Upstream M&A: taking advantage of the down-cycle

The time is ripe for buyers in the upstream M&A market to make deals and maximise the chances of creating value. GE's CEO Jeff Immelt summed up the case for the bold on the service sector takeover of Baker Hughes last month: 'I've been through five or six industry down cycles, and the people who leaned forward at those times have been rewarded as time goes on.' Why aren't more companies following his instinct?

First, the M&A market has been showing signs of life in recent months. The global deal count hit 38 in October, the second highest trade in assets for two years, and sustaining a recovery that's been underway since the abject low of January 2015 when the market all but froze over as oil prices collapsed.

Second, the value of M&A being done is also rising. Spend on assets in October was US$10.3bn, the highest since October 2014 and a monthly figure that wouldn't be out of place during the heady days of early this decade. However, the number is also a little deceptive in a highly polarised global market. The USA L48 is red hot, accounting for all but US$0.1 bn of the October tally with nearly all deals in unconventionals. Liquidity in the ROW and specifically in conventional assets has all but dried up.

Way more than half of the US$272 bn of deals in the global M&A pipeline are outside North America, but transactions appear log jammed.

Third, though more deals are being done, prices are falling. The implied long term oil price (ILTOP) in Q3 slipped to US$63/bbl, the lowest since the Q2 2009 low of US$62/bbl in the depths of the Global Financial Crisis. The ILTOP is our unique and consistent M&A metric, solving the oil price used in each transaction value based on our asset cash flow models and a 10% discount rate.

This last point highlights the growing potential for value creation from M&A in the current market. From the 2009 lows the ILTOP went on a five year winning streak, rising 55% to an all-time high of US$96/bbl by Q3 2014. Our recent analysis showed that deals done at a cyclical low have the best chance creating value.

So why aren't more companies taking advantage of this new low in the market and buying assets?

Chief among the factors holding M&A back are:

Oil market uncertainty - the industry is still split on the direction of oil prices, between the lower-for-longer camp and those who expect cyclical recovery. There are future challenges for oil markets that weren't so apparent in 2009, among them the influence of tight oil and the extent to which it will play the role of the market's swing producer; and progressively slowing demand into next decade influenced by technology disruption and climate change policy.

Access to finance - most of the industry does not have access to capital. Finance can be found in 2016 for deals with a compelling growth story. US independents in the best unconventional plays like the Permian have tapped the equity market for a near record US$24 bn in 2016, to fund low break even investment. Acquisitions that consolidate an existing advantaged position have also found support. But most companies are still haemorrhaging cash and balance sheets continue to deteriorate with an industry average Brent price of US$53/bbl needed to cover costs, investment and dividends in 2017/18.

Big oil is rationalising, not buying - besides Shell/BG, majors' activity on the buy-side has been modest. Relatively small deals like ExxonMobil/PNG LNG and Statoil/Brazil pre-salt show there is appetite to strengthen portfolios for the long run – and more of this may happen. But Majors already have robust production profiles and are in a cyclical selling phase aimed at portfolio high-grading and funding short term dividends.

Asian NOCs and Japanese companies could be dark horses that enter the market and break the log jam. Government-Government deals along the lines of the Indian NOCs accessing Russian assets in 2016 might play a part. The Chinese, absent from M&A markets for two years, are still absorbing lessons from the buying spree earlier this decade. But if Chinese NOCs are to address production declines that set in for some towards the end of this decade, they can't stay away for long.