Partner and Associate Director, Center for Energy Impact
The last time the world experienced simultaneous oil demand and supply shocks, in 1997–1998, the result was a set of megamergers that created the supermajors of today. But the current oil market turmoil, brought on by the COVID-19 pandemic and the unraveling in early March of the OPEC+ deal, is unlikely to produce the same industry consolidation in the near term. Capital allocation constraints, combined with uncertainty about oil prices, will stymie overall deal flow even as more assets become available—although we see the potential for one or two transformative deals.
Mergers and acquisitions were already getting hard to come by in the period before the COVID-19 crisis. (See Exhibit 1.) Both the number and the value of deals have fallen over the past three years despite higher oil prices. Overall deal value increased in 2019, driven by Occidental Petroleum’s $66 billion takeover of Anadarko. Excluding this transaction, however, the value of global deals dipped by $38 billion in 2019 from the previous year. Before the crisis, 2020 had witnessed only eight deals with a combined value of just $2 billion.
In the wake of the pandemic, a number of factors favor an increase in acquisitions. Company valuations are at their lowest since 2009, historically high acquisition premiums are set to fall, and many billions of dollars of oil and gas assets worldwide have already been put up for sale by financially stressed companies. (See Exhibit 2.) Nevertheless, M&A is unlikely to pick up pace while the extreme uncertainty of recent weeks persists.
The companies that would most likely be acquirers, such as the majors and other large integrated international oil companies (IOCs), face several challenges before they can consider transformative M&A. These large players already have significant disposal programs in place to meet existing debt reduction targets. And with oil prices at 20-year lows and the industry in crisis, they face severe constraints on their capital and the way they allocate it. The large IOCs have dwindling cash reserves: in 2019, cash and near-cash items as a percentage of total debt stood at 25% on average for these companies, down from 31% in 2018. (See Exhibit 3.) Most companies are still prioritizing dividend payments and have committed to massive capex cuts. Consequently, divestitures will be more important than acquisitions for them over the foreseeable future.
The quality of acquisition targets is also likely to give potential buyers pause for thought. Many of the most vulnerable companies, particularly those in US unconventionals, are under huge financial stress in the current environment. They are subscale, have deteriorating earnings, and are burdened by high, expensive debt. As acquisition targets, they are too small to move the dial for a large player and offer questionable upside at today’s oil price levels. Rather than being distressed assets, they look more like destroyed ones. Unless prices recover, the more vulnerable companies will go bankrupt, reducing the overall supply of oil. In the US, which has too many small and unsustainable producers, this could be beneficial in the long term.
At the very least, the effects of the pandemic will need to stabilize before companies can get a good line of sight on longer-term oil demand and prices in order to realistically value potential acquisitions. This is likely to take months, not weeks. Moreover, expectations of demand destruction and significant oversupply this year (and possibly into next) will encourage companies to be far more conservative in the longer-term price assumptions that they use to value deals. In the past, a long-range planning price of $60 per barrel was generally accepted. Moving forward, companies are likely to reduce this price assumption, possibly to as low as $35 to $45 per barrel.
Given these constraints, oil and gas deals will be thin on the ground in the months ahead. Although many billions of dollars of assets and companies are up for sale, the supply of large, world-class ones is limited. Only these will find buyers. Similarly, the highest-quality businesses—rather than the most distressed ones—will be the focus of corporate acquisitions. Where deals are struck, priorities will center on building scale, replacing reserves, and stripping out costs. Nevertheless, acquirers will need to dial back on their planning assumptions if the deals are to flourish.
The Center for Energy Impact (CEI) aims to engage a changing industry in new and different ways by providing challenging ideas to drive performance. We shape thinking about the future availability, economics, and sustainability of the world’s energy sources—and the implications for energy companies and their portfolios.