Oil Price Volatility Makes Discipline, Profitability Key Factors in M&A

Cautious optimism.

That’s how experts describe the mood of the oil and gas industry heading into the 2019 AAPG Prospect and Property Expo, or APPEX, set for March 5-7 in London.

Cautious, because an unexpected dip in crude prices in late 2018 softened the outlook for the industry’s recovery.

Optimistic, because activity in property deals and in mergers and acquisitions has rebounded after a year-end lull.

Jon Fitzpatrick, managing director for Gneiss Energy, and Gabriel Mynheer, economics and planning analyst for NexenCNOOC Ltd., serve as co-chairs for the 2019 APPEX gathering at London’s Business Design Centre.

The event brings together upstream decision-makers and investors in a conference and exhibition format.

Lowered Price Projections

Deal-making activity in the oil and gas industry tends to reflect the level of market and capital confidence, Fitzpatrick noted. Crude oil prices peaked in early October last year and then declined sharply, which tempered the industry’s enthusiasm for spending.

In January, investment firm Goldman Sachs lowered its 2019 oil price forecast in light of increased crude oil production, especially from U.S. shale plays. It projected benchmark Brent crude to average $62.50 a barrel for the year, compared to a previous forecast of $70 a barrel.

The firm also cut its 2019 price projection for West Texas Intermediate crude to an average $55.50/barrel.

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Cautious optimism.

That’s how experts describe the mood of the oil and gas industry heading into the 2019 AAPG Prospect and Property Expo, or APPEX, set for March 5-7 in London.

Cautious, because an unexpected dip in crude prices in late 2018 softened the outlook for the industry’s recovery.

Optimistic, because activity in property deals and in mergers and acquisitions has rebounded after a year-end lull.

Jon Fitzpatrick, managing director for Gneiss Energy, and Gabriel Mynheer, economics and planning analyst for NexenCNOOC Ltd., serve as co-chairs for the 2019 APPEX gathering at London’s Business Design Centre.

The event brings together upstream decision-makers and investors in a conference and exhibition format.

Lowered Price Projections

Deal-making activity in the oil and gas industry tends to reflect the level of market and capital confidence, Fitzpatrick noted. Crude oil prices peaked in early October last year and then declined sharply, which tempered the industry’s enthusiasm for spending.

In January, investment firm Goldman Sachs lowered its 2019 oil price forecast in light of increased crude oil production, especially from U.S. shale plays. It projected benchmark Brent crude to average $62.50 a barrel for the year, compared to a previous forecast of $70 a barrel.

The firm also cut its 2019 price projection for West Texas Intermediate crude to an average $55.50/barrel.

Fitzpatrick expects commodity prices to remain the main driver of M&A this year, influenced by the production price correction late in 2018, uncertainty surrounding OPEC’s response to sanctions and rising geopolitical tensions.

“Over the course of 2018, transaction activity and the number of deals has been robust. We have seen activity levels in the midstream sector largely driving the underlying levels. However, the number of upstream deals more accurately reflects the cautious optimism seen throughout the sector,” he said.

“Another trend we have seen is a growing number of independent upstream operators that are shifting away from exploration-focused strategies toward becoming localized production-focused players, as investors hunt for downside protection from underlying reserves and production,” he added.

Deal-making Uncertainty

Greig Aitken, director of M&A research for Wood Mackenzie in Edinburgh, will be a speaker at APPEX 2019. Price fluctuations in oil and gas lead to market uncertainty, and Aitken said that can pose a problem for deal-making.

Price volatility “really hampers deal flow and we saw that in December – not just in energy prices, but in equity markets – which was the slowest month for upstream M&A in almost four years. So that has to settle first,” he said

“In general, we see more deals when oil prices are higher: There’s more confidence, more interest in growing, and more money available. But history has shown that regardless of oil prices or share prices, there’s a consistent churn of assets and companies in the upstream sector,” he observed.

The recent softness in oil prices “certainly causes headwinds, but we’ll still continue to see deals,” Aitken said.

Tech Factor

Gneiss Energy projects that technology will become a critical factor in the market as companies seek to protect themselves against price risk and volatility, Fitzpatrick said.

“Increasing investment in utilizing digital- and technology-focused capabilities to extract value will likely be a key driver in M&A activity for the sector in 2019,” Fitzpatrick said.

“We expect technology-focused sessions at APPEX to gain significant interest as companies look to increase operating efficiencies and increase value in their projects,” he added.

Gneiss also sees regional/geographic consolidation as a core theme for the year, “as larger entities with more appropriately scaled operating costs provide a significantly more robust investment proposition,” Fitzpatrick noted.

In mature areas, a leaner and disciplined approach to operations will be essential to extracting value, he said.

“The growing prominence of energy-focused, (private equity)-backed startups, particularly in the North Sea, are seen as sector-disruptive players who are looking to fill the void as the ‘traditional’ players exit a mature basin,” Fitzpatrick observed.

“The application of leaner-and-meaner operating models to extract value in mature assets and push forward new developments, and synergies around partnerships in the upstream and services sectors, remain at the core of dealmakers thoughts,” he said.

Capital Discipline

Companies now are challenged by multiple demands on capital available for investment, a common theme for the industry, Aitken said. Capital allocation “is a question all oil and gas companies wrestle with constantly,” he noted.

“I think the big dilemma over the last year or so has been about how much to invest in growth. I’d say more companies have tended toward being prudent, opting to pay down debt, strengthen balance sheets and return cash to shareholders,” he said.

Companies stretched with existing large capital commitments, like investment in LNG developments, “obviously tend not to be acquirers,” Aitken noted, though those companies may sell assets to fund development or reduce capital commitments elsewhere.

“This usually affects particular companies rather than the whole industry at once. There’s a big infrastructure build-out going in the Permian just now, but a lot of this is being done by midstream and downstream companies,” Aitken said.

Today, deal proposals appear to hinge on a well-defined path to profitability. Andrew Dittmar, M&A analyst for Drillinginfo in Houston, said Wall Street “is ready to punish buyers who do deals without a clear profit strategy.”

“Investors continue to demand that companies deliver a clear line-of-sight to positive free cash flow,” Dittmar noted.

Andrew Latham, vice president of global exploration for Wood Mackenzie, said discipline is now key for upstream activities.

“The exploration industry has made huge strides to reset its economics and has been back in the black since 2017. Current prices are sufficient for disciplined explorers to continue to make good returns, but the watchwords remain ‘capital discipline,’” he said.

Wood Mackenzie expects more exploration to be completed in both the United Kingdom and Norway in 2019 compared to last year, with similar small increases in activity in many other international plays, Latham said.

Majors are the companies to watch most closely, since they will be operating many of the key wildcat wells scheduled for the year ahead, he noted.

“There are concerns that attitudes in the wider public arena are turning against the industry, with various bans enacted in several countries around the world. The risk that these may spread more widely is a concern,” Latham said.

For now, the consensus among analysts is that the industry remains just strong enough to be attractive for additional investment, especially if the annual average Brent crude price hovers around $65 a barrel.

Instead of “Show me the money,” the operative slogan for deals at AAPEX 2019 seems to be, “Show me a clear path to profit.”

“APPEX should be abuzz with companies looking for high-quality exploration opportunities that offer a ready route to market in a success case,” Latham said.