Tudor, Pickering, Holt’s 2023 M&A Playbook

The confluence of Super Bowl LVII, M&A and the NAPE Energy Summit in Houston proved too enticing an (extended) metaphor for Chad Michael, president of Tudor, Pickering, Holt & Co. (TPH) to pass up.

If most of 2022’s dealmaking seemed like a year-long series of fumbles – or, only slightly less awful, the equivalent of the New York Jets third-down conversions attempts – Michael brought his own statistical highlight reel. His point: Not everything about 2022 was quite as brutal as it first appeared.

Yes, “it was a difficult backdrop,” Michael said. “More broadly, geopolitical pressures, inflation, a Fed that appears to be very steadfast at driving the economy to a slower position” made the year, for all sectors, one long and annoying spin move.

But Michael said that after observing a year of M&A, a certain playbook emerged for 2022 – and a rather straightforward one at that. And, yes, 2023 seems to have its own set of offensive and defensive rules, with some more likely than others to get called. Look for long bombs, fake punts and lines of scrimmage most may not have considered.

First the backdrop Michael mentioned: In the U.S., all sector M&A volumes were down, capital markets dried up and in a U.S. market, M&A wobbled its way in 2022 to $1.2 trillion, down 40% from the $2 trillion counted in 2021.

“By any account, Wall Street deal making was just a bit slower,” Michael said.

Yet while 2022 upstream M&A on its own wasn’t great, it certainly wasn’t Dave Shula-bad.

Energy, though, was a top performer in deals despite an iffy 2022. Energy M&A volume relative to U.S. volumes accounted for about 10% of the market, despite the energy sector’s weighting to the S&P 500 –just 5% of the market.

“From an M&A standpoint, energy’s punching above its weight with respect to just M&A activity,” Michael said.

Dig a level deeper and upstream constitutes about half of that volume.

“If you think about how the volumes of upstream M&A compared today to yesterday, we had a $55 billion M&A market in the U.S. and upstream this year. Last year we had $65 bill,” he said. That’s down about 13% from upstream’s typical haul of $70 billion, he said.

“So it was a slower M&A year, but it wasn't the kind of year that the broader markets of … Wall Street experienced,” Michael continued. “So there was still plenty to do in upstream M&A is the point. So let's talk about what the upstream M&A playbook was in 2022.”

Watching the tape: the 2022 M&A playbook

Get ready for some football analogies. The bread-and-butter M&A play for 2022, Michael said, was what he called the “power run up the middle,” otherwise known as the bolt-on.

Michael said for many companies the play was easy to execute, a low risk to call and needed four “key blocks” to find success.

“The first key block would've been an invasive transaction, a bolt-on, so to speak,” he said.

Next, the buyer – usually a public company – buying an asset at a far lower multiple than the public. The deal had to be accretive to financial metrics, particularly cash flow and free cash flow.

The average acquirers’ multiple at the time of a deal announcement was 4.4x, according to TPH. The average transaction multiple? 2.6x. And the average relative performance for the buyers vs. the market one day after a transaction? 2.5x. In other words, arbitrage was everywhere.   

Such deals included Devon Energy’s purchase of Validus Energy or Marathon Oil’s purchase of Ensign Natural Resources.

Finally, the “play” needed to add inventory and, more than likely, the buyer was going to slow down the “pace of drilling activity to ensure that there could be accretion to free cash flow.”

Michael said that if those four elements came together, “you would end up with a share price that outperformed on a regular basis.”

“And, in fact a lot of touchdowns, so to speak … were scored as a result of this play,” he said. 

M&A saw other 2022 “plays,” Michael said. He termed one the “fair catch” – typically a combination of two companies.

“Fair catches maybe don’t seem very exciting,” he said. However, they’re often the smart move. Fair catches, in Michael’s vernacular, included mergers that were generally the same size, the same location and created new companies.

Such deals include the formation of Chord Energy from the combo of Williston Basin players Oasis Petroleum and Whiting Petroleum, and the creation of Permian Resources from the merger of Centennial Resource Development and Colgate Energy.

Next, 2022 saw a number of what Michael called “counter plays,” here referring to passive or non-op, which he said have grown dramatically in terms of value and sophistication, he said.

“It's been really exciting to see many members of this room start to institutionalize that. For the first time since we can remember, that part of the market … is well over 10% of the market now and, in fact depends how you define it,” he said, adding such companies’ share could have been as much as 15% of the 2022 market.

Offense in 2023 will be a mix of the familiar and unfamiliar.

M&A playbook 2023: enter the SMIDs

Some plays just work, and 2023 looks likely to stick with the “power run up the middle” for E&Ps. In 2023, they may require more work as companies will now face more consolidated basins.

“But every chance that play has to be run, we think it will be run and be run successfully,” he said. “The middle play is getting right at the heart of ‘let’s get bigger, let’s add more inventory, let’s improve the company. So you’re going to see more of that.”

But Michael sees a new tactic potentially emerging in 2023: the “run-pass option.”

“It took NFL football until about four or five years ago to see that options were really valuable,” he said. “So what do we mean by the run pass option play? We think the SMID-cap universe … has more options than it had in the past.”

The SMID-cap universe, as Michael defined it, comprises companies with market values ranging between $1 billion and $10 billion.

TPH sees such companies now mimicking the capital discipline and balance strength that’s been the hallmark of their large-cap peers. And it’s a sector of the upstream market that’s been growing. In the depths of the pandemic, SMIDs were worth an aggregate of about $10 billion. In 2022, SMIDs grew to as much as $100 billion in value before, more recently, settling in at about $75 billion, TPH said.

“Now, for context, that is a mirror image from a market cap standpoint to EOG [Resources],” Michael said. “You’ve got an EOG out there ... embedded in around 20 companies.”

Consolidation among SMIDs isn’t as simple as a linebacker blitz. But the potential is there.  

“A lot of alignment has to come together for that to occur,” he said. “These transactions are quite difficult to pull off.”

The apparent value, beyond potential upside, longer laterals and typical M&A synergies, is in overhead costs. Returning to the example of EOG, Michael noted that the G&A of that large-cap is about $500 million. For the 19 or 20 companies populating the SMID-verse, G&A totals about $1.6 billion.

“This group of companies we think are very efficiently run,” he said. There’s just a lot of them.

But it is possible “there’s maybe some kind of G&A prize there to be had.”

SMID-caps have also dramatically improved alongside their larger-peer rivals. SMIDs have gone from outspending like most of the rest of the sector to handling their money as tightfistedly as large-caps. SMIDs spend roughly 40% to 50% of their cash flow.

In some cases, the return on their equities has gone even higher than larger publics, Michael said. And many SMIDS have seen their balance sheets’ solvency improve, while their leverage has dropped to well below 1x.

TPH noted that 2023 year-to-date, reinvestment rate capex for the median large-cap is 43% compared to 54% for SMID-caps. Likewise, year to date return on equity in 2023 is 28% for large-caps and 31% for SMID-caps.

“We actually think that these SMIDs do have a lot of options,” he said. We expected them to be more active in the M&A marketplace. They’re more than capable of buying, potentially with cash or stock.”

Surprise and trick plays

Every game has its surprises, Michael said. After 2022’s false starts and occasional offsides, Michael  predicts there’s bound to be some unexpected trickery.

For one: the onside kick. The theory TPH has been toying with is that the days of low-premium public-to-public company transactions may be going away.

“Public company M&A, there's always a premium,” he said. While the pandemic, with lacerating effects on public company valuations that may have bled away premiums, in the upstream space the traditional markup has ranged between 20% to 40%.

“We just think that the return of the public to public premium is around the corner,” he said. “And so we won't be surprised if we see a return back to some public company premiums.”

He noted that among the broader S&P 500 M&A market, premium come downs have compressed but not as much as those seen by upstream E&Ps.

“We also think that fundamentals can justify it because we think there's some trading dislocation out there right now where premium can be justified,” he said.

Michael also said it’s possible that there may be an E&P that is willing to take on leverage – “the long bomb” – to increase its inventory. But in an era of capital discipline, it remains to be seen if a company would be willing to face the market. “I wouldn’t say it’s likely to happen,” he said.

Finally, Michael also believes a “fake punt” is at work, and private equity is ready to catch everyone off guard.

“We think the idea that private equity is going away was the fake punt,” he said. “Private equity has slowed down. Private equity has stopped raising as much money as it had raised.”

But there are indications that while private equity won’t return to the glory days of 2015 or 2017, TPH does expect a much more liquid private equity space this year with, as TPH measures it, roughly $15 billion being raised now.

“We think that’s really important for the industry,” he said. “We think the industry is going to [need] more private equity capital. We think there’s room to take a bit more risk. Private equity can help with that risk management.”