Switch to Value - Asset Market Set for Action

The level of activity in the global upstream asset market has been subdued over the past few years. The markets have focused on production targets and delivery as a key measure of an upstream company's success (as we discussed in the recent Horizons article Energy Issue 5: November 2002 - The End of Production Targets?). The emphasis on volumes, rather than value, coupled with high and uncertain oil prices has reduced the strategic need for the major players to dispose of non-core assets.

The significant transactions that have occurred have been due to government initiatives (e. g. the SDFI sell off in Norway) or corporate activity (e. g. the purchase and onward sale of Veba's upstream assets by BP, the acquisition of Enterprise by Shell and the sale of certain of Devon's international assets). Beyond these deals there has only been a limited number of transactions focused on improving the efficiency of corporate portfolios.

That is now set to change - in our opinion the asset market is set for action. ConocoPhillips' recent announcement of its intent to sell non-core assets worth around $2 billion could be one of the first steps in the long-awaited rationalisation of the majors' upstream portfolios. This note assesses the extent of the volumes of assets that could be put up for sale, what might trigger the process and what both sellers and buyers might do to prepare pro-actively for an asset market set for action.

What could the scale of the asset activity be?
We believe that any company should actively seek to review and, if appropriate, rationalise the bottom 5-10% of its global upstream asset base. As an example, we have assessed the tail of the assets that are currently held by six major companies that have all been active recently in merger or acquisition activities (BP; ExxonMobil; Shell; ChevronTexaco; Eni; and TotalFinaElf). To evaluate the potential size of the asset market, we have chosen to assess the portfolios on both an asset and a country basis.

Wood Mackenzie calculates that 90% of the value of the upstream portfolio of these companies lies in the top 14 countries of operation. While some of these "tail" areas may contain growth opportunities which have the potential to grow into future core areas we believe that in many cases these represent areas which may never rank as core for these companies.

Ranking of Value By Country

From an asset perspective, the value distribution curve paints a similar picture with 80% of the value of the portfolios being accounted for by between 15-30% by number of assets.

Future activity will result from both the exit from countries that do not have sufficient scale or potential to become core areas and the sale of assets that are peripheral despite being located in core countries. If the 6 companies included in the analysis dispose of (or swap) 5% by value of their current asset portfolios, the total value of properties to be traded would amount to some $15 billion.

What will trigger a rise in the asset market?
The main issues that are dampening activity are the focus on volume metrics, the current level of geopolitical uncertainty and the recent high (and uncertain) level of oil prices. For the flow of activity to begin in earnest the two areas where progress is certainly required is the switch to a focus on value metrics and the stabilisation of the oil price at lower levels to allow 'normal market' transactions. In addition, sellers need to ensure that non-core assets are packaged in such a way so as to be attractive to potential purchasers.

Efficiency gains and the natural owners
One of the objectives of asset trades is to improve efficiency. If a deal is to be 'win-win' then the buyer needs to be able to get more value from the asset than its former owner. This could happen in many ways. The buyer may, for example, have better or different knowledge of the area and of the reservoir potential; or be able to use proprietary infrastructure to reduce costs or extend field life; or be able to combine the acquired asset with others to increase operating efficiency.

As the oil industry in many parts of the world is either in the mature phase or getting there, this type of thinking will have to play a major role if the industry as a whole is to achieve the best overall result. With most companies finding profit growth difficult to deliver in a maturing world, the new maxim must be to increase efficiency - both in use of their capital and their managerial and professional resources. Companies will need to ask themselves whether they are really the 'natural owner' of all of their assets. If not, they should sell -and the best buyer ought to be the asset's real 'natural owner'.

Who are the likely buyers?
The major groups that would be involved in any activity would include:

Super-majors and majors. Despite being a likely source of assets (such as Eni's recent sale of UK assets), these companies are likely to be interested in any high quality assets that would increase the quality of their portfolios (as ENI demonstrated with its acquisition of Fortum's Norwegian portfolio). Materiality and control will be two of the key criteria.

National Oil Companies. Companies that have demonstrated their intent to acquire international assets include Petronas, Petrochina and CNOOC. We expect the NOCs to be increasingly active, reflecting their financial strength and, for some, increasing competition in their domestic markets. For these companies hurdle rates of return are likely to be lower than the IOCs.

Super-independents and independents. Although the focus for a number of the US companies has been a return to the US itself, the acquisition activities of companies such as Talisman, PetroCanada and the smaller independents have indicated a healthy appetite for the right opportunities. Profitability will be the key criteria here.

Start-up E and Ps. There are a significant number of smaller companies that would welcome the opportunity to acquire assets. As a demonstration of this underlying activity, in the recent 20th Licensing round in the UK there were 6 new entrants that acquired offshore acreage for the first time. Interestingly, while the markets (particularly in the UK) continue to be challenging as a source of funds for these companies, there seems to be a ready alternative with venture capital being provided to these fledgling companies.

Russian Companies. Companies such as Yukos and TNK have signalled their intent to acquire assets internationally, although to date they have been wary of overpaying given the high oil prices in recent years and the existing opportunities available domestically.

What should the prospective sellers and buyers do to prepare?
From a seller's perspective, the aim should be to conduct a review of its asset base in the context of the company's upstream strategy. This portfolio assessment could follow a process such as that outlined in the chart below where assets are classified in terms of competitive position and maturity to identify possible candidates for divestment or swapping. In addition, consideration (with supporting analysis) should be given to the universe of potential purchasers and their appetite for certain countries and types of assets.

Portfolio Assessment

From a buyer's perspective, a pro-active stance should be adopted rather than waiting for the packages to emerge on to the market. This proactive stance could involve:

Analysis of the sellers' portfolios. The question here is what should each seller be thinking and which countries and asset packages might be available for sale on an exclusive basis. In particular, purchasers should devise a strategy to approach a potential seller pro-actively, rather than being reactive (and often having to compete with other buyers in an auction process as a result).

For almost 30 years, Wood Mackenzie has been providing invaluable commercial analysis and strategic advice to the world's leading energy companies, covering upstream oil and gas, oil refining and marketing, downstream gas and power generation. During this time, we have developed a unique and unrivalled foundation of knowledge, experience and understanding of a broad range of markets and companies within the Energy Industry. Firmly established as the market leader in its field, Wood Mackenzie's reputation has been built on the provision of high quality and innovative Consultancy Services and Research Products.

Developing a strategy process to assess the optimal countries and/ or asset packages that would be of interest. In an ideal world the packages purchased should fit perfectly with the existing portfolios. For a company to be sure that this is the case, a review of the company's strategy should be considered.

Analysis of the competition. Earlier in this note, we listed the types of companies that would be interested in any asset packages. Given the importance of this subject a formal review of the competition, their stated intent and their portfolios would identify areas of competitive advantage (and threat).

Be prepared
Based on our analysis, the likelihood is that the combination of the switch from volume to value metrics and a lowering of the crude oil price to a sustainable level should result in a significant increase in the level of asset trading. In particular, this set of conditions could trigger the long awaited portfolio rationalisation to occur from the major companies that participated in merger and acquisition activity. This could take place for both countries and asset packages.

Even if the impending action won't occur immediately now is the time to get ready. Accordingly sellers should be reviewing their portfolios and buyers should be preparing. There will be first mover advantage whichever side of the equation the company sits.

For further information please contact:

David Morrison
Tel: +44 (0)207 877 0570
e-mail: david.morrison@woodmac.com
Matthieu Castellani
Director – Strategy Consulting
Tel: +44 (0)207 877 0587
e-mail: matthieu.castellani@woodmac.com