Soggy stocks, LNG and shale to drive M&A
Many small players in the natural gas space likely to get taken out
Merger and acquisition (M&A) activity in the Canadian oil patch has emerged as a dominant investment theme this year, and over the next year will likely transform the landscape for energy investors. In my mind there are three key reasons why the M&A activity that we’ve witnessed so far this year is but a taste of what is to come, and is an emerging theme that investors, CEOs, and board directors need to take note of.
The first reason for the increase in M&A activity in Canada is simply underperformance. Canadian energy stocks have lagged their U.S. counterparts by roughly 21 per cent over the past two years. Bad performance breeds discontent among investors and has resulted in something that Calgary has rarely seen in the past: investor activism.
Unfortunately, the oil patch has somewhat of a mixed reputation for mediocre corporate governance because some boards seem to be made up of CEO loyalists as opposed to a group of competent individuals who can provide adequate oversight and a forum for sober second thought. This can, however, result in opportunities where substantial value can be unlocked if one or more parties are able to overcome either management entrenchment or, alternatively, make a compelling enough pitch to the board to accept change.
We’ve seen several examples recently, such as West Face Capital’s involvement in Connacher Oil & Gas Ltd., where investor activism ultimately led to the sale or restructuring of a company. While the final chapter for Connacher is yet to be written, other examples – among them Nexen Inc. – point to the value that can be unleashed when the right buttons are pushed.
A second reason for an increase in M&A activity has been the need to capture resource, especially when it comes to West Coast liquefied natural gas (LNG). It was obvious late last year that this would be a theme for 2012 given the extent of the liquefaction plans presented by many large companies compared to their productive capabilities and reserves.
Progress Energy’s sale to Petronas is only the beginning. Within the next two years it is likely that many of the smaller players (and acreage positions held by larger companies) who hold strategic resource near Prince Rupert and Kitimat will become targets. Not only is there a known second bidder that has over $6 billion burning a hole in their pocket, but BG Group has already started talks with Spectra to build a pipeline to Prince Rupert and yet has exactly zero production to use as liquefaction feedstock.
Other than West Coast LNG, another emerging resource that lends itself to M&A activity is the Duvernay shale. With the potential of the wet gas window of the Duvernay to be 30 per cent larger than the Eagle Ford, combined with high capital intensity and the inability of many entities to afford to drill on their acreage, this play lends itself to strong joint venture activity.
The final reason for increased M&A is perhaps the least obvious and most contentious. For some time, it has become obvious that mainly as a result of technology, and to a lesser extent price inflation in services, the average well cost has increased materially. Today the average well cost is around $4 million, up materially from a few years ago. Less obvious is the impact of this trend on smaller companies.
For a typical producer pumping 2,000 barrels of oil equivalent per day, weighted 50 per cent gas and oil, respectively, cash flows of around $22 million a year mean that the company can drill a total of five wells on a cash flow-neutral budget. Given that these five wells not only have to offset declines but grow production, they had better have a 100 per cent success rate.
Some could argue that the small cap model is somewhat obsolete. This should naturally lead to consolidation in order to achieve greater scale (minimize well concentration risk and spread G&A overhead over a larger production base).
The re-emergence of Brett Herman, president and CEO of Torc Oil and Gas Ltd., into the public markets in September is a great step towards consolidating many junior companies that have high quality acreage but are simply too undercapitalized to drill.