New York — Soft oil prices, strained balance sheets and a lack of support from outside funding sources have left many US 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 oil price crash and 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's $13 billion purchase of independent producer Noble Energy, 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 and WPX Energy 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?
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 US 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 should be acquired.
"Chevron could do that; [Marathon Oil] 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. "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] won't do anything. [Diamondback Energy], do they need to do a transaction? They look good on a stand-alone basis," Sorbara said.
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 US 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'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.
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.