Soft oil prices, strained balance sheets and a lack of support from outside funding sources have left many U.S. independent oil and gas companies close to bankruptcy. For some, joining forces may be a way to stay solvent.
Most independent producers entered 2020 on unstable footing. The record oil price crash and the collapse in demand as a result of the COVID-19 pandemic drastically worsened their predicament, and a slow economic recovery has left many facing massive financial and operational cuts well into 2021.
"Consolidation makes sense — economies of scale will enable firms to lower supply costs; less fragmentation will ensure more efficient response to price signals and inventory constraints," Morningstar analyst David Meats said. Supermajors could look to snatch up a few appetizing independents and mergers of equals could continue to occur, Meats said, but "modest to zero premiums" should be expected.
Chevron Corp.'s $13 billion purchase of independent producer Noble Energy Inc., the biggest post-pandemic merger in the energy space, showed that traditional consolidation through acquisitions remains a possibility for the industry.
However, the September announcement that Devon Energy Corp. and WPX Energy Inc. would combine in a $12 billion, all-stock merger of equals also indicates that companies of similar size and with overlapping operations could look to join forces instead of slogging through on their own.
"Industry consolidation is becoming paramount," said Matthew Portillo, the managing director in the equity research department covering the exploration and production sector for Tudor Pickering Holt & Co. "Most major plays, with the exception of the Permian and maybe the Marcellus [Shale], need only one or two champions."
Speaking at a webinar in September, Portillo speculated that widespread industry consolidation could result in 10 to 15 large public companies, including four to five small to mid-cap players. "There's a very good chance that consolidation will take down 60% to 80% of the companies we cover," Portillo said.
Large producers: Sidelined or stepping in?
Recent buzz that ConocoPhillips could be interested in acquiring Concho Resources Inc. reinforced the industry's belief that consolidation is not just necessary but is unfolding.
However, many of the integrated majors are looking to sell, not buy, upstream assets as they embrace the energy transition in response to pressure from investors.
"Optically, an [exploration and production] acquisition would be the opposite of the message they want to deliver," said analyst Gabriele Sorbara of Siebert Williams Shank & Co. "You may have Chevron do something or Conoco, but it's going to be one-offs."
Duane Dickson, Deloitte's vice chairman and U.S. oil, gas and chemicals sector leader, said companies with financial stability and a solid asset base are the most attractive targets for potential buyers.
Few independent producers fall into that category right now, but Sorbara said Cimarex Energy Co. should be acquired.
"Chevron could do that; [Marathon Oil Corp.] could do that," Sorbara said. "You'll probably see one or two deals, maybe a few more in the next six to 12 months. Once some smaller companies start coming out of bankruptcy, you could see more mergers of equals."
In the meantime, potential buyers will likely remain selective about any acquisitions.
"It's a challenging environment for a larger corporation to come in and pay a premium to acquire a smaller rival," Edward Jones analyst Jennifer Rowland said in an Oct. 1 email. "The market will not reward the buyer unless it's deleveraging and based on a small premium. Any deal that requires significant cost savings or a higher oil price to justify the price paid will not be well-received. The hurdles remain high for corporate deals."
Most analysts agreed that supermajors are not likely to be heavily involved in the coming wave of M&A.
"Given the macro-economic environment, the COVID-19 pandemic, the depressed state of commodity prices, and the domestic political uncertainty fueled by the looming presidential election, energy deals will be predominantly bifurcated in nature — consisting of consolidations of strength and consolidations of necessity," said Nicholas Renter, vice president of sales at Datasite, which offers M&A software technology. "If history is any indicator, anticipated post-election regulatory changes may accelerate these moves."
Sorbara speculated that most of the big names among independents that are capable of doing deals may stay on the sidelines.
"[Pioneer Natural Resources Co.] won't do anything. [Diamondback Energy Inc.], do they need to do a transaction? They look good on a stand-alone basis," Sorbara said.
Mergers of equals in search of the right partner
While mergers of equals will be slowed by the oil market's sluggish recovery, Meats said more deals of this nature are likely since they can be concluded through all-stock transactions.
"Paying with stock enables firms to make deals and protect balance sheets at the same time. Exchanging undervalued stock for undervalued stock is the same as exchanging fairly valued stock for fairly valued stock," Meats said.
For successful mergers of equals to occur, balance sheets of both companies need to be solid, which would limit their frequency, Sorbara said.
According to data from S&P Global Market Intelligence, the pace of oil and gas M&A deal-making in the third quarter remained well below year-ago levels. The sector announced 25 fewer whole-company and minority-stake deals than in the third quarter of 2019: 88 deals compared to 113. In the same period, the number of announced asset transactions fell from 134 to 100 and their aggregate value declined $1.09 billion to $14.54 billion.
"There is room for further mergers, but it will be a challenge to find the right asset and balance sheet fits for accretive deals. It may take several more years for consolidation to play out," said Andrew Dittmar, senior M&A analyst at Enverus. The data analytics company's third-quarter upstream M&A report showed the number of U.S. oil and gas M&A deals during the third quarter tied the first quarter for the lowest in 10 years.
Sorbara also highlighted that past mergers of equals have failed to produce the desired effect.
"If you look at mergers of equals, none of them have worked," Sorbara said, pointing to Callon Petroleum Co.'s acquisition of Carrizo Oil & Gas as an example.
That difficult merger, which closed in December 2019, was supposed to stabilize Callon, but the company's net debt rose from $3.17 billion at the end of 2019 to an estimated $3.41 billion Oct. 13. Callon's market capitalization, which stood at more than $900 million at the end of 2019, is now below $200 million.
In the oilfield services sector, London-based offshore drilling contractor Valaris PLC filed for Chapter 11 bankruptcy in August, a little more than a year after it was formed through the $2.4 billion merger of equals between Ensco and its smaller rival, Rowan Cos. PLC.
The amount of debt accumulated in the sector could reduce the number of independent producers that are viable takeover targets and should limit the amount of M&A to levels well below what many are anticipating. The vast majority of independents are so saddled with debt that being acquired is almost out of the question, Deloitte said in a recent report.
"We only found about a quarter (of upstream companies) were attractive acquisition targets; 73% were uncertain or risky," Dickson said in a Sept. 22 interview.
"The need for scale and efficiencies to generate free cash flow at current low oil prices is paramount, so these kinds of deals will continue," Renter said in an email. "Some will use their strong balance sheets, competitive positioning and access to capital to diversify their strengths; however, any additional consolidation will be limited to a similar sector or subsector target."
Swift producer consolidation could become 'major problem' for oilfield services
Evercore ISI analyst James West said rapid consolidation in the exploration and production industry could be a "major problem" for the oilfield services sector.
During an Oct. 7 webinar, West pointed to the particularly hard-hit offshore drillers such as Valaris, Noble Corp. PLC and Diamond Offshore Drilling Inc., all of which have entered the Chapter 11 process and are likely to move into the M&A cycle next, according to Evercore.
However, analysts also see the need for consolidation among companies that provide onshore drilling and oilfield services, as evidenced by Schlumberger Ltd.'s recent agreement to merge its North American fracking business with Liberty Oilfield Services Inc. in exchange for a 37% equity interest in the combined company.
West said equipment and services pricing is about 35% below the 2014 peak and has little upside with too many services companies, too much capacity and a good number of producers holding too much debt.
Morgan Stanley analyst Devin McDermott said in an Oct. 7 email that contract drillers and pressure pumpers with relatively low returns on capital and higher overhead costs are generally more attractive targets for consolidation than other subsector companies.
Offshore driller Transocean Ltd., land driller Patterson-UTI Energy Inc. and onshore service and equipment company RPC Inc. are "attractive hypothetical consolidation participants," McDermott said. Additionally, National Oilwell Varco Inc. and pipe-maker Tenaris SA "could benefit from deals that spread their fixed costs over a larger asset and revenue base," McDermott said.
In the offshore market, providers of rigs, vessels and seismic services are struggling the most, according to Rystad Energy analyst Audun Martinsen. In the onshore shale market, the pain appears to be weighing most heavily on fracking companies and proppant providers.
"Here we see tons of debt, low or negative margins which can't handle interest payments, and a slow recovery in demand," Martinsen said in an Oct. 7 email.
As sustained low oil prices continue to weigh on the balance sheets — and livelihoods — of producers and oilfield services companies, consolidation in the industry could continue in the coming months and years. However, the compatibility of companies will likely be highly scrutinized in any forthcoming deals.
"A lot of these companies aren't culturally suitable; their cultures don't match well," Sorbara said. "Everyone is pounding the table on consolidation … and I see very selective transactions."