Powering Up M&A In The Oil & Gas Industry
The global energy sector – particularly oil and gas – is undergoing yet another period of considerable turbulence. As the novel coronavirus (COVID-19) began to bring the global economy to a grinding halt, oil prices were flattened. To add to the uncertainty, a dispute over supply between Saudi Arabia and Russia sent prices crashing 25 percent – their biggest one-day drop in almost 30 years. Then, in April, U.S. oil prices briefly fell into negative territory as traders started paying people to take oil off their hands to avoid the high costs of storage.
Political pressures and uncertainty caused by COVID-19 aside, the current picture is one of energy companies of all sizes facing cash flow issues and falling share prices. The sent prices crashing 25 percent – their biggest one-day drop in almost 30 years is causing many upstream producers to default on their loan agreements. This is causing credit risk associated with counterparties as financial stress flows through the sector.
Melissa Shepherdson, Aon’s head of Energy & Mining in Asia, explains that this is creating a favorable environment for companies with high-liquidity, and private equity funds, which are looking to invest in undervalued assets and commodities. “And currently, the oil and gas industry is a prime target.”
Oil price volatility has widespread impact. “For some businesses, lower oil prices can be a positive, resulting in lower fuel prices or raw material costs,” says Euan Nicolson, chief commercial officer for Energy at Aon. “For those across the oil industry, however, the price plunge might lead to delayed or deferred drilling projects, with ripple effects across the chain of contractors and suppliers that support the industry.”
Thanks to a combination of the collapsing oil price and the global economic uncertainty, there has been a near collapse in mergers and acquisition (M&A) activity since the beginning of the year. Data show that the value of international upstream M&A deals completed successfully in in the first quarter of 2020 fell to US$5.7 billion compared with US$17.3 billion during the same period last year. While this dramatic downswing is indicative of investor caution, it doesn’t mean that there are no M&A opportunities in the energy sector. It shows that investors are placing greater weight on potential risks than in previous years.
M&A transactions have always carried an inherent level of risk. Acquisition of companies should engender growth, yet the reality is often different, says Wong Hui Ling, director of Transaction Liability Insurance – Asia at Aon.
“These transactions often fail as companies do not have a full grasp of the risks involved in the acquisition, and there is a lack of understanding about the unique risks surrounding the target or asset,” Wong explains. “These can include human capital risks, unexpected environmental, contingent and tax liabilities, plus breach of seller representations and warranties in the sale and purchase agreement.”
However, with the right level of insight and advice, these risks can be negotiated to create successful M&As.
Navigating the Risks in Asia
M&A transactions in Asia can be complex, especially for industries like banking, insurance, manufacturing and construction, and energy, given the diversity of regulations and ways of doing business from country to country. This is especially true for multinationals doing business in the region for the first time. Some of the initial challenges can include integrating processes and systems or ensuring corporate-level finance guidelines are compliant with those of the host country.
“During M&As in the energy sector, like any others, multinationals also face human capital risks,” says Melissa Shepherdson, Aon’s head of Energy & Mining in Asia. “This is because many employees struggle to accept change. This can lead to a reduction in business performance and value creation after the transaction merger has been completed. It is imperative that the acquiring purchasing company understands that cultures are vastly different, and that they make allowances for this.”
Environment and Tax Liabilities
The energy sector is also vulnerable to changes in environmental law. “All buyers should seriously consider the possibility that the target they are acquiring may be affected by unexpected changes in environmental legislation,” says Shepherdson. “Issues in the future could include potential decommissioning liabilities, which are not always factored into the diligence process when a deal is being pursued.”
Taxation liability is another issue. The diversity of legislation in Asia creates another layer of risk. The purchasing company could find itself exposed to capital gains and contingent liability risks, depending on the local laws where they operate.
Transferring the risk
Participants in a M&A deal in Asia’s energy industry may be able to offset some of the risks performing due diligence and transferring transactions to the insurance industry. “With coverage like warranty and indemnity, for example, any post-close breach of representations and warranties on behalf of the seller are transferred to the insurance market at a fixed cost,” says Shepherdson.
This approach provides clarity so that transactions can be concluded as simply, and as quickly, as possible.
“In today’s volatile oil and gas market, any approach that offsets risk will create the right environment for a successful takeover, and, ultimately, pave the way for successful cost reductions, more capital efficiency and greater value generation over the long term,” says Shepherdson.