Stable oil prices to usher in the consolidation of the shale sector
Oil prices remain low but, perhaps more importantly, they also appear to be fairly stable. The American benchmark West Texas Intermediate has been trading around $ 40 a barrel since June. While $ 40 oil isn’t high enough to restart the prolific shale machine, the lack of volatility gives producers time to take stock of how best to survive the current Covid-19 slowdown.
I said here before that consolidation will be crucial survival of the sector, but the high volatility of the markets during the first five months of this tumultuous year 2020 made mergers and acquisitions effectively impossible. Volatility is the enemy of trading because it widens the gap between buyers and sellers on asset valuation.
But this “supply-demand” gap narrows when prices stabilize because buyers and sellers generally agree in the market, especially when it comes to the cash flows that certain assets can generate.
It should therefore come as no surprise that mergers and acquisitions are on the increase.
The combination of all Monday tight reservoir oil producers’ stocks Devon Energy and WPX Energy, which creates a $ 12 billion company with a strong upstream position in the Permian Basin, is the kind of deal that investors have long sought in the highly fragmented shale industry.
While WPX shareholders received no immediate bonus in the case, there is no doubt that the newly merged company is significantly stronger and has considerably greater long-term potential. Operating in today’s environment is a matter of survival, and Devon and WPX have taken steps to ensure that they will still be standing when the commodity cycle changes.
The proof was fully exposed on Monday. Devon’s stock climbed 11% while WPX stock value jumped 16%. Investors in the oil industry have put aside their traditional demands for large upfront bonuses because they know the alternative could be brutal. At worst, inaction could lead to dozens of new bankruptcies in a sector where creditors, not shareholders, get the first blows on the carcass.
Acquisition of Noble Energy by Chevron for $ 13 billion
The massive amount of debt accumulated by oil companies during the boom years of easy credit remains the biggest obstacle to further consolidation.
Many over-leveraged companies are also starting to realize that there is no stand-alone investment case for them. They are looking for alternative solutions in the mergers and acquisitions markets, in particular by waiving a premium for their social assets.
For Devon, which will own 57% of the new company, a merger with WPX made operational sense. Gains momentum by adding 400,000 acres in the Delaware Permian sub-basin, a position just behind that of Occidental Petroleum
The company’s combined budget will almost certainly be less than the sum of its parts, which means cash flow is expected to improve, which is the goal these days.
The agreement addresses three essential elements in this challenging operating environment: scale, reduced maintenance capital requirements and a beneficial business model. These three components are the essential formula for surviving the ongoing pandemic and set the stage for companies to return to profitability when rising oil prices return next year.
It is not easy to close such deals. But knowing that action is needed is taking hold across the industry, and that’s a positive development.
The worst is behind the oil industry, but several difficult months remain to come as the the recovery in oil demand has stalled as Covid-19 epidemics resurfaced in several key oil-consuming countries. Markets will improve over time, but this effect could be as good as it gets for demand until a Covid-19 vaccine and mobility return to familiar patterns.
Combining the OPEC-plus alliance production reduction agreement, which runs through April 2022, and lower drilling activity in the United States and other non-OPEC countries will improve the macroeconomic backdrop for 2021 and 2022, with higher prices needed to make facing what will likely be an under-supplied market in 2022.
The general idea remains that $ 50 oil will arrive in 2021.
It is not unthinkable that the big oil companies seek to strengthen their positions in the American market through agreements, but they should not be seen as saviors. Indeed, the five Western majors – BP, Royal Dutch Shell, Total, Exxon Mobil
Independent shale producers and the service companies that supply them must take matters into their own hands if they are to survive. Investors have shown their approval for smart mergers and acquisitions. It’s time for the industry to make it happen – with oil prices now stable, there should be no delays.