Disruption shapes oil and gas M&A at a time of oil price volatility
Technology's growing importance in building resilience to volatility means that digital capabilities will likely be a notable driver of acquisitions in 2019
Transaction activity is in many ways a gauge of market and capital confidence. If we look back over the last year, oil and gas transaction activity has reflected the sentiment across the whole industry value chain. Overall oil and gas deal volume has been resilient, but once you strip out some of the more structural transactions in the midstream, it is consistent with the cautious optimism that now characterises the sector.
While upstream assets are valued on a long-term view of oil and gas prices, short-term prices tend to increase uncertainty. Accordingly, volatility typically thwarts deal activity. Following the 2016 agreement between Opec and non-Opec producers to cut production, oil prices had stabilised this year and were rising until the third quarter of 2018. As a result, oil and gas companies started to increase investments again.
A consensus about the future outlook for oil prices has helped maintain mergers and acquisitions (M&A) activity in the upstream segment in particular. And recent market volatility, primarily driven by the perception of geopolitical tensions and ongoing uncertainty as to Opec's response to the impact of sanctions, is yet to stall the deal market. However, the markets will be watching closely the outcome of Opec deliberations to determine if recent volatility is a short-term phenomenon or indicative of a more structural change in price outlook.
The US has driven upstream M&A activity in 2018 to date, accounting for more than 60pc of deals globally, with activity in the Permian representing more than one third of US deal value. However, while US deal value has been steady over the last three years, the track record of other regions has been mixed. Activity in Canada and the North Sea has been subdued compared with last year, despite a number of deals in the pipeline.
The oil majors have maintained their focus on capital discipline and operational efficiency this year. They have continued to look for opportunities to optimise portfolios by acquiring material conventional assets that sit in the optimal segment of the cost curve. Notably, this has also been accompanied by clear moves from several of the majors to materially increase their exposure to US shale.
Over the last 12 months, the majors represented the largest bidders for deep-water offshore rounds in both Brazil and Mexico. Brazil collected record signing bonuses of around US$5bn from the auctions of deep-water blocks. The majors were also active in the Middle East and are continuing to build out their gas portfolios where access has been less restricted than for oil, and where the size, capital resources and global reach of IOCs provide a natural competitive advantage.
In the midstream, a change in US tax law has helped drive M&A activity. The industry has seen the highest levels of deal value over the last five years, with total value likely exceeding US$200bn before the end of 2018. We have also seen the highest levels of downstream deal value in the last five years, largely driven by a single mega-deal amounting to US$35bn.
Consolidation in the oilfield services sector continued, with robust volumes to date of 125 deals and activity primarily driven by ambitions to reduce over-capacity through consolidation. Private equity players were also notable buyers in both the downstream and oilfield services sector during 2018.
In light of current market volatility, it is difficult to hazard an informed prediction of where the oil price will land in the coming months.
Short-term financial results of oil and gas companies are driven by unpredictable geopolitical factors and volatile supply and demand dynamics, which have always made it challenging for management teams to make long-term capital allocation decisions.
However, today's businesses are grappling with additional levels of uncertainty owing to new production technologies. This is due to both the continuing cost evolution in unconventional projects and the impact of digital on conventional operating costs.
The coming years could see a significant increase in deals between renewables and utility companies
In addition, longer-term demand for hydrocarbons is now in question, and it is difficult to predict how this will unfold. How companies respond to these challenges will be driven both by their own perception of the future landscape, and how their current portfolios position them for opportunities to drive M&A activity.
One theme that may emerge in 2019 is the IOCs' ability to adopt technology that can differentiate relative performance on any reserve. This would provide them with a significant competitive advantage, potentially underpinning their buy-side M&A activity in the future.
However, to pursue this opportunity, the IOCs' investment community must decide how they want leadership to prioritise growth investment versus near-term cash returns through dividends and share buybacks. For the last decade, the emphasis has been very much on the latter. Oil and gas companies across the sector are increasing their investment in digital capabilities, which will likely be a notable driver of acquisitions in 2019.
Optionality has emerged as a strong strategic response to the complexities that the majors are currently facing. That is, maintaining a core focus on oil and gas while investing a defined threshold of capital in renewables. This will facilitate engagement in the changing energy landscape while accounting for divestment and curtailment, but without exposing the company to significant financial risk if the environment does not change within the anticipated time frame.
With electrification now also primed for high growth, the majors are exploring options to increase their footprint in alternative energy projects. While cross-sector deals have been limited to date, the coming years could see a significant increase in deals between renewables and utility companies, and oil and gas companies. From a capital deployed perspective, however, the principle beneficiary may well be increased investment in natural gas.
The downstream has proven that it can generate returns amid price volatility in 2018 and is set to continue to mitigate longer-term demand uncertainty. This is underpinning an active market for downstream assets as both hydrocarbon-long national oil companies (NOCs) and IOCs look to rebalance portfolios toward a heavier downstream weighting. Petrochemical attractiveness is also being reassessed. Although much of the capital will be deployed organically, this rebalancing will inevitably drive M&A activity, and new markets including India will continue to spurn interest from NOCs looking to acquire or invest in refining assets.
Meanwhile, independent upstream operators are increasingly moving away from the more traditional exploration-led strategy toward repositioning themselves as niche players in some basins. As a consequence, they are likely to form more alliances and joint ventures to cut costs, drive efficiencies and deliver returns, while maintaining their core IOC strategies.
And with a steep increase in production in the Permian resulting in a shortage in capacity to transfer oil and gas, several pipelines have been planned—or are under construction—that will likely come on-stream in 2019 or 2020. Increased investment in the midstream is also likely to continue to drive M&A deals next year, to capture benefits from economies of scale and the ability to offer flexible routes to customers.
According to the latest EY Global Oil and Gas Capital Confidence Barometer, 55pc of respondents expect their company to actively pursue deals in the next 12 months, and 60pc expect their deal pipeline to increase over the same period.
Clearly the market is resilient, but will it result in deals? Only time will tell.
Data source: 1Derrick (www.1derrick.com)
Andy Brogan, EY Global Oil & Gas Transactions Leader, is based in London. For more information, visit ey.com/oilandgas.
The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms.