Given today’s dynamic economic environment, companies need to continually assess their capital needs as well as potential sources of capital. Therefore, a strong capital agenda needs to be at the heart of all boardroom and management decisions.
The ability to raise capital, quickly and efficiently, is both a buffer to adversity and a means for seizing opportunity. Leading businesses are adopting a range of disciplines in four key areas to build competitive advantage:
Preserving: reshaping the operational and capital base.
Optimising: driving cash and working capital, managing the portfolio of assets.
Raising: assessing future funding requirements and evaluating sources.
Investing: strengthening investment appraisal and transaction execution.
Proactive portfolio management downstream has been a feature of the large, vertically integrated oil companies for many years, and as strategic aims and market conditions change, companies must actively manage portfolios to maximise shareholder returns.
Historically, oil&gas companies’ portfolio management decisions have had a number of key drivers. These include:
Potential market growth rates.
Current and predicted levels of ROACE (returns on average capital employed) compared with competition.
Supply-chain synergy with other parts of the downstream business.
However, with the recent downstream divestments announced by many of the super-majors, it is clear there is a new factor playing a key role in the portfolio management decision-making process: the need to raise capital to fund increasing upstream investment requirements.
In recent years, the costs associated with finding and developing new oil&gas reserves have increased sharply. In 1997, $1,000 would buy 350 barrels of oil equivalent reserves, compared with just over 50 in 2008.
In the same period of time, upstream expenditure costs have continued to increase. With the super-majors focused on reserves replacement – consistently achieving less than 100% would put an oil&gas exploration and production organisation in a longer-term close-down scenario – it is not surprising that a significant reduction in the value of each upstream dollar spent has correlated with a sharp increase in total upstream spending.
Over the past decade, the upstream business has produced higher levels of return compared with the downstream business. While oil was heading towards its peak of nearly $150 per barrel in the early part of 2008, supplemented by strong downstream margins, the high levels of capital expenditure required in the upstream business could be maintained through record levels of earnings, strong cash flow and the relatively cheap and abundant levels of capital in the market.
However, with the subsequent fall in the price of both oil and gas, a reduction in demand and a decline in upstream and downstream margins, the ability to maintain capital expenditure at current high levels has been adversely affected for all the oil majors.
In addition to the usual portfolio management issues the oil majors consider, a significant new market dynamic has emerged over the past 18 months.
The increasing capital requirements needed for very large exploration and production (E&P) development projects, combined with the reduced availability of capital, is forcing the majors to make tough decisions regarding how they allocate their capital. Upstream, with historically higher levels of return, appears to be the winner of that debate.
Downstream, particularly in mature Organisation for Economic Co-operation and Development (OECD) markets, provides the opportunity for the majors to divest what they perceive as non-core assets to generate capital for reallocation to their upstream businesses.
These assets, although historically, on average, producing lower levels of ROACE than the upstream business, present an exciting opportunity.
Potential purchasers of such assets are likely to include:
International oil companies (IOCs) looking to create market leadership and economies of scale in their preferred markets.
National oil companies (NOCs) looking to secure markets for their upstream activities, reduce their exposure to oil-price volatility and diversify their operations away from the upstream.
Private-equity (PE) firms may consider these assets to determine if they can extract additional value through control over the real estate.
Hypermarkets and independent retailers usually have a lower cost base and may find retail marketing more profitable than the IOCs and NOCs.
Property developers may be interested in sites and land banks located on prime real estate for restoration and development of residential or commercial properties.
For oil&gas companies, making a decision on retaining or selling downstream assets requires difficult trade-offs between expected financial returns, risk, synergies with other parts of the business, brand impact and a understanding as to how the proposed course of action aligns with the broader strategy of the overall business.
The major oil companies will regularly review their downstream businesses and consider whether their asset portfolios are aligned with their overall strategy. Assets will be evaluated against a broad range of criteria, such as:
What investment is required to maintain and develop the asset?
What is the market valuation of the asset and “value to me” versus its “value to others”?
Does the asset play an important part in the marketing strategy? Are there critical brand interrelationships with other parts of the business?
How critical is the asset to the performance and overall integrity of the upstream/downstream supply chain?
Based on these criteria, assets can then be classified as hold, restructure, grow or divest. Over time, the broader corporate strategy or the underlying performance of an asset when evaluated against these criteria may change. Indeed, the criteria themselves may be periodically updated – for example, as changes in economic conditions result in more or less stringent financial hurdles.
In today’s constrained capital conditions, it is not unusual for sellers to consider core businesses for divestment if their requirements for additional capital cannot be economically sourced externally and the seller has a better use for that capital.
Once the decision to divest has been made, the detailed transaction preparation and carve-out planning phases can be initiated. Prior to beginning the preparation phase, consideration should be given to:
Defining the package of the business(es) to be sold and whether there are different packaging options available (for example, whether the asset will be sold as a whole or in parts, or whether additional assets could be added to the package to enhance value).
Considering who the potential buyers might be and tailoring accordingly. For example, a financial investor would likely require a fully stand-alone business, whereas a strategic buyer will likely already have its own back-office functions.
At this stage, the potential risks and upsides from the buyer’s perspective should be considered and what data will be required to adequately assess the opportunity.
Detailed sell-side due diligence affords an in-depth view into the workings of the business, providing the seller with a unique advantage in negotiations.
It highlights undiscovered value and prepares management to respond to challenges that the buyer may discover. It is also an unparalleled opportunity to examine the divestiture’s impact on the retained business. A critical element of the work in this phase will be to assess the marketability of the asset.
Careful preparation is absolutely crucial, particularly given that many divestments will be executed in accelerated timescales – in a matter of days rather than weeks. Many sales processes with poor outcomes are the result of a lack of operational preparation of the assets for sale.
Common issues that affect the value of assets include:
Poor definition of the scope of the assets to be divested, which can result in uncertainty and wasted effort in all of the subsequent phases.
Failure to assess and manage the consequences of the divestment on the cost and organisational structure of the retained business.
Failure to engage with the appropriate expertise, both internally and externally. Internal sensitivity regarding the sale of the asset needs to be balanced with the need for fast, accurate data gathering and process support.
Not having researched potential buyers. Understanding to whom the asset may be of most value is critical to increasing the sales value.
Not understanding the true value of the business. A clear understanding of the assets is vital: EBITDA (earnings before interest, taxes, depreciation and amortisation); working capital, and individual asset values.
Divestments are a means of releasing capital to secure the future of an organisation, or a means to fund strategic investments, including acquisitions.
This current economic climate presents not just challenges for organisations, but also opportunities to drive significant organisational change to deliver the performance needed in the market of the future.
By developing the right buy/sell strategy and careful planning, companies will not just survive the economic downturn but will build a strong position for the eventual recovery.
Alec Carstairs is head of oil&gas for Ernst & Young in Scotland