2023-04-21 06:47:28 ET
Summary
- Energy security makes North American energy assets more valuable.
- FCF generation can lead North American O&Gs' M&A rebound.
- 18-year low sector valuations may be a further catalyst for M&A.
- Southwestern Energy has significant gas reserves.
- SWN stock is trading at compelling valuations.
Thesis
My thesis is divided into 2 parts. The first part establishes why I believe we are likely to see more M&A activity in the O&G sector:
- Energy security makes North American energy assets more valuable
- FCF generation can lead North American O&Gs' M&A rebound
- 18-year low sector valuations may be a further catalyst for M&A
The second part discusses why I believe Southwestern Energy ( SWN ) may be a prime candidate for M&A and how this would benefit minority equity investors:
- SWN has significant gas reserves
- SWN is trading at compelling valuations
Energy security makes North American energy assets more valuable
The Russia-Ukraine war has had a significant influence on geopolitical dynamics, and policy making across the globe. Energy security and asset risk and diversification has become a burning issue for both policy makers and enterprises. In fact, the theme of energy security trumped climate change in the list of governments' priorities in 2023.
Within the energy assets universe, natural gas assets have been in greater demand over the past year:
In 2022, 82% of global midstream M&A deals were for natural gas-based assets. This was driven by energy security and supply chain control trends. I anticipate this to continue being a key driver in 2023, especially as the Russia - Ukraine war continues. Hence, I think in this environment, the North American O&G majors, particularly the ones with decent natural gas exposures are likely to be perceived as more valuable.
FCF generation can lead North American O&Gs' M&A rebound
Over the years, there has been a substantial amount of consolidation in the oil and gas industry:
However, the COVID pandemic has adversely affected the number and value of M&A deals in upstream O&G due to a slump in oil prices as demand remained a concern. But more recently , a demand uptick driven by a Chinese economic activity rebound and cut in supply has led to a more constructive environment for oil prices ( OILK ). In the current environment where O&G companies focus on total shareholder return , and hesitate to spend on upstream expansion , the season is ripe for accelerated M&A activity as O&G majors benefit from higher free cash flows among North America's top 25 upstream O&G companies:
The chart above indicates McKinsey's forecasts of free cash flow generation based on oil futures.
McKinsey estimates that $100-230 billion of cash would be available in 2023 for M&A activity among North America's top 25 upstream O&G companies:
Reuters shares a similar view about greater M&A activity:
Soaring stock prices and cash levels at oil-focused U.S. energy majors has driven Wall Street talk of potential deals for European oil producers. Citi analysts in January speculated Chevron or Exxon Mobil ( XOM ) could acquire BP PLC ( BP ), Shell PLC ( SHEL ) or TotalEnergies (TTE) (TTFNF) due to valuation differences.
- Reuters
Chevron CEO Michael Wirth noted that even consolidation between the five top Western oil producers (which includes the names mentioned earlier in the Reuters quote and ConocoPhillips ( COP )) is on the cards although regulatory hurdles may be there at that scale.
18-year low sector valuations may be a further catalyst for M&A
At a sectoral level, the proportionate value of M&A in the O&G sector is at an 18-year low despite low valuations on a P/B level:
I believe this provides a macro valuation tailwind that is conducive for M&A.
All this makes me believe the chances for successful M&A in the O&G sector would be even higher, especially for a smaller company that is less likely to face regulatory hurdles. I think Southwestern Energy fits the bill here:
SWN has significant gas reserves
SWN is a top 3 natural gas producer with top 10 natural gas reserves in the United States. Over the years, a combination of successful drilling results and 2 acquisitions has led to SWN's total gas reserves to increase by almost 90% over the last 2 years from 9191 billion bcf to 17,362 billion bcf:
The lower-risk and more easily commercially available proven gas reserves stand have also increased by 54% over the last 2 years from 6,342 billion bcf to 9,793 billion bcf:
I believe this increases the value of SWN as a potential acquisition asset.
SWN is trading at compelling valuations
Upstream O&G companies such as SWN make money from finding and extracting crude oil or natural gas. Therefore, for these companies, the future earning potential can be estimated by the amount of owned reserves. Considering proven reserves in the calculation reduces the risk and variance range of the fair value assessment.
In its 2022 annual report , SWN reported reserves worth about $37.6 billion after tax based on the PV-10 metric :
On an EV/Reserves Value basis, SWN is trading at compelling valuations at just 0.27x:
Based on M&A transaction comps in the industry, the median transaction multiples have been 3.00x and 4.90x:
As can be seen in the exhibit above, these figures imply at least 61% upside potential for SWN. As a bonus, M&A transaction premiums have been increasing in recent times from 35% in 2021 to 41% in 2022 driven by large amounts of dry powder .
Summary
Other Seeking Alpha analysts have made the bullish case for Southwestern Energy, pointing to the natural gas sectoral tailwinds and the stock's low valuations . In addition to these tailwinds, I believe thinking in an acquirers' shoes reveals more reasons to be bullish on Southwestern Energy.
A combination of energy security trends particularly in the natural gas sector, high free cash flow generation by upstream O&G companies and low sectoral valuations provide a ripe environment for M&A. Southwestern Energy seems to be a high-potential candidate due to its lower size compared to the mega O&G players - thus having higher chances of sidestepping regulatory hurdles. As a leading natural gas producer that has had its proven natural gas reserves expand by 54% over the last 2 years, I believe the demand for the Southwestern Energy business' assets is enhanced. Finally, valuations are quite compelling on both an EV/Reserves basis and based on M&A transaction comparables in the sector. If the M&A catalyst plays out, I see upside potential of more than 60%.
Positioning
I believe Southwestern Energy is a good asymmetric risk-reward bet. If the M&A catalysts kick in, then there is a good chance of a sharp pop up in the share prices. If the M&A catalysts do not kick in, then I believe the low valuations provide some degree of margin of safety in the investment anyway. Regarding the time-horizon of the bet, I would consider 1 year and re-evaluate the position in April 2024.
For further details see:
Southwestern Energy: Think Like An Acquirer