February 2021, Vol. 248, No. 2
Features
CONSOLIDATION: Mergers and Acquisitions Embrace Oil Patch
By Richard Nemec, Contributing Editor
At the dawn of a new year, the U.S. macro-economy and capital markets had rebounded faster than expected in the second half of 2020, but the pace of recovery in the months ahead is still “highly uncertain” given COVID-19’s winter surge, Deloitte said in its oil and gas (O&G) outlook after the presidential election.
“Although the O&G industry is used to the highs and lows of economic and price cycles, this downturn seems unlike any other,” said the outlook, which was based on surveying 350 industry executives.
Uncertainty begets caution, which can lead to indecision. In the oil patch this eventually can lead to mergers and acquisitions (M&A) or Chapter 11 bankruptcy filings.
While there are predictions for both options building in the industry in 2021, there is by no means a consensus among various energy analysts on the topic. A lineup of heavy hitters – Chevron Corp., Occidental Corp. (Oxy), ConocoPhillips, Devon Energy and Diamondback Energy – have raced across the M&A playing field in a little more than a year’s time. Analysts expect even more, among some of the lighter hitting players, in the months ahead.
While Oxy’s acquisition of Anadarko Petroleum Corp. in 2019 was an aberration in its size and timing, consolidation and M&A activity should continue on a smaller scale in 2021, and companies with the flexibility to take on additional debt will be the ones most likely initiating these transactions.
Companies that in recent years have managed to slash their debt will likely be among the acquiring companies. Midstream companies in particular need to learn from their successes and failures so they can continue adapting and evolving, according to Tom Biracree, an analyst with RBN Energy.
Enverus, the Austin, Texas-based analytics company, called the M&A activity in the first and third quarters of 2020 “the worst showing in 10 years.”
It counted 28 deals in the third quarter of 2020 and noted that while the tempo was lackluster, the total transaction value turned out to be $21 billion, which Enverus considers “a strong quarterly total by historical standards.” The total was bolstered by the Chevron Corp.’s $13 billion acquisition of Noble.
For all of 2020 things changed. Upstream M&A accelerated dramatically in the second half of the year as a challenging economic backdrop spurred a wave of industry consolidation, Enverus noted, with activity cresting in the fourth quarter, including three multi-billion-dollar mergers centered on the oil-rich Permian Basin. “The quarter’s total value was $27 billion, the third most active quarter by value since oil prices lost their footing in late 2014.”
Loosely defined, M&A involves one company absorbing another enterprise, while “consolidation” traditionally involves a marriage of two equals.
“For many North American midstreamers, a key to success has been a thoughtful combination of expansion and diversification, especially when the broader energy industry is going through tough, uncertain times,” Biracree wrote in an analysis in late December.
He cites as an example the Canadian-based Pembina Pipeline Corp., which has spent C$14 billion in acquisitions over the past four years. Pembina has applied a “cautious” approach, relying largely on self-funding and rigorous return criteria, Biracree noted.
If debt levels are an important criterion in the potential M&A space, most exploration and production (E&P) companies are likely to be on the sidelines. Outlooks from Moody’s Investor Services have underscored the heavy leverage among E&Ps.
“We have commented for the past two years that aggregate E&P debt did not decrease much during the 2018-19 upcycle, so leverage is still high relatively speaking, and from our perspective we have a smaller investment-grade population [of companies] today than in earlier years in this century,” said Moody’s Sajjad Alam, vice president and senior analyst.
Even after a modest 3Q2020 comeback financially, E&P share prices were down collectively 69% in the last quarter compared to 2019 highs and 45% from the end-of-year 2019 levels. Most analysts in December were characterizing E&Ps as still being a long way from “normal.” That is after the 2020 third quarter produced the largest monthly gain in the sector ever – a 32% uptick in the S&P E&P Index.
Alam thinks most of the M&A activity that is coming will involve low-cost shale assets – either gas or oil.
“That’s where companies are able to make money even at low prices, and you have to be in the right basin and profitable at today’s prices,” he said. “It has to have the critical mass.”
During 2020’s downturn, the acquirers have been able to benefit from the scale by taking on the assets and driving down costs through synergies, such as what Diamondback is doing with the $2.2 billion QEP Resources Inc. acquisition in which QEP carried a relatively modest $1.6 billion in debt.
“It has to be a strategic fit for the acquirer,” said Alam, citing the example of ConocoPhillips looking for a bigger presence in shale through picking up Concho Resources (all-stock, $9.7 billion).
Among the criteria applied to M&A targets are:
- Low-cost assets available
- The deal being a strategic fit
- No excessive debt at the acquired company
- Opportunities for creating synergy growth
The typical attractive target for an acquirer is an operator with not too much debt while holding high-quality, low-cost assets.
Alam expects M&A to stay active in 2021 with most of the acquiring companies being investment-grade (“Aaa” or “Baa3” ratings). There will be a close corollary to the pandemic.
“If we can’t control the pandemic, people are going to be reluctant to drive or go back to their offices,” said Alam, adding that energy demand and COVID-19 are related, and he thinks there needs to be a “clear improving trend” in terms of cases, hospitalization and immunizations. “The oil demand and market sentiment will remain laser-focused on what happens with the pandemic.”
At the start of the worldwide lockdown, oil demand was down 15%; it was down 6%-7% in late 2020 before the resurgence between Thanksgiving and the Christmas holidays. “In early 2021, we don’t see energy demand growing in leaps and bounds,” Alam said. “It will be a gradual recovery.
“It’s possible more M&A could be stimulated because the overall valuations are still low. If the pandemic situation improves, I think it gives companies now hesitant to act the encouragement to pull the trigger and do a deal. At year-end 2020 they’re not sure; there is too much uncertainty.”
Deloitte’s 2021 outlook called the pandemic-driven downturn “the great compressor” of the oil and gas sector, putting the survival of many companies at risk and stretching out the longer-term decline in petroleum demand. As a result, “the next decade could look very different for the entire oil and gas value chain.” For Deloitte, this year will either be “a leapfrog year, or a test of endurance.”
In the pre-pandemic times, the Oxy-Anadarko combination skewed the discussion of M&A, but it was a one-off. In 2020, the U.S. energy industry experienced its most active M&A activity in recent memory, according to Alam.
There were a lot more marquee names; in 2016, 2017 and 2018, the deals were mostly in the private equity space, and they unfolded on a relatively slow time frame, compared to the deals lately that seem to arise out of nowhere and get completed in three months. Not since the late 1990s (ExxonMobil and Chevron-Texaco) have majors been involved in so much consolidation.
“There has to be a lot more consolidation,” said Vicki Hollub, CEO of Houston-based Oxy, talking to Daniel Yergin, at IHS Markit’s CERAWeek Conversations. “You have to create the scale necessary to optimize full-cycle development. Economies of scale are very important in shale development; otherwise, the good returns that you get on the drilling and completion of wells gets eroded by infrastructure. The smaller the scale, the more likely an operator is going to have to do something with respect to consolidation.”
Hollub envisions a new model for shale development that exploits infrastructure’s advantages over time. She thinks Oxy can further optimize that by applying carbon capture (CO2) and enhanced oil recovery (EOR) to the future shale process.
This can help mitigate ongoing concerns about shale, such as the value and low recoveries, and the fact that the decline is very hard to overcome over time. “This model, for us, is going to maximize the value and increase the value over what we had before,” Hollub said.
With the kind of consolidation that Hollub sees coming, U.S. shale oil may not get back to 13 MMbpd of production any time soon. Economics will drive a lot of decisions to not pursue small-scale shale projects, she said. Eventually there may be more interest in helping the small players consolidate to create a better chance that new developments will generate what Hollub calls “true returns and profitability.”
For Moody’s Alam, M&A deals in 2020 “seemed to come out of nowhere.” With COVID-19 lockdowns, various company CFOs working remotely online and the lack of “street talk,” deals were kept more confidential than normally. Their public exposure came quickly and were consummated in record times.
Investment bankers continued making pitches to potential acquiring companies with strong balance sheets to expose them to good potential deals, and these days most companies have their own M&A internal units that are scanning for potential marriages.
“A lot of times it is just a matter of being in the right place at the right time,” said Alam, adding that Diamondback finalized its QEP deal in a few weeks, and ConocoPhillips acted similarly. “Most of these recent transactions just popped up out of some due diligence.”
Heading into 2021, Alam thinks the number of logical buyers is dwindling, except for a few big players he thinks could probably do more buying. In contrast, oilfield services firms will probably continue to consolidate, he thinks, because most companies in the sector are volatile and financially weak, except for a few large operators in that space.
Just before the Christmas holidays, Diamondback revealed $3.1 billion of new acquisitions, and Moody’s analysts concluded they would provide a long-term “positive” credit outlook on the acquirer. Besides QEP, Diamondback acquired all of privately held Guidon Operating LLC’s leasehold interests and related assets in the Midland sub-Basin of the Permian Basin in Texas.
Diamondback provided 10.63 million shares of its common stock and $375 million in cash to Blackstone, Guidon’s private equity owner. “If oil prices rise and appear sustainable at a higher level, Moody’s could consider a positive rating action in 2021,” the rating agency said at year’s end 2020.
Based on the rating agency’s calculations, if Diamondback’s two acquisitions had been in place in 3Q2020, they would have produced 382,000 boe/d for the quarter and expanded Diamondback’s proved reserves by 1.7 billion boe.
“These acquisitions will help Diamondback establish a significantly larger, high-graded and more consolidated northern Midland acreage position,” Moody’s concluded.
This same story does not necessarily get retold in other robust basins, such as the Bakken in North Dakota where bankruptcies among E&Ps have come more frequently than M&A.
“We don’t keep track of these, but on the E&P side there really weren’t any M&A or consolidation transactions in 2020,” said Kristen Hamman, a spokesperson for the North Dakota Petroleum Council (NDPC). “There were some acreage swaps and things, but the players are still here.”
Among oilfield service operators, Hamman said it is suspected that there were many M&A/consolidation moves, but NDPC doesn’t track those either.
“The most significant, obvious and important effects of COVID-19-induced dislocation among [40] major E&Ps that we monitor are the unprecedented numbers of corporate bankruptcies and acquisitions,” said RBN Energy’s Nick Cacchione in mid-December as part of a blogcast.
Cacchione noted that in the last nine months of 2020, six of the E&Ps watched as RBN filed for Chapter 11 reorganizations, while another six companies will be acquired, five of which are going to other major producers. As top-tier companies combine, Cacchione speculated that they will achieve “economies of scale that enable them to slash operating expenses and increase cash flow.”
In the overall blog, RBN mentioned a “moderate whiff of optimism” in the near-winter air. “Equity prices in general were buoyed by news of the COVID-19 vaccines … that could finally bring the pandemic under control and improve industry fundamentals,” Cacchione said just before winter officially kicked in.
By then, six of the 40 RBN-monitored E&Ps had high debt and high operating costs push them into Chapter 11 – Chesapeake Energy, Whiting Petroleum Corp., Denbury Resources, Oasis Petroleum Corp., Gulfport Energy and Extraction Oil & Gas Corp. – collectively shedding $10 billion in debt. Cacchione noted that the other 34 companies being tracked collectively had more than $160 billion in debt.
This all points to a trend for M&A deals to be all-stock with little premium paid as the incentive for these transactions in the current high-debt environment. In mid-December, Cacchione indicated he expected “more consolidation activity among current top producers, given oil prices in the low-to-mid-$40s/bbl.”
As the curtain came down on 2020, Dallas-based Pioneer Natural Resources Co. was finishing two M&A transactions for the year, valued collectively at $6.2 billion. Permian-focused Pioneer picked up a Dallas neighbor in Parsley Energy Inc. in a $4.5 billion deal with a stockholder vote set for mid-January in the new year. Earlier in 2020, Pioneer added Evergreen Resources for $1.7 billion, expanding its portfolio into the Rockies.
RBN analysts noted that Pioneer and Parsley were among the top profit takers in 3Q2020 among the oil-focused E&Ps. Pioneer pocketed $287 million in quarterly net income, and Parsley ranked second-best with $201 million.
Parsley also managed to be the most profitable ($11.93/boe) and generated the highest cash flow ($20/boe). In contrast, Diamondback, which also had an acquisition, posted the largest loss in 3Q2020 ($1.2 billion, with a $1.45 billion impairment charge). The acquisition for ConocoPhillips scheduled to close in 1Q2021, Concho Resources, turned up the highest profit among E&Ps in the third quarter at $300 million, outdoing its acquirer’s quarterly profits ($251 million).
Ultimately, profits are not as important as steady – not spiking – energy prices and healthy balance sheets in determining the extent to which M&A remains an issue in 2021.
According to Deloitte, in the first 10 months of 2020, shale companies wrote down $145 billion worth of assets, and even “dirt-cheap” valuation of those assets are not attracting many buyers. There are now entirely altered market dynamics and financial outlooks for shale operators, Deloitte’s report concluded.
“Longer term, for prices to get to $50 or higher, demand needs to come back, and more demand will increase M&A,” Moody’s Alam said. “Will M&A increase? Generally, it picks up when prices are in the recovery stage, and we have seen some of that since mid-October [2020]. Things are looking up, and more M&A could materialize for the first six months of 2021, unless prices spike up a lot. When spikes happen, everyone becomes a little more cautious about bidding up prices.”
Low prices and too much debt is a bad combination from an acquirer’s perspective, but that may be eased with more price recovery and the passage of time.
Alam cites the hypothetical mid-sized operator with decent assets in a prominent basin, but with an overload of debt. This type of company would be much harder to get picked up in the current price environment, applying his metrics.
The lesson: It is risky to predict the future for M&A when the oil patch exudes so much balance sheet and market uncertainty.
Richard Nemec is PG&J’s Los Angeles-based contributing editor. He can be reached at rnemec@ca.rr.com.
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