Consolidation in the energy sector
September 2015 | TALKINGPOINT | MERGERS & ACQUISITIONS
FW moderates a discussion on consolidation in the energy sector between Kerri Langlais, a managing director at Beowulf Energy LLC, Allen C. Barron, president of Ralph E. Davis Associates. Inc, and Lance Brasher, a partner at Skadden, Arps, Slate, Meagher & Flom LLP.
FW: In your opinion, how is the energy sector faring at present? What economic factors are shaping its prospects?
Langlais: The energy landscape is currently transitioning from a period of growth and expansion, fuelled by the shale oil and gas boom, to a period characterised by low prices and oversupply, with oil prices recently dipping below $40 per barrel. In addition, factors such as global economic weakness, outdated infrastructure, regulatory changes and increasingly viable forms of alternative energy, such as energy storage, are also influencing the sector.
Barron: On the whole, the energy industry is faring just above middle ground as an industry. Fuel costs are down for those sectors requiring oil, gas or coal as a basic fuel or feedstock, so these areas are faring relatively well. Midstream sectors are on a more positive side with transportation needs remaining high and commitments to deliver being largely uninterrupted on either a local or international basis due to geopolitical activity. Restructuring has begun to take effect in some areas with several M&A transactions beginning to realign local projects into the hands of the larger players. The upstream sector is suffering with oversupply, limited demand growth, excessive debt and limited options except for restructuring, with many smaller and mid-size companies faced with elimination from the market.
Brasher: The upstream sector is in a challenging period. Economic growth in China, Brazil and other regions has been slowing. OPEC is pursuing market share while shale production remains strong and other supplies have become available. The effect is that global oil supplies are outpacing consumption by 3 million barrels per day and oil prices have plunged. Oil companies have responded by deferring capital expenditures as $200bn worth of new projects has been deferred, according to Wood Mackenzie. A number of oilfield-related companies, particularly those with heavy leverage, are facing severe financial constraints as their borrowing bases have declined. Meanwhile, growth in renewables has continued and with their increasing economic competitiveness and the backdrop of climate change, growth may accelerate. According to a March 2015 report, global investment in renewable energy – excluding large hydro projects – rose last year to $270.2bn, with particularly strong growth in the developing countries. We anticipate this growth in renewables to continue, notwithstanding the recent substantial decline in share prices for publicly traded renewable energy companies, and notwithstanding the drop in oil prices.
FW: Could you provide a snapshot of recent M&A activity in the sector? Have any notable deals caught your eye?
Barron: Recent M&A activity within the energy sector has generally been depressed in both the volume of deals and total value of transactions in comparison to similar periods of a year ago. Declining product prices in the upstream sector have resulted in transactions that are generally smaller in overall value. In the US, acquisitions by Exxon, WPX, Noble and Vangard have been made in the various shale plays, while international purchases by Vendata in India and Sequa in Norway were announced, with BP acquiring interests in a Siberian project. A difference was seen in midstream transactions that were up over 100 percent from a year previous, both in the number and overall value of the deals reported. Service sector M&A activity has been moved forward by Schlumberger’s announcement of the Cameron acquisition.
Brasher: The most dramatic response to the earlier oil price declines this year was Royal Dutch Shell’s £47bn takeover of the BG Group. Notwithstanding, a frequent view is that this will be a one-off transaction as upstream M&A has shifted toward asset deals. In renewables, there has been an increase in M&A activity, in significant part due to the rise of yieldcos and the demand for predictable and growing returns. SunEdison, the sponsor to two US yieldcos, TerraForm Power and TerraForm Global, has been a leader, with acquisitions of portfolios from First Wind, Atlantic Power, Renova Energia, Globaleq Mesoamerica Energy and Vivint Solar, among others. Given the momentum in renewables, infrastructure funds and private equity are taking positions in renewable companies such as KKR’s recent investment in Gestamp Solar. We have also seen two major natural gas utility acquisitions in the US this summer: Black Hills’ proposed acquisition of SourceGas, which operates four regulated natural gas utilities, and AGL Resources’ proposed acquisition by Southern Company, one of the largest electric utilities in the US.
Langlais: M&A usually takes a while to gain momentum during a downturn as buyers wait for lower prices and sellers wait for a rebound. However, given the sustained low price environment, consolidation and transformative transactions in the energy sector have accelerated. While many companies are focused internally on capital and operational efficiencies, many must also turn to M&A to regain profitability. Royal Dutch Shell’s $70bn acquisition of BG Group announced earlier this year represents the largest energy deal in over a decade, premised on a recovery in oil prices, significant cost synergies and operational overlap.
FW: To what extent are structural weaknesses and financial trouble driving industry consolidation? Is shareholder activism also playing a part?
Brasher: Before the Royal Dutch Shell/BG deal, oilfield companies had already been deferring or cancelling investments in response to the oil price decline over the past year, and smaller companies were struggling with heavy debts. So, when the Royal Dutch Shell/BG deal was announced, some saw it as a trigger for further industry consolidation. M&A involving companies in US shale areas – the Bakken of North Dakota and the Eagle Ford and Permian Basin of Texas – has, however, been sluggish. What we are seeing are announcements regarding large scale divestments and major restructurings due to either low prices, large debt burdens or a weakened economy. In Brazil, Petrobras and other Brazilian companies are looking to divest over $40bn in assets through 2018, including E&P, downstream and power assets. In Europe, we have seen some major restructuring by European utilities, also due in part to government policy, as in the case of E.ON which is in the process of spinning off its fossil fuel and nuclear generation. We are also seeing greater interest from regulated utilities, strategic investors, infrastructure and pension funds and others in the acquisition of regulated gas and electricity distribution utilities, such as the Southern Company/AGL Resources and the Black Hills/SourceGas acquisitions.
Langlais: Energy companies with shrinking profits, high debt burdens and inefficient cost structures are being forced to make difficult choices on capital spending and portfolio rationalisation, and will likely address these issues through strategic moves given the lack of available financing. Well-capitalised buyers with less commodity exposure can effectively capitalise on these opportunities. We’ve also seen increasingly powerful activist investors willing to place commodity bets in order to take advantage of low valuations and build positions they can exploit later. Carl Icahn, for example, recently took an activist stake in gas exporter Cheniere Energy with plans to influence operational decisions, capex plans, financings and executive compensation.
Barron: Lower energy prices and oversupply present challenges to industry. The first to be affected will be the service and supply companies as demand for drilling rigs and services continue to be soft, generating low revenues making it difficult to meet debt payments. Operators with high amounts of debt will struggle as many of them are now on credit agency watch lists. Operators in areas with higher drilling and extraction costs will have to optimise their operations to compete more readily with those that have lower costs to drill and produce. Most upstream companies will have a bank borrowing base that will be eroded, showing less available liquidity, leading to potentially more expensive preferred or second lien debt and distressed transactions. Some companies will have to restructure whether in or out of Chapter 11. Some distressed debt hedge fund providers may call loans as a way of owning the assets. All of these structural weaknesses will tend to drive industry consolidation, especially with the larger companies or supermajors targeting corporate acquisitions in key areas.
FW: In your opinion, what will be the long-term effects of the oil price slump seen over the last 18 months? Are we witnessing the dawn of a new era of mega-mergers?
Langlais: Commodity price downturns, as we saw in the late 1990s, have historically driven M&A activity for big energy companies given their financial strength and corresponding appetite for risk. Shell’s acquisition of BG represents the largest energy deal since the ExxonMobil merger in 1998. However, mergers of this scale are risky and rarely produce the advertised synergies. We do not expect the Shell/BG transaction to trigger a wave of mega mergers, but rather expect continued consolidation among small to mid size companies as stronger players – those with solid asset bases and modest leverage – shop for faltering rivals that can no longer ‘go it alone’.
Barron: The effect of the oil price slump over the past 18 months will be to redirect many of the exploration projects from higher cost unconventional to conventional plays, drive companies with poorly supported balance sheets from the marketplace entirely or into restructured ownership with equity positions gaining control of boardroom decisions, and assets changing hands to satisfy lenders’ demands to cover overleveraged positions. Mega mergers should increase market share, especially in the service sector. Fluctuations in price that have been in evidence as much as the price declines themselves, will aggravate the ability of companies to formulate development plans that can be adhered to with certainty, thereby reducing the confidence to the lender of repayment of capital in a timely manner with an expected return on investment. The overall impact may well be a limitation in workable capital when tremendous amounts of capital are waiting on the sidelines to take advantage of an industry in need of that very same capital.
Brasher: A long-term effect of the oil price slump is likely to be a continuation of what we are witnessing already – reduction in employment and deferral of capital investment in the oil sector. In addition, there is likely to be an uptick in transactions involving distressed assets with opportunities for strategic acquisitions and what are perceived as bargains. However, notwithstanding all the predictions for further industry consolidation following the Royal Dutch Shell/BG deal, we may not see the same kind of deal making as was seen in the 1990s which created today’s oil majors. What we have been seeing are reports of a systematic disposal of assets such as the recent announcements by Petrobras and by Total of all of its interests in two gas pipelines and a gas terminal in the North Sea. In the hunt for bargains during this oil price decline, private equity firms could prove a vital lifeline to the oil sector companies looking to sell oil and gas assets that are no longer affordable. According to Wood Mackenzie, in June this year, more than $40bn of private equity funds had been earmarked for E&P deals
FW: What advice would you give to energy sector companies looking to pursue M&A opportunities?
Barron: An energy sector company looking to pursue M&A opportunities should follow the tried and true practices of detailed analysis, extensive due diligence and utilisation of the best available advisory support they can afford. There is no new and magic method to succeeding in the M&A arena simply because an industry is in difficulty. A good business plan, attention to detail and solid financial backing can succeed in almost any market environment. The difference in the current energy sector situation may be the availability of forced divestitures or liquidations of good assets held by poorly financed companies; however, the competition for these assets may be significant.
Brasher: The current situation in the oil sector may present attractive opportunities to make strategic acquisitions, as well as purely opportunistic acquisitions to take advantage of perceived bargains. For companies looking to pursue M&A opportunities, they should position themselves to identify opportunities early and have funding arrangements and internal approvals advanced so that they can move quickly.
Langlais: While M&A can be an expedient strategy to manage risk and deliver near-term value, it is not without risk. Parties need to appreciate that increasingly stringent regulatory hurdles introduce more uncertainty and longer lead times. This was recently evidenced in the utility sector with the D.C. Public Service Commission’s rejection of the $6.4bn merger between Pepco Holdings and Exelon – a major setback for the proposed transaction, which was announced more than a year ago. In addition, potential changes to environmental rules can have a huge – and potentially lethal – impact on the expected economics of a deal. As a result, deal makers need to carefully assess and price-in any regulatory or environmental uncertainty.
FW: What strategies can investors deploy to evaluate the assets available against the backdrop of a consolidating market? What lessons can investors learn from consolidation waves of the past?
Brasher: We are seeing many investors, particularly infrastructure funds, pension funds and yieldcos seeking to mitigate or avoid commodity price and merchant risk. They are refocusing on more regulated assets, such as utilities, with an anticipated predictable return and on assets with contracted output, as we have seen in the case of the wind and solar acquisitions by renewable energy yieldcos. We are also seeing energy companies looking to enter into joint ventures with key strategic partners both to reduce risk and identify new opportunities. A number of recent high profile joint ventures have been announced in Mexico.
Langlais: It is important in the context of evaluating deal economics not to place too much emphasis on the ability to realise synergies or cost savings, at least out of the gate. These savings rarely materialise as expected. Buyers should instead focus on core strengths and look for opportunities that offer diversity and scale. Finally, buying at the right entry price limits downside risk and provides significant upside potential. This strategy is of course challenging in the increasingly competitive environment for high quality assets with predictable cash flows.
Barron: Whether a domestic or international, in order for an investor to realise superior returns, an energy company’s plan should be to provide: a favourable project entry with low upfront costs, technical justification and ability to attract JV partners; favourable returns while monitoring risk under various price sensitivities; meaningful project size with potential for organic replacement of reserves; a timely window to monetise assets, allowing for distributions; and a favourable political risk profile. In the past massive, consolidation and unprecedented cross-border mergers and takeovers happened with BP-Amoco, Chevron-Texaco, and Exxon-Mobil. As the industry continues its shakeout, there will be continued cross-border alignments and middle market companies will begin having a share, forming synergies with international companies, locking in demand, as for instance LNG companies securing international contracts for its product.
FW: How challenging is it for firms to make long-term decisions based on volatile markets? What steps can energy sector firms take to avoid being caught up in the valuation downdraft?
Langlais: Volatile commodity environments make it challenging for buyers and sellers to come together as the bid-ask spreads are often too wide. They key question becomes which companies can withstand low prices and higher volatility and hold out for a recovery. Hedging and other contractual arrangements represent an effective means to manage through volatility. While these arrangements will inherently cap upside, there are ways to extract value from contractual relationships which may not be obvious on the surface, but ultimately provide long-term value and flexibility.
Barron: Strengthening of the balance sheet by reduction of financial exposure is necessary for long-term decisions in any market. This may include monetisation of non-core assets by selling assets at a premium to the acquired cost. Firms should focus on key goals and spin off or outsource any business function not directly aligned with those goals. Valuation downdrafts can be avoided by careful scrutiny of a company’s financial measures. A good measure of a corporate risk profile going forward is a financial ratio of debt-adjusted shares that represents average debt divided by average share price plus average shares outstanding. This ratio treats debt and equity capital equally, as if the investors holding the debt held ‘debt shares’ priced the same as equity shares. Another ‘financial ratio’ used in oil company analysis is debt-adjusted cash flow (DACF). Astute oil and gas companies and investors are using these ratios to monitor debt, especially in volatile markets.
Brasher: Long-term decision-making is very challenging in the current volatile oil markets, which makes many investors cautious about the risks and focused on acquisitions that meet a particular strategic objective or which present a highly favourable opportunity. In addition, we have seen a refocus away from commodity price and merchant risk to situations with more certain regulated returns and assets with contracted output where there can be a higher confidence in valuation. We are also seeing more frequent use of joint ventures.
FW: How would you rate the chances of a recovery in the energy sector in the near term? How will this affect further consolidation through continued M&A activity?
Barron: The chances of a recovery in the energy sector in the near term do not appear too reasonable. Within the North American region the nearest thing to balance is the natural gas market, with the hope of LNG exports to maintain production at current levels. The oil market appears to be dominated by the availability of low priced imported oil and an inventory of uncompleted wells. On the international level, approximately 1.5 million barrels per day of oversupply will continue to keep oil prices depressed and natural gas requirements limited to fuel and feedstock demand with near term increases unlikely. The longer recovery in the international market for natural gas is now faced with a decrease in demand with Japan’s probable restart of its nuclear program and China’s slowdown in growth, thereby reducing the coal to natural gas conversion. Oil’s oversupply will probably be maintained throughout 2016 with Iran producing into the world market, China and India’s slowdown in growth, and North America producing significant volumes of oil due to lowered capital requirements for drilling and completion of new wells.
Brasher: We have a complex picture of global oversupply of oil that is not in step with global demand and the response of many oil companies to defer or cancel projects. However, the IEA is predicting a converging of oil supply and demand in the fourth quarter next year, as lower capital expenditures by oil companies resulting from deferred or cancelled projects are expected to slow non-OPEC supply significantly. In the meantime, banks may curb their lending to oil companies during what is known as the ‘redetermination’ season in the US coming up later in the year. During 2008-09, banks reduced ‘borrowing bases’ by approximately 10-20 percent on average, according to The Deal Pipeline. Accordingly, there are some prospects for a near term balancing of supply and demand and price recovery and therefore a potential need for bargain hunting purchasers to act quickly. Meanwhile, growth in renewables remains strong in many areas. With renewable energy becoming increasingly competitive, more markets embracing renewable energy and favourable costs of capital, we see M&A activity in the renewables sector remaining strong, although there may be some hesitation in activity given the recent volatility in share prices of public yieldcos and other renewable companies. We also expect to see continued frequent use of joint ventures in new markets and by new entrants into the sector.
Langlais: Given the uncertainty regarding future oil prices, we think a recovery in the near term is unlikely. If we see warmer weather this winter from El Nino and oil remains depressed, certain energy companies could become extremely distressed and will ultimately succumb to strategic forces.
Kerri Langlais joined Beowulf in 2010. Prior to joining, Ms Langlais spent 10 years at Goldman Sachs in its investment banking division and was most recently a vice president in the Natural Resources advisory group in New York. Ms Langlais has an extensive history with Beowulf, having served as adviser to MDU Resources in the sale of its independent power production business (Bicent Holdings) to Beowulf/NGP in 2007, and as adviser to Beowulf/NGP on the subsequent sale of the Mountain View wind farm to AES in 2008. Ms Langlais received a B.A. from Boston College. She can be contacted on +1 (212) 343 8353 or by email: email@example.com.
Allen Barron has over 40 years of experience as a reservoir engineer in evaluating domestic and international oil and gas properties, providing certification of reserves for public filings and regulatory reporting. The evaluation of properties includes analysis for the sale and acquisition of fields and projects, preparation of development programs and as an expert witness in legal proceedings. He is a University of Houston graduate in Chemical and Petroleum Engineering and a licensed Professional Engineer in the State of Texas. He can be contacted on +1 (713) 360 0301 or by email: firstname.lastname@example.org.
Lance Brasher is the head of Skadden’s North American Energy and Infrastructure Projects Group. He has served for more than 20 years as lead lawyer in complex acquisition, financing and development transactions involving energy and infrastructure facilities in the United States and around the world. Mr Brasher has advised energy companies, utilities, developers, investors and lenders in all phases of solar, wind and other renewable energy projects; gas and coal-fired power plants; transmission lines; electric distribution assets; LNG and gas processing facilities; natural gas pipelines; and sports facilities. He can be contacted on +1 (202) 371 7402 or by email: email@example.com.
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