Energy price falls and financing pressures are attracting the attention of credit and hedge fund investors on the lookout for cheap energy assets, says Jennifer Bollen
At a glance
• Continuing oil price concerns are increasing energy companies’ woes.
• Corporates are expected to increase disposal activity in 2016.
• Banks are under pressure to mitigate oil and gas-related losses.
• Credit and hedge funds with energy expertise should be well positioned.
The slump in oil price to just $26 (€23) a barrel in January has intensified expectation that stressed energy companies will create significant deal-flow for investors in the coming months. However, market participants warn that potential buyers could struggle to find a wealth of distressed opportunities.
Oil’s fall to $26 followed a huge surge in lending to the oil and gas sector in recent years that has since left many corporates searching for liquidity.
Today, advisers and investors cite distressed situations among mid-market businesses and a need for large corporates to find capital through divestment of non-core assets, although they are cautious to label the latter as forced sellers.
“It’s capital allocation decisions for the bigger companies,” says Jon Clark, oil and gas transaction advisory leader at EY. “For smaller companies it’s around navigating financial distress and overcoming difficulties in financing capex programmes at the same time as servicing their debt obligations.”
Andrew Liau, a managing director in the infrastructure team at the private equity firm Ardian, says: “We don’t view it as distressed [selling]; everything is cheap. It’s more that in today’s environment, the door is open to discuss assets that were not [previously available].”
Potential buyers, from private equity houses to institutional investors, are gearing up for an increase in deal-flow this year.
In March, the UK press reported that Tony Hayward, former chief executive of BP, was setting up a vehicle to acquire distressed oil and gas assets. In September, buyout firm Kohlberg Kravis Roberts backed the former management of Star Energy to target deal opportunities in the European oil and gas sector.
“On the one hand what’s happening in the oil and gas sector is clearly challenging,” says Liau. “But on the other hand we have growing interest from investors like ourselves with a slightly different approach to investing that makes deals possible today.”
However, acquisition activity has been patchy recently. Private equity firms, for instance, agreed $5bn of oil and gas transactions globally last year, down from $17bn in 2014 and $6.6bn in 2013, according to Dealogic.
Transactions in the past year include the $900m acquisition of the Denver Julesberg Basin oil and gas assets in Colorado from Encana Oil & Gas by Canada Pension Plan Investment Board in October, and a $100m equity commitment in September from private equity firm Energy Spectrum Partners to Bluewing Midstream, a company formed to buy and develop oil and gas storage and transportation assets.
“There has been a lot of talk for a long time about distressed M&A and it hasn’t really materialised,” says Dominic Morris, a partner at law firm Allen & Overy. “In part you’ve got to say ‘who are the buyers?’. You do need some very specific industry expertise and a lot of these people don’t necessarily have that expertise to operate those assets.”
Furthermore, lesser quality and development assets have put off some buyers. “There are things out there that are not necessarily attractive,” says Clark. “Some of the things in the market tend to be projects that need capital. If you’ve got a desire to invest in capital projects then some of these projects are attractive. Those with capital to deploy are in the driving seat in many transaction processes.”
Clark expects larger-scale assets to come to market this year as big corporates reaffirm plans to streamline balance sheets. Many potential buyers are likely to target midstream assets such as storage facilities and pipelines for their long-term contracts, cash-flow visibility and lack of correlation with commodity prices.
“We try to replicate the mindset of an institutional investor. They are our underlying clients,” says Liau. “This strategy is not really focused on capital gains and changing business strategy, it’s focused on investment characteristics that can match long-term liabilities.”
For Ardian, distribution companies and service stations fail to match up to its preferred profile due to lower margins and trading trends linked to local competition and consumer appetite.
With greater demand for midstream assets, prices are likely to remain high while a smaller buyer universe in the upstream and downstream sub-sectors is expected to lead to more favourable valuations for those businesses.
However, the partnership nature of upstream assets, with multiple investors holding significant minority stakes, can cause problems for buyers if certain shareholders decline to reinvest. Meanwhile, midstream assets have their own issues – potential buyers must pay close attention to the creditworthiness of the parties on the other side of a company’s contracts and ensure the vendor, which will continue to use its services post-sale, is able to negotiate a contract that works for both sides.
Elsewhere, banks are facing potentially huge losses from the sector – leveraged loan issuance to oil and gas companies globally hit a record high of $225.2bn in 2014, according to Dealogic – a 445% increase on such issuance five years earlier on the back of the shale gas revolution.
The 2014 figure compares with $88.5bn of oil and gas leveraged loans at the height of the credit boom, in 2007 and $183.9bn in 2013. Last year the total dropped to $140.7bn.
“We are seeing a withdrawal of liquidity, a withdrawal of borrowing facilities from the US oil and gas industry at an unprecedented rate,” says Chris Wheaton, an analyst at Allianz Global Investors (AGI). “We are going to see a situation where banks are really going to try and reduce their exposure as much as possible.”
Banks that have lent substantially to the sector include JPMorgan, which according to Dealogic ranked as the biggest lender to oil and gas companies globally last year with $144.7bn of loans; Bank of America Merrill Lynch, which ranked second last year with $135.4bn, and Wells Fargo Securities, which ranked third with $97.7bn.
“Banks’ shares and subordinated bonds took a pummelling in January and February because of concerns [about] loans,” says Adrian Hull, a senior investment specialist at the UK-based investment manager Kames Capital. “There’s no doubt the market is concerned about it; that has been priced in. Ever since March…the market is in a better place but it was very much an issue for banks at the start of the year.”
The concern comes as investors predict between 15% and 30% of US energy companies will default on their loans this year. According to Thomson Reuters, almost $5bn of energy institutional loans – a segment of the leveraged loan market – had defaulted in the year to 23 February 2016, representing about a third of overall institutional loan defaults in that period.
In March, Fitch Ratings said oil and gas and natural resources companies accounted for a third of corporate credit downgrades globally, excluding sovereign-related, last year.
Pressure among banks to cut their losses in the sector and regulation-driven efforts to reduce their exposure to risky assets are expected to create investment opportunities for credit investors.
“The smaller and more leveraged you are, the more desperate the bank is,” says Wheaton, who says he saw banks selling debt for as little as 30 cents on the dollar in early 2016.
Thomson Reuters says the average indicative bid in the secondary market for oil and gas institutional loans plummeted to 54 cents in February compared with 87.11 cents at the beginning of February last year.
“I’m going to a conference next month where attendance is up 40% year-on-year and the number of equity investors is flat but the number of debt investors is up massively,” says AGI’s Wheaton. “There are a lot of distressed debt investors circling the industry, not really having seen the opportunity last year but seeing it now.”
The opportunity has generated “aggressive” buying activity by some credit investors, according to an analyst at a large US alternative credit manager, while others have shunned the sector entirely, underscoring its inherent challenges. The difficulties mean hedge funds and credit funds with niche energy teams are expected to be the most significant new investors in oil and gas loans, he adds.
Fraser Lundie, co-head of credit at Hermes Investment Management, whose team is spending an increasing amount of time poring over oil and gas high-yield paper as it has become a bigger proportion of the high-yield bond universe than ever, emphasises the importance of sector expertise. “It’s cheap for some very good reasons… It’s about trying to find the survivors that are priced attractively,” he says.
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