By: Winston Shum, Roshni Padhi (Stanford) and Siddharth Tripurani, Akhil Vajjhala, Aman Singla (NYU)
Photo: Zbynek Burival (Unsplash)
Background
The COVID-19 pandemic has brought simultaneous supply and demand shocks to the oil and gas industries. The attacks on Saudi Arabia oil fields by Iran in September 2019 caused a supply shock, and a halt in industrial processes by the COVID-19 crisis caused further twin supply and demand shocks. That, in combination with a tumultuous market, has left the future for M&A deals in the oil and gas industry highly speculative.
On one hand, the current market has resulted in constraints on capital allocation on the part of international oil companies (IOCs), the typical acquirers for most M&A deals in the oil & gas industry. Furthermore, these companies are facing a cash crunch this year, with cash and near-cash items only being 25% of average total debt amongst companies, which is down from 31% in 2018. Even BP, a large company that is perceived as generally stable, has been forced to sell its petrochemical division to Ineos in an attempt to raise money and remain scarcely profitable this fiscal year. The graph below depicts the falling cash levels of these companies. IOCs are further prioritizing divestiture as a way of increasing their future profits as opposed to M&A deals – the overall deal value in 2019, excluding the Occidental-Anadarko acquisition, fell by $38B.
However, optimists may argue that lower valuations and decreased acquisition premiums (due to pessimistic oil prices and market volatility) may entice buyers within the coming quarters. The graph below outlines the decrease in valuations over 2020 and the record high acquisition premiums that are projected to decrease. The same thing happened between 1997-1998, with simultaneous supply and demand shocks causing unrest in the market, but what followed was a series of megamergers that led to the oil superpowers of today, the most notable example being the $77.2B merger between Exxon and Mobil. This optimism is maintained by big investors as well, with Warren Buffett himself taking a $9.7B long position on oil futures. Admittedly, current market conditions coinciding with COVID-19 leave the outlook of future M&A deals to be determined.
With 7 megadeals in 2019, the oil and gas industry recorded deals worth a total of roughly $350 billion USD by Q4 2019. The Oil Majors, a group of 6 companies that control the majority of oil tankers worldwide, are Royal Dutch Shell, BP, Exxon Mobil, Chevron, Total and ConocoPhillips. Along with their subsidiaries and other Oil Field Services (OFS) firms, they completed transactions alongside various downstream functions, as they expected cash flow problems. This resulted in significant consolidation in 2019, as evidenced by the following deals:
Callon acquired Carrizo for $2.7 billion (Delaware and Eagle Ford Basins)
Parsley acquired Jagged Peak for $2.3 billion (Delaware Basin)
Citizen Energy acquired Roan Resources for $1 billion.
Amongst others, the above transactions are in line with a gradual increase in the rampant sub-sector consolidation that took place before the economy experienced a drastic fall in demand earlier this year.
Taking the US market, investment was high in the upstream segment starting 2020 at $2.3 Billion: 11 Deals as compared to only 10 deals across both the midstream and downstream segments. Similarly, on a global scale, with a potential demand-driven price drop across the Oil and Gas industry similar to that of 2014, firms are eager to secure their future in a post corona-virus economy.
Recent Transactions
The first half of 2020 saw one major transaction with Chevron’s $5 Billion all-stock purchase of Noble. The total enterprise value, including debt, of the transaction is $13 billion. Chevron’s upstream services will now be enhanced by Noble’s proven, low-cost yet underdeveloped access to resources in the Eastern Mediterranean. The mutual benefit of this transaction lies in both companies’ newfound access to land in both the Permian and DJ basin, large oil reserves in the U.S.A's central corridor. According to Frank Mount, Chevron’s general manager for M&A, Chevron “had been monitoring Noble Energy’s progress in the Eastern Mediterranean.” It is important to note that this move by Chevron wasn’t executed just to survive in light of the economic downturn. In fact, for companies like Chevron with strong balance sheets and financial discipline, this is the perfect time to buy quality assets in a cost-effective manner.
Another acquisition that wasn’t executed just to survive the economic downturn was the joint acquisition of Lummus Technology, a subsidiary of McDermott International, by Haldia Petrochemicals Limited (HPL) and Rhone Capital. The transaction was valued at an enterprise value of $2.725 billion with HPL investing around 57% of the enterprise value while Rhone Capital will buy out the remaining stake. Having around 130 licensed technology and more than 3,400 patents, Lummus Technology is a leading licensor of technologies in refining, petrochemicals, gas processing, and others. For the HPL, this acquisition was based on lowering costs as Lummus Technology’s polymer products and downstream chemicals can provide sustainable values to clients in the materials technology sector. For Rhone Capital, the reasoning behind the acquisition lies within Lummus’ ability to become a market leader in petrochemical technology and licenses; with Rhone’s experience in partnering with multinational industry leaders, they believe that Lummus will be able to offer services and technology to a broader base of customers. For Lummus Technology, their new autonomous identity creates greater flexibility to develop core competencies, giving them the opportunity to become a model for self-reliance in the materials technology space in India. However, this move by HPL may have cost them more than they thought. To fund the acquisition, HPL raised a debt of $520 million and funded part of the acquisition using $180 million in their cash balance. In the current pandemic environment, the use of cash may harm their ability to operate. The India Ratings and Research agency has also reflected this risk by downgrading HPL’s long term issuer rating from AA to AA-. It will be important to continue following up on HPL’s performance under current coronavirus and economic conditions as Lummus Technology is integrated into their firm. In the future, these two acquisitions can also serve as a blueprint for later acquisitions in the industry. As most players are looking to conserve cash and prepare for the long run, cash movements like this will serve as important reference transactions for other companies in the future.
Outlook
As economic conditions remain relatively unchanged, financial debt and distress are expected to rise, forcing companies (especially those in North America) to consolidate to survive. Companies with strong balance sheets will likely continue to take advantage of the landscape to make strategic deals at a cheaper price, including bolt-on acquisitions. Because of this, buyers will likely consider possible target companies from a broader perspective, looking at long-term potential for resilience and other non-financial factors. In addition to stable companies, private equity firms could step up to acquire oil and gas assets.
In addition to consolidation, oil and gas companies have been taking steps to automate their supply chains, with almost 60% of them increasing their margins over the past two years thanks to increased digitization. This creates new possibilities for cutting expenses and optimizing operations, thus freeing up cash flow for M&A.
Beyond this COVID-centered short term outlook and with the rise of ESG investing, company leadership have been focusing on long-term goals, including decarbonization, the energy transition to fossil fuel alternatives, and the social impact of their actions. As this becomes a more important criteria by which companies evaluate each other, it will play an increasingly significant role in the M&A process.
All in all, the industry is projected to house a smaller number of larger players, be more efficient thanks to technology, and place more emphasis on long-term sustainability and resilience.