At a time when the industry appears eminently investable, the appetite for investment in oil and gas services has still not returned.
During the pandemic, oil and gas demonstrated its resilience and criticality. Huge strides have been made in both decarbonising operations and investing in accelerating the energy transition, not just by the supermajors but right across the oilfield services (OFS) supply chain.
With strong commodity prices leading to substantial earnings growth across the sector and a renewed focus on energy security—giving long-term visibility—the oil and gas industry is now a strongly performing segment.
Despite this, many investors see it as one to be avoided. Indeed, some institutions categorise OFS alongside firearms and tobacco. For an industry that has played a huge role in extending life expectancy and improving quality of life, keeps the lights on, is a critical component in thousands of everyday products, employs hundreds of thousands of people and is currently paying around £45mn ($53.4bn) in tax in the UK alone every day, this is extraordinary.
This negative sentiment appears largely driven by the continued, uninformed demonisation of the broader fossil fuel industry among some in Western society, reinforced by the media, and—as a consequence—by politicians.
Regrettably, there seems limited rational debate around the implications of solving the energy trilemma—security, affordability and transition. Many fail to grasp the length, complexity and nature of the energy transition. Oil and gas companies are deploying huge amounts of capital to invest in new energy technologies. This investment will decarbonise the oil and gas industry, drive energy efficiency and significantly increase renewable energy capacity. The cost of intermittency remains the single biggest barrier to renewable energy replacing traditional power generation and fuels.
The Chinese leader, Xi Jinping, recently stated that China will reach peak fossil fuel usage when the renewables industry is ready to displace it. On this basis, China will fully replace fossil fuels only when it has built sufficient alternative energy capacity. In contrast, the European strategy often appears to be to abandon fossil fuels before we have affordable and secure alternatives.
The stark reality is that the energy transition will not happen in the next decade. Oil and gas will still be a meaningful contributor to meeting global energy demand for the next 30–40 years and will require long-term financing.
Investment is urgently required in skills and capacity. The labour market is tight, with people having left the industry and some vilified for working in it. There has been limited investment in new assets and equipment for six-to-seven years.
Many owners of OFS businesses are looking to exit but have faced a slowdown in M&A activity despite the strong fundamentals in the sector. In many respects, the trading multiples of listed OFS companies and the acquisition multiples implied by recent M&A deals look attractive relative to many other industrial sectors.
The recent upward share price movements of the listed global OFS companies, following generally positive earnings updates for the third quarter of 2022, demonstrate that institutional investors are starting to re-rate the OFS sector and reward companies for underlying trading performance and positive statements on outlook. This is a positive sign and suggests capital markets may now be drawn back to OFS based on core financial metrics.
Private equity opportunities
Increasingly, private equity investors appreciate the positive outlook and see the potential for investment returns in the sector. However, many private equity investors are constrained by those who commit capital to them—the limited partnerships, largely pension funds and institutional investors, who are swayed by anti-fossil fuel rhetoric and ESG agendas. This could, of course, change after this coming winter if we experience blackouts across Europe which, in turn, may dramatically shift public opinion.
It is likely more private equity funds wake up to the fact that there are new investment opportunities in OFS. Some are already looking to acquire targets, potentially at lower values, before others come back into the sector and drive prices up. There is a particular opportunity for generalist private equity funds which are not saddled with an existing OFS portfolio and can judge each opportunity and each sector on its own merits.
The US market is seeing the effects of greater capital discipline among both the operators and their supply chains. Some investors perceived that executive management was rewarded in prior cycles for growth in Ebitda, not shareholder returns. Increasingly, executive incentives are being tied to shareholder return performance metrics. As this change in emphasis flows through the sector, investor interest in OFS could improve.
UKCS investment phase
The UK continental shelf is potentially on the verge of a very interesting investment phase, with several new oil and gas developments nearing FID; the 33rd exploration licensing round with four priority, fast-track clusters; the first ever carbon capture, utilisation and storage (CCUS) licensing round; the Intog seabed lease round, which is largely predicated on using offshore floating wind to decarbonise existing oil and gas assets; and the Scotwind leasing round, which will drive investment in almost 30GW of new fixed and floating wind. We could potentially see a situation where there are significantly more projects demanding capital than there is capital willing to commit. These projects will compete for the same supply chain and will, in aggregate, require massive investment.
Globally, there is almost no new rig or vessel building. Traditionally, these critical assets were not financed by private equity or investor groups but by industrial companies and specialist financing groups via their own balance sheets. The rig and vessel sectors remain highly leveraged from prior downturns, and speculative investors now lack the confidence in predicting the long-term demand outlook for these capital-intensive assets. Rig and vessel availability and day rates are the key cost component for offshore projects, so as these markets tighten, this will add inflationary pressure for the offshore sector. This in turn places a premium on technologies and solutions that can meaningfully reduce rig and vessel days.
OFS operates in several discrete geographical markets. The Middle East now appears a much more investable region given the extent of hydrocarbon reserves, low lifting costs and increased production targets. While Middle East producers understand the importance of decarbonising the industry, there is much less societal pressure to block oil and gas developments, so the region will become the fulcrum of hydrocarbon activity for decades to come. Middle Eastern NOCs want to maximise their single biggest economic asset and are therefore happy to play the long game.
Recent geopolitics demonstrate that Saudi Arabia and the Gulf Cooperation Council countries are not prepared to ramp up production and hence constrain oil prices at the behest of the US and Europe. As a result, M&A activity is, and will remain, relatively buoyant in this region. OFS businesses with a strong footprint in the Middle East or relevance in that region are attractive to both established Middle Eastern buyers and Western buyers looking to move into the region.
Opec+’s decision in October to take 2mn bl/d off the market demonstrates there is no current shortage of oil. Despite EU sanctions on Russian oil, the war in Ukraine has driven Europe into a gas crisis, not an oil crisis. A European gas crisis reverberates around the world due to supply and demand fundamentals, particularly in LNG.
Gas is widely seen as the transition fuel and is thankfully therefore less “demonised”, so investors now make the distinction between oil and gas.
Carbon capture and storage
CCS, a major solution to the gas emissions problem, is now moving forward as a mainstream sector but is still at a very early stage, with few schemes being investment ready. CCS is a new market for OFS businesses, which can drill injection wells, supply reservoir engineering services, build pipelines and provide project planning. Many traditional OFS companies are repositioning as energy services companies and will lead innovation in decarbonisation, clean gas technologies, geothermal, hydrogen and CCS. Others with an offshore focus are leading in offshore wind and other marine energy markets. The ability of the OFS industry to rapidly pivot and lead the energy transition should enhance its appeal to investors.
From a UK perspective, Norway appears an exemplar for national energy stewardship. One of the most environmentally friendly countries in the world, Norway has an abundance of oil and gas, has recognised that hydrocarbons will be needed for several decades and seems committed to capitalising on global energy prices and energy security concerns by maximising production. The country may well ultimately squeeze every barrel of hydrocarbons it can out of the basin for the benefit of the nation as a whole. As a result, Norway has a buoyant OFS industry, today the profits of which are invested into the energy transition, and it leads the world in decarbonising and lowering emissions.
The energy transition creates an enormous opportunity for the OFS sector, not only because of the critical role oil and gas needs to play but also because of the sector’s ability to act as lead innovator in all these new energy markets. This environment should create a compelling backdrop for investors to re-evaluate their appetite for the sector.
Mike Beveridge is the vice chairman of energy & power investment banking at Piper Sandler.
This article is part of our special Outlook 2023 report, which features predictions and expectations from the energy industry on key trends in the year ahead. Click here to read the full report