By Brian Tate, Energy & Natural Resources Group Head, Regions Securities LLC and Regions Bank
In 2018, merger and acquisition deals in oil and gas set a four-year high, reaching $82 billion. Volatility in energy prices, however, entered the picture late in the year, creating a ripple effect through the industry and contracting U.S. deal activity into the first quarter of 2019. Regions Securities, which provides advisory, capital markets and capital raising services to corporate clients in energy and natural resources, has been tracking market movements and its potential impacts on industry players.
Oil prices and business activity today
After reaching a four-year high, U.S. deal activity in oil and gas plummeted to a 10-year low, contracting to just $1.6 billion in the first quarter of 2019. In general, in the upstream space, business activity is aided by a stable to rising price environment. In 2017 and in most of 2018, commodity prices were accommodating, generally trending higher while service costs remained low. As a result, companies were able to expand their capital budgets.
Oil prices slipped in late 2018, dropping to the mid-$40s by year-end. Although prices rebounded somewhat in early 2019, they remain challenged. Given these headwinds, companies have had to reassess their capital expenditure programs, and many have had to scale back on their plans in response to the lower price environment. Further, deal activity in the space has been slow to rebound.
Evolving the bottom line
For publicly traded exploration and production companies, the bottom line is more than just about net income or EBITDA. The public markets are increasingly looking for companies to generate positive free cash flow after capital expenditures, as they want to see a demonstrated ability to generate a compelling return on investment for shareholders over time. This public market focus is evergreen, as it applies throughout the business cycle regardless of the direction of commodity prices. The expectation is that an upstream company will scale its capital program according to movements in commodity pricing.
Stability of valuations
As noted, oil prices have rebounded from their 2018 lows, but deals have been slow to return. Pressure may be driven by Wall Street and its desire for companies to deliver free cash flow. Additionally, the equity and debt markets are exhibiting some weakness in terms of available funding for prospective deals. We do however note that the energy sector appears to be in the early stages of producing significant free cash flow which should increase stock buybacks, reduce debt, and has the potential to accelerate deal activity in the quarters ahead.
At Regions, we have served as a leader in the energy and natural resources industries for over 40 years. Our team’s experience operating in various market cycles means we can support clients through market volatility and times of stress. With that in mind, financing has been consistent with broader market activity, with a very active period during most of 2018 and a slower deal pipeline now in 2019. Clients within the Regions portfolio have been cycle-tested and portfolio growth since the downturn has been concentrated on lower risk segments.
Segments to watch
As the industry has pulled back recently, the focus for deal activity has turned to lower risk upstream and midstream segments within the oil and gas space. Midstream companies have outperformed their upstream counterparts in the equity markets for the year-to-date through July 2nd, 2019. For instance, the Alerian U.S. Midstream Energy Index (AMUSX), a broad-based composite of U.S. energy infrastructure companies, is up 14.8% for the period, while the S&P Oil & Gas Exploration & Production Select Industry Index (SPSIOP) is down 4.8% for the same period.
The solid year-to-date performance of the midstream segment is indicative of its relatively stable nature despite a more volatile commodity price environment. Midstream has primarily benefited from rising domestic production. U.S. crude and condensates production rose to a record 12.16 million barrels per day (bpd) in April, an increase of 1.69 million bpd or 16% compared with the same month a year earlier.
While acquisition activity remains down through the 2nd quarter of 2019, Regions is an active lender and advisor to those in need of capital in the oil and gas space. Companies that can create value and actively manage risk are good bets no matter what commodity prices are doing, and we are looking to bank those companies and management teams through the price cycle.
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