A&D This Time

By Conway MacKenzie Capital Advisors August 26, 2015 News

    Conway Mackenzie Capital A&D This Time

    As the oil market turned down in fourth-quarter 2014, operators were chastened but optimistic. Even into the first quarter of this year, there was a general feeling that $47 was the nadir of oil pricing—that the recovery was to be V-shaped and impending.

    As of this writing, oil has settled in below $50 yet again, and the recovery hasn’t been V-shaped at all. Rig and frack-fleet utilization rates that had seen their first upticks in two quarters now seem ill-timed. If anything, we stand on the precipice of another prolonged decline in oil pricing.

    Operators who in the fourth quarter swore this market was a six- or eight-month hiccup? They weren’t selling assets then, and the bid-ask spreads for upstream saleable acreage, working interests, debt, equity and royalties reflected that perception. Potential sellers didn’t want to give away their interests to predatory pricing, and hedging protection was in the money, so they weren’t compelled to sell.

    Today, industry sentiment has dimmed. But that doesn’t mean sellers are prey to buyers looking to pick over assets like so much carrion. Players will have ample opportunity to participate in distressed acquisitions. To extract the highest potential return, however, they must recognize the unique complexion of this market.

    Not just like 1986

    If you were to run down a checklist comparing the oil price crash of 1986 to the current downturn, you’d find plenty of similarities. In 1986, in the midst of a sluggish global economy, OPEC couldn’t coordinate its constituent output with looming North Sea production. Saudi Arabia announced that it had no interest in maintaining the role of swing producer and acted accordingly. The resulting aggregate production injection flooded the market and oil prices went into free fall.

    The differences in this downturn are salient to understanding how to navigate it. First and foremost, the U.S. economy is healthy—so much so that the Federal Reserve is discussing raising interest rates. A healthy domestic economy, coupled with the ability to frack wells, portends a much faster resurgence of the sector once the price of oil rebounds.

    The availability of capital and, frankly, better capital, is another significant difference. The largest sources of financial sponsorship to smaller operators in 1986 came in the form of drilling funds—retail vehicles with burdensome fees for investors and sometimes suspect methods—and reserve-based lending. While a few artifacts of the retail drilling vehicle persist, in the interim, financial sponsors have grown much larger, more sophisticated and more reputable. Private equity, hedge funds, endowments and other large institutional investment managers are devoting resources to energy investing. Financial sponsors typically raise a total of more than $30 billion annually solely for energy investing, and this year is no different. Through May, more than $11 billion in energy-centric funding had closed.

    The last significant difference in the two downturns is the current proliferation of hedge protection. Companies that have hedged to satisfy lending covenants have had the consolation of an in-the-money revenue stream to alleviate the pain of the current market. While hedging is not an infinite resource, it provides breathing room to make strategically crucial decisions.

    The surge of institutional capital into energy, the availability of hedge protection and the ability to ramp up production are signals to buyers. There are inefficiencies in the market, and knowledgeable acquirers can find strategically beneficial targets.

    The all-stock deal

    One strategy to negotiate the downcycle is exemplified by Noble Energy’s $2.1 billion acquisition of Rosetta Resources, which closed in late July. It may be too rich for other operators to replicate with respect to scale, but the structure is sound. Noble effected an all-stock deal and, rather than dickering with asset valuations, saw the merits of acquiring the whole company (and even its associated debt) at a reduced valuation. Noble saw the upside potential and didn’t balk.

    All-stock transactions allow acquirers to purchase production and future production at a discount, making it cheaper than the current cost of developing production internally. More important, equity transactions leave acquirers with dry powder to mitigate risk in the downturn.

    This strategy isn’t limited to E&P companies. MPLX LP’s $15.8 billion acquisition of MarkWest Energy Partners in July shows how the strategy can be applied in the midstream. While there was a cash component to this merger, the bulk of the consideration was in the form of MPLX equity. While public transactions are referred to here, nonpublic equity conveyances are equally applicable, provided synergies can be found in the assets of the combined entity.

    While institutional investors can play in many areas, buying discounted companies outright is not a core competency. Buyers seeking complementary acquisitions where competition is limited can extract the most value.

    Distressed assets

    The start of the downturn has seen some lowballing of acquisition targets, especially those that are appropriately hedged. But this is not a sustainable or successful strategy. Aside from the fact that those presumed sellers are not under sufficient duress, there’s a psychological component to accepting such a deal: It takes a lot of time, effort, and capital to build a drilling program, and it is not easy to part with it.

    Institutional investors have entered the fray, either through the use of portfolio companies or by pursuing debt. Asset acquisitions will see a great deal of competition through year-end and, presumably, through 2016. As such, the most successful bids may not be the ones wedded to an outright purchase. Minority working interests, with upside sweeteners like a net profits interest (NPI) or equity waterfall, are more appealing if they allow a seller to continue to participate in (and potentially operate) a program.

    Downside risk can be managed by setting financial and operations covenants that assign remaining working interests if breached. This isn’t a “JIB [joint interest billing] to own” strategy, either. Knowledge transfer, establishment of a working relationship in a new play or area, and the potential to jointly secure future assets are all desirable outcomes from such a strategy.

    Competition will be fierce to acquire production and proven acreage. But only the most beleaguered companies will be forced to sell. Stepping into partnerships with operators that are not yet in dire straits can be mutually beneficial and helps the buyer sidestep other bidders.

    OFS caveats

    Hydraulic fracturing and drilling companies have been hardest hit in the downturn. At $100 oil, oilfield service (OFS) companies enjoyed nearly 35% margins, but the current price climate has eroded their pricing power. Doing a job at cost or a modest premium enables a frack company to keep its equipment utilized, its people employed and creditors at bay.

    Now the assets of OFS companies, many purchased on credit, are hitting the market. Unlike other segments of the industry, where distressed companies can expect a protracted process to untangle vendor claims, the process of freeing up OFS equipment moves quickly. Why? In the case of frack and rig equipment, lenders fear their landlords will lock out tenants and sequester the associated iron. Thus, equipment is repossessed or slated for sale much more quickly than an operator’s assets would be (outside of bankruptcy). Combine inventory entering the market with frack spreads being shed as part of the Halliburton–Baker Hughes merger, and auction houses now stand to move a glut of inventory at steep discounts.

    OFS historically has been the gateway for financial sponsors’ entry into energy investing. Institutional investors new to the industry have been quick to crow about their commitment to the space, but diving and helicopter companies in a portfolio that services offshore rigs do not an energy investor make. Financial sponsors quick to take advantage of opportunities presented by the downturn may see OFS inventory as a valid investment thesis. But there are reasons why that view may be flawed.

    First, financial sponsors’ rate of return is based on the time required to exit an investment and realize that return. The longer the downturn persists, the more the rate of return associated with holding equipment falls. Worse, there is little to no revenue to be garnered by a financial buyer holding inventory, and maintenance costs must be borne during that holding period.

    Second, inventory is a seemingly easy target for financial buyers in this market. As such, it is attracting interest that is artificially inflating sale prices at auction. A flood of new inventory, like equipment cast off by the Halliburton-Baker Hughes merger, or equipment injected into the market by a prolonged downturn, may moderate sale prices further. On the other hand, it may not—and that’s the crucial piece of the puzzle in determining whether to enter the OFS equipment fray. Rig and frack companies are extremely specialized and operate in nuanced fields with precious few analogs. Generalists beware. But, for those with a demonstrated competence in the space, there may be assets worth picking up after a little more pain is felt.

    Conclusion

    An oversupplied global market and an OPEC committed to maximum production bear many similarities to the crash of 1986, but there are crucial differences with regard to the resilience and responsiveness of U.S. operators this time around. Today, in combination with a healthy U.S. economy, the space is awash with funding capacity from institutional investors.

    The temptation in characterizing these financial sponsors is to compare them to drunken sailors whose ship has entered port and liberty has been sounded. That’s simply not the case. Financial buyers are smart, committed and will take considered shots at deploying capital. As such, they will focus on areas where they are experienced or can point to clear analogs.

    In contrast, other players in energy should concentrate on adding complements to their businesses. Focusing on corporate acquisitions where the cost is cheaper than generating production internally, establishing nonop working interests where knowledge transfer and relationships are beneficial, and acquiring OFS equipment where the risks can be sufficiently mitigated will yield the best outcomes for buyers in the downturn.

    Scott Cockerham is a managing director of Conway MacKenzie Capital Advisors, an energy investment bank in Houston and an affiliate of Conway Mackenzie Inc.