Continued E&P growth expected for North Sea in 2006

Feb. 1, 2006
Service, supply companies in line for profit gains

Service, supply companies in line for profit gains

Hans Middelthon,3i

Although the oil and gas market has experienced a prolonged period of upturn, we remain in a cyclical sector.

The oil and gas industry has been through a period of high oil price, a price which may remain firm in the short to medium term, but we expect it to edge lower over time as bottlenecks are tackled and investments in substitute sources of energy bear fruit. However, the market may stay somewhat nervous as a number of unknowns such as terrorism, wars, politics, and the weather have an increasing impact on the oil price.

There are several supply side issues that will impact the market in 2006; outlook on remaining reserves, OPEC power and finally price per barrel itself. The ability to meet demand is currently restrained by exploration budgets, rig availability, previous lack of investment in infrastructure, refining capacity, shortage of qualified people, entry into new frontier areas, uptake of new technologies, transport and logistics issues, and general conservatism.

The demand side has captured the imagination as it is driven by strong growth in China and India. Going forward, however, we believe there should be as much focus on a possible recession, especially if it is led by the US and is a consequence of the higher oil price itself. A recession for the OECD countries would halt the price increase, as would an adoption of “real” petrol prices by a number of Asian countries. In the longer term, alternative energy sources and a more efficient energy use will have an increasing impact on the oil price and oil market.

Although we may have reached a short term peak for the oil price, 2006 is lining up to be a strong year for the industry. The E&P companies are long of cash and are looking for ways to deploy it.

We would not be surprised to see more consolidation in the industry, (a recent example is Talisman’s acquisition of Paladin), further share buy backs and entry into new regions (such as BP’s review of China). Also, we expect the importance of the national oil companies to become more apparent as the visibility of their share of total remaining reserves becomes clearer.

Finally, the service sector is starting to fill its order books and achieve price increases. We expect to see increased merger and acquisition activity from the major service companies as they look to strengthen their core business and add earnings to their P&L spell out accounts.

Private equity will continue to play an important part in the sector. A number of E&P start-ups are looking for funding, many of which turned to the stock market during 2005. However, with a number of E&P companies still needing funding to fulfill their drilling commitments, this avenue is becoming saturated. Although this offers an opportunity for private equity, the challenge is the lack of differentiation among business models and the inherent difficulty to pick the winners. What we need is new business models.

North Sea

The North Sea has become a more attractive basin for E&P companies over the last 12 months. Not only has oil price made exploration opportunities and mature assets more sought after, but both the UK and Norwegian authorities are looking for ways to increase activity through a number of initiatives ranging from larger licensing rounds to taxation.

The UKCS is going through a transition, with a number of smaller start-up E&P companies entering the shelf as well as the majors developing renewed interest in the province. This was exemplified by the 23rd license round, which saw 24 new entrants to the UKCS, and ExxonMobil and Shell awarded 20 contiguous blocks (the largest single award in the history of the UK North Sea). In addition, 17 wells were committed with 152 licenses offered to 99 oil and gas companies. The UKCS has only seen 50% of recoverable reserves produced, and the high oil price environment will give a boost to activity in the short-term.

This year holds a number of challenges, in particular for the start-up E&P companies. We expect the transaction market to remain both quiet and expensive during 2006. Also, we believe that the shortage of rigs available in the market, combined with the ageing infrastructure, may cause delays in development plans or lead to a higher cost base than originally budgeted. Furthermore, the increasing shortage of skilled labor will prove to be a challenge for the E&P companies.

This year could also prove to be the start of a consolidation between many of the E&P minnows that are struggling to pursue growth plans over and above the first licenses obtained. If there were to be a correction on the alternative investment market (AIM), many may find it difficult to raise the funds needed or to get the attention they want from the markets. At one point during 2005, early stage E&P companies with no producing assets represented £7 billion of value on AIM. Private equity players may to some extent take over the role of AIM over the next couple of years and may become the catalyst for consolidation between the minnows.

3i remains involved on the UKCS through investments in CH4 (gas development and production in the southern basin) and Faroe Petroleum (exploration focus in Faroe and West of Shetland). However, with the persistent high oil price and increased competition both for producing assets and development opportunities, new business models are required. One such company, backed by 3i, is Energy Development Partners (EDP), which recently raised $335 million to fund its activities. EDP is best described as a technical fund, providing capital and development resource and whose reward in the deals it strikes is a share of production. It partners with existing asset owners and takes technical control of projects without owning said assets directly.

The importance of the UKCS as an energy provider to the UK mainland continues to increase and we believe that the North Sea will represent a good investment opportunity in the coming years with private equity playing a leading part in providing the necessary capital.

UK service sector

The UK service sector is improving after a number of lean years. Order backlogs are at a high and 2006 looks to become a strong growth year. However a number of challenges remain, most importantly the ability to deliver on time and on budget and to secure healthy margins, something that has proven difficult in the past. Furthermore, the UK service sector also faces the outlook of a dwindling and ageing work force and may increasingly have to look elsewhere for the right skill set.

This will probably be a year in which the larger UK service companies, such as Wood Group, Abbot, and Expro, rebuild their balance sheets and look for acquisitions or mergers. Abbot has already made its first move by acquiring Norwegian Prosafe’s drilling services division. We expect increased activity in the M&A market and higher prices to go with it, with trade buyers staying more focused on their core business than historically, and financial buyers looking for strong technology plays, turnaround opportunities and non-core businesses.

Norwegian E&P sector

The Norwegian E&P sector lies some 15 years behind the UK equivalent. Historically, the main focus has been on elephant opportunities in the North Sea and increasingly in the Norwegian Sea. However, drilling activity on the Norwegian Continental Shelf has been a fraction of that on the UKCS, and large areas of the NCS remain unexplored. In particular, the industry puts great expectation on the prospects of the Barents Sea (including the disputed area with Russia) and in the Lofoten area. Norway’s new, left wing government, which was elected in September, is facing a number of challenges as it aims to keep activity levels high. There are no large projects in the pipeline after the completion of Ormen Lange, Snøvhit, and Kristin.

The NCS is dominated by Statoil and Hydro. However, both these companies are looking to expand their business outside the region, as highlighted by Statoil’s acquisition of Encana’s assets in the Gulf of Mexico and Hydro’s acquisition of Spinnaker. Equally, Statoil and Hydro both aim to play a significant role in the Barents Sea, both on the Norwegian and Russian side. This may open up opportunities for other players on the NCS, through both a lack of focus from Statoil and Hydro and possible asset sales.

A number of new players recently entered the NCS. Most prominent have been the new Norwegian start-ups such as Revus Energy and Noreco, as well as Altinex, Pertra, Discover, Ener Petroleum, and PA Resources. Most of these companies have benefited from the larger licensing rounds as well as the bullish equity markets.

Other entrants include European integrated gas companies, such as Gaz de France and Eon. A final new group entering or looking to enter the NCS are Asian companies wanting to secure resources for their growing economies. We believe international E&P companies and integrated energy companies will continue to follow developments on the NCS closely, while Norwegian start-ups will find 2006 a more challenging year to secure funding.

A number of improvements have been initiated by the authorities with the underlying aim of bolstering activity. Most important are the new tax regime benefiting start-up companies and the larger license rounds. There also appears to be political support for further exploration of the Barents Sea, a basin Statoil believes is key to the future European gas supply. The oil and gas industry is pivotal to the Norwegian economy and it is important that activity levels remain high. Hence, we do not expect any major changes from the authorities that may negatively impact development of the NCS in the short-to-medium term.

As we enter 2006, a number of challenges face the smaller E&P companies operating on the NCS. The main issue is the shortage of rigs which is expected to continue throughout 2006. Alongside this, being tempted to overpay for producing assets remains a real threat and finally, the smaller E&P companies may struggle with funding and traction as they become victims of the short-term nature of the stock exchange.

Norwegian service industry

The Norwegian service industry has benefited recently from a number of large projects, such as Ormen Lange, Snøhvit, and Kristin. However, as these are coming to an end, the focus will shift toward smaller developments and opportunities abroad, especially in the Former Soviet Union. However, we believe that the Norwegian service industry will lobby Norwegian politicians to make sure that activity levels remain high, so as to secure employment in coastal areas.

The outlook for 2006 is very positive. Larger players such as Vetco Aibel, Aker Kvaerner, Smedvig, and Prosafe have historic high order books and are seeing margins return to reasonable levels. However, Norway has once again taken a leading role in the asset markets, in particular in funding the next wave of rigs, both jackups and semisubmersible, and we fear that there may have been overinvestment in this area and that day rates may start to fall in the second half of 2006.

Norwegian service companies have traditionally enjoyed a high level of technological content and a strong engineering skill set, but they have struggled to expand internationally. This has made them attractive acquisition targets for larger international groups, a trend confirmed by the recently announced acquisition of Plugging Specialists International by T. D. Williamson and Halliburton’s acquisition of Easy Well Solutions. We believe this trend will continue with a number of smaller, high quality Norwegian service companies maturing to a stage where international companies start to show interest.

The oil and gas industry has experienced an active and exciting 2005 with high oil prices as a result of high demand in Asia, unprecedented weather patterns, the historic lack of investment in infrastructure, and instability in the Middle East. As we enter 2006, we believe the industry is in good shape and that the North Sea in particular has found a new lease of life.

We expect 2006 to be positive for E&P and service companies, both on the UKCS and NCS, but believe some corrections may take place as a number of E&P minnows struggle to fulfill their growth plans and service companies stay focused on their core business. Private equity will remain a key provider of funds for the industry and will increasingly play the role of consolidator in the E&P sector, while also providing solutions for service companies as they focus on the next stage of their growth strategy.