Oil Majors Set to Gain As Smaller Rivals Struggle

LONDON (Dow Jones Newswires), October 23, 2008

Major international oil companies may emerge from the current financial turmoil and the sharp drop in oil prices strengthened as they cherry-pick reserves from smaller companies that run into trouble.

As access to financing dries up and share prices get hammered, some of the smaller oil and gas companies will become extremely vulnerable to forced asset sales or takeovers. And the cash-rich majors will be waiting to snap up vital new reserves at bargain prices.

"The majors are in a fantastic position," said Mike Wachtel, head of the oil and gas practice at Watson, Farley and Williams LLP, a law firm that advises on corporate mergers and acquisitions. "There are a lot of (small oil and gas) companies now that are having financing problems. They're going to have to either sell their assets, put themselves up for sale, or go to the wall. And of course that produces a lot of opportunities for both the hedge funds and a lot of the large, predatory companies."

The valuations of oil companies of all shapes and sizes have taken a pounding as the price of oil has more than halved since its mid-July peak. Shares in the world's largest oil companies including BP PLC, Royal Dutch Shell PLC, ExxonMobil Corp., Total SA and Chevron Corp. are down by more than a third from their peak in May.

Smaller companies have been hit even harder. The value of consultancy Ernst and Young's index of 20 oil and gas companies listed on London's Alternative Investment Market, or AIM, has halved since the beginning of 2008.

But the major companies have low levels of debt and the production and cash flow to get them through tough times. Many of the smaller companies don't.

"Against the backdrop of high and volatile commodity prices and a nervous market environment, many of AIM's junior oil and gas companies are finding it increasingly challenging to secure funding from investors," said a report from Ernst and Young. "Without cash, a company cannot progress from exploration activities to the development and production phase."

The smaller exploration and production companies "have no access to equity markets and no access to debt markets," said a London-based banker who advises on corporate transactions in the energy sector. "Anyone with a hint of financing problems has been whacked," and many of them will either go bankrupt, be forced to find a buyer or cut expenditures to the bone and drift along as "zombie" companies, the banker said.

There is plenty of evidence of AIM-listed companies facing funding difficulties and cutting expenditures.

Canadian company Oilexco Inc., which is active in the U.K. North Sea, lowered its 2008 production estimates and said it was having difficulty raising its credit lines to $1 billion from $700 million because of "unprecedented liquidity and volatility issues." In September, London-based Sterling Energy PLC was forced to issue new equity at a one-third discount to its share price and sell a portion of an oil field in Iraqi Kurdistan to raise funds.

Such problems create opportunities for larger companies with secure credit lines and stronger cash flow.

"Everyone is expecting a big pickup in (merger and acquisition) activity," said Andrew Bartlett, global head of oil and gas corporate advisory at the Harrison Lovegrove subsidiary of Standard Chartered Bank. "I look at '98 and '99 and see a lot of similarities."

The end of the '90s, when the oil price dipped to around $10 a barrel, saw the last great wave of consolidation in the sector. BP bought U.S. companies Amoco and Arco, Exxon merged with Mobil and Chevron began merger talks with Texaco. 

 'Everyone Is in Play'  

"There is fantastic value across all the sector. It's fair to say that everyone is in play, from the very big to the very small," said Bartlett. The best opportunities are for the major companies to pick off smaller players and boost their reserves. "The companies that have gone -- Imperial Energy, First Calgary -- have all had a very large undeveloped resource base," he said.

India's Oil & Natural Gas Corp. has made a $2.59 billion bid for Imperial, which has large reserves in Russia that haven't yet been developed. Italy's Eni SpA agreed last month to buy First Calgary Petroleum Ltd. for $868 million.

"Companies with more than 100 million barrels of oil equivalent of commercial or near-commercial resources...are in our view the most likely takeout targets," said a report from the research arm of corporate advisers Fox Davies Capital. It listed JKX Oil and Gas PLC, Regal Petroleum PLC and Cadogan Petroleum PLC, all of which are developing resources in Ukraine, among likely targets.

The steep drop in share prices recently means that even larger companies whose funding is secure may also be vulnerable. "I'd be very surprised if one of (the major oil companies) doesn't snap Tullow up just for the Jubilee field in Ghana," said Wachtel of Watson, Farley & Williams. At Tullow Oil PLC's current share price, "you could buy the jewel in the crown for 30% less than it's worth and get everything else for nothing."

"Cairn is exactly the same story. So there's a lot of opportunity out there for people with money and the appetite to go and do some of these deals," Wachtel said.

The London banker said North American gas is likely to be a big focus for the majors. Oklahoma-based gas-producer Chesapeake Energy Corp. looks particularly vulnerable, he said.

Chesapeake has been selling assets and cutting back on drilling as U.S. natural gas prices have fallen. The company also drained its credit facility to boost its cash on hand. Chesapeake has already sold large stakes in two shale gas resources to BP, which has expressed an interest in further deals.

The banker said Oklahoma-based Devon Energy Corp. and Texas-based Anadarko Petroleum Corp. are also potential targets.

"I think the majors are gearing up for more substantial transactions," the banker said. ExxonMobil and BP are the most likely acquirers because both are cash-rich, but don't have enough projects in the pipeline, so will need to buy more reserves, he said.

"The trigger point is Jan. 1," by which point banks should have less doubt over their own balance sheets and be willing to back deals again, the banker said. Even then they will remain cautious and $20 billion to $30 billion may be the maximum size of any cash deal, he said. Given the febrile state of equity markets, Bartlett of Standard Chartered said all-share takeover deals, such as Salamander Energy PLC's recently withdrawn offer for Serica Energy PLC, are unlikely to succeed.

"For companies with a hole in their production profiles in the longer term, this will be the time to seize the day and replenish the portfolio with quality reserves at low prices," said a report from analysts at broker Sanford Bernstein.

However, the Western oil companies won't be the only bargain hunters out there.

Jiang Zemin, the chairman of PetroChina Co. Ltd., told a shareholders meeting in Beijing this week that he was also looking at buying foreign oil companies caught short in the financial crisis, according to the China Daily newspaper.

"The Chinese are definitely back in M&A markets," said Bartlett. They weren't active this year, at the top of the cycle, but they have the cash and are definitely value buyers, he said.

Copyright (c) 2008 Dow Jones & Company, Inc.

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