Upstream M&A Through The Downturn

The graph shows the implied long-term oil price and deal counts on a trailing three-month average with the Brent price on a monthly basis. This captures deals of more than US$10 million in which reserves changed hands (excluding pure exploration ventures). The implied long-term oil price is calculated for a subset of the largest deals (more than US$200 million), weighted by dollar amount.

The upstream M&A market has endured huge turbulence over the past few years. The onset of the global economic crisis saw a collapse in commodity prices mirrored by a collapse in deal activity. After posting record transaction levels in mid-2007, the market ground to a near standstill by the start of 2009. How have the markets’s underlying long-term assumptions evolved? What does the recent uptick in deal activity signify? And, what might be waiting around the corner?

Wood Mackenzie has analyzed a subset of the largest upstream deals (all more than US$200 million) completed from the beginning of 2005 to date under its implied long-term oil price metric (all amounts are in U.S dollars unless noted). This proprietary deal-valuation method estimates the long-term Brent oil price that a buying company would require to generate a 10% nominal return on its investment.

In contrast to traditional “dollar-per-barrel” metrics, by basing the analysis on a comparison of future cash flows, the metric reflects underlying value and provides consistent benchmarking of deals across fiscal regimes and various types of assets.

Volatile market

As the price of oil continued its steady ascent from the start of 2005, so did the price that the market was willing to pay for deals: the weighted average implied long-term oil price tracked Brent until the end of 2007. Buyers seemed willing to accept a structural shift in the oil price, all the way from $40 per barrel up to $70. Cash-rich companies, many with fast-evolving strategies, and many struggling to access organic growth opportunities, pushed M&A activity to record levels through 2007.

At the beginning of 2008, however, the oil price and the M&A market decoupled. As Brent spiked over the first half of the year to peak at nearly $150 per barrel, the implied price held steady at around $70. Likewise, through second-half 2008, as commodity prices plunged, the metric again held at around $70 per barrel.

It seems that at the peak of the market, few buyers were confident they could make a return on deals completed at more than $100 per barrel, while at the bottom of the market, few sellers were content with less than $70.

For most of 2008, in fact, there were relatively few deals completed at any price. The number of transactions being undertaken began to fall early in the year, as the oil price approached $100 per barrel, and dropped dramatically during the second half. As the oil price plunged, so did the number of companies willing or able to do deals. Huge uncertainty was compounded by a liquidity crisis, as the gap widened between expectations of buyers and sellers. The flow of assets coming to market all but dried up, and by 2009, most buying opportunities were limited to distressed sellers and/or relatively poor assets.

Analysis of the long-term price on a deal-by-deal basis highlights the marked shift in market sentiment that occurred as 2008 began. From early 2005 to year-end 2007, deals were being valued within a reasonably tight range on a broadly upward trend. By early 2008, however, the trend had weakened and the range of deal valuations expanded considerably.

One stand-out feature of the market throughout 2007 and 2008 was the lack of “major” deals, as the largest players were reluctant to undertake material M&A transactions. There was a hiatus in deals greater than $8 billion from year-end 2006 (Statoil/Hydro) to March 2009 (Suncor/Petro-Canada—a unique deal by any measure). Throughout this period the majors were notable by their absence, preferring instead to focus primarily on organic-led growth, the pursuit of discovered resource opportunities and smaller strategic transactions. The Chinese national oil companies (NOCs) were also relatively quiet, spending significantly less as a group in 2007-2008 than they had over 2005-2006.

Uncertainty persists

Recent months have seen something of a turnaround. As oil prices bounce back and credit markets ease, there are signs that confidence is returning to the M&A sector. Engagement levels are high and deal activity has picked up. The second quarter of 2009 saw a marked increase in both the number and scale of deals being announced, and in the volume and quality of opportunities coming to market. Despite this recent uptick, however, a sense of uncertainty continues to pervade the sector, and the wave of large-scale deal activity that many industry observers predicted earlier in the year has yet to materialize.

As the implied long-term oil price rose, the dollar value of deals declined. Deals completed by the majors declined in size and deals by the large-cap independents and national oil companies increased.

It is fair to say that for many of the larger players, the rationale for major corporate deal activity looks compelling, particularly in terms of potential value creation. For some time now, many potential corporate targets have looked relatively inexpensive (on the basis of market valuation versus Wood Mackenzie valuation) when compared to asset deals, or even organic development activity.

At the turn of the year, our analysis of the 30 largest independent oil companies (IOCs) showed them, on average, trading at a significant discount to our base-case valuation (NPV-10) under a $70-per-barrel long-term oil price.

With none of these companies in a distressed sale position, however, the disconnect between buyers’ and sellers’ expectations and the cautious approach of potential acquirers has prohibited deals. Rising stock prices have since brought the average market valuation back in line with our base-case valuation (under the same assumptions). Nonetheless, many companies, including several notable potential acquisition targets, still trade at a substantial discount.

Obstacles outweigh drivers

In our view, the obstacles to large-scale corporate deal activity continue to outweigh the drivers in the current environment, and are likely to do so for the foreseeable future. The macro issues that stifled the M&A market during the second half of 2008 remain: economic uncertainty, oil-price volatility and liquidity constraints. For as long as this is the case, concerns about further weakness and the risk of acquiring prior to another drop in prices will limit activity.

With the oil price back at $70, and buyer and seller expectations better aligned, simple logic might suggest that deals should follow. But for potential buyers, some of the most attractive opportunities have disappeared (for now, at least), especially when the inevitable substantial acquisition premium is factored in.

Furthermore, given the outperformance of oils against the wider market over the past 12 months, there is no immediate pressure from stakeholders to undertake deals. When the global economy does turn, however, oils could be the last to follow (as investors instead favor higher-growth plays). In these circumstances, pressure to do deals may mount.

For potential targets, there is little immediate pressure to sell; companies that have avoided a fire sale to date are now well placed to hold out for a sustained bounce in commodity prices. The longer oil prices remain at this level, and with increasing confidence in an economic recovery, access to capital may facilitate organic growth for some previously moribund players, encouraging stakeholders to afford management more time to show the portfolio’s potential rather than lobbying for an exit via the asset market.

For potential buyers, capital restraint is still a stronger theme than growth through M&A, and for many of the majors, the need to protect dividends is paramount. The status quo has become attractive for a number of the larger names in the oil sector. In our view, the wait-and-see approach will likely persist. That said, it is conceivable that a credible first move could trigger something of a domino effect, with others unwilling to risk being left at the starting gate as the number of attractive opportunities dwindles. If market reaction to such a deal was favorable, companies that are currently happy to wait could come under pressure not to miss out on what could be a once-in-a-decade opportunity. Bear in mind, however, that there are only a handful of potential deals that could act as such a catalyst.

Market forces

Although they are widely perceived to be the most likely acquirers, for the majors, in general, the drivers for growth through acquisition are not nearly as strong as in the late 1990s. Most are on a firm financial footing and are content to focus on relatively strong portfolios that should deliver adequate performance on organic-growth metrics. Many of these opportunities require demonstrable financial capability, and will therefore take precedence over the potential for growth through acquisitions.

Accessing discovered resource opportunities will remain a strong focus for the majors but continue to present challenges. Opportunities are few, competition is strong, and there is little reason to believe that the investment climate in major resource-holding countries will improve. While we would not completely rule out large-cap acquisitions, deal activity will more likely track the trend of recent years, focusing on smaller opportunistic strategic and infill transactions.

Those that can afford to take a long-term view will target plays that offer material production growth and resource potential (global liquefied natural gas, deepwater Brazil, U.S. shale gas, Canadian oil sands, for example). The rationale—long-term growth, strategic fit, convergence on multiples, operational synergies, etc.—would need to be compelling; scale in itself is not reason enough. Mega-mergers are highly unlikely; the drivers are simply not there this time around, and the inherent political challenges pose a significant barrier to consolidation among this group.

Market premiums are compared, as paid by majors, North American large-caps and international large-cap buyers.

Arguments can be made for large-cap corporate activity, although the strategic drivers are different. All-share mergers (along the lines of Suncor/Petro-Canada) are a possibility in this group: for potential acquisition targets, as a means of self-preservation; for those with a weak balance sheet, to achieve a lower cost of capital; and for U.S. gas players, to realize operating efficiencies through scale. The main focus, however, will continue to be on cash conservation and cost cutting.

For most, deals—particularly large corporate deals—are not even on the agenda. Where they are, the push to access niche resource plays has diminished, and there is a need to be more selective. Asset deals (potentially involving innovative deal structures and joint ventures) and small-cap acquisitions are much more likely. A focus on value plays in fiscally benign regions makes strategic sense as well. Cash-flow accretion and quick returns are a prerequisite for many companies. To date, only BG Group has been bold enough to move, but with several of the peer group facing near-term production declines, pressure to reenter the M&A market will grow.

The expansionist NOCs are in a different position compared with their IOC rivals. The Chinese NOCs—CNPC and Sinopec in particular—have, over the past 12 months, adopted an increasingly aggressive M&A strategy. This is a marked departure from their historically conservative approach. With international capital markets stalled, the Chinese government’s access to huge financial resources affords these companies a strong competitive advantage.

Other NOCs—most notably Ecopetrol, KNOC and ONGC—have also become increasingly bold in their drive to internationalize through M&A over the past year. However, a bullish approach is, in itself, no guarantee of success.

Many NOCs prefer corporate deals (they are looking for people/expertise, as well as assets/resources), but opportunities are limited. Like the IOCs, the NOCs face an M&A market with relatively few attractive opportunities and even fewer willing sellers. Political barriers to large corporate deals represent as big an obstacle as ever for these companies. Thus, we expect to see a continued focus on deals that are small to medium in size, in areas that avoid direct competition with the international oils (such as the recent Addax deal), and an emphasis on relationship building.

Luke Parker is product manager for Wood Mackenzie’s M&A Service, featuring a proprietary global upstream M&A database and related analysis, launched recently. Visit woodmac.com/maservice.