Transformation has been the watchword for the energy & utilities space in recent years. Though the sector has long been viewed as a relatively safe investment destination, in reality things have changed drastically of late.
Technological developments, geopolitical issues and global economic headwinds have created a paradigm shift in the energy space. So too have changing consumer trends. Consumers in many markets have begun to crave cleaner, more affordable and smarter energy. Given the overabundance of oil & gas saturating the global market, particularly in prolific shale producing economies such as the US, consumers have become accustomed to cheap energy. If companies hope to prosper in this new energy environment, it is vital that they demonstrate an ability to adapt.
These shifting tastes have created the need for change on an operational level, and this has come at a point when the industry is facing one of its most challenging ever periods. In recent years, the energy space has had to endure huge demand growth amid falling investment and plummeting oil prices.
It is because of these developments that companies must learn to evolve, and quickly. Over the last two years, volatility has caused considerable distress. Since mid-2014, when the price of oil began its prolonged and rapid slide, scores of companies in the energy space have filed for Chapter 11 bankruptcy protection in the US, including, in mid April, the world’s largest coal company, mining giant Peabody Energy. Peabody became the fifth major US coal company to declare bankruptcy, joining giants such as Alpha Natural Resources, Arch Coal and Goodrich Petroleum Corp, which also filed for Chapter 11 protection in April.
Peabody filed for Chapter 11 protection in St Louis with a view to removing $10.1bn worth of debt. That a company of Peabody’s stature can be laid low – just 20 years ago the firm provided half of the US’ electricity – is noteworthy, however in the context of the struggles of coal providers in the US, it is not particularly surprising. Tastes are changing, and global market volatility aside, consumers and governments are trending toward more sustainable forms of energy production. Cheap shale gas has changed the energy conversation. US coal production has nosedived from 1.17 billion metric tons in 2008 to just 752.5 million in 2016. However, the woes of the coal market are not merely confined to the US; consumption in China, another crucial global market, has also cooled – a development which has been pivotal in the collapse of Peabody which made a considerable commitment to servicing the Chinese coal market in 2011 when it paid $5.1bn to acquire Macarthur Coal, an Australian mining firm.
With the global energy market in a state of flux, how companies operating in the space adapt will be critical for the future state of the industry. Organisations must be prepared to adapt and evolve their internal strategies to incorporate the changing nature of the global energy sector. China, for example, has begun to explore non-fossil fuel alternatives, as Nicholas Molan, counsel at Vinson & Elkins LLP, explains. “Over recent years, China’s adoption of non-fossil fuel energy sources – notably solar – has been among the most aggressive globally. We would expect to see this trend continuing and most likely accelerating over coming years. Largely in response to significant urban pollution, China has set aggressive goals to reduce coal’s place in its energy mix in the medium term. However, this remains a significant technical and commercial challenge, given that the country is currently the largest user of coal-derived electricity, generating 74 percent of its electricity or 3959 TWh per year, from coal as of 2014.”
In late April, China’s largest oil & gas producer, China National Petroleum Corp, emphasised the shifting dynamics in the global energy market by announcing its first ever drop in profits for 2015. The company reported $12.7bn in annual profit on revenues of $308bn – a 26 percent decline on 2014. CNPC’s listed oil and gas arm, PetroChina, saw its net profit fall 67 percent from 2014.
Furthermore, renewable usage in China has increased in recent years. Since 2012, solar capacity has climbed more than sevenfold and wind powered energy capacity has almost doubled as China seeks to generate 15 percent of its energy offering from renewables and nuclear by 2020.
China is taking steps to eliminate overcapacity in its heavy industries, particularly coal. The country’ total coal-production capacity, including mines under construction, is estimated at more than 5 billion tonnes, however there are efforts in place to reduce production to under 3.7 billion tonnes this year. Achieving this would require China to leave more than 20 percent of its capacity idle. Furthermore, in April the government announced that it would no longer approve land for new steel and coal projects. This restriction is another important step in China’s ongoing attempts to tackle the structural problems affecting its economy, which is undergoing a period of considerable reform.
The intervention of the Chinese government in the energy & utilities space, guided by the State Council’s Energy Development Strategy Action Plan, is aimed at drastically improving the state of the country’s energy systems. With China committing to reducing its pollution and energy emissions by 60 percent by 2020, efficiency, safety and sustainability are of paramount importance. The introduction of the revised Foreign Investment Industrial Guidance Catalogue will open China’s energy market to foreign investors for the first time, giving them access to the abundant opportunities the country presents.
In the US, Congress agreed to lift the near 40 year ban on crude oil exports in December. Though the move is not expected to have a particularly large impact on the global energy market, it is still interesting to note that Congress has finally acquiesced following considerable political pressure.
Globally, the energy & utilities space is becoming more constrained by regulatory and legislative developments. The UK, too, is enacting significant regulatory change. The Energy Bill will serve as the most noteworthy amendment to the oil & gas space in the UK for over 50 years, formally establishing the Oil & Gas Authority, and expected to bring forward the date for ending onshore wind subsidies.
Africa is also seeing regulatory progress. In Nigeria, two key developments have been introduced by the Nigerian Electricity Regulatory Commission in recent years, namely the Regulations on National Content Development for the Power Sector, and the Regulations for Investments in Electricity Networks in Nigeria. According to Awele Ojechi, an associate at F.O. Akinrele & Co, the Regulation for Investments in Electricity Networks in Nigeria, 2015 aims to create strong incentives to encourage transmission and distribution companies to make appropriate and sustainable investments in capacity expansion. “The regulations set out procedures for licensees and non-licensees investing in the Nigerian electricity supply industry, ranging from network investments structures, project financing structures, contractual framework and the procurement process to ensure compliance with best practices and transparency,” she says.
From regulatory pressure to falling commodity prices, companies are being forced to contend with considerable headwinds. Accordingly, efforts are being made to reduce operating costs where possible. Many organisations are opting to divest some of their assets, particularly in the offshore oil & gas space, where there are surplus assets.
The downturn in the sector’s fortunes has created considerable opportunities for acquiring companies. The renewables sector has seen substantial dealmaking activity over the last 18 months, and that is expected to continue. Precipitated by changing energy policies, the likelihood is that acquiring companies will have ample opportunity in the second half of the year, as companies look to restructure their organisations and shed assets.
According to a recent McKinsey & Company report, 2015 gave rise to a fertile environment for deals in the energy & utilities sector. Despite a lacklustre first six months, the second half of the year saw deal volumes and values climb. The year in total netted close to $200bn in deal value, up from around $177bn in 2014. Activity was driven by two major regions: Americas M&A exploded in the third quarter of 2016 with more than $50bn worth of deals agreed, while Asia-Pacific M&A hit around $40bn in Q4.
In certain jurisdictions, however, the decline in oil prices contributed to a wider malaise in dealmaking. “Although 2015 was a strong year for general M&A in Mainland China and Hong Kong, outbound and inbound M&A activity in the energy sector has been relatively low over the past 12 months,” says Mr Molan. “The continuing slower pace of M&A activity, particularly for outbound M&A, has carried over from the previous year and is driven as much by subjective considerations of the firms involved as external local and global pressures, including the impact of oil prices.”
Africa remains an attractive investment destination. Though the region has suffered from an economic slowdown in the last 12 months, deals in the energy space have occurred with regularity. The energy & utilities space has remained particularly attractive, recording the highest value and volume of deals last year, according to data from Quartz. Much of the energy sector dealmaking was done by foreign firms.
It is no easy task to predict how the energy & utilities sector will develop going forward, particularly in light of the volatility experienced in the market. However, it is clear that efforts are underway to change the nature of energy production forever. Fossil fuels have played a pivotal role in the social and economic development of the world; however, their impact is likely to be diminished by 2020. With governments and companies pledging to embrace renewable energy projects, the days of fossil fuels may be numbered.
In China, according to Mr Molan, the movement away from fossil fuels is likely to be a landmark moment in the evolution of China’s energy offering. “Such an exercise will require the cooperation of all participants in the energy space, including the multi-layered regulatory apparatus, public and private sector energy companies, technology providers and manufacturers, other service providers and end-users,” he says. “Such a development may also provide the stimulus and opportunity for energy pricing reform which is arguably overdue in the market. While each of these developments represents a mammoth task, we believe that expressions of support for such initiatives from various levels of government over the past 12 month bode well for their ultimate realisation.”
Regardless of the state of the market and the impact of volatility on the energy & utilities space, the pipeline of M&A deals should continue to flow. According to data from Dealogic, M&A in the energy & utilities space got off to a flying start in 2016, reaching its highest year to date level since 2011. Between the start of the year and 26 April, 362 utility & energy targeted deals were announced, with a total value of $76.8bn – a jump of 78 percent on the $43.1bn worth of deals announced during the same period in 2015. Should that level of activity continue throughout 2016, the sector could be in for a landmark year.
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