Deal And No Deal 2015: Living In A Haggler’s Paradise

Jeff Schlegel’s lament is probably familiar to many A&D professionals who have seen the gulf between buyers and sellers since January.

“There’s a lot of tire kicking, a lot of disagreement fundamentally on price,” he said.

Schlegel, co-head of global energy practice at worldwide law firm Jones Day, said he and fellow attorney Omar Samji have seen a lot of deals vaporize over the past several months.

“We’ve been involved in maybe $40 billion worth of transactions in the past several months, none of which went to a deal,” Schlegel said.

For months, the second half of 2015 has been heralded as the time when deals would pick up. E&Ps would be suffering after months of being pounded by low oil prices. Distressed sellers would emerge and the impasse between buyers and sellers resolved.

But many E&Ps are strong. They spent the early part of the year bulking up on billions in liquidity from public market equity raises and swiftly shifting to survival mode. The big selloff among E&Ps has been delayed.

But in all likelihood, distress is still stalking those companies.

Of the 87 public E&P oil and gas companies with revenues in excess of $100 million, excluding supermajors, five to 13 bankruptcies are expected between July and June 2016, said SOLIC Capital’s Kim Brady, head of the capital advisory and restructuring firm’s energy team.

Brady said oil prices, which have bounced up into the $60 range, will likely fall again as the glut in U.S. supply and elsewhere easily satisfies demand.

Still, optimism remains in one of the most upbeat of all industries.

The majority of oil and gas executives, 76%, expect to see their organizations’ headcount increase or stay the same over the next two years, according to the 2015 Energy Industry Outlook Survey conducted by the KPMG Global Energy Institute.

Of about 200 senior U.S. energy executives, 56% said they are in the process of or planning changes to their business models over the next two years in preparation to grow. And the method of growth may well by A&D.

“The recent collapse in oil prices is an issue on the mind of every energy executive,” said Regina Mayor, advisory industry leader for energy and natural resources at KPMG LLP.
Nevertheless, “we’re still seeing interest in growth in terms of assets and asset acquisitions.”

A&D observers have yet to reach consensus. The third and fourth quarters of 2015 could be better for deals. Or, perhaps just as likely, they could see more of the same.

Payment Due

If E&Ps have shown OPEC and the world anything in 2015, it’s that they their reputation as tough, hard working and kings of innovation isn’t empty words.

So far, oilfields have produced more oil even as rig counts have dropped by about 53%. Production is strong and growing.

Brady said that the U.S. Energy Information Administration predicted oil production of 9.3 million barrels per day (bbl/d) in May. As of last week, production was at 9.6 MMbbl/d, he said.

But companies may be pumping as hard as they can to service their interest payments, he said.

“Once they miss interest payments, they’re going to be in payment default and that’s going to be much too serious,” he said. “I believe there’s going to be more liquidation, chapter 11 liquidation and companies will wind down.”

Brady argues that expected debt defaults and bankruptcies have been deferred only by extra money and will hit by 2016.

Regardless of the recent climb in oil prices, basic economics.

“Traders are taking different views, but at the end of the day as a commodity has prolonged production that is higher than demand, the price will come down,” he said.

Add to that the bursting levels of inventory in storage that will play a role in keeping prices flat, Schlegel said.

Brady expects 38 E&P companies to default on debt in the next two years due to capital strain.

E&Ps are being cautious and know that capital is precious. In many cases, 2015 deals—especially the largest—haven’t been cash transactions. Many of the largest deals so far in 2015 have been stock-for-stock or unit-for-unit.

Brady said oil prices may slump back to $50 for a prolonged period, and then things will start to get ugly.

“I would suggest this is a short term rally,” he said of recent $60 WTI.

While most E&Ps have structured their bonds to being maturing in 2018 and beyond, they still have to spend capex and reckon the interest payments on their debt.

He said he expects at least twice the number of bankruptcies so far in 2015.

Schlegel agreed that some companies are operating on razor thin margins.

“There are companies that needed $90 oil in order to make money,” he said. “There probably will be a shakeout of companies that were probably in trouble when all this started and now they’re in more trouble.”

Aces And Eights

Whatever hand the oil markets deal them, executives at oil and gas companies aren’t pining for the past.

KPMG’s survey suggests that growth is on the horizon as oil and gas executives say they will allocate capital over the next two years to acquisition of a business, expanding facilities and business model transformation.

Mostly that involves efficiencies that expand beyond spud to completion times. E&Ps have been inefficient and are now revamping: managing costs through better staffing, planning and budgeting. Companies are changing service delivery models and optimizing costs related to inventory and repairs.

A surprising amount of fat is available to cut.

Mayor said she knows of one independent company conducting an exercise to take $1 billion out of operating costs.

“If you think you can take $1 billion out in operating costs, you are not very efficient,” she said. Operators are “getting lean and mean for a low crude environment.”

Service and supply providers, who were unprepared to deal with the more integrated demands of E&Ps and lower prices have not had time to adjust.

Brady said that oil service companies are being squeezed hard and for many the only assets they have to sell are equipment the market is uninterested in buying.

“I think people are going to be reluctant to buy any additional equipment. They have plenty of equipment they can’t utilize and plenty that’s being idled on the side,” Brady said. said.

But service companies have a natural place to streamline. Most are serial acquirers who haven’t fully brought new units into the fold, or even have them using the same software.

Larger companies are and will buy up smaller ones that have a strong set of technologies such as fracking, software or fluids.

“Some will survive and they’ll figure it out and others just won’t be able to make the transition,” she said.

For E&Ps, Mayor said independents are in a better position to grab acreage through bolt-ons in plays “where they’re going to choose to dominate.”

Such companies have developed the operational efficiencies to drive a price point that will be economical at prices as low as $30, Mayor said.

“They can withstand crude price risk and volatility,” she said. “We still see growth in acquisitions as strong part of what we’ll see in the next 12-24 months.”

Rock, Scissors, Liquidity

E&P deal haven’t exactly been showing healthy vital signs.

Investors and bargain hunters have been waiting on the sidelines for the big M&A boom.

Few companies have been willing to sell and the gulf between buyers and sellers remains too wide, Samji said.

“The bid-ask spread has remained pretty large and there hasn’t a catalyst for deals to get done,” he said. The availability of capital and banks willingness to work with oil and gas companies has staved off distress.

The major culprit for the dearth of deals is E&Ps that have shored up balance sheets with liquidity. E&Ps have been able to raise money, putting off distress events that would cause them to sell.

Jeffrey Robertson, Barclays analyst, said in a June 3 report that more productive wells, lower costs and strong liquidity and access to capital could continue to underpin U.S. oil and gas production in a lower commodity price environment.

Even E&P deals that get done are somewhat anticlimactic. Schlegel noted the June 1 E&P deal in which Pioneer Natural Resources Co. (PXD) sold its Eagle Ford Shale (EFS) midstream business for about $1 billion.

Moving money from one area to a more profitable area, especially in the midstream arena, is an expectation at this point, Schlegel said.

“You didn’t look at this transaction and go ‘Wow that’s fascinating,’” he said. “You kind of looked at it and go ‘yeah that makes sense.’”

But the bottom could drop, especially if oil prices sputter again.

Depending on the economics of where a company operates, even well finances companies could eventually have to sell if oil prices fall.

“We still expect to see uptick in M&A activity later this year, coming into this summer and particularly into the fall,” Schlegel said. “I think we will see more M&A, but we said the same thing in back in October of last year.”

Brady said deal activity is probably further off.

“I think people are expecting there would be more of that in the second half,” he said.

But companies wanted it both ways: higher oil prices and more distressed sales.

“I think it will happen next year. It’s getting pushed out,” he said.

Contact the author, Darren Barbee, at dbarbee@hartenergy.com.