Crude Observations

1+1 = 1.95623

Is it just me or does it seem like there are a disproportionate amount of Friday the 13ths this year? Here we are at another one and I am hard pressed to say whether anyone’s luck has changed since that other one way back in March when we closed our laptops and went home. Certainly not the oil patch, although recent stock price moves have been appreciated.


Casting about for a subject to write about this week I realize that the recent US election has left me exhausted. And while the result may be clear, the process is still not over as we have all the nonsense lawsuits and fraud allegations to battle through as well as the so-called “peaceful handover of power” and then the Georgia senate run-offs and finally, if we can keep it together until then, the inauguration which, virtual or not, should be a thing to behold.


Speaking of the whole bad luck thing, It has also been a pretty distressing week for Canadians as we await what appears to be a fairly certain series of lockdown measures related to the pandemic. It was only last weekend that we heard that we had lost two Canadian icons as Howie Meeker, a ubiquitous Hockey Night in Canada staple of the 1970s and 1980s and then Alex Trebek, our US-based, ex-pat Canadian to the core host of Jeopardy, both passed within 24 hours of each other.


Crappy isn’t it? Well as luck (good? Bad?) would have it, I did promise last week not to write about politics and get back to the nitty gritty of the business world and what is happening there. This should lift everyone’s spirits right?


Which industry is that you ask? Why the natural gas and oil industry. What’s that you say? Isn’t i the “oil and gas industry”?


Well you’d think so, but as I spend endless hours in Twitter I am starting to notice a subtle shift with the industry boosters, gradually downplaying the “oil” part and bringing the “gas” to the fore. Not even gas, they use “natural” gas. I guess they could call it “green” gas which is really the message they are going for, but then everyone would think they are talking flatulence and we all know where that is going to end.


Okay, sorry, I know.


No politics.


Fine. But the rebranding, it’s a real trendy thing. And businesses are nothing if not teenagers when it comes to a good trend – they pile on to it until it crumbles under the weight of their expectations and everyone is left to pick up the pieces.


The above rebrand effort is an example of a trend in the “energy” industry (wink) which is a concerted effort to greenwash itself in order to attract more investment, stave off the ESG warriors and, hopefully, boost their stock prices and executive compensation packages.


I talked about this a while back when BP mused about the peak demand being around the corner and loudly proclaimed it was going to achieve net zero by 2050 by selling down its portfolio of oil production assets and reinventing itself as … something else that doesn’t own as many oil and gas assets I guess.


This was followed by Royal Dutch Shell to much fanfare announcing it was closing a money-losing refinery in Louisiana that it had unsuccessfully been trying to flog in the market (during a pandemic no less) for months and followed that up by stating that it was going to reduce production at an Asian based refinery to get to net zero by 2050 (question, if the goal is net zero by 2050, why close it now? Isn’t closing it in 2050 just as effective a reduction?).


But I digress.


Just this week Occidental Petroleum (Oxy for those who care to use derivative nicknames) became the first US major to declare itself firmly on the net zero bandwagon, which is sure to be music to Joe Biden’s ears. This should also please investors still stinging from Oxy’s colossal blunder of an Anadarko purchase last year that almost made their stock price “net zero”.


Where am I going with this? Well the producers have read the proverbial writing on the wall. They can see where the train is headed and are pushing each other out of the way to hop on. It’s only a matter of time before this “green” mania sweeps into Canada and infects the Canadian oil patch.


What’s a war room to do with that development?


All kidding aside and enough mocking of poor old Oxy. The trend is your friend and if oil and gas companies can green themselves up and put a little air under their share prices by continuing to do what they were doing anyway but with publicity and ESG scores, I say more power to them.


But the trend I really wanted to get to and poke into a bit is actually the single largest trend happening right now: consolidation.


The wave started in the Permian and has accelerated and crossed the border into Canada.


Part driven by necessity – bankruptcy, lack of scale, capital – part driven by opportunity, it has been posited that when the dust settles the number of US domestic producers could drop by up to 80%.


Some of the headline deals include:


Conoco Phillips bought Concho Resources, Chevron acquired Noble Energy, Devon merged with WPX, Pioneer bought Parsley and of course the biggest of them all was EOG buying Exxon.


These Permian focused deals are all part of a bigger is shelter from lenders move in the prolific Permian basin.


What’s that? Of course. I knew that. I was just checking to see you were actually reading. To clarify. EOG has not bought Exxon. But how cool would that be? Can we get it trending on Twitter?


Not be outdone, in Canada we have seen some significant transactions as well with Cenovus “merging” Husky into themselves, Tourmaline absorbing Modern Resources and Jupiter Resources and CNRL buying Painted Pony.


These are all headline deals being done in a market where access to capital is scarce, sentiment is barely above “I give up” and stock prices are rattling along historic lows in terms of value and multiples. Energy companies aren’t just value plays, they are market pariahs like cigarette companies were (and still are – those free cash flow spewing sin bins), but they are also value buyers and the fact they are on a shopping spree should tell the market just how undervalued they are.


One remarkable aspect of this consolidation wave is how these deals are structured, almost invariably as share swaps and are typically not done at much of a premium to market, lest the buyer get destroyed in the market for daring to overpay in a bear’s bear market.


But as they say, out of the destruction of a fire comes green shoots of rebirth. Many of these target companies – heck even the acquirers, zombies at one time or another, will find themselves stronger and more able to withstand the vagaries of the commodity price, at least in the short term and, if it all holds together, should be market leaders on a forward basis, although they kind of have to be, since they could be all that is left.


As industry participants, the questions we should all be asking ourselves center around the implications of this merger mania, for the companies, their people and the industry.


Is Bigger really better? Is Bigger just bigger? Or is Bigger bad?


In many ways, these bigger companies are indeed better. They will offer better returns and attract more investor interest because of liquidity and scale. Presumably they will now be able to exploit the best properties of two entities not just one, so premium projects will be pursued. Where thought was actually put into why these companies were put together, synergies can be exploited, savings extracted, best practices pursued and, ultimately, incremental return will be delivered to shareholders through dividends and capital appreciation. As it should be.


Bigger companies are better able to fund future growth and access capital markets and in an environment where many companies were one OPEC hiccup away from the receiver, the increased size many times lowered overall leverage ratios and got the banks off their backs.


Finally, in a market where growth at all costs is no longer rewarded, these companies will be able to, in theory, exercise capital discipline, drive down costs and manage production growth so as not to swamp the markets with unneeded supply and hurt prices.


Sometimes of course, bigger is just bigger. So we will need to watch many of these entities to see what they do, watch their capex programs and see how their plans unfold. Are they content to sit on what they have or do they have some vision as to where they want to take their new toys. Will they be able to influence the market, especially in a rapidly maturing basin like the Permian? Rein in the excesses and keep the juniors in line? Or do they just become a group of bloated behemoths with no nimbleness or agility to react to market conditions.


Here in Canada, does the ever increasing size of the most influential producers buy them incremental regulatory influence both with a Federal government that in theory wants to see them put out to pasture and a provincial government that appears to get much of its policy direction from a more “old-school” cohort of industry participants.


Here in Calgary of course there has been much handwringing about what this current spate of consolidation is going to do to the local economy in terms of jobs, downtown office vacancies and the hollowing out of the Head Office community.


This is the bigger is bad camp, and for the most part they aren’t wrong. Cenovus/Husky has already announced significant layoffs to come, but in all reality, it’s not like these weren’t coming anyway, the entire sector is restructuring. It is easy to lose sight that the alternative to these mergers and subsequent layoffs was a fundamental restructuring of both buyer and seller and, in some cases, the seller just pulling the plug entirely.


No one wishes job losses on anyone and in Calgary it is particularly painful especially in the current environment. But this feels a bit different. In 2016 when the axe started swinging there was a very real sense that “this won’t be the last time” while this go around, there really isn’t that much left to cut.


At least that’s what the optimist in me says.


Again, it is what these companies do going forward that matters, not what could have been in some mythical recovery that was never going to happen. Capex plans are starting to roll out, and they aren’t as dire as many have predicted


Historically when these types of consolidations happen, management teams both senior and mid level as well as terminated employees branch out and we often see a renaissance of the junior sector. While this is possible when the larger entities start rationalizing and selling off non-core assets, I do not see this unfolding in the manner that we are accustomed to.


In the near to medium term mainly there is really no catalyst to make it happen – drilling activity is not expected to materially increase in Canada for years and a thriving junior sector requires the “frontier” nature of a resource boom to spark it. In addition, the barriers to entry for a junior are so much higher now than it was in previous cycles. Where once you could hang your shingle for $1 million and bootstrap a bunch of farm-ins and discarded leases into a 500-1000 boepd company attracting interest from the investment community, now you can’t get started for much less than $100 million. Some argue multiples higher than that. Unless your name is Mike Rose, it’s a different game.


So where will these budding entrepreneurs set their sights? These are highly functional and adaptable engineers, project managers and financial executives that know how to create and run businesses. When the wheels came off in 2016, many gravitated to the cannabis industry but that rocket has already crashed and burned. Where I actually see a lot of these people gravitating to is a different part of the energy complex –  renewables and alternative energy. Development, installation, service, technology. This is a trend that was already well underway here in Alberta and will continue particularly because that is where the capital is going, at least for now. Oil and gas’s loss is renewables gain and Alberta wins because these high value professionals will find reasons to stay.


What about the service sector?


Well, as the saying goes, what’s good for the goose is good for gander.


The service sector is going to have to follow suit or they will be on the outside looking in. I’m not just saying this as an M&A boutique that benefits from consolidation waves, it’s an existential question for many service companies, in particular upstream-oriented ones that have asset bases that are currently  underperforming from a utilization and ROI perspective.


Consolidation is already happening in the Permian and here in Canada as well, very much along the lines of producers with share swaps the order of the day followed by asset and personnel rationalizations.


With the average size of the producer increasing the scale of the service provider has to match. No procurement department wants the headache of dealing with scores of vendors when they can deal with only a handful and from the service company perspective, it is the only way they can hope to maintain pricing leverage. This is just cold hard reality. So look for increased deal activity in the energy services space as larger players look to protect and expand market share amongst a shrinking number of producers.


The loss of many of these smaller companies will hurt but the alternative many of them face is to take the excess assets to auction and hope to fight another day. Job losses will continue to pile up in the service sector, especially in the hardest hit basins like the Permian. We don’t believe it will be as painful or as headline grabbing as it is on the producer side as the labour force in the service sector is much more volatile to begin with and layoffs there don’t result in yet more empty towers in downtown Calgary. Not to mention we had already significantly culled the herd in our extended downturn from 2015 to March 13 2020. In the United States the job losses will be dramatic.


On a more positive note than the uncertain upstream world, in the midstream and infrastructure world there will be continued consolidation as well and this time it isn’t a battle for survival, rather it’s an epic battle for market share. There are hundreds of billions of dollars worth of major energy projects under way across North America and everyone wants a piece of it and Canada has its fair share. This run will last somewhere from 3 to 7 years but there is concern, at least on the oil and gas side, that major new projects at some point are going to be fewer and farther apart, although with the projected capital investment into the energy transition, I am not sure how much I buy into that. That said, given permitting issues on a local and federal basis, there is no real certainty that renewables projects will be slam dunk approvals either, but for now everyone is soldiering on.


As far as the big picture, I don’t have a crystal ball, so it is hard to say where the dust will settle. We should see a reduction by at least half of the names we know and love/hate on the producer side with a slightly less intense consolidation on the service side, at least as it regards the largest players. I anticipate one or two pipeline deals in the next few years but not much more since those ones cost actual money and not just an exchange of paper!


By that time the industry will have settled down, infrastructure will be in place, COVID will hopefully be in the rear view mirror and the energy industry will be ready for one last dash for greatness that we can all retire on.


At the same time, the renewables industry is going to grow up in Alberta and it will be increasingly populated by former oil and gas guys longing for the good old days but not actually missing it as much as they pretend. And it will be a growth industry, not a bubble like the cannabis industry.


So is bigger better? Well, it’s good for shareholders, lousy for employees in the short term but good for the industry for the long term. A bit of a wash in all reality.


On the other hand, it is entirely likely that by this time in two years we will all be part of CNRL. Worse things could happen. They have a great balance sheet.


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