Why Do Industries Consolidate? Explaining the Energy Sector Consolidation
In 2021, following the COVID-19 lockdown which limited energy demand across the globe, M&A activities rebounded about 20% from 2020. However, the outlook for energy suggests that further consolidation will take place, leading to increased levels of M&A activity in the coming years.
Smaller companies are finding it more difficult to compete on their own.
Similarly, larger companies need to further scale to improve profit margins and boost shareholder value, leading to consolidation in the industry sector.
The oil and gas industry remains highly fragmented. For example, there are over 2,300 companies producing less than 15,000 boe/d and only roughly 300 producing more than 60,000 boe/d. This quantity of independent producers creates many potential cost synergies within the industry. Is energy ripe for the next wave of roll-ups, as we have seen occur over the last several decades in various fragmented industries? Healthcare recently witnessed a dramatic surge of M&A activity, giving birth to the growth in specialty pharmaceutical companies and other such platforms for acquiring drug rights from 2010 to 2016.
However, investors continue to shift away from fossil fuels and into environmentally friendly renewable energy sources, such as solar and wind. This movement creates a constant capital flow headwind for the energy field’s potential for a similar growth in M&A, as acquiring capital for such energy acquisitions will be substantially harder.
While the conflict between Russia and Ukraine has squeezed oil supply, temporarily spiking price-levels in the U.S., prices should come back down eventually, leaving many of these smaller oil companies in more difficult positions.
The logical conclusion is that, in order to compete, these smaller companies will either need to merge to grow and lower costs through economies of scale or be acquired by larger oil producers. Current signs suggest that the energy transition will lead to massive restructuring and consolidation in the coming decades as the sector goes ex-growth.
The most important factor leading to the consolidation of the energy sector is the journey to more environmentally friendly and sustainable operations. Furthermore, this transition is forcing many of the largest companies to either divest their current assets. (Shell’s divestiture of Permian Basin assets) Or acquire renewable energy companies and disruptive technologies.
According to Bain & Co., energy transition deals accounted for about 20% of all energy-sector deals greater than $1 billion in 2021. Bain believes that the energy sector’s reliance on M&A in 2022 plays out across several themes: greening existing operations, repositioning portfolios, and carving out new growth opportunities.
Greening Existing Operations
Due to pressure from investors and regulators, large oil and gas producers will be forced to “green” their existing operations and strengthen their ESG assets. Companies are using M&A in order to reduce their carbon footprint, with the aim of achieving net-zero targets in their operations. For example, Occidental Petroleum is acquiring renewable energy sources. In order to power their drilling equipment, thus reducing their carbon footprint.
Companies are also using M&A to readjust their portfolios, by either divesting from oil & gas or investing for discounted prices. For example, Shell recently completed its $9.5 billion divestiture of acreage in the Permian Basin by selling it to ConocoPhillips. As seen, M&A can be used as an avenue to mitigate a producer’s carbon footprint and accelerate their future transition to renewable resources.
New Growth Opportunities
Companies are carving out assets in order to take advantage of the clean energy transition. In Bain’s report, they use the example of LG Energy Solution, which LG Chem spun out as a separate entity in 2020. Moreover, in a January 2022 IPO, this separate entity achieved a valuation of $98 billion. Allowing the company to achieve a multiple 8 times greater than its parent company. Furthermore, in carving out these new growth opportunities, large companies can capitalize on the energy transition by attracting a new class of investors that is willing to pay a higher multiple in expectation of higher growth than the parent company.
In summary, the fragmentation of the Oil & Gas industry and the pressures to reduce carbon emissions will continue to drive M&A in the energy industry for the foreseeable future. With companies repositioning their portfolios and acquiring innovative renewable energy resources. Thus, the great shift to a cleaner energy future presents great opportunities for the companies involved.
Case Study Deal: Shell & ConocoPhillips
On Sep. 20, 2021, Royal Dutch Shell (NYSE: SHEL) agreed to sell its Permian Basin assets to ConocoPhillips (NYSE: COP) for $9.5 billion in cash.
The Permian Basin is a sedimentary basin that stretches across Texas and New Mexico. Which account for nearly 40% of all U.S. oil production.
The transaction continues the general theme of consolidation activity. Moreover, that has taken place across the Permian Basin over the past few years. Shell’s sale of their Permian Basin assets is indicative of the two main differing views held by major shale producers: those who believe oil and gas is the future and those who are converting to renewable sources of energy.
Many of the world’s largest oil companies, like Shell, are facing increasing scrutiny and pressure from investors and regulators to reduce fossil fuel investments to help fight climate change.
Some companies have followed Shell. Aiming to shift away from fossil fuels and into the renewable energy space by investing in sources like solar and wind. Take BP (NYSE: BP) for example, which agreed to acquire the UK’s largest EV charging network, Chargemaster, in 2018.
On the other hand, some U.S. producers have doubled-down on oil & gas, like Exxon (NYSE: XOM) and Chevron (NYSE: CVX). Furthermore, ConocoPhillips has signaled their intent to continue heavy investment in oil & gas. These U.S. shale producers have used M&A deals to expand their operations and lower costs through economies of scale.
Shell’s sale of its Permian assets will leave its U.S. oil production almost entirely in the offshore Gulf of Mexico. As a result, Shell will return $7 billion of the deal’s proceeds to shareholders. Occurring in the form of dividends, while using the rest to pay off existing debt.
Lastly, the deal will also place ConocoPhillips among the leading producers in the Permian Basin. Between its acquisition of Shell’s Permian assets and its $13.3 billion purchase of Permian pure-play Concho Resources in 2020. ConocoPhillips has emerged as one of the largest players in the shale industry.
Morgan Stanley and Tudor, Pickering, & Holt, represented Shell, while Goldman Sachs represented ConocoPhillips in the transaction.
Written by Andrew Bernstein
Edited by Lorenzo Lizzeri, Avhan Misra & Benjamin Binday
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