Partnerships between NOCs, and among NOCs and IOCs, present great opportunities for the industry to work toward addressing the world’s longer-term energy issues.
Andy Brogan, Ernst & Young
The oil and gas sector is accustomed to commodity price fluctuations and the need to respond quickly to changing market conditions. However, the speed and severity of the current downturn, and the ensuing pricing volatility, took many by surprise. In the first half of 2008, oil prices were on a seemingly relentless rise to new highs of almost $150 per bbl. Few would have forecast that, just six months later, oil prices would be languishing in the low $30s. US natural gas prices fell more than 75% from their peak in the summer of 2008 and remain depressed.
Oil prices have since rebounded to the $70–$80 range, but the degree of uncertainty about demand is probably at its highest level in decades. Newspapers have devoted countless column inches to discussion of the likely strength, speed and sustainability of economic recovery. Predictions range from the downturn being followed by a rapid and sharp upturn (V shaped), to a double dip (W shaped) or a slow, hesitant recovery (flat U or L shaped).
The recent rally in equity markets has been prompted by tentative signs of economic recovery, such as data showing that the US and key nations in the Eurozone are moving out of recession. The raft of economic data coming out of the major economies is being closely analyzed by market commentators to assess if the oft-discussed green shoots of recovery have taken root. Despite many positive indicators, there are also data to suggest that any recovery is likely to be slow and painful. Unemployment continues to rise at a faster rate than expected in many countries. The US unemployment rate rose to 10% in November 2009, the highest level since 1983.
SHIFTING OIL COMPANY FORTUNES
The oil and gas industry features a wide range of participants from national oil companies (NOCs) to vertically integrated oil majors, independent exploration companies and oilfield services companies. The different subsectors of the industry have been unevenly affected by the economic downturn, and experiences among individual oil and gas companies vary widely.
Small- to mid-cap companies, especially those without producing assets, are finding it hard to maintain funding for existing projects and very challenging to gain access to funding for new projects. In addition, many state-owned oil and gas companies are less able to finance projects from cash generated from operations.
However, all oil and gas companies understand the need to balance short-term delivery with the necessity to establish a platform for sustainable growth. The sector attempts to smooth Capex through the economic cycle. Many exploration and production projects have long lead development times and are very capital intensive, and the costs of mothballing or restarting are substantial. The consequence of a major reduction in Capex today could be a major supply shortfall further down the road.
The ability of the leading industry players to maintain their Capex through a severe and prolonged downturn varies. International oil companies (IOCs), while all announcing significant reductions in profitability, still remain profitable, generally well-capitalized and with good access to capital markets for funding. Research by Ernst & Young shows that the majority of the NOCs and the largest oil majors are planning to maintain or increase their level of capital investment in real terms through the down cycle. In 2009, the largest NOCs collectively planned to invest more than $275 billion in the development of their businesses at home and abroad. By 2015, based on current estimates, these NOCs will have invested more than $598 billion in their hydrocarbon sectors.
There are some noticeable differences in both the scale and the scope of oil companies’ planned investments. China National Petroleum Corp. (CNPC) had the most ambitious investment program in 2009, totaling some $42 billion, although it was accompanied by a package of cost-cutting measures. Petrobras and the two largest publicly traded oil and gas companies, ExxonMobil and Royal Dutch Shell, also announced sizeable capital investment budgets for 2009.
In contrast, Russian oil and gas companies were more adversely impacted by the fall in oil prices, reduced availability of credit and investors’ flight from risk. Rosneft was the only major Russian oil firm that indicated that it still planned to increase spending in 2009.
Some companies have more compelling and unique reasons to raise investment levels. The pre-salt discoveries by Petrobras and its foreign partners promise to propel Brazil into the major league of oil producers. Petrobras plans to invest $28 billion in pre-salt areas as part of a $174 billion business plan for the period 2009–2013. About 90% of the total investment will be targeted at projects in Brazil.
Acquisitive reserves-seeking NOCs will be evaluating opportunities to acquire foreign oil and gas reserves now that targets are more affordable. However, many resource-holding NOCs may defer international expansion plans in the short term in order to finance prioritized domestic projects. For example, China National Offshore Oil Corp. (CNOOC) planned to diversify into domestic downstream activities while also furthering its international expansion. In China, some domestic spending has been mandated by the state as part of the economic stimulus plan for the sector. The NOCs of the Commonwealth of Independent States (CIS) countries planned to invest $36 billion in oil and gas activities in 2009 while Middle East and African NOCs announced $29 billion and $21 billion of investment, respectively.
OPPORTUNITIES FOR WELL-CAPITALIZED COMPANIES
The market turmoil has opened up new acquisition opportunities for cash-rich players. Reserves-seeking NOCs from Asia, in particular, have become more active again in the mergers and acquisitions (M&A) market now that targets are more affordable, Fig. 1. Their governments are willing to provide financial support as they target material assets, or even mid-sized E&P companies, that come to market. Typically, NOCs are not reliant on debt to finance acquisitions, which is likely to give them a competitive advantage in the M&A market while debt markets remain dysfunctional.
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Fig. 1. Transaction activities by NOCs.
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A number of transactions were announced by NOCs in 2009, including Sinochem’s acquisition of Emerald Energy, Sinopec’s acquisition of Addax Petroleum, and Korea National Oil Company’s (KNOC’s) agreement to acquire Harvest Energy Trust. According to reports, South Korea’s Ministry of Knowledge Economy said it intended to set up an $810 million fund to secure energy resources for the Asian nation. The fund will be used for direct investment in resource development projects, buying shares in projects and M&A.
Chinese NOCs are taking advantage of market conditions to secure strategic reserves to provide reliable, long-term supplies for the growing domestic market. The country’s NOCs have been involved in some of the highest-value oil and gas deals announced in 2009, and, between them, they spent more than $18 billion on overseas upstream acquisitions in 2009.
In addition, state-owned Chinese oil companies have access to low-cost capital and are less reliant on debt markets to finance deals. For example, it was announced that China Development Bank will provide a $30 billion loan to CNPC to acquire overseas energy assets.
However, having access to low-cost capital offers no advantage when a proposed acquisition comes up against political opposition. For example, CNPC announced it was pulling out of an agreement to buy Canada’s Verenex after it failed to obtain approval for the deal from Libyan National Oil Corporation. Following the termination of the takeover agreement with CNPC, the Libyan Investment Authority (LIA), the country’s sovereign wealth fund, entered into a binding memorandum of understanding to acquire Verenex.
Sinopec faces possible exclusion from future oil and gas licensing rounds in Iraq following its purchase of Addax Petroleum, which closed in September. Government officials in Baghdad warned that companies dealing directly with the Kurdistan Regional Government (KRG) will be blacklisted and excluded from bidding in the country’s future oil and gas licensing rounds. Sinopec gained two licenses in the politically sensitive Kurdish region of Iraq through its acquisition of Addax.
Chinese NOCs may have to rethink their overseas acquisition strategy in the face of rising energy nationalism. They may need to focus on asset deals, which are likely to receive less attention than corporate acquisitions. They may also need to focus on countries where there is less political sensitivity to foreign ownership of domestic assets and resources. Canada is one country where Chinese NOCs have had noticeable success in securing access to reserves. In August, PetroChina announced a $1.7 billion deal to acquire working interests in two oil sands projects. This is the largest Canadian oil sands acquisition by a Chinese NOC to date.
In a recent Ernst & Young survey, 55% of oil and gas respondents said they planned to make strategic acquisitions in the next 12 months, compared with just 34% of all respondents, Fig 2. Transactions in the short term are likely to include a high proportion of joint ventures involving smaller to medium-sized corporations and alliances of a strategic or tactical nature. Meanwhile, the carve-outs that followed the mega-mergers of the 1990s will continue as larger companies sell non-strategic businesses. While future deals will likely be structured in such a way as to be much less reliant on debt than had become the norm, there is financing available for the stronger oil and gas players to advance acquisition opportunities.
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Fig. 2. In the next 12 months, what actions do you plan to take to position your business to emerge stronger from the crisis than your competitors?
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NEW MODELS OF PARTNERSHIP
Even the NOCs have not been immune to the impact of the global economic downturn and downward pressure on oil prices. The economic slowdown has left many state-owned oil and gas companies unable to finance certain projects from their own cash flows. In a number of countries, higher oil revenues have helped fund social development projects. Many government budgets for 2009 were based on higher oil prices than actually experienced. The new economic environment may, therefore, lead to renewed government interest in foreign involvement and possibly investment in their hydrocarbons sectors. This provides a fresh opportunity for IOCs to partner with NOCs on a long-term, sustainable basis. IOCs, particularly those with sufficient liquidity, will be able to offer potential partners not only technological and operational expertise, but also access to much-needed capital.
IOCs are continuing to explore opportunities to add reserves through acquisitions, farm-outs, asset swaps and partnerships. Joint ventures are prevalent in the oil and gas sector due to the size, complexity and cost of projects. The projects that IOCs have been invited to participate in by NOCs are of such scale that no single company would have the technical capability or financial muscle to develop them alone.
As oil and gas projects have grown in complexity, so have the agreements governing joint ventures. On some projects there are several venture partners, each with relatively small stakes, which presents challenges in terms of delivering projects on time and within budget. The downturn is likely to increase the appetite for joint ventures as they provide the opportunity for companies to share the operational and financial risks of so-called mega-projects.
The new economic environment has also made the benefits of partnership between NOCs more compelling. Governments are becoming increasingly active in encouraging and brokering alliances in the oil and gas sphere. Last year, a number of alliances were announced between the governments of reserves-rich countries and those of oil-importing nations. In these mutually beneficial arrangements, finance and technical expertise is offered by reserves-seeking countries, in return for future supplies of oil, to help develop projects in countries that have plentiful hydrocarbons but limited resources or capability to progress the developments independently due to the changed economic environment. Such alliances provide security of demand for nations with indigenous reserves and improved security of supply for countries with a growing requirement for energy but limited domestic reserves. The parties also benefit from enhanced diversification of destination markets and supply sources.
For any arrangements made in the current downturn to be sustainable through the cycle, it is important that they are transparent, that they comply with the regulatory environment and that they are seen as fair to all stakeholders involved at any point in the oil price cycle. This means that oil companies wishing to foster partnerships should develop a thorough understanding of the stakeholder environment in which their potential partners operate and how this environment is likely to develop in the future.
In the long term, the overall structural issues surrounding location of reserves and achievable levels of production have not changed. Any renewed appetite from partnerships between NOCs, and also between NOCs and IOCs, represents a great opportunity for the industry to work toward addressing the world’s longer-term energy issues. 
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THE AUTHOR
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Andy Brogan is the leader of Ernst & Young’s global oil and gas transaction advisory services business. He has been with the company for 21 years and spent the previous 15 years specializing in transaction services with a focus on oil and gas. He has advised oil and gas companies on a variety of public and private transactions covering both upstream and downstream operations in more than 20 countries. Mr. Brogan also worked for various governments in connection with oil and gas transactions. He has a BSc degree in biochemistry from the Imperial College of Science, Technology and Medicine in London and is a UK Chartered Accountant.
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