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Due diligence: looking beyond financial performance

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Viken Chinien Viken Chinien
Head of due diligence, London, DNV GL - Oil & Gas

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With oil and gas industry mergers and acquisitions expected to pick up this year, buyers and sellers need to focus on more than financials during due diligence. Other key considerations include environmental and safety impacts of projects or assets.

Companies in the oil and gas sector are expecting increased merger and acquisition (M&A) activity in 2017 as a strategy to reorganize for the future, according to DNV GL’s seventh annual benchmark study capturing industry leaders’ priorities, concerns and confidence for the year ahead.

A third of respondents surveyed expect their organizations to increase M&A activity in 2017, compared with an already significant 23% in 2016. Overall, 78% expect increased industry consolidation in the year ahead.

Global professional services firm EY reports that it is starting to see an upwards shift in oil and gas deals as companies realize there may be a cost to inaction over potential or pending transactions.1 Deal drivers in the upstream sector, for example, include new transactions and refinancing to resolve distressed situations; greater availability of quality assets for acquisitions as companies accelerate portfolio optimization; the rise of creative deal structures, such as joint ventures, as parties seek to share project and capital risk; and a greater influence and presence of private equity.

“Because there is such a pressure on margins, there will be continual opportunities for companies with strong balance sheets to look for opportunities,” says Thore E Kristiansen, chief operating officer, exploration and production, and executive director for Portuguese integrated energy company Galp Energia, in an interview for DNV GL’s research. “I see this trend continuing in 2017 – possibly with greater urgency because buyer and seller expectations [on price] are getting closer.”

Some opportunities will stem from the five big international oil companies’ plans to sell some USD20-23 billion (bn) in assets this year. In January 2017, Shell sold up to USD4.7bn worth of assets in the UK and Thailand, for example.

So far though, there has not been a wave of mega-deals brought on by lower oil prices.

“I think this is down to increasing questioning of the big oil model, and because of the valuations in the marketplace, with few synergies working out at these levels,” says Edward Morse, Citigroup’s global head of commodities research for DNV GL’s study. “There are similar issues for medium-sized companies in terms of the struggle to agree valuations.”

As the big oil model comes under scrutiny, cost pressures are driving more industry collaboration. “Major oil and gas companies are becoming more dependent on smaller, more agile partners to develop certain discoveries, with the majors becoming predominately financiers towards some of these ventures, as opposed to implementing them,” says DNV GL’s Graeme Pirie, vice president, DNV GL – Oil & Gas. “Their simplification and cost optimization efforts, heightened awareness of breakeven pricing and risk sharing is driving them towards more joint venture agreements. Independents and smaller operating companies are a lot more nimble in their approach, as majors struggle with the realization that their present governance and work practices prohibit them from being cost effective.”

Diversification out of upstream oil and gas

Cost pressures aside, geopolitical factors are driving some companies to plan strategic moves towards decarbonization. Global energy supplier ENGIE, for example, is pursuing a transformation plan aimed at redesigning and simplifying its portfolio of activities towards a low carbon footprint and less exposure to commodity prices. As part of this plan, it has said that it could eventually sell its exploration and production (E&P) assets depending on the price.2

Maria Moræus Hanssen, CEO, ENGIE E&P, explains that the fundamental shift in ENGIE’s strategy is driven by decarbonization, decentralization and digitalization: “These three words describe the mega-trends that we see, and they are what we are aiming to reposition ourselves towards.”

She expects to see more oil and gas companies hiving off E&P businesses and anticipates private equity becoming a main buyer of such assets: “E&P used to be big companies, big corporates. Now I think E&P is going to be more and more about companies owned by private equity firms, who have very different perspectives and very different behaviour: a lot of these buy and turn around things.”

Non-financial due diligence for M&A

As increased M&A activity and expectations for new portfolio ownership models come into play, companies across the sector are taking on greater obligation to account for their environmental and safety performance in annual reports and other documents required by regulators and law.

Commenting for DNV GL’s research, Brian Sullivan, executive director of IPIECA, the global oil and gas industry association for environmental and social issues, says: “I am not seeing any compromises being made in response to the low oil price. Companies now view sustainability as part of their licence to operate, not as something that could be compromised.”

This trend is being given added impetus by the global decarbonization agenda. Indeed, only three per cent of senior oil and gas professionals say that their companies will be scaling down sustainability initiatives in 2017.

The industry’s appetite for continued sustainable practice will appeal to the investment community, which is seeking reassurance over environmental risks in deals. A cross-industry report published by PwC reveals that up to 40% of private equity investors have seen poor environmental, social and governance (ESG) performance as a reason to demand a material discount on a purchase price, or to walk away from a deal.3

“The potential or actual environmental liabilities associated with target deals across asset lifecycles can be substantial,” advises Elisabeth Tørstad, CEO, DNV GL – Oil & Gas. “Our due diligence teams provide regulatory compliance and management system suitability, safety, technical, commercial, and environmental due diligence for investing in or divesting oil and gas assets. They see that identifying and quantifying these risks allows purchasers and sellers to negotiate around terms and conditions that can make or break a deal.”

As the industry reorganizes, the trend toward smaller players owning and operating assets, and the anticipated greater involvement by private equity, creates greater need for technical expertise to support due diligence.

The PwC study suggests that private equity firms may be no less keen than current oil and gas asset owners to avoid unacceptable additional costs, fines or reputational damage. It finds ESG factors high up the agenda for private equity houses; more than two-thirds (70%) have made public commitments to invest responsibly across their portfolios. Of those surveyed, 44% plan to assess the impact on their portfolios of the United Nations’ 17 Sustainable Development Goals (SDGs), while 36% see reputation benefits in supporting these goals.

Meeting sustainability targets and requirements

DNV GL assists potential buyers and sellers of oil and gas sector assets to cost-effectively and safely meet business, regulatory and reputational objectives in the sustainability area. It can help the industry to align with the UN SDGs and with national regulations and initiatives implementing the COP21 Paris Agreement on limiting global warming.

To help minimize any negative aspects of oil and gas developments while maximizing positive impacts such as affordable access to energy supplies, DNV GL has developed a framework for benchmarking financial and reputational consequences of exploiting resources worldwide.

Maria Moræus Hanssen, CEO, ENGIE E&P
Maria Moræus Hanssen, CEO, ENGIE E&P

The framework measures total impact as the sum of economic, environmental and social impacts. It displays the results using a red-amber-green traffic light system. It is kept updated, and the results can be searched and visualized through the company’s online Resource Map.

“Our approaches allow better-informed decisions to be made on how and where to improve social and environmental performance,” Tørstad says. “Greater transparency on safety and environmental risk management processes and sustainability reporting will give the sector much-needed credibility and speed up sustainability improvements for competitive advantage.”


References

1 ‘EY Global oil and gas transaction review 2016’, EY, February 2017
2 ‘Engie CEO says in no rush to sell E&P assets’, reuters.com, 29 September, 2016
3 ‘Are we nearly there yet: private equity and the responsible investment journey’, PwC, November 2016

DNV GL's online Resource Map benchmarks economic, environmental and social consequences of exploiting oil and gas reserves. It displays results using a red-amber-green traffic light system.
DNV GL's online Resource Map benchmarks economic, environmental and social consequences of exploiting oil and gas reserves. It displays results using a red-amber-green traffic light system.

Disclaimer: 

DNV GL prides itself on providing accurate information but makes no claims or guarantees about the accuracy, completeness or adequacy of contents in this publication, and disclaims liability for any errors or omissions. The authors’ views here do not necessarily reflect DNV GL’s views.