For investors of a certain vintage, the perception of the average oil and gas executive is still influenced by watching JR and Bobby Ewing make (and lose) their fortune in Dallas during the 1980s. Brash, immensely self-confident and often reckless – they are seen as risk-takers destined to either win big or fail miserably. 
As with all stereotypes, it contains more than a grain of truth. In an industry where even a ‘low-risk’ exploration well only has a 33 per cent chance of being successful, a CEO must be able to retain the confidence of the capital markets, irrespective of whether his company discovers oil or not.
Unfortunately, it is these very qualities that will prove the greatest obstacle to further consolidation in the energy sector.
As the price of a barrel of Brent crude declined from a peak of $115 to a trough of $47 in the space of seven months, the fall was mirrored in the share price of UK exploration & production (E&P) companies.
Performance of indices over 2014
Source: FE Analytics
Investors and analysts repeatedly adjusted valuation models in an attempt to keep up with the move, frantically trying to calculate which companies may fail to survive the paradigm shift. When panic sets in, investors often overreact.
Faroe Petroleum, with producing assets in the UK and Norway, saw its share price decline to a low of 59p despite having a significant net cash position and a number of oil and gas hedges underpinning its budget.
Larger oil companies, able to look through the noise of short-term oil weakness, are almost certainly closely monitoring such opportunities. This does not necessarily mean investors should expect a flood of deals.
Current valuations of E&P stocks reflect little in the way of upside optionality from any future exploration success. Anyone fortunate enough to spend time with the chief executive of an E&P company will know they all have stakes in prospects with significant potential.
In management’s mind, any investor willing to sell at a price which merely reflects a slight premium to known and producing assets must be insane! If a targeted company’s board is going to recommend a takeover approach, in all likelihood putting themselves out of a job in the process, it needs to be a knockout offer.
Sadly, in the current environment, few buyers share that same degree of confidence about speculative exploration assets. An impasse is reached, which will remain until some catalyst causes either side to reconsider their position.
Such events, though, happen fairly frequently in the E&P sector. Companies like Valiant Petroleum and Salamander Energy were acquired at levels far below their peak share price after disappointing exploration results led to both entering a ‘formal sales process’.
Any industry experiencing as seismic a shift as the oil and gas E&P sector has suffered in the past year will take time to find a new equilibrium. It makes perfect sense for acquirers to make lowball bids to test the vulnerability of their prey; equally, targets are right not to forgo all the upside optionality of their exploration assets.
This may cause the expected wave of M&A in the sector to take longer than expected to materialise – but it does not mean that it will not happen. Unlike the Ewing’s, vulnerable management teams should not expect to wake up and find the past year has been just a bad dream.
Neil Veitch is manager of the SVM UK Opportunities fund. The views expressed above are his own and should not be taken as investment advice.
