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24 April, 2017
This article examines some of the key challenges which have created obstacles for successful upstream deals in the Asia Pacific region, and how these challenges will need to develop in order for the region to realise its M&A potential in the upstream sector in 2017.
Background
The oil and gas industry has been under pressure for a sustained period, with low and volatile oil prices creating an air of uncertainty across global markets for at least two years.
In previous oil price downturns, we have seen an increase in M&A activity across the oil and gas sector, as companies look to ride out the pressure to reduce costs and boost profitability by optimising asset portfolios.
The current downturn has been noticeably different. Although M&A activity has been up, in line with what we have seen in previous downturns, with the exception of a handful of very significant deals (Shell’s acquisition of the BG Group, for example, as well as interest in a takeover of InterOil Corporation, first by Oil Search and subsequently by Exxon Mobil), we have not seen the expected level of completed deals.
In 2016, Ashurst’s global oil and gas practice undertook a research report, “From Survival to Growth in a New Era”,1 which surveyed CEOs, CFOs and General Counsel at over 50 oil and gas companies, together with funders working in the sector, private equity-backed investors and investment bankers.
The report revealed that over 80 per cent of companies expected a “substantial” increase in mergers and acquisitions in the next three to five years, with respondents identifying the Asia Pacific region as the likely location of their next investment.
As the report results had anticipated, we saw continued and increased interest in deals in the Asia Pacific region across 2016, particularly in key Southeast Asian markets such as Indonesia, Malaysia, Thailand, Vietnam and Papua New Guinea, evidenced particularly by the sales/divestment processes initiated by a number of international oil companies (IOCs) in the region during this period. For example, Chevron and ConocoPhillips have both conducted divestment processes in the region in 2016, in particular, in relation to their respective interests in the South Natuna Sea Block B PSC in Indonesia. ConocoPhillips successfully completed the sale of its interest in the PSC (and associated gas transportation infrastructure) to Indonesia’s Medco Energi in September 2016 , with news surfacing on 28 March 2017 of the signing of a new deal between INPEX and Medco Energi in relation to the sale by INPEX of its interest in the same block. Repsol has also commenced divestments in the region, notably completing a sale of its interest in the Tangguh LNG project to the project Operator, BP, in December 2016. However, despite the availability of assets for sale; the anticipated levels of buyer interest; and the corresponding levels of deal activity, the level of signed and closed acquisitions fell short of expectations.
Transaction valuation
The “Value Gap” remains
A lack of consensus between buyers and sellers as to transaction valuation persists, resulting in a broader range of bid/ask spreads and, as a result, fewer completed transactions as buyers are unwilling to increase their offers, and sellers are unwilling to lower prices. This challenge is largely attributed to the significant uncertainty that remains around the oil price.
Although the oil price has risen slowly and steadily over 2016 (in line with what respondents to our report expected to see, $53/bbl by the end of 2016), the recovery has been protracted (supporting the prevailing “lower for longer” attitude to oil prices). Glimmers of optimism as the price reached levels not seen since 2014 were short-lived, and the confidence generated was undermined by subsequent price falls.
Even the price rises seen in the first months of 2017, following OPEC’s recent (and long-awaited) pact to curtail oil production, have been limited. Although there were hopes that the curtailment of production would result in price rises, the response from US oil producers to OPEC’s decision has moderated the level of recovery, with Brent prices currently hovering just over $50/bbl.
Until buyers and sellers alike feel more comfortable as to where (and when) the oil price will reach a landing point, we expect that we will continue to see a range of valuations.
Few real “bargains”
Another potential explanation as to why transaction valuations remain challenging is that many buyers still appear to be looking for “bargains” in this market. This is intuitive in the current challenging market, and we had expected to see this activity from opportunists (such as private equity-backed investors).
We have not seen the level of distressed asset sales that would typically be expected in this climate. This has meant fewer opportunities for bargains, and increased competition from other buyers, particularly those looking to strategically consolidate their portfolios, who are more likely to pursue a transaction at a valuation that does not necessarily represent a “bargain”, if the transaction serves their strategic focus.
Except where sellers are in distress, we have seen that the view of sellers is that quality assets should still attract prices which reflect that quality. This is particularly evident in the divestment programmes being conducted by the majors in Asia. Like many sellers, the majors are looking to optimise their portfolios and divest non-core assets, but they are not prepared to undervalue those assets in order to do so, resulting in some cases in lengthy transaction processes.
Valuation of mature assets
Compounding the issues associated with oil price volatility noted above, there is a significant degree of uncertainty regarding the future and longevity of some of the more mature assets currently held by IOCs in the region.
Where the relevant petroleum regimes do not grant a right of renewal to the current contract or concession holder, a lack of certainty regarding the potential for renewal (including details such as the term of renewal, the maximum participating interest held by the IOC, and potentially also the fiscal terms) can create challenges for valuation. Sellers often take a bullish view of the potential for renewal of expiring concessions, and so look for some value to be attributed to future concession periods, but buyers are of course more conservative and can be unwilling to proceed without assurances that renewals will be granted.
While a seller will always prefer that a purchase price be paid as a lump sum at closing, applying an element of deferred consideration (triggered by a renewal or extension) can be considered as a way to balance interests of the sellers and buyers in these circumstances.
The rise in significance of national oil companies (NOCs) in the region, and the trend in the region towards a renewed focus on the development of domestic resources to satisfy domestic demand, has also presented challenges for successful transactions where an IOC (or other non-domestic company) is an interested buyer. This has been particularly evident in Indonesia, where new regulations introduced in 2016 give Indonesia’s NOC, Pertamina, an effective right of first refusal in relation to the grant of new PSCs over expiring contract areas,2 of which there are up to twenty-seven scheduled to expire within the next five years. Even where regulations do not give an advantage directly to NOCs, buyers can face heavy competition for the acquisition of those assets from NOCs or other regional/domestic oil companies, who often apply different investment criteria (sometimes focused on national interest considerations) and, unlike IOCs, may not consider the relative position of the relevant assets as part of a global portfolio (in terms of priority for capital).
Spotlight on decommissioning and abandonment
Mature assets available
Although Southeast Asia is widely thought to have significant potential for future exploration and production, as noted above, there are also a number of mature or aging assets in the region. Mature or aging assets are clear candidates for the “first round” of divestments by sellers looking to reshuffle or consolidate their portfolios, and sellers are often insistent on a “clean break” on the disposal of these assets.
Buyer and seller interests in asset or share sale and purchase situations are never completely aligned. However, our experience in Southeast Asia in 2016 has indicated that this is the case now more so than ever, and particularly in terms of allocation of risk for decommissioning and abandonment liabilities.
Trends in decommissioning and abandonment regulations
Given the age of some of the assets in the region, decommissioning, abandonment and site restoration liabilities are a potential risk area for existing concession holders. The majority of mature assets in the region commenced operations before detailed regulations were in place, and the increasingly risk averse approach of sellers has largely been driven by a recent spotlight on the regulation of decommissioning obligations for concession holders.
There have been recent moves in a number of key Southeast Asian jurisdictions (notably Indonesia and Thailand) to tighten existing regulations and introduce clearer, and in some cases more stringent, obligations on concession holders, albeit with potentially different outcomes for contractors and concession holders.
In Indonesia, for example, the Government is currently preparing its first abandonment and site restoration regulation, which sets out procedures to propose abandonment and site restoration operations, provision of the relevant fund, and technical standards required. The draft circulated to the public in mid-2016 also provides that, in the case of transfers of operatorship or participating interest, obligations with respect to post-operation activities shall be transferred to the new operator or participating interest holder, as the case may be. This approach is, in essence, consistent with an earlier regulation concerning expiry of production sharing contracts issued in 2015, which provides for new contractors to be responsible for decommissioning and abandonment of facilities that are in place at the time of commencement of the new production sharing contract.
In Thailand, new regulations3 introduced in 2016 require a detailed decommissioning plan to be prepared by the concession holder, for the estimated costs of decommissioning activities to be audited and for the concession holder to provide security (in the form of cash or a cashier cheque payable by a bank, Thai government bonds, a letter of guarantee issued by a bank, an irrevocable standby letter of credit or other form prescribed by the Director General).
Draft regulations have also proposed that a transferee of a concession interest may remain liable for a share of decommissioning liabilities, having reference to cumulative production and remaining recoverable reserves at the time of transfer. This proposal received considerable negative feedback from concessionaires in Thailand.
Risk allocation approaches
Understandably, sellers wish to avoid liability for costs associated with the decommissioning or abandonment of facilities or site restoration associated with petroleum operations, certainly where those liabilities crystallise after the completion of the sale. 2016 saw sellers more motivated than ever before by a desire to avoid the potential exposures associated with decommissioning and abandonment liabilities, particularly where a sale process is being conducted as part of an IOC’s country or region exit.
As part of the trend for sellers seeking a “clean break” (and particularly in the light of potential regulatory developments), an increasing trend that we observed in 2016 was for sellers to attempt to allocate pre-effective date risk and liability associated with decommissioning and abandonment costs to buyers (e.g., through the sale and purchase agreement’s seller warranty (or the absence thereof) and indemnity mechanisms).
Buyers are naturally wary of assuming this liability. The buyer’s risks associated with potential decommissioning liabilities can be mitigated to an extent, including by comprehensive due diligence on the relevant assets and a sound understanding of the operation of the relevant regulations. Buyers may also mitigate risks contractually (for example, we have seen buyers pushing back on sellers, including by requesting a greater range of asset-related warranties, particularly regarding compliance with environmental laws and maintenance of any decommissioning and abandonment funds).
However, our recent experience shows that buyers are keenly aware that the risks cannot be mitigated fully. Even if buyers are able to agree an acceptable risk allocation under sale and purchase agreement documentation, in the current climate, some uncertainty around the future approach of host governments to the regulation of decommissioning and abandonment remains, and buyers may be required by host governments to assume liabilities going forward which cannot be passed through to a seller, in some cases for years after completion of the relevant transaction.
This misalignment in seller and buyer expectations for the allocation of risk for decommissioning and abandonment liabilities and regulatory uncertainty has been a key factor contributing to the more protracted deal negotiations for many deals in the region and the lower than expected number of completed transactions.
Outlook for 2017
Despite the challenges noted above, we expect a moderate recovery in M&A activity in 2017 in Southeast Asia, and have seen signs of this in the first months of 2017 through the signing of a number of upstream deals. M&A activity should start to gather more momentum, as buyers and sellers alike become more accustomed to the lower oil price environment as the “new normal”, with more certainty over future oil prices as the recent volatility reaches a plateau.
Companies that have focused on maintaining relationships with other players in the region will be best placed to take advantage of the changing market dynamics and execute strategic or opportunistic transactions in 2017.
Notes
1. Please contact us for more information about this research or to receive a copy of the report. See also: https://www.ashurst.com/en/news-and-insights/insights/energysource-issue-17-1-future-strategies-for-oil-and-gas-companies/
2. Minister of Energy Regulation 5/2015 concerning Management of Oil & Gas Work Areas Whose Cooperation Contract is to Expire.
3. Ministerial Regulation Prescribing Plan and Estimated Cost and Security for Decommissioning of Installations Used in the Petroleum Industry B.E 2559 (2016).
For further information, please contact:
Daniel Reinbott, Partner, Ashurst
daniel.reinbott@ashurst.com
