In our latest episode of Upstream in Perspective, we discuss trends within the mergers and acquisitions market, with Dan Pratt and Lysle Brinker of our companies and transactions service. Dan and Lysle will also be sharing some key takeaways from the Global Upstream Mergers and Acquisitions review in London. Here’s an excerpt from the podcast:

Kiran Sanghera: Let's start with the topic of deal flow. We've seen that deal flow around the world is shifting. I saw in a recent IHS Markit report that the upstream deal value for Europe increased substantially from 2016 to 2017. What should we expect for European mergers and acquisitions activity in 2018?

Dan Pratt: Well, you're absolutely right, and we did see a pickup in M&A activity in Europe in 2017. We saw quite a number of private equity-backed players enter the space as well as some large acquisitions, particularly Total and Maersk, so 2017 was a significant step up in M&A activity. In fact, in the second half of 2017, we saw more M&A activity in the North Sea then we saw in the Permian Basin in the U.S.

That said, I don't think you'll quite see that level of activity going forward. We would expect to see maybe some smaller deals get done in and around the North Sea. There is the potential for a very large merger out there, the LetterOne-BASF potential merger with Wintershall, so that could be a very impactful and sizable one but, other than that, I think you will probably see a little bit of a slowdown and maybe some smaller deals than what we've seen in the last 12 months or so.

Kiran Sanghera: There is a large inventory of opportunities on the market, but the quality of those opportunities is mixed. Can you talk about some of the regions you believe are key targets for buyers this year?

Dan Pratt: Sure. I mean I think if you look at just the trends the last several years, I mean, obviously, North American has been anywhere 50 to 60% of total transaction value globally the last several years, so we're going to continue to see that going forward. North America will continue to attract buyers and, I think, even within the sector within North America itself, we'll see M&A activity. We've gone through a period of what I like to called acreage building, position building, particularly in the Permian, and so now we're starting to, I think, transition more into some consolidation within that space. We already saw a deal this year with Concho and RSP Permian, and so what I think, we'll start to see a little bit more of some consolidation in unconventional US.

Dan Pratt: Now, obviously, that's not for everybody, so outside of the US we've seen a lot of interest in Brazil, in Mexico, and those areas will continue to attract capital. There have been very active bid rounds there, so we expect to see a lot of activity and interest in Latin America. Outside of that, I think it's a little more sporadic. I think areas across Africa, Asia have challenges, not only geopolitically, but in terms of their regulatory and fiscal regimes, and so there it's going to take companies who have very kind of focused niche strategies who think they can exploit value out of any of those assets, so internationally, it's hard to point to any one particular region. I think it's going to be kind of company by company, play by play, country by country as to where specific companies think they can extract value.

Kiran Sanghera: Upstream mergers and acquisitions slowed during the second half of 2017. How are oil and gas companies integrating mergers and acquisitions into their corporate strategies in 2018 and beyond?

Lysle Brinker: Yes, well, activity did slow. We have seen a lot of the larger companies, oil and gas companies, especially the global international players, are in a process of restocking their portfolios for a lower-price environment. A lot of their exposure had been at the higher-cost types of resources, such as oil sands and LNG projects, and they're restocking their portfolio at the lower end of the cost curve, including a lot of deep-water assets and unconventional assets in North America where cost deflation has significantly helped to bring down the breakeven points for some of these assets. Nonetheless, they are still constrained, to some extent, because of more limited cash flows in the current oil price environment, but nonetheless, longer term, they will need to continue to balance their portfolios with both short and long-cycle opportunities in order to meet the challenges of maintaining production and, perhaps, production growth in the decade ahead.

Kiran Sanghera: What do you see as some of the major impediments to mergers and acquisitions deal flow in the year ahead?

Lysle Brinker: I think, in 2017, one of the things that helped to support increased deal flow and deal activity was that oil prices had recovered or were recovering and were stabilizing, so that provided buyers and sellers with a little bit more confidence in terms of the outlook for pricing, which helps to reduce the gap, the price gap between what buyers and sellers are willing to arrange.

This year, we have quite a dichotomy of drivers in terms of the outlook. I'd say there's more uncertainty right now with regard to the forecast for oil prices. Even though prices are still in the 60, $65 range, the futures curve is very backward dated and to an extreme degree. Looking out for the next two or three years, based on the futures curve, all prices will decline, perhaps, by 7, 8, 9, or $10 per barrel, so that provides uncertainty. You also have geopolitical uncertainty as more of an issue this year given some of the events that are occurring in the Middle East and in Russia and so forth.

You also have, on the supply side, because oil prices are higher, that is certainly driving more volume, more activity in North America, which is providing more supply, and of course, the delicate balance that OPEC is trying to achieve with its supply management. All of these things are creating more uncertainty in terms of price outlook, and that is one thing that is dampening activity right now.

Dan Pratt: Yeah, and I would just add to that, one of the things that's very different about this down cycle than previous down cycles is the amount of debt leverage across the industry. Companies are still trying to deleverage to a certain degree, and doing acquisitions, particularly corporate acquisitions where you have to take on the debt of the buyer and, potentially, having to sell non-core assets in an already saturated asset market could be very challenging, so that's another hurdle to M&A activity.

Listen to the full interview with Dan Pratt and Lysle Brinker on our podcast. Or, you can learn more about our companies and transactions service.

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.