Depressed prices in a number of global commodities has taken a significant toll on UK manufacturers. Business news has been dominated by the steel industry crisis and a similarly negative story faces UK companies connected to the oil and gas industry. The dramatic decrease in the price of crude oil since summer 2014 has had global ramifications.
The price decline is attributable to various factors. There is, (as with steel) over supply. The addition of new production from unconventional sources such as US fracking, coupled with the apparent strategy of the Organisation of Petroleum Exporting Countries (“OPEC”) to maintain production levels, to defend and counteract this growing competition stateside, has served to drive down the average base rate of crude oil. The slowdown in China’s infrastructure expenditure, an easing in domestic demand and the drawn out economic recovery in the EU has also had its effect. A stronger pound is impacting on competitiveness leading to weaker export demand.
Against this backdrop, manufacturing businesses operating in, or connected to, the oil and gas sector should prepare for an increase in the distress anticipated as we move into 2016 and existing hedging positions begin to run off further up the chain. With cash flows depleted upstream, many oil companies (particularly smaller independent ones operating in the North Sea who do not benefit from the significant reserves enjoyed by the major international/national oil companies) may face difficulties funding operations, servicing debt, fulfilling contractual obligations and funding new projects.
These problems will inevitably get passed down the chain and companies connected, either directly or indirectly, should consider how they can best protect themselves from the anticipated contagion.
Contracts should be considered in light of the businesses own financial position, the possible distress of the counterparty and the risk of delay, breach and termination. Examination will be against a potentially altered financial dynamic to that in place when the contract was first entered into.
It is important that directors understand and identify both the risks and opportunities that will present themselves.
CUSTOMER AND SUPPLY SIDE RESILIENCE
Companies should monitor events as they occur, focusing particularly on the financial viability of contractual counterparts (customers, suppliers or sub-contractors). This will allow them proactively – and preferably pre-emptively – to address problems and, in some instances, improve bargaining positions.
Ensuring contractual rights are as robust as possible will be key. Are there retention of title or other contractual or security protections available in the event of the insolvency of the counterparty?
Can you negotiate rights of access or information likely to signal an early warning of counterparty insolvency to put you ahead of competing creditors? Where there is risk of delayed performance or, worse, complete failure to perform, the implications need to be understood.
Where a contractual default appears likely, planning in advance to manage the potential consequences of default is imperative. Focus will be on mitigation: particular contracts entered into pre-oil price collapse may no be longer be profitable and corporates are looking to extricate themselves. A full understanding of contractual rights and obligations is important to assess termination rights and, where termination rights are not available, to understand the consequences of breach. Once understood, it may then be possible to terminate or negotiate a more advantageous outcome. Particular attention should be paid to contract formalities (e.g. time limits and notice requirements).
The expiry of favourable hedge arrangements, constrained cash flows and depressed asset values increase the chance of covenant breaches. The rights and likely attitude of lenders in such circumstances should be understood.
Early engagement with financial backers and other stakeholders will increase the chances of a successful resetting of covenants or other form of restructuring.
A reduction in staffing levels has been a well-publicised feature of the downturn already. To the extent redundancy programmes are being considered, it is crucial the employment laws of the jurisdiction concerned are fully understood and complied with.
The aim should be to minimise financial liability and legal action consuming management time and damaging further employee and public relations.
SAFETY, HEALTH AND ENVIRONMENTAL ISSUES
Safety, health and the environment are vital topics particularly for those operating in the oil and gas sector. Non-compliance with regulatory requirements and failure to address potential liabilities both carry increasing financial risks. Ability to demonstrate good environmental and safety management is not only important for business reputation, but is often a key condition of obtaining both public and private contracts.
Directors of distressed companies should consider their own legal duties. Insolvencies in the sector are increasing and directors of companies in a precarious financial state should consider their own personal position in continuing trading.
Consideration should be given to the country whose laws will apply and which courts are likely to have jurisdiction.
Whilst possibilities may present in the form of opportunistic pricing, given the over-supply in the upstream market, as well as favourable contractual renegotiation with counterparties who find themselves in a weaker bargaining position, the key to survival is preparation for those challenges which will or may present as a combination of these factors conspire together to create an increasingly difficult and uncertain market for UK manufacturers. There can be no substitute for a thorough review of the business’ corporate hygiene to ensure it is best placed to weather the contagion that some commentators are predicting.