Mergers and acquisitions: Is the North Sea still an attractive region?

It is interesting to examine what has happened in the mergers and acquisitions market so far in 2006 and how it will develop in the rest of the year. The main question to be addressed is whether the North Sea is still an attractive province for deal-making.

In answer, I think the UK still has a lot of potential. However, the big issue for private equity investors continues to be price, both for E&P assets and service companies. In terms of E&P, many of the deals we have seen have required a forward curve oil price for at least the first three years.

This is a challenge in any leveraged structure, and results in an imbalanced risk-reward for the investor, especially in small companies that do not have a portfolio spread. As a result, private equity investors are having to move “up the risk curve” and be prepared to take development or even exploration risk to retain historic levels of return. This is a big shift in attitude and approach and has reduced the number of private equity funds that are prepared to invest in this market.

At 3i we have sought to address this challenge in two ways. Firstly, we are looking for new models to unlock some of the UKCS opportunities. This was the rationale for us supporting Energy Development Partners (EDP), a $335-million fund that invests capital and technical expertise in return for a share of production. We see this innovative model as an exciting way to access development opportunities.

The second approach we have taken is to expand our geographic focus, as evidenced by our recent investments in Salamander Energy, a South East Asian E&P company, and Noreco, a new-start Norwegian E&P company. We believe that these companies can replicate the successes of Pearl and Revus, which achieved successful IPOs last year in Singapore and Oslo, respectively. In the way that the oil companies rank their prospects on a global basis, investors are now doing the same. The UK retains its attractive features, but at current price levels it is difficult to see how one can start to build a conventional E&P company.

Another issue which is “high on the agenda” is the contracting and service sector capacity. Lack of rig availability, resource constraints, and escalating costs are all now seen as restricting UKCS potential in the short-term. Private equity activity in the service sector was lower last year than for quite some time. The highlight was the IPO of Petrofac, a highly successful 3i investment.

Petrofac is a quality service provider that has implemented a clear strategy, such that it has become a truly global player. Its CEO, Ayman Asfari, has done a tremendous job in building Petrofac’s service, brand, and financial position. The challenge for investors now is to identify which other UK service companies have this level of potential. In today’s market, capital is not a constraint - it is access to quality opportunities.

Looking forward, I believe there are a number of drivers that will result in a more buoyant M&A market:

Firstly, I think many service companies have now strengthened their balance sheets and built their order books. This has led to a more confident service sector that will be actively seeking to build their companies through acquisition since they will have little surplus capacity to grow organically.

Secondly, we are also seeing a more active quoted M&A market. The private company market tends to lag this by 6-12 months, which suggests that we may see a pick up in transaction into 2007.

Finally, the corporate finance community seems busy, and that is good news for investors. I expect there are a number of transactions that are just starting or are already under discussion.

I hope that, as the rest of the year unfolds and we move in 2007, we can make some deals happen that create the next generation of companies like Petrofac, Wood Group, Abbot, and Expro.

Graeme Sword
3i Partner, Oil, Gas & Power

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