Rich Pickings for Majors Amongst Smaller Oil Co.s

RelevanceStart up oil companies typically fund exploration through issuing equity, and fund development through issuing debt. Now that the debt (and most of the equity) markets have dried up, small companies are suffering. Particularly at risk are those with portfolios that are high in exploration assets (prospects) but low in discoveries and producing assets. Those companies with assets in high risk areas (technically and politically) may find that the recent collapse in oil price (and the growing perception in the market that it will stay lower for some time) has removed all the upside that justified the original investment in the first place. Such companies are vulnerable as their “cash burn rate” is eating up current financing and there is little prospect for immediate refinancing or generating revenues. In this scenario, cash rich, larger oil firms can pick up assets (or whole companies) on the cheap.

AnalysisTo borrow and adapt the name of a popular US toy retailer, oil firms can justifiably label themselves “Capex ‘R’ Us”. A very large portion of the oil firm’s cash flow is reinvested in gaining access to resources (e.g. signature bonuses, licence bids) and in the capital intensive activities of exploration, appraisal and development. Those small firms without existing production have to rely on finance to provide the funds for such investment, in the hope that they too will one day produce the oil that will generate revenues for reinvestment and provide a sufficient return to their investors.

Such small companies are usually high risk because they have a portfolio that is skewed towards the exploration end of the value chain, with no immediate prospect of generating revenues. Furthermore, they often have very few assets, betting that their chosen prospect(s) will come good. Those that are more adventurous and invest in less politically stable regions carry increased risk due to the simple fact that they are usually very small fish in a very large pond, with limited leverage to renegotiate their commitments to host government sponsors (for example, to renegotiate a drilling schedule). Those operating in Western countries may get more leniency when dealing with the government.

In today’s world, cash truly is king. The large oil firms, exemplified by the majors, have come off the back of a period of high oil prices with exceptionally strong balance sheets and strong cash flow generation. The result has been programs of share buy backs and dividend hikes by all the major oil companies. This has not gone unnoticed by the investment community that sees the majors as a safe haven during the tumult on the financial markets. Conversely, the financial community has punished the stock prices of small oil and gas players severely, anticipating that such firms will not raise further finance and therefore run out of cash, becoming distressed sellers of assets (or even the whole firm). The majors are ideally placed to snap up such assets and companies on the cheap.

Opportunities provided by distressed small oil firms (for example, those quoted on London’s AIM market, a popular market for raising small oil company capital) are in themselves not sufficiently material to attract the attention of oil majors seeking to buy assets as entry vehicles to new regions. However, majors that are seeking to add to existing assets, or are seeking to add assets in a strategic region, may find such targets appealing.

For their part though, the oil majors are likely to remain cautious. They too will want to conserve cash, as the uncertainty over finance and the direction of the oil price remains.

Deal making may be tough though. Small oil companies (e.g. those quoted on London’s AIM) are often controlled by their management, who generally believe that the firm’s value is well above its stock price. They will only sell if the firm is truly out of cash.

9 December 2008

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