The dos and don’ts of M&A in shale

(5 pages)

This article was written before the COVID-19 pandemic and the collapse in oil prices, but during booms and busts alike, our message remains the same: operators pursuing growth via M&A need a disciplined approach to avoid missteps and achieve transformative results.

During the recent boom, the “growth at any cost” mantra became a millstone around the necks of unconventionals operators. Nimble companies responded by shifting their development focus from volume to value, while high-volume drillers that proved incapable of reducing their costs were punished by the markets. The recent collapse in oil prices will accelerate these trends, and a new wave of consolidation can be expected, especially in the Permian Basin.

Some companies will pursue consolidation as a way to reduce costs, while others with strong balance sheets will see opportunities for growth. But a warning is in order: companies should proceed with caution in light of the uncertain outlook and the true costs of acquisition. Of the 30 largest deals of the past five years, the average premium paid was 12 percent, and the average market response was a 6 percent reduction in the acquirer’s share price. Similarly, an analysis of acquirers’ total returns to shareholders in the two years following the acquisitions estimated that returns were 6 percent lower than they would have been if the deals had not taken place.¹

Creating value comes from pursuing excellence and capturing synergies—which isn’t just a euphemism for cutting staff or a quest to add reserves.

From our work supporting North American unconventionals producers across a range of strategic and commercial activities, we have distilled a few lessons on successful M&A to help leaders capture opportunities and avoid pitfalls:

Do review your M&A plans in light of your growth strategy. Rigorously define your growth aspirations to get executives to focus on the right deals. That will narrow the universe of feasible deals so that you don’t end up making a deal just for the sake of it. If, say, your strategy is to increase your operated-rig years, make certain that you base your target’s asset valuation on a development plan that adds rig years, not just inventory, to your portfolio. Successful M&A adds both value and flexibility to an acquirer’s portfolio. The critical question to ask: Do we have a clearly defined strategic rationale for this acquisition?

Digging deeper: Subsurface diligence

As a starting point for due diligence, go beyond validating reserves. Ask more probing questions about your target’s subsurface assets:

What’s the confidence level of defined type-curve areas? Is it possible to achieve type curves reliably within the area, or are the curves based on creaming the best locations? Are trends in gas–oil ratio and water production predictable in the area?
How will future child wells perform? What degree of impairment will frac interference cause for the parent wells? Does the operator have a strategy for mitigating interference? How much could planning reduce future interference losses?
Does the current recipe for completion and spacing maximize section economics or production growth?
How much of future campaigns will be driven by lease obligations? Will that delay the drilling in the best locations or result in infills that are difficult to stimulate?
Are drawdown and flowback protocols optimized? What would be the economic impact of more aggressive or conservative protocols?
What portion of seismic data will still be available after the change of control? Is it valuable enough to justify an additional up-front payment?

Don’t shortcut due diligence. Earnings per share is the first metric to use in evaluating whether a deal is accretive, but it’s only the tip of the iceberg. Understanding technical fundamentals, operating philosophy, and stakeholder engagement is the minimum research work needed for an asset deal; an acquisition calls for all that and an understanding of the corporate culture. That means challenging everything and leaving no stone unturned (see sidebars “Digging deeper: Subsurface diligence,” “Digging deeper: Operations diligence,” and “Digging deeper: Capital diligence”). The critical question to ask: How do we avoid being surprised?

Digging deeper: Operations diligence

Operational efficiency will be the fastest way to create—or destroy—value in your target asset. Understand your target’s operations with these critical questions:

On average, how long does it take the operator to restore production from offline wells? Can we match or improve this?
What’s the downtime for gas compression? How much value could reducing it to the top-quartile level (2.5 percent) unlock?
What’s the operator’s water-management strategy? Could the right capabilities and use of capital improve water reuse?
What’s the operator’s artificial-lift strategy? Is the timing of lift activation ideal, or does it involve waiting until wells die?
What would be the impact of optimizing gas lift across wellbores and compressor stations?
Would reducing system back pressure or debottlenecking create value?
Is the operator’s maintenance strategy reactive or proactive? What impact would a predictive-maintenance strategy have on cost and uptime?
Could economies of scale or acreage contiguity reduce total lifting costs per barrel of oil equivalent? What’s the expected lifting cost a year after acquisition?

Do add value rather than reserves. Creating value comes from pursuing excellence and capturing synergies—which isn’t just a euphemism for cutting staff or a quest to add reserves. Adding reserves without planning to increase capital can destroy value by delaying future cash flows. Similarly, adding discontinuous reserves can destroy value if additional overhead is necessary. On the other hand, bolting on contiguous acreage can unlock operational synergies that outweigh the barrel value of reserves. Expansion that calls for niche skills, such as managing surface complexities, can also add value for the right operator. Successful acquisitions look below the surface to identify upsides. The critical question to ask: Will we create more value than the current operator can?

Digging deeper: Capital diligence

If you can deploy capital more effectively than your target can, your acquisition is far more likely to be a success. Assess your target’s capital efficiency with these critical questions:

How will we take advantage of acreage contiguity or economies of scale to drive capital efficiency?
How does the operator’s drilling and completion performance compare with that of peers?
Could achieving faster feet per day, more stages per day, or more efficient frac-crew planning accelerate cash-conversion cycles?
How many drilled but uncompleted wells does the operator have in inventory? What causes them? What value could careful planning to prevent future backlogs capture?
What are the dependencies affecting the timing of infrastructure expansions?
How effective are the operator’s logistics and procurement teams? Could we capture value by scaling and empowering corporate functions?

Don’t base your valuations on big assumptions. Acquisitions often require large premiums that, in turn, often rely on large assumptions. Don’t put your faith in changes in the commodity-price cycle or extraordinary operational improvements. Everyone’s investor presentations show that they have basin-leading wells, and there’s usually some statistical basis for the claims. The critical question to ask: What do we have to believe for our synergy assumptions to create value?
Do play to your strengths and grow in scale, not in complexity. Entering the North American unconventionals space to diversify your portfolio is a strategy fraught with risk. Play to your strengths to avoid sinking time and money into extensive capability building. Pursue in-basin growth via bolt-ons in areas that you know well or capitalize on operational strengths (for example, managing water or base production, optimizing development, and unlocking low-tier acreage). When evaluating acquisitions, think beyond general and administrative savings and identify technical synergies (for example, from scale-up, operational improvements, lateral-length extensions, and so on) up front. Build a case for retaining technical expertise to facilitate growth and continuity and strive to build a best-of-the-best enterprise. The critical question to ask: How can we capitalize on our core capabilities to create value from an acquired asset?
Don’t mortgage your future. Define your risk profile and protect your balance sheet accordingly. Consider potential concessions, such as divesting noncore assets—your own or your target’s—as part of the M&A, to achieve your growth aspirations. Carefully plan the capital structure of your acquisition in cash, debt, equity, trade, or some combination in light of the operational-synergy goal. The critical question to ask: After completing the acquisition, can we maintain the financial structure and flexibility we need to execute our strategic plan?

Digging deeper: Integration and transformation

Meeting aggressive synergy targets while integrating separate organizations requires rigor and focus. Aim for a transformative result by following these steps:

Establish a single integration-management office, with vocal sponsorship by executive leadership, empowering it both to ensure a successful integration and to meet synergy targets.
Set clear synergy targets based on a single baseline for the new company.
Use the “event” nature of the deal to catalyze cost transformation and mobilize the new company for change.
Don’t stand up separate working teams for merger integration and cost transformation; have one set of teams creating initiatives to capture value across both.
Set a tactical vision of what the transformed organization should look like. Be crystal clear on the new structure: specify the relationship between asset-based and functional groups and how corporate services will be shared or centralized.

Do plan your merger and integration carefully. Our experience indicates that an asset-takeover mentality is dangerously simplistic; a mentality of careful integration offers a better chance of achieving published synergies. Having a dedicated integration-management office can help you meet synergy targets (see sidebar “Digging deeper: Integration and transformation”). Set it up before you announce your deal and get it working immediately to prevent stranded costs, execute synergies, and deploy best practices in merger management. Think of the associated overhead and process burden as temporary but necessary assurances. The critical question to ask: How do we seamlessly integrate our new assets while maintaining our base business and meeting synergy targets?
Don’t expect your merger to succeed without business-development and M&A teams. In a global survey, we asked more than 1,800 leaders whether their recent M&A activity met or missed synergy and revenue targets. We also asked follow-up questions about M&A capabilities. We found that the companies that constantly evaluate their portfolios are more successful at meeting premerger targets. Excellence in deal sourcing, deal making, and execution during the integration process are key to successful business development. In unconventionals, that means subjecting every assumption to rigorous challenge from basin experts for subsurface, operations, land, and regulatory areas. The critical question to ask: Is our organization built for successful M&A?

As M&A activity picks up again in the US oil and gas industry, it’s worth bearing in mind that every failed acquisition doubtless started out with good intentions. Our work with unconventionals operators indicates that growth by M&A requires discipline and care to avoid common missteps. When done well, however, it can yield transformative results.