How could the downturn in the U.S. oil and gas industry impact M&A activity?
The oil and gas industry took another plunge in April 2020. The underlying mood of the National Association of Production and Exploration North American Prospect Expo (NAPE), the industry’s largest upstream oil and gas congregation held in February 2020 in Houston, Texas, reflected a hunkering-down mentality in preparation for an impending downturn. And, that was before the COVID-19 pandemic ravaged global economies.
The oil and gas industry largely consists of four major sectors: Upstream, Midstream, Downstream and Services, the last of which provides products and services that support aspects of operations for the other sectors. As a result of advances in extraction technology and increased production, the domestic oil and gas industry has experienced significant growth nationwide. As the industry boomed, investment opportunities in every segment of the energy sector abounded and interest from private equity firms increased dramatically. Smaller energy-focused private equity companies also grew as need for private capital expanded. At the start of 2020, the oil and gas industry represented 8% of GDP in the United States, supporting 10.3 million jobs, according to the American Petroleum Institute.1
Private equity investments, in general terms, focus on shorter term horizons, as opposed to strategically orchestrated transactions, which acquire businesses with the goals of consolidation and operational efficiencies. As private equity firm investment in the oil and gas sector expanded, so too did the use of Representations and Warranties (R&W) insurance to protect against transactional risks in mergers and acquisitions.
R&W insurance is a tactical tool utilized in merger and acquisition transactions to transfer risk of financial loss for a breach of seller warranties provided in a purchase agreement to an insurance company’s balance sheet. The insurance coverage can greatly reduce or replace the traditional need for the seller to set aside a large amount of money in escrow at the time of sale in order to cover post-closing indemnification needs. Depending on the length of the escrow period, this may tie up capital for years. R&W insurance is therefore attractive to private equity sellers as it can facilitate a clean exit, allowing the firm to leverage its capital for other investment ventures and/or pay out to investors as soon as possible.
What role will private equity now play amid the industry’s currently rapid downturn and how can R&W insurance play a pivotal role in offering transactional assurance? As of Q1 2020, the industry saw oil prices trending at just below $50.00 per barrel. Today, oil prices have sunk to some of their lowest levels in history as a result of 1) the Saudi-Russia price dispute; and 2) the far-reaching effects of COVID-19. In March 2020, a price dispute erupted between Saudi Arabia, OPEC’s most influential member, and Russia, when the two countries failed to reach an agreement on supply cutbacks. Then, as both countries increased crude production dramatically, the ensuing supply glut caused oil prices to fall dramatically. At the same time, despite historically low oil prices, the world-wide COVID-19 outbreak stifled demand with airplanes grounded, people following stay-at-home guidance in every state, and economic activity generally subdued. The combined effect of the dramatic increase in supply and the drop in demand caused WTI prices to close at a historic negative $37 per barrel on April 20, 2020.2 While this last plunge was the result of the characteristics of futures contracts and oil has since returned to positive territory, oil prices remain low. A recent Bank of America report projects that “demand will plunge by an average of 9.2 million barrels per day in 2020, more than double the originally projected 4.4 daily billion drop.”3 As of May 2020, the S&P 500 Energy Sector Fund (XLE) was trading down over 50% from a year earlier, as reported on the NYSE.
Oil and gas companies facing near-term debt maturities have likely either gone into bankruptcy or have hired restructuring advisors in advance. Should oil prices not improve, thus restricting cash flows, a wave of restructurings and foreclosures could be expected. Major lenders, such as JPMorgan Chase & Co., Wells Fargo & Co. and others, are reported to be setting up independent companies with management and operators in order to own and operate oil and gas assets after foreclosure. If lenders decide to sell assets for pennies on the dollar instead of operate them, this environment would provide an invaluable opportunity for private equity and other investors with access to capital. Such players will likely shift their focus to investing and acquiring distressed and deeply discounted assets. In a distressed acquisition scenario, along with the traditional benefits received from R&W insurance, R&W insurance can, subject to terms, conditions and regulation: (1) backstop indemnities to increase the appeal of distressed assets, (2) remove the need to hold funds in escrow, which allows sellers to liquidate quickly; and (3) ease concerns regarding collection of funds from sellers that can be difficult or costly to pursue.
Carriers offering R&W insurance will be poised to respond with sound, disciplined underwriting standards designed to help offer protection and increase buyer confidence for unexpected transactional risks during the oil and gas industry’s projected systemic shift.
- American Petroleum Institute, “Energy Works Data”; www.api.org
- Forbes, “April 20: WTI At -$37, Brent At $26! What Happened? What Comes Next? The Stories That Will Be Told…”; https://www.forbes.com/sites/thebakersinstitute/2020/04/21/april-20-wti-at37-brent-at-26-what-happened-what-comes-next-the-stories-that-will-be-told/#16ec3e414d4b
- Bank of America Report, referenced by CNN, “April 13: Cheap oil isn’t going away, even after record production cuts”; https://lite.cnn.com/en/article/h_555e5ccb331690ff269b7f342cb6346c
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