PetroGrand and Shelton Petroleum, why small E&P companies fail and the need of consolidation

2015-08-20 19:05, Edited at: 2015-08-21 13:12

The drop in oil-price has put many smaller E&P companies into a state of crisis, cash flow today is often negative and many companies do not have the financial assets to sustain normal operations. While some still manage to be profitable they rarely have the resources to further develop their assets resulting in decline of production and devaluation of their oilfields.

I have closely been a part of the oil-market on an everyday basis for the past 4 years and I see a clear pattern. “Successful” small E&P companies today often sit on a high quality asset that they have managed to bring into profitable production, often through the drilling of new wells or through heavy workovers on existing wells. Through their work they have managed to increase oil production while the general and administrative expense has decreased to a level where investments into their oil-fields in some cases can be self-financed.

Seemingly many of these successful companies are doomed to fail despite their success, why you ask?

The answer is quite simple: Oil price volatility.

The time it takes to develop an oil asset is often in the range of 4-6 years (less or more in some cases). During this time and for some additional years the company will invest most of its profits into further developing their assets and it is not rare to see some companies taking on debt to accelerate their operations. With a fixed oil-price this business model makes sense. In reality it is flawed.

Looking at the volatility of the oil-price for the past 10 years the probability of a E&P company to have 4-6 consecutive years of stable oil price is extremely low. Today the oil-price hit a record low; E&P companies that stand “strong” today are the ones who have managed to build up a strong base of cash and cash equivalents. They can survive the “storm” and take advantage the reduced costs of oil services that come with the decline in oil price. They also have the strength to acquire smaller bleeding companies which will increase in value if the oil-price rises back to old highs.

In other words they can become well positioned to benefit from the volatility of the oil price. It is however obvious today that small E&P companies are simply not strong enough to handle the existing volatility in the market, a volatility we always knew existed.

In a sense this “epiphany” seems naive, it is well established that the oil-market is associated with substantial risk and that most companies will fail, I do however believe that more companies have the ability to survive.

What happens today is that these “successful” small E&P companies get a couple of years in the limelight during times of high oil price, the stock market loves them and bring their valuation to unexpected highs and everyone is happy and positive minded about the future.

The oil price then decreases slightly, investors move their money to safer assets and the share price drops, often quite heavily and not in parity with the actual oil price. At this stage the board and management of these companies take little or no action until it is too late. From my experience a lot of people representing Swedish oil(probably abroad as well) companies have almost unrealistic expectations of their own assets, both in terms of the quality of the asset but also in terms of their own valuation. It goes to say the same about the shareholders of these companies.

The result of this is that when the decrease in oil price starts and no action is taken the companies get to a stage where it is no longer considered financially logical to ask shareholders for money through share issuances or similar ventures, this because the valuation of the stock is “unfavorable”.

At this stage the companies will not be able to sustain their own operations and will be forced to sell one or several assets (or even the whole company) at low valuations, effectively putting themselves years back in their development. Today it is noticeable that these companies should have had asked their shareholders for substantial amounts of money during the period of high valuation so that they are more adaptable to changes in oil price or other factors that might disturb everyday operations.

Plenty of companies refrain from doing these large share issuances because it is considered a sign of weakness and there is a general fear that the market will react negatively because of the dilution effect. Today the effect of this is that many small E&P companies instead need to be consolidated.

One has to realize that the average shareholders in these companies are not like the average shareholder in a large industry giant.

Many invest with the full knowledge of the considerable risks, often with a short investment span to benefit from the short term volatility that we see in all oil and gas companies.

The shareholders that choose to invest from a long term perspective do not seek to sit 10 years in a company that remains a small scale producer. A long term shareholder seeks to make an exit when the company is larger, stronger and a stable producer. This shareholder knows that this will take several years and that raising capital is a natural part of the life cycle of the company.

With that said companies like this should not be afraid to ask their shareholders for money during times of high valuation.

Of course sometimes share issuance is not a viable choice and this brings us to the title of this blog, PetroGrand and Shelton Petroleum and the need for consolidation.

After some unfortunate events E&P companies Shelton and PetroGrand today sit with a heavy cross-ownership. In this industry a cross-ownership of this magnitude has no strategical meaning, there are no apparent synergies and the cross-ownership instead generates diminishing returns for both companies.

After a recent acquisition made by PetroGrand both companies (depending on definition) are today oil producers. PetroGrand not taking into consideration their earlier ventures has been fortunate compared to Shelton. They have had a strong financial base and made their acquisition of a producing asset during this time of low oil price.

Shelton, based on their financial reports can no longer afford to develop their own assets and we see that their oil production is decreasing. The development of the PetroGrand asset is fully financed and they still seemingly have enough money left to manage G&A for several years. With this said not even PetroGrand will survive being a small scale producer like they are today.

Both Shelton and PetroGrand have, based on production and earlier profitability assets that could be considered out of high quality. While a cross ownership creates no synergies a merger (fusion in Swedish) between the companies could. It would very likely reduce administrative costs as well.

Together as a combined company the chances of becoming a mid-cap/large actor on the oil market are much higher than acting on their own. In the current environment it is so blatantly obvious that bigger is better, smaller companies struggle to survive on their own, as stated earlier, they simply cannot handle the volatility of this market. This is obviously true to larger companies as well but they have greater freedom to combat this.

Far from all companies will find success by discovering an “elephant” oil field. Instead the active search of synergies through M&As, joint ventures or other structure deals should be considered and become a more prominent activity among the companies dealt with in this blog, small E&Ps.

To further elaborate on the PetroGrand and Shelton case study:

A merger as defined by the Swedish companies act can because of different market listings only be made in one way. Shelton being on a regulated market and PetroGrand on an alternative market First North creates a situation where the merger of Shelton into PetroGrand (Shelton injected into PetroGrand) would require the approval from a 90 % majority during an EGM, and not only 90 % of attending votes but 90 % of all outstanding shares and votes. A process like this is therefore seemingly impossible.

By instead injecting PetroGrand into Shelton there would be a standard 2/3 majority requirement, this by number of shares and votes in the company and based on attending votes/shares during an EGM. A merger like this would also solve the cross ownership. PetroGrand shares held by Shelton would seize to exist before any payment would be issued.

The nature of the merger would result in Shelton acquiring Shelton shares (previously held by PetroGrand). These would by law over time seize to exist by becoming invalid. Cross ownership solved.

The only limitation to this is the valuation process which given the situation must be quite tedious.

During mergers the share price of the merging parties are often used as a strong base in order to decide on what amount of shares are being paid out for every share of the transferring company. Shareholders (and very likely the management of both companies) probably (and in case of shareholders seem to) value their assets higher than the stock market does.

This is not strange as there might be some truth to this. The decline in oil-price is by far not the single factor to the low valuation of both these companies; I have dealt with this in earlier blogs. Realistically I do however not think that during a merger there is much room in the law to deviate too much from the market valuations of both companies.

Today both companies are valued roughly the same and depending on what the next financial reports show in terms of cash flow, profitability, accounts receivables and cash/cash equivalents it would to some degree make sense to value the financially stronger part at a premium during a merger (regardless of market valuation).

It can however be seen from another perspective, the market valuation is the reality; other valuations might or even should be considered opportunistic.

I will end this blog here, no need to summarize the content.

Notice to readers:

To a large degree this blog is based on my own experience of the oil-market and oil companies listed in Sweden, as a result some people might think I am generalizing too much.

Some of the content is based on my knowledge and own interpretation of information. To this relevant sources are Swedish Companies Act (Aktiebolagslagen) whole of 19th chapter. Whole of 23rd chapter but specifically paragraphs § 15, §.

All in all a reader will have to take the blog as it is, if you have other experiences conflicting mine please share them! You can write in Swedish or English. The only reason I write in English is because of the vocabulary of this industry being more evolved and easy to use in English rather than Swedish. I am also very aware that some fragments should probably be revised or that the grammar might even be incorrect. My intentions are not to write a report or essay on the topic but rather to share my thoughts. I will not really spend any time proofreading this. As I said, a reader will have to take it as it is and I think regardless of unrevised fragments and potential flaws in grammar my point comes through quite effectively.