MorningWord 8/27/15: Oil Slick – $HAL, $BHI, $SLB

by Dan August 27, 2015 9:33 am • Commentary

Back in November 2014, when crude oil was down about 50% from its prior 52 week high, the number two oilfield services company Halliburton (HAL) agreed to acquire number three in the space, Baker Hughes (BHI) in a $34.6 billion cash and stock deal, sending Baker’s shares from the high $40s to the high $60s:

BHI 1yr chart from Bloomberg
BHI 1yr chart from Bloomberg

What stood out at the time was the unusually large break-up fee of $3.5 billion. That would trigger if, for any reason, regulators opposed the deal.  At the time, $3.5 billion represented 10% of the proposed purchase price. But now that the stock is below the levels where the deal was first announced it is a whopping 16% of BHI’s current market cap. Talk about an embedded put!

Puts against long positions in equities that are tied to the price of underlying commodities like crude oil are a useful thing, especially when there is no decay like the one in this break up fee.  To get a sense for just how damaging crashing crude has been on large oil service companies take a look at BHI sales since 2010. They rose $10 billion from then to last year’s peak at $24.5 billion, and back down to this year’s expected $16.2 billion. From Bloomberg:


The decline in revenue means BHI will go from a peak of $4.20 a share in 2014 to an expected loss of 20 cents a share in 2015.

Yesterday the number one player in the space, Schlumberger (SLB) threw their hat in the M&A ring with a nearly $15 billion cash and stock deal to buy Cameron (CAM).  CAM shares rallied about 40%, below the proposed 56% premium to the stock’s previous close as there will be a regulatory review. And the purchase offer is for .71 shares of SLB (plus cash), but SLB’s shares declined 4% on the day.

M&A has been a theme since oil’s collapse last year, with some mega deals. Per WSJ:

Royal Dutch Shell PLC said it would pay nearly $70 billion for Britain’s BG Group PLC; pipeline giant Energy Transfer Equity LP offered $48 billion to buy Williams Cos.; and a partnership controlled by refiner Marathon Petroleum Corp. announced plans to acquire MarkWest Energy Partners LP for $15.8 billion.

And it is likely to persist if oil stays at $40 for a protracted period of time as the larger companies will need to take-down costs and take-out competition.

But the urge to merge doesn’t signal that all clear in the oil patch.  Bloomberg highlights one big factor this morning: Oil Industry Needs Half a Trillion Dollars to Endure Price Slump that:

“U.S. drillers account for 20 percent of the debt due in 2015” and

“Slumping crude prices are diminishing the value of oil reserves and reducing borrowing power, even as pressure builds to find replacement fields” and

“If oil prices stay at these levels, the number of bankruptcies and distress deals will undoubtedly increase.” and

“Credit-rating downgrades are putting additional strain on the ability of oil companies to raise money cheaply.”

Lower for longer oil may cause a full on credit crisis that starts in the oil sector and spreads back to sovereigns and financial institutions.  I am not saying this is going to happen or if it did just how contagious it would be, but it’s important to know that this is a possibility.

For those Fed officials who have said the lower oil prices will only have transitory effects on inflation, they could be thinking about the whole situation wrong.  This view has recently been echoed by Fed New York Federal Reserve President Dudley. These comments remind me of Fed officials suggesting that the Subprime lending fallout on 2007, early 2008 was contained.  We know how that ended. The powers that be had “NO IDEA” as Jim Cramer famously said in the summer of 2007, or they were just lying in hopes of buying time.

Either way, as the largest players are getting busy buying rivals this time around, I think it’s safe to say they are not doing it out of a position of strength or optimism, but survival. At some point the risk reward of getting involved from the long side in one or two of these names may be impossible to resist. But if and when I am willing to take a shot on an oil rebound, I’ll likely dabble in a name like BHI that has embedded puts.