If you’ve been keeping an eye on oil and gas markets, you know there was a significant drop in oil prices in 2014, starting in June of that year. No news there. From a 3 ½ year average of $110 per barrel, prices fell steadily, hitting a low of $29 in 2016.
This had wide-ranging repercussions, of course. But let’s focus here on how investors reacted.
For starters, Master Limited Partnerships, which had been a favored investment for more than two decades and had benefited from the Shale Revolution, were hit hard, with many going bankrupt or facing restructuring.
The fall of MLPs set the stage for opportunity. And, from 2014 onward, Private Equity filled in the gaps and has made increasing investments in this sector as the downturn continued.
What happened to MLPs, which were the structure historically used by “midstream” companies that transport and store oil and gas? Even as oil prices rise, they haven’t regained their popularity.
The most recent tax reform bill reduced some of the tax advantages they had over corporations, for one. Then rising interest rates made other investments more attractive.
Fast forward to present day and MLP’s loss is PE’s gain as the price of oil increases. Since the bust, PE firms have been investing in smaller acquisitions through portfolio companies and snapping up acreage at discounts during the oil bust. And now they’re getting ready to cash in.
There are some obstacles in the form of a slow-down in M&A in the energy sector in the last year or so.
Factors in the M&A Slowdown
- Mid-term election results put many deals “on hold” to see what direction the government would be taking.
- Currently, there are fewer Buyers in the sector. Only the “super majors” (like Chevron, Royal Dutch Shell, etc.) are active players.
- Less drilling has been done as current sources are meeting demand.
- In the last six months of 2018, oil prices fell from $70 USbbl to $50 USbbl, bringing down revenues and valuations.
But, inevitably, these conditions are changing. The energy market, especially oil and gas, are irrepressibly cyclical in nature. So, while M&A activity has been slow recently, there are numerous signs of an increase in the coming year:
- The U.S. has become a net exporter of energy. So, while domestic demand may be steady, global demand from a more competitive U.S. supplier is sure to increase.
- In addition to energy, the need for developing infrastructure, such as pipelines and export facilities, is expanding. In Texas alone, projects are in the works for more than $40B to be spent to build or expand almost 10,000 miles of pipelines – enough to stretch from Texas to China.
- Since 2015, large sums of money have been raised in this sector and “capital can’t sit on the sideline,” as they say. So, expect the return of middle market buyers flush with cash to actively take advantage of targets whose value has been discounted with the drop in oil prices.
Where Will the “M&A Rally” Come From?
Look for Private Equity to lead the charge in M&A in the energy space for two reasons.
1. All the dry powder. Investors don’t want to sit on the money; they want to invest and make it work for them.
2. The availability of companies for sale at bargain prices due to the downturn.
While opportunities abound, the scale of capital required compels players to use caution.
Here’s what you need before engaging in any Mergers and Acquisitions in the energy industry:
You need the right advisors. You must have an investment banker with experience in energy and an M&A lawyer experienced in doing your type of deal. Don’t be scared of high fees from these experts – it’s worth it because they know the network and the relatively small energy M&A community.
It’s unlike other industries in that, because of the hundreds of millions used in capital projects, one little “mistake” could cost millions. The energy industry has its own language and legal/regulatory requirements. It’s complicated. Savvy Buyers seek expert help when conducting due diligence on potential acquisitions and during the transaction.
But it doesn’t hurt to have some extra protection for peace of mind.
This is why Representations and Warranty (R&W) insurance is essential to cover deals in this industry and is increasingly used.
An R&W policy removes the risk from the transaction from either Buyer or Seller and shifts it to a third party – the insurance company, who pays out if there are any breaches post-closing.
When Private Equity is on the sell side, they want a clean exit and the ability to distribute the proceeds to their investors quickly. R&W coverage accomplishes that by ensuring less money is held in escrow. And M&A is a great way to reduce risk and get a clean exit with no worry about clawback. Not to mention, it makes for much smoother, less contentious negotiations.
My recent podcast interview with Jimmy Vallee, partner in the M&A and Energy practices at the Houston office of law firm Paul Hastings, was invaluable in gauging where the energy sector is today and where it’s going – and why.
You can get more details here: http://www.paulhastings.com/home.