By Robert Merrick, Herbert Smith Freehills
Last year presented a difficult and turbulent time in the energy sector with the dramatic slide of the price of oil. The oil price, which had previously skyrocketed to over US$100 per barrel in recent years amid an unprecedented growth in US oil production, continued its plunge to as low as US$27 per barrel.
Traditional energy business models and large multinationals have had to undergo strategic changes and make difficult business decisions to deal with the uncertainty of the market and the risks that accompany the instability. With the World Bank adjusting its 2016 forecast for crude oil prices to US$37 per barrel, the low prices certainly affected the volume and appetite for energy-focused M&A.
These low oil prices promised to encourage oil and gas dealmaking as companies under pressure usually pursue cost synergies by merging with competitors in their particular industry. Moreover, the falling prices should have encouraged consolidation, portfolio rationalisation and opportunism. However, although the sector still witnessed a strong year of M&A activity, statistical analysis shows that global energy M&A levels in 2015 did not reach the heights that many were anticipating. Instead of boosting M&A activity, the falling oil prices created an enormous gap between value expectations of potential buyers and sellers regarding their forward prices forecasts. This made it a lot more difficult to agree on value for deals. Additionally, credit markets have significantly pulled back making debt and equity financing a major roadblock to M&A activity.
While the volume of deals dropped significantly from 2014, the value of cross-border M&A has continued to remain high into 2016. The value of energy, mining and natural resources M&A went up to US$174.7 billion in 2015, an increase of US$5.2 billion from the year before. Although oil and gas dealmaking struggled to get traction, activity in the power sector was stronger, fuelled by deals for renewables and network assets.
Herbert Smith Freehills’ “Beyond Borders: The future of dealmaking” report, a global survey about cross-border M&A and the outlook for dealmaking, revealed that the majority of cross-border deals in the energy, mining and natural resources sector were intra-regional rather than global. Businesses were more likely to prioritise acquisitions in their existing operating regions driven by the positive economic outlook of their markets, rather than internationally. According to the report, European buyers invested an astonishing US$95 billion within the region out of a total of US$100.9 billion. The Asia-Pacific region, which spent nearly half of their total M&A deal volume within their own region, confirmed the intra-regional focus trend.
The only conflicting result was that of North America, which chose to invest more outside the region: it invested US$13.4 billion in Europe and US$10.9 billion in Asia Pacific, but only US$6.9 billion within its own region. Companies in North America developed strategies that focused their acquisitions and investments elsewhere regardless of their stable market, which has been shaped by the high level of recovery of their economy. Europe, North America and Asia-Pacific were the main bidder and target regions for the energy, mining and natural resources sector.
With regard to overall M&A activity, the developed markets and Asian powerhouses see the most positive outlook. North America, Greater China and India will be the regions where there is most likely to be a significant increase of activity over the next few years.
Bidders have appreciated the resilient and swifter recovery of the North American economy from the global financial crisis leading to a sense of optimism and positivity. The recent increase of interest rates by the US Federal Reserve exudes confidence in the North American economy. North America also experienced a high concentration of midstream energy dealmaking, as acquiring midstream firms such as pipeline companies and other suppliers, was seen to reduce exposure to commodity prices while still benefiting from the expansion in North American drilling.
Although China’s economy has slowed down with its lowest GDP growth of 6.9 per cent in a century, the Chinese market remains attractive based on the relatively cheap prices and future growth potential. Foreign bidders are also finding it a lot easier to enter China with the increasing liberalisation of foreign investment rules.
There has also been a growing interest for foreign investors in M&A activity in India with the relaxation of its foreign direct investment regime. Indian Prime Minister Modi’s pro-business disposition has led to an implementation of favourable policies encouraging investment. In particular, M&A in the Indian energy sector was very active in 2015.
Despite recent difficulties in the sector, M&A activity in the energy and oil and gas industry generally tends to react in the opposite direction. Notwithstanding some recovery since the low of US$27 per barrel, there now seems to be a consensus that the oil price is likely to remain “lower for longer” ushering in a turning point with regard to the expectations of the future prices of oil. Potential sellers, who have previously been too reluctant to offload assets at heavily discounted prices in the hopes that the prices will recover, have come to the realisation that deferring transactions is becoming a less practical option. This understanding of the current market effectively reduces the gap between the sums buyers and sellers are willing to pay and accept, enticing more deals to be done.
Several international firms have already announced more asset impairments, project deferrals, strategic reviews, portfolio rationalisations and, in some cases, distress. These actions allow sellers to divest assets without taking a big hit to their profit and loss accounts. In particular, highly indebted firms will be forced to shed assets and enter alliances with other companies to help create value from underutilised assets. M&A has simply become a necessity for survival, profitability and the maintenance of production levels.
While dealmaking will primarily be motivated by economic factors, legal and regulatory factors also influence deals. Herbert Smith Freehills’ “Beyond Borders: The future of dealmaking” report identified the most pressing legal and regulatory challenges that will influence dealmaking in 2016. The report highlighted that legal and regulatory factors have been the most difficult and demanding aspects of deals completed in recent years and will continue to pose complications with regard to future deals.
The issues that potential buyers worldwide were most concerned about in the energy sector revolved around environmental regulations and antitrust compliance. Though to a lesser extent, import and export regulations, labour and employment regulations, money laundering regulations, bribery and corruption regulations, data protection and cybersecurity regulations rounded out the list of major concerns firms raised in making their next acquisition.
Businesses planning deals in Central Europe, Eastern Europe and Australia pointed to environmental concerns as the most common and imperative challenge they needed to consider before making an acquisition. Environmental issues are often regarded as key regulatory deal-breakers due to the substantial operating costs and liabilities that attach to the laws and regulations. The likelihood of increased regulations, relevant permits, licences and approvals required in every transaction are typically accompanied by time stipulations and onerous conditions that convert into additional obstacles in energy focused M&A deals. To an extent, environmental concerns may negatively affect M&A deal value if the issues are not managed carefully. These concerns emphasise the importance of undertaking extensive environmental due diligence in every stage of the acquisition.
The second most common concern in energy M&A activity reported was regarding antitrust regulations. In particular, antitrust concerns are high for companies considering making acquisitions in North America and the Middle East. In previous years, many deals that failed to be completed identified antitrust issues as the main reason for the collapse. Many firms have raised concerns regarding the inconsistencies and lack of clarity of the laws and regulations in less developed markets and the increasing reach of antitrust regulators. Additionally, there has been a steady rise in national regulatory regimes, which in turn has generated more obstacles in the form of M&A control clearances. These complexities pose substantial implications to the structure of the acquisition and may consequently cause a delay in deal completion. It is therefore vital that procedural and substantive antitrust concerns be carefully considered at the initial phases of each transaction.