Homing in on exploration & production companies, 3i’s head of oil, gas and power pointed out that everything was great in the petroleum garden with $140-plus oil. That meant every project was economic at $100 a barrel.
“E&P has been living in a very fortunate period. I think that has probably bred inefficiencies. I think the business model of ‘when we’re developing an asset, we’ll keep going back to AIM to raise more money; we’ll manage to get enough equity to fund our next project pretty much’ … 18-24 months ago, the availability of debt was not really an issue,” said Sword.
“Today, these businesses are having to reinvent themselves. I’ve said for years that consolidation has to come in this sector. We have too many sub-scale players. There will be no room for sub-scale players. People will have to have stronger balance sheets because the chances are that they’re going to have to fund developments from equity rather a combination of equity and cheap debt. That means the cost of capital is going to increase. If the cost of capital increases at the same time as the cost of the commodity comes down, a lot of these E&P companies are going to feel a real squeeze.
“I think that we now have a two-tier market in the North Sea.
“At one end, there are large companies not investing as much as we would want them to. At the other end, there are a lot of small companies that might have quite a lot of capital commitments for their developments. They’re not sure where they’re going to fund these. I think the AIM model is no longer available for those companies.
“They have few choices if they want to survive. One is that they sell themselves … they waken to the fact that they’re never going to achieve scale. Another option is mergers, and I think some of the deals that might happen are companies genuinely merging rather than being acquired because I think people will want to hold their capital back for developments.”
But if they’re all cash-strapped, what is the value of merging?
Sword insists that there is value to seeking scale, including enabling portfolio rationalisation.
And what about projects?
“I think, in this market, they will self-select. People will say that the project that was due for development but which had a break-even of $70 per barrel was looking like it would get through screening this time last year. This year it won’t.
“Therefore I think that, for some of those companies, there will be benefits. And some of them do have cash. But one of the issues that, again, the E&P sector will have is that, if you are an E&P company in this market sitting on cash, what do you do with that cash? Do you just sit on it because cash is king?
“Liquidity is going to be key in this market and it could get worse before it gets better.”
Sword agrees acquisition is not always a sensible option.
“Why acquire them if all you’re going to do is take on more problems. You go back eight or nine years and you probably saw people trying to acquire tail-end production rather than development. Or, in a listed case, if you really feel you’re undervalued, probably the cheapest barrels you can buy are your own … so you do a share buy-back.”
The notion might be crazy but, given the savage reduction in company valuations on the AIM board, does Sword see any merit in company bosses extricating themselves from a listing via a P/E deal of some sort?
“I think theoretically it could be cheaper. That said, look at the premium on the Revus deal. It’s one thing having a low share price, but can you do deals at that low share price or are you going to have to pay a big premium?”