M&A activity in the energy sector looks set to take off again but with commentators predicting that global oil prices will stabilise somewhere between $43 and $75 a barrel this year, we examine how the credit crisis has changed the energy M&A landscape and consider new approaches that must be taken for deals going forward.
Where are we now?
Targets and sellers
It is clear that the credit crunch has vastly reduced financing options and left highly leveraged energy companies in a weak position. The small and mid-cap companies, however, are amongst those that have been hit the hardest. The recent volatility in oil prices and unstable markets together have made it difficult to secure critical funding, without which, exploration and development cannot continue. It therefore seems likely that many small and mid-cap companies may soon find themselves becoming acquisition targets.
Players in the market that bought oil and gas assets prior to the recession are also now wondering how best to deal with these assets. While some companies are suspending or delaying projects for 3-6 months to see if the costs of contractors and suppliers will fall in line with oil prices, others are considering terminating projects. Closing down projects comes at a price however and companies need to balance the costs of proceeding against the contractual costs associated with suspension and termination. In particular, for those companies with a number of non-producing assets or more distressed oil and gas companies, the only option may be to sell (or farm-out an interest in) the project. Whilst this is not ideal, where there are real liquidity problems companies are left with little choice. A farm-out may be the best compromise for some of these projects but this requires careful analysis as it involves the same risks as bringing in a JV partner to share risks and costs of a project.
Analysts anticipate that M&A activity will rise as the oil majors, national oil companies and other investors such as the sovereign wealth funds, use this opportunity to address reserve issues by picking up smaller companies with sizeable portfolios. These potential buyers are less concerned with the current low oil price and are better positioned to hold out for distressed oil and gas company sales as they are relatively cash-rich or have easily accessible credit lines. Those in this buyer class are now looking to capitalise on lower asset prices and are also likely to take a longer term strategic approach to such acquisitions as the oil price stabilises. The unique position of these buyers and the current recession will inevitably impact on the terms of acquisitions in the future.
Whilst M&A might rise again, it seems inevitable that the terms of deals struck now will have a different emphasis.
Below we look at some examples of issues which though examined as part of every due diligence process by buyers are likely to hold even greater importance in the current recessionary climate:
- Target’s solvency: When reviewing assets, companies will look for greater assurance over the financial health of target companies especially in the context of distressed sales. The risk that insolvent or technically insolvent target companies may trigger event of default provisions under various contracts with suppliers, banks and JVs that underpin the value of assets may scare some buyers away whilst others will simply push for a lower purchase price and seek to refinance and/or renegotiate contracts.
- Hidden liabilities: Buyers will also scrutinise target company balance sheets more carefully. They will seek comfort that besides those liabilities shown on the financial statements that other potential liabilities such as delay in payments to suppliers or contractors have also been disclosed and adequately assessed as part of the due diligence process. To the extent that such potential liabilities are unearthed, it will be important to ensure that these issues are resolved as part of the acquisition terms.
- Supply contracts: Buyers should also take greater care in their review of supply contracts and of suppliers themselves. At this stage of the due diligence process buyers will be more focussed on ensuring that the supplier’s solvency or ability to complete work is not a concern.
- Partners: Issues relating to partners in target projects will also need to be duly assessed in case there are any problems progressing the project in the future. Buyers will be particularly wary of partners with solvency issues or those who are taking strategic reviews themselves on whether they should proceed with a project. As most oil gas and projects are premised on the basis of joint liability, insolvency of one partner could lead to revocation of the underlying concession.
Adequate measures need to be incorporated into the contractual documentation to monitor the target company between signing to completion. One of the most important provisions to consider for these purposes will be the ‘material adverse change’ clause. Buyers should look to ensure that MAC is clearly and objectively defined rather than relying only on general definitions. Sellers will inevitably seek to negotiate carve outs to MAC clauses to cover scenarios such as changes to general economic climate or other exceptional circumstances so that they have greater certainty over when such provisions might be invoked.
Another important issue that should be dealt with is how claims that arise post completion will be dealt with. There is a greater risk in the current market that sellers might become insolvent or otherwise disappear themselves and thus will be unable to settle claims in the future. If the buyer is not satisfied with the financial strength of the seller's group, it will be necessary for the buyer to consider other forms of protection such as, (a) reduced purchase price; (b) deposit of a portion of the purchase price into escrow; or (c) a guarantee from a member of the seller's group or bank for an agreed sum. Requests such as these need to be considered carefully in the light of all circumstances applicable at the time especially where an auction is involved, as they may reduce the competitiveness of any bid put forward by the buyer.
Insolvency searches on sellers should always be carried out. However these will not reveal whether a seller is in financial difficulty or technically insolvent – further due diligence on solvency and credit is always recommended.
In this market, buyers should also be aware that in most jurisdictions there are various forms of "claw back' which could apply if a seller becomes insolvent. Guarantees are particularly liable to be set aside on insolvency.
Given the fall in the oil price and the number of distressed oil and gas companies in the market, many argue that we will now see a shift to a buyer's market for oil and gas assets. It is not clear that this prophecy will hold true, especially if asset prices have been reduced to 'market' level. For example, where sellers are achieving a small or even negative margin on the sale of their assets, they may be less inclined to give extensive warranties over their assets.
Distressed sellers in the current climate are also likely to seek a clean break at the end of any asset sale by reducing the scope of warranties/indemnities they give and the length of the applicable warranty limitation periods.
The new dynamic in the energy M&A market brought about by the credit crunch will inevitably lead to more complex and challenging negotiations in energy M&A and a need for more creative solutions. It is important to remember that despite the shift in the market and the recent difficulties borne by potential sellers, the pendulum has not swung so far as to render future deals a one-sided affair. It remains critical that buyers and sellers both achieve value in transactions by balancing the potential as well the actual value of assets against the purchase price and the contractual protection extended to the buyer.