Independent oil and gas companies are coming to terms with the realities of the downturn which has led to the end of the 5 year commodity “supercycle.” Brent crude at US$147 per barrel is just a memory and it is predicted that total demand for oil will fall in 2009 for first time in 25 years.
Mid-tier companies with production are paring their costs to the bone but for the most part are surviving, some by raising capital via a rights issue. However many of the junior explorers are running out of cash. The majority of E&P companies on London’s AIM Market have less than £10 million in cash, with the debt markets closed or only lending at punitive rates and there has been a retreat of institutional investors from the sector. Further, hedge fund redemptions are pushing down the share price of their investee companies, falling oil and gas prices are reducing production revenues, and companies without reserves are being shunned by the capital markets.
In fact the impact of the downturn was at first masked by healthy capital raising, with more than £800 million in equity raised in the sector on AIM in 2008. Overall, companies need to demonstrate value, stimulate liquidity and search for innovative means and sources of finance.
These North Sea explorers need help, but the Government’s latest proposals to provide them with tax relief have been met with a lukewarm response.
Impact on the capital markets
E&P market capitalisations are commonly below their net asset values. With traditional methods of valuation no longer providing certainty, this has proved a disincentive to mergers and acquisitions.
Despite this, institutional investors are becoming activist. Investors are focussing firstly on the quality of management and then the quality of the assets. There is in particular a flight from frontier or riskier locations. Shareholders want to know whether management can retain the assets and execute their operational plans. Valuations are clearly higher for companies with booked reserves, but having production does not necessarily increase a company’s market valuation by a significant extent.
This year, with the accounting reporting season imminent but the outlook for the next 12 months unclear, a significant number of E&P companies will be debating with their auditors as to their going concern status. Modified audit opinions are likely to be increasingly common and some will find their audited accounts qualified.
In the longer term investors will wish to see measures taken by the London Stock Exchange to energise the AIM Market, stimulate liquidity, improve transparency and possibly increase minimum issuer size.
Explorers are above all prioritising cash preservation, by focussing on near term developments, cutting overheads, deferring seismic and drilling programmes and seeking to agree if possible the deferral of work programmes.
It is also helpful for companies to improve their profile to encourage investment, with an emphasis on improved reporting and news flow, via better use of PR advisers and the brokers. It remains to be seen, however, whether news of a discovery would raise the company’s share price unless it has the cash resources to lift the oil. In any event, positive news can be slow to be reflected in the share price.
Clearly companies should upgrade and book reserves where possible. Companies will also initiate cost sharing by farm-out programmes, entering into joint venture, strategic shareholding and partnership arrangements and disposing of non essential assets and licences. No doubt in many cases management will be pushed into action sooner than they would wish.
Will operating costs come down? Certainly rig rates have been slow to fall, though experience varies depending on supply, location and the suppliers’ existing contractual commitments.
Possible alternative sources of finance
Will private equity come to the rescue? PE funds are not typically investors in upstream oil and gas and equally do not typically invest in listed entities, but the specialist funds are beginning to make selected acquisitions.
Companies are also tapping their existing shareholders for funds. Rights issues have become a theme of 2009, the recent Treasury initiated reforms having made the process easier. Shareholders may have little choice but to take up their rights or suffer the consequences.
Consolidation and merger
In many cases it is currently cheaper to acquire reserves by way of a corporate acquisition than through drill bit. Will the NOCs and majors be tempted?
There are numerous advantages for smaller companies combining, as well as some risks. In addition to combining cash resources, scaling up enables:
- synergies and economies of scale
- a higher corporate profile
- the potential to upgrade the stock exchange listing
- focussing resources on the best assets of the combined group
- diversifying, de-risking and balancing the portfolio
- leveraging expertise in adjacent territories or blocks
The challenges remain for companies to accurately and realistically value each entity, as well as the usual issues of management succession and, for the better capitalised, the risk of utilising their precious cash on unknown assets.
Recent transactions in the sector
There have already been some examples of junior and midcap mergers and acquisitions.
- Granby Oil and Gas was bid for by Silverstone Energy, another North Sea explorer, to benefit from scaling up
- Victoria Oil and Gas merged with Bramlin partly after local litigation led to the shut down of its Kazakh production
- Imperial Energy was acquired by ONGC Videsh, which was prevented from delaying its bid by the Takeover Pane
Some businesses have not escaped the downturn as demonstrated by Oilexco North Sea being placed in administration after failing to refinance its debt. Others have been more successful, including Tullow Oil whose recent positive news enabled it to mount a £440 million rights issue.
What of the future? It is likely that in the mid to long term prices will rise, driven by a number of factors. Further cuts in production by OPEC are possible, there will be renewed demand from the emerging markets, especially the BRIC countries, lower investment will eventually lead to future capacity constraints, as occurred after 2003, and production from mature fields will continue to decline.
Rising oil and gas prices will in turn fuel the next investment cycle.
Are other trends discernable? In the near term there will be increased leveraging of companies’ own assets until investor appetite for risk recovers. Share prices currently look oversold and in general share prices in the sector should rise.
To remain competitive and retain the confidence of investors, the London Stock Exchange may decide that its AIM rulebook needs to be re-examined, perhaps with a requirement for E&P companies to publish annual reserve reporting and possibly even for a minimum market capitalisation to be introduced as a new condition to listing. Even so, there may be a movement from AIM to the LSE Main Market to benefit from a perception of better valuations and higher liquidity, especially by AIM companies with commercial levels of production.
UK Treasury support for North Sea explorers
After much industry lobbying and consultation, the Government announced their tax reforms in the 2009 Budget. Do these reforms go far enough? A recent report by the House of Commons Energy and Climate Change Committee questions whether the reforms will stimulate the investment the industry needs.
UK energy policy must balance the need to reduce carbon emissions with the need to ensure security of energy supply, which includes making the best use of the UK’s remaining oil and gas reserves. The UK’s oil and gas industry supports 350,000 jobs and oil companies alone provide around 30 per cent of the UK’s corporation tax receipts. Oil & Gas UK says the industry currently provides around 70 per cent of the UK’s primary energy needs. By 2020 it could still be producing 65 per cent of the country’s oil and 25 per cent of its gas needs, if capital investment remains at £5 billion per year and the production decline rate holds at 5 per cent per year.
The UK oil and gas industry, however, faces increasing challenges because of the economic recession, lack of access to credit, high production costs and low oil prices. Levels of capital investment are falling, and it is estimated that they will continue to fall further. If capital investment is to be maintained, the Government must act to support the industry and encourage production.
Consultation with the industry
The Government has been in consultation with the industry over the past few years, and has discussed various proposed tax reforms aimed at both the industry in general and at specific areas. Oil & Gas UK describes the current tax regime as “… no longer fit for purpose. It appears to be designed to maximise short-term revenues for the Treasury at the risk of long-term recovery of reserves and security of energy supply.” The Treasury consultation carried out in the run up to the 2009 Budget concluded that the right tax incentive could increase investment, leading to an increase in production. After considering various suggested measures, the Government favoured introducing a “value allowance” targeted at those marginal fields that face the greatest challenge in development, reducing their tax on ring-fenced profits.
Budget 2009 – field allowance
As expected, the Government introduced the “value allowance” (as a “field allowance”) in the Budget on 22 April 2009, with draft legislation appearing in the Finance Bill 2009. There are three types of field allowance, each with its own qualifying conditions. While the three types follow the categories originally discussed in the consultation with industry figures, the details have in some cases shifted considerably.
The new field allowance will apply to small fields, ultra high pressure high temperature (HPHT) fields and ultra heavy oil fields. Companies with fields meeting the qualifying conditions which get development consent on or after 22 April 2009 will be able to use the allowance to reduce their ring-fence profits once the field has started producing. They will be able to use the field allowance over several years until it has been exhausted, and there is a cap on how much they can use in any year.
The level of the field allowance depends on the type of field:
- Small fields – i.e. fields with oil reserves (or gas equivalent) of no more than 3.5 million. The allowance will be £75 million for fields with reserves of 2.75 million tonnes or less, reducing on a straight-line basis to nil for fields with reserves of over 3.5 million tonnes. The company can use a maximum of £15 million of the allowance in any one year.
- Ultra heavy oil fields – i.e. fields with an American Petroleum Institute gravity below 10 degrees and a viscosity of more than 50 centipoise at reservoir temperature and pressure. The available allowance is £800 million, with a cap of £160 million for any one year.
- Ultra HTHP fields – i.e. fields with a temperature exceeding 176.67 degrees Celsius and pressure of more than 1034 bar in the reservoir formation. The available field allowance is the same as for ultra heavy oil fields at £800 million, with an annual cap of £160 million.
In his Budget speech, the Chancellor announced that the field allowance “could lead to an extra two billion barrels of oil and gas that would otherwise remain under the North Sea”.
Response to the field allowance
Industry appeared initially to welcome the reforms, but more in-depth industry feedback has been obtained by the House of Commons Energy and Climate Change Committee (the ECC Committee). This cross-party committee is tasked with examining the expenditure, administration and policy of the Department of Energy and Climate Change. It gathered written and interview evidence from across the industry. The ECC Committee published its first report (the Report) on 30 June 2009. It analyses the difficulties and opportunities faced by the UK offshore oil and gas industry, and recommends possible Government action to ensure that the UK continental shelf’s (UKCS) remaining reserves are used efficiently. The Report highlights the North Sea fiscal regime as being a key factor to ensure the continuing survival of the UK oil and gas industry to meet the UK’s energy needs. Having examined the responses of witnesses from various parts of the industry, it sets out the ECC Committee’s view on the reforms.
It welcomes the allowance as the Government’s acknowledgement that the tax burden on UKCS operators needs to change to encourage investment. It goes on, however, to express concerns that the field allowance “seems to be flawed in a number of fundamental ways”. These are that:
- the allowance does not encourage incremental investment in existing fields;
- it is likely to be ineffective in increasing investment west of Shetland, where possibly a fifth of the remaining UKCS oil and gas reserves are located, but where production is expensive and challenging;
- the qualifying conditions for the allowance are so demanding (in particular for HPHT) that it is likely to have a minimal effect; and
- even in those fields that do qualify, the allowance itself is on a modest scale which will not significantly encourage investment.
The Committee concludes that it shares the concerns of those it consulted with that “the allowance will not stimulate the production of the two billion extra barrels of oil hoped for by the Chancellor”.
Other Budget changes
The 2009 Budget introduced several other changes to the North Sea tax intended to “assist asset trades and give companies the certainty and stability they need to underpin investment”. The report also looked at these measures, which were:
- changing the chargeable gains regime as it applies to the North Sea ring-fence so there will be no chargeable gains on licence swaps and an exemption for gains from ringfence assets where they are reinvested within the UKCS;
- changing the North Sea fiscal regime so it is easier to access by projects such as gas storage, carbon capture and storage and wind energy, which use North Sea infrastructure for non-ring-fenced purposes;
- changing the petroleum revenue tax (PRT) regime so companies with expired production licences may still be able to benefit from PRT decommissioning relief; and
- making it simpler to comply with the PRT regime and repealing obsolete legislation.
The Report notes that the industry generally welcomes these measure, which, although modest, “provide very helpful certainty and stability”. It also notes positively that the “Change of Use issues identified in the November 2008 PBR were included in the Budget papers”. HMRC has also confirmed that it will treat Cushion Gas in Change of Use projects as plant for the purposes of the capital allowances legislation.
What next? – Recommendations of the ECC Committee Report
The Report recommends that the Government should review the operation of the field allowance in its first year. The Government should be prepared to extend the scope of it, in particular to enable it to apply to investment west of Shetland. They should also alter the qualifying conditions to ensure that a meaningful number of new fields will qualify.
The Report also suggests that the Government should consider the “bolder moves” which have been favoured by many industry insiders. These might include introducing a capital uplift or enhanced capital allowance for investment in both new and existing fields, incentives for exploration west of Shetland and reducing (or even removing) the supplemental charge.
In addition, the Report urges the Government to further explore the costs of enabling smaller companies to benefit from unrelieved tax allowances earlier, which would help with cashflow for investment before a project was making profits. This proposal was put forward by the industry in consultation in the run up to the 2009 Budget, but disregarded by the Government. It may be even more relevant as the recession continues.
The reforms brought in so far seem to be regarded by the industry as no more than a welcome but modest “step in the right direction”. There is a powerful combination of factors which make current market conditions very tough for operators on the UKCS, and the energy security of the UK is dependent on using its North Sea oil and gas resources effectively. The ECC Committee concludes its Report in agreement with industry figures by expressing concern that the new measures may not be “sufficient to create the competitive environment needed by the industry nor provide a strong enough incentive to exploit fully remaining resources”. It hopes that “more wide-ranging and generous reforms of the fiscal regime will be forthcoming”.