% of respondents said they expect to use debt to finance deals, up from 30% six months ago. “Financing deals with cash is often fast and easy,” Brogan says, “but lower rates and better availability of debt financing are likely to encourage corporate acquirers to use more debt.”
The initial public offering (IPO) market for juniors remains pretty well shut. “Our view and the wider market view is that there’s more people trying to raise IPO money than will be successful and so are working through broader capital strategies rather than just focusing on an IPO that may or may not happen,” says Clark.
Part of the challenge new companies face is that the over 100 existing companies on AIM are capital hungry themselves, meaning they are hoovering up a big proportion of the equity financing available. In 2011, total oil and gas IPO fund-raising on London's AIM market was £223m, which was dwarfed by the over £1bn of secondary fund-raising. And in the first quarter of this year this weak trend continued, with just £4.2m raised in an IPO, compared with £189.4m in secondary offerings.
“Investors are having to put more money into existing businesses… and there’s not that much left over to support new stories, and new companies must have something different in portfolio, or team or strategy to be attractive,” says Clark.
Such difficulties are being felt elsewhere in the global equity markets, where recent energy IPOs have had a mixed reception. While Forum Energy Technologies, which provides products and services to the oil and gas sector, in April sold its shares at the top end of the price range to raise $379m, other oil and gas companies like New Source Energy and Poland's Lotos have all shelved IPOs in the last few months.
What this means for Chesapeake, which in April announced plans to IPO its oilfield services division in the hope of raising up to $862.5m, remains to be seen.