Jamie Avey; Deloitte LLP
The dramatic volatility in WTI crude oil price, breaking five-year lows while tumbling over 50 per cent between June 2014 and January 2015, has stunned the oil & gas sector and is driving a ripple effect across the global economy. The crash was driven by excess supply from the North American shale revolution and weakening demand in Asia and Europe, and it was accelerated by OPEC nations that held firm on production in a battle for market share with higher-cost US producers.
Oil prices are, of course, cyclical, and we’ve been here before (2008, 2001, 1997, etc.) with recent cycles mostly due to slumping demand. This cycle, however, is more supply-driven, with echoes of the 1986 collapse, spurred by a glut of crude as OPEC nations flooded the market. Faced with low prices, two of the largest oilfield-services companies, Baker International and Hughes Tool, merged in 1986.
Fast-forward to November 2014, and the announcement of Halliburton’s US$34.6-billion acquisition of Baker Hughes in a similar price environment, illustrating how M&A can be a vital tool for managing volatile times by providing cost savings, generating revenue synergies across service offerings, eliminating key competitors and improving negotiating power.
With an uncertain price outlook for crude and challenging capital markets, it will be critical for energy companies to maintain liquidity through cost reductions, operational efficiencies or M&A. Although break-even prices vary greatly, upstream companies are managing cash flow by cutting discretionary capital spending, reducing dividends and layoffs. Net new projects will be deferred, but maintaining production levels will be prioritized where possible. Significant maintenance, repair and operational (MRO) spending for major oil sands projects will also continue for regulatory and safety reasons.
The role of M&A in managing uncertainty will ultimately depend on where oil prices go — whether we are looking at (a) a “V-shaped” price recovery, where the price returns swiftly after the fall; or (b) a “U-shaped” environment, with protracted low prices and a gradual recovery; or even (c) a “reverse hockey stick” with a long period of stagnant depressed prices.
> V-shaped Recovery
Oil & gas company valuations have been pummeled, with the broader energy sector moving in close correlation to oil prices. However, not all companies are impacted to the same extent. In December 2014, Repsol announced the US$13-billion acquisition of cash-strapped Talisman, which appears timely if prices are expected to rebound and attractive compared to deals completed at the high end of the cycle only a few months earlier. Although oil & gas M&A was exceptionally strong in early 2014, the rapid shift in prices has created huge gaps in value expectations between buyers and sellers. Until prices stabilize, many M&A processes may be stalled.
> U-shaped Environment
If we are entering a prolonged period of weak prices, smaller oil & gas companies with highly levered balance sheets and cash flow constraints will be at risk, triggering a wave of corporate M&A transactions as those with strong balance sheets acquire distressed companies. Private equity will also take a counter-cyclical view and seek opportunities in a dislocated market.
Oilfield service companies focused on exploration and drilling will be hardest hit from the pullback in upstream activity, coupled with increasing margin pressure from their customers, and may consider M&A to diversify services or merge with competitors to remain viable. Companies most sheltered from lower prices will provide recurring services (e.g., oil sands MRO), offer capital efficient solutions to boost production (e.g., recompletion) or have contracted volumes (e.g., midstream).
> The New Normal?
The abundance of shale gas unlocked from horizontal and fracturing technologies drove a collapse in North American gas prices in 2008, which remain low. The same change in tight oil supply may also signal a structural shift for crude. Gas producers had the opportunity to reallocate capital to more economical liquids-rich plays — this time, options are much more limited. Only best-in-class companies will survive in this environment and will use M&A to further solidify their position.
There are positives from a Canadian perspective. Canadian producers are used to operating with low prices from wide differentials and are partially buffered by the depreciating Canadian dollar relative to the US dollar. The price decrease also provides motivation to reset cost structures and drive further efficiencies.
Markets will eventually rebalance. In the interim, volatility provides considerable M&A opportunities for companies with the ability and willingness to assume greater risk, while those tackling liquidity challenges still have a chance to chart their own course before these options disappear.
Jamie Avey is a partner in Deloitte’s financial advisory practice. He can be reached at [email protected].