Josh Sherman and Sean Clements Respond to the Issue of Capital Availability for E&Ps
YOU DON'T WANT TO hear it again, I know, but let me frame my column with what we already know: A three-year period during which crude oil prices hovered near US$100 has morphed into the gut-check that is the current state of the industry. Also transpiring during that time: Unprecedented production growth from the US, continued production growth from OPEC, and lower than expected demand came together to create an oversupplied market. Lifting of Iranian sanctions is expected to add to supply concerns.
The irritating-on-many-levels phrase "lower for longer" has stuck as forecasts continue to roll in. Moody's Investors Service added its thoughts in December when it "sharply reduced" its oil and natural gas price assumptions "in light of continuing oversupply in both the global oil markets and the United States natural gas market."
Acknowledging widespread capital spending cuts and a decline in the US rig count by more than half, Moody's pointed out that it was only recently that US production began its decent. Outside the US, both Saudi Arabia and Russia have increased production to levels not seen since the early 90s. "We do not think global production will fall before the second half of 2016 at the earliest, when the effects of this year's investment cuts lead to less new production to offset existing declines," Moody's declared, warning that the increase in world oil supply continues to outpace demand.
So what happens when you add another variable-that of increased M&A activity-to the mix? Companies continuing to struggle with low prices are apt to sell assets in 2016 to patch gaps in cash flow. While some companies may encounter difficulty accessing capital, money is available, and there will be no shortage of potential buyers for key assets. Companies can smell a deal, right?
Oil price volatility challenged the M&A space in 2015, but deal activity is expected to pick up in 2016. Almost 90% of oil and gas executives surveyed the October 2015 release of EY's Capital Confidence Barometer said they expect the oil and gas deal market to improve over the next 12 months. More than two-thirds of the oil and gas executives surveyed said they expect to pursue an acquisition during that same time. According to the survey, "companies plan to use the downturn to make opportune acquisitions, with 26% of capital allocated toward acquisitions, alliances and JVs."
Will those assets be tucked away until prices rebound, or will better-capitalized companies make quick plans for development? Does that add to the threat of prolonged oversupply and continued pressure on prices?
Looking back to mid-2015 and a June 2015 OGFJ article on capital availability for E&Ps, Josh Sherman and Sean Clements, partners with Opportune LLP, pondered one potential impact of increased M&A in the current climate. "A concern is that a feeding frenzy among the better-capitalized owners able to drill and develop assets could further stress the market by refueling oversupply and reinvigorating the downward pressure on commodity prices."
I took this concern back to Sherman and Clements for their thoughts as we enter the New Year. "Given that oil and gas reserves are depleting assets, E&P companies must feed the beast, either through acquisition or capital deployment to maintain both their balance sheets and cash flow. Capital deployment through the drill bit is currently difficult to justify, so it is not surprising that the majority of oil and gas executives forecast that they will be acquisitive in 2016 (probably looking for either cash flow based acquisitions or upside assets that do not require much current capital to be preserved). The challenge for buyers will be finding assets of distressed companies, or those that are trying to reposition their portfolio, that work in this market considering the current cost of capital," they offered.
"Seasoned energy investors and private equity firms have likely learned their lessons from the last A&D cycle; the more likely risk is that an unprecedented amount of inexperienced (with respect to E&P) domestic and foreign capital will bid-up acquisition pricing in attempt to aggressively "buy low" based on historical crude pricing. The more new entrants pay for reserves/acreage, the faster they will have to drill to achieve their goal IRRs, which will prolong depressed commodity pricing absent significant changes in global demand, OPEC production and/or the strength of the US Dollar," they continued.
I posed the same question to Andy Brogan, EY's Global Oil & Gas Transactions Leader, upon receipt of the aforementioned EY survey. His thoughts? "A&D may lead to the emergence of some larger better capitalized companies. Whilst these would have more financial capacity to drill than their predecessors, they will also have a larger and more varied portfolio which will enable them to concentrate spending in the more cost effective plays. Therefore, A&D should accelerate the targeting of capital on the most productive opportunities rather than encourage more indiscriminate development."
The deal market may indeed heat up this year, but variables remain. As mentioned by Moody's in its forecast, many CAPEX budgets are on ice. A December update by Wunderlich Securities on a survey of 71 independent E&Ps and 10 large integrateds showed CAPEX estimates down $17.1 billion from the previous check-in in September. Given that some companies hadn't yet reported, the door was left open for even greater reductions, thus lower production. Additionally, some growth will be offset by declining fields, the analysts said, "but that will take time." In the near-term, the significant spending reduction "could lead to a shift from an oversupply to an under-supply of oil as fields decline and new investment wanes."
The stage is set for a reshuffling of the industry in 2016. The fate of production as assets change hands will be something to watch.