The investors’ perspective

Historically, private equity (PE) was not attracted to exploration and production for cyclical market reasons. It was oil price driven. It was not a private company environment, and there were few available assets.

Many people have expected this to change. In the mid-late 90s the market was in transition and the mega-mergers had resulted in expanded portfolios and generated drivers for rationalization - materiality, maturity, and decommissioning concerns. It was also a lower oil price environment.

The first of the new breed of private equity backed independents were Venture Production and Highland Energy. Both were 3i investments, and both were very successful. The model was that PE investors were looking for a production base, operatorship, and a management team that knew the basin/assets.

Despite the rhetoric, the market never developed. Post-merger sales did not materialize, production targets led to retention, and merger and acquisition (M&A) activity did not grow at the expected rate.

There have only been 11 private equity backed UK E&P companies in the past eight years. The combined equity raised is close to £300 million compared to an overall UK private equity investment of approximately £5 billion.

Now, the market dynamics have changed. We are in a higher oil price environment, and there is more competition from North American independents, emerging European companies, and other UK start-ups.

Investors want growth; so this necessitates a move from production-only strategies to development and possibly exploration, but can PE-backed companies take on exploration risk?

Investors want to support companies that can deliver sustainable growth. This needs to be more than low cost. Companies need to access assets and then have a strategy to add value through bringing in specialist skills, investment plans, delivering upside through infill, drilling, and satellite or commercial synergies. Private equity investors want to build companies of substance.

There are four elements to private equity investing - having a company with a clear strategy, having an aligned management team to implement it, having a financial structure to support growth and maximize returns, and having a clear realization plan.

The market - asset availability

Why hasn’t the market developed? The high commodity price resulted in record cash flows and strong balance sheets, but there is continual pressure to deliver returns. The result of a lot of cash and few opportunities has resulted in a very competitive M&A environment, making it extremely difficult for private equity companies to acquire assets. However, the UK Continental Shelf is still a large and liquid market, second only to North America, and is a hugely attractive arena for private equity.

Market volumes increased fivefold from 2000 to 2003, but slowed in 2004. 3i recently undertook a study with Deloitte Petroleum Services Group on a field-by-field basis, estimating a £1.7-£2.3 billion M&A asset market over the next four years. This excludes corporate disposals and presents a significant level of opportunity.

Average deal size has remained at $70-$110 million over the past four years, and there is a considerable spread of single-asset packages. Average price trends have remained flat over the past three years at approximately $4/boe, but there is a wide range within, with production assets $2.15 to $9.58/boe and development assets averaging $0.74/boe (excluding Buzzard).

In this market, we need to be clear as buyers about what sellers of assets are looking for from the new independent start-ups. This is a key to accessing opportunities.

Limiting factors in the growth of UK independents

Competition for assets is a major issue, but other factors are inhibiting growth in this sector.

First, we need to see consolidation. We have not managed to replace Lasmo and Enterprise and create a UK independent of £1 billion market cap.

There are 149 participants in the UKCS, including 30 that have operated production. Thirty-seven participants have potentially commercial reserves, reserves under development, and discovered underdeveloped reserves. Fifty-two companies have exploration interests only.

There are huge differences in scale. Are we aggressive enough as financiers? I think our model needs to change because it is too slow. To date, we have funded teams to set them up, refine strategy, recruit and hunt for assets, and then build their portfolios on an asset-by-asset basis.

There are too many single-asset companies, which not only creates risk, but discourages other players from backing start-ups. However, there is no shortage of either private equity or public capital. Similarly, there is plenty of private equity capital available for opportunities that meet the investors’ requirements.

Typically, more than £5 billion private equity flows into the UK each year. Most stock markets have about 12% in E&P. Crudely, this suggests that there is more than £500 million available!

Of course, this investment is not taking place, so why the disconnect? Investors believe there is a dearth of quality opportunities. Should we be looking to create 20 single-asset companies, or is there more value in fewer, larger players with more diverse portfolios?

PE’s role

I think private equity can provide more than just capital. We are often a “screening” process - few companies that cannot raise equity can acquire assets. More importantly, we instill discipline in managing risk and developing strategy.

The North Sea has the corporates, governments, and entrepreneurs all wanting to stimulate activity. Our challenge is to help bring some of these groups together.

Graeme Sword
Director Oil and Gas team, 3i