U.S. OIL DEBT - 2
Plunging oil prices look set to trigger another wave of industry consolidation after a decade when mega-deals were scarce, but investors want to see mergers that can squeeze out cost savings and only after a lavish dividend is paid.
Over the last 18 months Big Oil has faced shareholder pressure to prioritize value over volume – to improve their return on capital rather than focus on production growth targets. As a result, oil majors have been in disposal mode.
But with oil 40 percent cheaper since June, companies are likely to change tack and consolidate, with everything from mega-mergers to opportunistic buys of distressed shale oil producers on the cards.
"Anyone who doesn't think consolidation is going to happen must be mad," said Charles Whall, a manager of the Investec Global Energy Fund. "The exploration performance of these companies has been woeful. They have to replace reserves, and they're not doing that organically so they need to do it inorganically. But all we have seen are disposals."
There are signs that the industry mood music has changed in recent weeks, with a proposed $35 billion tie-up between oil services companies Halliburton and Baker Hughes.
"There is some talk you could see that take place within the oil majors community, and a return to mega-mergers as we saw in previous downcycles like 1997/98, 2002/3," said Will Riley, a manager of the $314 million Guinness Energy Fund.
He believes a merger of majors could make more financial sense than an acquisition because both parties would benefit from synergies and cost savings without having to stretch and stress their balance sheets.
"A number of the European and U.S. super-majors could fit together because they're all international producers with diversified portfolios that could work together," he said.
Exxon's 1998 merger with Mobil is widely held to be one of the most successful tie-ups in any industry. Within five years, it had the same number of employees as before the deal, but the business was 50-60 percent larger.
Some investors believe Spain's Repsol, which is showing renewed interest in Talisman Energy, has the balance sheet to make a similar game-changing deal, with Barclays analysts tipping it as a key investment for 2015.
However, Christopher Wheaton, manager of the Allianz Energy fund, said mergers couldn't just be about cost-cutting, there had to be a strategic rationale too: "It's about enabling a project to happen – bringing net asset value forwards. M&A has to be built on value creation."
But he believes transformational M&A would be really difficult to pull off: "It's a rule of thumb that the vast majority of M&A destroys value."
Crucially, investors want to make sure oil companies don't sacrifice the dividend – one of the main reasons to hold integrated oil and gas majors in portfolios. "Dividends come first and M&A and everything else comes second," Wheaton warned.
The oil price slump is also expected to put pressure on independent producers, particularly those in the U.S. shale industry, opening the door to consolidation amongst shale players, or opportunistic bolt-ons for majors.
"The U.S. shale industry boom has been built on debt," said Wheaton. Although these producers hedge their output about 12 months forwards, they are also heavily dependent on issuing debt in the high yield bond market or raising new equity from shareholders.
But some energy-related issues are already trading in distressed territory, a sign of financial strain, and defaults are expected to rise.
"We can see companies that reasonably quickly could get into distressed positions," said Whall, speaking about independent oil producers in general. "We do see companies that will have to consider approaches and that are very vulnerable to approaches."
Wheaton pointed out that oil majors like Shell have said they would not chase these assets but if they came up in distressed sales they might be interested in looking at them.
"Shell's gearing at the end of Q3 was about 15 percent – that is a balance sheet that could withstand several years of low oil prices and do some acquisitions."
Both Riley and Wheaton expect to see consolidation within shale basins as the strong take out the weak. "Where companies have strong market share within a basin, whether it's the Permian or the Bakken, they're going to get stronger because they'll be able to consolidate competitors," Wheaton said.
Riley pointed to the recent "merger of equals" between Whiting Petroleum and Kodiak Oil & Gas, both independent producers operating in the Bakken, North Dakota. "These were two basin players consolidating their acreage, creating cost synergies by doing so," he said.
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