Warning to energy investors: Beware ‘the great cram-down’

More energy M&A ahead?

Royal Dutch Shell is buying BG Group for $70 billion, in what Thomson Reuters reports is the third-biggest oil and gas deal of all time. It is also the biggest energy acquisition since Royal Dutch Petroleum purchased Shell Transport & Trading in 2004. That's the deal that created Royal Dutch Shell itself.

So will the news lead to a spur of acquisitive activity in the energy space, and how should investors try to play the coming deals?

Wolfe Research energy analyst Paul Sankey says the only major company that could still be set to make a large deal is ExxonMobil. Potential targets for Exxon include Permian Basin plays Occidental Petroleum, Pioneer Natural Resources, Cimarex Energy and Concho Resources, and Bakken-exposed names Hess and Continental, according to Sankey.

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Looking at the options market, Andrew Keene says traders appear to be betting on a deal for natural gas company Energy Transfer Equity.

And Larry McDonald, head of U.S. strategy with Societe Generale's macro group, says that BG Group and Hess were the cheapest large energy stocks, based on the net present value of their oil and gas reserves. That could make Hess the next to go.

But McDonald also has a warning for those tempted to buy energy names just for the potential of a takeout.

A floorhand works on an oil rig in the Bakken shale formation outside Watford City, North Dakota.
Getty Images

Taking the example of Whiting Petroleum, McDonald notes that "everybody thought this was a case where Whiting was going to be acquired, but in the end, they were not, and they had to do a massive amount of bond sales…. They had to issue bonds and then had to issue stock."

For the energy sector overall, McDonald reports that plenty of companies have taken to the debt market, with bond issuance in the first quarter up 60 percent compared to the fourth quarter of 2014.

The problem with the bond sales is that in a concession to those who might otherwise be unwilling to buy the debt, a convertible provision is often attached, such that the bonds can be converted into stock. In fact, 25 percent of the convertible securities issued this year are energy related, McDonald said.

That means that energy equity investors could suffer what McDonald calls "the great cram-down," whereby existing shareholders see their stakes diluted by bond investors who convert their debt into equity.

For Whiting specifically, "there was massive dilution there for the Whiting deal that was forced upon it by the bondholders. So the point is that there's going to be massive winners and losers."

"If you get acquired, great. But if you don't, you're probably going to have to dilute your shareholders in many cases," McDonald warned.

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