As a song from the memorable show and movie Cabaret reminds us: “Money makes the world go round” and it is certainly crucial for the future health of the UK North Sea.
We live in a time when cash is absolute king. To an extent the free cash-flow picture for the UKCS has improved from the £4.2billion deficit last year.
But Oil & Gas UK warns in its 2016 Economic Report that there may be a £2.7billion deficit for the current year.
“When existing operations are generating marginal, if any, returns for investors, the prospect of raising further capital to invest in new projects is extremely difficult, as shown by the lack of new commitments this year,” warns OGUK in its analysis.
“This has caused a knock-on effect on profitability throughout the supply chain as projects are postponed or cancelled.
“Furthermore, with capital employed in the basin (North Sea) continuing to increase and depressed prices causing revenues to fall further, the average rate of return for extraction companies fell to just 0.2% in the first quarter of 2016.
“Despite ongoing efforts to improve efficiency and reduce costs, it may yet fall further over the rest of the year and into 2017 unless (commodity) prices begin to recover.”
It is important to realise that the North Sea is not alone as, globally, almost $1trillion of capital investment earmarked for new oil & gas projects over the next five years has been postponed or cancelled. worldwide. There have been over $80billion of busts in the US alone; that’s how bad it is.
OGUK is right, many investors are simply unwilling to sink capital into new opportunities at this time so it is very hard to raise new equity.
It reports that debt financing is also harder to secure as the collateral against which banks lend, most commonly reserves, is now worth less, so tightening borrowing capacity.
“Ultimately, in a fiercely competitive, mobile industry, only the most attractive prospects around the world are able to secure development finance.
“In the UK, capital investment is falling rapidly after years of record expenditure that peaked at £14.8billion in 2014. Last year, around £11.6billion was invested and this is likely to decline to around £9billion this year and £7billion in 2017.”
More and more E&P companies have had to restructure their finances to survive. Many have taken on more debt to replace the lack of free cash-flow being generated from existing operations and equity markets are distancing themselves from oil & gas investments.
However, access to debt has been possible and OGUK says this has “been a blessing”.
Firms in a bind have in some cases at least been able to sustain ongoing operations and finance new projects committed to before the downturn, while they readjust their businesses in light of lower revenues.
Debt finance is in any case commonly used to help businesses grow; Aberdeen has many supply chain firms that have used such facilities successfully, at least prior to the current crunch, perhaps linked with a private equity deal or some other form of financing.
OGUK: “Most, if not all, recent UKCS development projects will have been partially debt-financed and many would not have been able to proceed at all without access to such capital. Data on 14 companies operating on the UKCS – a broad sample ranging from majors to small independents – show that the average net debt to asset ratio has increased by around one-third over the last two years and is now around 20%.
“The higher leveraging results in an increased reliance on sustainable access to affordable debt and implies greater financial risk. With the levels of net debt growing and the value of equity within oil & gas companies falling, exploration & production companies on the UKCS are becoming more highly geared.”
The report notes that average gearing has climbed from 15% to 22% since the start of 2014. For some smaller companies, gearing ratios have risen to over 50%. That’s a killer surely.
As the basin has become more reliant on debt finance, three key potential risks cannot be ignored:
Increased chance of financial distress
Increased cost of equity
Increased chance of financial distress
Higher net debt and associated interest repayments mean that businesses are more reliant on steady cash-flows to service agreed debt payments.
The preferential treatment of debt means that failure to meet repayments can lead to business failure, even for companies with positive EBITDA.
That said, OGUK points out that a number of smaller companies on the UKCS that have breached their debt convenants with lenders over the last 12 to 24 months have been able to renegotiate new terms.
“Banks have, for the most part, supported their oil & gas clients resulting in few bankruptcies to date. The increased reliance on the banking sector, however, does give lenders greater bargaining power when negotiating the cost of new debt.”
Increased cost of equity
As debt is treated preferentially to equity (creditors get paid before equity holders in the event of corporate bankruptcy), equity often becomes less readily available and more expensive as investors demand higher returns to offset the greater risk.
Even if the oil price recovers, companies that have exceeded targeted debt levels will likely “cash-sweep”, that is, using excess cash-flow to deleverage by paying off debt rather than reinvesting returns into projects.
As such, OGUK argues that there is likely to be a minimum one to two year time lag between any recovery in long-term price expectations and any recovery in investment in the UKCS as companies prioritise the rebalancing of their financial structure.
I think it will be at least five.
After the 1986 crash when the North Sea was a young province, it took seven years for recovery to get going again. Indeed it had to be kick-started with the Cost Reduction Initiative for the New Era.
After the late 1990s crash, when the North Sea was at peak with extensive hedging in place, recovery only really kicked in 2004/5, helped by Oil & Gas Industry Task Force target setting.
The current crash is naturally different again . . . more prolonged and the UKCS is now regarded as a very mature province with heavily depleted production. Based on the time it took to recover from the past two crashes, I’d say OGUK is being a tad optimistic.
That said, it would be good if green shoots start to appear over the next 12 months.
We all need them.
As a song from the memorable show and movie Cabaret reminds us: “Money makes the world go round” and it is certainly crucial for the future health of the UK Continental Shelf.