The Permian Basin is at the center of a strange conundrum. The region has been an impressive success story with advancements in hydraulic fracturing technology and horizontal drilling leading to unprecedented levels of oil production. Yet, investors backing oilfield services (OFS) companies are now balking as global oil prices linger in the mid $50/bbl range, and financial returns remain underwhelming for both OFS players and many of their exploration and production customers.
The period between 2012 and 2018 saw sizeable investments in equipment and technology by OFS players in the Permian Basin. Capital – raised largely through debt but also equity – was not a constraint. These investments significantly improved the efficiency of drilling and production (figures 1 and 2).
However, global oil production also increased simultaneously, which, in tandem with geopolitical and logistical issues, has kept oil prices from returning to the $100/bbl levels seen prior to 2014. With commodity prices tightening, the industry that had been relying on capital markets to fund investment through debt is struggling to generate sufficient cash flow to cover even its interest expenses. This dynamic, in turn, has severely limited investments in new technologies and resulted in downsizing and cutbacks by OFS players. Ironically, the current challenges are in many ways rooted in the incredible technical and productivity improvements made by the sector over the past 10 years, which has resulted in excess capacity and prices below reinvestment economics.
While mergers and acquisitions (M&A) activity offers one potential solution to improve profitability and cashflow, OFS companies must remain cautious about this approach and look closely at what factors within a prospective deal are likely to drive this incremental cashflow.
IN THIS MARKET, INCREMENTAL VALUE VIA M&A MAY MATERIALIZE IF:
- The combination is positioned to accrue market power,
- The deal brings new capabilities together that deliver a set of services at a lower effective cost, or
- Enough excess capacity is retired from current active duty to potentially change the supply and demand dynamic.
In the lower 48, with the current capacity and oil price outlook, situations that may result in the incremental value outlined above appear to be very limited.
AlixPartners conducted an analysis that compared the benefits of capturing operating as well as selling, general and administrative expense synergies from a hypothetical consolidation of seven pureplay companies in the hydraulic fracturing sector to the benefits of each company improving its own performance to that of best-in-class player levels (figure 3; see summary on page 5 for additional details). It is worth noting that the seven companies analyzed together have more than $1.2 billion in long-term debt maturing between 2021 and 2023, which puts them at risk given current cash flows from operations.
The results were surprising as the analysis pointed to a higher benefit from individual companies improving their own performance than the likely benefits derived from M&A synergies alone. In general, the collective benefits of each individual company improving to best-in-class level in the sector generated close to $0.75 billion in incremental cash flow. However, applying prevailing demonstrated synergies in typical M&A transactions to the sector generated only around $0.3 billion in incremental cash flow. The difference was significant – around $0.5 billion in cash flow or approximately $2.5 billion in enterprise value, using prevailing multiples from companies improving their own performance rather than through capturing M&A synergies.
While the study did not go into how each company may improve its efficiencies, the magnitude of the chasm between top and bottom performers was indicative of the opportunities available within many of the companies to make meaningful cashflow improvements. Levers range from pricing optimization, market participation decisions, material cost improvements, labor cost reductions, and back-office cost efficiencies. Although OFS companies have tried to focus on leaner operations, our analysis indicated that more can be done to broadly improve the cost structure and profitability at many OFS companies, including addressing the age-old operating models that may not suit the new reality of sub-$100 oil and razor-thin operating margins.
With the current oil price outlook, constraints on cash, and higher investor expectations, OFS companies should take a hard look at every available lever to improve their internal efficiencies – especially companies whose performance lags the top competitors in their respective sectors. While M&A executed well can create benefits and bottom-line improvements in a fragmented market, looking inwardly and improving performance may be a more prudent approach in light of challenging market conditions and to better prepare for the next boom – whatever form that may take.
Investors – strategic or in private equity – should take a deep and hard look at any M&A opportunities that are available. Would they truly add value? Even in cases where M&A could be the right solution, investors should also focus on operational improvements for additional value creation.
The mega merger scenario assumed:
- No topline synergies (i.e. no incremental revenue from added scope or pricing improvements).
- Industry average targets (based on published synergy targets by recent OFS mergers) for labor, materials, services, and overlapping selling, general and administrative expenses (SG&A) (i.e. no synergies assumed for SG&A in non- overlapping basins/regions).
Efficiency improvement in individual companies assumed:
- No topline changes - assumed that each company can keep its revenue share.
- 80th best percentile performance of key metrics (such as labor, materials, services, SG&A as a percent of revenues) and the resulting proforma profit and loss.
- Essentially a top quartile performerÂ in the industry.
- No assumed changes to capital 4 expenditure or debt obligations (i.e. no added interest expense, etc.).