The oil & gas industry suffered its weakest quarter for M&A in more than a decade in Q1 2020 as a combination of falling demand during COVID-19 lockdowns and prolonged low oil prices sent activity into steep decline.
Deal value dropped almost seven-fold on Q4 2019 figures to US$7.8 billion, a fifth down on figures for Q1 2020. Deal volume has more than halved on Q4 2019 levels and showed a similar drop on Q1 2019 numbers to only 43 deals.
The deal numbers are reflective of what has been a turbulent period for the sector. Oil prices have fallen by more than two-thirds during the last year, with WTI crude down from just over US$63 per barrel in May last 2019 to less than US$25 per barrel in May 2020. At one point in April, the WTI price even fell below zero. This has left large numbers of projects untenable. The Dow Jones Oil & Gas total return index, meanwhile, has shed more than half its value this year, with the FTSE All Share Oil & Gas falling similarly into the red.
A price war between Russia and Saudi Arabia early in the emergence of the COVID 19 pandemic did not help matters. The result was an already stressed market flooded with supply at the same time that demand was drying up. Companies that 12 to 18 months ago had an optimistic view on pricing, and borrowed in favorable lending markets to bring on extra production, have landed in a vulnerable position.
This volatility is impacting a number of deals that were struck in 2019, but which (principally for regulatory reasons) have not yet closed. While MOL completed its US$1.57 billion acquisition of certain assets in Azerbaijan from Chevron, a number of other deals signed in 2019 remain to close and pressure is increasing on buyers given current prices and market outlook. Certain of these look likely to be renegotiated, while in other cases buyers will prefer to walk away, paying any agreed break fee in compensation.
Right deals and the right time
As difficult as the backdrop for the oil majors and national oil companies has been, those with strong balance sheets and sufficient downstream infrastructure to absorb the current supply glut have continued to find deal opportunities.
Total, for example, acquired Tullow Oil’s Ugandan assets in a US$575 million deal in the last week of April, and Exxon Mobil struck a memorandum of understanding with Algerian state-owned oil group Sonatrach to enter exploration opportunities in Algeria. Downstream assets, meanwhile, could also attract interest from oil groups seeking capacity to absorb the excess supply in the market.
The larger players will therefore continue to acquire appropriate assets as they emerge. Despite very soft valuations, there are sellers in the market who have been pushed into asset disposal programs in order to shore up cash balances and avoid insolvency.
The universe of sellers in the US is already substantial. A number of smaller, highly leveraged companies have been courting buyers since 2019 without transacting.
As financial distress intensifies and vendors are obliged to swallow lower valuations in order to secure rescue capital and manage liabilities, more deals will be forced over the line, especially as no sector players have been able to secure equity capital market raises of sufficient size at current market values and the debt markets have been available only to the strongest of the group.
The squeeze on pricing and demand has taken its toll on shale producers in particular. Whiting Petroleum was the first sizable shale company to file for bankruptcy, and Chesapeake Energy recently announced they were hiring advisors to explore options including bankruptcy, raising doubt about its ability to remain a going concern.
The expected downsizing of reserve base lending facilities, which expand and contract in line with the value of a borrower’s oil reserves, has added further pressure to balance sheets. Redeterminations of reserve base values, which take place in the US every year in the spring and the fall, is seeing credit facilities shrink in concert with weakening oil prices this spring, with more reductions expected in the fall without a return to pre-COVID-19 demand levels. The result is likely to force a larger wave of companies to the deal table.
The US market is better placed to facilitate quick deals brought on by distress, as reserves are not state-owned assets and changes of ownership do not generally require government clearance. In other markets, however, where oil & gas resources are state-owned and licensed out to operators, change of control agreements will nearly always be subject to state consent.
Governments are taking longer to approve restructuring deals because of resource nationalization policies and concerns about the creditworthiness of acquirers, particularly if there are potential decommissioning liabilities attached to the assets. Any requirement for state consents on a change of control, or an inability to enforce security over state-owned assets without any such consents, will weaken the position of creditors looking for a quick solution via a debt-for-equity swap or pre-pack administration.
Private equity passes
Any deals that do close in the face of current headwinds are almost certainly going to be led by strategic buyers, especially for upstream assets. The bulk of deals forced to come to market involve either distressed companies or stranded assets that don’t lend themselves to consolidation. Private equity buyers will therefore be anxious about investing, even though valuations are materially lower.
Storage-related issues have put another obstacle in the way of private equity activity in the sector. Given the high levels of product in the market, there are no guarantees that even at very low prices the volume of oil & gas can be worked through the system to generate the needed cash flow. Strategic players may find themselves in a substantially better position because of integrated midstream and downstream operations that provide a more diversified business position.
Accelerating change
As disruptive as the last quarter has been for the oil industry, the COVID-19 crisis may have merely catalyzed a shakeout of the industry that was already underway. The consolidation of an overcrowded oil field service market has sped up, there is increased clarity on the battle lines among the world’s largest producing countries, and on a deeper structural level the preparation for energy transition may well accelerate as lockdowns are lifted.
As oil prices do stabilize with the COVID-19 demand shock normalizing, it seems unlikely that global demand will result in ever-increasing oil production. If returns in upstream oil & gas don’t rebound significantly, whether through normalized demand, consolidation, or both, investors will continue what was already a move away.
As economies bounce back, they will continue to need oil & gas. But the demand disruption brought on by COVID-19 may have long-lasting impacts on the industry.
