Unblocking the pipeline: why the North Sea needs an innovative approach to deal-making
November 20, 2015
With a depressed oil price, you’d expect to see a buyer’s market for assets in the North Sea Basin. But that’s not the case. M&A deals are being stalled by concerns over massive and still unquantified decommissioning liabilities, along with lack of clarity over forward oil prices.
The industry urgently needs these deals to happen so assets can be moved into the ownership of companies that are likely to invest in maximising the lifespan of the Basin’s reserves. If the market doesn't get moving soon, we’ll start to see increasing numbers of offshore production assets coming under pressure as mature operators find better uses for their capital elsewhere. That could mean areas of the Basin being mothballed before reserves actually run out or fields locked in as assets around them disappear.
Concerns over decommissioning are nothing new. The oil price has been the catalyst for the current situation. Operators are making much less profit from assets that are, in many cases, just five to 10 years away from decommissioning. The companies coming in and seeking to acquire these assets are much smaller and less developed. And with minimal credit histories and/or asset bases on which to secure a debt facility, they’re struggling to obtain the letters of credit they need to put up as collateral. The inability to put a price on decommissioning compounds their difficulties.
So what can the industry do to deal with this problem and create some momentum in the M&A market? As well as re-evaluating how risk is assessed and split, we believe innovation in how deals are structured is critically important from now on. It’s not just buyers and sellers that need some blue-sky thinking. The massive tax implications arising from decommissioning make this a tripartite conundrum – government has to be closely involved too.
Right now, collaboration is in short supply. We need to see buyers and sellers working together on a bilateral basis to come up with a new approach. In the past, once a deal was priced and signed, the seller walked away from their obligations, subject to whatever contingencies might have hung over the agreement. That scenario’s no longer realistic. Parties need an innovative approach based on risk sharing.
How can a risk-sharing agreement be put together? You really need to look at the economic value derived over the lifetime of the asset. One recent deal we have seen brings this to life. The buyer’s banks had declined to provide a letter of credit, so the parties reached an agreement under which the seller would retain their share of the decommissioning costs in proportion to the perceived value they’d enjoyed from the asset. In this instance, it was determined that they’d already had by far the majority of the economic value, so they should take on the equivalent in percentage terms of the decommissioning cost.
Although that deal was done on a fairly simple basis, the underlying calculations could easily become much more complicated. You could base the risk share agreement on backward-looking net present values, for example, factoring in all the various capital expenditure on the asset over its lifetime.
The overall principle, however, seems perfectly fair. If you’re unable to button down risk quantum, such that it can be priced into a deal, then you have to have a deferred mechanism for pricing that quantum. And the risk share in that – the period of ownership and reserve extraction – seems like a fair way to proceed for all parties concerned.
Tax considerations will be critical, however a deal is structured. It should be borne in mind that decommissioning is an end-of-life cost, whereas profits and associated tax charges have accrued over the life of the asset. If you haven’t paid that tax, because you bought the field late in its life, you don't have the capacity to offset the decommissioning. In situations where decommissioning costs could exceed £100 million, that’s a major consideration.
If the new owner agrees to transfer back the decommissioning liability to the seller, they won’t have to pay decommissioning cost, but they’ll lose out on the 50 percent tax relief on decommissioning costs). If they instead buy the company holding oil licences, they’ll take on the seller’s tax capacity and be able to carry back the decommissioning costs.
Provided parties can find a way to push these deals over the line, it’s a win/win/win for all parties. The seller is getting an unwanted asset off their books. The buyer is acquiring an asset where they identify additional economic value. And the government’s happy because it’s in the buyer’s interests to push decommissioning out as far as possible, meaning the burden on UK taxpayers gets pushed further out too.
We’ve been exploring other approaches as well. An interesting angle could be for the ‘buyer’ to effectively lease the field and asset for a fixed period and then hand it back to the ‘seller’. In this scenario, the newco might lease a field for 10 years, and produce during that period, before returning it to the original operator for decommissioning. Another possibility could be for oilfield services companies to develop specialist decommissioning expertise that can be sold across multiple projects, giving them the opportunity to profit from the execution efficiencies that they develop.
Because of the age of the North Sea Basin, these are the first offshore oilfields in the world where considerations like the ones we’ve outlined here have arisen. That means we’re at the leading edge of how these deal structures can be made to work in practice. Provided the industry can come together to develop some solutions, there’s an outstanding opportunity to export this innovation worldwide.
Have you considered how a risk-sharing agreement can be put together? Share your thoughts below or schedule a meeting to discuss your situation in confidence.