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Why hasn’t the price crash brought a wave of corporate deals?

The M&A activity that does occur will predominantly involve assets rather than full takeovers – a continuation of the clear trend seen last year, when asset transactions made up 80% of upstream deals

A sluggish oil and gas mergers and acquisitions market may splutter into life in 2016, but buyers will try to pick off individual assets rather than entire companies.

Last year, you might have expected distressed oil and gas firms to increase divestments to boost cash flow, but M&A activity was modest. Total transaction value for global upstream oil and gas M&A deals fell by 22% to $143bn from $184bn in 2014, says IHS Energy, a consultancy. Worldwide deal count – including asset and corporate deals – almost halved in 2015 to its lowest level since 2001.

The little activity that did occur was embellished by the year’s biggest deal: Shell’s $48bn acquisition of BG Group. That transaction alone accounted for almost four-fifths of the total value of the 10 biggest deals, and the top five upstream deals accounted for two-thirds of total M&A deal value, according to Deloitte, an accounting and consultancy firm. Embryonic signs of recovery after a dire first quarter for M&A business – one of the slowest on record – failed to develop into a meaningful recovery. It’s all very different from the M&A bonanza that arose during the oil-price slump of the late 1990s.

As the first quarter of 2016 drew to a close, things were still slow. The main reason is volatility in the oil price, which has made it difficult for buyers and sellers to agree on asset valuations.

Premium cash

Last year, hedges provided producers’ cash flows with some protection – giving weaker companies breathing space. Many also, perhaps surprisingly, continued to have sporadic access to capital on the debt and equity markets. Those two factors helped them resist the urge to sell, in the hope that the oil price would rise, lifting cash flow and asset valuations with it. But that hasn’t happened: oil prices have stayed low and, with hedged positions expiring and lines of credit being cut, small and medium-sized companies are running out of cash.

“Access to debt capital is likely to go down with borrowing base redeterminations in the spring,” says John England, Deloitte’s Americas and US oil and gas leader. “Last year, a lot of distressed companies sold non-core assets to raise cash. Now they’re going to have to dig a little deeper – with potential sales of more core, more interesting assets.” A recent Deloitte report identified some 175 highly leveraged or otherwise cash-constrained upstream companies – about a third of oil producers globally – at risk of bankruptcy, saddled with more than $150bn in debt combined.

Meanwhile, as the available pool of assets rapidly stacks up – especially in the US onshore – healthier companies are under no pressure to buy. By waiting another quarter or two, buyers might be able to buy assets even more cheaply or – if the oil price does rise – find themselves paying a bit extra, but for more stable assets. Either option seems preferable to buying at present.

Inevitably, the longer buyers wait to pounce – assuming there is no substantial upward movement in the oil price – the more asset valuations will feel the pressure. And the prospect of Asian national oil companies (NOCs) lending support to asset values through strategic acquisitions has all but disappeared. According to IHS Energy, their share of global upstream oil and gas acquisitions in 2015 fell to its lowest level since 2007.

Mounting distress among buyers will lead to an increase in deal flow in 2016, if prices stay low, says Wood Mackenzie, a consultancy. “Balance sheets will become ever-more stretched without asset sales to balance the books. Financing options will be more limited.”

The M&A activity that does occur will predominantly involve assets rather than full takeovers – a continuation of the clear trend seen last year, when, according to IHS Energy, asset transactions made up 80% of upstream deals. But the acquiring companies, softened up by the depth and duration of the oil-price slump, will be extremely cautious when assessing any purchase; they are likely to target assets in business and geographical areas in which they believe they already have a competitive advantage.

“Oil and gas companies will want to add to their expertise in a particular basin, but they won’t want all the stuff that goes with it,” says Iain Armstrong, an analyst at Brewin Dolphin, a stockbrokerage. For instance, at a time when most upstream companies are cutting back on exploration activity – often dramatically – acquirers won’t want to have to explain to shareholders why they are buying companies with extensive exploration portfolios.

The great debt burden

Meanwhile, many small and medium-sized companies are struggling under unmanageable levels of debt. Corporate takeovers would require the assumption of those debts and, depending on loan terms, might trigger obligations – known as change-of-control provisions – to repay them straight away. In such cases, it would be necessary to renegotiate loan terms with banks before the completion of any transaction, another barrier to deal flow.

Nonetheless, compelling corporate synergies – which made sense of Shell’s acquisition of BG, even in a raging bear market – might give a handful of buyers reason to look beyond the downsides of full takeovers. Indeed, long-term strategic thinking might be what is required to get the M&A market up and running again, says Seenu Akunuri, US oil and gas valuation practice leader at financial-services firm PwC: “For M&A activity to resume at a reasonable pace, it will take buyers who are patient and have long-term perspective on the potential value of the assets.”

Finding deals with synergies on the scale of Shell and BG, which had overlapping activities in multiple markets and areas of business, won’t be easy. But, says Wood Mackenzie, there will always be counter-cyclical buyers, confident of an eventual recovery – NOCs and majors, but private-equity too, which “seeks to exploit exactly these kind of value-based opportunities”.

Much, of course, depends on the oil price. Wood Mackenzie says Brent could rise in the second half of 2016 and average over $65 a barrel in the final quarter, and keep strengthening thereafter. That would inject fresh belief into a tottering market devoid of confidence. Deloitte sounds another optimistic note concerning the industry’s toughness and adaptability – attributes evident in previous market crises. “While low commodity prices and cost-cutting efforts continue to be a focus, in the long run, we expect the industry to adapt, innovate, and ultimately emerge more resilient.” Certainly, the sector is facing one of the sternest-ever tests of its mettle.

Sales in the shales

The US should could become the hub of global oil and gas industry deal-making this year, as majors and private-equity buyers seek to reinforce their exposure to shale.
So far, the pace of mergers and acquisitions in the US’ shale basins has been underwhelming (see p59), but in the past two years North America still accounted for the biggest chunk of global upstream M&A; excluding the Shell-BG deal, the continent accounted for about 60% of worldwide upstream deal value in 2014 and 2015, says consultancy IHS Energy. That should remain the case, with shale gradually emerging as the busiest sector.

Many small and medium-sized companies are struggling under unmanageable levels of debt. Corporate takeovers would require the assumption of those debts and might trigger obligations – known as change-of-control provisions – to repay them straight away

Activity in shale should pick up over the course of the year partly because of the growing strategic value of shale assets within the portfolios of big companies, says Guido Boero, an M&A and portfolio-strategy adviser at Accenture Strategy Upstream (formerly Schlumberger Business Consulting). “Being a major today and ignoring shale could have strategic consequences,” he says. “Exposure to shale allows control over a key marginal source of supply. Also, due to its geological characteristics, shale offers greater flexibility for rapid cost management in a downturn.”

The other reason why shale should take centre stage is the degree of distress being experienced by highly indebted onshore operators in the US, many of which are clinging to lifelines from the banking sector. Companies such as Whiting Petroleum and Continental Resources – with long-term drilling and production prospects in the Bakken shale, all but free of political and exploration risk – are looking attractive strategic bets. EOG Resources, Pantheon Resources and heavily indebted Chesapeake Energy could also be targets. Total – relatively underexposed to US shale – and ExxonMobil, which recently raised $12bn in a bond sale, are candidates on the buy side.

The field of potential targets – in shale and beyond – encompasses much bigger players too. In March, for example, Anadarko said it was cutting its capex by nearly 50% year on year and reducing its onshore US rig count by 80% – hardly the actions of a company riding out a storm in comfort. Anadarko and other medium-sized North American independents such as Murphy Oil, EnCana and Noble Energy might find themselves on the shopping list of majors such as ExxonMobil, BP and Chevron, which plans to focus increasingly on shale.

But the majors themselves aren’t distress-proof. Having spun off its downstream refining business, ConocoPhillips is more exposed to movements in the oil price than integrated majors, which are enjoying a mini-resurgence in refining. ConocoPhillips has been divesting assets, but may be forced to sell more than it would like if difficult market conditions persist.

Some state-owned companies are in trouble too and may be forced to reshape their portfolios by selling assets. Prime among them is Brazil’s debt-laden Petrobras, which plans to raise $15bn through divestments. Petrobras would like to restrict sales to non-core areas; in early March, for example, it said it was discussing the sale of its Argentine assets to Pampa Energia, Argentina's largest power utility. But eventually it might be forced to put up some of its choice deep-water acreage for sale – such as part of its share in the 8bn-12bn-barrels-of-oil-equivalent Libra field.

Beyond North America, the North Sea is in need of consolidation: hamstrung by fragmented ownership, it is searching for more operating. Premier Oil, Enquest and Ithaca could be targets, but high debts, high operating costs and uncertainties regarding decommissioning liabilities are significant deterrents to potential buyers.

Globally, natural gas assets might also – gradually – become a growing source of M&A activity. Consolidation in onshore US gas assets could happen because local gas prices have fallen so low, depressing asset values and exacerbating the distress of gas-focused producers. More widely, though, climate-change commitments could start to generate more interest in gas companies.

Yet, for now, in all cases, the problem is not identifying sellers or assets for acquisition. With an estimated $300bn-worth of assets on the market and sustained and significant recovery in oil prices taking its time to materialise, the problem is finding buyers.

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