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Energy M&A: Business uncertainty discourages deals

RFP
Activity has been surprisingly slow. Will it pick up soon? The 70% drop in oil prices since 2014 has pushed many energy companies to the brink. Meanwhile, private equity (PE) sits with $100 billion or more in dry powder ready for energy investments. Taken together, conditions seem ripe for consolidation in the oil and gas (O&G) industry.

That hasn’t happened, at least not yet: 2015 was one of the slowest years for M&A in recent memory. Asked in the 2015 Grant Thornton LLP survey of U.S. O&G companies about their biggest M&A challenge, respondents overwhelmingly said it was the difference in buyer and seller pricing expectations. That’s true; but it’s more a symptom than an explanation of the lackluster M&A environment, which has resulted from a confluence of the following factors.

Domestic oil production is declining only moderately
U.S. oil production was about 9.1 million barrels per day in January. That’s down somewhat from a peak of 9.6 million in April 2015 but still well above the 8.7 million average for 2014 — and millions of barrels more than output just a few years ago.

Kyle Reid, managing director in Grant Thornton’s Transaction Advisory Services practice, explains the continued high production. “Here’s the situation the producers are in: You have an oil well, and I have an oil well. You can win only if I turn mine off; I can win only if you turn yours off. So producers are not turning their oil wells off, and supply doesn’t go down — at least not enough to make a real difference in the global price. And it’s price that drives all valuations and what people are willing to pay for properties.”

Despite the pressure to curtail production, U.S. oil producers have maintained output by:
  • Improving production processes and becoming more efficient.
  • Negotiating lower rates from oilfield service companies.
  • Receiving credit relief from banks that prefer a struggling customer to a bankrupt one.
  • Realizing higher returns through hedges. As prices decline, they’ve become less useful, but they continue to help some companies.

The energy industry faces extraordinary uncertainty
The energy sector’s greatest difficulty may be its lack of predictability. “Over the past 18 months, you may as well have used a dart board to forecast the price of oil,” says Ryan Maupin, director of Corporate Advisory & Restructuring Services at Grant Thornton. “The predictions of the experts on industry conditions haven’t been right … not even close,” adds Reid.

The uncertainty about what the oil business will be like even a few months hence has clouded transaction negotiations. In the exploration and production (E&P) sector, buyers and sellers can’t agree on a value for the company’s O&G reserves — the crucial component in assessing a producer’s worth — because of the use of differing price curves and valuation techniques.

In the midstream and service sectors, “Buyer and seller may agree on historical EBITDA [earnings before interest, taxes, depreciation and amortization],” says Reid. “But going forward, they don’t necessarily agree on customer turnover and sustainability. Even if companies have been able to sign on new customers, are those customers going to be around six months from now? And what will the margins be like? So the PE funds are holding off.”

Maupin adds, “A lot of people are still waiting on the sidelines, trying to figure out where the low point is for oil.”

Difficult industry conditions constrain both financial and strategic buyers
As operating companies, potential strategic buyers have many of the same problems as potential targets. The drop in oil prices has diminished cash flow; acquiring funds, despite some recent infusions from the capital markets, remains difficult; and business prospects are cloudy. Even large and stable strategic buyers wonder if they can handle an acquisition, especially one that’s sizable.

In oilfield services, which have been as hard hit as the producers, if not more so, there are some well-managed companies that do see the opportunity to make acquisitions. But some potential sellers still hope they can cut back their operations and survive.

Somewhat different constraints discourage financial buyers — PE, hedge funds and so forth. These acquirers have a specific investment thesis with specific metrics, which most distressed companies can’t meet.

Many small E&P producers in trouble are mostly an irrelevancy; for them, there’s no M&A option — only an auction process. As for the larger, more suitable targets, they have a tough time meeting investor requirements. Maupin comments: “Many financial buyers say they are targeting distressed businesses. But when presented with an actual distressed business, their reaction is often, ‘well, not that distressed.’ Financial buyers want to know: What’s the turnaround story? Unfortunately, the answer right now for many companies is that there is none.”

The O&G industry may be on the cusp of an M&A revival
As the collapse in oil prices approaches two years, however, there are signs that the industry may finally be at the point where consolidation is inevitable. At some point, the banks that have been working with companies and not forcing them to sell their business may decide they’ve seen enough. So there could be a lot more consolidation in 2016.

Reid believes that restructuring the O&G business will require financial creativity — and lots of it. “The question for CFOs is: ‘How do I get smarter than my competitors in the new world we’re in?’ What you should see going forward is unique financing structures as parties try to buy out the existing debt and equity holders. You could see multiple layers of equity as buyers try to provide incentives to all parties, including the current owners who currently have little incentive to sell. You’ll see more creative deals that close the valuation gap between buyers and sellers through terms that reward parties for a rebound in oil prices.”

Succeeding in the current M&A environment
Given the vastly changed industry conditions, have the ingredients for M&A success changed as well?

“For the acquirer, you approach M&A pretty much as you always have,” says Reid. “You need to understand the cost structure of the target. You need to determine whether the seller’s business is sustainable, or whether they just made temporary improvements to get through this period of low prices. You approach due diligence as you have before, but with even more care because of the uncertainty. The one area that now requires special focus is tax because the rules for debt forgiveness, which will be important to many deals, can get complicated.”

As for the distressed companies that are potential acquirees, Maupin sees obtaining the right advisers as essential. “Getting the right professionals on board to advise the prospective buyer in a bankruptcy sale scenario is crucial. If there’s going to be a sale, there are a variety of advisers who specialize in bankruptcies that can guide the way. Among the alternatives they may look at is a Section 363 sale under the bankruptcy code.”

Maupin also emphasizes the importance of data to prospective buyers. “Whether the buyer is financial or strategic, they’re going to want to see clean, reliable data so they can make an intelligent decision. Most of the larger companies have the systems in place to do that, but many smaller ones do not. Thorough sell-side preparation is crucial if sellers want to have a successful transaction.”