How We'll Profit from Oil's M&A Cycle

The continuing swoon in crude oil prices, combined with a rapidly advancing crunch in energy debt, has once again ushered in expectations of a merger and acquisition (M&A) cycle among oil companies.

The first indication that such a cycle is underway came a week ago... in Australia.

One of that country's leading oil producers proposed a merger with another in what would be one of the largest energy M&A deals ever seen "Down Under." Woodside Petroleum Ltd. (OTCMKTS ADR: WOPEY) announced an all-stock deal valued at more than $8 billion ($11.64 billion AUD) for Oil Search Ltd. (OTCMKTS ADR: OISHY). The merger would create one of the dominant players in the Australian market. Oil Search initially rebuffed Woodside's offer but talks continue.

Before the dust settles, we are going to be seeing a lot more of these moves. So far, interest has centered on the American oil sector. But the Woodside-Oil Search development makes it abundantly clear that the next M&A wave is going to have a far more expansive impact.

Here's what that means for the oil industry... and how we'll profit from it...

Why the Oil Industry Is Consolidating

oil cycleNow, this M&A wave should hardly catch us by surprise. After all, we've amply discussed this topic in past issues of Oil & Energy Investor. Through the first week of this month, the global dollar amount of deals reached $321 billion, a total that eclipses the previous record of $228 billion set for the entire year of 2010 and more than twice the amount during the same period in 2014.

The huge Royal Dutch Shell Plc. (NYSE ADR: RDS.A) move on British giant BG Group Plc. (OTCMKTS ADR: BRGYY), along with the Halliburton Co. (NYSE: HAL) acquisition of Baker Hughes Inc. (NYSE: BHI), certainly grabbed the headlines.

Of the total, the bulk has been in the United States, with almost half of the dollar amount thus far this year centered there.

For some, the current climate is reminiscent of the 1990s, when huge mergers occurred putting together the likes of BP Plc. (NYSE ADR: BP), Arco and Amoco, Chevron Corp. (NYSE: CVX) and Texaco, Exxon and Mobil.

But this time, it is going to be the total volume of smaller deals that will provide the real texture of this unfolding shakeout. It has all the earmarks of one of those sector-changing events that only hits every other decade or so.

That does make it more difficult for "asset shoppers" to decide what to buy, since it requires a greater sophistication in reading the smaller imprints of companies that tend to operate only in certain locales or basins. Nonetheless, many billions of dollars have been assembled by hedge funds and similar players in anticipation of a fire-sale mentality building up. They are just not quite comfortable moving beyond the main deals.

In the United States, for example, anything much below the $3.7 billion acquisition of Rosetta Stone Inc. (NYSE: RST) by Noble Energy Inc. (NYSE: NBL) is a difficult read for analysts with experience largely in other market segments.

The problem often comes down to understanding the rationale in advance of the M&A market move.

For some, such as Woodside or Shell, the decision has been to grow larger in an attempt to wrestle enhanced market position. Shell, for example, fully intends to challenge Exxon Mobil Corp. (NYSE: XOM) as the largest non-state-held oil and gas producer in the world.

For Halliburton, on the other hand, the acquisition of rival Baker Hughes is the latest indication that vertical integration is continuing in the oilfield services (OFS) space. There, Halliburton and Schlumberger Ltd. (NYSE: SLB) continue to compete in parallel attempts at stringing together components spanning from equipment manufacturers, to rig providers, to well completion, and field services in "one-stop shopping" assemblages intended to restrict competition in all but the most specialized of OFS provisions.

The specific objective of an M&A, therefore, may vary from deal to deal, but the overall goal remains the same: to streamline participation in advance of sector stabilization and the inevitable rise in raw material prices. That still makes for difficult handicapping for those not versed in the oil patch.

Why the M&A Cycle Is Strongest in the United States

Through all of what is unfolding, there is one overriding factor that dwarfs all others, and it is one that is animating the quickly developing situation in the United States.

Most operating companies, especially smaller ones, have been cash poor for some time now. Put simply, this means they bring in less revenue from the sale of production than it costs to run E&P (exploration and production).

In a market where prices are regularly in excess of $65 a barrel, this is of little consequence. Companies can simply roll over debt and reserve cash on hand for other purposes (e.g., stock buy backs, dividends, warrants, and options).

However, with oil prices hard-pressed to stay above $40 a barrel, this financing tactic is simply not viable now. Companies in distress can't afford the interest being carried on new debt, even if they can find it. Energy debt occupies the top stratum of "high-yield" issuances (better, and less affectionately, known as "junk bonds").

As the price of oil remains inordinately low, the interest charged increases. Companies are forced to sell (or acquire) debt while providing a significant discount in proceeds at exorbitant yields. As we move into the final quarter of the year, there is no company in this situation I am aware of that is able to run debt at less than 14%... if they can find it.

Assuming there is no meteoric increase in crude oil prices over the very short term, the hammer is about to fall - and it will fall hard.

That's because before the end of October, banks will be adjusting their loan portfolios, and they won't look kindly on the diminished revenue and asset value of oil companies. As the weakness inherent in energy debt becomes more pronounced, fewer companies will be able to prolong the agony, and one of three results will take place.

First, some oil companies will begin selling attractive assets (e.g., producing wells, drilling leases, and infrastructure) to avoid default.

Or, second, they will simply go belly up in bankruptcy.

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The third alternative, of most interest to us, will be the oil companies that manage to solicit (or attract) M&A interest from bigger fish.

It is this final category that will occasion nice opportunities for retail investors, as the values of such companies increase in tandem with their status as M&A targets.

In fact, I'm assembling a watch list to pinpoint these profit opportunities, with the companies that, due to having good assets in cheap and reliable oil plays, will be the prime acquisition targets in this M&A cycle.

So stay tuned. This is going to get real interesting.

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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