Expert Insight

Cash is King! (again)

November 2015

CASH IS KING! (AGAIN)

Stock Taking

It is not a secret that the oil & gas industry is currently unable to fund its large capex programmes and cover dividends via organic cash flow generation. Santander estimate that in 2015 the large IOCs alone have had a cash flow gap post M&A of over US$45 billion to fill, which has been mostly done via the bond markets and internal liquidity. In 2016 and 2017, the annual gap can narrow through opex and capex reductions to around US$25 billion, supported by anticipated US$20 billion of divestments each year. However, the IOCs will have to find buyers for these divestments which may become a struggle in itself as the gap between buyers’ and sellers’ expectations keep widening.

A deja vu? Over the last years, the global E&P sector was not able to generate sufficient cash from operations to cover their growth projects and dividends even at an oil price above US$100. The big difference was though that the capital markets had ample appetite to support the oil & gas sector and its spiralling cost base. Debt markets were enthusiastic across the whole risk spectrum, whilst equity markets were selective in seeking quick and high return stories.

Today, this appetite has substantially changed. New oil & gas issue volumes in the global public equity markets are down by more than 25%, whilst UK is down by 70%. Private equity has seen an influx of commitments in their oil & gas funds, but deal activity so far has been predominantly in the US and this increased spending power has yet to spill over into Europe or other regions. In the debt markets, investment grade companies continue to find ample liquidity, but have a strong focus on managing their credit metrics to maintain their desired credit quality. In the non-investment grade segment the air seems to be getting thinner though. Volumes in the US high yield market are still just about holding up, but in Europe the sector is carried first and foremost by banks. Undoubtedly, adjusted price decks in E&P financing, as well as scrutiny of the level of risk to the sector by risk committees and regulators, have reduced liquidity in the banking market. On top of it, many E&P companies are getting close to their covenant levels and are reliant on lenders loosening these levels to avoid defaults. These reductions also spill-over into the services sector, having a detrimental effect on oilfield service companies, particularly for those active in exploration and development and asset heavy business models such as drillers.

Why M&A is not the (sole) answer

E&P M&A volumes fell severely by nearly 35% in the first nine months of 2015 and total transaction value has only been held up by a few elephant deals. Buyers and sellers are not aligned and it will likely require at least another round of adjustments of the asset base through impairments as well as mounting balance sheet and liquidity pressure, before we see activity picking up. However, we believe that the universe of buyers will be substantially reduced compared to what we saw in previous years and shifting assets is going to remain a struggle. Meanwhile, integrated players will be able to attract funds and Private Equity for infrastructure assets, that are less oil price sensitive.

Whilst divestments continue to be an important source of liquidity, there is no guarantee for timely and successful execution of transactions to fill the substantial liquidity gaps.

Shift the cash flows

The recipe for creating additional sources of liquidity sounds quite simple: monetise future cash inflows and spread significant cash outflows.

The monetisation focusses on the one hand on working capital management, i.e. faster inflow of receivables, reduction in inventory, and longer payment terms; on the other hand, future revenue streams can be monetised by pre-payments of production, which can also have the added benefit of being “off-balance sheet”.

We have seen growing activity of the latter and have successfully structured and led an increasing amount of pre-payment transactions in various parts of the world. The working capital topic is still one that has been somewhat neglected by the industry when it comes to external solutions, but we believe that it is only a matter of time until companies start seeking advice from financial institutions. Interestingly, we see a by far stronger cash conversion in the US than in Europe, expressed by very low cash-to-cash ratios in the last years. Often this is part of using negotiation power differently, but it can put pressure on the supply chain. We have been using supply chain finance structures to create a win-win situation for companies and suppliers alike and this seems to be a good formula for the future.

Spreading of capex related cash outflows is a question of ownership of the assets. In parts of the value chain, lease structures have been used for a long time, for example in the FPSO market. However, there are certain project assets, equipment and installations with substantial value, which had not been considered for lease or service structures in the past. Correctly structured, there is value and a good return for third party owners to be found. Santander has structured and has provided equity into lease arrangements for offshore assets in the last years, but there is still more work to be done.

To conclude …

Oil & gas companies and the finance industry don’t have to completely re-invent the wheel to find ways to tap new cash sources or to just preserve cash. Often structures and systems are already there, but have to be applied differently for the right fit for the oil & gas industry. Equally, companies need be open for different approaches and need to be willing to think outside of the box.

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