Slow, incremental recovery expected as players consolidate and insolvencies take their toll
The COVID-19 pandemic is expected to result in a wave of M&A transactions as the oil and gas industry consolidates to achieve greater efficiencies and stronger balance sheets, says Stikeman Elliott LLP partner Ben Hudy, with much of this consolidation to be affected through insolvency proceedings.
“While 2020 was a brutal year for the oil and gas industry in Canada, there is reason for optimism on M&A in 2021,” says Calgary-based Hudy. Stikeman recently released a report on the sector saying prospects will improve following the pandemic's negative impacts and the OPEC price war that kicked off before the pandemic even started.
The report notes that Canada is one of the few jurisdictions in the world that opens its oil and gas resources to domestic and foreign investment. It also has the third-largest crude reserves globally — 171 billion barrels, of which 166 billion are in the oil sands — and is the fourth-largest oil producer and the fifth-largest natural gas producer.
Hudy acknowledges that there are still challenges ahead, despite the price of oil being near 10-month highs and Saudi Arabia’s decision to cut an additional one million barrels per day in February and March. Still, he expects a “slow, incremental recovery of the sector,” which could play out in several ways for Canadian oil and gas M&A.
One of the first things we should expect in 2021 is “consolidation M&A,” Hudy says, where larger, better-capitalized companies are looking for growth and would prefer to grow through acquisition rather than drilling. Instead of looking at future potential and buying reserves not yet proven, these companies will be looking for acquisition targets that can be purchased at a discount and provide “immediate bottom-line returns.”
Mergers and acquisitions through insolvency procedures will be another feature of 2021, Hudy says, and will be particularly prevalent among junior and intermediate oil and gas plays, which are having a tougher time these days. “There might be some smaller, liquids-rich plays, or light-oil plays that can be extracted quickly, who won’t get into as much trouble,” but for others, it will be insolvency.
“Insolvencies are always a structure of last resort,” Hudy says, noting that, by definition, shareholders are getting zero out of the transaction. No one chooses to go into insolvency, he adds. “But when you’ve concluded that you’ve hit the end of the line, you can’t attract capital, and your bank is sick and tired of you and won’t relax lending covenants, insolvency becomes inevitable.”
Another aspect of M&A in the oil and gas sector is “green” targets attracting conventional oil and gas companies' interest. “This greening of the sector is happening because investors are demanding it, and governments are requiring it,” Hudy says. Companies that have cut capital spending and earmarked much of what they have left towards targeted green assets, Hudy adds, pointing out Suncor, CNRL, and Whitecap Resources have all made investments in the green sector, such as carbon capture and sequestration.
As for buyers of oil and gas assets, Hudy says we will likely see more private equity activity as they start to feel comfortable with the market during COVID-19 and beyond. PE will also look to consolidate within their existing portfolio companies. Also, PE money that was once earmarked for Canada but was going to the U.S. might end up returning to Canada as PE looks to diversify from a U.S. market that might be impacted by a Democrat-dominated government with a green agenda.
Pension fund money will also become more active in the sector, Hudy says, especially in areas such as midstream, processing and pipeline facilities. Along with PE, pension money looking for exposure to oil and gas sees midstream and pipeline assets as more predictable thanks to fixed contractual commitments.
Oil and gas companies have also looked to spin out midstream assets because investors do not fully recognize their value when part of the parent company. A good example of this is Calgary-based Topaz Energy Corp., a subsidiary of Tourmaline Oil Corp. that was spun out publicly for proceeds of more than $200 million.
As for making deals while COVID-19 is still a factor, Hudy says one of the bigger challenges is getting large groups of people to gather virtually rather than in person. And conducting sensitive conversations, such as go-forward plans for management, is much harder when done over Zoom or Microsoft Teams. “The topics that are personal and emotional are easier to address across the boardroom table.”
Site visits are also more difficult, but in most cases, the assets are outside, Hudy says, so the bigger issue is travelling to the site. Technologies such as drones are also being used.
Still, in most cases, solutions have been found to these challenges as the pandemic continues, as some may likely stay after it is over, Hudy says.
Another challenge is psychological — trying to narrow the gap between the minds of buyers and sellers. Hudy says buyers are keen to make deals at current valuations. Still, sellers are having difficulty accepting current prices when they think of the frothy markets of a few years ago and feel their assets aren’t being fully valued.
To help bridge the gap, Hudy says there are “tools in the toolbox” that can be used as lawyers look to reduce risk while finding ways to make a deal happen.
For example, stock-for stock deals will likely be more common because the seller will be getting shares in the acquiring company. As for buyers, they are guarding their cash and balance sheets, and stock-for-stock deals are a good solution.
Earnouts and future contingency payments based on performance are other tools that can bridge the buyer and seller's valuations.
Hudy notes that while M&A activity will improve in 2021, deals likely won’t receive the same bubbly response as they once did, thanks to the pandemic's social distancing aspects. “The days of closing night dinners are gone — for now."