A ‘Strange and Broken’ Year For M&A

In August, Jud Walker, president and CEO of EnerVest, put a preemptive epitaph on the 2022 A&D arena: The year has been “strange and kind of broken,” he said at the TIPRO Summer Conference in San Antonio, Texas.

Strange, perhaps, because the oil and gas industry is richer than in years past, but its deal-making remains halting, at best. Broken because of war and wildly escalating commodity prices.

M&A started January with swagger as Chesapeake Energy Corp. announced more than $3 billion in deals, including the acquisition of Chief Oil & Gas in the Marcellus Shale. But the A&D market lurched forward awkwardly in late February as Russia’s so-called special military operation in Ukraine added a war premium to oil and gas prices, causing severe disconnects between buyers and sellers.

In a sign of the remarkable volatility that ensued, between January and March, WTI spot prices shot to $123.64 by early March from $75.99 in January — a two-month, $47.65 ride of unpredictable chaos for dealmakers. Yet by September, with oil prices in the mid-$80s, OPEC+ announced it would reverse course on an earlier, announced increase in oil production.

Likewise, natural gas prices began the year at average weekly prices of less than $3/MMBtu — before blowtorching its way, in the last week of August, to a choking $9.56/MMBtu.

The robust consolidation seen in the wake of the COVID pandemic also cooled as E&Ps began looking inward for deals and away from potential bolt-ons. Companies have largely chosen to pay shareholders, either through dividends or buybacks, while their stock prices remained undervalued compared to commodity prices. The only major public-on-public E&P combination announced this year was the $6 billion merger of equals between Whiting Petroleum Corp. and Oasis Petroleum Inc. that on July 1 resulted in the creation of Chord Energy Corp.

“Going into 2022, it looked like it was going to be a really buoyant year for deal flow because price had risen,” said William Marko, managing director of Jefferies’ energy, power and utilities group. “Then Russia-Ukraine happened and prices rose dramatically, both on the oil and gas side and deal flow hates volatility, especially extreme volatility.”

One bright spot for A&D has been the resurgence of mineral and royalties companies buying interests, particularly in the Permian Basin. In early September, Brigham Minerals entered into an agreement to combine in an all-stock merger with Sitio Royalties Corp. in a deal valued at $4.8 million.

Andrew Dittmar, director at Enverus Intelligence Research, a subsidiary of Enverus, said mineral and royalty deals were challenging in 2020 as companies slashed capex and drilling plans were scrubbed. That’s changed.

“You really didn't know what was going to happen and A&D subsequently collapsed,” Dittmar said. “We did like a billion and a half or so – about 50% less. This year we've done $3.3 billion in deals, so we're pretty much back to the 2018, 2019 highs.”

If prices manage to stabilize, M&A could take off in the next three to six months, but now with the lingering inflation, the possibility of a strong recession and demand destruction. That could present different headaches for an oil and gas industry that still needs to slim down, analysts and dealmakers said.

“You could see deal flow really take off if prices stabilized,” Marko said.

‘Slow motion’ consolidation

Both corporate mergers and acquisitions have been stifled by turbulent commodity prices, albeit in slightly different ways.

Marko said the bid-ask spread between buyers and sellers broken open as commodity prices spiked, with sellers naturally wanting to cash in on the highest price point while buyers balked.

“A lot of the buyers were trying to cautiously buy and a lot of the sellers trying to figure out how what was enough to sell. And some sellers kind of stay unreasonable – ‘If I can't achieve strip of the day, I won't sell.’ Others might need to sell for non-core reasons and strategic reasons,” he said. “They test the market.”

The result has been a deals market that is “elongated” with more time spent getting assets ready for the market.

“If we're working on the sales side, we're trying to set seller expectations to the market,” Marko said. “And then we're trying to talk buyers up obviously to find the most aggressive buyers who is going to go deepest into paying toward the strip.”

In the processes overseen by Jefferies, buyers remain stingy when it comes to paying for upside potential.

“A lot of the buyers were trying to cautiously buy and a lot of the sellers trying to figure out how what was enough to sell." – William Marko, Jefferies

“In the process we've seen, it really depends upon the quality of the asset. If you've got okay assets, then it's hard to get any money for anything beyond PDP,” he said. “If you've got good to great assets, then you can get increasing amounts of value paid for near-term development.

“That's where we spent a lot of time, too. How do you demonstrate the development, and then how do you get the buyers to pay for some of that to satisfy the sellers?”

Marko said the emphasis on shareholder returns and capital discipline has changed the way in which company’s do deals from an ultra-competitive growth perspective to a far more thoughtful process in which acquisitions are part of the company’s story on growing payouts.

“I think people do have to think about deals differently,” he said. “It's really the free cash flow is what people are solving for and the ability to generate that rather than, ‘Hey, I'm going to grow 10% a year.’

“Whether you're private or you're public, you're looking for 30%, 40%, 50% free cash flow generation, and you're looking for the ability to dividend out payments and the ability to do stock buybacks.”

Dittmar said price volatility has buyers and sellers sitting out of the deal market.

“High prices have led to a blowout in the bid-ask spread between buyers and sellers,” he said. “Buyers don’t want to credit assets at the kind of prices we’re at now. They think they need to bake downside protection in, because … there’s broad consensus that maybe we’re closer to a top than a bottom. Nobody wants to buy at the top.”

Sellers, at the same time, can decide that it makes more sense to just produce on their assets and harvest cash flow, he said.

Deals also vary based on the need for inventory, which has typically drawn buyers in 2022 to the Permian, the Haynesville shale or the Eagle Ford shale.

“We’re seeing a trickle of deals out there,” Dittmar said. But when an occasional transaction breaks loose in the Eagle Ford, as with Devon Energy’s announced acquisition in August of Validus Energy for $1.8 billion, it’s of use to the broader market. 

“It gives you an updated comp in the current price environment for the fair value on these assets,” he said. “And maybe it makes the next deal a little bit easier, because you have that to build off of. A steady trickle of deals can sort of snowball as buyers and sellers coalesce around a reasonable pricing point. So I think as long as prices stay sort of understandable, we're at settled for a bit, uh, we should see increasing activity over the next three to six months.”

Unsettled M&A

Corporate M&A has been similarly affected as prices have gone up, but E&P equity values have trailed.

“Despite this tremendous amount of cash they’re generating and the dividends and buyback programs that they have in place, they haven’t really run up in the underlying share prices,” Dittmar said.

E&Ps are instead looking at their options and choosing between a deal with another company or buying back their own shares, which the industry may view as remarkably cheap.

“Maybe that looks like a better investment of capital … than going out and buying someone’s assets,” he said. “So, that’s causing the problem for M&A markets.”

The case for consolidation — including more efficient operations, longer laterals and synergies from G&A costs — is still strong, Dittmar said. “There’s just not a lot of urgency to do it when you’re generating tremendous amounts of cash and doing well as an underlying business.”

“Buyers don’t want to credit assets at the kind of prices we’re at now. They think they need to bake downside protection in, because … there’s broad consensus that maybe we’re closer to a top than a bottom. Nobody wants to buy at the top.” – Andrew Dittmar, Enverus

In the absence of huge, multi-billion-dollar deals, Dittmar said merging mid-cap companies together might not be necessary for the business but would help attract more attention from Wall Street.

“You need to grab that attention … and basically make yourself competitive for the investment dollars that are available,” he said. “I think we will see more. There’s just not a lot of urgency. And as the companies get larger, the case for consolidation gets smaller.”

Marko said he also expects small- and mid-cap companies to consolidate but thinks it will happen in “slow motion.”

“If there are 40 companies in that space, I don’t think you’re going to see a dozen deals happen. But I think you’ll continue to see a deal or two here and there happen as companies kind of eye each other,” he said.

But larger consolidation, particularly after COVID lockdowns, was the result of companies with stronger balance sheets buying those with more stressed finances.

“There weren’t dozens of them, there were a handful of them, and that was in super volatile times,” Marko said. “The big players in the industry, in general, are going to continue to consolidate over time, but it’s not going to be a feeding frenzy. Companies are going to be choosy.”

Uncertainty persists

Minerals companies continue to rebound from the pandemic and in 2022 have been among the most consistent acquirers with total M&A now eclipsing $8 billion.

Prior to its announced merger with Brigham, Sitio announced two Permian deals totaling $547 million. The company itself was formed from the merger of Desert Peak Minerals and Falcon Minerals in combination valued at $1.9 billion.

At the time of the merger’s announcement, came about two weeks after Brigham announced its largest deal so far — a pick-up of 3,900 net royalty acres in the core of the Midland Basin for about $132.5 million in cash. Brigham also announced a Permian acquisition in February for $32.5 million.

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Dittmar said mineral and royalty companies may see an all-time high in A&D activity this year as drilling plans firm up, E&P development of assets becomes clearer, and investors continue to see such companies as an “inflation hedge at a time when that’s a major concern for investors.”

The next major risk the oil and gas industry faces is the wider, global economy. The Federal Reserve and other central banks have signaled they will continue to increase interest rates if necessary.

Dittmar said a recession could stall deal flow because of worries over downside risk.

But that’s been the story of 2022.

“It’s very uncertain,” Dittmar said. “Every time it feels like it’s more uncertain than before. Maybe it’s like a recency bias. It seems like we’re in unchartered waters, but you could have said that in 2020 or 2021 or 2019. That’s the nature of the world that we live in.”

Marko also sees an energy market that’s dragged into a new reality due to the reshaping of gas flows by Russia. Along with inflationary pressures, there are also supply chain problems, with even frack sand becoming hard to come back in some cases.

Natural gas prices may stay higher, meaning above $3, for “a really long time,” he said.

“The U.S. market is really connected to the worldwide market more than ever before,” Marko said. We’re not just going to have regional pricing.

Were oil prices to settle in the $80 to $90 per barrel range, it could make for a more attractive deal flow in the coming months. But fears of a recession may also spoil dealmaking.

“With a recession, you’d have demand destruction and then price destruction and that would chill the A&D market,” he said. “If we had a severe recession again, where there’s blood in the water, that could actually boost an M&A market to, again, where strong balance sheet guys can shop for weaker [companies].”

Alternatively, should prices remain at higher levels, the A&D market may see utilities and steel and chemical companies considering whether they want to purchase assets to reduce their energy generation supply costs.

“They do this every time supply cost goes high and mostly, they never execute on it, but occasionally they do,” Marko said. “I think this time it may stick for a long time.”