March 16, 2015
Interviewed by: David Snow
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How PE Can Benefit from Oil-Price Volatility

As lower oil prices and continued volatility impact companies along the spectrum of production, from downstream to upstream, an opportunity presents itself to private equity. Deborah Byers of EY explains why volatility in the sector is the norm, what players in each subsector are ripe for M&A, and what will drive a resurgence in oil prices.

As lower oil prices and continued volatility impact companies along the spectrum of production, from downstream to upstream, an opportunity presents itself to private equity. Deborah Byers of EY explains why volatility in the sector is the norm, what players in each subsector are ripe for M&A, and what will drive a resurgence in oil prices.

How PE Can Benefit from Oil Price Volatility
With Deborah Byers of EY

Are lower oil prices a buying opportunity for private equity?

Deborah Byers, EY: The current low oil-price environment can definitely be a buying opportunity for private equity. The real question is, it’s going to vary by subsector, whether you’re in the upstream, downstream, midstream or the oil-field services sector.

A lot of companies are going into it and there’s such a divergence of views. And certainly if you’re looking at the papers the last few months, you can see that the prices… dropped much further and faster than anyone anticipated.

If it’s short-term and it recovers like some people might anticipate in the late part of 2015, a lot of people are going to hang on. They’ve got enough cash flow. They’re either hedged or they feel like, “Hey, valuations are down. Why would I sell at the low end when I know prices are going to come back and I’m going to recover?”

So I think there’ll be a bit of pause. A number of experts are predicting that this is a typical, more u-shaped recovery. You’ve heard that term back during the financial crisis. That means perhaps prices don’t recover until 2017, in which case people are going to run into cash-flow issues. And that’s where private equity firms that have a lot of capital can step in the place of banks, for example. Where—if liquidity is an issue from traditional lending sources or equity markets are tight—it’ll be a great opportunity. But in the short-term: no.

How do lower oil prices affect players in each subsector: midstream, upstream and downstream?

Byers: The low oil prices, interestingly, have a bit of a different impact depending on which subsector you are. If you read the papers, you see a lot of focus on XXY upstream oil and gas company has cut capital expenditures by 15% or 20%. The impact of that is, a lot of it’s immediately felt by your big oil-field service companies because once they cut CAPEX or they stop drilling programs, of course, it directly hits their revenue.

If you look at it, it starts with [asking] what’s the budget that the upstream companies are setting? They went through a pretty big flurry of resetting their budgets because prices were continuing to move, are still continuing to move and [are] quite unpredictable at this point. Once that happens, it just trickles down. The biggest sector that’s been hit, I think, is going to be the drilling sector immediately. That’s some of the more immediate impact. Then, it just goes right down the supply chain. If your end customer is the producer, the upstream side, then they’re cutting CAPEX. Then, if you’re a driller, you’re going to cut your CAPEX, and so on.

On the downstream side, of course, to some extent, this has been a boon for them because feedstock prices are low. On average for downstream, it’s been really good. But again, if this low oil price remains sustained for a year or 18 months or so, supply’s going to automatically come off the market because when they’re cutting CAPEX, that means they’re not drilling as much. The programs are being delayed.

Midstream is probably going to weather this pretty well. Clearly, as I indicated, oil-field services is going to feel the impact. But this is a very resilient industry. You can’t be in the oil and gas industry—which is highly dependent on a commodity that can be very volatile—and not have a plan for when there’s a downturn, because there have been cycles. In fact, this last two or three years of what I’ll call “stable, high-price environment” of $95 or $100 a barrel oil is actually unusual if you look at the history of where commodity prices have gone. It’s been very volatile. That’s the norm. Volatility with some type of aversion to a mean price that is supported by market fundamentals.

What will drive a rise in oil prices?

Byers: There are a number of things that could cause prices to come back. First of all, you have to buy into the fact that $45 or $50 oil is really not the norm based on what the consumption on a global basis, and even moderate increases in global demand, would justify. The fact is, we have an oversupply. You take supply off the market. Then this oversupply, which is the primary driver of the downturn in the oil price, just becomes a self-correcting mechanism. The question is, when does it self-correct and at what level does it level out, if you will, to a mean?

The other thing that’s been a little surprising, although it shouldn’t be, is how quickly, for example, U.S. shale producers have reacted to cutting back on supply. They’ve been much more nimble. And companies have been quicker to pull the trigger to take cost out of the system, as well as push off certain projects that may not have been started or may not be economic. Those are really on pause. They’re not eliminated—they’re just on pause. This is an industry [where] it’s not like you’re turning on a faucet. Once you stop something, it’s going to take a while. You push off a capital project for a year and that project wouldn’t have resulted in production for another two or three years. So you see how the supply and demand will catch up and then, you’ll have a resurgence of price.

The other factors are just pure geopolitical unknowns. Some of the big (if you want to call it) losers in the low oil-price environment are those governments that are heavily dependent on exports of oil for their revenues, as well as very limited diversification in their economy. Let’s look at the list of those countries: Venezuela, Russia, Iran, Iraq, Syria. These are not the most stable countries from a geopolitical standpoint. So the stress on their economy, the fact that they have some instability already—you have one big geopolitical event or crisis in those countries. That’s going to take a lot of supply off the market.

How will this volatility affect the M&A market?

Byers: One thing people might have lost sight of, especially if you’re a bit new to the industry and thinking, “Wow! This is a great sector to invest in” because you hear all these wonderful stories. They’ve invested in this oil and gas field and all of a sudden they’ve got a 4, 5, 7x returns. That’s great in that good timing, smart move. But this is a commodity-based industry, as I said earlier, the relative high prices at fairly stable rates is an aberration. The norm is volatility. I think you’re going to see consolidation, for example, in the oil-field service sector just because of the merger announcement with Halliburton and Baker Hughes in the fall. That’s creating momentum for the whole industry to say, “We need to be competitive. There is going to be divestiture.” So there’s going to be a lot of M&A that comes out of that as other competitors look at their strategic positioning and ask, “What do we need to do to be competitive here in the market?”

This is a great opportunity for the smart buyer. The next two years could be a great window of opportunity, but knowing that you need to go ahead and price in; that you are entering a commodity-based market. It’s subject to shocks that you really can’t predict, because it could be a geopolitical issue. It could be a policy issue. There could be a regulatory change and suddenly [it’s] “game over” for someone wanting to produce in a certain area. So you’ll see some shakeout of marginal producers. Maybe some investors will leave. That will allow better opportunities for the core group that are more veterans of the industry, who really understand it. You’ll see better deals getting done.

What energy sectors have the most opportunity for M&A?

Byers: There are really two subsectors in oil and gas that have the best opportunity right now for M&A. The first is the obvious, which is upstream. Whether they’re distressed, they’re hitting the cash wall, can’t get bank liquidity or equity liquidity—it’s a great opportunity for private equity to provide transition capital. So that’s one. The second one is going to be in the oil-field service sector where there’s going to be more consolidation. And interestingly, while the strategics consolidate, some of them may be divesting of assets in order to buy. Then, post-consolidation, they may be rationalizing assets. That creates a great opportunity for private equity.

To be really highly competitive, they probably need a strong management team that canimmediately step in and convince the seller that they can take this off their hands quickly, close quickly and operate without a long lead time and transition services agreements and things like that. So doing a little homework and setting up their own infrastructure even before they go in to bid on assets could put companies or private equity investors at a competitive advantage.

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