Look to Energy Sector for Fashionable M&As

Significant merger and acquisition (M&A) action is currently happening among private equity firms in many sectors. Dealogic, a national research firm, announced that through May 21 of this year there has been $2.3 trillion in announced deals. This puts it on track for $4.7 trillion in 2007, a 20% increase over the record set in 2000 at an inflation- adjusted $3.9 trillion.

In the past, troubled companies were purchased, made profitable, and then went public, often resulting in gains for shareholders. But the process was timeconsuming. Today's strategy is to acquire healthy companies that can immediately contribute to the bottom line.

A few years back, a major M&A trend swept through the energy industry. Exxon merged with Mobil. British Petroleum merged with Amoco, and then bought Arco, etc. That trend, however, is over. It was driven by unique circumstances; the plummeting oil prices of the late 1990s took a huge toll on energy companies. Plus, the big companies needed the scale and size necessary for their massive projects in Asia and Africa. Now that they have it, there's little incentive for more mergers.

The current M&A boom is ready to spill over into the energy markets, creating potential gains for those positioned properly. In the coming years, the interesting action will be in small oil companies. When one of the giants devours one of the small fries, there are big profits to be made. Keep in mind that stock prices go up following an acquisition. So the message here is to hold on to your stocks in the right energy companies and look for opportunities with others.

The process will not originate with private equity firms; they will avoid oil stocks because they are regarded as risky. One major problem has been evaluating political risks in countries throughout the Middle East. Private equity firms don’t understand the heavy crude market. They fear the possibility of alternative energy programs. Many are too impatient to deal with long-term exploration activities that may or may not result in finding new reserves. For these and other reasons, M&A activity will be somewhat incestuous.

But, why, with record profits, are the majors in this acquisition mode? Initially, it would appear that companies like Exxon and Mobil should be thrilled with current profits and a situation that has them drowning in cash. One recent report has Mobil making more than $4.7 million in profit hourly. Other companies are also gushing cash and their debt levels are low.

These record profits also bring pressure to maintain performance for shareholders. They all have plenty of cash, but no time to replenish reserves. For example, new projects in West Africa won't yield oil for at least 10 years. Major oil companies have to perform for shareholders today rather than a decade from now. The only way to keep dollars pumping is by acquiring smaller companies with these reserves and other benefits. So, the pressure is on the CEOs of major energy companies, and it is this pressure that will fuel M&A.

As an investor, it would be worthwhile for you to look at small energy players, which may be targets for acquisition. Consider the following criteria:

• Do they have significant reserves?
• Do they have seasoned/experienced management teams?
• Are they involved in new geographic areas of exploration?
• Are they developing new types of technology that can identify and then mine oil?
• Are they available at good prices?

If this activity is of interest, avoid traditional private equity firms and go directly to the source. Research smaller companies and see if they are candidates for acquisition.

James DiGeorgia is editor and publisher of the Gold and Energy Advisor Newsletter (www.goldandenergyadvisor.com) and the author of the popular books The New Bull Market in Gold and The Global War for Oil.