MERGER AND ACQUISITION activity in the upstream sector of the oil and gas industry reached record levels in 2014 due in no small part to the extraordinarily high oil prices during the first part of the year. Everybody wanted a piece of the action, particularly a slice of the North American shale pie.
So far, 2015 has been a polar opposite. Upstream deals in North America are down about 94% as we approach mid-year. Internationally, the only major transaction has been Shell’s $81.8 billion offer for UK gas giant BG on April 8. This ranks as the second largest merger in industry history, barely below Exxon’s $82.3 billion acquisition of Mobil Oil in 1998.
The Shell-BG deal seems like a good fit, but it’s something that only a deep-pocketed oil major or very large international oil company could pull off given the current economic climate. Shell is one of a handful of global companies with the ability and wherewithal to look far into the distance and take action that will benefit the company and its shareholders many years into the future.
The main issue with declining M&A activity in the United States is the lack of sellers, say industry analysts. There is no shortage of potential buyers, domestically and from Asia, in particular. However, asset-holders see oil markets flirting with $60 and $70 oil prices and are adopting a wait-and-see attitude. According to reports from several Houston-based investment banks, Japanese investors and Middle Eastern firms are actively looking to buy into North American shale plays to assure access to supplies.
For many US shale operators, oil production is economic with prices at $60 or above, so they see no immediate need to sell core assets. And with fully-loaded private equity funds in the wings, they are more inclined to sell equity in the company than to lose high-quality assets. Management doesn’t want to look foolish if prices make a comeback later this year.
Besides, the bid/ask spread is wide, says Neal Dingmann, manager of E&P and oilfield services for SunTrust Robinson Humphrey, whom we talked with for this month’s cover story. "I believe that a period of relatively stable prices – more than just a rebound in prices – is needed in order for deals to increase, as the price stability would likely cause the narrowing of bid/ask spreads, which appears to be the reason for the lack of recent deals."
It’s a bit of a different story outside North America, says Ranulf Couldrey of London-based TRBP Ltd., writing in the May issue of OGFJ ("Trends in upstream M&A").
"Even at $100 per barrel, a large proportion of projects have been uneconomical for the larger IOCs," he said. "Over the last decade, operating costs have risen by 300% while production has only risen by 12%. For the super-majors, only the largest of margins (more and more often provided by mega-projects with greater than $1 billion in CAPEX requirements) can cover soaring G&A and operating expenditures."
Even Shell, says Couldrey, announced last year that one-third of its portfolio was making a neutral return.
Highly leveraged companies, typically mid-sized and smaller independents, are facing a dilemma due to the unavailability of conventional funding to develop their assets, but the necessity of generating revenue from production in order to service their debt. Over the past few years, says Couldrey, the industry has drawn down more than $1.2 trillion in credit. He concludes that "a rash of upstream companies can’t be far away from a wave of defaults and Chapter 11s."
Kim Brady of SOLIC in Chicago, writing in the current issue of OGFJ ("On the brink of extinction"), says, "Most E&P companies are heavily leveraged and must keep drilling, even at the current oil price, to survive and meet their debt service obligations. This is the reason why consolidation has not happened more rapidly. Company valuations are still too high due to expectations that the oil prices will recover by the fourth quarter to the $70 to $80 range. The Shell-BG deal doesn’t count because that was a gas deal."
Brady seems to agree with Couldrey that we can expect to see more E&P companies filing bankruptcy and seeking formal reorganization this year.
"I’m [not] optimistic that oil prices will recover to the $70 to $80 range by the end of the year, though I wouldn’t be surprised if it gets back up in the $60 to $70 range by then," says Brady. "Yet, for many E&P companies, this won’t be enough."
Whether or not these scenarios play out, producers do not seem particularly motivated to sell assets at this time – not at the bottom of the market. They know the true value of their assets, and they prefer to hold on to them until prices recover sufficiently or they run out of options.