Tomlinson: Culling the herd needed for oil and gas industry to recover
Bring on the zombie killers to clear the way for the energy revival
Oil prices may be headed higher, but a bust like this one isn’t over until bankruptcies, mergers and acquisitions clean up the detritus left behind.
Almost two years after oil prices hit their most recent peak at $107 a barrel, most analysts believe the worst is over. Prices for West Texas Intermediate bottomed at $26 in February, and lately they’ve been hovering around $45. We could see $60 oil by year’s end.
The price collapse has devastated the global industry, with 350,000 people laid off, $1 trillion in capital spending cut, and trillions more lost to bankruptcies and collapsing stock, bond and real estate prices. Those losses have hobbled the oil and gas sector, turning it into a zombie with just enough revenue to stay afloat but too much debt to recover.
Luckily, a reckoning is beginning.
Big banks have cut $6.3 billion from oil company credit lines, shrinking them an average of 18 percent, according to data compiled by Bloomberg. With bond payments coming, 72 oil and gas companies have filed for bankruptcy since 2014, with 20 filing for Chapter 11 protection in March and April alone.
Mergers and acquisitions, though, have been the missing piece, and I’m not talking about the monopolistic Halliburton and Baker Hughes kind of deal. Healthy companies buying distressed companies to develop the best fields is how the industry normally culls the herd, and that hasn’t happened as expected.
M&Aactivity is down 40 percent from 2014, when deal activity and oil prices peaked, according to our colleagues at The Texas Lawbook. Dealmaking was down 8 percent in the first quarter of 2016 compared with the same period last year, the group reported, citing data provided by research firm Mergermarket.
The problem has been the huge distance between what sellers want and how much
buyers were willing to pay with prices swinging wildly. An independent exploration and production company’s main asset is the value of its proven reserves, which is subject to the spot price of oil and gas, except for the barrels already sold using valuable futures contracts.
“I think it’s hard for sellers to overcome the psychology of selling at a price that is below their expectation for the future,” said Brent Ross, a principal in the energy practice at A.T. Kearney, a management consulting firm.
Buyers during a bust want low prices so they can profit when prices rise, while sellers want something closer to the most recent peak. Oil executives have held out by living off futures contracts, cutting expenses and delaying debt payments.
After two years, almost all of the futures contracts have rolled off. That’s why many are excited that prices are up 70 percent since February.
“If we see a continued run-up, or strength around the current price level in the mid- to high $40s, you’ll see people trying to put deals together again,” Ross told me. “We have a lot of distressed companies in the marketplace, and once they feel they are not going to sell at a loss, they are going to rush to get deals done to avoid bankruptcy.”
The problem is finding enough buyers. Inter- national oil companies are selling off assets, and national oil companies are under pressure to save. That leaves only strong independents and private equity.
M&Aattorney Jim Rice, co-managing partner of Sidley Austin’s Houston office, said his clients believe “2016 looks like it is going to be the acquisition opportunity of a lifetime.”
“There is a belief that the second half will see the pace of deal closings ramp up significantly,” he said. “In the vast majority of cases, the buyers are private equity, hedge funds and the like. This could mean that the seeds are being sown for some potentially exciting times over the next few years as the new owners exit or monetize these investments.”
These buyers will be the zombie killers, or the predators that eat the old and feeble, or pick your own metaphor.
Investors who bought when the market peaked in 2014 will suffer major losses. Employees at the worst-run companies will lose their jobs. That’s what happens during mergers and acquisitions, but it’s the best way to clean up the bad debt and establish realistic valuations to move forward.
Most importantly, though, the pain caused by the bust presents a teachable moment for the industry and its investors as they rebuild. They can no longer rely on OPEC to prop up prices. Instead, the world’s largest producers have become competitors trying to supply the cheapest barrel possible and fundamentally changing the oil markets.
Surviving companies will have to focus on pumping the cheapest possible barrel, using the lowest-cost technology and tapping only the best reservoirs. The days of indiscriminate borrowing and drilling are over.
Just as it took six months for oil companies to feel the price collapse, it will take at least as long for them to benefit from the recovery.
The market may have bottomed, but the healing is just beginning.