Merger Arbitrage: Energized by All-Stock Transactions in Oil & Gas

Jason Hill and Anthony Vecchiolla, CFA

Summary Points:

• In the US merger arbitrage world, opportunities are emerging, despite volatility and regulatory uncertainty.
• The energy sector stands out, with an increasing number of stock-only transactions.
• Although the frequency of all-stock deals may fluctuate, the strategy itself has been a consistent feature of energy sector M&A.
• As we progress through 2024 and beyond, the prevalence of all-stock mergers in the energy sector may serve as a barometer for industry sentiment and liquidity conditions.

Merger arbitrage is bottom-up driven, and Calamos Merger Arbitrage Fund’s portfolio reflects the idiosyncratic nature of the opportunity set. Below, we’ll take a look at one area where we’ve recently found interesting opportunities: all-stock mergers in the energy sector.

An all-stock merger is a form of corporate consolidation where the acquiring company uses its own shares as currency to purchase the target company, rather than using cash or a combination of cash and stock. In this type of transaction, shareholders of the target company receive a predetermined number of shares in the acquiring company in exchange for their existing shares. The exact exchange ratio is typically based on the relative valuations of both companies when the merger agreement is signed.

Utilizing all-stock transactions in energy sector mergers is not a novel phenomenon but rather a cyclical strategy that has ebbed and flowed with market conditions and industry dynamics. Characterizing this as a recent trend would be an oversimplification of a complex, long-standing financial instrument in the sector's M&A toolkit.

These deals are particularly attractive from a trade-structure perspective because short interest rates are currently relatively high, directly boosting profitability. Typically, when investing in all-stock deals, our strategy involves buying long stock in the target company while shorting the acquirer’s stock on a specific ratio within the deal terms. With short rates hovering around 4% to 5% for some time now, this approach has become even more appealing than when rates were near zero. The reason is simple: higher short rates translate directly into profit through the income generated from shorting stock. Typically, when borrowing stock to short, the borrower can expect to earn approximately the short-term interest rate (fed funds rate) minus 3/8 of a percentage point as long as there are shares available to be borrowed. In cases where there is less liquidity and/or more volatility, there could be fewer shares available to borrow, and the investor who is shorting stock could earn a smaller rebate.

Preservation of Cash Reserves

The trend toward all-stock mergers in the energy sector represents a strategic pivot from the cash-heavy deals that dominated the sector during periods of elevated commodity prices and ample liquidity. The rationale behind this shift is multifaceted. Primarily, all-stock mergers allow energy firms to preserve cash reserves—a crucial consideration in an industry known for its capital-intensive operations and vulnerability to price volatility. By utilizing equity as currency, these companies can pursue growth and consolidation strategies without depleting their balance sheets, thereby maintaining financial flexibility in an uncertain macroeconomic environment.

Alignment of Interests

The structure of all-stock deals provides an inherent risk-sharing mechanism between the acquiring and target companies. As both entities' shareholders retain ownership in the combined entity, they share in both the merger’s potential upside and downside. This alignment of interests can be particularly advantageous in an industry subject to commodity price volatility and short- and long-term challenges associated with energy transition pressures and evolving regulatory landscapes.

Valuation Flexibility

From a valuation perspective, all-stock transactions can mitigate the complexities of determining fair value in a sector prone to cyclical swings. By exchanging shares rather than cash, companies can sidestep precise point-in-time valuations, which can be especially challenging during periods of commodity price volatility or when future cash flows are difficult to project.

Recent Examples

Recent high-profile mergers in the energy sector have utilized all-stock deals, including ExxonMobil's acquisition of Pioneer Natural Resources, and Chevron's merger with Hess Corporation. These deals, as well as others announced in 2023, showcase the growing preference for stock-based transactions among industry leaders. We have had a favorable view toward these energy deals being completed for a few reasons. Although nearly all transactions valued at more than a billion dollars have received second requests from the Federal Trade Commission (meaning that the Commission requested more information from the involved parties leading to another lengthy stage to the review), the energy landscape is highly diversified and their products are undifferentiated, which means that even the combined entity wouldn’t have market power that would pose risks to consumers.

For example, Exxon has a 3.8% market share in global oil and is the largest US producer, and encountered no problem purchasing Pioneer Resources, which had a nearly one percent global market share. This deal cleared antitrust despite the combined entity having a 40% share of the Midland Basin, a component basin of the larger Permian Basin, the most productive oil field in the United States.

Moreover, mergers in the energy and materials sectors have had the lowest historic takeover premium of any industry due to the commoditized nature of the businesses and all producers’ products being fungible. In a risk-arbitrage trade, this translates to lower downsides in deal breaks and, thus, lower ultimate risk compared to deals in other sectors. We continue to like the outlook for energy deals and expect the consolidation to continue.

A Cautionary Note on All-Stock Transactions

The trend of all-stock transactions is not without potential drawbacks. The dilutive effect on existing shareholders and the potential for market volatility to impact deal values are not trivial considerations. Additionally, the success of these mergers will ultimately hinge on the realization of synergies and the combined entity's ability to navigate the evolving energy landscape.

The Cyclical Nature of All-Stock Mergers in the Energy Sector: A Historical Perspective

Historically, the energy industry has witnessed alternating periods of cash-dominant and stock-dominant deal structures. The prevalence of all-stock mergers tends to correlate inversely with commodity prices, balance sheet strength, and overall market liquidity. During periods of robust oil and gas prices, such as the early 2010s, cash transactions often dominated because the companies making acquisitions had strong cash flows and the ability to leverage balance sheets.

However, the industry has repeatedly turned to all-stock deals during downturns or periods of uncertainty. For instance, the late 1990s and early 2000s saw a wave of all-stock mergers as the industry consolidated in response to low oil prices. Similarly, in the aftermath of the 2014–2016 oil price collapse, there was a noticeable shift toward stock-based transactions as companies sought to preserve cash and share risk.

The current resurgence of all-stock deals should be viewed in this historical context. It represents a cyclical return to a familiar strategy, driven by factors such as the need for consolidation in certain subsectors, particularly shale; and balance sheet preservation in light of energy-transition pressures.

In Closing

What we are observing now is not the emergence of a new trend, but rather the re-emergence of a time-tested approach adapted to current market conditions. Looking forward, the persistence of this trend will likely depend on several factors, including:

• The trajectory of commodity prices
• The pace and nature of the energy transition
• Broader macroeconomic conditions and their impact on capital markets

All-stock mergers in the energy sector are a recurring strategy rather than a novel trend. Their current prevalence reflects the industry's adaptive response to present challenges, echoing similar periods in its cyclical history.