American Oil and Gas Reporter - March 2023 - 38

McKinsey: Here Comes An M&A Wave
NEW YORK-Historically high cash
generation across the North American
upstream sector may create the perfect
market conditions to accelerate merger
and acquisition activity for market leaders,
suggests analysis from McKinsey & Co.
" The oil and gas industry has a long
and storied history of M&A transactions
and strategic deal making, " the firm considers.
" Inorganic investment decisions
have shaped the portfolios of industry
players and determined the ultimate success
and long-term growth trajectories
of these companies. With the industry on
the precipice of historically high cash
flows, we expect another wave of M&A
to dominate near-term actions. "
The Remaining Option
According to McKinsey, the singleminded
focus on growth that characterized
so many producers' strategies not
so long ago has given way to a more
thoughtful approach. " Over the past few
years, investor sentiment has driven the
oil and gas industry to practice capital
discipline and prioritize financial resiliency
and cash flow generation above
growth, " the firm observes. " When prices
surged in 2022, upstream companies
maintained their strategy of 'no-to-low'
capital growth. This focus on capital
discipline and cash generation has resulted
in record cash flows. "
McKinsey says its examination of historical
cash flows and projected operational
and financial performance for 25 leading
North American exploration, drilling and
production companies has yielded some
impressive findings. According to the
firm, operating free cash flows reached
approximately $85 billion in 2022, with
a year-end cash balance of $70 billion$100
billion.
" This industry turnaround is dramatic,
given negative cash generation the previous
three years, " McKinsey comments.
" Free cash flows are projected to remain
high, with levels between $70 billion
and $90 billion in 2023 and between
$50 billion and $70 billion for the following
four years-even if oil prices
drop to around $65-$70 per barrel over
the coming years. "
It goes on to indicate that operators
have used their strong cash flows to pull all
38 THE AMERICAN OIL & GAS REPORTER
the traditional levers of capital management,
such as shoring up balance sheets and returning
value to shareholders. " However,
there is so much cash coming in that many
of these levers are hitting a natural cap or
are already exhausted, " the analysis finds.
The levers McKinsey has analyzed
include:
· Capital expenditure re-investment;
· Debt reduction;
· Shareholder returns; and
· Energy transition investments.
Only some of the available cash flow
will be reinvested, McKinsey suggests.
The firm explains that producers throughout
the industry have explicitly announced
plans to maintain capital discipline and
only increase capex in line with inflation,
even if prices remain high. Should the
trend endure, capex likely will be constrained
to current guidance issued by these companies,
capping future cash flow allocation
for this purpose.
Meanwhile, the firm reports, debt for
the 25 production companies in its analysis
shrunk $25 billion from 2021 to 2022
and is predicted to drop another $15 billion-$20
billion by 2027. " Forecasted net
debt for many operators may approach
zero-an outcome unthinkable just a few
years ago, " McKinsey considers. " Payments
are expected to be capped at
expiring notes only, reaching up to $10
billion in 2023. "
With debt burdens reduced, the analysis
forecasts direct returns will become the
priority. Share buybacks tripled from 2021
to 2022, reaching $21 billion for the
report's 25 independents and representing
approximately 5% of total outstanding
shares. " Likewise, dividends doubled over
this period to reach an all-time high of
$23 billion, and are expected to climb to
between $30 billion and $40 billion over
the next year, " McKinsey adds. " However,
direct returns will likely also have a natural
ceiling in the range of 25%-30% of total
sector operating cash flow. "
Regarding its suggestion that companies
are directing cash toward the energy transition,
McKinsey says many operators are
investing to reduce their emissions or make
early moves to participate in energy-transition
value chains. Even so, it allows, " we
expect a ceiling of 5% of operating cash
flow to be allocated to these efforts. "
Hearty Appetites
After the 25 companies in the firm's
analysis exhaust every option for spending
their cash, McKinsey predicts, they still
project to retain a collective " war chest "
of hundreds of billions of dollars in 2023
alone. " The primary tool left in the corporate
finance toolkit is deployment of
cash through M&A, " the firm reasons.
McKinsey's analysis describes the oil
and gas industry as, in many ways, " the
epitome of competition and free-market
capitalism, " and goes on to cite the M&A
aphorism that " you are either at the table,
or you're on it. "
" This is a harsh reality, but companies
with strong M&A capabilities and bold
strategies often exit the cycle fully fed
and healthy, " the firm muses. " Dealmaking
in the North American upstream sector
in 2022 generated relatively low upstream
transaction value compared to previous
years, due to a range of factors in the upstream
sector, such as high oil prices,
and macroeconomic factors impacting
all sectors, including geopolitical instability,
inflation and the possibility of recession.
However, our analysis of the
fundamentals indicates that a new M&A
wave is coming. "
According to McKinsey, industry trends
suggest that numerous strategies are driving
the latest wave of consolidation. It
divides these transactions' buyers into
several categories based on their strategies,
including " basin consolidators, " which it
says are likely to try and add scale and
leverage operational advantages to achieve
outsized returns; " integrators, " which will
pursue assets in adjacent portions of the
value chain to expand margins and increase
resiliency; and " the bold, " which probably
will invest some of their cash stockpiles
in seed businesses to reshape their portfolios
and position for the energy transition.
" Overall, consolidators will likely be
those that have pulled the operational
levers to have better cash flows than
their geographically proximate competitors, "
the firm says. " As in the past, successful
industry players will work tirelessly
to define and deliver a strategy
rooted in sound M&A investments-
honing their evaluation skills and integration
capabilities-to accelerate their
future growth and performance. " ❒
American Oil and Gas Reporter - March 2023

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