Following Morgan Lewis’s most recent Evening in Energy, hosted in the firm’s Houston office, Energy Industry co-leader Andrew Gallo spoke with the event’s keynote speaker Steve Almrud about the trends he’s seeing in the traditional energy sector. Steve has 30 years of experience in oil and gas investment banking, most recently having served as the head of Global A&D for the energy group of Barclays Capital.
Andrew: What is the current state of merger and acquisition (M&A) activity in the traditional energy sector?
Steve: Q1 M&A in upstream oil and gas deals is at its highest level since 2017. We are seeing significant consolidation in the industry, with acquisitions primarily by the industry’s largest players, including the supermajors. If you look at a list of the top 20 US tight oil players in 2020, ten of those companies—including the eight smallest—have been acquired by larger companies on the list over the past four years, with ExxonMobil and Chevron clearly dominating in sheer dollar amount.
What are the key drivers of this M&A boom?
It is a combination of things driven by long-term strategic views of corporate management and their boards and the return of institutional investors to exploration and production (E&P) investing with well-defined investment criteria. The US majors and large independents are showing confidence in sustained multi-decade demand for hydrocarbons as fuel and petrochemical feedstock. Additionally, institutional investors are requiring adherence to basic measures like earnings, return on capital, return of capital, and limited capital reinvestment. Therefore, companies need to acquire/merge with rivals to benefit from size and scale, gain meaningful core drilling inventory, achieve cost and operational synergies, optimize field level operations, and invest in new technologies and best practices.
Importantly, you have to remember that the majors do not have a successful track record of organic growth in shale production and are better suited to be opportunistic consolidators. These large buyers currently have preferential access to capital markets and lenders to execute deals, while small public companies are challenged for financing and private equity-backed companies have seen limited exit options (no initial public offerings) in recent years, driving these entities to consolidate up the food chain.
Can you speak more to the capital markets piece? What is the relevance there?
We are seeing a fight for relevance with institutional investors as they return to E&P investing. Investors are emphasizing size, scale, profitability, and conservative capital management in the form of dividends, buybacks, and debt reduction. The correlation between company size and cash flow multiple is very strong, as is the correlation between cash reinvestment rate and multiple. Bigger entities with lower cash reinvestment are being rewarded.
On the lending side, many regional banks and UK/European banks have permanently exited oil and gas lending, disproportionately impacting smaller E&P companies. Major US banks, however, remain willing to lend to larger companies as they consolidate and their portfolios grow. Partially filling that funding gap, we are seeing alternative forms and sources of lending emerge for smaller producers and transactions, including the asset-backed securities market—which has been surging lately—and private credit funds.
Outside the state of capital markets, what legal and regulatory considerations are impacting the traditional energy sector?
A big one is the US Environmental Protection Agency’s proposed 2023 rule that would require fossil-fuel generators to use carbon capture and green hydrogen to reduce CO2 emissions. The Inflation Reduction Act has created significant incentives for investments in green energy. President Joseph Biden’s executive order pausing liquid natural gas export approvals has had a major impact on the planning and financing of new projects. On the other hand, many entities that previously took hard-line positions against the traditional energy sector are stating publicly their belief that hydrocarbons remain a significant source for energy generation and will be needed throughout any green energy transition. Because the United States is the world leader in natural gas production, exports are inevitable and will be fueled by European and emerging economy demand.
How do oil and gas interplay with renewables in terms of capital investment?
Oil, gas, and renewables are competing for the same finite investor dollars and the attention of policymakers for advantageous rules, policies, and tax treatment. And while there is a large campaign to make everything seem like an either/or choice between the two, that is a false premise. Just look at Texas, which is both the nation’s number one producer of oil and gas and the number one producer of wind power (and soon, by some forecasts, the number one in solar power). Supermajors are viewed as investing in energy transition incubators and startups to keep up with emerging technologies, with return on investment a secondary objective (and largely driven by the previously mentioned tax incentives). But oil and gas investment still drives their profits and remains part of a balanced energy future.
Following COP28, the countries of the world agreed to “transition away” from fossil fuels. Where does this leave fossil fuel producers?
According to the EU International Energy Agency (IEA), demand for oil needs to shrink from 100 million barrels per day to 24 million barrels by 2050 to meet climate objectives. Faced with this scenario, many frame a limited range of options for fossil fuel producers. They can walk a fine line with investors, policymakers, and regulators and hope they outlast their rivals. They can pivot to other forms of energy that emit little or no carbon dioxide, gradually wind themselves down while returning cash to shareholders, or some combination of those. But US majors and E&P companies are assuming that demand for oil will not decline dramatically, and they are pursuing growth through acquisitions and drilling, subject to investor criteria (note that we are currently experiencing global supply and demand growth for hydrocarbons).
While hydrocarbons used for energy generation get the brunt of public and environmental policy retaliation, we can’t forget that oil and natural gas have innumerable other uses and are, for example, turned into plastics and polymers that are used in a variety of products, including wind turbines. The IEA has also stated that petrochemicals will account for one-third of growth in oil demand, so a steep decline in demand may not occur in the near to mid-range future.
With all that said, what is the outlook for traditional energy markets?
The energy sector companies currently represent less than 4% of the S&P 500, which is down from about 7–8% historically. In fact, energy companies and utilities are the only sectors not currently trading above their 25-year highs (recall that ExxonMobil was the largest public company in the world in 2011). However, there is some optimism for 2024, based on earnings per share and return on capital employed growth, and more M&A deals in the industry. Institutional investors generally want to do good for the environment and also do well for their investors. While Wall Street tends to have reservations about capital expenditures, production decline is natural and inevitable, reinvestment will have to occur, and the subsequent growth will be rewarded as long as the industry convinces investors that equity returns are real, repeatable, and reliable.