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KPMG Paper, Will High Oil Prices Impact Energy Deals?
Posted: 15 December 2004
High oil prices have already trimmed about three-quarters of a percentage point off economic growth in 2004, according to a speech given by Federal Reserve Chairman Alan Greenspan. However, one economic sector has seen substantial growth as a result of increasing oil prices—those involved in M&A. While the major integrated players have largely been selling off assets, the “independents” have been extremely active buyers. And private equity investors have takenon the role of both buyer and seller.
The large “independents” appear to be the primary buyers
Frequently, when asset prices are high, there is a limited amount of M&A activity. But this year, there has been “a massive acceleration in deals driven by high oil and gas prices,” according to Phil Pace, an oil and gas analyst at Credit Suisse First Boston. He says that the market isbeing fueled by a large number of sellers and buyers. In the first half of the year, energy related M&A activity in the U.S. and Canada totaled $17.8 billion, approaching the value of all North American deals announced in 2003. At least one industry expert believes that oil prices are likely to remain high. Boone Pickens, CEO of BP Capital, an energy-oriented investment firm that manages separate commodity and equity funds says that, “the new pricing structure will be around for awhile, especially with China coming on line. I think you are going to see oil at $60 a barrel before you see it at $40.” Timothy Murray, an executive vice president, and manager of the energy group at Wells Fargo says that he believes that the positive M&A trend is also likely to continue, at least in the short term. The seven largest Western oil companies are expected to generate $71.3 billion in free cash flow in 2004, according to The Wall Street Journal. However, most of the majors have been using their excess cash for stock buy backs and dividend payments and have been divesting legacy assets in an attempt to rationalize their portfolios. Tony Bohnert of KPMG says that “although the major integrated oil companies are enjoying record profits, the current deal environment is less than ideal for these large strategic buyers. Acquisition prices are high and the deals that are attractive to the independents will not have a significant enough impact on the bottom line for the majors.” At the same time, the large independents have been using their plentiful free cash flows to buy reserves, in some cases picking up assets from the major players. For example, XTO Energy announced plans in May to buy $1.5 billion of oil and gas assets from ExxonMobil and ChevronTexaco. And in May, Pioneer Natural Resources, an exploration and production company, agreed to buy Evergreen Resources for $2.1 billion. KPMG’s Truc To says that “an asset may be more appealing to an independent than to a major because an independent may be able to focus more attention on a previously neglected asset and better manage profits with a lower cost structure. This is especially true if the asset is contiguous or has a similar reservoir profile to that of the independent.” In addition, a several billion dollar deal—something insignificant to a major—may increase an independent’s portfolio by a significant percentage. In addition, some private equity firms are taking advantage of the current high asset prices to monetize their investments. For example, in June, Chesapeake Energy purchased Greystone Petroleum for $425 million, a company backed by private equity investors. After selling out, these private equity firms frequently re-invest with the same management teams and start looking for new energy properties, according to Wells Fargo’s Murray , turning these firms into buyers, as well as sellers. Pickens says that “there is a tremendous amount of oil in the tar sands of Canada and with oil prices having moved over $50 a barrel this year, a lot of private equity guys might start to focus on that part of the world.” In addition to high prices and an abundance of sellers, Cameron O. Smith, senior managing director of Cosco Capital Management, a financial adviser to the energy industry expects the M&A market to continue to be active for other reasons. Hedging strategies have created an atmosphere where buyers may be able to lock in substantial profit margins for several years, he says. In addition, low interest rates and a favorable capital market have created a positive deal environment. Indeed, even though some public companies may believe that their stock prices are still under-valued based on the commodity’s futures prices, many of them have the option of financing deals with cash or readily available debt.
Regulatory issues may also be putting a damper on mergers among the majors
Some industry analysts also believe that regulators would be less than enthusiastic if the majors went on a substantial shopping spree while gasoline prices remained high, according to KPMG’s Drew Koecher. It’s not clear if the mega-mergers of the last decade, or general merger activity has had any affect on gasoline prices. However, this summer, the General Accounting Office (GAO) and the Federal Trade Commission (FTC) issued competing reports on the topic. The GAO report states “mergers could result in greater market power for the merged companies, potentially allowing them to increase prices above competitive levels.” The GAO report concludes that mergers may have raised gas prices by as much as seven cents a gallon in some states. The FTC, which is responsible for reviewing anti-competitive affects before a merger takes place, concludes in its report that “most sectors of the petroleum industry at the national, regional or state level generally remain moderately unconcentrated,” and concludes that “mergers of private oil companies have not significantly affected worldwide concentration in crude oil. This fact is important, because crude oil prices are the chief determinant of gasoline prices”. What does this regulatory environment mean for companies contemplating merger activity? Bill Vigdor, a former FTC Commissioner who specialized in oil and gas mergers and is currently a partner with the law firm of Vinson & Elkins, says that he does not believe that merger activity has had a significant impact on gasoline prices. That being said, gasoline prices are a political issue that may have a significant impact on inflation. He says that “it is therefore likely that Congress will be carefully monitoring the FTC’s review of oil and gas deals. While it is unlikely there will not be a material affect on the regulatory standard used and that the same types of deals will be approved, the review process may take an extra two or three months.”
Conclusion
It is impossible to predict how oil prices will move in the next year. However, with prices at their current levels, it is likely that M&A activity in the oil and gas industry will remain robust since theses deals continue to offer profitable options for both buyers and sellers.
Paul Callaghan is a Senior Manager with KPMG Oman involved with providing audit, tax and transaction services to oil & gas clients.. Any opinions in this article, unless quotes from other parties, are his and not those of KPMG
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