An Ernst & Young Study: Declining upstream asset valuations to trigger M&A

Impact of global economic slowdown on the oil and gas industry to be limited to liquidity constraints, as domestic consumption continues to grow and production is expected to remain largely in deficit
• Declining global asset valuations to drive M&A by cash-rich upstream players
• Acquisition of reserves to become more competitive
• Strong potential for alliances between national oil companies and industry in resource-rich nations

Mumbai, 17 November: The impact of the global economic slowdown on the oil and gas industry will be limited to liquidity constraints, as domestic consumption continues to grow and production is expected to remain largely in deficit, says the Ernst & Young report titled Upstream oil and gas - challenges and opportunities, which was released here today at the Oil & Gas India Summit 2008 – Exploration and Production. Domestic crude oil consumption has registered a 6.4% compounded annual growth rate since FY04, one of the highest among the world’s top oil-consuming nations.

The report further adds that while the global crisis will impact availability of funds from the debt and equity market, cash-rich companies are expected to follow the inorganic growth route. Further, if the condition persists, private equity and hedge funds, who are bearing the brunt of the downturn, may need to do distress sales of their oil and gas assets. Says Dilip Khanna, Partner, Ernst & Young’s Oil & Gas Practice, “with the ongoing economic downturn and the resultant crash in oil prices, the valuation of oil and gas companies has decreased and this offers Indian companies the opportunity to buy global assets at more reasonable prices than earlier.”

“Mergers & Acquisitions (M&A) is a viable option for independent players to increase their asset base, reduce costs and enhance operational efficiency, a well-structured transaction can significantly reduce combined overhead functions, create opportunities to reduce supply chain costs, remove redundant functions and strengthen the resource base,” he adds.

The report also states that with the reduced capital outlay, the industry is expected to focus more on higher-return projects, which will be financed through internal accruals. Capital-intensive ventures, such as oil sands and deepwater projects, will be hard-hit, as falling crude oil prices have made their economic feasibility uncertain. The tight demand-supply situation in the Oilfield Services industry is expected to assuage on the back of new supplies and lower capital spending.


With debt financing becoming unviable, more innovative financing options such as equity convertible debt instruments may be used to attract funding for projects.

According to the report, competition in the global upstream segment has changed significantly in the last three years with national oil companies from the Middle East, China and India becoming more aggressive. This has raised the levels of competition for acquisition of oil and gas assets. Put together, India’s ONGC Videsh Limited (OVL) and Oil India Limited (OIL) have acquired 38 assets across 18 countries. OVL, OIL India and the Indian Oil Corporation (IOC) have hitherto spent approximately INR 210 billion and INR 20 billion respectively on the acquisition of oil and gas assets abroad. These investments have cumulatively yielded 28.14 mt of oil and oil equivalent gas so far.

With these players aggressively seeking reserves, the competition for the acquisition of oil and gas assets has intensified. The upsurge in competition for assets is largely attributed to higher cash flows from the increase in oil and gas prices till recently, which provided upstream companies with the funds necessary for acquisitions.

The emergence of national oil companies has rapidly transformed the global oil and gas industry. Private players and national oil companies in resource poor nations can enhance their resource base either by forming alliances with national oil companies or developing their expertise in unconventional oil and gas sources. The report recommends that domestic companies should strike partnerships with national oil companies belonging to resource rich nations.

Having already demonstrated their capability to build and operate complex refineries at high utilization levels, Indian refiners can offer to develop and operate the neglected downstream sector of resource-rich nations in exchange for stakes in upstream projects.

Challenges for the sector
Resource nationalism constrains access to foreign players
In the 1970s, international oil companies held approximately 85% of the world’s oil and gas reserves. However, with the advent of resource nationalism just three decades later, their share of reserves has plummeted to less than 10%, with the remaining 90% being held by the national oil companies. Ernst & Young has analysed that only 9.7% of global oil and gas reserves can now be categorized as open for exploration and production by private/ foreign companies. Resource-rich nations such as Venezuela have either closed their reserves or restructured their contracts with foreign players and tightened fiscal terms. Even in mature and open economies, access to resources are being limited by environmental restrictions.

Organic growth
Acquisition costs have soared since 2005 as the bargaining power has shifted to resource holders. This has led to higher bids and larger signature bonuses at auctions of exploration licenses. In 2007, the weighted average cost of acquisition of proved reserves was thrice the level in 2003 – although, there was a 22% y-o-y dip, mainly due to lower transaction values realised during the Russian government’s auction of former Yukos assets to its National Oil Companies.

Human capital
Though this issue is more critical in the western countries as they face the problem of an aging workforce, the human capital deficit is a major challenge for the industry in general. In order to remain competitive, it is imperative that companies strengthen their scientific, engineering and project- management skills by hiring and retaining skilled employees.


How the government is lending a helping hand
“India’s growing dependence on imported crude oil remains a serious concern and the Indian government has launched various initiatives to address this concern. The government is encouraging the exploration and development of domestic oil and gas sources by providing various incentives under the NELP,” informs Dilip. Sources of unconventional and alternative energy sources such as coal bed methane, gas hydrates, coal-to-gas, coal-to-liquid and bio-fuels are also being explored.

The government is also supporting the acquisition of oil equity abroad by providing economic and diplomatic support to domestic National Oil Companies in their endeavor to acquire equity stakes in overseas upstream projects. The government is also encouraging Indian private companies to participate in conducting upstream business in foreign acreages. Government– owned downstream and upstream companies are also collaborating with each other to acquire crude oil reserves outside India.

NELP is driving development of upstream segment
The NELP has been instrumental in attracting private sector and foreign investment to the domestic upstream segment. In the seven rounds of bidding conducted so far, a total of 207 blocks have been awarded to various players who have made a cumulative investment commitment of nearly USD10 billion. Unexplored acreage in the country’s total sedimentary area has dropped from 41% in FY ’99 to 15% in FY ‘07. The pace of accretion to reserves has nearly tripled; the average annual reserve accretion rate during the period 2005–07 was 317.4 mt of oil equivalent. This increase can be credited to larger amounts of capital being invested for exploration and development activities, which, in turn, led to major oil and gas discoveries such as the Krishna Godavari basin

Ends

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