In 2011, we saw signs of renewed activity in mergers and acquisitions (M&A) among energy companies. This was especially noticeable with oil, gas, and midstream providers.
Still, what happened last year is nothing compared to what is coming in 2012…
And this is what I want to talk about today, because it will dictate how we oil and energy investors approach the market.
You see, as crude oil prices rise in both New York and London trading, and natural gas pricing remains stagnant (due to a continuing oversupply and unusually warm temperatures), the dynamics of the M&A activity will play out differently than they have in the past.
Understanding how and why is always the challenge, and I'm here to explain them both.
Renewable Sources Continue to Struggle
The combination of a collapse in lithium prices, supply quite in excess of demand, and the end or delay of government subsidies and project commitments on both sides of the Atlantic has suppressed solar prospects.
Meanwhile, biofuels are also feeling the pinch from the end of the U.S. ethanol subsidies and the ongoing lack of a genuine breakthrough in alternative sourcing.
Now, there are still advances taking place in the newest energy sectors, but the anticipated demand increase simply has not materialized. Most of these opportunities are becoming more difficult as genuine investment prospects, given the lack of ongoing state support.
With the exception of a few market drivers in solar, wind, and geothermal – where the emphasis is rapidly moving to Chinese companies – this is not likely to be a year of significant M&A, beyond what's necessary to stave off the disappearance of companies altogether.
On the other hand, both oil and gas producing companies will find a significant new round of activity.
And this is where we stand to profit if we understand who the main beneficiaries will be over the next 12 months.
Three Features of the Big Winners
The first is a well-focused approach on tested bases for production.
In short, those companies most likely to be primary M&A targets will have been successful in particular basins and fields in specific regions of North America, Africa, and South America.
U.S. and Canadian candidates are the most obvious ones initially.
But remember that the primary increase in global oil demand is not coming from the developed countries of North America and Western Europe (the OECD nations).
OPEC and Russia may lead the world's production index, but, in these regions, state companies control the main production, with significant legal and regulatory limitations on foreign investment.
The non-North American oil opportunities will center on areas where production is cheapest and demand is intensifying.
However, the main opportunities to profit from M&A will still be in the U.S. and Canadian markets.
Second, the most desirable companies have both documented sustainable production underway and prospects for additional field expansion. These tend to be recording good flow rates at contiguous wells with infrastructure in place.
Third, the most intangible of these factors – but the one in my estimation viewed with greatest interest by prospective movers – is sound management.
Some of what goes into "sound management" results from a good balance between debt and operational coats, on the one hand, and revenue generation, on the other.
Good management is also able to utilize its volume flow, rather than resort to frequent issuances of stock. This is best accomplished by sticking to what they know best: familiar regions, crude oil types, and markets.
On average, we will once again find that small companies that satisfy these criteria tend to produce higher return for investors than larger vertically integrated oil companies (VIOCs).
Aggregate production costs will continue to rise in the development of greenfields (new fields). This results from extractions coming from smaller fields, inferior grades of crude, geological and pressure problems, along with a range of expensive infrastructure, delivery, and processing requirements.
The bigger boys, therefore, will rely upon buttressing their book reserves by snapping up those of smaller companies. Remember, reserve totals, not current production, determine the relative value of a company's shares.
Natural Gas Is a Different Story
In the natural gas sector, the decided transfer of interest from traditional freestanding gas deposits to unconventional shale basins has transformed the M&A market.
This transition has placed a premium on acquiring companies that have both the expertise in horizontal drilling/fracking, as well as ones that control fields under production.
Often behemoths in the sector are orchestrating this M&A activity. For example, ExxonMobil (NYSE: XOM), the world's biggest private oil company, acquired XTO for these reasons. The company is now the largest U.S. gas producer.
It's true that the current oversupply of gas in the North American market is restraining price, but that is unlikely to lessen the M&A drive.
For one thing, demand will increase as natural gas replaces both coal in electricity generation and oil as a feeder stock for a range of petrochemicals.
The movement to natural gas as a main transport fuel will only boost that demand further.
However, there is yet another development certain to increase demand. This year will register a significant increase in the transport of liquefied natural gas (LNG), with the curve expanding even more appreciably by 2014.
The result will find well-placed companies and equity-issuing partnerships in the LNG chain (terminals, processing facilities, feeder pipelines, storage, and LNG tanker traffic) becoming primary acquisition targets. We will see both an expansion of main players within the LNG sector and cross-M&A activities as new types of VIOCs develop.
And that leads me to the most exciting M&A topic of all.
As oil prices rise and the diversification of gas usages expands, the position of midstream providers will only become more attractive.
The market will produce a rising number of pipeline, processing, gathering, and storage facilities mergers, with the position of Master Limited Partnerships (MLPs) and the equity issuances from them, becoming even more decisive.
Another related element will emerge in the use of oil and gas production trusts as an intensifying source of both capital appreciation and substantial dividends. Trusts and MLPs will continue to lead the energy sector in providing shares with annualized dividends that are significantly higher than market averages.
In the process, there will be increasing M&A activity among MLP assets and the creation of additional trusts to control proceeds from drilling.
This is going to be one interesting and profitable year throughout the energy sector.