Fuel for thought
7 July 2003
There has been significant corporate consolidation in the oil and gas industry recently. BP merged with Amoco and acquired Arco. Exxon merged with Mobil, and Shell acquired Enterprise. New energy giants such as TotalFinaElf, ChevronTexaco and ConocoPhillips were created by mergers. There has also been consolidation in the service sector, particularly among the drilling companies.
There has also been change in the North Sea part of the business. The production profiles of most UK players have peaked. In order to maintain margins, costs must continue to reduce at least as quickly as the decline in production. This, as much as post-merger synergies, has led to further restructuring.
This is the context for the provision of legal services to the sector, both by in-house teams and those in private practice. According to some forecasts, we have produced only half of the reserves that will ultimately be recovered. Whether or not that is correct, there is no doubt that the North Sea has entered a new phase, which has implications for investment, for changing asset ownership and for the lawyers working in the sector.
The industry is continuing to invest to manage production declines, but will do so only if there is a robust business case. 'Net present value' (NPV) and 'internal rate of return' (IRR) are critical parts of the equation. NPV is the net present value of future cashflows (discounted at the cost of capital to reflect the time value of money). It measures the profitability of the investment, but not the efficiency with which investment funds are used. To look at efficiency, the companies turn to IRR, which is the discount rate at which the NPV is reduced to zero. Most companies will also look at the ratio of NPV to the discounted development costs, the development costs per barrel and how quickly the cumulative cashflows become positive.
New technology is playing its part in creating new investment opportunities. There have been advances in seismic testing. High-pressure/high-temperature wells have been drilled. Multilateral wells and through-tubing drilling will bring cost savings. Tie-back distances (where the rig is remote from the reservoir) are increasing. Sub-sea pumps have been installed and sub-sea processing is being developed. Lower midstream and transportation costs are crucial. New projects are increasingly tying back to existing production and processing facilities and accessing existing pipelines.
Where a company has consolidated its interests in a core area, it may be able to utilise infrastructure aligned to its new production in which it already has an interest. But many companies will be net tariff payers. The industry is responding to the commercial reality that marginal fields will only be
sanctioned if the infrastructure owners are prepared to accept lower tariffs than those paid by the large fields in the earlier phases of the North Sea. Access to third-party infrastructure is an area of particular interest to the Department of Trade and Industry (DTI) and the competition authorities, at least in relation to gas pipelines.
Mature asset specialists
The mature asset specialists have a particularly significant role to play in the current phase of the North Sea. These companies will have to identify assets that are worth more to them than to the existing owner.
Such assets will probably have two characteristics. First, they will be assets that the purchaser can operate more cheaply than the current owner. The purchaser may be able to operate with fewer people, taking incremental commercial, but not safety, risk. To do so, it may need to rely on a more flexible, often outsourced, workforce that can be up and down-manned to match activity levels. Second, and perhaps more importantly, the assets will have investment opportunities that return good economics but which are unable to compete with the seller's other investment opportunities. The purchaser may also have to demonstrate a greater appetite for risk than the incumbents, both in terms of its long-term oil price assumptions and the speed with which new technology can be developed and applied.
BP has been particularly active on the disposal front. It sold its flagship Forties field to Apache this year; it also disposed of Montrose/Arbroath to Paladin, various Bacton-related assets to Tullow and Thistle to DNO. But other companies have also been active, with some deals announced and others currently being negotiated.
Deal activity levels have increased significantly, but may not continue at this rate. The recent cash deals were difficult to create over the past few years because of the focus on volume targets, a focus that has now been replaced by a more balanced set of performance indicators that speak to capital efficiency and quality as well as to volume.
The North Sea generates a significant percentage of the profits of the majors and super-majors. It will continue to do so for many years to come, albeit that the percentage is reducing. The North Sea is also an area of low political risk (Budget changes excepted). A significant premium would be required to persuade these companies to sell UK assets with low lifting costs and competitive investment prospects.
Several senior industry players have left the oil companies or the larger contractors and formed their own companies. These entrepreneurs face the same issues as the mature asset specialists in identifying suitable assets to purchase.
They also face the challenge of raising finance. Banks and venture capitalists are looking for early cashflow, and therefore capital may only be available for buying an interest in a producing field. Producing fields provide greater certainty of cashflow, but there is also less upside to capture. In addition, their cost of capital will be significantly greater than that of the asset's current owner, who can raise cheap debt on the bond markets. Having a higher cost of capital makes it less likely that an entrepreneur can create a value gap between their NPV and that of the seller, and without that gap they will be unable to secure a sale.
Bruce McLeod is an energy partner at Paull & Williamsons