UK small cap E&Ps
HOW HAS THE SECTOR REACTED TO THE FALL IN OIL PRICE?
TOM FOX AND ADAM MITCHELL, STRATEGICFIT, LONDON
LONDON'S AIM MARKET is one of the key financial hubs for junior E&P companies, with 89 currently listed on the exchange. This sub-section of the oil and gas industry is often overlooked and unbiased, in-depth research is scarce. What can we learn from how these companies have been affected by the recent weakening in Brent crude price? We aim to answer three key questions.
- How have valuations been affected by the falling oil price?
- How has financial strength affected the response to low oil price?
- What could this mean for these companies in the future?
HOW HAVE VALUATIONS BEEN AFFECTED BY THE FALLING OIL PRICE?
The UK AIM market has seen investors divest from junior energy companies as the Brent oil price has weakened. The total market capitalization has fallen by 55%, losing $7 billion of value since June 2014.
Surprisingly, equity prices have only fallen in lock-step with the drop in Brent, despite the amplified effect on already fragile income streams. While in 2014 70% of the 42 producing companies delivered positive operating cashflow, 2015 could see this fall to below 10%. This is driven by the $45 difference in average oil price between 2014 and 2015.
HOW HAS FINANCIAL STRENGTH AFFECTED THE RESPONSE TO THE LOW PRICE?
Sustained high prices have allowed these smaller companies to raise debt finance (debt refers to the portion of liabilities which bear interest) over the past five years. While equity valuations were strong the ratio of debt to market capitalization (debt ratio) was low. The fall in share prices has raised the debt ratio which has weakened the group's financial strength. The drying up of E&P financing has compounded this issue.
Up until January 2015 companies with both high and low debt ratios suffered a similar decline. Since the New Year there has been a more pronounced dip in the value of companies with a high ratio. The widespread acceptance that there would not be a v-shaped recovery in oil price may have triggered this.
The price of crude recovered across Q1 and Q2 2015 but then dipped back to $50/bbl. This may have quashed hopes of a quick recovery. Investors are likely reacting to the reality that it is much harder for these companies to service their debts in a low oil price world, and M&A hasn't yet been forthcoming.
Analyzing 2015 interim results indicates that hedging only supported prices by more than $10/boe for one company. The average revenue per barrel was $50/boe, across the companies which have released results (excluding those which produce solely gas), showing that the expiry of hedges is not a factor in the divergence of valuation.
WHAT COULD THIS MEAN FOR THESE COMPANIES GOING FORWARD?
This has put a strain on the balance sheets of many companies. The number with a moderate debt position (debt ratio greater than 40% but less than 100%) has increased by a third while the number of companies with a concerning debt position (debt ratio greater than 100%) has quadrupled. A major question for this group is whether signs of a sustained recovery will cause a spur in corporate action?
Five companies have been taken over or sold the entirety of their assets in the period examined. But larger independents may have been too preoccupied with shoring up their own cashflow to take advantage of low valuations. Could this mean a race to acquire undervalued smaller players on a market rebound?
Despite the fall in the valuation of these junior companies there does not seem to have been much consolidation - yet. A first mover in M&A would have a lot of scope to take advantage of this situation. In the recent past (1998-2000), sustained low prices saw a wave of M&A across both small and large players. There are many different ways to analyze these companies; market valuation, their asset portfolios and their financial positions. However, investors seem to be overwhelmingly driven by sentiment around the price of crude at the moment. Does this mean for the right buyer some portfolios represent particularly good value? Our first step to finding that value is to analyze and identify potentially attractive companies using a database which covers the whole of AIM E&P.
ABOUT THE AUTHORS
Tom Fox is a consultant at StrategicFit, a strategy consulting firm specializing in the upstream oil and gas industry. He previously gained experience analyzing the finances of oil companies while working with KPMG in Aberdeen. Fox holds an MSci in Physics from Imperial College London.
Adam Mitchell serves as a principal at StrategicFit. He has 20 years' experience helping energy companies. He has led consulting projects addressing challenging issues in E&P, power, renewable energy and CO2. He holds a BSc in Physics from the University of Bristol and an MBA from Imperial College Business School, London.