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Merger arbitrageurs invested in the Baker Hughes (BHI)/Halliburton (NYSE:HAL) deal spread continued to ride the roller coaster in January. The spread widened again in mid-January to just under $14 per Baker Hughes share, before coming back in to ~$11 level as of the end of last week.
The spread remains extremely wide, indicating that the market is giving the deal at best a 50/50 chance of going through.
A market-neutral arbitrage trade position - depicted by the spread on the graph above - would consist of going short 1.12 HAL shares for every 1 BHI share on the long side (the spread is adjusted for dividend distributions on a looking-back basis). A long position in the spread is a bet that the deal will eventually close.
The significant development on the regulatory review front in January was the announcement by the European Commission for Competition that it would launch the second phase of its investigation into the deal, which could last until late May. The announcement was anticipated. European regulators had indicated competitive concerns related to more than 30 product and service lines, which suggests that the review will be intense and eventual approval should not be taken for granted.
The lack of news on the divestiture front does not add much confidence in the deal's success either. Halliburton has been running sales processes for large asset packages for many months now. However, no announcements have been made to this point.
While the announcement by the European Commission is the most obvious factor driving the recent spike of skepticism with regard to the deal's outcome, the deterioration of oil price environment may be another contributing factor.
With the commodity prices setting new lows in December and January and the outlook for 2016 being uninspiring, it is possible that the market is anticipating that regulatory authorities will take an even stricter view on the deal's potential impact on the industry's competitive landscape as a result.
On one hand, one might argue, lower commodity prices have created significant spare capacity in the industry, reducing the deal's impact on pricing in the immediate term.
However, there is another angle that regulators may have to take in consideration, given that the cyclical trough is proving to be more extended than anyone could expect. Regulators cannot be unconcerned that under a "much lower for much longer" scenario, the number of viable industry competitors may be materially reduced. It would be logical to expect, therefore, that regulators will be increasingly looking at the combination not only in the context of the current competitive lay of the land in the oil service industry, but also on a "pro forma for attrition and consolidation" basis, looking few years ahead under a variety of scenarios.
Regulators would need to take into consideration not only the large number of smaller industry participants that may be forced to close up shops in the next few years, but also larger participants who will be handicapped as competitors due to their distressed balance sheets. Weatherford International's (NYSE:WFT) challenges and ultimate decision several months ago not to bid for Halliburton's assets offered for sale - arguably, due to balance sheet constraints - is the case in point.
Given that under a pessimistic scenario attrition and consolidation in oil service industry may be significant, such forward looking "pro forma" tests may prove to be much tougher for the proposed deal to satisfy.
While many investors are likely expecting a significant merger-related update and guidance to be delivered during Halliburton's Q4 2015 earnings conference call tomorrow morning - which may be a reason for the deal spread narrowing sharply in advance - a case can be made that in the current commodity price environment slowing down the process may be Halliburton's preferred strategy, with the hope that oil prices will stage a quick recovery in the next few months. Higher commodity prices may lower the bar in the regulatory review. In addition, Halliburton may be able to receive higher valuations in the massive asset divestitures that will ultimately be required (possibly beyond the already announced packages).
In this context, the decision by European regulators to pursue a full review of the deal may be a convenient excuse for both Halliburton and Baker Hughes to extend the deadline for the closing.
Clearly, both Halliburton and Baker Hughes are critically motivated to see the deal succeed. For Halliburton, the deal's failure would likely equate to the $3.5 billion break-up fee coming due, hundreds of millions of dollars of merger-related costs without payback, and, very possibly, a leadership change. For Baker Hughes, the $3.5 billion fee would not offset the loss of the lavish premium being paid in the transaction.
While it would be premature to conclude that the merger is not happening, the current deal spread, even after the strong pull back, suggests that the market has little confidence in the outcome at this point.
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