Upstream growth back on the agenda: the M&A ‘barometer’ is signalling better climes ahead

A sure fire measure of an oil and gas industry under severe pressure is a seized-up M&A market. That's how it was for much of the period since late 2014 when the brutal combination of glutted commodity markets and low prices stretched industry finances close to breaking point. So much uncertainty and so little finance - few deals could be done.

Now the worm is turning. A strengthening flow of deals is a clear indicator that the M&A market is getting back to business as usual, and companies are starting to think of growth again.

How bad have things been? One measure is deals under US$5bn, a dataset that captures the bread and butter transactions that are the life blood of the industry but excludes bigger, transformational corporate deals such as Shell/BG.

Our M&A Tool shows the total value of these smaller deals globally slumped to US$55bn in 2015, 60% down on 2014 and about half the annual run rate of over US$100bn this decade. The nadir was Q1 2015 when deal making all but stopped – just US$5bn of assets changed hands.

As oil prices began to recover, so too did M&A. A trickle that began in Q2 last year has turned into a flood of activity, as if a log jam finally broke.

Q4 2016 spend was US$38bn, easily the best quarter by value since Q2 2014, and the third best this decade. December 2016 was the third best month in five years. The type of deal being done suggests the industry's outlook has changed.

'Survival' deals, reflecting an immediate need to strengthen balance sheets, have not been all that common considering the financial pressures - only a desperate handful of companies have been forced to dispose into a buyers' market. Some companies have chosen to exit assets with heavy near term capital requirements, easing future balance sheet stress.

Other pure upstream players have chosen instead to restructure debt to buy time, and where possible raise equity. US operators with low breakeven unconventional drilling have found equity markets surprisingly welcoming. The sale, for material considerations, of chemicals assets (Total), gas pipelines (Sinopec) and mid-stream properties (Apache) illustrates the wider opportunity set the more diversified companies have been able to lean on.

Strategic repositioning for the future has become more evident in recent months as companies seek to 'Adapt'.

A big driver is consolidating existing advantaged portfolio positions. Good examples are Anadarko's purchase of Freeport's deepwater GoM position, and the two big Permian deals of January 2017 – Noble/Clayton Williams and ExxonMobil/Bass. Statoil's exit of oil sands is the other side of the coin and a sign of things to come – we expect other non-specialists to exit high cost assets with high exposure to green house gases.

Now more deals are being done for 'Growth'.

Shell's acquisition of BG was about acquiring future production low on the cost curve – and at the low point in the cycle to maximise potential for value creation. Others have begun to follow this template, albeit in smaller scale. BP buying a stake in Zohr and Total's twin deals in Uganda and pre-salt Brazil are three transactions in the last two months that indicate a tentative, but rising, confidence in building for the future.

The industry's financial position is far from rosy yet. Spend on investment exceeded cash flow for the sector as a whole in Q4 2016 and balance sheets for many will finish the year in worse shape than end 2015. Some companies still need to deleverage, whether through issuing equity or asset sales. The good news is that the appetite for both is much improved.

Critical to confidence is that finances should stabilise and start to strengthen again this year. Self-help through cutting costs and spend has reduced the industry's cash flow break even oil price to US$55/bbl Brent in 2017, down from almost US$100/bbl in 2014. Lower costs coincide with improving oil prices after OPEC's decision to cut production for the next six months.

If our 2017 forecast of US$57/bbl Brent proves right, the sector will turn cash flow positive this year.

This all suggests that the industry is moving further along the path from 'Survive' and onto to 'Adapt' and 'Grow'. Rising M&A activity this year will be a key barometer of the sector's improving confidence in the future.