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№ 11 (November 2009)

Ernst & Young’s review of global oil and gas transactions in 2009

In this report Ernst & Young looks at some of the main trends in oil and gas merger and acquisition activity in the last 12 months and considers the outlook for deal activity  across the sector in 2010.

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Ernst & Young concluded last year by predicting that the global economic downturn may lead to a slowdown in oil and gas activity in the next 12 months, but the longer-term fundamentals remain favorable. 2009 has indeed been a year of considerable challenge for many, but opportunity for some, and the fundamental outlook for the sector continues to look positive. It’s clearer a year later that there is light at the end of the tunnel, rather than a train coming toward us.

 In total, 837 deals were announced in 2009, with upstream accounting for 72% of these. The volume of deals was down 24% compared to the previous year. The total value of oil and gas transactions announced globally stood at US$198b, up some 10% compared to the previous year. This is perhaps surprising given lower than average commodity prices in 2009, although the statistics have been dominated by a few large transactions. If Exxon had not announced its US$41b acquisition of XTO in December, the figures would have looked very different. M&A activity was much stronger in the second of half of 2009 (485 deals versus 352 in the first half), reflecting the improving capital market conditions and growing consensus on oil price outlook.

 Corporate oil and gas valuations started 2009 at subdued levels, reflecting depressed commodity prices and wider capital markets malaise. This presented opportunities for well-capitalized acquirers, such as Asian reserve-seeking National Oil Companies (NOCs), but naturally drove sellers toward asset-level transactions. Overall, would-be acquirers had the upper hand and the total value of announced corporate transaction levels were up considerably in 2009, accounting for 66% of total deal value compared to 44% in 2008.

 The positive trends that we have seen in recent months are likely to continue into 2010, and the outlook for oil and gas transactions is healthy in upstream and oilfield services. In the downstream world, over-capacity in some regions is likely to drive a longer period of uncertainty and transactional challenges. But as this year has aptly demonstrated, one person’s challenge represents another’s opportunity.

 Upstream

 2009 has witnessed the much speculated green shoots of recovery in the upstream sector. The oil price has strengthened, equity capital is starting to flow back into the sector, development projects are coming back on stream with increasing frequency, and stronger exploration budgets are being set for 2010. However, the year has been uncomfortable for many across the sector. The mixed fortunes of the upstream universe continues to leave a wide divide between the haves and have-nots. The increased oil price may have generated a flurry of equity investment, but funding constraints continue to affect many, be it equity or debt, and the success of proposed IPOs in 2010 will be carefully monitored. Companies’ increased cost of capital has not necessarily been factored into transaction valuation methodologies as much as might be expected. Commodity pricing, another key valuation parameter, has not been universally positive either. Oil has spent the second half of the year hovering around the anticipated US$70 per barrel mark, a welcome improvement for many from the mid-30s seen at the start of the year, but there is an ongoing short-term pricing concern given depressed levels of global demand and surplus OPEC capacity. Natural gas pricing has had a tougher year, and possible development projects continue to face delays as companies wait for improved pricing and stability. In a year of ups and downs for the industry, M&A activity began to pick up pace, increasing by volume quarter by quarter over the first three quarters of the year. Improved access to funding and relative economic stability have encouraged those that can to take advantage of reduced valuations and less competition for opportunities. This has largely been to the benefit of wellcapitalized  organizations with a long-term commodity outlook or need, such as Asian NOCs with growing energy-hungry economies and gas utilities seeking a physical hedge. Deal activity within the independent sector has been lower.

Corporate deal volumes on the up through a period of more depressed share prices

 Despite the increased M&A activity in the second half of the year, transaction volumes fell short of 2008 levels, with 605 upstream transactions announced in 2009 versus 730 in 2008. Significantly, asset deals showed a 22% drop in volume from 2008 levels while the number of announced corporate transactions, was consistent with 2008 levels, accounting for 21% of deals by transaction volume and over 70% by deal volume as acquirers looked to take advantage of depressed market pricing. The combined value of announced deals in 2009 was US$149b according to data from IHS Herold Inc. comparing favorably to the US$112b in 2008. However, two transactions made up US$62b of the value being Exxon Mobil’s announced deal with XTO and Suncor’s acquisition of Petro-Canada.

 North America continues to be the most active market

 A little over 50% of global upstream deals announced in 2009 were in North America, down from the 80% bias that we reported last year. While Canadian volumes were consistent, 2009 witnessed a 42% drop in US deal volume. This is a clear demonstration of the market impact of difficult funding conditions and a challenging short-term natural gas outlook in North America.

 In terms of deal value, North America accounted for over 65% of announced transaction values according to IHS Herold Inc, with 5 of the 10 largest transactions targeting North American reserves. Exxon Mobil’s announced US$41b acquisition of XTO in December and Suncor’s US$21b acquisition of Petro-Canada in March were the year’s largest announced transactions, and are reflective of a longer-term outlook being taken on unconventional resources, such as oil sands and shale gas, from the larger independents and International Oil Companies (IOCs). More generally, however, the relative weakness of natural gas prices in the US shifted acquisition activity back to conventional reserves; oil represented about 50% of acquired US proved reserves for the year until Exxon’s announcement swung the bias back to natural gas. US private equity activity in the upstream sector showed strong signs of improvement during the second half of the year. Sizeable private equity investments included: Global Infrastructure Partners’ investment of US$588m in Chesapeake Midstream Partners; First Reserve Corporation’s US$500m investment in Southeast Asia-focused KrisEnergy; Apollo Global Management’s US$500m acquisition of Parallel Petroleum; and KKR’s US$350m investment in East Resources. We anticipate a renewed interest in the sector from private equity through 2010. There is, however, a backlog of businesses to exit that may affect the quantity and timing of new investments.

 Asian NOCs funding rapid expansion

 National oil companies were the focus for much of the M&A speculation in 2009, targeting reserves and production to support continued domestic economic growth. Being Government-sponsored, such entities typically rely less on external financing, which is a key advantage in a fundingconstrained market. Sinopec’s US$9b acquisition of Swiss oil explorer Addax, announced midway through the year, and KNOC’s US$4b acquisition of Harvest Energy Trust in October are among the top five transactions by value this year. Both transactions are representative of Asian NOCs, recent international expansion and deep pockets — Chinese NOCs, for example, have spent almost as much this year on upstream investments as they have over the last five years combined. Their focus isn’t just on conventional reserves — PetroChina’s US$1.7b purchase of a majority stake in undeveloped steam assisted gravity drainage (SAGD) projects represents the largest Chinese NOC acquisition in the Canadian oil sands to date.

 IOC-NOC joint ventures are indicative of future trends

 We anticipated at the start of the year an increasing likelihood of additional strategic partnerships between NOCs and IOCs. These arrangements offer reserve-hungry NOCs access to reserves and experienced international partners, while the IOCs benefit from access to capital and potentially service or infrastructure capabilities. Many of the recent license awards in Iraq exemplify this theme. Looking forward, things may be less positive for IOCs in these arrangements as we predict that reserve-seeking NOCs in certain areas may partner directly with other reserve-holding NOCs, leveraging political ties to access opportunities and expand operations.

 CNPC and KMG’s US$3.3b acquisition of MangistauMunaiGas (MMG) from Central Asia Petroleum and China National Offshore Oil Corporation (CNOOC) and Qatar Petroleum’s E&P sharing agreement are examples of the adoption of more international NOC partnering. With Sinopec’s acquisition of Addax resulting in its exclusion from the second Iraq licensing round, NOCs may look to be more selective in their targeting.

 Outlook for 2010

 With stability comes market confidence, and we have seen equity investment returning to the sector. A number of IPOs are planned for 2010, and if successful, we can expect to see increasing investor interest in the sector. Lessons have been learned regarding the risks of investing in single-asset, pure exploration companies, so we anticipate that companies successfully coming to market will have larger portfolios, probably spread from exploration into production operations. Further commodity pricing volatility is likely in the short term as global demand is predicted to remain below supply capacity into 2010. As economic recovery drives demand growth, greater pricing stability is expected in the medium term, although the precise timing and shape of recovery remains a subject of muchspeculation. This strong medium-term consensus will be a key enabler in upstream transactions in 2010 as buyers and sellers share the outlook for a critical component of pricing. NOCs have arguably been more active than the majors in 2009,but Exxon Mobil’s announced acquisition of XTO may be the trigger for a wave of acquisitions as the majors emerge from a year of restructuring and internal reorganization with balance sheets that are stronger than many, certainly looking across other industries. Service costs have fallen in 2009, and 2010 may see a return to investment in longer-term capital projects, often in unconventional resources, such as shale gas, oil sands, and coal bed methane. The heavy investment requirements of these projects has left a number of IOCs without financing options to meet required development costs, and these continue to be targets for those with liquidity. A large proportion of the junior universe continues to face financial difficulties. Although investors have demonstrated appetite for secondary financing, much of this is aimed at the larger entities with current or near-term production opportunities. There has been less consolidation activity at the smaller end of the market than expected, but because financing remains hard to come by and asset inactivity continues, many of these entities will be forced to take action or face asset relinquishment.

   Continuing decrease in transaction activity during 2009

 The downstream sector experienced further decline in transaction volumes during 2009, continuing the downward trend which started in the previous year. There were 153 transactions in the sector in 2009, some 30% lower than 2008. The disclosed value of downstream transactions was US$38b in 2009 compared to US$40b a year earlier.

The diverse buyers involved in downstream transactions included IOCs, NOCs, independents and private equity. Based on disclosed values, the top 10 deals in the sector during 2009 had a combined value of US$24b, accounting for some 65% of the disclosed value of all transactions in the sector globally. Included in the largest announced transactions of the year were Enterprise Products Partners’ acquisition of TEPPCO Partners for US$5.9b, E.ON’s sale of its wholly owned subsidiary Thüga AG to the municipal buyer consortium Integra/KOM9 for US$4.3b, and Snam Rete Gas S.p.A.’s (Snam Rete) acquisition of Eni’s natural gas distributor Italgas S.p.A (Italgas) for US$3.8b. Snam Rete is 50.03% owned by Eni and Italgas was wholly owned by Eni. As a result of this divestment, Eni has exited regulated gas distribution activities in Italy, as required by the local regulators. Similar to 2008, the volume and disclosed value of asset transactions exceeded those that were corporate in nature. There were 127 announced asset transactions with a disclosed value of US$19.2b, compared to 26 corporate transactions with a disclosed value of US$18.7b. Over 45% of downstream transactions volumes were in North America (70), with Europe (38) and Asia (21) together accounting for a further 40% of volumes.

 No shortage of refining opportunities in 2010

 World oil product demand is estimated to decline by 2.5 million barrels per day during 2010 due to the economic downturn. Recovery in oil product demand in the short term is anticipated to be slow due to the weak global economic growth and could potentially be significantly dampened should the US Senate vote favourably on a comprehensive carbon regulation. As such, there is significant over-capacity in the global refining sector, predominantly in North America and Western Europe. Furthermore, additional refining capacity scheduled for the short term, particularly in Asia and the Middle East, would exacerbate this issue. Excess refining capacity is one of the principal factors fueling the current environment of low utilisation and low margins.

 Refiners are looking to address these issues through one or a combination of the following:

Partial shutdowns of key refineries and of full shutdowns of

less complex sites

Postponing new refining capacity and upgrading projects

Divestment of non-core refining assets

There were 13 refining transactions during 2009, and a number of refineries are currently being divested. We expect that the major integrated oil companies, as well as independent refiners, will continue to divest their non-core refining assets throughout 2010. There is likely to be interest from various groups of buyers, including those from Asia, for the relatively complex refining assets. On the other hand, interest for relatively simple refineries is expected to be low and would probably end up being converted as storage facilities to defer expensive remediation and clean-up costs.

 Oilfield services

 Transaction activity plunged in oilfield services in 2009.  From the highs of Q2 2008, when IHS Herold recorded 73 announced transactions with a combined value of more than US$13b, by Q1 2 009 transaction levels had slumped to just 13 deals, with a total value of below US$1.4b (based on deals where transaction values were disclosed). The evaporation of funding, the impact of lower oil prices and cutbacks from operators were the chief causes. An analysis of deal statistics reveals some interesting trends. Based on transactions where the deal value was revealed, the average value fell year-on-year from US$237m to US$192m. This reflects the near-impossibility of concluding billion-dollar buyouts for a period in 2008-09. In 2008 there were seven deals greater than US$1b in disclosed value, with financial investors such as Alpinvest, First Reserve and JC Flowers among the investors. Last year — there was just one, and it was a trade deal (Baker Hughes’ acquisition of BJ Services discussed on page 9). Even in the absence of mega-deals, a handful of larger deals made up the bulk of the US$11.3b total disclosed value of 2009 OFS transactions. The top ten deals made up 76% of this amount. Excluding the Baker Hughes deal, average transaction values were more than halved compared to 2008, to US$110m. Looking at transactions by geography, North America continued to be the most active market for mergers and acquisitions, with 60% of deals involving a target primarily located there. This proportion was unchanged from last year. Although it is risky to draw strong conclusions based on such a quiet market, Asia and Africa were comparatively active with 26% of all deals taking place there, up from 15% last year (though the actual number of deals was lower). European deals fell sharply from 21% of the total to 13%.

The year was not without excitement on the corporate front however. Three themes were notable:

Buyers who entered this phase of the cycle with strong balance sheets took advantage of others’ distress to

complete opportunistic bolt on deals.

Money could still be found for top-quality transactions.

Deal flow and expansion planning began to pick up towards the end of the year.

 Opportunities in adversity

 Despite the doom and gloom in the market, numerous major oilfield services (OFS) companies entered the downturn with strong balance sheets, having elected to hold on to cash rather than spend it on acquisitions at the top of the market in 2008. Some players began to put these war chests to use. FTSE250- listed John Wood Group, for example, said at the start of the year that it expected to see opportunities, and that the extension of its £950m loan facilities would enable it to pursue them. By the end of the year, Wood Group had concluded several transactions, in Europe, the Americas and Asia-Pacific including the US$38m acquisition, for cash, of Baker Energy — the energy business of Michael Baker Corporation, the energy and engineering consultancy listed on the NYSE Amex exchange.

A second trend was a rise in distressed sales, where deals were done, often at nominal prices, to take assets – and sometimes liabilities – off the hands of sellers who were retrenching to focus on core operations. One indicator of this shift is the increase in the proportion of deals that comprised the trade and assets of a business, as opposed to corporate transactions. In 2008, less than one-third of OFS deals were sales of the trade and assets; a year later, 54% of deals were in this form.

  A good deal can still be done

 There was a handful of landmark deals during the year. Pick of the bunch is surely Baker Hughes’ US$5.5b acquisition of BJ Services, announced in August. This was the biggest OFS transaction in more than a decade. It represented 44% of the disclosed value of all deals during the year. BJ’s pressure-pumping expertise — technology to increase production by injecting water and chemicals into wells — was a key driver for uniting the two Houston-based businesses, with Baker Hughes forecasting that this side of its business will grow from its present 1% of revenues in 2008 to more than 20% postacquisition. Transforming this side of the business will enable Baker Hughes to catch up on its major OFS competitors in the sector, such as Schlumberger and Halliburton. The deal was priced at a 16% premium to BJ’s pre-announcement stock price, and was paid in a combination of cash and shares, leaving BJ stockholders with a stake of around 27.5% in Baker Hughes. BJ, spun out of Baker Hughes in the 1990’s, had long been touted as a natural fit in an environment where the integrated OFS model is popular once more. The deal was done in the region of 6.9 times trailing EBITDA, although BJ had recently posted a Q3 net loss of US$32.3m. BJ’s shares rose 4.2% and Baker Hughes’ fell 9.6% as the deal was announced.

By way of contrast, one of the top UK transactions was the June acquisition of Wood Mackenzie, the Edinburgh-based consultancy and research provider to the global energy, metals and mining sectors. While Woodmac is not a typical OFS business, the deal was important because it showed that leveraged deals could still be done — a trend that emerged across several industries as the year wore on — and that mainstream (as opposed to specialist) private equity houses were still keen to get oil and gas exposure. It was a positive sign of the rising market that by the end of the year the Woodmac deal no longer held the crown for the biggest UK private equity deal of the year.

The £553m deal, concluded in a matter of weeks, was a landmark for leveraged deals. Private Equity News reported that four equity providers were shortlisted to back the deal: Bain Capital, Charterhouse, Hellman and Friedman, and Warburg  Pincus. On the banking side, the deal was backed by £170m of debt (as well as £70m of mezzanine finance). The lenders, including HSBC, Lloyds Banking Group and Nomura, had syndicated their loans, according to Private Equity News.

The deal also relieved pressure upon Candover, which was in the middle of a stabilization program. Its shares rose more than 10% on 19 June, when JP Morgan Cazenove predicted proceeds of the sale would revalue Candover’s portfolio upward by 18%. Sale proceeds to Candover itself were £36.2m.

 Recovering deal activity to continue into 2010

 By Q4, deal volume had clearly picked up from Q1’s slow start, as the graph shows. The examples given above suggest a number of positive trends for 2010, buy it may take longer to play out fully. Funding conditions, both on the debt and equity sides, are improving as private equity begins to refocus on external opportunities rather than managing existing portfolios. As valuation expectations of sellers adjust from the heady days of 2007, trade buyers are back in the game. The public markets are recovering and a number of privately held OFS companies are being positioned for possible flotation. As operators plan new capital expenditure in a healthier oil price environment,pricing pressure reduces and order backlogs build up, it seems unlikely that 2010 will be as quiet for OFS transactions as 2009.


-Ernst&Young
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