What the Future Holds for Energy M&A
A pandemic, war and ESG have made an already volatile industry even more frenetic. Where does that leave energy M&A in the middle market?
There’s never been anything quite like the oil price fluctuations of the past few years.
“The closest to it would be the global financial crisis in 2008,” says Sanjiv Shah, global co-head of energy and power investment banking at Piper Sandler. “These swings are the biggest I’ve ever seen in my career.”
The pandemic and geopolitical conflict have rocked the supply and demand balance that bolsters stable commodity prices, while growing environmental concerns have further complicated the outlook for mergers and acquisitions in the energy sector.
The COVID-19 pandemic tipped the first domino.
This is an excerpt of a report that originally appeared in Middle Market DealMaker’s Summer 2022 issue. Read the full story in the archive.
Illustrated by Dan Page.
In April 2020, the price of West Texas crude oil briefly dipped below zero dollars per barrel. Demand for oil tanked, and energy M&A deal volume fell across the world, according to PwC’s Global M&A Trends in Energy, Utilities and Resources: 2022 Outlook. Deals made during this period typically came from bankruptcies or forced sales, Shah says.
In early 2021, pent-up demand for oil coincided with increases in commodity prices and M&A. Law firm White & Case LLP reported in January 2022 that deal values rose by 24% to $102.7 billion from 2020 to 2021, and the number of deals increased by 16%. The firm wrote that it expected prices to be more stable in 2022, “absent a major shock.”
A month later, Russia invaded Ukraine.
The Impact of the War
Energy M&A—at least in the upstream oil and gas market—was running hot early in 2022, according to Keith Buchanan, managing director and head of oil and gas investment banking at KeyBanc Capital Markets. But in March and April, he watched as deals halted after prices skyrocketed due to a U.S. executive order in March that banned the import of crude oil and certain energy products, a year after America imported approximately 700,000 barrels from Russia.
“The Russia invasion of Ukraine brought the overall capital markets to a really slow pace with so much volatility,” Buchanan says. “But even more so, the volatility in the commodity markets—both oil and natural gas—has made it difficult for buyers and sellers of oil and gas assets to agree on a purchase price. That doesn’t mean deals are not getting done, but there’s a much lower volume of transactions.”
Supply pressures look unlikely to recede any time soon. The war has extended multiyear underinvestment in conventional energy across
the world, according to Shah, which means lower production will continue.
“Oil and gas as a business model is a hamster wheel,” he says. “If you stop investing, the wheel stops spinning and declines naturally. You have to invest to hold flat production—if you have multiyear declining investment, you will have multiyear declining production.”
While none of this creates a friendly environment for M&A, Shah says that deals haven’t stopped entirely.
“There’s a very conducive macro environment for these companies to generate good cash flow, and therefore a good conducive macro environment for M&A activity,” Shah says. “It’ll all come down to whether the companies make money or not. If the companies can show that they generate earnings consistently, then people will want to buy them, particularly as other parts of the economy have maybe gotten more expensive.”
Austin Elam, partner and co-chair of Haynes and Boone’s Oil and Gas Practice Group, says that U.S. companies in particular have been looking for ways to become energy-independent and diversify energy sources even before the war, especially sources that can be exported to those in allied countries.
It’s incredibly difficult to value a company when prices are dynamic. If you factor in commodity hedges, and you’re looking long term, you can probably find some meaningful ways to invest.
Haynes and Boone
Oil and gas markets will always be riddled with volatility, prompting companies and investors to think long term.
“It’s incredibly difficult to value a company when prices are dynamic,” Elam says. “If you factor in commodity hedges, and you’re looking long term, you can probably find some meaningful ways to invest. But you’re certainly never going to bet on the near term, because that’s always going to be dynamic.”
Against the backdrop of the war in Ukraine and COVID-19 aftershocks, a seismic shift is underway in the form of attention to environmental, social and governance issues by investors and companies, which is transforming how the financial world views the energy industry.
Buchanan has seen banks exit oil and gas entirely, especially certain U.S., Canadian and European lenders. “We don’t expect to see them coming back,” he says.
Reuters reported in March that oil and gas investments rose while demand for sustainable investments dipped—a phenomenon that’s likely due to increasing demand for oil and gas in concert with the sanctions against Russian energy suppliers. And there’s still pressure for large lenders and investors to put money into oil and gas.
Tron Allen, chief commercial officer at independent asset-based lender Eclipse Business Capital, says that his firm is less influenced by larger investment trends than big banks. Eclipse is willing to lend to oil and gas companies, so long as they have a chance to grow. While ESG makes it harder for bigger lenders and investors to transact in nonrenewable energy, Shah says that the debt market is more open this year than it was before the pandemic. Non-bank lenders—direct lenders and hedge funds, for example— are still very interested in investing in oil and gas.
Doing Deals Today
Over the last six months, increasing oil prices have prompted companies to make greater capital expenditures, Shah says, leading to more energy service-related M&A transactions in the middle market. But M&A activity is still far from where it was before the pandemic.
For now, says Allen, many companies are working on their balance sheets by refinancing their debt and searching for alternative capital. “We worked with a couple of groups that acquired distressed assets from companies that had to unwind their asset position,” he says. “But nothing from an M&A perspective.”
Related content: How Public Scrutiny of ESG Impacts Private Equity’s Investment Strategy
Creative touches will be needed for the M&A deals that do occur, notes KeyBanc’s Buchanan. That creativity could come by way of an oil field owner selling oil into the futures market, Shah says. Or it could come in the form of hedging. Elam has even seen companies that own royalty interests hedge their positions to protect against risks at the expense of future upside.
Environmental considerations will also play a role in transactions, including those that don’t involve an explicitly “green” business, Elam says. He recently closed a deal with an oil company where one of the last-minute changes to the transaction was adding systems to monitor the volume of fresh water used in drilling operations and the amount of gas being flared, seeking to reduce both over time.
“There’s a tangible ESG element to show investors how they’re being good stewards for the industry,” Elam says.
In an industry rife with volatility, forecasting the future is challenging. But each expert interviewed believes that the health of the energy sector and M&A will improve in the second half of 2022.
Allen, for example, believes that rig counts and production will return to pre-pandemic levels. “Hopefully, it will result in cheaper gas prices for us all,” he says. “We see more upside potential in investing and lending to energy companies today than we did a couple of years ago.”
Elam feels optimistic that large and small M&A transactions alike will take place over the next six months to a year, especially if oil prices become less volatile. M&A deals will pick up greatly if the war in Ukraine ends peacefully, he adds.
If you’re willing to invest indiscriminately, it’s a good place to invest because you’ll get more bang for your buck
Shah believes that oil and gas is bound to perform better than it has in years. Buyers likely won’t assume oil will be more than $100 per barrel forever, he notes, but could it make sense to underwrite an investment based on $75 or $80 per barrel? Either way, oil and gas assets could be great investments for willing participants, especially since some have left the sector due to ESG concerns.
“If you’re willing to invest indiscriminately, it’s a good place to invest because you’ll get more bang for your buck,” Shah says.
Buchanan doesn’t think the next six months can possibly be as volatile as March and April. He believes that price swings will settle, and transactions will follow. Companies in the oil and gas space, specifically upstream, are doing well at the current commodity prices, so they can make money while owning and acquiring more assets. They can also sustain a higher cost of capital and generate good return for investors.
Buchanan believes that the number of M&A deals will pick up as the market settles. “It just takes one buyer and one seller to agree,” he says, when asked when stability might return. “That’s all it takes.”
Hal Conick is a writer based in Chicago.