BRYAN FREDERICKSON AND ERIC SWANSON, GULFSTAR GROUP, HOUSTON
THE SENTIMENT around the oil and gas deal-making community seems to be, at long last, one of cautious optimism as we begin 2017. Investors raised billions of dollars early in the downturn seeking to take advantage of the financial distress caused by the dramatic fall in commodity prices, only to discover in many cases that the timing of deployment was premature or that the quality of assets marketed was insufficient to meet investment hurdles.
Second lien financings and secondary purchases of both public and private debt accelerated when WTI pricing appeared to stabilize around $60 per barrel in the spring and early summer of 2015. But within months, many of those investments were already deeply impaired as oil continued its decline to less than $30 per barrel in early 2016. Predictions for a quick recovery repeatedly proved wrong and a wait-and-see attitude permeated the capital markets and merger and acquisition communities.
Many of the catalysts that investors expected to trigger investment opportunities, including mergers and acquisitions, were slow to materialize. Expectations were widespread that senior lenders would force a round of asset divestitures, refinancings, and recapitalizations. Banks, however, proved to be surprisingly patient with their troubled borrowers, recognizing correctly that forcing transactions would only serve to realize paper losses. Borrowing base redeterminations among oil and gas producers were less drastic than anticipated and over-levered companies thus had limited incentive to replace relatively inexpensive senior debt with higher-priced, junior capital or to sell assets at depressed valuations.
In many instances when sellers did test the market, the persistent divergence in the bid-ask spread proved prohibitive to consummating transactions. As an alternative, many companies chose to bolster capital positions through incremental equity. Frequently the public markets rewarded companies that chose to issue equity, even at low levels, to remove capital plan uncertainty during the depressed commodity cycle.
Markets were also supportive of equity offerings in conjunction with transformative acquisition announcements. Well-capitalized buyers frequently chose to pursue high quality assets at potentially premium prices, particularly in the Permian and SCOOP (Southern Central Oklahoma Oil Province) and STACK (Sooner Trend Anadarko Basin Canadian and Kingfisher Counties) regions where large positions are scarce. However, companies with less financial distress did pursue strategies of raising capital and optimizing portfolios by selling smaller, non-core and non-op positions that did not compete for capital in the current environment or exiting midstream and other associated businesses.
PRIVATE CAPITAL OVERHANG PERSISTS
Fueling the imbalance between investment appetite and the supply of sound opportunities was the continued amassing of new investment capital throughout 2016, on top of the remaining dry powder from existing funds. Estimates vary, but at least $25 billion of new capital was raised in 2015 and 2016 and relatively little has found a home.
Fortunately for investors and companies alike, we enter 2017 in an environment where oil prices have successfully tested lower bounds and are in a price range that renders more US production economical. The unanticipated November 30 announcement that OPEC nations agreed to limit oil production by 1.2 MMbpd with an additional 600 Mbpd cut from non-OPEC countries, including Russia by the first half of 2017, sparked an immediate market rally and provided additional cause for optimism and the potential for market rebalancing by mid-2017. However, we will have to wait and see how the execution of these agreements plays out in early 2017. These circumstances are in sharp contrast to the uncertainty and disarray facing companies and markets a year ago with little hope of an OPEC cut on the horizon.
Lenders and investors enter the year more confident in the long-term outlook for companies seeking capital. Expectations for acquisition of deeply distressed companies and assets are not as widespread; rather, there is a trend among investors towards seeking to support growth in the survivors. This includes private equity groups committing hundreds of millions of dollars to seasoned teams of executives pursuing both greenfield initiatives and consolidation strategies. For established businesses, due diligence evaluations are materially simplified. The ability to survive a prolonged downturn is now a matter of record and establishing best and worst case scenarios requires little more than a review of a company's 2013 and 2015 financial statements. Further, bid-ask spreads in merger and acquisition transactions have narrowed considerably as owners accept that valuations established two years ago are no longer relevant.
EXPECTATIONS OF INCREASED PACE OF DEAL-MAKING IN 2017
Many business owners and management teams that are seeking to raise acquisition capital recognize a generational opportunity to go on the offensive through consolidation of market share, especially among smaller, thinly-capitalized competitors. Examples are widespread of recent transactions, commitments and capital raises. Baker Hughes recently announced an agreement to divest the former BJ Services pressure pumping unit to private equity group CSL Energy and West Street Energy Partners to create a pure-play North American land pressure pumping company. In addition to capital contribution, CSL is contributing Allied Energy Services, which provides hydraulic fracturing and cementing services.
Private equity has also stepped in to back existing and startup companies in scale. Blackstone Energy Partners committed $1.0 billion to form Jetta Permian LP to target assets in the Delaware Basin while Oaktree Capital Management and Charger Shale Oil Company LLC formed a $900 million joint venture focused on the Permian Basin. In October 2016, Kayne Anderson announced the closing of its Fund VII with $2.0 billion of LP commitments. Such investor confidence will serve to support continued investment and acquisition activity.
After the IPO market remained dormant for almost two years, service and upstream companies returned to market in late 2016. Investor response was cautiously discerning, yet encouraging. Service and upstream companies such as Smart Sand, Mammoth Energy, and Extraction Oil & Gas accessed the IPO market with other private equity backed companies likely to access the IPO market during the first half of 2017.
Despite the favorable trends, beneficiaries in the near term will remain relatively consolidated. Activity will continue to pick up in the order of basin efficiency. The Permian Basin led the rig count recovery from mid-2016 lows as operators continued to drive efficiency gains. Activity in the SCOOP/STACK has increased along with activity in the natural gas focused regions of the Marcellus, Utica, and Haynesville. Core areas of the Eagle Ford and Bakken will see uplift as well economics improve and producers seek to maintain core leasehold.
Despite the uptick on the near months of the WTI futures curve, the rally was limited as the longer dated futures contracts do not anticipate a return to $60 pricing - at any point. While this may change, industry reaction within the foreseeable future will necessarily involve a continued focus on managing expenses and improving drilling efficiency.
Expense management among operators will continue to place stress upon oilfield services companies and equipment providers. Rate compression and shorter contract duration were a way of life for the last two years as producers sought to renegotiate or enter new contracts at reduced rates. In addition to price concessions, service intensity increased as producers remained focused on optimizing completion techniques and improving well efficiency gains through longer laterals, increased proppant usage and higher frac density. Service companies will be quick to increase prices to return to profitability, potentially at the expense of maintaining market share. Service companies remain poised to ramp up and expand activity.
Well-capitalized industry participants have selectively acquired businesses that fill product offering voids and allow for expansion or new services. While producers have become accustomed to lower rates, the struggle between incumbents seeking to increase profitability may open the door for new entrants with recent equity capital commitments to take share and keep downward price pressure in the market. Operators are also consolidating their vendor lists and seeking to support the viability of key service providers.
The midstream space faced strong headwinds in early 2016 as investor concerns regarding the potential impact of lower commodity prices on the midstream space drove the Alerian MLP index down to levels not seen since 2009, before rallying more than 50% by mid-summer. Questions about future infrastructure investment, distribution growth and the risk of contract renegotiations weighed heavily on investors.
Similar to service company peers, investors became keenly focused on customer credit ratings as one indicator of financial health. For most of the year, capital market access was available only to the strongest names in the space with the IPO market dormant until Noble Midstream Partners LP, backed by Noble Energy, Inc., priced its offering above the filed range in September 2016 after delaying its November 2015 offering. Over the course of 2016, midstream companies diligently focused on reducing costs and bolstering their balance sheets.
As upstream companies finalize their capital budgets for 2017 with a more constructive, yet flat price outlook, optimism is increasing around future infrastructure projects. However, similar to the upstream space, midstream investment is expected to be basin specific. The Permian and SCOOP/STACK will drive growth in the liquids plays while increased drilling activity in the Marcellus/Utica and Haynesville should help drive investment in gas plays.
Based on consensus estimates, midstream EBITDA is expected to grow at a slower rate relative to 2016 levels as growth capex for many companies is expected to decline year over year. Continued consolidation to achieve greater scale or targeted new entry in active basins should help drive M&A activity in 2017, in addition to continued dropdown activity from companies with corporate sponsors.
Investors seeking to maintain exposure to the oil and gas industry while limiting, to the greatest extent possible, commodity price exposure continue to target opportunities in the downstream segment. Much of the activity associated with refineries and petrochemical plants is either mandated by regulation or essential to the ongoing safe operation of the assets. This creates a baseline demand for recurring maintenance and repair services that investors, especially private equity, find attractive. The market for these services continues to expand with ongoing refinery expansion and petrochemical plant construction.
Operating conditions remain challenging for most of the industry's participants. However, a more confident return of capital to the market may be a bellwether that the worst is behind and actionable opportunity exists. Clearly recent capital markets and M&A activity indicate a gradual return of risk appetite largely absent for more than two years. Commodity price stability, improved industry efficiency and the increasing global demand for energy are, in fits and starts, providing much-missed tailwinds heading into 2017.
ABOUT THE AUTHORS
Bryan Frederickson is a managing director at GulfStar Group. He has 19 years of investment banking and corporate finance experience that includes execution of merger and acquisition, financing, venture capital placement, recapitalization and restructuring transactions.
Eric Swanson is a managing director at GulfStar Group. He has more than 17 years of investment banking and corporate finance experience that includes mergers and acquisitions transactions, debt and equity offerings and corporate finance advisory. He joined GulfStar from Morgan Stanley's investment banking group in Houston, where he spent eight years focused on the E&P segment of the oil and gas industry.
