FW: Reflecting on the last 12 months or so, what are some of the major trends you have witnessed in oil and gas M&A?
Hansen: Within the past 12 months, the energy sector has gone through yet another dramatic transformation that began in 2019. The impact of both the coronavirus (COVID-19) and the Saudi Arabia-Russia oil-price war has caused companies to focus internally and externally on the key value driver in this environment: cost-cutting. Whereas in the past, synergies through cost-cutting measures were the third or fourth reason for going ahead with a merger behind increased growth, diversity of asset base, and so forth, it is now the primary reason.
This feeds the free cash flow (FCF) metric, which has quickly become the critical driver for generating shareholder returns or debt reduction and is central to the new investor sector paradigm. At the same time, companies are assessing the impact of $40 a barrel of oil on oilfield economics. Estimates run as high as 50-75 percent of exploration and production (E&P) assets being inferior. This makes it challenging for acquirers to find willing targets with superior assets to accept all-stock offers at low premiums.
FW: How would you describe the current appetite for M&A? What factors are driving deals in today’s market?
Hansen: In terms of M&A appetite, it is estimated that around 25 percent of E&P companies have the ability to reduce costs and debt, attract investors and remain independent. Another 25 percent are estimated to need to merge and create scale to meaningfully reduce costs – and they will become acquirers or targets. The final 50 percent are believed to have inferior assets at today’s commodity prices and will have limited options going forward. M&A options, opportunities, and challenges will be frequently discussed by management and boards going forward.
The most important factor driving deals is to create an “investable” model incorporating lower corporate and field costs, low leverage, and FCF to distribute cash to shareholders. It seems this has been embraced by industry and equity research analysts who are quickly adopting this paradigm in price targets for public companies. Private companies, formerly able to sell for cash to public buyers to achieve growth, will find it very difficult to exit through a cash sale.
“The most important factor driving deals is to create an ‘investable’ model incorporating lower corporate and field costs, low leverage, and FCF to distribute cash to shareholders.”
Some private equity firms have elected to exchange private company stock for stock in public companies, allaying concerns over increased leverage. While the industry is rapidly embracing the paradigm, time will tell as to whether a wary investor base will be satisfied that, while changes are positive, it fulfills the “investable” definition long term.
FW: Are you seeing different M&A strategies adopted since the coronavirus (COVID-19) crisis started to take effect?
Hansen: Successful M&A has always been an extremely difficult and time-consuming process. Starting with management approval and progressing through the board and shareholder approval can often take months. Historically, personnel decisions such as the chief financial officer, chief executive, and board members are generally highly contested and negotiated face-to-face. COVID-19 has hampered this interaction. However, most chief executives are highly tech-savvy and are at large corporations. They are familiar with conducting remote meetings on important subjects.
Further, while highly competitive, the industry is also cordial where executives often interact on a professional and personal basis. Therefore, while face-to-face time may be limited by COVID-19, executives are generally already familiar with both the professional track record of potential merger partners and also the personal connections that have already been made.
FW: In what ways are deal dynamics likely to evolve as the economic downturn continues? What impact do you expect this to have on buyer and seller valuations?
Hansen: Industry supply and demand conditions are being adjusted almost every day. Only recently, the Organization of the Petroleum Exporting Countries (OPEC) announced the possibility of deferring an additional 2 million barrels of oil supply anticipated in January due to COVID-19 concerns. While the economic downturn continues and hope for a recovery has lifted oil futures in the second half of 2021, excess capacity remains an overhang.
Saudi and Russian excess capacity is estimated at 8 million barrels-per-day, and it is clear that the production increase in April 2020 was meant to severely handicap U.S. production growth. Thus, expect low oil prices to keep valuations in check.
FW: What general advice would you give to parties on negotiating, structuring, financing, and closing oil and gas deals in today’s market? What key areas need to be considered?
Hansen: On M&A deals, it has become clear that recent successful deals are all stock-for-stock deals at low premiums with substantial cost savings and low post-deal leverage. It appears that one of the key selling points to a target is that a ‘go-it-alone’ strategy today is not going to attract investors unless the target can accomplish cost cuts and leverage targets independently. Acquirers should focus their pitch to targets on the difficulty in surviving in a no-growth, capital-constrained, environmental, social, and governance (ESG)-focused environment, with renewables looming in the distance. Without scale, facing these challenges will be daunting.
“Acquirers should focus their pitch to targets on the difficulty in surviving in a no-growth, capital-constrained, environmental, social, and governance (ESG)-focused environment, with renewables looming in the distance.”
On the acquisitions and divestitures (A&D) front, it seems buyers will have to reduce return hurdle rates to close more deals. Sellers have been buffeted by the loss of proved undeveloped reserves (PUD), drilled but uncompleted wells (DUCs), and acreage value. Making matters worse, they are not able to receive value at minimum levels such as proved developed producing (PDP) PV10. Buyers are demanding higher discounts, but many sellers have decided not to sell, potentially waiting for higher prices.
FW: Could you highlight some of the risk-related issues that need to be addressed when undertaking an M&A transaction in the oil and gas sector? How can acquirers manage those risks to enhance future value?
Hansen: The biggest risk in an M&A transaction is post-deal execution. Expectations on any number of improvements will exist. Primary among them will be cost-cutting synergies at the corporate and field level and realization of production and FCF estimates. An experienced M&A team will conduct deep due diligence and have a high degree of confidence in appropriate post-deal staffing.
For shale players, the proper spacing of parent and child wells has become increasingly important in production projections. A highly seasoned competent management team is necessary to evaluate drilling options. Negative variance to estimates will have long-term consequences for the new company.
FW: In what ways has the disruption and uncertainty surrounding COVID-19 impacted the distressed M&A landscape for oil & gas deals? In what ways are cash-rich buyers leveraging their position to obtain more favorable transaction terms?
Hansen: On a granular level, the biggest impact on M&A deals surrounding COVID-19 is the disruption to the due diligence process. Physical inspection of properties, for example, has been challenged, leading to longer lead time in deal closings, as well as to changes in representations and warranties. From a larger perspective, the uncertainty regarding a return in pre-pandemic oil demand levels continues to be a major overhang to the A&D market.
While traditional wisdom dictates that the asset sale market slows during periods of rapidly escalating or declining commodity prices, the A&D market remains frozen even with relative price stabilization. The distribution of effective vaccines to the population appears to be just around the corner, but with rising cases, forecasted oil prices seem range-bound within a $40 to $50 a barrel level for the near term. Sellers wishing for higher prices may have to wait until well into 2022.
FW: Looking ahead, how do you expect oil and gas M&A activity to unfold over the coming months? What major trends do you predict will dominate the industry?
Hansen: While many suggest consolidation will continue over the coming months, resulting in as few as 10 very large E&P companies, others are suggesting that the prime companies in key basins have been picked off. Certainly, being a low-cost producer in a sector with excess capacity will keep the focus on combinations reducing costs, and improving supply chain efficiencies. Other factors that will become more critical as management and boards weigh their options include the move to mature assets with slow decline curves.
Additionally, research analysts are now including metrics detailing compensation, diversity of boards, and a whole set of ESG measures. These will now enter into consideration as merger candidates are chosen, in addition to an emphasis on the new company generating improved FCF.
The following Q&A article was originally published in the January 2021 issue of Financier Worldwide Magazine (FW). Republished with permission.