FARM-OUTS: A New Business MODEL?

FARM-OUTS: A New Business MODEL?

By Nataša Kubíková

The last tumultuous years in the global oil industry have unleashed the power of creativity performed through smaller and mid-size independents. This wave of alternative approaches is likely to continue.

Previously, the oil and gas business was run by international oil giants (IOCs) in a rather conservative manner for decades, ending up on its knees with a gigantic burden of low oil prices hovering above it. While under the weight of the 12-year low crude price, the international oil and gas market was counting its winners and losers almost on a daily basis. This has led many firms to re-strategize their businesses and search for new methods to withstand the pressures.

Amidst these challenges, mid-size independents have been the ones who have set a new trend for the business. “The mid-2000s saw a wave of independents flock into the [MENA] region, seeking to catalyze on the potential to acquire sub-giant fields in these notoriously IOC-dominated countries,” noted Samuel Merlin in a recent analysis for Gulf News. The impact of the independents’ business model has been noticeable in Egypt as well.

Standard Oil Transactions Declining

In the low crude price environment, some of the companies divested high cost assets and redirected their investments to areas with lower production costs in order to maximize their profits. For some of them this had turned into a struggle for survival.

Given the restricted business conditions, the global upstream sector had to shift from “opportunistic mergers and acquisitions (M&A) to capital discipline and targeted transaction activities,” wrote Ernst & Young Global Limited (EY) in its Global Oil and Gas Transactions Review 2015, “as those with stronger balance sheets [restructured and] focused on portfolio optimization and acted conservatively in light of oil price volatility.”

This reflected on the volume of oil and gas deals that has been decreasing since the mid-2000s at a striking level, according to EY’s 2015 Review: “Total global reported deal value declined in 2015 to just under $380 billion, a reduction of 17% compared with 2014, while the total number of oil and gas transactions declined by almost 33%.”

The November 2016’s OPEC – non-OPEC freeze plan significantly helped to re-bounce the declining trend, yet, the overall M&A deal volumes were still depressed, the EY’s Global Oil and Gas Transactions Review 2016 summarized. As M&A were sidelined, the priority for the companies was to delineate a new path that will sustain their businesses. Currently, “the oil and gas industry continues to reconfigure its business model to enable to sustain and grow in a low oil price environment,” further explained EY.

In these attempts, the oil and gas players had to venture alternative tactics, even if those were to function only temporarily, as urgency calling for un-traditional approaches was felt strongly across the globe since mid-2014. Hence, the oil and gas firms sought new forms of partnerships and deemed diversification of their portfolio as a necessity. As a result, this has opened a gap in the market allowing for smaller and mid-size companies to make their way through as influential partners, equal to giant IOCs.

While rising to prominence, indeed, the role of junior oil actors contributed majorly to setting up a new creative business model, inspiring others to refrain from the old style of running the business with its established certainties, as today there are truly none left to rely on anymore.

From Portfolio Rationalization to New Partnerships

In identifying new business parameters, major oil and gas upstreamers re-evaluated their massive projects. EY wrote in its 2016 Review that “the majors have been engaged in portfolio rationalization. The stress placed on their balance sheets by the price downturn and the implicit obligations to maintain dividend distributions have, if anything, accelerated the focus they place on this activity.”

As it turned out, IOCs’ strategy to diversify and integrate internally was the first step towards sustainability. “Lower commodity prices have forced companies to re-evaluate their portfolios, diversify or close non-core or underperforming assets while pursuing vertical integration and scale,” further noted EY. Yet, “this impact of ‘flight to quality’ and ‘equity compression’ has meant that companies with low-risk portfolios and thus lower cost of capital are able to leverage this position to expose themselves to higher-risk and higher-return assets,” which necessarily opened up a door for newcomers from among the independents.

“In a lower for longer environment, the ability to find oil has in many ways become secondary to the ability to produce it cheaply. In this context, low-cost basins that the shifting geopolitical landscape has opened to participation have proved attractive,” analyzed EY in 2016.

In line with that, in many cases, IOCs identified the need to opt for an alternative form of partnerships that would enhance cheap production. This came to be framed through farm-in/farm-out deals with a plethora of mid-size independents.

Farming out of interests in certain oil and gas concessions, the companies found new collaborators and with their help sought to minimize corporate risk. Having multiple oil companies partnering on the development of large concessions, with a vision to generate higher returns on investments regardless of the market environment, has proved as a wise strategy that can generate considerable benefits for all parties.

Oil and Gas Junior Independents

Junior partners thus became key trend-setting actors. “The country seeing the biggest wave of independents flocking to the market is Egypt,” the Gulf News’ analysis argued. And these “junior exploration-and-production companies are well positioned to capitalize on the [current] investment environment,” as The Oil & Gas Year indicated already in 2015, especially in the context of low crude prices.

They can benefit from the current environment thanks to their smaller balance sheets, which they have turned into an advantage in the Egyptian industry. These firms have a large appetite for investments, yet, their financial limits make smaller assets preferable, which is a suitable option for the country that eagerly eyes new investments to tap into its unexplored, even if smaller, concessions with strong hydrocarbon potentials.

From the perspective of a newcomer to Egypt, Tom Maher, President and COO of Apex, acknowledged to Egypt Oil&Gas in an interview that the appetite for investments is there and enthusiasm behind the company’s first bid in 2016 is enormous. “As a new US-based E&P company entering Egypt in mid-2016, Apex was very fortunate to receive its Commercial Registration from Egypt’s relevant authorities just days before bids were due in the 2016 EGPC Bid Round. On December 1st, 2016 Apex was awarded two of the six Western Desert blocks that EGPC placed for bid. EGPC expects these new concessions to be approved by Parliament and ratified into law by June of this year.”

Although Apex relies on an initial investment commitment of up to $500 million from Warburg Pincus, other companies stand face to face with a rather constrained capital. “Many of the mid-size to smaller E&P companies in Egypt are suffering from lack of capital to meet their work commitments and increase their production,” said Tom Maher. These smaller players thus had tougher times to confirm their position in the market, which until recently has been dominated by global majors.

In this respect, smaller to mid-size oil and gas firms had to strategize between their participation in Egypt’s bid rounds to acquire new concessions, on one hand, and partnerships with others in their working interests through farm-outs, on the other, with a considerable success.

In May 2015, DEA Deutsche Erdoel AG’s farm-out deal with BP of its $12 billion South Disouq project in the West Nile Delta (WND) helped to better balance the company’s portfolio. The deal included the sale of a portion of DEA’s stake in the ongoing Phase 1 development of 5tcf of gas resources, wrote Offshore Energy Today. Thomas Rappuhn, CEO of German-based DEA, stated to media that “recognizing the world scale of the development, divestment is in line with our strategy to manage risk through greater portfolio diversification.” Hence, by simplifying the holdings to as low as 17.25%, DEA has achieved efficiency and its field cost management improved.

Affirming Juniors’ Market Influence

In the recent period in Egypt, the perception of smaller and mid-size oil and gas firms has significantly changed. “New players, whether big or small, provide the Egyptian oil and gas sector with much needed capital to invest,” Apex’s President and COO noted. Yet, smaller companies may seek better capitalized partners, and they are therefore open to forge partnerships with oil majors through mainly farm-outs or possibly through farm-ins in concessions with low production costs that IOCs may deem uneconomical. As Maher continued, “Apex, with its up to $500 million line of equity from Warburg Pincus and Egypt operating experience, can potentially provide these [smaller] companies with a total exit or a capital infusion in a win-win partnership. This is good for Apex, good for the company needing access to capital, and good for Egypt that is trying very hard to attract foreign direct investment.”

Whether with a higher or lower initial capital, smaller and mid-size companies as well as all new actors can contribute to the development of the Egyptian industry by becoming a reliable partner of oil majors. In this regard, Tom Maher noted: “Apex would be happy to partner with larger players, including Apache, Shell, and Eni in the Western Desert, should those larger companies be interested in selling down or farming down of their positions to deploy capital in other areas.” Providing a safer net for international giants who may decide to divest some of their smaller concession areas, active junior companies prove their influential position in the market and allow for a larger portfolio diversification across the oil and gas sector.

New investors simply have an added value to the market, because bringing in fresh capital, smaller or bigger, does not only mean huge cash, it also implies brand new attitudes, creativity, and boldness to apply untested approaches and expand E&P activities beyond the standard production zones. As Tom Maher added, “our award of the two blocks comes with a significant investment commitment to explore,” and therefore, “we are actively looking to acquire producing assets in Egypt.”

Juniors Farming-out

Given their limited funds, smaller or newer companies to the Egyptian market thus seem to be jointly establishing a new business model as an inspiration of today, but, possibly, as a necessity of tomorrow. Even when not ready to farm-out their freshly acquired acreages in the Egyptian concessions, this eventuality is highly likely to occur in the near future as the companies would need to free some of its capital to make new acquisitions. “Farm-outs of high-interest concessions could help leverage further investments in other Egypt opportunities and thus spread risk to multiple investments,” affirmed Maher. In case this scenario materializes for Apex, the company’s President hopes that “any partner we might bring in could offer Apex other investment opportunities,” which would be a pre-requisite for win-win transactions and lasting partnerships.

Besides the opportunities to boost the company’s capital, indeed, as he further elaborated, “farming out of interest in exploration blocks can be an effective means of mitigating risk and raising capital.” However, as Apex’s President Maher also explained, the timeline of the company’s strategy is subject to change: “At this point Apex is more interested in receiving the remaining subsurface geological, geophysical and engineering data on our two blocks to complete our evaluation before considering farming down our 100% working interest. Apex is well capitalized to execute our work program and financial commitment for both blocks, so any consideration on farming down to bring in a partner(s) would be made after better understanding the risk/reward profile.”

Creativity in Oil Business

Smaller and mid-size companies are forced to approach their financial assets more creatively by economizing and strategizing their capital. These two features show that their new business model comes with bigger flexibility and diversity in order to prove successful. As EY argued, the low crude oil prices prompted IOCs and independents into action through a variety of tactics. Business performance visibly shifted “from defensive survival tactics to those actions required to be market leaders and winners.” Hence, with new players in the picture, who have contributed to the alternation of the business transaction structures, there is a clear indication that the oil and gas industry will, in the foreseeable future, be informed by “transaction excellence” as a key for success, predicted EY in its 2017 outlook. “Transaction structures may increase in complexity as swaps and strategic alliances become more common.” In addition, as EY continued, “transactions with milestone payments rather than pure cash up front may become the norm,” which serves smaller and mid-size companies better in order to help them establish their business portfolios even with a lower capital level.

Accordingly, “the oversupply of farm-outs with near-term capital requirements is likely to continue,” with the overall objective to generate larger profit in the existing conditions. As Apex’s President concluded, the company’s “mission (motivation) is to grow a profitable E&P company of scale by investing in a mix of exploration, development, and production enhancement activities.” And this can come in different forms; farm-out deals being one of several likely options.

Therefore, in consequence, the support of smaller and mid-size companies by the Egyptian petroleum authorities may prove inevitable for the exploration and production from a range of “low-risk onshore assets with low operational costs in an environment with limited competition,” as the Gulf News’ analysis suggested. The success of such a dynamic business model is not certain, however, the prospects can be positive, if the turbulent forces, which have been dictating the path for the industry worldwide in the past decades, are accommodated.

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