Is energy M&A finally about to boom?
The long-awaited M&A boom in energy might finally be here. Big Oil has had a shocking lack of big deals, considering how far asset values have fallen during the commodity crash. But analysts are now sizing up major potential deals that could come to pass over the next several weeks. Tens of billions of dollars are being raised by institutional investors, and the implication from this capital raising is that it will be used for sizable deals.
In addition, Big Oil firms have cut costs to the bone in the aftermath of the oil crash. Some of the biggest operators have enough financial flexibility to preserve their balance sheets and make significant acquisitions. This was the impetus for Royal Dutch Shell (RDS.B) acquiring BG Group for $52 billion in early 2016. The deal was the largest in Royal Dutch Shell’s history, and could be an indication of things to come.
While it is unlikely the energy industry will see another deal of that size and scale come to pass, there is nevertheless good reason to expect a surge in M&A deals in the coming weeks.
What’s the hold up?
On paper, the conditions seem perfect for a boom in energy mergers. Asset values are very low, due to the fact that the price of oil sits at less than half the level seen just two years ago. Smaller exploration and production firms are in dire need of cash, as many are incurring significant losses and are saddled with high levels of debt. Normally, it would be customary for one or multiple industry giants to pounce and buy up acreage or other companies outright. After all, when there is blood in the water, it does not take long for the sharks to swarm.
Add to this the fact that the deep-pocketed integrated super-majors like Exxon Mobil (NYSE: XOM) have bided their time, raising billions of dollars through cutting costs and asset sales. With lots of money on the sidelines, there may be no better time than now for Exxon or one of its rivals to embark on a spending spree. But as of yet, this has not transpired.
One reason for the delay thus far is that companies with money to spend are simply waiting out smaller, highly indebted firms to declare bankruptcy, so that their assets can be bought for pennies on the dollar. Another reason is that Big Oil is increasingly aware of stranded asset risk, which is the risk that man-made climate change could permanently wipe out the value of oil and gas assets in reserves. The oil industry has come under heavy public and regulatory scrutiny as climate change becomes a more pressing environmental issue. If climate change itself, or the actions taken to combat it, result in oil giving way to renewable forms of energy, there are billions of dollars’ worth of assets sitting on balance sheets that may not be recoverable.
Look for energy M&A to heat up
Despite the significant risk posed by stranded assets, it is still likely that the oil and gas industry is about to see a major increase in mergers and acquisitions activity. The reason is simple; oil still accounts for the majority of energy production in the U.S., and high-quality reserves are increasingly hard to find. The premier oil fields in the U.S., including the Permian Basin and Eagle Ford, are intensely competitive. Finding new oil fields organically would be an extremely time-intensive and costly endeavor. It is far easier for Big Oil to simply buy up distressed competitors.
This is why it should come as no surprise that, according to recent reports, more than $100 billion has been raised by private equity and other institutional buyout investment firms since the oil crash started in 2014. Private equity buyers are snapping up a wide range of assets, from acreage to distressed loans.
The accelerating investment activity on the part of private investors could be the spark needed to incentivize Big Oil to get cash off the sidelines, to avoid missing out. The sense of urgency is heightened for the potential takeover targets, which are running out of time. There are many highly indebted companies that are still not breaking even at $50 oil. Making matters worse for them, bank funding is being cut off: Bloomberg reports that the eight biggest U.S. banks cut loans to the energy industry by 6 percent in the first half of 2016.
Companies to watch
In addition to Exxon, one global integrated giant that has some cash to spare and could be on the prowl for a suitable takeover, is Chevron (NYSE: CVX). Chevron has embarked on an ambitious cost-cutting program over the past two years, designed to protect its balance sheet during the oil crash. It suspended share buybacks this year, cut capital expenditures by $5.3 billion through the first half of 2016, and is looking to sell $5 billion worth of assets in offshore China, as well as another $2 billion in Indonesian assets, to raise additional cash.
In the meantime, there are smaller companies that may be pursuing deals. Oil refiner CVR Energy (NYSE: CVI), which counts noted activist investor Carl Icahn as a controlling shareholder, has reportedly shown interest in buying smaller rival Delek U.S. Holdings (NYSE: DK). This could be more of a partnership built on necessity; both refiners are struggling with contracting crack spreads and elevated costs. Both stocks have lost more than 50 percent over the past one year, but combining the two could give the company and its investors more breathing room and flexibility to wait out the downturn.
Bob Ciura is an independent equity analyst. Since 2012, his work has focused on fundamental investment analysis of publicly-traded companies in the energy, technology, and consumer goods industries. Bob has a Bachelor's degree in Finance and an MBA in Finance.