In periods of low and flat oil prices, historical trends suggest that M&A activity picks up as distressed companies get picked off by incumbents seeking competitive advantage. New research highlights, however, that not all motivations for M&A create value in such periods, and some may even come to destroy value.
Following almost a decade of relatively high oil prices, changing market dynamics – on the back of a glut from OPEC – saw per barrel prices fall to below $30 at the start of 2016. While prices have picked up again, to around $50 a barrel, current conditions are still below the breakeven price for a wide range extraction techniques and basins. Oil & gas extraction companies, and the wider supply chain, have been feeling the squeeze – as well as countries financially dependent on oil revenues for government expenditure, including Saudi Arabia and Nigeria. One of the effects of low oil prices is that distressed companies may be going relatively cheap, incentivising M&A activity.
In a new analysis by McKinsey & Company, the firm explores historical trends within the oil & gas sector to identify how well the M&A market performs in a time of low oil prices.
The research predicts that a new wave of M&A activity is likely to begin within the near future. While activity has been muted so far, the increasing vulnerability of players as low prices continue to bite, may see stronger companies seek acquisitions to strengthen their competitive position while they are going cheap. The historical data, going back more than 100 years, highlights that there is a strong correlation between decreasing oil prices and M&A deal activity.
To explore the wisdom of M&A in a low price environment, the consultancy explores a range of historic M&A data for the industry going back 30 years. The research segments deals into four themes that characterise most deal activity—megamergers, increasing basin or regional density, entering new geographies, and entering new resource types. The firm contrasted the value-creation performance of the deal themes under the two main pricing environments in force during the period: low prices from 1986 to 1998 and rising prices from 1998 to 2014 (with the exception of 2008 to 2009).
The results from the research suggests that during a period of low prices, care needs to be taken around M&A activity, lest value be lost in the long term due to the deal. Of all the deals evaluated for the 1986–98 period, only megadeals outperformed their market index five years after announcement. In contrast, in the 1998–2014 period, when prices were generally rising, more than 60% of all deal types outperformed their market index five years after announcement.
The research highlights that when oil prices are flat, a range of deal activity tends to result in low or negative value creation. Building density in a basis resulted in -0.1% compound annual growth rate from the deal, while entering a new basin has a -9.1% compound annual growth rate. In contrast, building scale during a downturn has a positive effect on growth of 2.5%. Deals during rising prices period tend to result in value creation, particularly entering new basis (7.4% CAGR), as new top-line revenue capacity is added, and building density within basis (4.3% CAGR). Interestingly, building scale motivations add little to growth.
The research suggests that the M&A activity leading to building scale in periods of flat oil prices has a positive effect on growth due to operational cost cutting and efficiency results from synergies. According to the report, “Improvements to returns on invested capital (ROIC), including cost reductions and raising capital efficiency, are usually more effective approaches to unlocking value. Our research on upstream North American companies bears this out: the data show a strong correlation between total returns to shareholders and ROIC in the 1992–98 period, when oil prices were flat and low, and a weaker correlation after 1998, which marked the beginning of the next oil-price up cycle.”
The authors conclude that in a protracted period of low and relatively flat prices, companies can best seek M&A deals that support the reduction of costs, while the quality execution of M&A deals too remains a key, according to the consultants.
An analysis by Wood Mackenzie, a research firm specialised in the oil & gas domain, released earlier this year, found that a wave of mega deals could even "reshape the face of the energy industry" globally.