Register to receive a printed copy(For Lexis Practice Advisor® Subscribers Only)
Lexis Practice Advisor®Free Trial
Learn More AboutLexis Practice Advisor®
By: I. Bobby Majumder, Reed Smith LLP
2019 has been eventful for the domestic oil and gas industry. Oil and gas acquisitions in the United States hit a 10-year low in the first quarter, with deal value plunging by over 90% just from the fourth quarter of 2018. A rapid reduction in oil prices in late 2018 is believed to have triggered these effects. However, the second quarter of 2019 brought a resurgence, with deal value spiking to $118.7 billion, an all-time high for a second quarter, according to a study by PricewaterhouseCoopers.
Oil price volatility is a pervasive factor in the industry’s deal statistics, inevitably affecting deal value each quarter. When prices are stable, it allows both buyer and seller increased confidence that a deal is not heavily favorable to the counterparty and further suggests a maturation of the cost-cutting measures taken by domestic shale producers. More stable economics allow typical sellers—generally distressed sellers that are considering selling assets to de-lever their balance sheets—and typical buyers—generally strategic buyers and financial sponsors making bets that the market has reached a level of stability with respect to oil and gas prices—to have comfort that their decisions are not going to be second guessed because of massive fluctuations in price.
From 2009 to 2014, deal-making relied on stable oil prices between $70 and $80 per barrel. In 2015, oil prices fluctuated wildly, leading to uncertainty in deal making. Oil prices then stabilized, ranging between $42 and $52 per barrel beginning in June 2016, and that stability led to a moderate increase in oil and gas acquisitions and dispositions. 2017 brought similar stability at a range between $50 and $60 per barrel, but deal value and deal count took a small dive, with experts citing lasting effects of caution arising out of the lower for longer business environment of the past several years. Oil prices reached a four-year high by October 2018 before plunging and leading to such a dismal start to 2019.
Notably, three mega-deals (deals valued at $5 billion or more) represented 75% of the deal value in the second quarter of 2019, demonstrating a comeback of blockbuster transactions. Though it is unclear precisely whether this uptick in large acquisitions and dispositions will continue through the fourth quarter of 2019, the current geopolitical and macroeconomic landscape has the potential to create even more oil price volatility.
The oil and gas industry is capital-centric, so without adequate access to capital, oil and gas companies cannot survive. Low or volatile oil prices force oil and gas companies to be creative in their efforts to raise capital. The threat of a decreased borrowing base often motivates producers to consider strategic dispositions or alternative capital providers. These alternative providers include private equity funds and mezzanine funds, though these funding sources often come with heavy strings attached, and many private equity funds with substantial available cash are instead content to withhold capital and poach prized assets out of bankruptcy.
The oil and gas industry comprises four main sectors:
Because of the different role each sector plays in the production and distribution of oil and gas, each sector experiences different effects from fluctuations in oil and gas prices. Accordingly, trends in merger and acquisition (M&A) activity are best examined at the sector level.
The upstream sector accounted for the majority of the U.S. oil and gas deal value in the second quarter of 2019. Deal activity is increasing due to the continuing attractiveness of shale plays, particularly in low-cost-of-production basins. The Permian basin and Marcellus basin each have a break-even point that is approximately $20 per barrel below that of higher cost-of-production locations. In 2018, upstream deals in the Permian basin had an aggregate transaction value of $25.7 billion, more than twice the value of deals in the next most active basin. The geology of the Permian basin and the high number of vertical wells drilled there lead to lower production costs. Additionally, most of the deal value is derived from the sale of undeveloped acreage—a product of producers being more willing to explore in low-cost basins than acquire producing wells in higher cost basins. Buyers possess more confidence when acquiring companies operating in low-cost basins because of the decreased costs of operation, which helps preserve positive operating margins. Conversely, dry gas production basins such as the Bakken have seen fewer acquisitions because of the higher costs of production; however interest has grown some over the past few years. Buyers are content to let operators in high-cost areas file for bankruptcy in order to secure a more attractive deal through the purchase of producing assets via transactions under Section 363 of the U.S. Bankruptcy Code.
Many small to midsize upstream companies have been pursuing royalty deals as a means of raising capital. With 29 deals worth $2.2 billion total for the year 2018, royalty deal volume and value reached an all-time high. All of these deals were for proven but undeveloped assets, which suggests a trending interest driving future growth by minimizing the risk involved in operating the assets. When 2019 comes to a close, it will be telling to see whether this trend has continued.
Oil Field Services Trends
Aggregate deal value in the oil field services sector fell to a five-year low in 2018, and there was limited activity into the first half of 2019. While market valuations of oil field services companies fell by nearly 40% from 2017, the last quarter of 2018 marked record-high asset sales of more than $6 billion. As the demand for rigs per drilling unit has decreased and midstream bottlenecking has held back demand growth for equipment, oil field services companies have resorted to selling assets that were not producing sufficient revenues.
A common strategy in oil field services deals is to supplement existing services as opposed to creating new segments. Nearly all the oil field services deals in 2018 were between a buyer and seller with significantly overlapping business models, which suggests that companies remain conservative at this time, focusing on what they already do well in the industry.
The Ensco/Rowan merger was the top oil field services deal of 2018. The merger’s goal was to combine the companies’ rig fleets and infrastructure in order to increase scale without neglecting high-specification assets. After years of bankruptcy and overcapacity in this sector, improving offshore margins is important for oil field services companies.
With years of low oil prices causing decreased deal activity, the midstream sector saw an increase in aggregate deal value in 2018, surpassing upstream deal value in three out of four quarters. Activity in the United States decreased in the first half of 2019, but a general bottlenecking of infrastructure has resulted in a general increased interest in existing, completed pipeline assets over the past couple years.
Long-term, fixed-price contracts are common in the midstream sector, as these agreements protect midstream revenue. Industry analysts believed the fixed-price contract structure would protect the midstream sector for a significant amount of time. However, deal activity in the midstream sector is susceptible to a prolonged downturn in oil prices. Since its spike in both deal count and deal value in late 2016, the sector has not quite picked up again, with deal counts ranging from about 10 to 20 each quarter. Gathering and processing deals have been at the forefront of deal activity in this sector, particularly in 2018.
Master limited partnership-backed deals continue to slow down in the midstream sector after the Federal Energy Regulatory Commission enacted an unfavorable tax policy toward this type of structure in early 2018. Private equity continues to show interest in the midstream sector, demonstrating the many creative ways an oil and gas deal may be structured. Special purpose acquisition companies (SPACs) have also proven to be a viable deal-making strategy in the sector, a notable example being the SPAC Kayne Anderson Acquisition Corporation’s $3.5 billion deal that created the first debt-free, cash-rich, publicly-traded, pure-play midstream corporation in the Permian Basin.
Worldwide, the downstream sector achieved a record aggregate deal value in 2018. Marathon Petroleum’s acquisition of Andeavor is one of the chief reasons for this accomplishment, as this U.S. transaction was not only the largest downstream deal globally to date, but one of the largest deals of the oil and gas industry in 2018. Increased activity in the marketing and storage business verticals also contributed to this deal value. Nearly half of the downstream deals in the last quarter of 2018 were in the storage vertical, and activity in this segment is slated to only increase over time.
The downstream sector comprises only a small portion of the U.S. oil and gas deal distribution in 2019. While the downstream sector provided 7% of oil and gas deal volume in the second quarter of 2019, it only comprised 4% of the total deal value. This is likely attributable to the increased activity of smaller-sized companies.
Deal structuring issues tend to turn upon two factors: first, the involvement, if any, the sellers will have in the ongoing assets or enterprise; and second, the tax ramifications of the deal in question. In terms of post-transaction involvement, management of the selling entity will seek to retain some form of upside. A royalty spin-off and earn-outs are two attractive methods sellers use to protect upside.
The cost of production is the first and foremost due diligence issue in oil and gas M&A. A low oil price environment demands an accurate cost of production picture. Due diligence must therefore be precise and complete. Engaging reputable industry consultants who are independent and not incentivized to close helps dealmakers gain a more accurate rendering of the cost of production. Additionally, due diligence concerning title issues, environmental liabilities, third-party processing and transportation agreements, and storage facilities continue to be necessary when conducting oil and gas due diligence.
Most commonly, oil and gas transactions are regulated by organizations such as the Environmental Protection Agency and the relevant state-level administrative agencies (for example, the Texas Railroad Commission). However, many practitioners would be unaware of the need to get approval from the Bureau of Land Management (BLM) (a part of the U.S. Department of the Interior) for transactions involving production or leases on Native American reservations. The BLM is an inherently convoluted and cumbersome area of regulation; therefore, the help of a BLM specialist is important when constructing deals that require BLM approval. For instance, the Dakota Access Pipeline—noteworthy due to Native American protests—had to receive permission from the BLM in order to develop the pipeline.
I. Bobby Majumder is the co-office managing partner of the Dallas office of Reed Smith LLP and co-head of the firm’s India practice. He focuses his practice on corporate and securities transactions primarily in the energy (oil & gas and coal), mining, health care, and information technology industry verticals. He represents underwriters, placement agents, and issuers in both public and private offerings of securities; public and privately-held companies in both cross-border and domestic mergers and acquisitions; private equity funds, hedge funds, and venture capital funds in connection with their formation as well as their investments; and companies receiving private equity and venture capital financing. Special thanks to Reed Smith associate Brooke Dorris for contributing her efforts to this article.
RESEARCH PATH: Corporate and M&A > Trends & Insights > Market Trends > Articles
For a review of special purpose acquisition companies (SPACs) and their place in the initial public offering (IPO) market, see
> EXPERT INSIGHTS: SPACS CONTINUE TO GAIN TRACTION IN THE IPO MARKET
RESEARCH PATH: Energy & Utilities > Corporate Transactions > Practice Notes
For a discussion of the reasons why confidentiality agreements are important and the provisions a confidentiality agreement should include, see
> CONFIDENTIALITY AGREEMENTS: OIL & GAS INDUSTRY
For an overview of environmental due diligence in corporate merger and acquisition (M&A) transactions, see
> ENVIRONMENTAL DUE DILIGENCE IN M&A TRANSACTIONS
For an outline of the terms that should be included in an oil and gas purchase agreement, see
> OIL AND GAS PURCHASE AGREEMENTS