2015 has been a busy year for mergers and acquisitions in the downstream energy industry. Since October 2014, when oil prices dropped over 40%, six oil and gas companies have filed for bankruptcy. Debt service, which can be 10%+ of revenue, is often the culprit as well as poorly performing gas service bonds in the high-yield energy index. Most recently, Sabine Oil & Gas Corp. sought Chapter 11 bankruptcy protection, making it the sixth and largest US oil producer to file as a result of cheap crude oil prices.
2016 will hold some interesting challenges for those in downstream energy. Below are some of the issues we believe the industry will face in 2016.
At the tail-end of 2015, the Federal Reserve made headlines by announcing a quarter-point increase in interest rates for the first time in almost a decade. They also announced that further increases are on the horizon, albeit at a gradual pace, as they watch the economy and monitor the effect of each incremental increase.
For mergers and acquisitions, this of course affects loans and eventually results in a market increase in the cost of capital for the industry, affecting lender credit terms. Raising capital always has challenges, and increased interest rates doesn’t help.
Additionally, rising interest rates will have a negative impact on the unit prices of master limited partnerships. MLP’s performance fell 38% in 2015. Comparatively, the S&P 500 slipped less than 1%. Whether real or perceived, falling crude prices is triggering an exodus of capital as investors exit the energy space, which includes MLP exposure. MLP’s need capital to fund already-committed-to projects as MLP growth has been largely acquisitive. As profits paid back to unit holders have decreased or even stopped entirely, MLP prices drop and investors move elsewhere. It’s the proverbial catch-22: stock prices drop and cost of capital increases. Raising capital is an option but unattractive due to cost and resulting dilutive effect to investors. Its likely multiples will decrease and downstream M&A activity will slow.
Acquisitions of convenience store chains will be affected by the ever-increasing pattern of higher wages. This is a challenge for store owners and managers to get creative about profitability. Of course store owners want their employees to be able to support themselves, so the challenge here is to make sure that individual employee compensation doesn’t endanger overall company stability.
Further down the line, changes in health insurance could positively affect business owners. If the United States does move toward a single-payer system, businesses will be relieved of the burden and cost of providing health insurance as a benefit. These savings can then be put toward direct compensation. However, these changes will not happen in 2016, and wage increases have already been on the rise. The cost of keeping employees could result in less willingness to acquire c-stores, and more focus on less employee-dependent ventures.
Weaker IPO Market
In addition to interest rates, the slowing of the US IPO market has already had a negative impact on businesses that had planned on forming master limited partnerships. The volatility of the stock market has investors less willing to take risks, causing companies to delay going public. If the IPO and overall stock market doesn’t rebound in 2016, we expect MLP’s waiting to go public will continue to wait, which will serve to flatten M&A activity and values on the retail and dealer wholesale business segments.
All in all, 2016 brings unique challenges and changes to the M&A market. With continually low oil prices, rising interest rates and stock market volatility, downstream energy is experiencing a lot of caution from investors. Despite this, M&A activity does remain strong, and companies that approach the year with a strategic financial strategy will be able to meet these challenges and maintain profitability. While the existing MLPs and national convenience retailers will continue their acquisitions, we expect valuations to decline which may generate more “peer-to-peer” transactions in our industry.