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Upstream M&A Market Lukewarm But Expected to Heat Up

When oil prices began collapsing last year a lot of prognosticators said it was only a matter of time before oil majors and large independents began eyeing their smaller brethren for takeovers. A year later, there's little consolidation, but that should change within the next few months, experts say.

BDO USA's Clark Sackschewsky, a partner with the Natural Resources practice, said he thinks more mergers and acquisitions (M&A) aren’t necessarily going to be the mega-mergers. He told NGI that deals more likely are going to be "focused on assets than actual mergers. I see joint ventures happening more. I don't see too much activity around acquiring other companies because of debt loads and environmental issues, etc."

The industry has been moving toward more strategic asset purchases "that fill out portfolios, that fill out specific needs, especially with reduced pricing, with reduced production happening," he said. Challenges loom in any case.

"The question is whether you want to take on the liabilities or work with the people you already have," Sackschewsky said. “When you acquire a company you bring all of the people with you and that brings a big overhead cost that you may not necessarily need."

Acquiring assets is a much simpler way to increase reserves. And more activity may happen before the end of the year, said the BDO expert.

"It's going to be definitely more in the area of acquiring assets. I think there's going to be with reserve base lending... resets; there's going to be a lot of activity over the next month."

As to what the buyers are interested in, the play's the thing, he said.

"It's going to be based on formations. I think the Permian is still going to be hot and heavy, without a doubt. I'm seeing quite a bit of activity in the Louisiana area, which I found very fascinating." Louisiana activity is around the Haynesville Shale area as natural gas activity heats up.

"I think it's going to be focused on consolidating acreage in areas where a company already has significant acreage," Sackschewsky said. "I don't see a lot of people hopping from one formation to another. They are going to concentrate their efforts in a particular area, one they know well and try to consolidate their holdings in these particular areas."

The types of companies that may be in an acquisitive mood fall into three basic profiles. The first is a company with a strong balance sheet without much debt that has cut back on overhead costs and has the cash available or the ability to borrow cash to acquire assets.

"These strong balance sheet companies can take advantage of a reduced price market," Sackschewsky said.

"The second profile we're seeing are the NOCs -- the national oil companies -- particularly China, that are making investments in the United States. They're doing it with other companies here, some already established, so they've been pretty active in the market already acquiring assets."

The third type of buyer, he said, is private equity (PE) money.

"The private equity guys have a ton of money sitting on the sidelines and they have for a long time. A lot of people have seen what's happening and have held back to wait for the bid and the ask to narrow down so that they can go acquire assets. That bid to ask price is really going to start to narrow here over the next month or two."

Deutsche Bank's Kristina Kazarian said a lot of PE money is waiting to be developed. Even in this year's down market, she said there have been 19 fund raises for a total of $35 billion, with 36 funds currently raising money. Of those 36, eight are new entrants that have raised $8 billion. There were only four new entrants last year, she said.

"The overall trend is that large funds continue to grow. And while we think valuations at the parent level look compelling, asset-level prices appear difficult" because of the PE bid.

Balance sheets for all types of companies are key in 2016, according to Deutsche.

"Leverage/balance sheet management has become the most important focus for management teams," Kazarian said. "To this point, we think two routes will be taken by corporates: sustaining business models to survive the cycle intact and creating an opportunity set to be able to participate in M&A."

Analyst Neil Beveridge of Sanford C. Bernstein & Co. noted that every major downturn in oil prices over the past 50 years has been accompanied by an M&A cycle.

"While activity has been muted so far, M&A activity should accelerate as we head into 2016," Beveridge said. With the exception of the Royal Dutch Shell plc/BG plc merger announced earlier this year, "the response so far this year has been underwhelming."

Bernstein estimates that announced upstream M&A transactions year-to-date in early November were running at about $200 billion below 2014 levels.

"While overall M&A intensity -- transaction value in U.S. dollars divided by oil price -- is higher than 2014, the global deal count continues to be below what should be expected if we are at the bottom of the cycle," Beveridge said.

Several explanations are possible for the scant M&A activity to date this year.

"The most obvious is that that the industry believes the bottom of the cycle is still to come and that CEOs can afford to be patient," he said. "Other explanations for the lukewarm M&A response so far include equity valuations, which are arguably not as cheap as they could be, financing alternatives for highly levered companies and the reversal of NOC activity."

The lukewarm response by the majors is "consistent with recent commentary from CEOs of oil majors," such as BP plc and ExxonMobil Corp. (see Daily GPIOct. 30Oct. 27). BP CEO Bob Dudley and ExxonMobil's Rex Tillerson "are in the 'lower for longer' camp with oil prices remaining low for several years," the Bernstein analyst said.

"Secondly, equity valuations are embedding a long term oil price of at least U$65/bbl, which is consistent with the long end of the forward curve, but well above the current spot price of $50/bbl. Adding in an acquisition premium, significant cost synergies need to be achieved to justify the decision to acquire. In short, there are few real bargains in the market."

Low interest rates and the ability to raise equity has enabled highly levered companies to avoid being pushed into distressed asset sales, but "there are clear signs that both equity and debt markets are becoming prohibitively expensive as funding dries up."

In North America, it's difficult to identify specific targets, said Beveridge, "but we expect companies with interim CEOs or transitional management teams might find themselves more willing to part with an enterprise."

Four large E&Ps that have interim CEOs and/or new management teams are Occidental Petroleum Corp., Devon Energy Corp., Anadarko Energy Corp. and Encana Corp., "which could all fit within the M&A theme." Anadarko became the pursuer recently of Apache Corp., but it dropped its bid shortly after it was disclosed in November (see Daily GPINov. 11).

Evercore ISI's Doug Terreson, who heads energy research, expects to see more consolidation, particularly among the majors, as big integrated operators focus on returns instead of growth. During a recent webinar, he noted more cash flow now is being directed to paying down debt than at any time since 1999, conditions that make it more possible for acquisition activity in the exploration and production space.

If a major or a large producer consolidates with another company, their joint debt would be restructured under more favorable terms, he said. And when they are combined, E&Ps/majors typically would spend about two-thirds of what they would have spent separately.

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