Interview with Vinson & Elkins
Turbulent Times – Key Trends, Challenges and Opportunities in the Oil & Gas Market in 2020 and Beyond
Tell us about some of the recent types of transactions (M&A, A&D, Capital Raising) you’ve been involved in recently? What are you noticing in terms of trends?
We have been seeing a broad spread of transaction types, including M&A (share and asset) deals across the upstream and downstream oil and gas sectors (including in the LNG space) and oilfield services. We have been advising a range of clients on these matters, including IOCs, NOCs and private equity and hedge funds.
Amid the current crisis, we are still seeing a number of strategic transactions proceeding in the face of general market uncertainty. A number of E&P companies are continuing with the strategic rationalization of their portfolios, particularly where the planning phase started in late 2018/early 2019. Certain majors, in particular, appear to be proceeding with their programs to divest non-core assets.
There is now a trend of buyers and sellers using increasingly creative structures in M&A transactions, including sellers providing loans to buyers facing difficulties in accessing debt finance. We have also seen a rise in innovative mechanisms to address the costs of future decommissioning liabilities which may otherwise deter savvy buyers, particularly in the sale of more mature assets. In the UK North Sea we have seen various models involving sellers retaining all or some liability for future decommissioning costs and providing buyers with assistance in posting decommissioning security.
We saw prior to the current crisis an uptick in LNG-related work, despite the dual challenges of an increasingly saturated market and lower prices. Some investors seem bullish on the longer-term prospects for the LNG market – this is generally driven by the expectation that, in the medium-term, supply growth will slow as the “new wave” of LNG projects under construction are completed, resulting in a more balanced market, while in the longer-term demand will continue to grow – particularly in Asian markets where pipeline or domestic supply is insufficient to meet rising demand. As a “cleaner” alternative fuel to coal and oil, some investors also see natural gas (and LNG in particular) as a smart longer-term investment as the world transitions to a lower-carbon future. However, with a sharp drop in gas demand caused by the COVID-19 pandemic and some buyers claiming force majeure to reject LNG cargoes, short-term supply cuts now seem inevitable.
And in terms of challenges?
As a result of the travel bans, office closures and “social distancing” measures, we are now seeing parties running M&A transaction processes entirely virtually – meaning remote management presentations, virtual due diligence and online Q&A. So far that approach has been successful, although some slippage in M&A timelines is inevitable as parties adjust to remote ways of working, and it is not clear that parties will finally close transactions with no face-to-face negotiations and with no physical data rooms with workstations to verify seismic and geological data.
Some transactions will inevitably be suspended or abandoned as sellers see valuations fall and as buyers struggle to raise debt finance to fund acquisitions in an unstable market. Even for those buyers with funding in place, agreeing a valuation and purchase price with the seller will be a key challenge. As we saw after the last oil price collapse, we are now likely to see parties structuring consideration (wholly or partly) to be deferred or contingent, for example, linked to future commercially recoverable reserve volumes, production levels or oil prices.
Once deals are signed, buyers and sellers are likely to face increased delays in obtaining regulatory and counterparty consents to allow transactions to complete, as governments themselves grapple with the challenges of the COVID-19 pandemic. The delays are likely to be particularly acute in emerging market jurisdictions, where approval processes are slow in any event, and where technology, remote-working and contingency planning procedures will all be less effective. The delays could be a particular concern for distressed sellers or others in urgent need of cash, who may therefore look for alternative structures to avoid some of these regulatory requirements.
A challenge we were already seeing prior to the COVID-19 crisis was the increased tendency of governments of oil-dependent economies to squeeze IOCs for cash, either through increasing the size of the fees payable to governments to obtain consent to the sale of upstream assets (as has been happening in places like Nigeria), or in the form of tax assessments on IOCs. We anticipate this trend of “government-grab” to continue (and possibly become more widespread) as those economies face falling oil revenue.
It is worth remembering that many E&P companies are partially shielded from the current low price environment through having hedged all or part of their production. Those with hedges in place will be faring better than others – at least for the time being. Those companies will need to be planning for the challenges ahead, however, as hedges expire (and are unlikely to be renewable on similar terms) later this year.
COVID-19 and subsequent oil price collapse, what do you anticipate to be the mid-term impact for the industry?
Companies are understandably demonstrating caution when it comes to future investment commitments and we are seeing many E&P companies moving to cut capital expenditure significantly. As a result, 2020 is likely to be characterized by a lower level of project sanctions, while budgets approved during 2020 for the 2021 financial year are likely to be slimmer than in recent years.
We expect that E&P companies will continue to announce cuts to capital expenditure and exploration budgets. A low oil price environment in the mid-term might result in the shut-in of higher cost production and even the early abandonment and decommissioning of assets in higher cost basins.
Conversely, we anticipate an uptick in M&A activity in the mid-term led by distressed sales and consolidation in the upstream sector.
As we saw following the last major oil price dip in 2016, we anticipate a steep rise in disputes in the industry, many of which will be triggered by an increase in defaults, as JOA partners struggle to pay cash calls and post decommissioning security. Work programs and budgets are typically approved by operating committees during the fourth quarter of each year, while decommissioning security typically expires and will need to be renewed towards the end of the calendar year. Companies should be thinking ahead and preparing contingency plans to avoid the risks of forfeiture or withering of their interests in a default scenario.
With 2020 thought by some to have been the year of the private equity exit, how have things changed?
We were not convinced that 2020 would be the year of a private equity exit, and an exit in 2020 could have been regarded as premature in the case of many investments. A number of E&P private equity investments are still quite recent and the relevant portfolio companies, particularly in the North Sea, are still very much in growth mode. However for those private equity investors who were in fact seeking an exit, 2020 is proving challenging, with IPOs out of the question and the risk of selling assets or corporates at what appears to be the bottom of the market.
Our perception is that there are a number of private equity firms who still have dry powder and who are willing to brave a volatile market. Those investors are optimistic about the opportunities that exist now and in the months ahead for bargain hunting and for picking up world-class assets being offloaded by distressed sellers. Private equity funds, as well as other financial investors, are also likely to step in as entities face difficulties tapping debt and equity markets to fund acquisitions and working capital requirements.
In today’s low oil price environment/ distressed market, do you think we’ll see a new wave of activity from sector agnostic investors ready to pick up opportunities?
Yes, to an extent. We are cautiously optimistic that, while there might be significant volatility in the short term, there will nonetheless be an uptick in activity as investors – including those that are agnostic to the oil and gas sector – move in on opportunities. Low asset prices and under-investment, brought about by the slump in demand coupled with a low oil price, mean that some investors (at least those not reliant on leveraging their investments with third party debt finance) now regard this as a “once in a generation” buying opportunity with an expectation of extraordinary returns as oil prices recover.
Investors are also likely to find good opportunities in the downstream sector. Although the pandemic has caused a demand shock for many end-products, the decline in oil prices means that downstream projects are currently benefitting from significantly lower feedstock costs.
However, as investors become increasingly focused on the energy transition this, coupled with the current state of the markets, may discourage many sector-neutral investors from investing in fossil fuels altogether. We therefore expect the bulk of investment to continue to come from experienced oil and gas investors, including energy-focused private equity and hedge funds and special situations investors, as we have seen in previous downturns.
E&P opportunities and hotspots – Who, what and where to watch in 2020, 2021?
The current crisis presents opportunities for a range of potential buyers. Those with available cash, including some private equity players, hedge funds, state-backed NOCs, and sovereign wealth funds, are likely to be at an advantage for as long as difficulties persist in tapping debt and capital markets and while low-priced buying opportunities exist. 2019 witnessed strong investment into the oil and gas sector by NOCs and Chinese state-owned oil companies, for example with CNOOC and CNODC the only foreign investors to put up the multi-billion dollar signature bonuses to participate in the Brazilian “Transfer of Rights” offshore area auction round. We may see a continuation of this trend into 2020 and 2021.
We expect there to be significant activity in upstream asset and share sales, especially as stronger field partners move to buy out their smaller partners who are in need of capital.
In terms of “hotspots”, the current crisis has exposed the challenges faced by the US shale industry, including relatively high transportation costs and break-even prices. This was very publicly illustrated when WTI contracts traded at negative prices for the first time in history, triggered by a lack of available storage capacity leaving buyers unable to take physical delivery of crude. Investors with the right level of political and risk appetite are therefore increasingly likely to look for opportunities in emerging markets, including those that might have deterred investors in the past. In countries that use a production sharing contract model for upstream contracts, the contractor’s share of profit oil is commonly linked to an agreed oil price benchmark (typically Brent); while this model was typically introduced to benefit sovereigns in times of high oil prices (by giving the government more oil and the IOC less oil when prices are high), those mechanisms offer IOCs a corresponding degree of protection against low oil prices (by giving the IOC more oil and the government less oil when prices are low). PSCs and Concessions in many developing economies also often include economic stabilization provisions, which act to shield IOCs from adverse changes in local law and regulation, and therefore mitigate some of the political and fiscal risk (e.g. the risk of changes in local taxation regimes) that could otherwise deter investment.
OFS & EPCs – M&A, A&D and consolidation; is today’s OFS industry fit for purpose and sustainable?
Unlike E&P companies, which can achieve some protection from adverse market conditions through a diversified asset portfolio and hedged production, OFS and EPC companies are fully exposed in a falling market. This is nothing new and OFS and EPCs are accustomed to weathering lows in a cyclical industry. The sector had already engaged in significant cost reductions and supply chain improvements during the last downturn, so OFS companies have been quick to react to the present crisis, as is evident from the speed at which companies have moved to cut costs and stack rigs.
The short- to medium-term outlook appears challenging for the OFS sector in particular. We have been seeing an upturn in disputes with contractors as E&P companies cancel OFS contracts and we expect this to be a theme of 2020. But, in contrast to the previous downturn, this time the situation is complicated by the distressed position of many OFS companies.
The US market has already seen a series of OFS bankruptcies in the first quarter of this year. We anticipate seeing a high rate of OFS insolvencies as the current downturn plays out. A long-term, low oil price environment is likely to lead to further consolidation in the OFS market as players seek to wring out even greater efficiencies and the protection of stronger balance sheets. Smaller or indigenous OFS and EPC companies may be least able to withstand the current downturn, with many likely to face the risk of insolvency or to be acquired by the larger players.