Sub-Saharan Africa oil industry faces crude reality

By Rolake Akinkugbe, head of energy and natural resources at FBN Capital

The big picture

Brent crude oil prices have fallen by more than 60% since June, in a downward spiral that historically could be one of the most challenging periods for Africa’s oil and gas sector. 

During the past four years, the US’s bid for energy self-sufficiency has ruffled sub-Saharan Africa’s (SSA) main producers, principally  Angola and Nigeria. Predictions made a decade ago about rising imports of West African crude – then forecast to reach 25% of total US crude imports by 2015 – into North America, now seem naive in light of the shale oil and gas revolution. 

Since 2011, the US has added three million barrels per day (BPD) in new crude oil capacity to global markets, largely thanks to unconventional production. In the same period, US imports of Nigerian oil for instance have dropped by more than 80% and, on the last count, were down to near zero.  

The impact of shale growth on oil prices is startling. With little sign of output curbs from the world’s only oil cartel OPEC, both main global benchmarks – Brent and WTI - have fallen below $50 per barrel (bbl) as the supply glut overwhelms sluggish oil demand.   Demand is unlikely to be stimulated to rebalance the market in the short term even with current oil-price lows 

Since the economics of upstream ventures is in peril, many operators will have to trim their spending plans, postpone or cancel new projects, while trying to maximize existing production. Even if global demand stages an uptick it will probably be quickly met by the excess supply, while a reversal of the downward price trend could put many of North America’s small shale producers back on track to fracking investment . The industry would quickly enter a vicious cycle.

SSA’s exploration and production frontiers The West Africa and Gulf of Guinea regions account for a third of the world’s new oil discoveries. According to the US Geological Survey, the West African coastal province has an estimated 3,200 million barrels of oil. Offshore oil production now accounts for an average of 70% of the region’s total output. 

The depletion of onshore and shallow-water fields has compelled a move further offshore for those with technical expertise and financial capacity; International oil companies (IOCs) have been the pacesetters offshore. That new focus has brought with it advances in deepwater, pre-salt exploration, and even a search for oil in Africa’s unconventional onshore areas. 

One consequence of the shale revolution is that drilling technology used to exploit unconventional wells in North America have made it possible to reduce costs elsewhere through technology transfer. This phenomenon would also account for the gradual decline in break-even costs for offshore West Africa projects, which would have been in the region of $120/bbl a decade ago, but now average between $40/bbl and $50/bbl.

Still, many oil and gas projects are at risk. Projects that are yet to reach Final investments decisions are the most vulnerable to deferral. SSA has several frontier exploration regions, such as the West African Transform Margin, which primarily feature high-risk exploration assets, and are dominated by large, medium-sized and small independents. 

In more mature markets such as Angola and Nigeria, IOCs lead oil-production market share. As a result, response strategies amid the oil price fall are likely to be different across the full spectrum of players in the region. Companies that are able and willing to quickly adopt a ‘counter-cyclical’ strategy will be best positioned to endure the price storm.

How different players might respond

In 2014, IOCs in West Africa were big drivers of the M&A market as they sold many non-core assets to niche buyers or smaller local players. IOCs’ move to the offshore constituted a major boon for production in deepwater, since many of those projects are typically funded from IOCs’ internal balance sheets and less through bank debt. 

Within SSA, more than 60% of producing oil and gas assets is located in West Africa and the Gulf of Guinea. The risk weighting assigned to investment decisions on near-term production assets would likely tip the bucket in favour of West Africa. Many IOCs have portfolios of assets across both African sub-regions, and the economics of East Africa’s liquefied natural gas (LNG) projects are already being tested in the current climate. This is because gas due to be sold from East Africa’s LNG would most likely have oil-linked contracts, that could pose a threat to LNG project profitability in light of falling oil prices.

As a result, any attempts by IOCs to rationalize their asset portfolios in the current climate would most likely result in retrenchment in East Africa LNG projects that are yet to be developed. 

In 2015, it is also possible large IOCs with a diversified regional footprint could choose to dispose of assets in non-core countries. The majors and large independents are estimated to hold around $9 billion of assets in countries described as non-core – such as Shell in Gabon or Canadian Natural Resources in Cote d’Ivoire. 

Frontier drilling in West Africa is led by small and mid caps. For these smaller players, short-term exits are possible, though exploration asset farm-ins might still prove attractive to globally diversified larger independent companies. 

A key challenge of the current price cycle is that the trickle-down effect that independents enjoyed during the last commodity price upswing has diminished. Then, the fortunes of large IOCs such as ExxonMobil and Shell were closely locked-in with the small firms – that is, the tradition of independents farming down assets, once discoveries have been made, to the bigger players, was prevalent. Now, IOCs might not want to play that game, given capital constraints and portfolio rationalization.

Spending and funding expectations

With more than 70% of capital expenditure (capex) on many development and production assets in the West Africa/Gulf of Guinea region already sunk, operators are unlikely to cull back production given the need to recoup costs. Some might actually choose to store production in the hope of a price upswing. 

Where capex is being shrunk, this will primarily be in the area of exploration. Anglo-Irish independent Tullow Oil,  for instance, in January announced it would shrink its 2015 exploration capex to just $200 million from $1 billion in 2014 – an 80% drop. For those with little flexibility to tweak their portfolios, who struggle to cut discretionary spending, or who ended 2014 highly leveraged, plans to divest or sell might be in the offing.

On the buyers’ side, those with the financial muscle to benefit from the current price weakness could take advantage of asset and corporate acquisition opportunities, particularly as the gap widens between market valuation and core net asset values (NAV) for many African independents. This trend would be accelerated due to the rising cost of capital in a high--risk environment. 

Many upstream Africa-focused independents are now trading at up to an average discount of 41% of their NAV. For some potential targets of acquisition, the negativism might be overdone, since the oil-price environment belies what are otherwise sound fundamentals and good asset footprints. Still, they could be attractive targets for the cash-rich buyers who are fully funded and can rely on healthy cash flows.

The volatility of current prices will also create greater mismatch between buyers’ and sellers’ expectations, with the latter prone to viewing the current rout as a short-term hitch and thus reluctant to lose value on deals. 

Nevertheless, in markets such as Nigeria, a softening in valuation premiums is possible. Bids for IOC assets in the past 24 months in Nigeria sometimes came in at up to two-times the market consensus. Conservative bidders for Nigeria's IOC asset sales were always sceptical about pricing, even when oil prices were north of $100/bbl. Their more bullish counterparts might now pause for thought, given the current bear market.

The difficulties of attracting finance at sub-$50 oil

Oil production in the West Africa and Gulf of Guinea region alone could reach eight million BPD by 2020.  The capital requirement needed to reach that production figure is estimated to be somewhere in the $40 billion region. However, it will be difficult to attract capital at reasonable costs.  Debt financing limits are already being seriously tested in the African market, even for de-risked assets.  Financial institutions are hardly exempt from current market jitters. Many face limits on credit exposure to upstream exploration and production. Banks in the region have issued nearly $20 billion in reserved-based loans during the past six years, and the coming medium-term focus will be on the restructuring and refinancing of existing exposures. 

Equity markets have been a major source of funding for Africa-focused E&P firms in the past few years – representing an average of 46% all new issues on LSE/AIM in the past five years (versus average of only 7% in the previous five years). Since late 2014, however, investors have penalized Africa-focused oil and gas stocks heavily in the current oil-price environment. The massive sell-off saw oil and gas stocks plunge by as much as 40% in one day of trading in 2014. 

These dynamics will test the ability to launch IPOs in the next 12 months. While alternative capital markets, such as bond markets, might also be sought to finance new development opportunities, the impact of quantitative-easing tapering in the US means the low-interest rate window made available in the past 24 months is being squeezed. 

For smaller local oil producers, with marginal assets, the focus should now be how to optimize field output. Some might even prefer to incur minor operating losses than face the prospect of parting with hundreds of millions of dollars in field decommissioning. 

Those not willing to yield too much equity will consider hybrid structures, such as mezzanine and other high-yield financial products. For top-tier borrowers, there might still be well-priced deals out there, but the current market rout and elevated risk perceptions have all set the stage for a difficult year for the E&P business in Africa.  Ultimately, companies with the necessary speed and flexibility to adapt to current conditions and little need for external funding in 2015 will emerge winners.

Rolake Akinkugbe is head of energy and natural resources at FBN Capital, Lagos, Nigeria. You can follow her on twitter @rolakeakinkugbe

ABOUT FBN CAPITAL FBN Capital is the wholly owned Investment Banking and Asset Management subsidiary of FBN Holdings in Nigeria, providing financial solutions to a broad range of high net worth clients, institutions and governments. FBN Capital offers financial solutions through five key divisions: Investment Banking; Markets; Trust and Agency Services; Asset Management; and Alternative Investments. FOLLOW FBN CAPITAL You can follow FBN Capital on twitter @FBNCapital Like us on Facebook    Follow us on Google+