Economic crises have a way of driving Merger & Acquisition activity.  When companies with similar business models join forces, operating costs can be reduced.  One of the largest corporations in the world – US based Oil and Gas giant Exxon Mobil (NYSE:XOM) – came into being as a result of a merger between the two independent operators in response to an economic crisis in their sector – the price of oil had fallen to $10 per barrel in 1999.

While cheap oil benefits consumers and other business sectors, the current slide in prices is truly a crisis for companies and countries that rely on oil to thrive and survive.  In Australia we have already seen large scale proposed acquisitions of both Santos and Oilsearch fall by the wayside.  

In the past week Beach Energy (BPT) stepped up and acquired former Cooper Basin rival Drillsearch Energy (DLS) in a deal that sent DLS stock spiking 26% while the BPT price remained essentially flat.  Although year over year DLS is down 32% and Beach has dropped 45%, both stocks were in an uptrend prior to the announcement.  The uptrend began as the price of Brent Crude rallied for a brief period in early October.  Here is a one year chart for the price of Brent Crude.

Now here is a one month price movement chart for DLS and BPT showing the rise.

Experts predict more M & A activity in the Oil and Gas Sector and there are other ASX listed producers/explorers with assets in the coveted Cooper Eromonga Basin in Queensland and South Australia.  The Cooper Eromonga Basin boasts the largest and most mature deposits of oil and natural gas in Australia.  The maturity is key, as with 50 years of drilling history the needed infrastructure is in place. 

Does the newly constituted Beach Energy merit consideration as a buy?  And do some of the other potential M & A targets in the Cooper warrant your consideration?  Given the price volatility we have experienced and the uncertainty regarding when and by how much the price of oil could recover, is any investment in the Oil and Gas Sector best left to punters?

The Beach/Drillsearch deal has gotten positive reviews from big brokerage firms, including Credit Suisse, Morgan Stanley, and UBS.  There is another compelling reason, still largely under the radar, that suggests a medium to long term investment here could be a worthwhile move.

The reason rests in the financial condition of the government of the one of the world’s largest oil producers – Saudi Arabia.  Oil prices plunged from about $115 per barrel in June 2014 to under $70 by the end of the year. High at the list of explanations for the drop was the explosive growth of oil production in the US, with some analysts stating the US had overtaken Saudi Arabia as the world’s largest producer by some measures.  

Historically when the price of oil has fallen leading producers cut production to stabilise the price.  Perhaps sensing an opportunity to cripple the US shale oil production, OPEC countries, led by Saudi Arabia, decided not to cut production.  At that time much was written about Saudi Arabia’s massive cash reserves; with estimates ranging from $700 billion to $900 billion. Conventional wisdom was that Saudi Arabia could weather the storm of lower prices while protecting its own market share through the anticipated slowdown in oil production in the US.

Despite concerns from other OPEC countries, Saudi Arabia maintained its position of refusing to cut production as the price continued to fall in what seemed to many as an economic war with US producers.  In July 2015 – a little more than one year from the onset of the collapse – the Saudis hit record high oil production. 

The first glimmer of trouble appeared around the same time when the Saudis raised roughly $5 billion dollars through bond sales – the first such sales since 2007.  Although the Saudis had expected to run deficits, their reluctance to cut spending has led to larger than expected deficits.  The conflicts in Yemen and bonus payments to Saudi military and state workers instituted by the new King have made a bad situation worse.  The governor of the Saudi Arabian Monetary Agency predicted there would be further borrowings.

The country had already been withdrawing funds held in foreign assets, a trend which continued with analysts estimating the country has taken out between $50 and $70 billion in assets over the past six months.

In late October the IMF (International Monetary Fund) came out with a startling prediction that Saudi Arabia’s remaining cash reserves could last only another five years.  The financial press was filled with article titles including the “B” word – bankruptcy.

Some analyses that followed the report speculated on spending cuts in Saudi Arabia but few, if any, mentioned another possible response – cutting oil production to drive up the price of oil.  Should the Saudis reverse course and do now what markets expected them to do last November and cut production, a substantial upswing in the price of oil, and by extension the stocks of oil producers and explorers, is likely.

That prospect would seem to make investing in Beach Energy and the other Cooper producers more attractive.  At the very least, retail investors should be scouring the news for anything relating to the financial condition in Saudi Arabia.

With that in mind, let’s look at some numbers for Beach Energy, Drillsearch, and two other Cooper Basin oil companies listed on the ASX.

The marriage between Beach and Drillsearch appears ideal as DLS has extensive exploration acreage in addition to its existing operations which the company recently projected would grow by 50% over the next five years, subject to continued success in its exploration projects. For FY 2015 Drillsearch reported $250 million in revenues.

Although Beach has assets elsewhere in Australia and in Africa, the company’s core focus is the Cooper Basin. Beach reported revenues of $750 million in FY 2015, three times that of Drillsearch.  The combined company will be the largest operator in the Cooper, with both conventional and unconventional gas production to complement its oil operations.  The deal is expected to save the combined company about $20 million in yearly operating expenses.

The unsuccessful bids for Santos and Oilsearch piqued investor interest in takeover prospects in the Cooper Basin so both Senex Energy (SXY) and Cooper Energy (COE) got bumps in share price on the news of the Beach acquisition of Drillsearch.  Here is the chart.

Cooper Energy is the smallest company in the table and generated $39 million in revenue in FY 2015 from its Cooper Basin operations and gas assets in the Gippsland Basin near Melbourne, along with oil producing assets in Indonesia.  The company holds 15 production tenements in the Cooper, with 11 leased to Beach Energy as operator and the remaining four operated by Senex Energy.

Senex Energy also has shared assets in the Cooper Basin with Beach, making this company along with Cooper potential takeover targets from the newly constituted Beach Energy.  Like all these stocks, Senex saw declining revenues and profit in FY 2015.  The company has extensive exploration and production tenements in the Basin. Of 23 exploration permits, four are in joint venture with Beach and Drillsearch, and another four with Cooper.  Of 18 production tenements in the Cooper Basin, five are in joint venture status with Beach.  

Despite the dramatic drop in oil prices note that three of the four stocks in the table are expected to show positive earnings per share (EPS) growth over the next two years. The percentages listed can be misleading for stocks coming off a low base.  In addition, Senex Energy has forecasted EPS growth for one year only.  Here is the actual reported EPS for FY 2015 along with the expectations for 2016 and 2017.

Most are of the opinion that the price of oil will eventually rise.  Although no one can accurately predict when that might begin, there is another condition beyond a Saudi Arabian led cutback in production that could act as a catalyst.  Investment in exploration and development has dropped substantially, raising the prospect of not enough supply to meet future demand.  Certainly forecasts have been wrong before, but the following chart from international shipping association BIMCO and the IEA shows demand rising in the second half of 2016.

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 This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article.