Graeme Pearson:
Well hi, and welcome to the Industries in Motion podcast from RBC Capital Markets, where we will be exploring what's new and what's next in today's fast moving markets. Do please listen to the end of the podcast for all the important disclaimers.
I'm Graeme Pearson. I'm the co-head of Global Research at RBC Capital Markets, and today I am delighted to be joined by Greg Pardy, who's the head of Global Energy Research, as well as our Canadian Senior E&P and integrated oil analyst. We also have Scott Hanold, who's a managing director and our US E&P analyst, and then Biraj Borkhataria, who is the Global Head of Energy Transition Research, as well as our European and US large-cap integrated oil analyst.
Today, we will discuss themes in M&A and capital allocation amongst the global energy producers. The global research team at RBC has recently produced two reports in our Energy Insights series which addresses these themes. One titled, “M&A – Who's Next?” Which explores trends and the considerations, and the other called “By the Numbers”, which looks in detail at the shareholder returns and balance sheet positioning. So with that, Greg, let's get underway. Let's kick it off. So why is M&A front and center again in the energy sector right now?
Greg Pardy:
Yeah, Graeme, M&A activity amongst energy producers is always a wild card and one the team's been talking about for a couple of years now, but the tidal wave of consolidation activity unfolding in the US is like a fever that has yet to run its course. Our thinking is that fortified balance sheets, as we've explored in a couple of reports we recently published, are the strongest we've seen in over a decade. With net debt at the end of 2023, about one half that seen in 2020 during the pandemic, and this has opened the door to intensified M&A activity via increased funding capacity. The M&A playbook has also changed. In the past, shareholders of potential targets were typically offered attractive premiums to sweeten the pot. Today, the sheer number of deals mentioned to the press prior to official transaction announcements has drawn attention to possible combinations.
And in a lot of cases, that has served to equilibrate share exchange ratios in advance of formal releases, and that's very different than what we've seen in the past. So in order to assist energy investors with analyzing who might be next from a consolidation standpoint, our global energy research team has applied its judgment to group companies within our integrated producer oilfield services, even midstream coverage into three buckets. The first are logical acquires including bolt on assets, the middle bucket or the neutrals where we have no strong stance either way. And then the third bucket has to with logical targets including sellers of non-core assets. And we've outlined that in the report you mentioned earlier, “M&A – What’s Next?”
Graeme Pearson:
That's great, Greg. Thank you. And Scott, from your perspective, what's driving this intensified M&A activity, I guess particularly in the United States?
Scott Hanold:
Yeah, that's a great question. Last year was a record in terms of the number of public mergers and in total dollars as well. On top of that, there were a significant number of private deals. Now, the key driver in many of these transactions are to enhance the sustainability of the free cash flow profiles, which is a major driver in the value of energy stocks today. What stands out are synergies that are not only significant but also highly tangible, and many of the benefits are occurring more rapidly than anticipated. Now the US is moving into a more mature stage of development, and while there's still a good four to five years of North America's top-tier core inventory, most investors want to see that closer to a decade. Accordingly, we see more modest growth plans along with M&A to further enhance that runway.
Graeme Pearson:
Got it. And thanks, Scott. And Greg, I suppose the same can be said of Canada, particularly the oil sands and possibly the Montney.
Greg Pardy:
Well, there are some differences here, and I think Scott's making a really important point on the maturity of basins in the US. And again, that's where Canada's different. So in the oil sands resource abundance and shareholder returns remain in sharp focus amongst the major players. And as such, our thinking is that we will see opportunistically driven transactions of all sizes rather than a feeding frenzy. Now if we shift gears to the second part of your question, US producers and others may seek to pivot into Canada's Montney, which our colleague RBC analyst Mike Harvey has done a lot of work on. Now the Montney offers a still early-stage condense-rich play that is going to benefit from approved egress via LNG Canada, which of course is slated to start up in late 2024.
Graeme Pearson:
And Biraj, moving to you, how might the European majors become further involved in M&A in the United States?
Biraj Borkhataria:
Thanks, Graeme. So I guess when you look at the landscape, it's important to recognize that it is a depletion business and there are effectively two ways to replace reserves as you produce. The first one is exploration and exploration spending for the majors has fallen substantially. In 2013, the global majors were spending about $30 billion a year. Now that number is about 6 billion. So even with better hit rates, it's unlikely that the majors can replace reserves on purely a organic basis. That opens the door up for M&A. And this is one of the themes we focused on in our RBC Imagine™ report, “Fantasy M&A - Managing optionality through the energy transition” back in December. We think the European majors may have appetite to acquire North American gas assets to rebalance their short positions via US LNG off-takes, as well as the chemicals businesses in the US. Conversely, we think the US majors may be net sellers of assets as they digest the recent acquisitions.
Graeme Pearson:
And to that point, and maybe stepping back a bit, we did start the discussion by noting that stronger balance sheets among the global energy producers have opened the door to this intensified M&A activity by increasing funding capacity. So Greg, can you just talk us through how balance sheet positioning and capital allocation have changed over the past few years for the industry and what that means going forward for shareholder returns?
Greg Pardy:
Yeah. The new model that energy producers have embraced globally fuses financial resilience with shareholder returns. Now at the outset we talked about how we looked at our global coverage and said, Hey, when we look at net debt at the end of '23, it's about half of that in terms of what we saw versus 2020. And again, that is very different from what we've seen in the past. And while oil natural gas prices, even refinery cracks eased substantially last year after spiking in 2022 in connection with the Russia-Ukraine conflict, commodity prices remain at healthy levels as do cash flows. And even though we saw free cash flow being cut about 50% last year, shareholder distributions of all kinds were only down about 7% year over year.
So that really is a reflection of the new shareholder model that the companies have embraced. When we look at organic investment amongst our coverage group, that actually rose about 20% sequentially. It's a big number. It's about $40 billion in 2023, and that was a reflection of producers adjusting to cost inflation and also pursuing select growth projects. Now, that's not a bad thing. Ultimately, we believe that disciplined capital investment will bear fruit in the form of higher mid-cycle cash flow generation down the track. And all of this suggests to us that energy producers are well-equipped to afford durable shareholder return optionality, whether that be buybacks or dividends here in the coming years. So we're in a very good place.
Graeme Pearson:
Thanks, Greg. Seems like a good place to wrap it up there. So Greg, Scott, Biraj, thank you very much for your time and insights into the global energy sector on this episode of Industries in Motion, which was recorded on the 4th of March 2024. Please do make sure you subscribe to Industries in Motion wherever you listen to your podcast. And if you'd like to continue the conversation, please contact your RBC representative directly or visit our website, which is RBCCM.com. Thank you all very much.
Speaker 5:
This content is based on information available at the time it was recorded and is for informational purposes only. It is not an offer to buy or a solicitation and no recommendations are implied. It is outside the scope of this communication to consider whether it is suitable for you and your financial objectives.