In this article, we share our insights on the key decision-making and valuation approaches that are required to avoid such under-delivery. These insights are based on our extensive experience in large and small oil and companies, with acquisition and divestment deals and with private equity and sovereign wealth funds.
2020 was a slow year for acquisitions in the oil and gas industry. Particularly in the first half of the year activity almost stopped. This is of course associated with the disruptions caused by the COVID-19 pandemic and the related drop in demand and oil price. The second half of 2020 saw a reasonable recovery, primarily through a number of sizeable deals in North America. However, the overall upstream deal count in 2020 was down by 40% compared to 2019, and the total deal value was down by 50%.
But now in 2021, activity levels have already picked up significantly as the world and the sector started to recover from the crisis. We expect this to continue. Companies will reflect on the new reality, the opportunities and threats it brings, and rethink their strategies. This will inevitably lead to more assets changing hands.
Historically though, many M&A deals have failed to deliver value. In this article, we share our insights on the key decision-making and valuation approaches that are required to avoid such under-delivery. These insights are based on our extensive experience in large and small oil and companies, with acquisition and divestment deals and with private equity and sovereign wealth funds.
While this article is written from the perspective of asset acquisitions, similar principles apply to divestments.
First-principles – strategic ambition
Firstly, executives should decide whether the asset under consideration fits with the growth ambition of the organisation. This can be in terms of geography, the lifecycle of the asset, the oil/gas mix, cash generation and desired footprint (CO2, technology, size). A clearly stated, tested and communicated strategy serves as an excellent first testing principle for an acquisition target. This applies to both large and small enterprises.
There are risks associated with organisational biases, that could be driven by over-ambition, stakeholder pressures, or over-confidence in the ability to deliver. To acquire assets purely for strategic ambition without proper valuation and due diligence is a recipe for value destruction. When oil and gas executives signal their desires to the deal team, these in turn may seek to find the information that confirms a positive view of the opportunity and ignore the data that doesn’t. Also, the fear to miss out on potential industry gold rushes (new plays opening up) can lead to such value destruction, except possibly for a (few) lucky, early movers.
Ability to add value – the best owner
When considering the acquisition of an oil or gas asset, it is critically important to assess whether as a buyer you believe you are a better, or the best, owner of that asset. In order to avoid paying the full asking price, the value upside needs to be recognised that the seller doesn’t appreciate. This can come from multiple sources. Examples are the identification of resource upsides, supply chain opportunities, application of technology or operational strengths and fiscal positions. A comprehensive inventory of these upsides is important, whether a numerical value can be attached to them at the evaluation stage or not. It is important that potential co-venture partners or regulators, who may need to approve the deal and/or future budgets, will share your views and welcome you as a better owner.
Assessing upsides to you as the new owner can be challenging when there are many unknowns and uncertainties, pre- or post-due-diligence. If you are already in the asset or the play and want to deepen, these will be less of an issue than for a greenfield opportunity away from your current expertise. The valuation of brownfield developments tends to be well understood by the industry and the competition. In case uncertainties and risks cannot be assessed and reduced pre-deal, deal structures can help to tackle these. Such constructs include for example contingent payments and risk-sharing.
Valuation of oil and gas deals – the pitfalls
The next step is to generate a numerical valuation (e.g. in terms of intrinsic business value, free cash flow and/or payback time) and hence the price you are willing to pay for the asset. Apart from the economic valuation, impact on the financial health of the acquiring organisation needs to be equally well understood.
A proper economic valuation incorporates an assessment of uncertainties, risks and up-and down-sides. It tackles items such as:
- The range of recoverable reserves, the associated costs and production timelines, abandonment liabilities
- Commodity price scenarios (and hence revenues) over time
- Taxation of revenues and deal consideration, potential changes in fiscal regime, carbon tax requirements
Establishing a view of the value and oil and gas asset to the seller helps to determine the offer price (deal consideration). Ideally, this comprises an assessment of both the economic, financial and strategic value to the seller.
We have encountered a number of pitfalls that can undermine the validity of a valuation. Whether it is a large or small deal, in general, there are many (potentially dependent) variables, unknowns and uncertainties. This makes it impossible to define the value of an asset within a narrow range. Obviously, the proper valuation range is smaller for brownfield developments than for greenfield opportunities (e.g. away from the current organisation’s expertise, its footprint, or into an under-explored or under-developed play). Yet, there is often a desire to narrow the range of the valuation in order to help decision-makers. This may lead to a biased valuation, an unrealistic perception of remaining uncertainties, or to a loss of deal speed.
Our experience shows that instead of claiming that this asset is worth 200 MM USD, it is much more helpful to decision-makers to make statements like there is an 80% probability that this asset is worth between 100 MM USD and 300 MM USD. Furthermore, to deliver more than 300 MM USD depends on our ability to bring drilling costs down by 20% compared to our base scenario, etc. There are approaches such as scenario analysis and probabilistic economics to calculate this range in a practical manner. To do it is important that the underlying data, assumptions and future possibilities are understood, credible and documented.
Decision-making for asset acquisition in oil and gas, and delivering value from the deal, is very challenging for a number of reasons. We have shared some of the pitfalls we have seen in the industry and suggested ways to avoid them. Being aware of these pitfalls and implementing ways to deal with them will help companies and investors in making the best possible deals.
ValVestris’ experience with oil and gas deals
We have seen and analysed many oil and gas deals across the industry, all around the world. Some of these were very material, in the order of $ billions, and others much smaller, of $ millions magnitude. A significant number of them have fallen far short of their initial valuations, but some have delivered material value to the acquirer.
We have a deep understanding of the technical and operational components that are important, the field development scenarios that may unfold, and the key drivers that ultimately determine value from the deal. We have extensive experience in creating and implementing commercial constructs that cater for possible technical outcomes. These mitigate against downside risks, yet make sure that upside value can be captured. Most importantly, we have the ability to integrate the two and offer solutions that maximize value.
Finally, we offer a fully independent view of the value of the deal. We look at the ability to add value to the asset, at competitive strengths and weaknesses, and at the valuation. We provide an honest and objective assessment. Biases that may exist in the client organization do not affect us. If you are considering an acquisition or a divestment and want to know more, please get in touch with us.
Johan Pieters is the former Vice President of Internal Audit at a major International Oil Company. Prior to this position, he held many executive roles in M&A and oil and gas field development.
Paul van Rijssen is the former global head of Business Development at a major International Oil Company. He is currently a partner at ValVestris and specializes in Mergers, Acquisitions & Divestments, Investment Appraisal and Strategy Development.
Both Paul and Johan have close-range experience with the Shell BG merger in 2016 and many other major oil and gas deals.
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