Going Green: Rebounding Energy Sector Calls for Diversification
The energy sector is much more than the oil and gas industry. Damon Dickens of Sallyport Commercial Finance outlines where the evolving energy space stands today and outlines how factors can be successful when working with energy-focused clients.
BY DAMON DICKENS, EXECUTIVE VICE PRESIDENT, SALLYPORT COMMERCIAL FINANCE
The energy sector has experienced a strong rebound in the past two years. It was a little over two years ago, in April 2020, when oil futures became negative for the first time in history at -$37 a barrel and the spot price of oil dropped to $11 a barrel. Since then, oil prices have steadily climbed to a peak of $124 a barrel in March.
As the lockdowns of the COVID-19 pandemic have (mostly) passed and the world economy has opened, the energy sector has ridden the wave of increased global demand. More recently, however, the global economy has hit more turbulent times, with an energy supply shock from the ongoing conflict in Ukraine dampening the economic recovery and sending inflation skyrocketing to levels unseen since the early 1980s. Still, despite the S&P being down 16% year to date, the energy sector has been the only sector which has experienced growth, with gains of 30%.
2022 Outlook
With inflation really biting consumers, President Joe Biden recently visited the Middle East in an effort to persuade Saudi Arabia (and OPEC) to increase oil production, preempting the scheduled Aug. 3 meeting of OPEC. At present, domestic inflationary pressure is the single most significant political issue facing the U.S. economy and the recently proposed Inflation Reduction Act only highlights that. The increase in inflation has led to interest rate increases not seen in decades as the Federal Reserve tries to combat inflation. The 0.75% interest rate increase in late July was the second consecutive rate rise and some of most hawkish monetary policy action seen in many years.
Against this backdrop, a Deloitte study on the oil and gas industry had some interesting predictions for the industry through 2022 and beyond, identifying five trends to watch:
High oil prices are expected to boost the transition away from fossil fuels. This was counterintuitive to my thinking; however, the rationale being that with a strong and buoyant ‘core’ business, companies will take more risks on greener technologies and green energy sources. In fact, a survey found that 76% of oil executives said oil prices of more than $60 a barrel would expedite their energy transition plans.
Environmental, social and governance initiatives will play more of a role in M&A activity in the sector. Rising oil prices typically spur rising M&A activity; however, that has not been the case with the current cycle. Companies looking to meet net zero targets are looking for deals which are not only financially accretive but also meet ongoing ESG goals.
The oilfield services sector has had to reduce costs and improve efficiency in order to stay afloat (even prior to the COVID-19 pandemic). It is expected that this sector will undergo a significant structural shift in the next few years in the wave of the energy transition.
A shift away from traditional internal combustion engine vehicles to more electric vehicles (EV). This is being driven by more widespread adoption of EVs and changing demographics.
The volatility within the sector is being taken into account when employees are considering stability of employment. The oil crash of 2020 triggered some of the fastest layoff rates in history, with more than 100,000 people exiting the workforce. The subsequent rebound has led to a return of only 50% of those jobs.
Closing Deals in the Sector
As a business headquartered in Houston and with our founders deeply rooted in the oil and gas industry, many deals in the energy space come across Sallyport Commercial Finance’s desks for review and we are seeing some interesting trends.
As banks had initially reduced funding limits across the sector in 2020, there has been some resistance from those lenders to increase limits as oil and gas businesses have experienced growth again in 2021 and 2022.
As an example, a business that provides repairs to oil and gas refineries was referred to Sallyport from a bank, which had a longstanding relationship with the business. However, the business was experiencing rapid growth and the bank was not comfortable enough to increase its facility limit. The business experienced a sharp decline in its business as capital spending ground to a halt in 2020 and 2021, with customers wary of any big capex spending in such an uncertain environment holding back most repair work. With the economy opening up and the energy sector now much more buoyant, the business has been forced to push through several years of backlogged capex in 2022. Sallyport structured a facility for the business that generated extra working capital for the business. The facility was also structured to allow the business to return to the referring bank without any termination penalties.
Sallyport has also experienced an increase in referrals from other oilfield services companies from banks and private equity sponsored businesses. The inability of banks to provide flexible funding structures has meant that several businesses are looking for a more accommodating partnership with their senior lenders, including partnerships without the restrictions of sector percentage caps or financial/performance covenants.
As another example, a sponsor-backed business which Sallyport funded earlier this year was looking for a senior lender that could provide significant A/R availability while being aware the business was in turnaround mode and that typical financial and performance covenants would be breached. Sallyport structured a package which allowed for repayment of a loan note used to acquire the business while also generating working capital for the business’ day-to-day operational needs.
Challenges Faced
Contractual and progress billing remain the typical challenges facing factoring clients in the oil and gas industry. These challenges need to be managed correctly during underwriting and operational procedures, which need to be fit for purpose. In the examples earlier in this article, Sallyport provided additional working capital with a flexible approach. However, Sallyport was also approached to look at a prospect where the business had just acquired another business and was in the middle of the integration process. In this case, the acquired business was billing in advance for annual maintenance and the billing procedures were not a good fit for a factoring facility. That was unfortunately a facility where Sallyport could not structure a suitable solution.
Beyond billing, there are challenges in obtaining accurate and up to date debtor information in the energy sector, as the traditional credit rating bureaus have a weak spot in coverage with oil and gas businesses because many are privately held. This is a challenge to overcome, so it important to utilize contacts in the energy space to help bridge this information gap and make a more informed decision on debtor credits.
The Non-Oil & Gas Energy Sector
When we hear energy sector, we typically assume we are discussing the oil and gas industry; however, in recent years, we have seen greater factoring activity in the green energy space. With the majority of these industries being startups or with minimal track records despite experiencing rapid growth, they need help with working capital cycles; this is where factoring can be an ideal fit.
Sallyport recently had success in the green energy space working with an importer of solar panels. The relationship was referred to Sallyport because the company did not qualify for traditional bank financing due to a lack of trading history. However, the company desperately needed working capital in order to keep pace with its growth. The business has since doubled its facility size with Sallyport, which partnered with a purchase order financier to further allow the business to grow sales.
Sallyport also recently worked in partnership with its equity investment division to structure a combined equity investment and factoring facility for a manufacturer of solar powered signage and benches. The business, which was a startup and did not qualify for bank financing, won a contract to provide green energy spaces for the upcoming World Cup in Qatar and needed a provider that could provide payments to overseas suppliers to kickstart the manufacturing process.
The spikes in the price of oil from the conflict in Ukraine have sharpened the focus on diversification away from traditional fossil fuels, and the push toward more green energy (along with nuclear energy) is gathering momentum. As new businesses enter this space, they will become ideal candidates for factoring, as they’ll be fast growing entrepreneur-backed companies with minimal trading history. The volatility in the energy sector can mean that timing is everything and although energy is a hot sector currently, things will inevitably swing the other way. It is easy to deploy capital into deals when energy is robust, but make sure to consider the downside and the potential need to extract capital back if things take a downturn.