Capital raising and marginal production…

A very good article in the Houston Chronicle outlines the scale of the capital being raised in the US to pour into shale and the related infrastructure:

Private equity firms have raised more than $200 billion in funds for energy investments since 2014, including $50 billion set aside for shale drillers, according to research firm IHS Markit. They have stakes in more than 350 privately held U.S. oil producers, including 73 companies launched last year with $12.4 billion in investments, according to research firm 1Derrick. Those investments came in about one-third higher than in 2016.

Private equity firms also were involved in $15 billion worth of oil-production transactions last year, three times more than from 2008 to 2012. They were party to 15 of the 20 biggest deals last year. Now, roughly 40 percent of the 979 rigs drilling across the continental United States are tied to private equity-backed companies, investors said…

In Houston, 20 local private equity firms have raised a combined $56.3 billion in funds over the past decade, most of it meant for the oil industry, according to Preqin, a company that collects data on alternative investment industry. A portion has been set aside for investments in the health care, manufacturing and other industries.

In contrast, and not strictly a fair one, last week Chariot Oil and Gas, a small London offshore explorer listed on the Alternative Investment Market (“AIM”), announced the final stages of a capital raising, having raised USD 15m earlier in February the follow on issue seeking €5m got only 41% acceptance. Chariot looks to be a well run company, focused on Atlantic frontier exploration, but the sentiment is simply not there in the equity market to back these offshore exploration companies at the moment. I think that this is one of the few capital raises on the whole of the London Stock Exchange for oil and gas companies in 2018. The money just isn’t there.

The London AIM market has always been a good proxy for the availability to fund marginal offshore developments. By virtue of history and the leading position taken by the UK and Norway in developing the offshore industry (Brazil would not have been possible without the pushing of the technical envelope that was achieved in the North Sea) there was a base of investors who understood, and would back, offshore projects.  EY used to publish an index of the Oil and Gas companies on AIM, the fact they have stopped  (2014) is a data point alone in how this source of funding is declining in importance. As a comparison in 2012 and 2013 here are the stats for capital raising in London:

LSE funds raised.png

Nearly all the capital was destined for riskier, more marginal, offshore projects: Cameroon, Nigeria, Senegal, Mozambique, and the UKCS amongst others. On the main board Premier Oil raised money for Falklands exploration and Enquest was riding high as investors felt the protracted process to get these marginal fields into production was worth the time as risk capital. It’s not just a billion of risk capital that has been withdrawn, it’s a reflection of a wider market sentiment of the difficulties faced in raising money for offshore projects.

And that is really the link: AIM used to fund marginal production, new risky exploration and development outside that which larger, and more cash rich, E&P companies would undertake. Now in the US that source of capital is being provided by PE companies (and high yield debt) which reflects both the potential geological opportunities available but also where the highest profit at the least risk can come from. And that capital isn’t backing offshore anymore it is backing shale. When the price of the underlying commodity is so volatile, and not on a seemingly unstoppable upward trend, then smaller bets in an industry with lower upfront costs and a lower risk payoff profile seems like a better place for money to go. For an industry as dependent on capital as offshore E&P is this is not a good macro indicator. Capital begets capital in a self-referencing cycle sometimes because it provides the illusion of liquidity and asset price appreciation for investors, the more private equity money that piles in, the easier an exit will be, so more private money piles in.

If you look at Enquest and Premier Oil, two major independent investors in the UKCS, they are struggling under enormous debt loads and have prioritised payments back to debt and equity holders over development activity. With Enquest bonds trading at ~88% of par, £1,9bn in debt, and only £344m of equity, it is easy to see why: lenders and shareholders want their money back not worry about IEA predictions of impending supply shortages. It is worth noting in Jan 2017 when Enquest took over the Magnus field from BP that BP had to lend them the money, one can assume as both parties knew that external funding, even for such a good strategic deal at only £75m,  was unavailable. Shareholders in these companies don’t feel rich they feel like they might not lose everything:

Enquest Bonds over 1 Year (hardly investment grade as of 28/03/18 and as recently as Sep 17 pricing in  default effectively):

Enquest bonds.png

Enquest Share Price over 5 Years (as at 20/03/18):

Enquest Share Price 5 Year.png

If you are a shareholder in Enquest the current oil price doesn’t make you want to go mad on increasing production it just gives you comfort you might get your money back. Enquest is a leveraged bet on an increase in the oil price no matter how well run. This is emblamatic to me that even today some people talk about an increase in offshore spending as if it is a given as the oil price improves, but no one can actually explain in a logical fashion where the money is coming from? Or how companies like Enquest could actually afford to spend more? Increased offshore spending isn’t simply a linear function of an increased oil price it requires a change in capital market conditions as well.

The UK is a marginal development region meaning it needs higher prices to sustain E&P: $60 – 70 oil keeps the lights on and the administrator away, it isn’t a money making machine.  When credible forecasts come in that the oil price could drop as low as $51 in 2018 shareholders are pressing oil companies to lower CapEx and not rush into projects. Enquest also won’t be turning on the maintenance spend more than needed in this environment as a relatively small price decline would cause it real issues given the high fixed cost base and finance commitments. If anything it needs to build some financial latency if it can.

Coincidentally I came across this amazing video of the Ithaca Energy’s Stella development (it really shows off the scale of the development and the capital commitments). Ithaca both an AIM and UKCS success story, recently sold to the Israeli energy company Delek, for less than some of its longer term investors were happy about. Historically using the AIM market Ithaca was able to raise sufficient capital over a number of years to increase in size and gradually develop ever more complex and sizeable developments. You couldn’t repeat that trick now as the money and market sentiment isn’t there.

Ithaca also highlights that investors in these companies were hoping not just for the business to work but also for a takeover premium when the company got to a certain size. A bid in the form of a takeover often carried >25% takeover premium. Investors wanted not just exploration and production success but also dreamed of the next Cove Energy. Cove raised money on AIM over time at an ever increasing premium:

  • June 2009: £4 million at £0.12 per share
  • September 2009: £42 million at £0.20 per share
  • March 2010: £26 million at £0.40 per share
  • November 2010: £110 million at £0.76 per share…

… And then attracted a bidding war that Shell eventually won (at a 70% premium to the undisturbed share price). Everyone got rich. Whereas Ithaca, a great and successful company, showed how remote chances are for a massive takeover battle for an offshore-based production company are. Again as a contrast takeover activity in the US Shale sector is booming, last week Concho Resources paid a 15% premium to access RSP Permian (an $8bn equity acquisition).

Yes, private equity has made significant investments in the UKCS, but these are essentially deals that allowed others to exit. Chrysoar, Siccar Point, and Ineos were all mainly exit deals for someone else. All the purchasers have a significantly higher cost of capital than the sellers and must surely rely on some profit on exit to make the economics work? As private equity companies prefer to use leverage they will also face a constraint on how much cash flow from operations they risk on development spending as the price of oil fluctuates.  Their debt commitments are fixed and they have less to spend on development if prices do not rise.

News that Siccar Point is looking to offload half it’s stake in Rosebank to reduce CapEx commitments show the feeling of their shareholders (Blackstone with $7bn in energy portfolio investments and Blue Water Energy) regarding UKCS developments and their likelihood of recovering this with increased oil prices (although both are going long in Norway with Mime). I see this news as a real marker for a change in investment sentiment in the PE community for investment in offshore. The longer the oil price stays range bound at current levels, and forecasts come in for the downside, expect PE investors to be far more nervous about offshore CapEx commitments than industry companies. The constant focus on delaying Rosebank until costs have been driven down to an acceptable level show that while the supply chain may get some utilisation from this project they are unlikely to make money from it.

The statistics point to the UKCS entering a period of massive investment decline, larger than relative to the rest of offshore, that will be very hard to reverse, and the AIM/London Stock Exchange reflects not a lack of potential projects but a lack of willingness to invest in a sector with such long-term and risky structural characteristics.

I think there are two factors that are really important for the UKCS:

  1. The payback time for offshore projects is significantly longer and more complex than for shale projects: see the decision tree at the top of this article. The cost of a well for shale is ~USD 10-12m and the payback, although lower, can start to come in months (this is true globally as well obviously).
  2. Tax: one of the reasons the Norwegian shelf has held up better compared to the UK is that you get a cash reimbursement of 78% of actual drilling costs from the tax authorities, this is consistent with loss aversion theory which recognises that people prefer to avoid losing money than acquire an equivalent gain. The UK fiscal regime takes less but you have to find oil first at a significantly greater risk weighted loss ratio.

For the wider offshore community I guess given the size of the funds being raised in Houston that people will end up trying to raise funds there more than London. In that way new offshore projects will end up being evaluated side-by-side with shale projects, some investors may like the diversification element. But the trend for offshore to be focused on fewer “mega projects”, dominated by cash rich larger companies that can afford the financial and technical risks, seems to be locked-in for as long as capital markets remain in their current state. It’s not the end of offshore it’s just a different offshore, particularly at the margin.

For the offshore supply chain in general any recovery story that is credible needs to explain where the capital is coming from to fund projects. Because without the capital there clearly won’t be an increase in project demand and the Demand Fairy will fail to appear (again).  For an industry too long on supply that is where the adjustment will be made.

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