Much has been written about the maturity of the North Sea oil industry, with a number of commentators equating maturity with death, but nothing could be further from the truth.
As the older fields start to show signs of depletion, they become less attractive for the major oil companies to hold. Assets that were critical to a company a few years ago may well be seen as non-core today, particularly in light of the recent rounds of consolidation activity in the production sector.
However, just as the creation of the oil industry on the UK continental shelf (UKCS) in the 1970s and 80s produced acquisition opportunities (through the licensing of new blocks), so the depletion of those assets and their shift for many major companies to non-core status creates acquisition opportunities for smaller companies. For an organization striving for profits of hundreds of millions of dollars every year, an asset capable of generating only £1-2 million per annum of net cash may be more of a distraction than an advantage. But for a smaller company, any asset capable of generating that level of free cash is viewed as an attraction.
Over the past two or three years, the legal profession has seen significant growth in this sector - Stronachs now has six lawyers, the bulk of whose work comprises upstream oil and gas clients, both in the UKCS and internationally. Although most of the purchasers in this sector are smaller production companies, with essentially, the same corporate drivers for making an acquisition as any of the larger companies, the market has started to see one or two "special purchasers" emerge. For example, whereas most purchasers are production companies that regard oil production as their core business, some purchasers may be financial institutions interested in acquiring actual production at the source in order to hedge their own hedging commitments.
The next 12 months may see an increase in the number of deals closed in this sector as a result of some developments in the insurance market. One hurdle a small company has to cross when attempting to acquire an interest in an oil field in the UK is to convince the Department of Trade and Industry and the partners in that field that it has the financial capability to meet the field's anticipated abandonment liabilities. This has proved to be a stumbling block in many acquisitions in the past. It is extremely expensive for a small company to provide security for abandonment - historically, that security would take the form of a traditional letter of credit issued by the company's bank or by a cash sinking fund, locking up cash resources, which could be used otherwise for expansion.
In the nature of most smaller companies, any cash that is locked up in this way needs to be replaced by equity funding, typically costing 25-30% compounded. With the abandonment cost of even a small field running into several million pounds, the economics of making an acquisition can be destroyed by the cost of providing abandonment security. However, the insurance market has now reacted to this, and there are one or two specialist brokers that can provide, in effect, an insurance-based product to support a letter of credit. As the issue of the letter of credit is supported by insurance, its issue no longer eats into the borrowing base of the company. The costs of such insurance are significantly less than the cost of raising an equivalent amount of capital in the form of equity. This development is bound to influence positively the number of acquisitions in the coming year, although the cost and availability of such insurance may well be impacted by events in the US last September.
Lower oil prices - a good thing?
If an oil field is bought on a valuation that reflects a prevailing oil price of $30/bbl, the acquisition may still work if prices remain at that level. However, it is unlikely that prices will stay that high over a sustained period, therefore reducing the upside potential on that acquisition. The potential for that acquisition proving to be uneconomic is therefore greater than if the acquisition had been made at a lower oil price. Anyone who managed to persuade their bankers and equity providers to fund the acquisition of oil reserves when the price was $10/bbl last year is likely to have done well over the last 12 or 18 months. However, anyone who purchased assets on an assumed market price of $30 may be looking toward the rest of 2002 with less confidence. For this reason, although a softening in oil price may be bad news for the contracting industry in the UKCS, it may stimulate greater acquisition activity by smaller companies.
Overall, if the oil price stabilizes at around $20-25, or even slightly lower - and taking into account the recent developments in the insurance market - the stage is set for greater acquisition activity by the smaller independent oil companies in the future.
David Sheach is Managing Partner and head of the oil and gas unit at Stronachs, 34 Albyn Place, Aberdeen. Telephone 01224 845845. Further details of Stronachs and their services can be viewed at www.stronachs.co.uk.
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