Will $80/bbl Oil Bring more Mergers, or more Spin-Offs?
Shrinking profits for whatever reason, can stimulate the M&A activity in any industry. We still remember consolidations in upstream sector following oil price crash in 1999, but what will happen this time if the oil price stays in the $80-$90 range, say for 6-12 month? Should we expect consolidations, or more spin-offs?
According to EIA “shortfall between cash earnings from operations and expenditure — mostly CAPEX and dividends — has widened from $18bn in 2010 to $110bn during the past three years”. Companies have been borrowing more to keep the same dividend payouts, to catch up with raising cost and to buy-back shares; thanks to record low interest rates which has made borrowing cheap. This is how industry managed to boost shale production from 3 bcf/d to 35 bcf/d in about 7 years (EIA). Nevertheless, the demand for investment in current and future projects is expected to stay in the range of $0.9t-$1.0t in next 3-5 years (IEA) which means the industry won’t be out of the woods soon i.e. profitability of the sector will stay under pressure. Big part of the current and the future E&P projects need a break-even oil price of $80 and above (read more on Ambrose’s recent review in The Telegraph in here).
So, the sad story of diminishing profitability will even be more immense in next few years at $80-$90 /bbl oil. The free-cash-flow challenge will be bigger with lower commodity prices.
So what does this mean to the M&A activity?
It sounds that no one is immune from what is happening in the market. Independents and small-to-mid-cap energy companies are more vulnerable to split as activist investors have a bigger vote, and better access to the board. Oxy, Murphy Oil and Hess track record in 2013/2014 are good examples.
BHP CEO pushes to spin off ‘unwanted assets’ of about $18b to make earnings more predictable (more in here). ConocoPhillips split the downstream segment to allow more focus on exploration and development. BP spun off its shale unit to boost the profitability of its shale gas portfolio in US (more in here). In a similar fashion Shell spun off its midstream segment to Swell to improve competitiveness by allowing flexibility in International M&A and business development (more in here). Here in Canada Encana has divested non-core assets in stages to consolidate the portfolio around a core to better leverage resources, knowledge, and processes i.e. their competitive advantage.
Integrated operations model has enabled few integrated oil companies such as ExxonMobil, Shell and Chevron to softened the impact of 18% drop in crude price in Q3’14 (higher downstream margins; read more in here). Nevertheless, most of the players have already picked spin-off as the strategy to improve competitiveness, focus, culture, and predictability and in order to target higher profitability. As a result a fueled A&D activity and continued spin-offs are expect in 2015-2017. Divestment of non-core assets/businesses will stay as the primary mean to source capital and get debt to capital employed (and income) under control.