Global oil dynamics are signaling a demand slowdown, resulting in a downward pressure on prices. Despite recent price strengthening underpinned by Middle East supply volatility, a long-expected recession will aggravate investor disappointment in exploration and production (E&P) industry and companies’ ability to generate adequate returns on invested capital.
Harsher investor views are already hammering public E&P company share prices and restricting capital access, leading many management teams and boards to investigate mergers and acquisitions (M&A) as a value-adding and equity-preservation strategy. But should they? Our research shows that odds are significantly stacked against the merge-your-way-out approach – unless the company has or can obtain proven operating capabilities and management discipline.
A rapid decline in public E&P company valuations is the most visible investor concern indicator. Over the past 14 months, the overall market capitalization of the top 50 independent US-based E&P companies fell by 35% (Figure 1). At the same time, domestic oil and natural gas production increased by 16% and 19%, respectively, and oil and natural gas prices declined by 5% and 8%, respectively (Figure 2).
An often obscured but equally significant negative investor sentiment result is restricted capital markets access. Capital, both debt and equity, is the lifeblood for management teams accustomed to borrowing to drive reserve growth and capital appraisal and development plans. Other than for the strongest upstream players, very little new debt and equity issuance is available or occurring. Constrained capital is causing upstream leaders to fundamentally rethink operating and business strategies. Management teams must now be laser focused on businesses, basins, and assets where they operate. Critical survival questions include: what are appropriate capital productivity and balance sheet goals; which operating expenses are affordable; and should drilling and production growth be restricted to demonstrate cash flow generation.
Many boardrooms are also seriously considering M&A as they try to create value and rebuild shareholder confidence. But M&A is no panacea.
AlixPartners analyzed more than 240 asset/property and corporate transactions made by publicly traded companies between 2006 and 2018, comparing the combined total equity value for both the acquiring company and the target 90 days before an M&A deal announcement to the combined equity value one and then two years after the transaction closed (note a 2018 two year performance review implies 2016 deal close).
Over the 13-year period, there were several instances when value destruction was nearly guaranteed (Figure 3). More than 90 percent of all transactions closing in either 2013 or 2014, the period just before the oil price collapse, resulted in a lower equity value for the combination. Of course, commodity prices factor large in E&P revenue and profitability calculations, and this period may not be a balanced acquisition success indication period. However, even among transactions executed in relatively stable commodity price environments, roughly half were value accretive after year one and two of the deal closing.
While the data is not encouraging for M&A-inclined E&P management teams or their shareholders, successful M&A is not impossible. There are several factors that can push a deal into value-accretive territory:
1. Clear and proven strategic rationale that underpins the value creation proposition
Companies have used wide-ranging strategies in the past to justify pursuing M&A in the upstream sector, including diversification, vertical integration, resource play access, talent access, technology access, balance sheet leverage, and tax incentives. In the current environment, however, only a few key core strategies will resonate with shareholders:
- Localized Operating Scale: M&A that enables a company to build operating scale in a specific basin or field and thus drive down lease operating expenses and general and administrative costs and drive up capital productivity. Examples include acquiring offset operators or contiguous acreage assets so that consolidation synergies can be immediately captured and well designs, supplier leverage, and field infrastructure can be optimized.
- Advantaged Technical and Operating Capability: M&A that enables a company to extend already proven distinctive technical capabilities and expertise across a broader footprint. In effect, this strategy provides more running room for a company to apply its distinctive competencies ranging from capturing resource potential or operating efficiencies that the seller does not recognize or cannot achieve, to enhanced oil recovery, to optimizing spacing decisions in appraisal and development.
For example, when EOG Resources acquired Yates Petroleum in 2016 they gained more than 300,000 net acres in locations contiguous to existing EOG Delaware and Power River Basin assets. The transaction allowed EOG to leverage leading well designs across 1,700+ identified Yates drilling locations. The transaction was priced at levels below similar-sized peers on a net acreage basis and contributed to the 35% EOG share price appreciation in the ensuing two years. If executed correctly, such a move can result in rapid and visible accretive economic benefits that shareholders reward.
2. Financial discipline to avoid overpaying
Before finalizing a merger or acquisition, management teams must establish clearly defined free cash flow return and return on capital employed thresholds. Companies must have the analytical ability to run robust scenarios on pricing, operating, and supply cost variations to better understand underlying risk and what must be done to deliver on investor expectations. Leadership must also brutally and honestly assess relative operating capabilities – both the target and the acquirer. There must be a proven lower-cost operating model for field or back-office operations to add to the deal valuation and the acquiring company must guard against being too aggressive and optimistic on resource additions, drilling and completion productivities, cost improvements, and implementation speeds in deal value modeling.
3. Rapid and disciplined pre-acquisition synergy diligence and post-acquisition synergy capture
Analyzing historical transactions indicates that value is created or destroyed within the first year of a transaction. Management teams and boards must then conduct rigorous, private-equity level diligence and analysis and create detailed and workable plans - with expected results, timing, and responsibilities - that are clearly articulated prior to closing. There must also be a healthy post-merger program in place to ensure that productivities unfold, costs move out as planned, and resulting operating gains are achieved (Figure 4).
As disenchanted investors become more frustrated with the E&P sector leadership and investment performance, the odds and consequences for M&A mistakes are high and increasing. It is therefore imperative for upstream companies to conduct careful analysis before making an M&A decision. Ultimately, when M&A is done with the right strategy and discipline, after careful financial consideration, and through thoughtful tactical planning and flawless operating execution, they can deliver value to win investor confidence. Upstream players that master capital and operating discipline and deploy value-generating merger strategies will attract new capital and be positioned for accretive growth.