Takeover activity in the oil industry shows signs of revival
Equity valuations are falling as financing becomes more difficult and hedges are used up
It’s known as “Drilling on Wall Street”: building up oil and gas assets not by pushing a drill-bit into rock, but by buying companies. At times it has been a very cost-effective way to acquire reserves. It served T Boone Pickens very well, for example: he became a billionaire by acting as a combination of oil wildcatter and corporate raider.
That’s not true at the moment. Right now, the oil you can find on Wall Street is some of the most expensive in the world. But it has been getting cheaper.
Equity valuations for the US exploration and production sector imply an expected price of about $65 per barrel for benchmark US West Texas Intermediate crude, says Pearce Hammond, an analyst at Simmons & Company. That compares with required average break-even prices of $29 per barrel for reserves onshore in the Middle East, $57 per barrel in ultra-deep water and $62 per barrel in North American shale, according to Rystad Energy.
Add on the 28 per cent premium that has been the average for acquisitions announced so far this year, according to Dealogic, and you get to a price of about $83 per barrel: higher even than the average break-even price of $74 in the Canadian oil sands.
Those valuations explain the sluggish pace of takeover activity in the oil industry this year, in spite of the spur provided by the oil price rout. The one big deal has been Royal Dutch Shell’s $85bn cash and stock offer for BG Group, and it is easy to find people in the industry who think its offer — worth about 27 times BG’s expected earnings this year — is at a very full price.
The markets do not seem to be in much of a mood to reward acquisitive exploration and production companies.
The largest recent deal among US exploration and production companies has been Noble Energy’s $3.7bn acquisition of Rosetta Resources, and since it was announced in May, Noble’s shares have lagged behind the sector average. It’s no surprise that the biggest bids in the US oil and gas industry have been in infrastructure rather than production, including Williams’ $13.9bn offer for the 40 per cent of its affiliate Williams Partners that it does not already own, Energy Transfer Partners’ $17bn bid for its affiliate Regency Energy Partners, and Energy Transfer Equity’s $51bn offer for Williams, which was rejected over the weekend.
The bargains that some investors hoped for at the start of the year have failed to materialise. The number of exploration and production companies in financial distress has turned out to be smaller than many had expected.
When in March and April banks reset the borrowing bases, reflecting estimated values of reserves that are used to determine the credit extended to E&P companies, they were more forgiving than they could have been. WTI had fallen about 50 per cent since June 2014, but borrowing bases were typically cut by only about 15 per cent.
There is still new financing available for E&P companies in the debt markets, too. Halcon Resources and Goodrich Petroleum are among those that have arranged “second lien” debt financing, subordinated to the senior debt but still secured on assets and ranking ahead of unsecured lending.
US E&Ps raised $16.6bn from bond issues in the first five months of this year, compared with $13.1bn in the equivalent period of 2014, again on Dealogic data. As a result, the number of E&P companies facing immediate financial distress has remained relatively low. There are just not all that many forced sellers out there yet.
However, there are reasons to think that will start to change. Another round of borrowing base redeterminations in September and October will again ratchet down available liquidity for the industry.
More than 30 companies have already raised new equity finance so far this year and they will find it hard to go back to their shareholders to ask for more. Hedges that have sustained revenues for many companies, protecting them from the worst effects of the commodity price fall, will start to be used up. Put all that together, and the number of companies putting themselves up for sale is clearly likely to rise.
There are already tentative signs that activity is picking up. May was the most active month for oil and gas M&A since December, excluding the Shell-BG deal, according to GlobalData, thanks to the bids launched by Williams and Noble, among others.
At today’s equity market valuations, it will remain tricky for CEOs to justify acquisitions to their boards. But the US exploration and production sector index has already dropped almost 12 per cent since the start of May, while US crude has remained roughly unchanged at about $60. If oil equities carry on like this, sinking a few more wells into Wall Street might start to look quite attractive again.