Journally Speaking: Post-COVID consolidation

Chevron Corp.’s deal to acquire Noble Energy for a total enterprise value of $13 billion made headlines for myriad reasons, and the deal may offer momentum to an industry arguably in need of consolidation, but challenges remain.

Oil and gas mergers and acquisitions (M&A) were “already slow headed into 2020, and the worldwide COVID downturn slammed the brakes on any potential deals. However, it also created potential opportunities down the back half of the year…and less than one month into Q3 we have our first major acquisition,” said Enverus senior M&A analyst Andrew Dittmar.

The deal “lays out the blueprint for what post-COVID consolidation will likely need to look like with all-stock consideration, a moderate premium, and asset fit and synergies that are an easy and natural story to tell investors,” he said.

“While potential targets may be more plentiful, there aren’t that many companies with Chevron’s balance sheet strength and investor support to make up a buyer base.”

Continuing challenges

Given complimentary positions in the Permian basin plus Noble’s international gas development in the Eastern Mediterranean, the deal is a natural fit for Chevron—something sought by investors as they eye development strategies—Dittmar said. But the deal also reflects Chevron’s cautious outlook. Chevron “is choosing to issue all equity and the deal is priced at a moderate premium relative to what is often seen in corporate M&A,” he said.

While there has been a broad consensus among the analyst community for years that consolidation would be a net positive, actual corporate deals have been hard to come by, Dittmar said.

“Partly it is just challenging to find a target that compliments a potential buyer’s existing asset base well and is open to a sale. There are also limited companies that have the balance sheet strength and appetite for pulling off an acquisition,” he said. Chevon “was a bit of a unicorn,” he said, as it has one of the strongest balance sheets in energy.

What the industry is more likely to see now, he said, are more ‘merger of equals’ combinations between companies with small- and medium-sized capitalizations and complimentary in-basin assets, similar to last year’s deal between PDC Energy Inc. and SRC Energy Inc.

Industry consolidation after years of oversupply would be healthy for oil market fundamentals, UBS CIO energy equity strategist Nicole Decker said, echoing that despite the perceived benefits, “the current appetite for M&A among both buyers and sellers remains low, given uncertainties in the oil markets.”

Consolidators are moving with heightened caution to preserve balance sheet health. Deals aren’t happening, Decker said, because assets of potential sellers would not enhance returns and cash flow for potential buyers. Buyers are unwilling to take on the sellers’ high debt balances—particularly given investors’ reduced tolerance for debt leverage—and some sellers “want a higher-than-current valuation, reflecting a midcycle oil price versus current trough valuations. This would require high premiums over current share prices which buyers are unwilling to pay.”

A few things need to happen for broader consolidation to occur, she said, and this willingness to accept low-or-no premiums could be the first step.

If low oil prices persist, we could see a greater willingness to sell, she said, but buyers are using a return-focused strategy, and are uninterested in investing in resources that do not meet return hurdles.

Cautioning that in a $55+/bbl WTI oil price environment “smaller operators’ earnings and cash flow growth could outpace the larger companies owing to their greater operating leverage,” potentially emboldening “financially burdened operators to stay the course,” Decker said UBS believes the consolidation trend will pick up once another factor—the bid-ask spread—is resolved.

How and when that occurs, given the great uncertainty the industry will face for the balance of the year, is unclear.

Speaking to second-quarter US upstream M&A activity, Dittmar noted a small recovery to $2.6 billion from first quarter’s $770 million. Despite the uptick, however, the numbers landed the quarter as the third lowest value since 2009. “With the uncertainty around oil, the limited buyers largely targeted low-cost natural gas assets,” he said, adding that “the market for new deals remains highly challenged, particularly in oil plays.”