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Oil and gas capital confidence barometer: Part two

Hydrocarbon Engineering,

According to EY, the appetite to execute deals is cautiously growing, and deal pipelines are set to expand further. M&A activity is about to reach pre-crisis levels. Transformative M&A will continue; however, the strongest growth in M&A activity in the coming year will be middle market momentum as companies strengthen their core businesses.

An improving view of the resilience of the global economy, strong equity markets and enhanced corporate earnings have helped boost the outlook for M&A among oil and gas respondents. But their optimism is a cautious one, given that the strength of the optimism has declined over the past year. While 2014 has been notable for several high profile megadeals, overall oil and gas deal activity has been disappointing. However, the Barometer suggests that middle-market M&A will provide a significant lift to deal activity.

More than half of all oil and gas respondents expect deal volume to increase further in the next 12 months, again somewhat less so compared to the previous two Barometers. Importantly, the number of respondents anticipating deterioration in the M&A environment is now negligible. North American-based assets have dominated activity in recent years, and are expected to continue to do so next year.

Oil and gas companies’ appetite to do M&A remains modest and has declined over the last three Barometer surveys, with 25% of oil and gas executives expecting to pursue acquisitions in the next 12 months, down from 30% in the April 2014 survey, and down from 39% in October 2013. As noted earlier, growth has become less of a focus for oil and gas companies, with companies increasingly focusing on cost reduction and operational efficiency.

Dealmaking challenges still persist: just over 40% of oil and gas executives are confident about the likelihood of closing acquisitions. This may be because of increasing rigour in the search for strategically aligned assets, more thorough due diligence or greater competition. More than half of all oil and gas executives are however, confident in the quality and number of acquisitions that are available.

Middle market growth

Oil and gas professionals expect that core and bolt-on acquisitions will drive middle-market growth.

EY’s previous Oil and Gas Capital Conference Barometer correctly predicted the rise of multibillion dollar deals in 2014. These megadeals are having a significant ripple effect on the M&A market. They increase confidence in M&A and trigger transaction activity further down the deal chain.

Even with the restrained appetite to acquire, EY now expects to see a new wave of M&A with much more focus on mid-market-sized deals. This new middle-market momentum should lift M&A activity as companies seek to strengthen – and expand – their core business. The oil and gas climate continues to remain favourable for large acquisitions as well, but the growth of M&A should be defined by the major shift in focus among respondents looking to do deals valued at US$ 250 million and under. The upper end of the M&A market should continue to see some megadeals, but a formerly subdued middle market can now be expected to vigorously enter the fray. The net result should be a far more buoyant deal market than we have seen for the past five years.

The majority of oil and gas companies are focusing on acquiring businesses in their core sectors, with an eye to boosting market share, managing costs and improving margin growth. As cost efficiencies are paramount, for the vast majority, planned M&A activity will consist of bolt-on acquisitions that will complement their current business model.

The increasing influence of shareholder activism is helping to ensure that cost management remains a critical component of organic and inorganic growth strategies. Half of respondents say that cost reduction has been elevated on the boardroom agenda as a result of shareholder activists.

Expanding deal pipelines

The number of oil and gas companies that have more than five deals in the pipeline has increased significantly. Renewed discipline in dealmaking is forcing companies to thoroughly examine many more investment opportunities to find the best strategic fit.

A further sign of growing momentum: more than two thirds expect M&A pipelines to expand further over the next year – almost twice the number expecting increases six months ago. This move toward larger pipelines bodes well for a rebound in M&A in the near term – especially in the middle market, where there are more assets for companies to target.

Dealmaking focuses on core business

Oil and gas companies are planning to strengthen and expand the core. They are assessing a range of transaction drivers – but cost efficiencies are paramount. The majority of companies are focusing on acquiring businesses in their core sectors, with an eye to boosting market share, managing costs and improving margin growth. This is strongly aligned to their focus on organic growth plans.

Consequently, for the vast majority of companies, planned M&A activity will consist of bolt-on acquisitions that will complement current business models or be adjacent markets. A third of oil and gas companies plan to make acquisitions that give them access to new technologies or intellectual property.

In the current climate, transformative M&A – high value acquisitions that significantly change the size of the acquirer – and deals that shift the scope of their business look set to continue. More than a third of respondents are considering such transactions. However, middle-market deals look set to drive volume in the M&A market over the coming 12 months.

Stable valuations to enable dealmaking

There is strong consensus among oil and gas survey respondents. More than one half of executives see only a small discrepancy between buyers’ and sellers’ expectations on asset valuations. This, combined with the outlook for stability in the valuation gap and the overall value of assets, will encourage dealmaking in the near term.

The number of respondents that see the current valuation gap as either higher or lower than 25%, which would be difficult to resolve through negotiations, is now down only about 1%.

The more stable outlook for both the valuation gap and price of assets in the next 12 months reinforces the view on stability in macroeconomic conditions and the M&A market. As buyers become more confident in newly acquired assets’ long term value, and sellers no longer hold out for higher prices in the future, volumes should accelerate – especially in the lower middle market, where the valuation gap is most easily bridged.

Debt to fund future dealmaking

According to EY, leverage has declined since the global financial crisis, thanks mainly to increases in equity value. More than 70% of the oil and gas companies in the survey report a debt-to-capital ratio of less than 25%, leaving them well positioned to withstand any near term increase in interest rates.

More than half of oil and gas executives expect their companies’ debt-to-capital ratios to increase over the next 12 months, indicating confidence in credit availability and a willingness to take on more debt to fund growth ambitions. Their willingness to do so has risen sharply over the past year.

As a result, more than half of the oil and gas respondents expect debt to be the company’s main source of financing over the next 12 months.

Pursuing deals across multiple markets

Oil and gas executives see their acquisition and investment focus increasing across a wide array of markets, both developed and emerging. In EY’s survey, oil and gas respondents saw their focus turning slightly more to the emerging BRIC markets than the non-BRIC emerging markets, with the increase in focus on developed markets also less.

Oil and gas executives see political and regulatory risk as the biggest deterrent to making investments in other markets. Concerns over the lack of infrastructure to support growth were also seen as very important, as was slowing economic growth.

Oil and gas executives see their own internal capabilities (or lack thereof) as the biggest challenge to their deal strategy and success. Deal execution and post-deal integration capabilities were seen as the top challenge, while lack of managerial focus on M&A was seen as the second most important challenge. Notably however, as could be implied from the earlier discussion, shareholder activism was also seen as a big challenge.

Despite concerns with internal capabilities affecting prospective dealmaking, oil and gas executives believed that overestimation of strategic value and/or willingness to pay too high of a multiple was the most significant factor that caused recent deals to not live up to expectations.

Adapted from a report by Emma McAleavey.

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