The state of regional M&A activity in the oil and gas industry

Current market conditions are posing strong headwinds for the M&A sector, particularly in oilfield services, says Mustapha Boussaid, managing partner, Arkad Advisors

Worldwide social distancing to combat the COVID-19 pandemic and the severe oil price slump in early 2020 had the dual effect of reducing capex and delaying the completion of maritime offshore oil and gas projects and affecting the oilfield services sector in general. Undoubtedly, oil and gas industry players will continue to feel the impact of the pandemic as we move into 2021. What remains to be seen are the consequential mergers and acquisitions in the industry, following the economic fallout of 2020.

From an asset pricing perspective, a confluence of a substantial demand drop coupled with a supply glut is the main culprit. Oil demand was forecasted to witness a year-on-year 13 per cent drop to an annual total of 87 mbpd in 2020 (compared to 100 mbpd in 2019). The supply surplus was estimated at around 20 mbpd before any OPEC+ planned production cuts. These developments, along with substantial stock piles worked to keep prices depressed.

Consequently, global offshore oil and gas project spending was to be to the tune of US$31bn assuming an average 2020 oil price of US$30 per barrel (or US$39bn assuming an average 2020 crude oil price of US$40 per barrel). In contrast, 2019 offshore oil and gas project spending was around US$104bn.

‘Oilfield services’ refers to the economic sector that supports the oil and gas business throughout the value chain – from exploration and production, all the way to decommissioning, both onshore and offshore. One such subsector that witnessed an increased level of attention from investors during the last two decades is the offshore support vessel owner’s operators.

This particular subsector employs knowledge of the oil and gas sector as well as shipping fundamentals. It is directly impacted by the level of exploration and production (E&P) spending and global supply and demand of fleet tonnage. During prolonged periods of E&P spending cuts caused by lower oil prices, oilfield service company valuations suffer. Additionally, oversupply of offshore support vessels (OSV) lowers both fleet utilization rates and charter rates, which in turn may lead to lower valuations.

In boom times, financial sponsors, especially regional private equity funds, actively bought OSV and other oilfield services assets, deploying substantial amounts of their managed LP funds, further fueled by easy credit. Several were caught unawares by the 2014 oil crisis as the sector suffered and the much-needed cash flow to service the high leverage quickly dwindled. Moreover, regional banks found themselves facing several non-performing loans from regional OSV players all backed by PE-houses unwilling to inject any additional cash.

We estimate regional banks’ exposure to have been more than US$1 billion in distressed debt. Many lenders struggled to restructure or recoup their assets and found themselves de-facto owners in an unknown business facing substantial balance sheet write offs.  As a consequence, bank credit available to support leveraged buyouts in the sector became scarce, especially to financial sponsors.

Another peculiarity specific to the region is that the bulk of the oilfield sector players fall in the middle market segment. This segment has struggled historically due to limited shareholder support bandwidth, unsophisticated mid-market lenders and the absence of a clear go-to-market strategy.

Lenders have adopted stricter guidelines focusing on well equitized government-related sponsors, lower LTV deals and borrowers with longer contracts with quality client lists. These conditions are usually absent in an asset-heavy business that relies historically on short term contracts or spot trading catering to cash-flow challenged clients. Even when banks extend credit to finance mergers and acquisitions, they impose restrictive terms and higher pricing. The upshot – financial sponsors’ ROI requirements are made unattainable.

The two driving elements required for a healthy and active M&A market – namely investors and lenders supporting them – continue to face strong headwinds. Investors are having difficulties adjusting to a lasting environment of low real yields and tight spreads. Meanwhile the banking sector is grappling with substantial increases in expected credit losses (ECL) and a significant decrease in mark to market valuations, triggering a wave of write-offs.

Timely interventions by regulators such as SAMA in Saudi Arabia, we saw only subdued measures of foreclosures and uneconomical debt-restructuring. However, these interventions and stimulus packages were not enough to support any fresh leveraged buy-outs in the oilfield services sector, amid a persisting strategy of continued hyper-vigilance.

Getting back on track

One solution to reinvigorate the regional oilfield M&A is by adopting a strategy that takes advantage of special purpose acquisition company (SPAC) vehicles to fund future deals. SPACs are listed entities, created and funded through IPOs for the sole purpose of making subsequent acquisitions within a pre-defined market and target criteria.

In the Middle East, SPAC were already used in few transactions. In 2017, a Nasdaq-listed SPAC which raised US$229 million acquired National Petroleum Services. Two years later, a similar deal valued at roughly US$1 billion was concluded involving the UAE-based Brooge Petroleum and Twelve Seas.

The COVID-19 pandemic has exacerbated the systemic pains in the regional oilfield services sectors by further depressing demand. This will certainly broaden the financial distress and restructuring wave. Going into 2021, we reckon consolidation of struggling assets will be the main driver behind the regional M&A activity; firstly led by strategic players and then, to a lesser extent, by financial sponsors. In the absence of any innovative forms of financing such as SPAC vehicles, institutional deal sponsors will find it difficult to achieve desired returns until regional banks re-open credit lines available to back leveraged buyouts.