The Edge

Making the case for upstream M&A

Sector consolidation and getting lower on the cost curve

1 minute read

Obstacles to M&A have abounded these last three years. Money’s been tight, and for many companies acquisitive growth wasn’t needed after a period of heavy of investment earlier in the decade.

There’s a perception that investors in the sector are M&A-averse, still smarting from the value-destroying deals struck earlier in the decade. Instead, investors have wanted management to show contrition and to focus on value, cash flow generation and returns to shareholders.

But all that has not stopped deals happening. A total of US$57 billion was spent on acquisitions in 2017 just by the 60 companies covered in our Corporate Service.

Two oil sands deals were transformative for Cenovus (US$13 billion and the first-ever asset deal in the tens of billions) and CNRL (US$11 billion). There was a clutch of other smaller but still material deals over US$1 billion executed by ExxonMobil, Total, Statoil, Noble Energy, OMV, Marathon and Shell.

By and large, investors weren’t fazed by these deals. An exception was Cenovus, whose shares fell 43% in 2017 to rank among the sector’s worst performers. The purchase of ConocoPhillips’ Canadian oil sands assets doubled the company’s core oil sands position, but it also stretched balance sheet ratios.

The other acquisitions had similar portfolio logic of enhancing existing strengths or plugging a gap, but were smaller in scale and more readily financeable. The share prices of these other buyers on average fared not much worse than their peers in a year when the sector overall badly under performed the global equity market.

It’s an important message for any company looking to beef up and build their business in the coming year. Investors will support acquisitions that are complementary, so long as there’s demonstrable potential for value upside and the financing does not inflict inordinate strain on the balance sheet.

There are plenty of reasons to expect more deals in 2018.

First, there’s more cash around.

The sector’s financial position has improved markedly over the last year. Balance sheets are strengthening, costs are under control, and we expect most companies will generate free cash flow for the first time since the downturn.

Improved shareholder returns may be the first call on cash – promises of buy backs proliferated towards the end of last year. But business development teams will be champing at the bit and arguing the case to do deals.

Second, portfolio high grading will continue to feed assets into the market.

The downturn has reminded the industry of the need to make capital work, and the futility of retaining unproductive or non-core assets.

Intensified focus of portfolios around advantaged and low cost assets will mean more disposals. The bigger programmes like Shell’s may have all but run their course, but there will be no shortage of opportunities available. Greig Aitken, Principal Analyst, says the ‘Deal Pipeline’ in our M&A Service currently shows 394 potential deals (just below last November’s record) with a combined value of US$217 billion.

Thirdly, the Trump Administration’s tax cuts will incentivise more deal-making in the US.

The US accounted for nearly 40% of deals done by value in 2017, with the growth prospects of tight oil and the Permian in particular a prime driver.

Moreover, the unconventional oil and gas landscape in the US is still very fragmented, and ripe for further consolidation.

The sale of BHP Billiton’s portfolio, spread across the Eagle Ford, Permian, Haynesville and Fayetteville, is a rare opportunity for new entrants to access a material starter platform.

We don’t think large-scale deals are on the industry’s immediate agenda, though Shell’s success with BG has piqued interest in boardrooms.

Shell’s US$5 billion p. a. upgrade to its cash flow forecasts for 2019-21 in late November reflects much better merger synergies than expected at the time of the acquisition two years ago. As companies look to position lower on the cost curve, consolidation – where there is a sound rationale in a combination of portfolios – will surely play a part.