At a time when deal activity in the energy and natural resources sector has slowed dramatically—down 26.2% globally year-on-year—one development in particular may define the industry’s near-term future.
In mid-May 2020, French oil major Total opted not to pursue a deal, announced in 2019, to purchase the African assets of Anadarko Petroleum, a U.S. producer that was being acquired by Occidental Petroleum. Two weeks after it withdrew its $8.8 billion proposal for offshore oil and gas properties in Ghana, Total announced it would spend about $3.8 billion for a majority stake in a renewable energy project in the British North Sea. Total’s decision to move away from traditional oil and gas investments could be an indicator of what lies ahead for the industry.
The oil and gas sector was already on the brink of radical change before the COVID-19 pandemic crushed global demand for energy. Facing a capital shortage as the shale revolution foundered, and a lagging stock performance, fossil fuel producers are under mounting investor pressure for cleaner energy in an effort to combat climate change. Traditional oil and gas producers are rethinking their long-term strategies, and increasingly, they are diversifying outside of the traditional oil and gas space.
Bargains in the Oil Patch
In the “Oil Patch,” the outlook is far bleaker. With West Texas Intermediate crude prices hovering just above $30 a barrel, few companies can make meaningful profits. Oil and gas businesses are desperately moving to control costs, and deals are more likely to focus on distressed asset sales, especially among smaller U.S. producers, which have been the hardest hit by the price and demand declines in the first half of the year. Not surprisingly, North America suffered the steepest decline among regions for second quarter (Q2) 2020 energy and natural resources deal value, falling 84.4% from a year earlier and 28.9% from the first quarter. It did, however, post one of the smallest declines in volume, falling 22.6% year-on-year, with 205 deals in Q2 2020. By comparison, Western Europe saw a decline of 42.4%, with 166 deals.
This could be a sign that some oil and gas assets remain attractive, albeit at lower prices. The likely potential buyers are some of the biggest players in U.S. shale now—majors or larger independents that have the financial resources to survive the downturn. These companies may decide to consolidate their positions and take advantage of the bargains.
The agreement between OPEC countries and Russia that extended production curtailments of 9.7 million barrels a day—or about 10% of global output—through July, could encourage more deal activity in 2020. However, some smaller members of the cartel may be hard-pressed to maintain lower quotas, and an uptick in U.S. production could send prices tumbling again.
It is worth noting that the current market is quite different from the last oil downturn. In 2016, capital markets were flush, which propped up asset values. This time around, capital markets have largely dried up for the industry. As a result, as the year goes on, we are likely to see quality assets available at low prices.
Private equity players, especially distressed funds, are also likely to remain key investors in oil and gas properties, but only at rock-bottom valuations, and it may take several months for the market to balance. Buyers will be looking for significant bargains, while sellers will be looking for higher prices to raise much-needed cash. When deals begin to flow, the primary targets will likely be smaller companies and assets with the lowest cost of production.
Bankruptcies and Restructurings
One factor likely to fuel deal activity in the sector will be bankruptcies. Rystad Energy, a Norwegian research firm, predicted that as many as 73 energy companies may file for bankruptcy this year. That number is expected to grow to more than 240 by the end of 2021 as oil demand remains weak, keeping prices depressed.
The bankruptcy surge could spark some consolidation across the industry. We may also see out-of-court restructurings in which the core business emerges with a new set of owners. Any consolidation that occurs outside of forced restructurings, however, will likely come through equity mergers, given the lack of investor capital available.
An important participant in the restructurings will be investors who loaned money against companies’ reserves. These reserve-based lenders have been hit hard by declining commodity prices. With few other options, they will take equity positions in restructurings, essentially betting that over time they can receive a higher recovery than if they liquidate assets immediately.
One issue that could cause some potential buyers to pause is environmental liability. The rapid shutdown of U.S. production has raised concerns about environmental consequences of unplugged wells. Private equity and other financial buyers in particular will be reluctant to take on significant decommissioning and abandonment liabilities, and may look for sellers to retain at least a portion of these liabilities, as we have seen in recent years in UK North Sea deals, for example.
We are already seeing a growing number of situations in which environmental liability could play a role, such as when an operator files for bankruptcy after shutting-in as many as half of its wells to conserve cash. Many of those wells are unlikely to come back online quickly, if at all, and many states require that they be plugged.
But buyers typically only want to purchase producing wells. If bankruptcy courts approve the sale of the producing wells, it could leave state regulators with a bankrupt debtor that is unable to plug wells properly. Courts may order the sale proceeds from producing wells to cover the costs of environmental liabilities, leaving fewer proceeds for distribution among unsecured creditors.
Eyeing a Renewable Future
Like other facets of the energy industry, renewables have been affected by the global lockdowns and stay-at-home orders brought on by the pandemic. Factory closings, in particular, have cut electricity demand, disrupted supply chains, and created delays in the construction of new wind farms and solar arrays. But unlike oil, which faces the prospect of long-term demand declines and continued weakness in pricing, electricity demand is expected to rebound as economies reopen around the globe.
This rebound may be somewhat tempered in the U.S. because of very low natural gas prices, which tend to pressure electricity prices. But broadly, this backdrop is creating opportunities for traditional energy players to potentially pick-up renewable assets, at least those operating as merchant power plants, on the cheap—before longer-term trends start to reemerge.
Energy transition remained a motivator for deal activity throughout the first half of 2020, as governments around the globe continued to call for reductions in greenhouse gas emissions. While distressed oil and gas assets may result in bargain hunting in the Oil Patch, relatively strong activity continues in the power and utility sector, with an eye toward renewable energy.
A prime example occurred in June when the Abu Dhabi National Energy Co. (TAQA) completed a transaction with Abu Dhabi Power Corp., creating one of the EMEA (Europe, Middle East, and Africa) region’s largest utility companies, and its third-largest publicly traded company by market capitalization. TAQA now has 23 GW of power generation capacity globally, of which 1.4 GW are from renewable sources, and 4.4 GW under development, of which 2 GW are from renewable sources.
Additionally, COVID-19 stimulus packages around the world may provide an important source of capital for deal activity in the renewable and power sectors. In July, the European Union announced a COVID-19 recovery fund, of which 30% or €550 billion must be spent on climate initiatives over 2021–2027.
Even in the U.S., where the Trump administration has been more supportive of conventional energy production, the Treasury Department extended the deadline for onshore wind and solar projects to qualify for the production tax credit (PTC) and investment tax credit (ITC). Onshore wind projects that started construction in 2016 and 2017 now have five rather than four years to finish construction for the PTC benefits. For solar developers, the IRS will now allow equipment bought in 2019 to be delivered into October 2020, while still retaining its eligibility for the ITC.
Prior to the COVID-19 outbreak, and especially when compared with oil and gas, renewables were in a state of growth driven as much by public policy and sentiment as by economics. But those factors will not change as the pandemic subsides. If anything, the recovery from the COVID-19 shutdowns may serve as a catalyst for the change that was already underway in the sector, with big oil following the trend set by Total in early June, and shifting its focus away from fossil fuels to a cleaner future.
—David Locascio is a partner in Hogan Lovells’ Houston office, Erin Brady is a partner in Hogan Lovells’ New York City and Los Angeles offices, Sarah Shaw is a partner in Hogan Lovells’ London office, and Elizabeth Titus is a partner in Hogan Lovells’ Denver office.