M&A Activity Set To Explode In The Energy Sector: Here's How To Play It

by: The Independent Investor

We all knew Europe was bad, but this bad? As various U.S. and European Banks disclosed their profits in their investment banking divisions after the fourth quarter, it has becoming increasingly clear that Europe has continued to be a dead zone when it comes to mergers and acquisitions.

Most in the financial community presumed that European credit issues would likely hamper near-term growth prospects and limit public sector spending. Still, the fact that mergers and acquisitions came in at a seven year low was worth noting.

We all knew Europe was weak. Still, the fact that companies that do a lot of work in the merger and acquisition field in Europe, like Citigroup (NYSE:C), missed earnings estimates is alarming. While most of the major European markets have lagged the S&P 500 (NYSEARCA:SPY) by a fairly wide margin even during the recent rally, the total lack of current or even planned buyouts in Europe caught many in the financial community by surprise.

Goldman (NYSE:GS), Bank of America (NYSE:BAC) and Lazard (NYSE:LAZ), also reported similarly horrendous numbers within their European investment banking divisions. While the consumer spending numbers reported by a few companies like Apple (NASDAQ:AAPL), were fairly strong in the eurozone, individuals and companies dependent on European banks for credit continue to experience extreme levels of difficulty in accessing the capital markets.

This is why I found it so interesting to hear the recently optimistic comments of executives who work in the merger and acquisition field in Europe when they discussed the near-term prospects for increased buyouts in the eurozone this year.

Just a couple days ago, analysts at Nomura talked very bullish about the likely pick up in merger and acquisition activity in Europe later this year. Several major European hedge funds are also beginning to talk about significant increases in merger and acquisition activity in the eurozone this year as well.

One area where merger and acquisition activity has been fairly nonexistent for the last several years is in the energy sector. While the uncertain economic outlook and credit crunch in Europe have made corporate acquisitions difficult, the regulatory uncertainty stemming from the BP spill only worsened the environment for takeovers in this sector. Revolutions in Egypt and Libya didn't likely increase the risk appetite of most energy companies looking to make major acquisitions either.

Obviously, exploration and production by oil companies is done all around the world. Still, with the future of massive deepwater projects in the gulf in doubt, many oil companies likely wanted to to see how legal and regulatory developments surrounding the BP spill would unfold.

Today the oil and gas sector is ripe for takeouts. While new oil fields are increasingly difficult and expensive to find, the oil production numbers of mid-majors like Apache (NYSE:APA), EOG Resources (NYSE:EOG) and Marathon Oil (NYSE:MRO), are far superior to that of the majors. The mid-majors also generally have market capitilazations that are less than 10% of the largest companies in the industry like Chevron (NYSE:CVX) and Exxon-Mobil (NYSE:XOM).

Chevron and Exxon also have enormous cash surpluses with the potential to borrow at historically low rates. These companies are having an increasingly difficult and expensive time simply replacing their existing oil reserves. Exxon recently reported just a 1% rise in gas and oi production for the whole year. Chevron actually reported a drop in oil production for the year of nearly 5%.

So, with capital available at historically cheap levels, the majors having huge cash, and the largest and strongest oil companies having trouble simply replacing new reserves, what are the likely targets?

I think the most likely targets of the oil majors will be the companies with the strongest production numbers that are positioned in a different oil field than they are. Three companies that have significantly above average production growth and market caps below $40 billion are Marathon Oil, Apache and EOG Resources (EOG).

Marathon Oil is probably the strongest likely target of the three since the company has a unique and strong position in highly sought after oil fields in West Africa and Libya, where oil is mostly the more sought after sweet crude, and extraction costs are lower since oil in this region tends to be closer to be on land and close to the surface. Marathon also trades at just 7.5x an average estimate of next years likely earnings, and has a market cap of just $22 billion. Marathon is also well positioned in the Oil Sands and Bakken and Eagle Ford Shale.

To conclude, while merger and acquisition activity hit a perfect storm in the energy sector with credit issues in Europe, and regulatory as well as legal issues stemming from the BP spill, oil prices are high and economies around the world continue to recover. Also, now that BP has reached a civil settlement with most plaintiffs, a likely settlement with the Gulf States and federal government is likely near as well.

While this sector has seen few buyouts over the last couple years, the prospect for the oil major of diminishing reserves and historically cheap capital could change fairly quickly if inflationary pressures force central bankers' hands early. With the prospect of a possible rate raise by the Fed now seemingly likely to occur sooner than some thought even a year ago, oil companies are unlikely to see a better environment for buyouts for some time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.