No sector of the economy should be considering the urge to merge more than Canada’s beleaguered oilfield services (OFS) business. The signals are powerful: overcapacity in virtually every product and service line; prices down to slimmest of margins; bankers are unhappy and getting twitchy; shareholders are morose and OFS operators have to do something because doing nothing is no longer an option.
The short- and medium-term outlook is not promising. Oil prices are going down, not up. The recent nuclear deal with Iran will continue to overhang well-supplied world crude markets into next year. Even if oil rose sharply tomorrow, Alberta would still suffer from heightened uncertainty until the royalty issue is clarified.
New oil sands projects are dead. LNG is paralyzed by price, cost and global market turmoil. E&P companies looking to drill are demanding the lowest prices possible. Bankers who have been patient for months cannot kick the forbearance letter can down the road forever.
Because of a collapse in business, along with oil prices, oilfield service managers have been cutting costs since late last year. Workers have been laid off by the tens of thousands. Capital spending and maintenance programs have been slashed or postponed. Discretionary expenditures like travel and entertainment have been cancelled. Pay cuts have been instituted. Dividends reduced or eliminated. Principal payments postponed where possible. Related: Toxic Waste Sullies Solar’s Squeaky Clean Image
The last major expense not yet addressed in any meaningful way is a measurable reduction in administrative (non-revenue generating) costs per dollar of revenue. This is the CEO, COO, CFO, VP marketing, HR manager, safety officer and corporate head office. Reduced expenses for field service locations and product and service delivery. Increased purchasing power in other words.
How do you do that?
Selling out is ideal because operating the company is no fun at all. The problem in cyclical OFS is valuations are at multi-year lows. Owners will want to sell from last year’s numbers and buyers will be focused on 2016. Businesses sell at a multiple of cashflow and there’s very little free cash flowing.
Consolidation by merging with one or more competitors is a way to preserve equity in a business and sell at a future date when valuations are higher. Exchange control of the current organization for a meaningful but smaller equity interest in a bigger and more efficient entity with a greater chance of success. Reduce administrative costs in a meaningful way as a percentage of revenue and, in the process, put together a strategy an unhappy and skeptical banker might believe.
It’s already underway. The granddaddy of all mergers is the US$35 billion combination between Halliburton Co. and Baker Hughes Inc. Announced last November and approved by shareholders in March, closing has been extended to later this year to deal with anti-trust concerns. There will be massive fixed cost reductions when this deal closes. The second-largest OFS company in the world is getting into fighting trim to profitably service its clients even if oil stays below US$60 forever.
Closer to home, Canadian publicly traded drillers CanElson Drilling Inc. and Trinidad Drilling Ltd. agreed to tie the knot in June for exactly the same reason. One public company, not two, and a commensurate reduction in administrative costs as a percentage of revenue. When the two companies start consolidating fixed support costs, savings will be in the millions of dollars annually. Related: Can A Carbon Tax Save Canada’s Oil Sands?
This is not new. The emergence of successful giants Precision Drilling Corp. and Ensign Energy Services Inc. from the battered private contract drilling industry of the 1980s are but two of the more successful examples.
And this is what clients want. Oil companies lost a lot of the upside of $100 oil to high costs and low productivity. One growing trend is doing more business with fewer vendors. It costs a lot more to deal with hundreds of suppliers generating thousands of transactions, each requiring quotes, reviews, purchase orders, field tickets, invoices, back office processing and payment.
Why aren’t more OFS operators combining to cut costs and give clients what they want: more efficient organizations capable of working at current prices and margins? The two biggest issues are valuations and egos.
On the valuation side, it is easier being public. The market determines value every day. You may not like the price, but the number is there. It’s impossible to ignore and the investment is indeed liquid.
Private companies are different. Valuation is based on a variety of factors. The smaller the company, the lower the multiple. Many owners are not sophisticated in matters of valuation so their default opinion invariably lands on the high side. Too many companies don’t have quality financial statements or detailed internal reports needed for third parties to make a quick and accurate assessment.
Valuations are at a major turning point. There are still fond memories of what the business was worth in 2014 and a reluctant, but growing, realization that in 2016 it is only going to be a fraction of that amount. There is said to be tons of money on the sidelines looking for OFS investment opportunities, both debt and equity. However, new investors are only interested in how the business will do next year. Last year is fast becoming a reference point, something to compare with if oil ever hits $100 again.
But if you merge with a direct competitor, the valuation methodology will be easier because you’re both in the same business, own the same assets and operate in the same market. Related: ExxonMobil Could Turn Guyana Into A Major Oil Producer
As for ego, for business founders and owners it comes with the territory. Entrepreneurs who have started their own company and succeeded are rarely short of confidence or self-worth. It’s in their DNA. They are highly competitive and reluctant to trust their competitors. That’s why they started their own business in the first place. At some level they believe they are smarter than everybody else, certainly those they compete with.
This manifests itself in “corner office syndrome,” the corporate finance term for one of the greatest obstacles to consolidating competitive businesses. The CEO, founder and owner cannot conceive how the business could possibly go forward without him or her at the helm. It’s all about control, even if it isn’t really there because of the balance sheet or business environment. Therefore, even when a merger makes sense for owners, investors, lenders, customers and even most employees, egos too often get in the way.
So all too often merger discussions never get past the first meeting. Who’s going to run it? This is perhaps counterintuitive to the uninitiated. But anyone with experience in mergers and consolidations knows the person who would benefit most financially from a corporate combination—the founder, boss and major shareholder—is too often the greatest obstacle to crystallizing at least some of his or her investment and sweat equity in a smaller but less risky ownership position in a larger organization with a less challenging future.
If conversations haven’t started already, OFS owners and managers should be thinking hard about becoming part of bigger entities with a better chance of surviving in a shrinking and intensely competitive business environment. If you can survive and succeed on your own, that’s great. If you can’t, be realistic and protect as much capital as you can.
By David Yager for Oilprice.com
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