E&Ps Defy Uncooperative Market, Continue Deal Making

[Editor's note: A version of this story also appeared in the January 2019 edition of Oil and Gas Investor, which can be found here.]

If there’s one thing that Denbury Resources Inc. (NYSE: DNR) and hedge fund Mangrove Partners agree on, it’s that Penn Virginia Corp. (NASDAQ: PVAC) is a compelling investment.

Denbury and the hedge fund’s view diverges there, with Mangrove considering its investment in Eagle Ford operator Penn Virginia a compelling standalone investment, Mangrove said in a Nov. 13 regulatory filing.

Mangrove’s rebuke of the $1.7 billion offer made by Denbury came 12 days after the deal, largely to be paid in stock, was announced. The investment firm also noted, in case Denbury had not, that its shareholders also appeared disaffected. Denbury’s share price had already plunged by more than 40%.

RELATED: Denbury Adds Eagle Ford Core With $1.7 Billion Penn Virginia Merger

Nearing the end of November, Mangrove took a more aggressive stance, according to Securities and Exchange Commission (SEC) documents. Mangrove spent nearly $40 million to up its Penn Virginia holdings to 10.7% from 9.5%. Mangrove reported offering an ultimatum to Denbury: kill the acquisition or the fund would vote it down.

Such spats betray the core uneasiness of investors in the energy space. More passively, the public equity markets have entered a mini-ice age since the downturn, according to prominent players in banking, private equity and M&A attorneys who spoke in late October at Deloitte’s Oil & Gas Conference in Houston.

An acquisition’s strategic rationale, accretive potential and price have seemingly lost relevance to investors, which are often quick to smite deals.

“Even the largest companies right now are very nervous about doing [a] large transaction because they’re scared their stock is going to get absolutely hammered,” said Andrew T. Calder, partner at Kirkland & Ellis LLP’s office in Houston, who spoke Oct. 30 at Deloitte’s conference in Houston.

Angelo Acconcia, senior managing director for The Blackstone Group LP, said he’s been stunned by the market response until then in commodity prices. In the past three or four years, oil prices have fluctuated greatly, sinking to about $27 per barrel to begin 2016. Still, no one could have prepared him for the response once prices rebounded.

Those years, Acconcia said, have been fascinating. Had he been told in 2015 that prices would dip below $40 and then go up to $70, yet “the general equity indices of the upstream sector would be largely unchanged, I would have laughed. That’s what’s happening.”

Since the conference, oil prices continued to fall, with West Texas Intermediate spot prices at roughly $50 at the end of November.

The market’s cold shoulder reflects the paradigm shift that now dogs every E&P at quarterly earnings time.

“I think this risk-focus in the market has manifested itself in a ‘show me, prove it to me’ mentality,” he said. Acconcia, who shared the stage alongside Calder and Stephen Trauber, vice chairman and global head of energy, Citi. “And the easiest way to do that is with free cash flow and dividends.”

Trauber said public equity markets are closed to the energy sector as generalist investors figure out whether oil and gas will be competitive, on a return-basis, with other sectors.

“Today, the S&P 500 is probably about 6% energy,” he said. “There is no generalist investor who’s going to outperform his peers by investing energy.”

Many upstream private companies face the dilemma of having matured to stage in which they would be better served as public vehicles but cannot muster support for an IPO.

“Just in our own backyard we have at 10 IPOs that want to go public that aren’t able to go public,” Trauber said, adding that gas-oriented E&Ps and Gulf of Mexico operators are among those out of favor.

To feel out the market, investors are waiting to see whether upstream, midstream and service companies can actually generate economic returns greater than the cost of capital.

“There’s not a lot of capital today coming into the energy sector, which remains a problem,” Trauber said.

Upstream companies and others are stuck, unable to access capital to grow and punished by markets for transactions intended to bring scale.

RELATED: M&A Experts: In This New Wave, Bigger Is Better

“Where we are today is the market is saying [companies] need to generate free cash flow, which is putting a constraint on companies to grow organically and inorganically,” Acconcia said. The larger message is, “we’re not coming back until you change.”

‘Misalignment’

Calder has seen firsthand the turmoil of the disconnect between investors, particularly those without a history in the oil and gas business.

“We’ve been involved in deals that have fallen apart as a result of the stock market reaction,” Calder said.

While Calder didn’t mention any specific deals, his clients have included Bonanza Creek Energy Inc. (NYSE: BCEI). In 2017, SandRidge Energy Inc. (NYSE: SD) offered $746 million for Bonanza, before the transaction was crushed under pressure from activist investors including Carl Icahn.

Volatility in the oil and gas sector hasn’t been limited just to market caps and oil price swings. That’s changed what Acconcia called the market’s “panel of judges.”

“A lot of the investors are shortsighted,” he said, adding that management teams know their costs, inventory and strategic M&A needs better than anyone else. “You’re being held accountable to those people, which can create a misalignment.”

Nevertheless, management teams continue to make deals.

“They realize they aren’t necessarily going to get appreciated by the public markets today, but they have more information than the markets about their business and they’re going to make the right decisions,” he said. “That accountability [to shareholders], while negative today, will prove up to be a winning strategy.”

Acconcia said he applauded companies such as Oasis Petroleum (NYSE: OAS) as well as Chesapeake Energy Inc. (NYSE: CHK), which the morning of the conference agreed to purchase WildHorse Resource Development Corp. (NYSE: WRD) for nearly $4 billion.

Denbury, too, was due congratulations, he said. Mangrove filed its first report with the SEC that day, saying Penn Virginia should command a higher premium than Denbury offered.

Denbury’s impasse with Mangrove over Penn Virginia hasn’t been an isolated phenomenon.

In July, Concho Resources Inc. (NYSE: CXO) closed its deal to buy RSP Permian after initially losing 9% of its value following the $9.5 billion transaction. This summer, Diamondback Energy Inc.’s (NASDAQ: FANG) shares were also sapped by about 10% of their value after announcing its deal to buy Energen Corp. for $9.2 billion.

As public markets have closed their doors, in particular to E&Ps, the business of deal making has fundamentally changed, Calder said.

New York hedge funds didn’t always understand the basics of the industry, such as working interest or how basins play out.

“The downturn basically sent all these hedge funds to school,” he said, adding that those funds have sway over 10 to 15 upstream companies after their debt in a company was converted to equity.

“The problem is they don’t see industry the same way traditional management teams see it,” he said. “They also don’t believe any one basin should be 10 companies with separate G&A. They believe there should be consolidation.”

Calder added he wasn’t opining on whether the approach was right or wrong, “but that’s their view of the world.”

In Energen’s case, Icahn and other activists wanted the company to sell, resulting in the deal that brought Diamondback in as the new owner on Nov. 29.

Trauber sees merit in the investor demands to find scale or greatly increase shareholder value. Even “brand name investors” are increasingly playing the role of activists, though they may do so behind the scenes.

Management teams also tend to become entrenched from time to time and genuinely like running their companies, even if that may not be in the best interest of shareholders.

“I can’t think of any more fragmented sector of the world that benefits from putting these companies together,” he said, noting the huge economies of scale and cost savings that result.

“You’ve got to look at these combinations and the benefits that they bring,” he said.

With the drawbridge to public markets pulled up, Calder some companies are finding alternatives.

“Public companies are looking for another avenue to make these transactions that may not simply rely on going to the public markets,” he said.

Darren Barbee can be reached at dbarbee@hartenergy.com.