Investor Strike in Oil and Gas?

In my previous posting “Blind Spots” I referred to the 2014 Oil Council Africa conference and how certain questions had sparked in me a wider reflection on the state of the Energy industry.  This year at the Oil and Gas Council (more on that timely rebranding in a subsequent post…) in Paris some of us were really surprised by the almost bullish atmosphere of the O&G companies.  The oil price rally from the “depths” of $43 in the spring, to the then almost $65, was being seen as a strong indication that ‘the worst is over’.   

The two main sessions on financing were at the very end of the three day conference – which allowed the mainstream presentations and panels (corporate and NOC/Governmental) to proceed with ‘business as usual’.  Seen from the lens of the financing community this could be better characterised as sleepwalking.    Many great projects, top notch geology and technical stories, as well as mediocre ones  – and no consideration (I exaggerate for effect) of the financing of these project or of the likely returns on capital that these projects might, or indeed should, create.

Having participated just a week before in a major US conference for the Private Equity community, my colleague had returned chastened.  The O&G session attracted some 40 people, with the focus almost exclusively on US unconventionals, and there was no excitement.   O&G in emerging Markets was almost dismissed as being irrelevant when there was no obvious route to superior returns to offset the real and perceived higher risks.  The Health-Tech session on the other hand was absolutely buzzing and had 400+ attendees.  Likewise the renewables and smart energy/tech session.

Why the lack of interest in O&G?  Well, there appear to be multiple drivers:

Oil Price – investors who were bullish just a year ago, have seen existing investments go bad very quickly with the oil price crash.  Whilst most people within the industry see this as a great opportunity, fund managers are hard pressed to convince their investment boards to put money into a sector which is hurting.  This view was expressed clearly in a blog by Richard Wilson of the Private Equity Investment Group, questioning why the investors were not charging in when there is Blood on the Streets.

…fund managers were more worried about keeping their jobs, and protecting their portfolio against the unknown and against a further drop in value. One endowment fund said “we follow the other big endowments funds and allocate to large asset managers, the board can’t really fire us for doing what everyone else is doing.”

…less than 10% of these investors were still allocating into the oil and gas industry at all, or had a plan for navigating it, the rest were simply turning their backs, selling, or had hit the pause button for now on that portion of their direct investment portfolio.

We don’t hear much about the downside of shale but there is a huge question mark on the financial success of the US unconventionals.  Yes it is producing a lot of oil, but clearly not all shale is created equally – Itochu exited Samson Resources recently, having turned $1bn into $1; and this is not an isolated case.  Indeed David Einhorn – who famously shorted Lehman before the crash – thinks the big US Shale players are something of a Ponzi scheme   (not Einhorn’s term it should be emphasised); the full slide deck is available online and is worth reading.

Clearly investors have been hurt in both conventional and unconventional (and indeed OFS) investments in the last 12 months.

Lack of success  – according to Cobalt outside of Russia and Iran, the biggest exploration successes in 2014 were Orca in Angola (403mmboe) and SNE in Senegal (330mmboe) – these are not big by any measure.  Then as we go down the tail, FAN also in Senegal (240 mmboe) is 7th (and probably not commercially viable) and at 10th place there is Bicuar, Angola with 150mmboe.   Previous years have been similar.  Beyond just exploration, we should also ask ourselves hard questions about our ability to deliver projects on time and on budget.  Delays getting to first-oil/gas hurt returns just as much as cost overruns.

Lack of financial success – probably requires a whole blog post or two to itself, but suffice to say, many ‘technical successes’ have not resulted in the financial returns that investors expect.  Multiple causes, but the combination of tight fiscal terms and high costs have rendered many projects marginal.  Sticking with Cobalt, independent observers reckoned in 2014 that their Angolan discoveries needed $85 oil to be commercially viable.  Cobalt themselves believe that the number is significantly lower – based on revised projects.  But even at lower break-evens, it is hard to see how you pull the trigger on such projects with oil at or below $60.   

We can also cite Kosmos – a stunning technical success, yet the early investors who hoped to cash out with a sale to Exxon in 2010 were disappointed when the sale was blocked by the Ghanian government.  Clearly it could have been handled better, but notwithstanding this, the subsequent IPO with lock-ins and liquidity limitations has not provided the simple exit that investors would have liked.  The perceived “cost of government” in Emerging Markets is off-putting.

Divest – Fund managers, especially of large university endowment funds, are being steered away from Fossil Fuel investments, just as they were from Apartheid era SA, and Big Tobacco.  Although not a huge movement, it could become a bandwagon – the irony of the Norwegian SWF not investing in Fossil Fuels is lost on few. The other side of this coin is that Emerging Market O&G investment does not have the image problem that unconventionals do in the US – so there are some some positives.

Mobility of Capital – given the volatility, the image problem and the historical lack of returns, it is little wonder that global capital can and does look elsewhere.  Within our industry we are focused on the competition for capital from the North American ‘domestic’ market; but most capital is sector agnostic and can just as easily skip our sector completely.  That being said the first half of 2015 raised more ‘Energy’ focused money than the whole of 2014 ($60bn vs $50bn) – but only a tiny proportion of that will be directed at non US O&G projects.  A much larger amount has been raised in the expectation of ‘distress opportunities’ – discussed below.

And let’s be clear here – the Private Equity funding route is currently seen as the best hope for O&G, as the public markets have all but dried-up (across almost all extractive industries – indeed the mining sector is in many ways much worse), and the debt funding landscape is changing.

What of debt?  well it is still available, and interest rates are still very low – but we see a major change in the market – the traditional banks are focusing on known clients and specifically those with material projects and needs.  Indeed almost all banks are getting more selective, with some big names pulling out of geographies that were previously core.   In the recent past local banks have filled some of this void (especially in Nigeria) but they now have significant exposure to the sector, in many cases they are overweight – so we don’t expect any salvation from this angle.

Although the connection is strong, it may not be entirely obvious – equity investments need readily available debt such that the leverage supplied helps generate the returns the equity investors require.  An absence of debt severely limits equity appetite.

The high-yield market is surprisingly buoyant – although as per the comments above about the shorting of the US shale players, there is an expectation of a lot of pain in the Bond market around energy companies.  Indeed, many finance houses have had a lot of press about raising distressed debt funds in 2015.   The logic is impeccable, but the reality has been less simple.  It appears that many (reportedly non sector specialist) funds have been pouring money into struggling companies to keep initial investments above water (at least on paper) – thus depriving the distressed funds of any targets.  Recall the “Ponzi scheme” reference above?  A further downturn in the oil price could make the tide go out for real.

Clearly there is a dislocation between the US vs rest of the world, but that shouldn’t hide the overall malaise in the sector.   If you believe in Buy Low, Sell High, this should be a great time to invest, so long as you are disciplined on finding low-cost oil and gas opportunities.  

We are calling this the Great Investor Strike – and the strong feeling we got from the OGC conference was that this is simply not being noticed by the O&G industry, yet.  

Is this Blind Spot number 2?