From KPMG: Visions of Cheese
Whilst we are seeing a clear uptick in activity and the UK oil and gas industry is certainly on the way up again, the industry must continue to move forward. However, under current market conditions, how can companies capitalize on change whilst remaining stable and sustainable and, more importantly, will there be enough return for all?
Over the past five years, the UK oil and gas industry has had to weather some fairly challenging economic conditions. The $100+ per barrel averages of a ‘gold-plated era’ that supported record levels of capital expenditure to a $20.7 billion UK Continental Shelf (UKCS) peak ended abruptly at the close of 2014, and now seems to be an increasingly distant memory.
Having emerged from the depths of the 2015 to 2017 period that followed, the sector undoubtedly found itself in a leaner, more sustainable and more cost efficient state. As a range of major mergers and acquisitions (M&A) transactions were announced across the North Sea last year and oil prices marched toward the mid $80’s (in Q3), momentum seemed to be building towards a full-on ‘renaissance’.
The subsequent 40% fall, then a bounce in Brent pricing across the last two quarters has, of course, just acted as a gentle reminder (not that it was needed) that volatility is a fact of life in this industry. Right now, eyeing a spot price north of $70 and a 2019 outlook in the $60 to $65 range , it feels like there are some reasons to be at least ‘quietly optimistic’ once again.
There are a few factors tempering more overt optimism, including the omnipresent oil price volatility, but also including the political and wider economic uncertainty in the UK. Of course neither the average observer on the street, nor the elite of the corporate boardroom, can do very much about these macro-economic factors, so where does that leave those earning a crust in the industry and its supply chain?
The Oil & Gas UK (OGUK) March 2019 Business Outlook report once again drew attention to Vision 2035, which alongside the Oil and Gas Authority (OGA), they hope will extend the productive life of the UKCS for another generation.
The OGUK report presented some high level numbers in support of Vision 2035: $259 billion expenditure; to deliver circa 8.4 billion barrels of oil equivalent (BOE) (being 3.5 in existing business plans, 2.5 in resources under consideration, 2.4 in resources yet to be discovered); producing circa $649 billion in pre-tax revenue at a $60 price assumption, and thus an approximate $389 billion return across the remaining 16 year horizon.
A couple of ‘big picture’ observations immediately come to mind. Firstly, the investors who will stump up the $259 billion to earn the $389 billion return over these 16 years will understand that they could earn the equivalent on any investment that returns around 6% per annum on average in the same period. Secondly, at a $50 price assumption (roughly the long term inflation adjusted average) the return falls to nearer $259 billion and that ‘alternative investment’ comparison is just 4.75% per annum.
There are of course a wide range of individual project returns to be achieved within the Vision 2035 project and financial backers, whether they be oil majors, private equity, independent new entrants, capital markets or debt providers, will appraise each on their individual merits relative to their own ‘alternatives’. The project is also essential to support employment and provide energy security for the UK.
However, to an impartial external observer it feels somewhat short of ‘slam dunk’ territory without incremental incentives. One would imagine significantly higher returns are on offer elsewhere in other geographies and sectors. The FTSE 100 ten year average annual return with dividends reinvested is seemingly 8.8% , as just one example.
So, aside from the elite of the corporate exploration and production (E&P) boardroom who have plenty to think about, where again does that leave those earning a crust in the industry and its supply chain?
Deirdre Michie’s eloquent foreword to the OGUK Business Outlook Report provided some guidance here: “Vision 2035 means we add a generation of productive life to the UKCS while expanding supply chain opportunities at home, abroad and into other sectors.”
Spencer Johnson’s 1998 motivational business fable “Who Moved My Cheese?” seems an appropriate analogy here. In this tale, which will be familiar to many, the author highlights that change happens and those that anticipate, monitor and adapt quickly to “move with the cheese”, exploring new opportunities and savoring the adventure of that process, will enjoy the taste of new cheese again and again.
On the UKCS, capital expenditure was the plentiful supply of cheese that kept many grazing in quiet enjoyment in the first half of the current decade. However, with a 70% reduction in that capital expenditure in the last 4 years, the cheese has definitely moved. Whilst operational restructuring, the implementation of strict cost control measures, and the development of new efficiencies have all been sensible and appropriate responses, “exploring the maze” must also be a key component of the supply chain’s business survival strategy.
In exploring new supply chain opportunities at home, abroad and in other sectors, businesses must of course maintain cost and cash flow discipline, assessing the funding requirements across different scenarios and quantifying the impact on balance sheet and liquidity positions to give appropriate comfort that new investments are both prudent and able to deliver sustainable returns.
There are several key steps that will help businesses remain stable and sustainable in the current benign market conditions whilst also supporting some movement ‘into the maze’:
•Maintaining clear visibility over operational and financial requirements. This includes having trading and cash flow projections across a range of scenarios, both up-side and down-side, with working capital volatility factored in. Both BAU-activity and new projects / ventures need to be within the financial planning scope.
•Understanding what funding you need for new ventures. Exploring the maze may come with significant new risks and dipping into facilities designed for ‘business as usual’ activities would be ill-advised. Funding providers, whether debt or equity, will have a range of risk appetites and it is important that they are aligned with your business development strategy.
•Having a Plan B. Capital expenditure profiles on the UKCS may have leveled out in the short term, but it would not be unreasonable to foresee further decline ahead. Expanding business into new territories and/or sectors will also have pitfalls to be navigated. If ‘the wheels come off’, having a well-developed contingency plan ready to implement with appropriate professional support will be invaluable.
In our experience the sooner businesses can identify the issues, the more options they will have to adapt, change, move and enjoy the taste of new cheese again. In a final nod to Johnson’s analogy - smell the cheese often so you know when it is getting old.
Geoff Jacobs is Director for Deal Advisory at KPMG UK