Bankers' Outlook for A&D: A Slow Unwinding of Asset Sales

The Lower 48’s frenzied pace of upstream consolidation has captured the attention of the industry and outsiders alike for more than a year. As the trend’s sweep of the E&P space barrels forward unabated, financial experts are weighing how this cycle differs from previous iterations and how it may reconfigure the sector’s landscape. Oil and Gas Investor Editor-in-Chief Deon Daugherty talked with top energy bankers, including Mike Dombroski of CrossFirst Bank; Marc Graham of Texas Capital; Jason Reimbold of BOK Financial; and Jeff Treadway of Comerica to gather their insights into the consolidation dynamic and its implications on financial, corporate and operational fronts.

Deon Daugherty: Where do you believe the E&P space is in this consolidation cycle? Is there more to come, and if so, in what form?

Mike Dombroski, CrossFirst: In the space we play in—I would call it the lower middle market ($20 million to $200 million equity)—where it’s mostly private companies, we’re losing most of our upstream deals to consolidation. 2023 was a tough year for us just to keep pace. It felt like we were on the hamster wheel, constantly finding out somebody who’s in the market was looking to sell and [we were] having to replace those loans.

It’s slowed down this year, so I think we’re more than halfway through maybe the “big” consolidation. We still have deals that are looking to go to market, so it definitely still seems like our borrowers see a consolidation market out there and they’re trying to take advantage of it.

We’re very early on in seeing some of the activity flow down to the level of where we play in the market. The activity from a finance standpoint for us has been pretty slow. I would say the end of last year and beginning of this year was historically slow. It really seemed to pick up probably in May. We started seeing some activity where we had clients and prospects that were starting get some traction on some asset packages and winning some deals. So, it started up, but it still feels pretty early for the downstream effect of it from our part of the market.

Marc Graham, Texas Capital: In baseball terms, probably the sixth or seventh inning. There will certainly be more consolidation to come. There are companies that have not announced transactions yet that I would expect to do so because their peers have. There may also be larger companies that missed out on a specific asset opportunity because of these long FTC (U.S. Federal Trade Commission) review periods and may now be thinking of consolidation of the acquirer. There are companies who have grown so quickly via multiple smaller acquisitions that they themselves may now be attractive consolidation targets. And there are equity holders who would be receptive to an approach because it would allow them to monetize their positions. I also wonder whether, given all the advantages of Lower 48 production (relative cost, politically stable region, CCUS initiatives, etc.), we won’t start to see foreign companies begin to pick up U.S. domestic producers.

Jason Reimbold, BOK Financial: We might see the corporate level consolidation begin to slow. Certainly that would make sense. But I think where the opportunity is going to come for this next wave of A&D activity will be … the reconfiguration of what are now these asset profiles that were the result of the consolidation.

There will be assets now that are now going to be less core to that combined profile, and we’ll start to see some of those assets come to market. But I think there are other factors that are influencing that as well. We have started to see very recently, I would say certainly in this calendar year, much stronger valuations in A&D. And as we see more of that, I think companies are going to be more likely to consider selling properties.

So that’s going to help drive A&D activity in the near term, which will be a welcome departure from where we’ve been recently, where it’s been at the asset level. Yes, there’s been a lot of activity at the corporate level, which I would distinguish to make the distinction for our sector as M&A versus A&D. While M&A has captured a lot of headlines, A&D has been sluggish, but I think we’re going to start to see a change in the coming months and certainly into 2025.

Jeff Treadway, Comerica: [The A&D post-M&A] is somewhat starting now. We talk a lot to private equity. More than half of our loan portfolio is private equity-backed firms, private equity-backed companies for those. We talk to the firms directly and they all think that rationalization is coming. It’ll be a thing. I just think if we’re thinking of it in terms of a game, we’re maybe just now after kickoff. We’re still pretty early in that one. Until it takes hold, I think it’s hard to determine how big it’ll be and what the potential is. But now it’s a common industry trait, and I think you can apply this to many industries that after big periods of consolidation, there’s going to be periods of rationalization.

I think you’ll start seeing some deals around the edges, but it’s going to take time for Exxon [Mobil] to digest exactly what they have with Pioneer [Natural Resources]. It’s going to take time for Diamondback [Energy] and Endeavor [Energy] to really figure out if there are truly non-core things that they’re holding that they’re just never going to get to.

Some of these transactions, you’re not going to necessarily see them publicly announced. But a lot of the private equity firms we talk to, they’ve got teams that are just trying to peel off the crust from these big deals. It’s hard for them to get the attention of the companies that are in the midst of this M&A, but they are trying to—either through acreage, trades, farm-outs—achieve little “company makers.” For Diamondback plus Endeavor, a $50 billion company, it doesn’t really matter to them. So, there’s going to be those little or smaller deals around the edges. It’s actually rationalization, [but] not of a billion-dollar scale.

DD: To what extent does size/scale matter in accessing public equity for consolidation?

MD: From the selling perspective, funds are just trying to make returns to investors and a lot of those funds are probably a little bit longer in the tooth; those are probably pre-2020 type investments. It’s time to get out of those. From the buyer’s perspective, to me it seems it’s about the inventory we’ve seen. I wouldn’t say every deal we’ve had [that sold] to a larger company has been 100% Permian with inventory or Tier 2 or 3 additional inventory for a bigger player.

We have seen a little bit of more strategy and in some of the latest deals, I think they’re just looking for scale. The acquirer is looking for scale. There are refrack opportunities and it’s a little bit more traditional oil and gas consolidation than just the pure shale. That probably has been the store in the last two years [and] there’s probably not drilling, but it’s more PDP refrac operational type of assets that are selling to a larger player. I don’t know if that’s going to be a trend, but it definitely seems [to be] more of a scale game as companies are just trying to get bigger.

MG: It still matters very much. Larger companies have demonstrated many advantages, including access to cheaper capital and stronger equity currency for acquisitions. This has been demonstrated by higher valuation multiples or lower required distribution yields. This has mattered for upstream consolidation because vendors are more willing to accept the equity of a larger company.

DD: How do you view the sentiment of the public equities market toward traditional oil and gas?

MG: Sentiment is shifting in favor of traditional oil and gas as the markets accept that hydrocarbons are not “going away” (in the very near future) and alternative energy sources are not readily available. The return of capital model that has been adopted by most companies in the industry has also attracted investors who appreciate current income as well as capital appreciation. Consolidation has also decreased the number of companies that are competing for the attention of public equity investors.

JT: Coming out of COVID, I would say the sentiment was not necessarily positive, but the returns were, and now I think we’re in a little bit of, “All right, show me how long you can do this for.” I think equity markets are still a little bit skittish about being truly long in the commodity or truly long in the industry this year. Energy is kind of a middle-of-the-road performer on the whole, I think it’s up roughly 10%. There are certainly other industries that have performed better than that, but I think these equity investors are curious about inventory, they’re curious about costs. They want to see that capex spending is not getting out of hand, that they’re still generally living within their means, not levering up to grow. Those kinds of things are important for the equity investors to see because those are all things that got everybody in trouble five to 10 years ago.

I would say they’re still generally fairly skeptical. I mean, the sector only trades at roughly 4x to 4.5x cash flow. So, that’s pretty light. It doesn’t instill a lot of confidence. But I think in the meantime, these investors are generating some nice returns. They’re getting distributions. There’s still plenty of buybacks out there. I think over time, if the sector continues under this discipline setting, the equity investors will return. But it’s still a sector that’s always had its challenges and not going to be as high flying as others.

DD: To what extent might a robust secondaries market have a role in A&D for the E&P sector?

MG: Companies with a strong public equity currency are able to use it as consideration for attractive asset acquisitions. With a robust secondary market, the sellers will be more comfortable holding that equity, knowing that they can divest it easily in the market to a receptive audience. Look at the “revaluation bump” that many companies received when they announced their accretive acquisitions. Because the vendors were comfortable taking equity as partial compensation for their asset, their ultimate sales prices were actually significantly higher than the originally announced purchase price. Without a robust secondaries market, this would not be possible, and sellers would not benefit from all the synergies that the acquisition brought to the buyer.

JT: In the public markets, there have only been a couple of IPOs this year, and they were unique asset bases. In a lot of cases, if you’re sitting back and you’re a big private equity-backed company that’s already making distributions back to your LPs, it’s like, well, I can go do this for three more years and still be the same size I am today, and then sell for three times or four times. That hold case is pretty compelling, right? So a lot of companies did that and got them several turns more worth of return versus, I can go be a publicly traded company and sell it four times right now. Sometimes these guys are so big, they’ve had to take equity from the buyers. If they’re selling to a big public company, they’ve had to take some equity to help get the deal done. There have been a lot of secondary offerings this year because of prior A&D transactions in which the seller had to take stock. It’s definitely playing a role.

DD: What are emerging options for oil and gas consolidation?

MD: It seems like, in the consolidation effort, there are companies working together a little bit [differently]. Northern (Oil and Gas) announced a sale and it was taking a non-op piece, and the buyer [SM Energy] was taking 80% for the operated piece. We’ve seen that a little bit more even on the smaller, non-public side.

We’ve done a lot of non-op [deals] over the years. It’s fit well with the type of the size debt and the commitment size. It’s fit well for us, and we’ve seen really good results on the non-op side where you don’t have to have the full G&A burden. You can get in some better rock with better operators rather than trying to get an operated play with maybe a third tier or second tier type position.

Those companies are going to continue to get bigger. The non-op pieces are going to get bigger, the public markets potentially [will] be there for the non-ops and you’ll see more deals happening where there’s somebody taking down the lion’s share of the operated piece, but there’s a non-op player there as well. I haven’t seen that as much in the past where you have two parties playing together nicely to take down assets.

MG: There is a spectrum of options. I think that we will see the formation of new publicly listed companies via IPOs. This will give those companies public currency to facilitate acquisition transactions. We have also seen several buyers team up with non-op partners in order to decrease their purchase price. There have also been transactions that have utilized ABS [asset-based securitization] issuance concurrently with the acquisition in order to provide a return of capital to the divesting shareholders.

JR: I think the Permian Basin will continue to be a focus point for the industry for many reasons. We will see the Permian Basin, as large as it is, certainly it is finite as well. And the industry has always, over my career, been able to identify and create value across the Lower 48. And so, I think that we will see more activity pick up certainly throughout Texas, throughout the Midcontinent as well, the Williston Basin, just to name a few places. We’re going to see an expansion, or at least let’s call it an increase, in deal flow and transaction activity in basins outside of the Permian.

JT: The Permian has been the center point for some of the biggest deals, but we’ve seen activity in almost every basin. We’ve been a part of financing or been on the sell side of a deal … I think we could probably check off every single basin in the last 12 months.

But it’s not just a Permian circumstance here. It’s all different basins. Permian’s the biggest. It’s got the most, theoretically longest runway and most upside and all that kind of stuff. That’s where we’ve seen so much activity there, but we’ve seen it in every play at this point.

DD: What role will debt have in the next wave?

MD: It doesn’t seem like there’s a whole bunch of levering up. We’re not involved with a lot of these much larger companies, but the banks that are financing that type of acquisition are still people we play with, and I can’t imagine—at least on the senior side—that those banks would be comfortable with much more leverage than we’re seeing downstream.

It seems to be a big chunk of equity financing for us. I haven’t really seen companies running much more than 1x or 2x leverage, really 1x or less. That trend seems to be holding.

I don’t think there’s a huge push to lever up to buy these assets. It seems like some of the larger companies that have made acquisitions are announcing they’re going to reduce the rig count or the drilling pace on a lot of these deals. So, I couldn’t imagine they’re levering up too much and then pulling back production growth.

Even the non-bank lenders don’t seem to be stretching too much. They seem to be in a great position [in which] they’re able to lend sub-3x—maybe in the 3s initially—but it’s not the 4x to 6x leverage that you used to see those kind of non-bank lenders doing back in 2014 or 2016.

MG: The optimal capital structure is not debt-free. While capital structures will remain prudent, debt will enable purchasers to pay a cash component of the acquisition price.

JR: I think that as transactions, as A&D picks up, there will be a greater demand for debt financing. However, at the same time, I don’t know that we will see the terms around that financing change. I don’t know that we’re going to return to the days of living outside of cash flow. Not to say never, but memories are not that short. I don’t see that on the horizon, at least in the conversations and the transactions that we’ve been a part of. I would say there’s still a fairly conservative approach to how debt is utilized.

Given the relatively low levels of debt in conjunction with, candidly, a softer A&D market—and I mean softer in the last couple years—there was not much motivation for the reconfiguration of asset profiles, which is why I don’t think we’ve seen a lot in the way of so-called non-core sales fall out of these larger consolidations. That’s one point.

However, once we can start to see some relief on interest rates, which at least as of right now, there’s still talk about that coming combined with stronger valuations that we’ve seen in the market [in 2024]—which I think is also a function of limited deal flow—participation on broad process A&D mandates has been very high.

The conversion of ask-to-bids has also been very high. I think that is largely the result of a limited opportunity set for companies to make acquisitions. We’ve seen some valuation recovery that, combined with lower interest rates when that should occur, I think will give companies—not just the large publics, but the smaller mid-cap and even small-cap companies—motivation to consider going to market with assets. And that would be, of course, the hunting ground for new teams, management teams, people who were displaced as a result of these consolidations. That would be the opportunity for them going forward.

I would also say this: We hear a lot less about ESG as a consideration at this point. And I think with what banks have been experiencing in payoffs and pay-downs, they’re now looking to at least maintain, if not grow the loan portfolios.

Although we haven’t seen the Fed decrease interest rates yet [Editor’s note: The Federal Reserve announced a 50-basis point cut in September], we have started to see some competitive pressure on rates for loans in the market simply because there are more banks now pursuing these lending opportunities.

Most of the appetite that we’ve seen has been from the smaller regional banks. I think the larger money center banks, the ones that wanted to stay in the sector, certainly did. But the ones who exited, I think that was for some other considerations, and I have not seen signals that they will return at this point. Of course, that could change. But right now, the higher level of appetite for making loans to this sector seems to be coming from other regional banks.

JT: I think that the unique part about the industry this time around is that it is pretty well capitalized. It is pretty well underlevered relative to prior cycles. So, maybe you see companies say, “You know what? I don’t actually have to sell this asset to help pay down debt or get my balance sheet back in order.” So many of these companies aren’t necessarily going to be forced into doing that because their balance sheets are all in pretty good shape.

I think the bond market is pretty constructive right now. If we’re talking about the bigger public companies, they’ve been able to go and tell the story of “We’re getting bigger.” Maybe some of these folks have been able to get their ratings improved with S&P and Moody’s and Fitch, and that allows them to achieve a little bit tighter priced bond if they go to the market to term out debt. So yeah, debt is there. I mean, banks are generally supportive of the industry. Credit facilities are inching up in size versus prior years. I would’ve said two to three years ago, you couldn’t raise more than $1.5 billion under a bank facility. Now we’ve seen several go north of $2 billion, some near $2.5 billion. So, it can be done. It’s getting done. Banks are supportive.

It just comes back to the discipline. As long as the discipline is there with these E&P companies living within cash flow for the most part, and then their shareholders are getting their returns through 5x and dividends. If you’ve got that discipline and you’ve got discipline on the debt provider side, terms are still favorable for both sides of the table. So yeah, there is a role for debt, but historically it’s not 3x to 4x leverage in the company’s balance sheet. Getting north of 1.5x, you got to be telling a really positive story about how you’re going to get that down. So, there’s always going to be room for some debt. It’s much less than it used to be, as we all know. That’s been well documented, but it’s there for sure.

DD: How, when and in what form do you expect the divestiture side of the recent consolidation trend to catch up to the acquisition side?

MD: There are always cycles and I think we’re just in a different cycle, maybe the early stages of it, but it is a fine line for the private equity companies. Like I said, funds maybe aren’t as big and there’s not as many. A lot of times they want an asset or to back a team whereas, before, they were giving their backing to teams without an asset. It’s kind of a fine line of these assets coming. When are they going to come to market? How many people are going to be bidding on them or without money and all that coming together?

Then to get the next stage of growth and innovation, it’ll be interesting to watch. But yeah, it’s not like it was in the earlier 2000s where you had teams getting back to buy assets and there’s a lot of money out there. It is definitely going to be more of a balancing act than it has been in the past.

I think they’ll probably be more sporadic across the Lower 48, potentially more conventional. Maybe it gets back to the old-school private equity model of lowering costs. Maybe a little bit of drilling, but not as much of the greenfield [approach to buy acreage and drill]. You could go back to more of the conventional approach, probably a decent amount of PDP buys; maybe the vesting of assets that were drilled 10 years ago and there’s potential for people to come back in with refrac; or maybe the next wave of innovation is the refrac potential or different technologies that come out of going back into the wells that were drilled in 2014 or 2015, and that is the next phase of innovation.

MG: The divestitures may take time. It won’t be easy for consolidators to divest the cash flow associated with their mature, low-decline assets until the synergies associated with their acquisitions are realized. Then, we will see those divestitures happen slowly. I don’t expect a flood of assets to hit the market all at once. I think that it will be a well-coordinated process.