Blockchain is by now known as one of the leading technologies of the 4th industrial revolution and is set to have an impact as far and wide as the internet did. This month Finance Monthly delves into the growing world of blockchain, its biggest uses and the top companies that are using blockchain in their corresponding sectors: Banking, Energy, Retail and Gaming.
Once treated with caution, blockchain technology is now expected to cause substantial disruption to the banking industry, as banks and bankers are consistently seeking use of blockchain technology in order to transform sizeable areas of their business. From payments, settlements and compliance or identification, the accessibility to a decentralised platform by multiple parties at one time, cost-effectiveness and security benefits are winning legions of fans within the banking sector. Some of the main advantages and usage to blockchain technology within banking are:
Payments – Banks are able to shift their payment systems on to blockchain (or at least part of) or for launching digital currencies.
Trade finance – Blockchain technology provides a modernised update that many feel is necessary when it comes to working with various parties on goods shipment. The technology simplifies the process by enabling numerous parties’ access to the same information, at the same time, removing the need for unnecessary paperwork.
Identity – Due to the cryptographic protection blockchain technology provides, it is able to share a constantly updated digital record at all times to more than one person, or company - Great for customer identification and ensuring trust between consumers and banks.
Syndicated loans – Ideal for managing the lifecycle of a loan, Credit Suisse has already adopted the fashion of putting syndicated loans on blockchain technology.
Blockchain technology promises to help the energy industry radically transform its processes and markets. Although one of the slower industries to adopt the technology, for those who have, one of the many capabilities on offer is the adoption of a peer-to-peer trading model, which changes the way in which energy is bought and sold.
The rise of renewable energy sources that connect back to a wider grid, has helped convert energy consumers in to producers, therefore letting them sell excess power back to the grid and cutting out the middleman; in short it connects those who want green energy, to the producers who can supply.
The other common use within the energy industry is within the development of cryptocurrencies for monetary payments – something only a handful of companies have begun to trial, such as MARUY.
There are a few areas within the retail sphere in which blockchain currency can add value. The first is with trust and transparency. With the rise of online shopping, it is harder for retailers to earn trust from their customers, as the human element of a company is essentially being removed.
Blockchain technology will help to support the transparency desired by consumers. Similar to banking, all parties involved – supplier, manufacturer, retailer and consumer – can all trace a products journey and history and therefore, reaffirms the trust between retailer and consumer.
A second and obvious use for the technology is of course with payments. Blockchain promises a shared ledger where all financial transactions are recorded, eliminating the margin of error within the transaction. Blockchain also permits retailers to bypass the fees of intermediaries with a currency such as Bitcoin – this offers all the benefits of traditional currency, but without transaction fees and reconciliation issues.
One retailer trialing the use of blockchain technology at present is Walmart. The US chain is using the technology within its food division. The retailer is able to identify and remove food from its stores that has been recalled and using blockchain, the company is able to obtain crucial information from its suppliers, on its food sources, to ensure all vital food standard requirements are being met.
Developments within the gaming industry are not uncommon and blockchain technology is now the next, or for some the latest, wave of disruption to the industry. The key shifting factor for gaming is taking it from a traditional hardware platform and on to the cloud, via a decentralized gaming ecosystem. Blockchain technology naturally lends itself to achieving this.
With blockchain, the gaming industry can be a much more enriching experience for gamers, as currently gamers – both casual and hardcore – invest a lot of time and money in to obtaining collectable, limited edition items within their games, however with the help of blockchain, they’ll be able to play and pay for their gaming needs using tokens, such as Playkey’s token, PKT.
Blockchain technology helps in this shift by encouraging owners of powerful gaming PCs and GPUs, to “rent” their servers to the individuals who don’t necessarily have the funds, or hardware they require, to play the games they desire. This means gamers will not have to invest in expensive gaming consoles and other hardware. The more developers look into blockchain technology, the more it becomes obvious that it is a natural transition for the industry.
Following this week’s news on a two year high for the Brent crude oil, Richard King, Trading Manager for Inprova Energy, discusses the current impact of oil price volatility on company energy bills worldwide.
Brent crude oil prices hit a two-year high of more than $58 a barrel on Monday 25 September. Although prices have since reduced slightly, analysts don't expect prices to fall back.
Outlook for oil prices
Oil price increases have been largely driven by cutbacks in supply from the oil exporting cartel OPEC. Market experts predict that OPEC will continue its deal to cut production beyond March 2018 as part of its strategy to rebalance oversupply in the global oil market. Market analysts expect the oil price to be within the range of $55 to $60 a barrel for the remainder of the year, with potential for higher levels in 2018.
In a further boost to recovering oil prices, US producers are struggling to fill the supply gap, and the independence referendum in Kurdistan has the potential to disrupt Middle East oil supplies due to the Iraqi government's call to boycott Kurdish supplies. Mounting political tensions between North Korea and the USA could also be a bullish force.
Impact on energy prices
This is having a knock-on effect on UK business energy market prices. Both gas and electricity contracts for delivery in the next few months have posted significant gains of 2-3%. This has reversed recent decreases in energy prices, linked to the currency improvements for Sterling against both the US dollar and the Euro.
Energy market volatility
Oil prices are firmly linked to wholesale energy prices, which will, undoubtedly, increase energy market volatility in future months. In addition, as we head into winter and uncertain weather conditions, and continue to face energy supply reliability problems from continental Europe, further price swings are inevitable.
Such volatility is becoming the new norm. During the past 12 months there was a 45% price swing in the wholesale power market, which was more than twice as volatile as the average movement of the five years prior.
Smarter energy purchasing
While overall electricity and gas commodity prices remain well below the levels reached in 2014, the sizeable commodity price movements underline the imperative of getting timing right when purchasing energy.
Flexible procurement strategies can be less risky than fixed purchasing because there is the facility to buy energy little and often when wholesale prices are favourable, rather than gambling that the prices are best on the day that you fix your purchase. There is also the facility to take advantage of forward prices, which are currently very attractive beyond 2018.
Above all, it is imperative for energy buyers to manage their energy purchasing within a robust risk management strategy, which will set price limits and guard against buying at the top of the market - helping to counter market uncertainty.
Below, Richard Smith, Director of Business Strategy at Inprova Energy discusses phase two of ESOS, the latest energy compliance rules.
Phase 2 of the UK Government's Energy Savings Opportunity Scheme (ESOS) has been given the official go ahead by each of the UK's environment agencies. This ends recent uncertainty surrounding the future of the mandatory energy assessment scheme, which was under review as part of the previous government's 2015 energy efficiency tax landscape reform.
Who does ESOS concern?
ESOS applies across the UK to 'large undertakings', such as organisations with more than 250 employees, or a turnover in excess of 50 million Euros and balance sheet worth more than 43 million Euros. It requires qualifying organisations to measure their total energy consumption and identify energy efficiency opportunities, but is not applicable to organisations that are required to comply with the Public Contracts Regulations.
There are four-yearly compliance phases. The first phase covered from 6 December 2011 to 5 December 2015 and phase 2 follows on from 6 December 2015 to 5 December 2019. Organisations that participated in ESOS phase 1 must repeat the exercise if they continue to meet the criteria, but cannot use the same data. There are also likely to be a number of new organisations that now qualify for the second phase due to a growth in employee numbers or turnover.
The scheme administrators have taken robust action to penalise organisations that fail to comply with phase one of ESOS. As well as fines of up to £50,000, non-compliant organisations are also 'named and shamed'.
How to comply with ESOS phase 2
Benefits of ESOS
Although ESOS doesn't yet require organisations to implement the recommended energy saving measures, there is powerful evidence of the financial wisdom.
From more than 150 ESOS audits completed by Inprova Energy during phase 1 of the scheme, our assessors identified energy savings opportunities ranging from 5 to 20%. This could amount to tens and hundreds of thousands of pounds worth of potential cost savings for typical sites.
Routes to compliance
Organisations can achieve automatic compliance with ESOS by gaining accreditation under the international ISO 50001 Energy Management Standard, which specifies the requirements for building, maintaining and continually improving a high functioning energy management system. When choosing this route to compliance, it is important for all of your organisation's energy data to come within the scope of your ISO 50001 certification.
Alternative routes include implementing ESOS compliant energy surveys to identify energy saving opportunities; commissioning Display Energy Certificates (DECs) with accompanying advisory reports; or Green Deal Assessments.
ESOS Lead Assessors may also be able to consider audit work undertaken within the four-year compliance period (2015 -19) as part of other energy audit schemes, such as activity under the Carbon Trust Standard, and Logistics and Green Fleet Reviews, where these meet the requirements of ESOS.
The environment agencies are encouraging organisations to begin the auditing process as soon as possible. In particular, the ISO 50001 route requires early action, as it can often take well over 12 months to achieve certification and put in place a high performing energy management system. Allowing plenty of time will also avoid the last minute bottlenecks experienc
Angela Knight, the former head of Energy UK, talks to ELN about whether she believes the government will go forward with the price cap.
By Magnus Walker, Director of Trading and Risk for Inprova Energy
To increase gains and avoid losses when playing the 'lottery' of flexible and volume energy purchasing, businesses must carefully manage risk, says Magnus Walker, Director of Trading and Risk for Inprova Energy.
He sets out a five-step process to help businesses prepare a risk management plan and trading strategy that can ensure resilience in the face of bullish wholesale commodity market conditions and sharp increases in non-commodity charges.
Don't dice with volatility
The wholesale energy market is incredibly volatile and unpredictable. Prices can move dramatically in response to market triggers - such as a cold snap, geopolitical instability, currency fluctuations or supply and capacity problems.
With professional help, this risk can be contained. It's often believed that fixed rate contracts are less risky than flexible contracts, which is a fallacy. While fixed rates do provide budget certainty, the odds are 1:365 of picking the day of the year when the market is at its lowest to fix a deal.
In comparison, flexible purchasing offers more opportunity to buy chunks of your energy volume at points in time when the commodity market dips.
The obvious danger is missing the market troughs and then purchasing energy when the market peaks because you're only watching the market occasionally. This is why any flexible purchasing strategy should be supported by a robust risk management system and trading strategy to limit potential losses by ensuring that you never hit the top of the market. .
A risk management process/system should identify the risks to be measured and valued, the company’s objectives and risk limits, and the amount the buyer is willing or prepared to miss out on. These risk limits or “triggers” should also account for unwind time (the time it takes to hedge a position) amongst other factors.
Seek sound advice and involve your board
To implement a corporate energy risk management strategy – rather than simply managing market risk, an integrated approach should be developed at board level.
Risk management is complex, so it's sensible to seek expert advice to carry out an initial forecast assessment using established and proven modeling techniques. This will highlight the options available and determine your appetite towards price risk.
It's important to quantify the potential risk and fully understand how a change in the wholesale energy price will impact your energy purchasing costs. From there, an optimum price and risk strategy can be agreed, implemented and monitored.
Reputable energy advisers, and some energy suppliers, can support you.
Understand risk management methods
There are various methods used to manage risk. In the case of market risk, ‘forward purchases’ of different contracts will help to mitigate the risk of leaving contracts until an inopportune point. For example, you could purchase a proportion of your expected energy requirements at a fixed price for the duration of the contract, then build up the remainder by purchasing fixed-price blocks on the forward market at different times.
Alternatively, you may link wholesale prices to a benchmark or index of market levels, but then include a risk management strategy to guard against sharp price moves.
Some larger energy users may also have their own on-site generation, trading surplus energy on the grid to limit exposure to higher prices.
Get to grips with limits
A risk management plan, in which the trader is only allowed to make purchases within a set range, can limit any potential market losses, but can also constrain gains should the market drop.
Further levels of complexity could be added with automatic triggers and trades, should certain price movements take place and close out against indices near to delivery.
However, complex deals, which require more market monitoring, will be costlier to manage. Sometimes simpler and more straightforward risk management strategies can be equally effective, if professionally managed by experienced teams with access to live market prices.
Risk management is a continuous process
Your actual risk position will change day-to-day in line with the market, so ongoing monitoring and analysis of your market position is required. As in financial markets, mark to market (MtM) principles allow you to regularly assess the risk of your market position. Feedback by your professional manager on your open positions will help to determine the trading strategy throughout your flexible contract, ensuring that you buy at the right times to maintain energy price risk within agreed levels.
What works for you at the start of the contract is likely to change, so regularly review and discuss your buying strategy. A good consultant should offer this as a matter of course for large energy consumers with complex and changeable energy requirements.
Your risks to your overall energy spend will rise with increased market volatility. It can be contained, but only through a properly managed and written risk management solution. This should follow an in depth assessment of your organisation's appetite for risk and procurement needs.
With an appropriate recorded and agreed trading strategy in place, procurement should be executed by a team with live market price feeds, the right monitoring and reporting systems, and ability to recognise changing market conditions. This team should be proactive in advising customers on the best energy procurement routes, and review and amend the strategy, with the aim of avoiding market shocks.
Inprova Energy is one of the UK's top ten business energy procurement and management consultancies and manages around 3,000 gas and electricity supply contracts on behalf of clients, including Virgin Atlantic, Hotel du Vin, National Grid, Carlsberg and retail group White Stuff.
Further information: www.inprovaenergy.com, 0330 166 4444
The UK has climbed back into the top 10 most attractive countries for renewable energy investment but the outlook for the industry remains cloudy amid a lingering lack of clarity around targets and subsidies.
In the latest RECAI, the UK has arrested a slide that had seen it fall from 4th place in 2013 down to an all-time low of 14th in October 2016.
The RECAI says that the UK investment environment is more settled than recent years, which were beset by subsidy cuts, but the future post-Brexit remains uncertain. While the UK is behind schedule to meet its 2020 EU renewables target, coal-fired power has declined significantly and even reached zero for a day on 21st April.
Ben Warren, EY’s Head of Energy Corporate Finance, says: “The UK’s reappearance in the RECAI top 10 is the result of other countries falling away – notably Brazil which cancelled a wind and solar auction in December - rather than any particularly encouraging resurgence.
“The UK continues to underwhelm investors who are waiting to see if future UK policy will support and encourage the renewable energy industry towards a subsidy-free environment, where consumers can benefit from the UK’s excellent natural resources for renewable energy.
“Investors are still waiting for clarity around the post-Brexit landscape. Question marks linger around renewable energy targets, subsidies and connections with mainland power markets. Unfortunately, the likelihood of getting complete answers to those questions before the UK exits the EU are slim.”
In April the UK kicked off the second round of renewable energy auctions for Contracts for Difference (CfD) subsidies. The Government plans to allocate £730m of annual funding over three rounds, including £290m in the current round.
Warren adds: “The CfD funding allocation is relatively modest and there is continued uncertainty around the outcome of the mechanism. In the absence of a buoyant CfD regime it’s difficult to see how the UK can force its way back among the front runners for renewable energy investment.”
Emerging offshore wind sector offers hope for future
This round of CfD auctions is open to “less established” technologies such as offshore wind, wave, tidal stream, geothermal and biomass with combined heat and power. Falling costs and advances in technology in the offshore wind industry now represent the UK’s best hopes for future investment, according to the RECAI.
Warren says: “The offshore wind sector is showing signs of creating a sustainable industry and driving down costs to provide more value for money for UK plc. The technology is becoming increasingly competitive and we are likely to see offshore wind emerge as the clear winner from this round of auctions.”
US drops to third place
The RECAI also saw China and India surpass the US, which fell to third in the index following a marked shift in US policy under the new administration.
The report identifies the US Government’s executive orders to rollback many of the past administration’s climate change policies, revive the US coal industry and review the US Clean Power Plan as key downward pressures on renewable investment attractiveness.
Warren says: “Movements in the index illustrate the influence of policy on renewable energy investment and development – both productive and detrimental. Supportive policy and a long-term vision are critical to achieving a clean energy future.”
In China, the National Energy Administration (NEA) announced in January 2017 that it will spend US$363b developing renewable power capacity by 2020. This investment will see renewables account for half of all new generating capacity and create 13 million jobs, according to the NEA plan.
India continued its upward trend in the index to second position with the Government’s program to build 175GW in renewable energy generation by 2022 and to have renewable energy account for 40% of installed capacity by 2040. The country has added more than 10GW of solar capacity in the last three years – starting from a low base of 2.6GW in 2014.
Warren says: “The renewable energy industry is beginning to break free of the shackles that have stalled progress in the past. More refined technology, lower costs and advances in battery storage are enabling more widespread investment and adoption of clean energy.”
Economically viable renewable energy alternatives coupled with security of supply concerns are encouraging more countries to support a clean energy future. Kazakhstan (37), Panama (38) and the Dominican Republic (39) have all entered the index for the first time.
For the complete top 40 ranking and insight on battery storage, offshore wind and rooftop solar developments, visit ey.com/recai.
As the prices on energy continue to rise in the UK, Business and Energy Secretary Greg Clark wants to press hard on energy firms and mitigate the damages of energy pricing, claiming they are milking loyal customers in light of inflation.
In the last few months, most UK energy providers raise their default tariffs to consumers, blaming investment requirements, government demands and the falling value of the pound.
Finance Monthly heard Your Thoughts on the price spike this week, and below are a few comments from experts on the matter.
Magnus Walker, Director of Trading and Risk, Inprova Energy:
Nothing's ever certain in the highly volatile energy markets, but the general wisdom is that prices are rising - driven both by a return to more bullish wholesale commodity market conditions and sharp increases in non-commodity charges.
According to the latest analysis from energy market tracking company ICIS, the cost of power in the first quarter of 2017 was almost a third higher than the same period in 2016, while forward gas commodity prices were up by 42% year on year. This market level has since softened, but we're unlikely to witness the very low commodity prices of winter 2016, largely because the price of oil has since doubled. Nevertheless, market costs fluctuate dramatically, dependent on a range of external factors, which is why it's so important to pursue a smart long term purchasing strategy to mitigate the impact of higher prices.
By contrast, businesses have little wriggle room to avoid sharply rising non-commodity costs. Five years ago, these charges accounted for about 30% of a total power bill, but in today's market it's about 55%. The continued need to remove polluting coal plants, incentivise greener energy supplies and retain security of supply, is expected to drive these charges up to around 60% of total power costs by 2020. For gas bills, there's a split of around 65/35% wholesale to non-energy costs.
Whether using a fixed or flexible purchasing strategy, forward planning is critical. It's commercial suicide to renew a fixed contract at the last minute when you may be forced to purchase at the height of the market. Instead, it makes more sense to lock in to favourable rates well in advance of the contract renewal date.
Fixed rate contracts do offer budget certainty and simplicity, but flexible purchasing offers more opportunity to buy chunks of your energy volume at points in time when the commodity market dips and still provide budget certainty. Your trading strategy must, however, be underpinned by a robust risk management strategy that matches your requirements. A good strategy ensures you never hit the top of the market. This is a far more considered approach than 1:365 odds of picking the day of the year when the market is at its lowest to fix a deal.
It's essential to seek expert, trustworthy professional advice to navigate the complexities of the energy market. If you're using a consultant, make sure they have full and live commodity market access, buying performance supported by evidence, and that any recommendations are fully aligned with your needs and attitude to risk.
Of course, the cheapest energy is what you don't use. Effective data management is especially important in illustrating how you are consuming energy and pinpointing where you can make savings.
Phil Ivers, Head of Customer Optimisation, Gazprom Energy:
Wholesale energy prices have an impact on the cost of gas and electricity for the end user, as market increases will be reflected in the rates that energy suppliers offer. Government policies, such as subsidies to support renewable energy projects, can also contribute to increases in energy rates.
For small businesses, a long-term, fixed-price energy contract may offer the best protection against rising energy prices. This is when the total energy price is fixed for the duration of the contract term, meaning it won’t change in line with the wholesale energy price.
Those managing business energy contracts should keep an eye on wholesale pricing and the market in general, so as to avoid surprises when their contract ends. It’s also prudent to pay attention to factors likely to affect the wholesale market, which can include weather conditions, current affairs and world events.
By keeping abreast of price fluctuations, you can pinpoint the right time to lock into a suitable energy contract – and remember, you don’t need to wait until your current contract is nearing its end date to put in place future arrangements because many suppliers can offer contracts that start in 12 – 24 months’ time.
We would also love to hear more of Your Thoughts on this, so feel free to comment below and tell us what you think!
By Aaron Kibbey, Robert Rasor & Brian Bostwick
Whether in court or out of court, in most restructuring situations involving stakeholders with various claims to a Company’s assets, the valuation of these assets is a critical component. In restructurings involving oil and gas reserves, the valuation analyses are often more complex because of the technical data and skillset required to value these reserves.
In the recent Sabine Oil & Gas and Energy XXI cases, stakeholders clashed over competing interests, and claims hinged on very different views of the value of the respective companies’ assets. These cases highlight the importance of retaining professionals who fully understand the technical aspects of performing a valuation analysis on oil and gas assets, and who can also apply their experience in valuing these types of assets in order to tailor their assumptions and inputs to the unique characteristics of the specific assets associated with the restructuring. In the Energy XXI case, Loughlin Management Partners + Company (“LM+Co”), a boutique restructuring advisory firm based in New York, partnered with HJ Gruy and Associates, Inc. (“Gruy”) a petroleum engineering firm based in Houston, to provide a comprehensive valuation analysis on a specifically targeted portion of the Company. This article outlines the general approach LM+Co and Gruy applied in their analysis, and also suggests several important considerations for teams attempting to value oil and gas assets.
Although valuing oil and gas assets is not necessarily more difficult than valuing other asset classes, valuing these types of assets requires a detailed understanding of the relative merits of traditional valuation methods. Valuing oil and gas assets, which comprise a depleting asset base where value is correlated to constantly changing commodity prices and historical production trends, demands a thorough understanding of the technical details included in a company’s reserve database. Although commodity prices fluctuate, the value estimates of the underlying oil and gas assets should be based on current conditions, and are not intended to reflect unforeseeable economic or environmental events that could alter the fair market value subsequent to the valuation date.
The Market Approach and Income Approach
When estimating the value of a company or a group of assets, both a Market Approach and an Income Approach should be employed, and this holds true when estimating the value of oil and gas assets. A Market Approach, such as a Comparable Company Analysis or Precedent Transaction Analysis, provides the relative value of the target assets based on how investors price similar assets. The Market Approach provides an estimate of value based on external information of the subject company, specifically how investors view the value of similar assets. An Income Approach, such as a Discounted Cash Flow (“DCF”) Analysis or, specifically when valuing oil and gas assets, a Net Asset Value (“NAV”) Analysis, provides an estimate of value based on internal information from the company, specifically the projected cash flows attributable to the target assets. It is key to recognize, when utilizing any of these methodologies, that there are relative merits and limitations associated with each, and these merits and limitations are magnified by the financial detail available in each unique situation.
The most common and widely accepted method to value an oil and gas company is a Net Asset Value Analysis, and nearly every valuation estimate for oil and gas assets will include a NAV analysis. However, relying solely on the results of a NAV analysis leaves the estimate of value susceptible to some potential shortcomings of this method. Although a NAV is essentially a very detailed DCF Analysis which includes very specific information on the selected oil and gas reserves, all of the other methods mentioned above should be considered and evaluated when performing a valuation analysis on oil and gas assets. The quality of the data available will ultimately dictate which methods to use and the appropriate weighting of each method.
A Market Approach provides an estimate of value based on how investors price similar assets by using a multiple on a common metric. Although sales, free cash flow, and EBITDA are commonly used metrics in this approach, the metric need only be observable, not necessarily financial. Care needs to be exercised when selecting the metric for a Market Approach valuation.
Comparable Company Analysis
A Comparable Company Analysis looks at publicly-traded, comparable companies and calculates a valuation using multiples of financial data based on the Total Enterprise Value (“TEV”, the combined value of the equity and the debt, net the cash on the balance sheet) of the chosen comparable companies. This approach provides the public market view on the value of similar companies or assets, but may be limited by the subjectivity inherent in trying to determine the relative similarity of the “comparable companies”. Comparable Company Analysis is recognized and well received by the US Bankruptcy courts. Two notable recent cases that included this method were Penn Virginia[i] and Swift Energy[ii].
When using the Comparable Companies approach, the selection of the comparable companies is critical. Finding companies that are similar or nearly identical would be ideal when applying this approach; however, it is typically very difficult to find such companies. An important consideration when using a comparable company valuation analysis is that a comparable firm need not be identical, in all aspects, to the subject company. Rather, the key requirements are that a comparable firm have similar cash flows, growth potential and risk[iii], [iv]. In the Energy XXI case, it is important to note that, although there were no other comparable publicly traded companies operating in the shallow waters of the Gulf of Mexico, other onshore oil and gas companies contained cash flows, growth potential and risk profiles similar enough to be used to estimate how the market would likely value the Energy XXI assets.
Precedent Transactions Analysis
A Precedent Transactions Analysis looks at companies comparable to the target company that were recently bought or sold and uses a multiple based on the purchase price to estimate the value of the target. This method is also susceptible to subjectivity of how “comparable” is defined, as well as the availability of information regarding recent and relevant transactions. To apply a Precedent Transactions Analysis, a multiple must be defined. Although earnings based multiples such as revenue or EBITDA generally provide the best indication of value, the multiple can be based on any observable, relevant metric. When valuing an oil and gas company, daily production may be a sector-specific metric on which to base a valuation. Regardless of the metric selected, this metric needs to be defined clearly and applied consistently across the transactions.
As critical as company selection is to Comparable Company Analysis, so too is the transaction selection in a Precedent Transactions Analysis. The transaction must stand up to the same level of scrutiny as the companies chosen for a Comparable Company Analysis. Recently acquired companies identical to the target would be ideal, but the data on acquisitions may be limited compared to the abundance of public market data. Because of this, a longer time frame is typically acceptable for Precedent Transactions Analysis. The characteristic of each transaction needs to be carefully reviewed and understood to ensure the metrics used and multiples applied are consistent across each transaction. Often times the reported consideration includes contingencies and considerations that can significantly alter the calculated value and this information should be taken into account as part of the Precedent Transaction Analysis.
Discounted Cash Flow Analysis
The traditional and most widely accepted Income Approach method is a Discounted Cash Flow Analysis. In the oil and gas industry, though, this is largely replaced by a NAV analysis. A DCF typically discounts the future projected annual aggregate free cash flow of the entire company. It requires a detailed understanding of the company and its economics. A Weighted Average Cost of Capital (“WACC”) reflective of the risk of the projected cash flows must also be calculated. Because a DCF analysis requires a complete understanding of the underlying assumptions used in the cash flow projections, without full access to company’s management, there may be limited opportunity to examine and audit the underlying assumptions. This is the most significant limitation of a traditional DCF analysis.
Net Asset Value Analysis
A Net Asset Value Analysis determines the value based on the subject company’s reserves and is the standard approach for oil and gas assets[v]. This method provides a detailed discounted net cash flow analysis that extends over the life of each property. To apply the NAV method, cash flow for individual wells or multi-well projects is forecast based on the projected income from the sale of produced oil, natural gas and natural gas liquid. Operating expenses, local production taxes and future capital requirements are included for each well, multi-well project and platform. The projected discounted net cash flow extends over the life of each entity, which may be up to thirty years from the effective date.
Net cash flow projections for the individual entities can be generated using the commercially available ARIES Petroleum Reserves and Economic Software with a provided ARIES Database. Aggregate net cash flow summary forecasts for the various hydrocarbon reserve categories are generated and used as the base for subsequent risk adjustment factor application, resulting in value determination. During the forecasting, minor changes and additions may be required in order to adjust for property reserve categorization or additional costs. In a low price environment, reserves data may not include critical wells or other assets due to economic write-offs, which could be temporary, but profitable if commodity prices increase. Inclusion of additional costs such as Asset Retirement Obligations (ARO), Lease Operating Expenses (LOE), and General and Administrative (G&A) costs is required to account for recognized expenses that are not included in an original ARIES Database. The costs can be incorporated within the primary forecasts or outside of the cash flow projections. Incorporation within the forecasts forces a more accurate economic limit on each projected property, typically resulting in a more correct forecast.
The prices used to project the cash flows are typically based on the West Texas Intermediate crude oil prices and Henry Hub natural gas prices. The applied price projections are based on NYMEX futures and should be selected as close to the valuation date as is reasonable to ensure the forecast takes into account the current market views. Because the valuation is based on current market sentiment, the NAV approach may not be an accurate indicator of Total Enterprise Value when the market prices are set near cyclical peaks or troughs. Additionally, because projected commodity prices are one of the strongest drivers in the computation of a NAV analysis, a sensitivity case should be presented wherein a completely independent crude oil and natural gas price forecast, such as the one available from the U.S. Energy Information Administration (EIA), is applied. Cash flows generated from the reserves and price forecasts are discounted using a WACC and then adjusted using Risk Adjustment Factors (“RAFs”). Adjustment is needed to account for the uncertainty associated with distinct reserve categories. The adjustment procedure is accomplished by applying an individual RAF to the discounted net present value for each reserve category. This method is well established in the oil and gas industry when performing a NAV approach to valuation. Three different sets of RAFs can be applied to generate low, mid and high market value estimates.
Despite its ubiquity in the oil and gas industry, the NAV analysis has limitations that can significantly alter the derived value of oil and gas assets. A NAV is only as accurate as the underlying reserves data and assumptions. An incomplete database or incorrectly applied RAFs can produce unreliable valuation estimates and ultimately have devastating consequences for investors. Additionally, the NAV approach may not be a good indicator of Total Enterprise Value when the “strip price” (pricing derived from the forward NYMEX curve) is set near cyclical peaks or troughs.
Risk Adjustment Factors used in a NAV analysis should also be vetted carefully. Applicable RAFs are dependent on circumstances and quality assessments surrounding a particular oil and natural gas property or portfolio of properties. The application of standardized RAFs, such as those from the Society of Petroleum Evaluation Engineers (“SPEE”) Annual Survey of Parameters used in Property Evaluation ignore the intricacies of NAV analysis. Notably, SPEE itself warns that the information in the Survey is limited in scope, possibly lacks real world detail and likely reflects biases based on individual respondent’s personal experience[vi].
Understanding both the Science and the Art of Oil and Gas Valuation
Valuation is an inherently complex and imprecise process. The Market Approach (Comparable Company Analysis or Precedent Transaction Analysis) provides an estimate of value based on external information to arrive at a relative value. The Income Approach (Net Asset Value Analysis or a traditional Discounted Cash Flow) provides an estimate of value based on internal information from the subject company and attempts to arrive at an intrinsic value. Ideally, one should perform a thorough analysis using all of the accepted valuation methodologies to arrive at a comprehensive view of value. In practice, however, the quality of data available and the circumstances will dictate which methods to use. Based on the relative merits and limitations of each, not all approaches may be appropriate in each instance. Every effort should be made to combine the estimates of value derived from a Market Approach with the estimates of value derived from an Income Approach in order to estimate the value using both internally (company-specific) generated information and externally (market-specific) generated information. In a November 2012 publication on applying fair value measurement, Ernst & Young noted that
“The fair value of a business is often estimated by giving consideration to multiple valuation approaches; such as an income approach that derives value from the present value of the expected future cash flows specific to the business and a market approach that derives value from market data” (Ernst & Young Publication – November 2012 Fair Value Measurement, IFRS 13 Fair Value Measurement)
We believe this guidance holds true when valuing oil and gas assets, particularly when the valuation analysis is part of an overall restructuring plan. Whether in court or out, stakeholders should strongly consider retaining advisors/professionals who understand the complexities and technical issues unique to the oil and gas industry and relying on their experience and expertise. Hiring valuation professionals well-versed in both the science and the art of valuing oil and gas assets is a critical component of a stakeholder group’s ability to achieve a favorable outcome.
About the Authors
Aaron Kibbey is a managing director at Loughlin Management Partners with more than 20 years’ management experience in operations, restructuring, corporate finance, sales and marketing, business development, and mergers and acquisitions. Aaron also has significant experience serving in crisis management positions within companies facing operational and financial challenges. Through his education and professional experience, Aaron has developed expertise in valuing businesses in various industries, including oil and gas, media and entertainment, and telecommunications.
Robert Rasor is the Executive Vice President and Manager of Engineering of H. J. Gruy and Associates, Inc. With more than 30 years of experience in oil and natural gas valuation, Robert has performed hundreds of oil and natural gas valuations, and has served as an expert witness in numerous national and international litigation and arbitration proceedings.
Brian Bostwick is an associate at Loughlin Management Partners with experience in financial restructuring and process improvement. He graduated with honors from Northeastern University.
[i] “Expert Report of Richard Morgner, Jefferies LLC, Penn Virginia Case 16-32395-KLP Doc 438 filed July 18, 2016”
[ii] Swift Energy Company Valuation Analysis, Case 15-12670-MFW Doc 244-5 filed February 5, 2016
[iii] Damodaran, Aswath. Damodaran on Valuation, Security Analysis for Investment and Corporate Finance, Second Edition, John Wiley & Sons, Inc., 2006.Print.
[iv] Pratt, Shannon. Valuing a Business, The Analysis and Appraisal of Closely Held Companies, Fifth Edition, The McGraw Hill Companies, Inc., 2008.Print.
[v] Sinha, M.K. and Poole, A.V., “Selection of a Discount Rate or Minimum Acceptable IRR”, SPE Paper 16843, Proceedings of the 1987 SPE Annual Technical Conference and Exhibition. Print.
[vi] SPEE. “Society of Petroleum Evaluation Engineers Thirty-Third Annual Survey of Parameters Used in Property Evaluation,” June 2014
Global M&A value in the power and renewables sector has reached the highest level seen in the current decade – up 70% year-on-year - and any further upward movement would begin to move sector deal value back towards the heady levels last seen before the credit crunch, according to PwC and Strategy’s latest annual Power and Renewables Deals report.
The report states there is plenty of potential in the global power and renewables M&A pipeline but the latest surge may not be indicative of the long-term trend. A more globally-balanced spread of deals is expected in 2015 with fewer of the US mega-deals that buoyed 2014 totals. But the flow of divestment- and privatisation-driven deals looks strong and so there are plenty of reasons to think any dip in US deal value will be taken up, in part at least, by activity elsewhere.
The report found total worldwide power and renewables deal value rose from $143.3 billion (€126 billion) in 2013 to $243.1 billion (€215 billion) in 2014. It’s the first time the total has broken out of the $100-200 billion (€88-176 billion) range established since the pre-credit crisis year of 2007.
A series of big but one-off restructuring deals in the US gas sector, involving Kinder Morgan and Williams, contributed $92.2 billion (€81.4 billion) to the worldwide M&A total.
Diminishing financial returns for utilities have put at risk the ability of the electricity sector in OECD markets to raise the estimated $7.6 trillion (€6.5 trillion) in investments needed by 2040 to meet energy policy objectives, according to a new report from the World Economic Forum. This investment is needed to simultaneously decarbonise the sector while maintaining energy security.
The Future of Electricity report offers guidance on transforming the electricity sector to a more sustainable, affordable and reliable system, and outlines recommendations for policy makers, regulators and businesses in developed markets to attract needed investment. It is part of a broader Future of Electricity initiative, which was launched at the World Economic Forum Annual Meeting 2014, and aims to provide countries, companies and societies with a platform for dialogue and learning amid the transition to a lower-carbon electricity system.
“Since 2000, OECD countries have invested more than $3 trillion (€2.6 trillion) in new renewables, conventional power plants and distribution structure, but about 20% more investment a year is still required over the next 15 years,” said Roberto Bocca, Head of the Energy Industries at the World Economic Forum. “Collaboration across stakeholders will be critical to achieving this goal and providing the holistic perspective needed to successfully make the low-carbon transition.”
“The electricity sector is at a crossroads. We are entering a period of unprecedented investment to meet our energy policy goals, but decreasing returns and increasing risk are raising questions over future investment,” added Julian Critchlow, a partner at Bain & Company, which collaborated with the Forum on the report. “OECD countries will need to take immediate action to ensure continued investment across the energy value chain.”
According to the report, root causes of the sector's investment challenges include:
BP's business activities in the US helped generate close to $143 billion (€121 billion) in economic impact in 2013 and currently support nearly 220,000 American jobs, according to the company's recent US Economic Impact Report 2014.
Released early January, BP's new report provides a detailed, state-by-state look at the breadth and impact of the company's activities in America. Since 2009, BP has invested nearly $50 billion (€42 billion), making it America's largest energy investor. In 2013 alone, BP spent $22 billion (€18.6 billion) with vendors across the country on products and services, ranging from offshore drilling rigs to gasoline-producing equipment for its refineries.
“No energy company has invested more in the US over the past five years than BP,” said John Mingé, BP America Chairman and President. “Our investments not only provide the energy to power the nation, but they also support hundreds of thousands of jobs that fuel the economy.”
BP's business investments in the US include oil and natural gas exploration and production, fuel and chemical refining, lubricants, shipping, trading, renewable energy production and technology research and development. The US also is home to a number of operations that serve BP's global businesses, such as the Centre for High-Performance Computing in Houston, which houses the world's largest supercomputer for commercial research. Nearly 40% of BP's publicly traded shares are also held in the US.