There was a significant increase in oil and gas M&A and related financing activity in 2014 compared to 2013. By the end of November the value of M&A transactions was over $46 billion, more than three times the aggregate value for the same period in the previous year.
Reasons for this increase in activity included:
- The extremely cold winter in North America increased natural gas prices and raised the values of natural gas producers.
- Several large US producers, including Devon, Apache and EOG Resources, consolidated their Canadian operations, disposing of non core properties. Devon’s sale of its Canadian conventional assets to Canadian Natural Resources for C$3.13 billion was the largest asset deal of the year.
- The shale plays in the Montney, Duvernay and other areas of Alberta and BC continued to attract investors looking for significant reserves in close proximity to proposed LNG projects on the West Coast of British Columbia. Kuwait Petroleum Corporation’s US$1.5 billion purchase of 30% of Chevron’s Duvernay assets and Apollo’s purchase of Encana’s Bighorn assets for C$1.9 billion were examples of these kinds of transactions.
- Access to capital markets provided the financing required for energy M&A transactions.
This increased activity occurred despite growing concerns that proposed pipeline projects to key export markets may be further delayed or even prevented by increased opposition to those projects, and notwithstanding a lack of significant participation in M&A from Asian acquirors, including state owned enterprises (SOEs). However, the rapidly declining oil prices rapidly declined in Q3 and Q4 of 2014 slowed the M&A activity by year end and the capital markets window for energy issuers closed.
1 | M&A activity will pause, but for how long?
Oil prices started to decline in June. By mid-December, West Texas Intermediate had fallen from US$100 to below US$55 a barrel; a drop of more than 45% in just six months. While historically OPEC would reduce production to support price, this time OPEC refused to change its aggregate 30 million barrel a day output. Presumably, this refusal was an effort to drive high cost oil, such as that produced from US shale plays, the Alberta oil sands and offshore projects, out of an oversupplied market to preserve market share for OPEC.
Initial reaction to the price slide was tempered concern. Participants in the sector proceeded with caution, but were intent on staying the course with capital programs and other commitments that had already been made in advance of the winter drilling season. But as prices continued to fall through one predicted “floor” after another, producers slashed 2015 capital budgets and cut projected dividends to conform to reduced cash flows.
These kinds of dramatic declines in oil prices have happened before. In the late 1990s oil fell to US$10 a barrel only to rise to US$150 a barrel by 2008. During the recent Great Recession prices slid to US$35, but recovered to the US$100 a barrel range by 2014. So for many the question this time is not whether oil prices will recover but when and to what extent.
Some M&A activity will continue notwithstanding these price declines. Deals that already have been announced and transactions focused on dry gas plays are likely to proceed. There will also continue to be activity involving midstream assets. Keyera acquired gas plants in Q4 and remains acquisitive. AltaGas has said that it plans to double its asset base over the next five years. And in December Veresen and KKR formed Veresen Midstream to acquire gas gathering and compression assets from Encana and the Cutbank Ridge Partnership and to expand midstream facilities for Encana and CRP in the Montney region of north east BC.
But for deals involving oil assets or that are otherwise affected by the price of oil, expect a pause in M&A activity that will continue through the first part of 2015. During this pause buyers will wait to see if prices keep falling before committing to acquisitions, while sellers will try to avoid selling at the bottom of the cycle.
The lower that oil prices go and the longer that those low prices last the greater the negative impact on the sector. Time will not be on the side of the undercapitalized. They will have to quickly identify exit or recapitalization strategies. Producers that need access to capital markets or debt to fund operations will look to consolidate, particularly in share for share deals and may be forced to unload assets to raise cash or sell out completely. Restructurings, recapitalizations and other forms of insolvency or quasi-insolvency processes involving producers unable to service their debt obligations are also likely to occur.
By contrast, well capitalized participants will see this as a time of opportunity.
Asian investors saw opportunities in the Great Recession to make substantial investments in the Canadian energy sector, particularly in the oil sands. They and other foreign investors may be attracted back to Canadian energy opportunities created by the current low oil price environment, particularly if:
- Ottawa’s SOE Guidelines and other restrictions on foreign investment can be modified to encourage their investments.
- Some progress can be made with the proposed pipeline and LNG export projects to diminish the perception that Canada cannot get these projects done.
2 | A new merger wave may occur
In the past, prolonged periods of low commodity prices and weak energy stock market valuations have led to consolidation in the sector. After the deep price drop in the late 1990’s BP acquired Amoco and Arco. Exxon bought Mobil and Chevron acquired Texaco to become so-called super majors. Following the price declines in 2009 larger firms picked up smaller companies while others shed exploration assets or projects that were a drag on profits. Although the current oil price decline has only lasted six months Repsol’s US$13 billion take over of Talisman that was announced in December (the largest deal in the Canadian energy sector in 2014) may be an early indication of things to come. Some have commented that this transaction is not indicative of an M&A trend but rather the result of Talisman’s two-and-a-half-year sale process. However, the rapid drop in the price of oil was clearly a factor in reviving stalled negotiations and getting the parties to agreement. Other factors that may produce more transactions like the Repsol/Talisman deal are:
- The oil price decline has reduced the value of energy companies. In some cases market capitalizations may be less than the value of assets.
- The Canadian dollar has fallen against the US dollar, providing a discount to acquirors with US dollars.
3 | Funds will look for bargains
Private equity funds have been significant investors in the Canadian energy sector. To the extent the values of their existing investments have declined with the plunge of oil prices, their exits from positions in both publicly traded and privately held producers may be delayed.
Many of these private equity participants raised large new funds before oil prices fell such as Warburg Pincus’ recently completed US$4 billion dedicated energy fund. Other participants may raise new funds now on the basis that this is the time to buy, like Blackstone’s current raise of its second energy fund with a limit of US $4.5 billion. We expect accordingly that private equity’s appetite for deals will remain strong. They will look for buying opportunities as producers are forced to bridge cash shortfalls by selling assets.
There should be more deals like Aspenleaf’s recent bid for Coral Hill Energy. Aspenleaf is backed by ARC Energy Fund and Ontario Teachers. Those funds can provide the money that Aspenleaf needs to take the development and exploitation of Coral Hill’s properties to the next stage, something Coral Hill may have been delayed or prevented from doing alone by lack of required capital. By offering the option of Aspenleaf shares for Coral Hill shares, Coral Hill shareholders will be able to participate in any value creation that may result from Aspenleaf’s development and exploration program.
Pension funds are also likely to look for bargains in Canadian oil and gas producers as the market reprices at the bottom of the cycle.
4 | Pressure will build on Ottawa to revise its SOE guidelines
Although there was significant M&A activity in the energy sector in 2014 until oil prices started to decline, that activity was dominated by deals involving conventional oil and gas assets. Only a few deals occurred in the oil sands. There was also significantly less activity involving foreign investors - particularly SOEs.
Some of the transactions involving SOEs that did occur included:
- Indian Oil Corporation’s acquisition from Petronas of a 10% interest in Progress Energy’s natural gas properties and in the Pacific North West LNG Project.
- Kuwait Petroleum Corp.’s US$1.5 billion purchase from Chevron of 30% of Chevron’s interests in its Alberta Duvernay play.
Other transactions involved the termination of joint venture arrangements such as:
- PetroChina’s $1.184 billion purchase of the 40% interest in the Dover oil sands project that it did not own following Athabasca Oil’s exercise of its right to put that interest to PetroChina; and
- PTTEP’s swap of interests in oil sands properties with Statoil that resulted in PTTEP owning 100% of some of those properties and Statoil owning 100% of the remainder.
The PTTEP/Statoil swap transaction was significant because it was the first acquisition by SOEs of majority interests in oil sands properties to be approved by Industry Canada following the announcement in late 2012 of changes to the SOE Guidelines including that majority acquisitions in the oil sands by SOEs would only be permitted on an “exceptional basis”.
In addition to changes to the SOE Guidelines, the Government has increasingly used its national security powers under the Investment Canada Act. Despite pronouncements welcoming – indeed urging – foreign investment in telecommunications, national security reviews led to the demise of two proposed high profile foreign telecom investments in Wind Mobile Canada and in Manitoba Telecom’s Allstream division.
Many energy sector participants have blamed the increased hurdles for SOEs as well as the uncertainty surrounding national security reviews for the steep drop in deals involving foreign investment in the oil patch, particularly by SOEs. The Alberta Government as a result has called on Ottawa to take another look at those rules. Furthermore, the Canadian Association of Petroleum Producers has said that Ottawa should raise the dollar threshold for scrutinizing foreign investments – now set at $354-million based on the book value of the Canadian business – because it is hampering the ability of smaller companies to make deals.
The requests for change come as SOEs grow increasingly sour on Canadian energy investments, owing in part to their struggles to make profits from the many billions already spent in Western Canada.
5 | Acquisitions and offerings involving royalty vehicles will occur
In 2014 Encana completed the spin out of 5.2 million acres of fee simple mineral title lands in Alberta to PrairieSky Royalty Ltd. Encana established PrairieSky to provide exploration opportunities on its fee simple mineral title lands to third parties rather than conducting those operations itself. PrairieSky retains royalty interests in those lands and dividends its net royalty receipts to its shareholders. Encana then proceeded to sell its interests in PrairieSky through an IPO and subsequent secondary offering.
The IPO of PrairieSky was one of the biggest public offerings in Canadian history. Over $1.67 billion was initially raised by Encana as it sold down its interests in PrairieSky to 54%. The PrairieSky shares were priced at $28 in the IPO. They quickly traded up to $40 in the weeks that followed. That encouraged Encana to sell its remaining interests in PrairieSky for an additional $2.56 billion.
The success of the PrairieSky IPO and subsequent secondary offering has other owners of fee simple mineral title oil and gas rights considering whether to monetize their interests in those kinds of properties in a similar manner to the PrairieSky deal.
Cenovus, CNRL and other owners of significant fee simple mineral title lands have commented that they are considering PrairieSky kinds of transactions. An alternative may be to sell those fee simple lands to PrairieSky. In December, PrairieSky acquired Range Royalty, a non-publicly traded royalty vehicle with 3.5 million acres of royalty lands, in a $700 million transaction. PrairieSky has announced that it is looking for other targets of this nature.
Expect more IPOs like PrairieSky and more transactions like PrairieSky’s acquisition of Range Royalty in 2015.
6 | Challenges for oil sands projects will continue
Oil sands projects, whether open pit mines or steam assisted gravity processes, are expensive to develop and take a long time to produce revenues. Rising construction and equipment costs, shortages of labour and the growing criticism of the environmental impact of these projects are among the challenges facing developers. In addition, there are concerns that repeated delays in proposed export pipeline projects will limit access to overseas and other markets and reduce the value of the heavy crude produced from these projects.
For these and other reasons, a number of proposed projects were cancelled or suspended in 2014:
- Suncor cancelled its $11.6 billion Voyager Upgrader.
- Total and Suncor suspended the $11 billion Joslyn oil sands project.
- Statoil suspended its Corner project until at least 2017.
- Royal Dutch Shell halted work on the application that it was developing in respect of its proposed Pierre River Mine.
- Sinopec and Total indicated that they were considering either shelving or selling their Northern Lights oil sands mine project.
Meanwhile a few of the smaller entities in this space including Connacher, Southern Pacific and Sunshine, struggled with technical and other problems that consumed capital and constrained production from their projects. When oil prices fell below US$70 a barrel, Connacher and Southern Pacific quickly announced strategic review processes.
Even before the dramatic decline of oil prices in the last part of the year, M&A activity in the oil sands had stalled. This was blamed in part on the changes to the SOE Guidelines that barred SOEs from buying controlling interests in the oil sands after CNOOC’s acquisition of Nexen and Petronas’ acquisition of Progress that were approved in 2012. Some deals occurred:
- Osum purchased Shell’s Orion oil sands project for $325 million.
- The remaining 40% of the Dover project was put by Athabasca to PetroChina for $1.184 billion, a discount from the $1.32 billion that was initially agreed to be paid.
- PTTEP swapped assets with Statoil to end their joint venture.
For the most part, however, sales processes were abandoned when acceptable bids were not received.
These challenges will continue and intensify in 2015. While low oil prices may slow activity and reduce costs for oil sands developers, they will also increase the pressure on companies with projects in development to reassess the viability of proceeding. Companies that are dependent on access to the capital markets or debt to finance the development of their projects may be stalled and forced to sell out to opportunistic acquirors with access to the necessary capital.
7 | BC LNG: A year of reality checks
During 2014, many of the significant LNG projects proposed for the West Coast of British Columbia seemed to be making progress.
Required environmental and other regulatory approvals at the federal and provincial levels, including LNG export licenses, were granted in the ordinary course without the delays and absent the passionate opposition that proposed oil pipeline projects experienced. Indeed, in November, Environmental Assessment Certificates were issued for three LNG projects in northern BC: the Westcoast Connector Gas Transmission pipeline, the Pacific NorthWest LNG export facility in Port Edward and the Prince Rupert Gas Transmission pipeline.
The Province also introduced:
- The Liquefied Natural Gas Income Tax Act that provided tax rates on LNG production that were substantially reduced from the rates initially suggested by the Province; and
- the Greenhouse Gas Industrial Reporting and Control Act establishing the carbon taxes applicable to these projects.
This legislation was generally favourably received by project developers and provided them an important part of the certainty that they needed to determine their economics.
However, certain realities regarding fundamental elements of these projects came into sharp focus as the year progressed, raising serious doubts as to whether some of the proposed projects will proceed on schedule, or at all. These include:
- The challenges of controlling costs, securing sites and entering into the necessary commercial arrangements and alliances with First Nations and other stakeholder groups.
- The risk that LNG demand will be diverted from Canada to brownfield LNG projects on the US Gulf Coast, which have proceeded far more rapidly than expected as a result of fewer regulatory hurdles and their use of existing infrastructure.
- Increased competition for the Chinese market that will result from the massive gas export deals entered into between Russia and China.
- The fall in the price of oil. LNG pricing has historically been effectively linked to that commodity, and at least some project proponents expect to price their LNG off oil if their projects proceed.
These concerns have disrupted progress:
- Petronas recently announced that its final investment decision would be delayed past 2014, citing construction costs, falling oil prices and various approvals that still had not been obtained.
- British Gas delayed a final investment decision on its Prince Rupert LNG Project plans until 2017.
- Apache withdrew from the Kitimat LNG Project and sold its interest to Woodside Petroleum. Whether Woodside will continue to develop the Kitimat LNG Project as a priority remains unclear.
- Douglas Channel LNG sought CCAA protection in late 2013.
- KOGAS has been looking to sell a further portion of its remaining 15% interest in LNG Canada, having earlier sold a 5% stake to Shell.
In 2015 at least some LNG project participants will struggle with the viability of their proposed developments and the trend to defer, suspend or at least re-organize projects will likely continue. Some projects may even be consolidated or abandoned as the field gradually narrows. What has become clear is that these are complex and costly projects, with economics that may be difficult to predict and which face competition from LNG projects in other countries or regions some of which have inherent competitive advantages. Consequently, we expect that there will be various M&A opportunities in respect of these proposed developments even before the first LNG project in BC is completed.
8 | There will be continued resistance to proposed (and approved) pipeline projects
Increased pipeline access to refineries in the US and Eastern Canada and to the Canadian east and west coasts to access international markets remains critical for Canadian oil producers in order to:
- Reduce the discount that Western Canadian Select heavy crude sells for; and
- Mitigate the impacts of declining demand for Canadian crude as the US increasingly relies on its domestic production.
Proposed pipeline projects that would provide that access have faced fierce resistance. As a result, they have not progressed significantly during the past year. We expect continued opposition to these projects in 2015, including resistance to TransCanada’s Energy East from Ontario and Quebec and more objections to the TransMountain expansion from the city of Burnaby.
Also watch for decisions on the proceedings commenced to challenge the Federal Cabinet’s approval of Enbridge’s proposed Northern Gateway project, and appeals from those decisions. Among the key issues to be resolved are whether the Federal government met its duty to consult with and accommodate First Nations interests regarding that project.
9 | Oil will continue to be moved by rail while major pipeline projects struggle to be approved and built
Production of crude oil from Western Canada continues to exceed the capacity of existing pipelines to deliver that oil to refineries and markets. Meanwhile, construction of new pipelines to provide needed additional capacity continues to be delayed. While waiting for those new pipelines to be built, a significant role has emerged for rail. The lack of public opposition to shipments of oil by rail and the existing extensive web of rail lines across North America have made rail an increasingly popular method of transporting excess crude production to market.
In 2014 the amount of oil moved from Western Canada by rail averaged approximately 220,000 barrels per day – up 80,000 barrels per day from 2013.
It is estimated that an average of 400,000 barrels of crude per day will be shipped by rail in 2015 – nearly double the 2014 average – although recent oil price declines may reduce shipments as producers either scale back production or balk at paying the premiums for shipping a barrel of crude by rail.
Regulations to improve the safety of shipping oil by rail will be passed in response to an increase in the number of spills that have occurred as more and more oil is being shipped by rail. In this regard, we expect further amendments to the Transportation of Dangerous Goods Regulations in 2015, in addition to the previous amendments enacted and Protective Directions issued in response to the Lac-Mégantic disaster that occurred on July 6, 2013.
10 | Shareholder activism will escalate
Historically Canada has seen relatively few activist campaigns but that may be changing.
Based on data from Activist Insight, Canadian targets represented approximately 6% of worldwide activism in 2013 and through the first half of 2014 Canada had the third highest global level of activist activity. We anticipate that trend to strengthen, and an escalation of activist campaigns to occur in 2015.
A number of factors contribute to that anticipated escalation, including:
- Historical success of campaigns when measured against the activists’ objectives such as the activist campaign orchestrated by Bill Ackman through Pershing Square in relation to CP Rail in 2011.
- Increasing market acceptance and support for activists.
- Early warning disclosure of shareholdings not being required in Canada until 10% or more of share capital is acquired, as compared to disclosure requirements of 5% holdings or greater in the US. This allows activists to discreetly accumulate a more significant toehold.
- Corporate legislation that is favourable to activists including proxy rules in most Canadian jurisdictions that allow solicitations of up to 15 shareholders without a proxy circular, shareholders with 5% or more being able to requisition meetings, and shareholders of 1% or more being able to propose resolutions.
- TSX-listed issuers having to conduct annual elections for the entire board. Staggered elections are not allowed.
In addition the following recent or anticipated changes are likely to further heighten shareholder activism in 2015:
- Directors of TSX listed issuers are now subject to a majority voting standard, rendering them susceptible to campaigns by activists who withhold their votes in respect of particular directors, thereby compelling the resignations of those directors if the votes “withheld” exceed the votes “for” them.
- Advance notice policies designed to prevent stealth board contests at shareholder meetings have been constrained by Institutional Shareholder Services (ISS) and by a recent Ontario Superior Court of Justice decision that those policies are intended to operate to shield management from ambush, not as a “sword in the hands of management to exclude nominations given on ample notice” or as a mechanism to “buy time to develop a strategy for defeating a dissident shareholder group.”
Given these legislative and other changes anticipated in 2015 and the commodity price trend that has hammered the market capitalizations of Canadian oil and gas companies over the last half of 2014, these companies should think proactively in relation to the potential for an activist campaign as they head into the 2015 proxy season and should understand and be responsive to the concerns of both the activist and average shareholder alike.
The authors would like to thank the following contributors: Glenn Cameron, Keith Chatwin, Jonathan Drance, Rachel Hutton, Susan Hutton, Keith Miller, Craig Story, Cameron Anderson, Zhuo Chen, Brandon Mewhort and Allison Sears .