In the first of a series of articles on different market sectors, Marialuisa Taddia looks at how a commodity price crash is affecting lawyers who specialise in oil and gas.
The oil industry is not new to periods of boom and bust, but this time it’s different, lawyers say. Crude oil prices fell below $30 a barrel in January, a very steep descent from June 2014 when the price of the world’s most essential commodity touched $115. It may be some time before the price returns to $100, if it ever does.
In its annual outlook for the world energy market issued in November, the International Energy Agency said that under its ‘central scenario’ it does not expect the price of crude to return to $80 a barrel until 2020. Thereafter, the energy watchdog expects only lukewarm demand growth for another two decades, as renewables expand their share of the overall energy pie.
Adding to the negative outlook are the EU-US sanctions against Russia, the world’s largest producer of crude.
Against this backdrop, oil majors such as BP, ExxonMobil, and Shell have slashed investment and jobs. In January, BP announced that it would cut 4,000 jobs, including 600 from its North Sea operations, in the face of falling profits. Cutbacks have been even deeper at the more vulnerable exploration and production companies and the oilfield services (OFS) providers. In one telling vignette, the Guardian recently reported that in Aberdeen former oil workers are queuing up to use food banks.
The upshot for lawyers is that legal budgets are being reduced and clients are relying more on in-house teams.
Mark Saunders, partner and head of energy in Berwin Leighton Paisner’s finance group, says: ‘Prices have been low before, but perhaps not for such a long period of uncertainty and not in the current context.’ Demand is cooling from China; there is now a ‘surplus’ in the US following the country’s shale revolution; and Opec is ‘disunited’. While Algeria, Ecuador, Iran and Venezuela have been urging the cartel to cut production to halt the decline in oil prices, other Opec members such as Saudi Arabia are continuing to pump oil to preserve market share.
Value of upstream oil and gas projects postponed since the 2014 crude oil price slump
When analysts predict oil will return to $80 a barrel
Job cuts at oilfields services company Schlumberger. Insolvencies of UK service companies were up 55% in 2015
Percentage of oil and gas executives who expect the M&A market to improve in 2016
Value of Royal Dutch Shell’s takeover of BG Group
‘Most people would agree that this is different. It’s a dynamic we haven’t seen before,’ says Pinsent Masons partner Paul Goldrick. ‘There is a global economic and financial malaise, and we also have geopolitical issues to deal with.’ He points out that Iran is likely to go back into production now that the sanctions have been lifted, adding to the ‘production glut’. And with rising tensions between the two neighbours, it is unlikely Saudi Arabia will cut its supply.
So what is the impact on private practice lawyers? One major change is a shift in focus away from M&A and projects to refinancing, restructuring and dispute resolution.
‘If you are an M&A oil and gas lawyer, it is a good time to bring some of your colleagues from other disciplines along to client meetings,’ Latham & Watkins corporate partner Simon Tysoe says. ‘The likelihood is that you are not going to get a call from your clients announcing “we are doing this mega-deal”. The likelihood is that they are going to say “we have got an issue that we need to sort out”.’
New breed of buyer
M&A deal volume in the sector has tracked the oil price downwards. In the first three quarters of 2015 the volume was ‘dismal’, according to a survey published in December by consultancy firm EY, with activity falling nearly 40% from the same period in 2014.
Tysoe says: ‘The oil price slump has made M&A transactions more challenging. There are fewer of them around and those that are happening often take longer to close, or simply [the parties] may have a deal… but can’t reach an agreement on pricing.’ Tysoe specialises in cross-border mergers and acquisitions, investments, joint ventures and project development work in the oil and gas sector.
Clients are also changing. There is a new breed of buyer in the market, Tysoe notes, because oil and gas companies do not have sufficient cash reserves to buy each other out if they are forced to sell. ‘Non-traditional investors’ such as private equity houses and integrated chemical groups are stepping in, taking advantage of the difficulties oil and gas firms have in raising bank and equity finance.
‘These are buyers who were always traditionally squeezed out of the market because of the higher prices, but they are now in the happy position of having cash,’ Tysoe says.
An example of chemical groups stepping into the fray is Switzerland’s Ineos, which recently bought a dozen British North Sea gas fields from Russian billionaire Mikhail Fridman’s investment fund LetterOne – a divestment linked to sanctions against Russia – for an estimated $750m. Latham & Watkins acted for one of the sale’s bidders, among which were two private equity-backed groups.
Private equity houses looking to buy assets include Carlyle and CVC Capital Partners, which in June announced that it had set up Neptune, an oil and gas investment vehicle to invest in large oil and gas portfolios.
The UK’s North Sea basin has been one of the areas hardest hit by the oil price collapse, and, in a bid to cut costs and offset weaker revenues, major companies such as BP and Total have divested their ‘midstream’ assets to private equity and infrastructure funds, with the trend set to continue. In August, Total sold for £585m its Scottish gas terminal St Fergus and all of its interests in the FUKA and SIRGE pipelines to North Sea Midstream Partners, an affiliate of private equity firm ArcLight Capital. Pinsent Masons advised Total on the deal.
Private equity investors’ appetite for midstream assets, which involve the transportation and storage of gas and crude, is not confined to the North Sea. Global law firm Dentons is advising a consortium of private equity investors comprising Russian Direct Investment Fund, Gazprombank and a Middle East sovereign fund on the acquisition from Russia’s Sibur Holding of Sibur Portenergo, a liquefied petroleum gas and light oil products terminal in the Russian port of Ust Luga.
Capex on hold
The fall in oil prices means that in jurisdictions that are politically difficult or higher-cost, capital spending on new oil and gas projects has been put on hold. This includes Nigeria and Angola, the Arctic and the North Sea.
But the nature of the business means it’s not all bad news for lawyers. Linklaters partner Fiona Hobbs, who specialises in projects and project finance in the energy and infrastructure sectors, says: ‘For major oil and gas projects the lead time is very significant, so what happens when the oil price goes down is that companies defer the start of projects they have not yet pumped a huge amount of money into.’ But, she adds: ‘The big projects in which [companies] have already heavily invested are more likely to carry on.’
For Linklaters, these include a $10bn floating liquefied natural gas (LNG) project for a consortium led by Italy’s Eni in Mozambique, by far the largest infrastructure project in sub-Saharan Africa, and potentially the largest LNG project in the world; and a $1.55bn fuel pipeline between Ethiopia and Djibouti which is being developed by Black Rhino Group, the African infrastructure investment company of US private equity group Blackstone.
‘There are still a surprising number of highly strategic, very large projects that are moving forward despite the oil price, particularly in Europe,’ says Tim Pick, project development and finance partner in the energy, transportation and infrastructure team at Freshfields Bruckhaus Deringer’s London office.
The magic circle firm is advising on the Trans Anatolian Natural Gas Pipeline Project, which entails the construction of a 1,850km-long pipeline to supply gas from Azerbaijan to Turkey and Europe; and on the $11bn Nord Stream 2 project, led by Russia’s Gazprom, a gas pipeline connecting Germany and Russia through the Black Sea. ‘We are still seeing a lot of activity in the east Mediterranean,’ Pick adds, pointing to the firm’s work on a proposed pipeline to bring Israeli gas to Egypt.
If there are big projects moving ahead in the midstream and downstream sector, there is much less appetite to invest in the upstream side of the oil chain, which involves exploration and drilling. Oil and gas companies have deferred 68 large upstream oil and gas projects worth $380bn since the crude price slump in 2014, according to research by industry consultancy Wood Mackenzie in January.
‘The market for exploration assets where you just have oil and gas licences and you are hunting for reserves is really difficult,’ Tysoe says. ‘People don’t want to take the risk and spend the additional money required for what is effectively a chance. So, to the extent that deals are being done, they are often in relation to discoveries that have already been made or even [been] put into production.’
‘The large international oil companies are looking very carefully at where they spend money,’ says Slaughter and May partner Hywel Davies. ‘Many of the African projects are either exploration or development projects, and there has been a slowdown.’
This has in turn hit the OFS companies that oil businesses hire to find and extract oil and gas. OFS firms were thriving before the oil price collapse, but many are now struggling with heavy debts. In January, the world’s largest OFS group, US-listed Schlumberger, reported a $1bn loss for the fourth quarter of 2015 and 10,000 job losses.
Independent oil companies which focus on exploration and production are also struggling, as they cannot repay the loans they took out when oil prices were much higher. ‘People who borrowed against an assumed oil price of $75 or $100 [per barrel] now find themselves in a position where they simply can’t service that debt and have to consider refinancing options,’ Pick says.
Russian bear market
Russia’s energy sector has been hit both by the oil price slump and sanctions imposed by the west in 2014 in response to its annexation of Crimea and the crisis in eastern Ukraine.
There are restrictions on the export from the west of high-tech goods and associated services to Russia for deep water and arctic oil exploration and production; and shale oil projects. The sanctions have also banned credit and capital flows to big Russian banks and corporations in the energy sector.
Brian Zimbler (pictured), Moscow managing partner at US firm Morgan Lewis, says: ‘The energy practice has been severely affected by the sanctions. A number of projects that require international capital and technology, especially deep-water and Arctic drilling, and shale, have been directly hit. Some have either been cancelled or significantly changed.’
‘The technology-intensive side of the business has suffered the most,’ says Dentons’ Moscow-based partner Doran Doeh, who specialises in corporate and financing transactions in energy and natural resources.
Despite the difficult environment, and in some respects because of it, Doeh says ‘there are deals going ahead’. Speaking to the Gazette in December, he said: ‘Things were relatively quiet for half a year after the price went down, but in the second half of this year we have been very busy.’
For example, Dentons advised ONGC Videsh, the overseas arm of India’s state-owned Oil and Natural Gas Corp, on the purchase, announced in September, of a 15% stake in the Vankor oilfield of Rosneft for $1.35bn. The Russian state firm is reportedly heavily indebted after buying TNK-BP in 2013 for $55bn, and sanctions have since restricted its access to new finance from the west.
The debt reorganisation process means two things. The first is refinancing, whereby an oil and gas company takes out a new contract at better terms (reflecting lower oil prices) to repay a loan. Slaughter and May has been supporting clients who are either seeking more advantageous financing terms or ‘alternative forms of finance’, Davies says. This can be from hedge funds or private equity investors, or through ‘forward-sale’ and ‘royalty and streaming’ transactions.
The second is debt restructuring to avoid default – renegotiation of a loan contract, for example, to extend the payment date. ‘For the first time in my career, I have been on joint marketing trips with our restructuring and insolvency people,’ Pick says. ‘We are seeing a lot of activity on the oil and gas restructuring side.’
Tysoe argues that the balance sheet consequences of the oil price crash, particularly for the OFS companies, will be felt from this year as contracts are terminated or expire and are not renewed. ‘We will see more and more urgent restructuring,’ Tysoe says. ‘We will begin to see insolvencies come through, if [OFS companies] fail to restructure their debt.’ Already, the number of insolvencies of UK oil and gas service companies rose 55% in 2015 to 28, up from 18 in 2014, according to research published in January by accounting firm Moore Stephens.
Law firms are also seeing an uptick in dispute-related work. ‘The focus has turned more from M&A and projects to dispute resolution,’ Saunders says.
Goldrick concurs: ‘What has increased is the legal support we provide to oil and gas companies in terms of refinancing and restructuring, and also, rather sadly, there is an increase in dispute resolution support. That might be in the form of actual live disputes going through arbitration or the courts, but for us the real increase has been around dispute advisory work: how to avoid the disputes getting to the point where there is a formal resolution procedure, as opposed to there being a discussion or a negotiation.’
There are two main reasons for avoiding the courts. First, as Tysoe notes, there have been ‘some fairly drastic cuts’ in oilfield services contracts, which have either been terminated or the terms renegotiated. ‘In other circumstances or in other markets if someone turned around and said “I am not paying that”, it might have resulted in a dispute. But since the oilfield services companies need to make sure that they maintain some income streams, then that does not necessarily result in litigation.’ Not yet at least, he adds.
Second, as Hobbs notes, the oil and gas industry is fairly incestuous. ‘What you always have to remember about the oil and gas sector is that, because everybody is in a joint venture with everybody else in so many different places, litigation is not something that people necessarily jump into, because they will be in partnership with that entity somewhere else in the world.’
In-house fee squeeze
With the oil price in decline, clients have reined in spending on external counsel. ‘Oil company cutbacks include contractors, and external law firms are just another contractor,’ says Saunders, who adds that over the past 18 months the downward pressure on fees has also increased.
But not everyone agrees that this is a phenomenon solely linked to the oil price. ‘The downturn has made people focus on cost, but in terms of legal fees there was already a trend by large clients of flexing their power to get the best possible deal and using panel arrangements to do that,’ Pick says.
It is not all doom and gloom, of course, and private practice lawyers remain cautiously optimistic.
‘Notwithstanding low oil prices, many in the industry take a long-term view and are prepared to commit funds to enable themselves to remain competitive in the medium- and long-term,’ says Moscow-based Dentons partner Doran Doeh. He points to the 26 applications received by Norway’s Oil and Energy Ministry in December for drilling permissions in the Barents Sea, near the border with Russia. Statoil, BP and Chevron were among the applicants.
Licensing rounds do not usually create much legal work for private practice lawyers because oil companies typically do that in-house, but, as Doeh says: ‘It shows that there is still life in the sector despite current low prices.’
Furthermore, there are areas of practice that are unaffected by oil price trends. BLP, for example, has been busy advising the oil sector on safety issues. The firm is outside counsel to Oil Spill Response Ltd, an organisation comprising most of the world’s oil majors that works to prevent accidents occurring and, if they do, helps to mitigate any consequences.
Firms are also shifting emphasis to other energy sectors, including renewables, which received a further boost from the Paris climate change agreement, signed in December, to limit greenhouse gas emissions. BLP, for example, recently advised Golden Square Energy, a joint venture between Ingenious Clean Energy and AGR Renewables, on the long-term refinancing of a portfolio of 18 single turbine onshore wind projects in the UK.
There are new geographical areas to exploit too. Following the lifting in January of international sanctions against Iran over its nuclear programme, the country’s oil industry is soon to re-enter the global economy. On the one hand, this may fuel the downward spiral in oil prices in a market already awash with supply; but on the other it is a big boon for international law firms. In Iran there are huge opportunities for oil and gas companies, Goldrick says, and consequently for their lawyers.
For Davies, ‘Iran is one to watch’ in 2016. Slaughter and May has advised oil and gas companies, and their service providers on sanction-related issues and business opportunities in the Islamic republic.
Sarosh Mewawalla, Linklaters projects partner in Dubai, says: ‘Iran is keen to secure vital technology and investment to increase production in its oilfields and develop its gas export capacity. The expectation is that new contracts will make the returns for international oil companies acceptable and also be structured to allow them to book reserves.’
But given the low oil price, ‘intense’ competition (including from Russia and Mexico) to attract investment for energy projects, and the risk of a ‘snapback’, which, under the Joint Comprehensive Plan for Action, allows for the reinstatement of the sanctions in the event of non-compliance, uncertainty remains. ‘Iran has its work cut out to secure vast sums of foreign funding and technological expertise to produce at the ambitious levels it is hoping,’ Mewawalla concludes.
This year will bring more restructuring, insolvency – and dispute-related work, but could also see a rebound in M&A activity.
Close to 90% of oil and gas executives believe the M&A market will improve in 2016. Most deal volume is expected to come from middle-market deals valued under $250m, although a third of companies are planning deals between $250m and $1bn, according to the EY’s Oil and Gas Capital Confidence Barometer published in mid-December. But price volatility meant the valuation gap between buyers and sellers had widened.
When oil prices are high, sellers do not do deals because they could go higher; when prices are low they think they will revert to a higher range, Doeh explains. ‘But eventually there is a range that is acceptable when there is pressure to either sell or buy,’ he says.
In such a depressed market, lawyers can benefit from bargain-hunters, however. ‘Increasingly, people are looking for opportunities on the expectation that the oil price will rise, therefore it’s a good time to be buying at the bottom of the cycle,’ Davies told the Gazette in December.
Slaughter and May is one firm that has thrived in this area, despite the difficulties, thanks in part to its client mix, which has been less exposed to the problem area of exploration and projects.
Davies says: ‘We have been very lucky in that we have been involved in a lot of the significant M&A work that’s been going around – 2014 and 2015 have probably been our busiest years in the sector.’
The magic circle firm has won key roles in some of the biggest M&A deals in the industry, representing: Germany’s RWE in the $5.7bn sale of oil and gas arm, RWE Dea, to Mikhail Fridman’s LetterOne; Britain’s Royal Dutch Shell on its £47bn takeover of BG Group; and Canada’s Talisman Energy plc, in its $8.3bn takeover by Spain’s Repsol.
Slaughter and May is also working on ‘early-stage strategic transactions’ such as mergers, asset swaps and joint ventures involving ‘the stronger players looking for opportunistic buyers’, Davies says.
‘If you look back at previous downturns, you’ll find in the end that some very big M&A deals get done,’ says Doeh, who has been in the oil industry since 1975. ‘The question is the timing. You can sit around and wait for a long time and nothing happens, and then it all comes in rush.’ Fortunately, responding to the ups and downs of their clients’ markets – in this case, oil – is something lawyers are more than capable of doing.
Marialuisa Taddia is a freelance journalist