This Could be the Demise of Oil M&A
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This Could be the Demise of Oil M&A

by | published October 4th, 2019

Well, I’m writing this sitting in another airport awaiting another flight. By the time you read this, I will have landed and be off to my next series of meetings.

I have spent the last several hours digesting an inside report on oil industry finance developments authored by a close contact of mine in energy banking. What it describes is unexpected and may well portend an important shift in the sector.

Based on a multi-month study, the report concludes that mergers and acquisitions (M&A) in the U.S. oil patch are declining, and in some locations, they are simply drying up.

If this situation persists, project finance may be in for a nasty jolt.

Here’s the reason…

The Times They Are a Changing

Most American oil and natural gas operating companies run cash poor. They rely upon lines of credit (i.e., debt, most often of the high risk or “junk” bond variety) to pay for new drilling and production.

Revenues from raw material sales are largely reserved for other purposes – dividends, stock buybacks, certain aspects of infrastructure, research and development (R&D), and some part of M&A expenses.

Normally, the use of debt to pay for the bulk of operations is not a problem. Provided the market price for oil or natural gas is decent and the company has an acceptable track record, the funding is found. True, the debt carries higher interest rate payments than investment grade paper, but the companies have enough latitude to pull it off and still make an adequate profit.

Over the past 18 months, however, matters have changed.

Funding for operations has been continuing, but investment banks have noticeably moved away from providing funds at acceptable rates for M&A.

The emergence of such a bearish tendency among the energy investment banking community has been rapid.

The report suggests several contributing factors.

Oil is a Battlefield

First, the current and projected tradeoff between extractable reserves and wellhead prices is making underwriting of more known oil/gas less attractive. The wellhead price is the first arm’s-length transaction when volume comes out of the ground. The price is at a discount to market, and represents the proceeds made by the operator.

Second, there are additional concerns over gluts in main production basins. This is particularly the case with the highly prolific Permian Basin in West Texas and Eastern New Mexico. Lifting more volume simply magnifies the problem and further depresses the price obtained.

The remedy requires expanding pipeline capacity along with more capital expenses for increasing storage.

With the Permian, new pipelines are moving more of the excess production to the Gulf Coast for export to higher paying foreign markets. This is essential because increasing volume for domestic use beyond realistic demand estimates is a recipe for reducing the bottom line of operators.

Having acquisition targets with nice and available booked reserves is no longer as enticing for sources of finance if the result will merely lower what that oil or gas can command in the market.

Third, the report identifies a range of factors that are beginning to mitigate the essential reason for most M&A transactions in oil and gas.

A publicly traded operator acquires other companies to enhance booked reserves. The known volume available in the ground (and thereby available for future extraction) is what supports the acquiring company’s traded stock moving forward, not current production.

There is simply less acquisitions interest in the present market due to limited return potential.

So, what is this likely to mean?

We’re Heading to the Road Less Traveled

There will still be M&A where the move is part of a broader corporate strategy.

In such cases the absorption is not triggered by an opportunity, but by a longer-term intent. Such growth, on the other hand, still has its limits.

While reducing competitors may still be an objective in some cases, controlling more reserves in what is approaching a saturated market does not result in better bottom line figures.

The report does note activity among private investment groups to acquire producers, with the acquire companies either remaining private or becoming so after the ink is dry. But the finance available here is selective, and the history of such moves not encouraging.

The bottom line here appears to be this:

Unless the supply/demand dynamics and price improve, we are probably going to see a rise in bankruptcies as acquisitions decline.

And there is also a more disconcerting element in all of this.

For decades, there has been a direct correlation between the availability of finance for operations and acquisitions. It is not unusual for the same funding source to be involved in both. Conversely, as interest declines in one, it will decline in the other.

And that is going to introduce a major problem, one I have addressed before here in Oil & Energy Investor before.

The U.S. sector has been delaying major, new full cycle field projects for some time, preferring to emphasize additional step out drilling at half cycle fields. That is, most activity is taking place where drilling already is occurring, and infrastructure is already in place.

Unfortunately, we are approaching – and in some basins have already reached – a point where replacement volume requires new fields. The delay in moving into meeting this challenge will mean that the costs will be higher.

That may be disconcerting if the financial parameters don’t improve.

Sincerely,

Kent

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