At the end of 2016 we wrote about a new era for oil and a new pricing pattern that we thought would hold into 2017. Is the snake still stuck in the drain? How well is our price prediction holding up and what does it mean for M&A and the much beleaguered oil field services sector in 2017?
Snakes (still) in a drain
The last time we covered the oil sector here in mid-December, news of an OPEC deal to cut production had pushed the price of Brent Crude over the $50 mark. But – we argued – the price probably wouldn’t get much higher than this, due to the likelihood that more supply would come online as soon as the price moved much higher. In other words, the oil price would rise, but would wiggle in a higher band.
So far, this ‘snake in a drain’ model is holding. The oil price has been in the mid-$50/barrel range since New Year and consensus is building around the $50 to $60 mark.
Friday’s report from The International Energy Agency supports this thesis. OPEC compliance is around the 90% mark, but the IEA still expects oil stockpiles to remain at elevated levels – at least through the first half of 2017 – with higher prices encouraging more drilling in non-OPEC countries such as US, Brazil and Canada. Given the uncertain political climate – and the chequered history of oil prices consensus – we can’t count any chickens. But, the mere fact that we’re at even talking about price stability and consensus at all is a big change from this time last year at c.US$30/barrel when we asked if oil could be too cheap.
Consensus fuels deal activity
An uncertain price environment in the first three-quarters of 2016 was always going to make it difficult for companies to pin down valuations – and at US$30/barrel there were other pressing issues. But changing industry paradigms meant that the need and desire for deals was there. So when we saw a price consensus emerge in the final quarter and when valuation gaps closed, the deal floodgates also opened – especially in North America and Russia
And this late-year surge was enough for the value of global deals in 2016 to surpass 2015 (excluding 2015’s Shell and BG deal) as parties gained the confidence to pursue larger capital deployments, according to the EY Global oil and gas transaction review 2016.
Upstream this activity focused on lower cost and fast response activity – especially in the Permian basin, which has become a hotspot of M&A activity in the shale oil industry, thanks to an impressive production profile and low-cost resources. Midstream has been dominated by North American activity, where we’ve seen significant number of deals consolidating asset ownership and delivering cost of capital synergies. Downstream, margins have been tightened by higher oil prices and the sector has seen fewer, but larger deals.
We expect this deal momentum to carry into 2017, so long as the cost and availability of capital remains favourable. Oil and gas was certainly one of the most talked about sectors in January, with 68 deals worth US$43.5b. Upstream, we expect more activity as portfolio optimization continues, distressed situations are resolved and PE becomes increasingly active. In midstream, a resurgence of capital spending in shale and North American petrochemical and LNG infrastructure projects should lead activity in 2017. We expect to see companies transacting here to generate synergies and relieve distress. This is also expected to be a stronger year for downstream transactions, with deals motivated by the desire for upstream and downstream integration to create value – a strategy that lapsed during the period of high oil prices.
Oilfield services still under pressure
So far I haven’t mentioned the OFS sector – in recently years usually prefixed by “beleaguered” or similar. The sector came under pressure before the oil price fell due to increasing sector capital discipline – as our UK profit warning data shows. In 2013, a quarter of the UK quoted FTSE Oil Equipment, Services and Distribution sector issued profit warnings. This figure hit 50% in 2015 and 55% in 2016 – although warnings tailed off at the end of the year, when the sector seems to have found some stability along with the oil price.
But, as our latest report on the UK OFS sector underlines, the work isn’t over. The OFS segment now needs to evolve its thinking from short-term survival to long-term success.
Lower commodity price levels have dramatically lowered activity and changed footprints, both in terms of both geography and reservoir type. And although there are some encouraging signs – even in high cost areas, like the North Sea – capital expenditure is only marginally increasing. In response to changing industry dynamics, operators are seeking greater alignment with their supply chain across the entire asset life cycle – including changes to their organizational and purchasing behaviour. Decommissioning offers OFS companies an excellent opportunity to grow a significant line of business with huge export potential. But companies also need to think of decommissioning as something that is integrated with ongoing oilfield operations and development activity.
Thus companies need to think beyond cost reduction. Their aim should be to create a higher margin sustainable business, characterised by new commercial relationships, new technology and innovation. As a result, we expect to see further consolidation in the OFS sector in 2017. We expect the best positioned and financially healthy OFS companies to drive this consolidation through opportunistic acquisition of distressed assets or through strategic deals – to expand their integrated services via new technology, to increase their international footprint or to reduce risk by reshaping their market exposure. Strategic alliances also look set to become an increasing trend in 2017, particularly in high-cost areas of development such as marine and subsea.
A transitional year
Thus, if prices remain around current levels we expect to see a continuing transition from survival to value creation in the global oil and gas sector – with an increasing focus on growth. Capital availability, a closing valuation gap and a stable oil price should also make it an interesting year for transactions. The surge in activity in North America doesn’t just extend into M&A, but also capital raising. There is a queue of around 20 companies – mostly in fracking who are expected to IPO in the next few months.
But, the last few years have also left their scars across the wider commodity sector. Energy and metals & mining companies account for 15.9% of Moody’s total EMEA speculative-grade rated universe and 35% of the B3 negative and lower list. This is still a new normal.