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Merger mania goes midstream in oil and gas sector

After a flurry of major M&A deals in the upstream segment last year, cash-rich companies are making moves a little further up the value chain

There is still a degree of merger and acquisition (M&A) activity in the oil and gas sector. However, it has retreated slightly, and is shifting from the upstream to the midstream segment, with China is facing more competition for assets from other Asian players.

A slowdown in the pace of energy M&A follows a flurry of activity towards the end of 2011. Weaker prices for oil and gas and persistent worries about the effect of the Eurozone’s sovereign-debt crisis – and its impact on global energy demand – have taken a toll, affecting companies’ ability to raise finance for transactions. According Deloitte, a consultancy, the total industry deal count fell to 231 in the first half of 2012, compared with 256 in the year-earlier period. Total deal value also fell slightly, to $106.0 billion during the first half of 2012 from $108.6bn a year before.

“The credit markets have been volatile this year due to financial turmoil in Europe,” notes Jason Spann, partner at Deloitte’s tax and M&A transaction division. “This creates uncertainty that affects everyone who is looking to commit large amounts of money to M&A activity. Periods of high volatility in the credit and equity markets make it difficult to price deals, amid uncertainty.”

Cash-rich Chinese energy companies are less concerned about financing – and are still taking the opportunity to pounce on cash-poor foreign producers, acquiring assets, reserves and technology in the process. China National Offshore Oil Corporation’s (CNOOC) huge $15bn bid for Canada’s Nexen Energy is dominating the headlines, but it only the largest of a bunch of deals in 2012 between Chinese and foreign firms.

CNOOC Ltd, the listed upstream arm of the parent company, has been busy elsewhere. In July, it agreed to acquire a 25% stake in two of Shell’s exploration blocks offshore Gabon, West Africa, and in February it completed the acquisition of a third of Tullow Oil’s Uganda assets for $1.47bn.

PetroChina, Asia’s largest oil and gas producer, kicked off 2012 with a deal to buy out Canada’s Athabasca Oil Sands’s 40% interest in the MacKay River project in northern Alberta for $674 million, making it the first Chinese state-owned company to wholly own a Canadian oil-sands project. More recently, PetroChina in July agreed to acquire 40% of exploration and production rights for Qatar’s block 4 from GDF Suez Qatar, which is the operator of the block, and in August agreed to buy Australian firm Molopo Energy's coal-bed methane (CBM) assets in Queensland for A$41m ($43m).

Sinopec has also been active, agreeing in July to buy a 49% stake in the UK unit of Canada’s Talisman Energy. This followed a deal with US producer Devon Energy at the start of the year that will see Sinopec invest $2.2bn for a third of Devon’s interest in five developing fields as part of a long-term partnership.

All in all, according to Thomson Reuters data, Chinese acquisitions of overseas energy assets so far this year have amounted to $5.1bn, which compares with $16.3bn in 2011, down from $23.4bn in 2010. In total, China’s non-financial direct outbound investment reached $35.4bn in the first six months of 2012, up 48.2% from the year-earlier period, commerce minister Chen Deming told newswires.

Getting better at buying

While Chinese companies might be attempting less M&A, they are becoming more successful at it – signs, analysts say, of their greater experience in pursuing such deals. The general economic slowdown in the developed world has also helped them: a desperate search for inward investment tends to trump suspicions about such money coming from the Chinese state.

The country’s firms now have a higher success rate in completing mergers, says Australian law firm Freehills, which makes an annual survey of Australian M&A. “This is particularly impressive,” notes Freehills, “given that only 40% of Chinese deals in fiscal 2012 were launched with the recommendation of the target board.”

For now, the law firm says, Chinese attention remains focused on natural resources. “It remains to be seen whether Chinese investment in Australian public companies will, in the future, extend far beyond the energy and resources sector,” Freehills says. Chinese bidders have only accounted for two successful non-energy and resources transactions in the past three financial years, it added, in the agribusiness and biosciences.

Much Chinese M&A has focused on the unconventional oil and gas business in North America and Australia. As well as the gas, the buyers acquire technology needed to exploit its own huge estimated reserves of unconventional hydrocarbons. Beijing puts the country’s CBM reserves as high as 36.8 trillion cubic metres (cm), far higher than its proven (conventional) gas reserves of 2.8 trillion cm. Tapping the CBM riches, analysts say, will require sophisticated mining techniques including fracturing vertical and horizontal wells, U-shaped wells and cluster wells, adapted to meet local formations.

Consolidation breeds competition

Unsurprisingly, given the scale of their shopping spree, Chinese companies appear to be turning their attention to consolidating their purchases, opening up opportunities for other Asian companies. Thomson Reuters data show that while there is a general slowdown in oil and gas M&A from Asia, it is nevertheless still substantial at $13bn so far this year, compared with $28bn for 2011 and $44bn the previous year.

North America’s unconventional gas industry is the target for these firms, too. The long-running slump in Henry Hub gas prices offer good opportunities to pick up cheap assets. Eventually, these assets may produce gas for export as liquefied natural gas (LNG) to Asian markets, where it commands much higher prices.

Recent examples include Malaysian state oil company Petronas’s offer for another Canadian gas producer, Progress Energy Resources. Its C$5.17bn ($5.3bn) offer was steep but, points out Raymond James analyst Kristopher Zack, it reflected “the massive resource potential of the company’s Montney land base and a strategic premium for integration with the Petronas LNG plans on the west coast of Canada”.

Japanese companies likewise are keen to secure liquefied natural gas (LNG) supplies to replace the fall in nuclear energy following the Fukushima disaster. In February, Mitsubishi agreed to pay C$2.9bn to buy 40% of Encana’s gas assets in British Columbia, in Canada’s west.

Nonetheless, few think the Chinese will disappear form the scene anytime soon. Simon Reed, a partner in Freehills’s corporate group, says the country’s need for foreign energy hasn’t changed, even if its ability to complete deals cheaply has. “I don't see a softening and, if anything, they'll continue to be a very strong player.”

Rushing in, Russia out

Outside North America, Russia may also see some big ownership changes in its oil and gas sector this year, driven by political instability, huge investment needs as the industry moves from onshore reserves to trickier frontier areas, and weak equity prices.

“We consider 2012 to be the year of changes in the Russian oil and gas sector as political and economic situations in the country develop,” says Ilya Lushnikov, an analyst with RUXX, an index that tracks Russian equities traded overseas.

Chief among them is the high-profile exit of BP from its TNK-BP joint venture, announced on 1 June. BP has had a lucrative run in Russia. But the poorly structured joint venture with Alfa-Access-Renova (AAR), the consortium of oligarchs that controls the other half of TNK-BP, and a terrible miscalculation in trying to strike a deal with state-owned Rosneft behind AAR’s back, has meant the end of the company’s latest Russian adventure.

There are only two real possible outcomes for TNK-BP: either one of the partners buys out the other, or a state player replaces one of them. The trend of growing government presence in the sector makes the second outcome more likely.

Energy still accounts for a hefty 70% of the Russian state’s revenues, says Lushnikov, so it is “understandable” that the government would want to consolidate its control over the income. It can do this by putting “the most lucrative assets in the industry in the hands of businessmen and companies it sees as loyal”.

Analysts at Moscow-based investment bank Renaissance Capital (RenCap) believe the Kremlin will increase its control of the energy sector from 33% now to around 50%. Inconsistent regulations and falling returns have depressed some asset prices, too. “Investors seem to us to have thrown in the towel and are ready to write off almost $500bn of value in the sector, as they see little opportunity to share in any future upside,” Renaissance says.

Like BP, ConocoPhillips appears to be heading for the door after selling its 20% stake in Lukoil and nearing the completion of the sale of its share in Naryanmarneftegaz. Reports suggest the US major is now looking to offload its share in Polar Lights, a joint venture with Rosneft, and its last asset in Russia. Surgutneftegaz and Lukoil, which both enjoy low valuations and strong balances sheets, could lead this consolidation in the sector, says RenCap.

Caught midstream

Meanwhile, M&A is also shifting from the upstream to the midstream.

While the Deloitte figures show the value of overall oil and gas M&A falling slightly during the first half of the year, global midstream transactions rose to $29.3bn in, up from $17.2bn a year earlier. The largest deal was Energy Transfer Partners’s acquisition of Sunoco, which owns both refining and midstream assets, for about $9bn. This followed Kinder Morgan’s purchase of El Paso Corporation during the fourth quarter of 2011, another multi-billion dollar transaction.

“The bright spot for the industry in the first six months was midstream,” Roger Ihne, a principal with Deloitte, told reporters at a Houston luncheon to release the consultancy’s midyear M&A report. “It is taking on a different dimension.”

Deloitte expects more M&A activity in the midstream sector, the size of which has grown sixfold, to $300bn, in recent years, and is heading towards $1 trillion. Ihne sees a new landscape emerging within the segment. “We now have at least three tiers of midstream players: four or five very large companies, a second tier of mid-sized companies, and then a third tier where you have a lot of players in the $10bn-and-under size,” Ihne says in the report. “Across that landscape, the big question is how much consolidation will eventually occur.”

This is backed by another consultancy, PwC, whose own data for the US oil and gas industry show that midstream deal value, of $15.8bn, accounted for 55% of the second quarter’s total, an almost 200% increase when compared with the year-earlier period.

“The second quarter experienced a softening of oil prices and, combined with the continued lows of natural gas prices and the global economic uncertainty, many oil and gas companies started to pull back from new investments in the upstream sector,” says Rick Roberge, principal in PwC’s energy M&A practice. “However, dealmakers put their capital to work in the midstream sector where they focused on building out the infrastructure to transport, process and store the oil and natural gas extracted from shale plays they previously acquired. We believe that this infrastructure-related build-out will continue to be a focus for the remainder of 2012 and into 2013.”

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