Takeaways: We still live in interesting times. The year ahead will bring further gyrations in monetary policy, currency and commodity prices along with political change and undoubtedly something from leftfield. Stakeholders are increasingly applying the “how does this look with….?” test, be that $60 oil, a stronger pound, Eurozone deflation or higher interest rates. Companies need to demonstrate resilience in these markets. Volatility encourages selectivity. Oilfield service and equipment companies were feeling the pressure at $100 a barrel – $70 (and below) requires a new more resilient approach. Meanwhile, there is still every incentive for strong companies to secure profitable growth via acquisition and shifting sector dynamics are creating ‘motivated’ buyers and sellers. For those looking for a different type of financing, direct lending funds are certainly coming of age.
Tales of the unexpected
If the last six years have taught us anything, it’s that the recovery from a financial crisis is long and highly unpredictable. And, just when you think nothing else can surprise you, the price of oil falls 40% in a matter of months. It’s why we’re increasingly thinking about resilience: how companies can build in flexibility and adaptability into their operating and financial models to help them ride out the storms and make the most of calmer seas.
The roster of unpredictability rolls into 2015. In the year ahead we have a UK General Election that may trigger an EU referendum; probably the first rise in interest rates in the US and UK since 2006/7; the Eurozone fighting ideological battles over deflation and stagnation remedies and almost certainly something no-one has thought of yet. We’re already seeing global GDP forecasts downgraded and dampened further by increasing geopolitical risk and an increasing sense of market uncertainty. Our analysis of UK profit warnings shows how many UK companies are struggling to move with the changing tides in the global economy and adapt to rapid technological and social change. UK plc has already surpassed last year’s annual total of profit warnings and there can be a high price for getting it wrong. In Q4 so far, the median share price fall for companies warning is the highest since 2011. It seems that investors are increasingly looking for companies who can demonstrate resilience, who can flex their cost and capital base when faced with market disruptions or opportunities and who can adjust to changing sector and macro-economic dynamics.
Life at $70…$60 a barrel?
According to the IMF, a 10% fall in the oil price normally generates a 0.2% rise in global GDP. Another canon we’re about to test? As we discussed last week, the oil price plunge has two faces, with positives for large importers like India and tough consequences for many exporters – see dollar-parched Venezuela asking China for more loans and recession bound Russia. The fall in oil price should boost spending and be a net positive; but by how much depends through what prism consumers and businesses view the fall. The effect could be distorted by lower confidence or deflation that will encourage saving and delay.
Forecasting the impact is also tricky whilst there is so much uncertainty over where the price of crude will go next and so much speculation over the motivations – and even alliances – behind the fall. Is this a game of chicken? Is it a gambit to bring some market discipline to the sector? Or is this a grand conspiracy? Hard to say, but it’s hard to see crude going above $100 a barrel in the near future or the market become much less volatile. This puts oil services and equipment companies right in the crosshairs. Even over $100 a barrel, the sector was showing signs of strain. Profit warnings rose dramatically in 2013, as International Oil Companies (IOCs) capex fell in response to shareholder demands for capital discipline. Changing industry dynamics have also heightened the sector’s vulnerability. The era of easy oil is over. Deeper and more challenging projects offer more technical and operational challenges and higher risks. Competition has also intensified, encouraging more aggressive tendering for contracts. A rapid increase in costs in recent years, in particular due to increasing health and safety needs and competition for skilled labour has stretched thin margins even further.
And now we’re at $70 – a potential tipping point where a high number of fields become uneconomic and explorers retrench further from risk. Anecdotally, $70 a barrel is also the point at which banks begin to review lending. By one reckoning, nearly $650bn of high yield debt has been issued in the sector since 2011 – so clearly the stakes are high. Companies can build resilience and limit vulnerability to swings in operating and capital expenditures by increasing diversity in geographical coverage, customer mix and contracting structures. Recent high levels of sector consolidation reflect these growing needs. Of course, companies should also be thinking about their operational efficiency, particularly working capital and risk management processes – especially important for those involved in lower margin or lump-sum contracts. It’s a bit of a reality check, but the sector should come out of this much stronger.
Debt fund market comes of age
Uncertainty hasn’t thrown companies off the M&A trail – far from it. We’ve seen a number of deals announced this week, from John Laing’s bid for Balfour Beatty’s investment business to Kier courting Mouchel. Corporate development officers we speak to see the glass very much half full, with opportunities out there for the quick, the knowledgeable, the selective and the disciplined. Some multiples are still pretty rich – especially the US. Sector dynamics are also driving deals in TMT (as we highlighted last week) and of course in oil services & equipment as per Halliburton’s match up with Baker Hughes.
The outlook for funding also remains positive, with more options opening up in the mid-market. The EY Credit Markets Report*, out next week, highlights the coming of age of direct lending funds in Europe. Just to underline the growth of this market, last week Alcentra announced it had raised €850m for its first pan-European direct lending fund — 70% more than its initial target. Bank lending to mid-market companies is picking up, but companies looking for additional flexibility are increasingly turning to alternative providers. These are in turn being backed by increasing amounts of liquidity from pension funds, sovereign wealth funds, asset managers and insurers. It will be interesting to watch how the increasing involvement of funds – and their more active approach to management – plays out in the next cycle.
*If you’d like a copy of the EY Credit Report, please email: firstname.lastname@example.org
Autumn Statement Coverage
To quote JK Galbraith: “Politics is not the art of the possible. It consists in choosing between the disastrous and the unpalatable.” The statement was pretty much as expected – given the limited room for manoeuvre – with a few extra tax rabbits. However, as ever, the devil is in the detail. You can follow the EY ITEM CLUB’s analysis <here>.