Ernst & Young: O&G Industry Should Look Forward to Strong Growth, Demand

This year has been one of the most volatile years on record for the oil and gas industry. Mid-year crude prices hit an all time high at almost $150 per barrel. By December, prices were down to less than one-third of that historic high. Despite this near-term softening in demand, the long-term picture is unchanged: The industry faces modestly strong long-term demand growth and a challenging long-term supply picture.

The credit collapse has created liquidity challenges for O&G companies, however, and impacted the volume of company and asset transactions. Short-term financing is more difficult to obtain, debt rollover is challenging and capital-raising events have been postponed. There's a downward pressure on credit ratings and letters of credit have been challenged. While the first half of 2008 saw only a minor (2 to 5%) decline in transaction activity, the second half witnessed a much more marked 30% decline according to Ernst & Young LLP's Energy Center. This slower pace, however, is not expected to last long.

While the number and dollar value of deals are down, the decline could actually be a signal that a new wave of consolidations is about to begin. The vast majority (more than 70%) of the nearly 600 respondents in a Dec. 9, 2008 Ernst & Young LLP webcast thought it'll be more than 12 months before the O&G mergers and acquisitions market returns.

"Credit will start flowing again," said Charles Swanson, Houston area managing partner for Ernst & Young LLP. "When it does, companies will be subject to much greater scrutiny. Those who are successful at raising capital should be the companies with their financial house in order."

The current downturn provide the opportunity for larger, well-capitalized companies to take advantage of easier, cheaper access to producing properties and possibly talent that many of the smaller energy companies possess. Other companies are relying on alternative financing methods. Volumetric production payments and other mineral conveyance opportunities familiar to oil and gas companies, such as farm-ins and carried interests, have been used in the past and are being used again to fund the acquisition of businesses and property for exploration and production.

"We're still seeing an expectation gap between what sellers want and what buyers are willing to pay," said Jon McCarter, transactions leader for Ernst & Young LLP's Oil & Gas Center. "This gap might close over the next few months. The transactions we're seeing now are desperation driven."

Right now, oil and gas companies should be in a capital allocation mode that is based on a long-term view of pricing and demand, according to McCarter. "It's critical to maintain a long-term outlook to take advantage of the right investment opportunities and bargains that will undoubtedly be available in the medium term. Be disciplined," he said. "Take the emotion out of it. And stay the steady course."