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Oil firms back in the black

Investors want to see oil companies striving for value rather than volume in the year ahead

This year's progressive rise in worldwide oil and gas mergers and acquisitions activity has built on 2016's recovery from the depths of the 2015 oil-price crash. The industry as a whole has shown increased discipline as oil prices have more than doubled since their early-2016 nadir. Companies are broadly aiming to be cash-positive at prices over $50 a barrel, targeting returns in the mid-teens for new projects and over 20% for brownfield expansion and consolidation projects.

The mood is one of "cautious optimism", according to Wood MacKenzie corporate analyst Tom Ellacott. "I don't think you're going to see a surge of investment next year," he says. "You may see a small improvement." Investors, he adds, are imposing their own discipline on the sector, wanting to see cash flow from investments, where previously they rewarded volume.

Upstream M&A activity in 2017 has largely been based on four themes: portfolio consolidation, restructuring, investor returns and concentration on short-cycle projects addressing the volatility of oil prices. The second half of the year has also seen increased activity by private equity groups concentrating on perceived restructuring plays that boost productivity. Most of the year's activity has been centred on North America, although other hot spots are emerging, particularly in Latin America, and in the Eastern Mediterranean and Africa—home to big gas plays.

Upstream earnings rise

Much of the market's attention this year has been concentrated on the US independent-producer sector. Investors pushed management to incentivise shareholder returns and cash generation rather than production volumes. Independents appear to be listening to their financiers: the US Energy Information Administration notes that in the second quarter of the year 79% of the 108 publicly listed companies, whose financial performance it follows reported upstream earnings. These were up nearly 50 percentage points from the second quarter of 2016, while cash from operations was $86bn over capital expenditure over the year to June 2017.

Within the leading independent-producer acquisitions during the first half of the year, Parsley Energy emphasised its concentration on the Permian Basin by acquiring a large swath of additional producing and undeveloped acreage for $2.8bn, while in the prolific northeast US Marcellus shale, EQT Corporation acquired Rice Energy for $8.2bn, approximately 80% of total upstream M&A spend in the region. Meanwhile, among major oil companies, ExxonMobil and Chevron have announced that, in addition to acreage acquisitions, they'll be concentrating on improving efficiencies at their US unconventional oil and gas operations.

Investors pushed management to incentivise shareholder returns and cash generation rather than production volumes

Wood Mackenzie's Ellacott notes that upstream oil companies are concentrating on high-return, short-cycle opportunities in the tight oil sector, in part to address volatility in oil markets. One attraction of US shale discoveries has been their capacity essentially to track oil price trends, offering quick output increases at times of high prices, and relatively short life cycles in low oil-price periods. Companies increasingly appreciate this flexibility as they face volatile oil prices and the potential risk of stranded assets as energy markets adapt to the risks of climate change.

Consolidation, debt reduction, and corporate refocus were the driving factors behind two of the largest upstream transactions of the year, Shell's and ConocoPhillips's sale of Canadian oil sands holdings to Canadian Natural Resources and Cenovus respectively. These sales totalled approximately 26% of the total $92bn in overall upstream M&A activity in the first half of the year, according to Deloitte Touche Tohmatsu's Oil and Gas Mergers and Acquisitions Report-Mid-Year, 2017. ConocoPhillips dedicated a significant proportion of its revenue from the sale of its assets to debt reduction and a share buyback programme, while Shell's sale aimed to reduce debt and refocus its operations on natural gas and Brazilian offshore oil opportunities, following its 2016 acquisition of BG Group.

Largely away from the principal producing basins in the US, private equity groups emerged in the third quarter as significant buyers of assets perceived to be underperforming, or to have been ignored by industry leaders. Through the third quarter of the year, private equity interests had completed 19 transactions valued at a cumulative $8.95bn, according to PWC's US Oil and Gas Insights third quarter 2017. In that period, private equity transactions totalled 36% of overall US deal volume.

More gas-sector consolidation

While oil transactions have taken most of the limelight this year, Wood MacKenzie's Ellacott thinks additional gas-sector consolidation may also be in the offing. The Permian basin is a prolific associated-gas province, and many see US gas prices pushing below $3 per million British thermal units in the medium-term, which could spark acquisitions. Tight oil and gas prices have influenced each other since the beginning of the shale hydrocarbons boom.

Outside the US, M&A activity in the UK North Sea appeared to have settled down over the year, with Total's acquisition of Maersk Oil for $7.45bn. This marked the establishment of a new balance between majors and independents in the now-mature oil province, with an industry-wide philosophy of maximising efficiency well in place. Additional acquisitions by private equity groups may be on the cards, however: The Carlyle Group of the US is reported to be raising £1bn for a new fund aimed at acquisitions outside the US, and may be followed by others. Some cite Aker BP's October agreement to buy the Norwegian assets of US oil firm Hess for $2bn as an example of companies continuing to consolidate their positions in the North Sea by buying out minority interests in projects.

In other areas, large gas-asset acquisitions by ExxonMobil and BP in Mozambique and Egypt show major oil companies adjusting their assets, as opportunities also arise in jurisdictions such as Argentina, Guyana and Mexico. ExxonMobil's Liza development in Guyana has garnered much attention since June when the company took its final investment decision to proceed. But such opportunities will continue to be conditioned by majors' renewed discipline in seeking value before volume and maximising shareholder returns. Projects will be required to be cash-generative at $50/b to be developed.

This article is part of a report series on Oil and gas finance. Next article is: Time for financial discipline

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