Table is finally set for takeovers in the energy sector

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The next stage of the Great Oil Patch Downturn is upon us.

When Suncor Energy, which portrays itself as the benevolent face of Canadian energy, goes hostile with a bid for one of its trusted partners, it's a signal that bargains in specialty areas can no longer be ignored.

There is a tiny list of possible bidders for the target in question, Canadian Oil Sands, the largest interest holder in the Syncrude Canada Ltd. joint venture, and Suncor can likely wring the most value out of it, based on its deep knowledge of the business. In fact, the rest of the list might include just the other Syncrude owners, led by the well-funded Imperial Oil.

On Monday, Suncor ruined the COS board's whole day by going straight to hard-hit shareholders with a $4.3-billion all-stock offer after failing to negotiate a friendly deal. The betting is that COS will spurn the initial bid, judging by how its shares flew past the offer price. What isn't known is whether a white knight will step up, or if Suncor and COS will get together and sweeten the deal. Rare is the hostile volley that immediately hits the mark.

Either way, it appears Canadian Oil Sands, created to make rich payouts to shareholders based on sales of Syncrude's synthetic oil, outlived its usefulness as oil prices cratered and dividends slashed. It has also been bedevilled by Syncrude's operational mishaps.

Its shares tumbled to multiyear lows, as have those of many energy companies. Since Suncor launched its bid, stocks throughout the sector have surged as investors wager on the next target and Darwin's theory begins to play out.

Sure, there have been months of expectations that the oil collapse would beget a takeover frenzy, and then the chirping of crickets. This time, however, it will be tough to avoid.

The sector has been hit by two distinct commodity slides in the past year, and the most recent one that started in June has done the most damage to companies' finances. This means the number of would-be (or, more accurately, don't-want-to-be-but-have-to-be) sellers has jumped. That's a recipe for mergers and acquisitions, says Adam Waterous, co-head of global equity and advisory at the Bank of Nova Scotia.

The lengthy oil slump into the $40s (U.S.) a barrel has squelched cash flow – the lifeblood of capital spending – and made overhead and operating costs rise sharply as a percentage of companies' overall value. Also, as Suncor's play for COS shows, well-funded companies can bulk up on assets within their areas of expertise and geography while promising that money can be spent more efficiently, Mr. Waterous says.

"Deal activity will pick up quite dramatically now and over the next few months. We're already seeing it to some extent," says the veteran deal-maker.

Suncor, which just last month paid $313-million for part of Total SA's interest in the jointly held Fort Hills oil-sands project, has been one of a few companies tipped as "consolidators" due to their mighty balance sheets. Others include Imperial and Canadian Natural Resources. These are uniquely positioned to acquire assets in the oil sands, a portion of the Canadian energy sector that has been under severe pressure due to inherently high costs.

Among potential targets, Cenovus Energy and MEG Energy, both oil-sands developers, keep coming up as investors dig in for a long period of tempered growth expectations.

Investors have also keyed in on players that had been burdened by high debt levels. Penn West Petroleum, which has been selling assets left and right to reduce its borrowings, has surged 45 per cent in the past two days. Baytex Energy is up 27 per cent.

It's a big repricing in a small period, though it's important to note that the sector is still down 35 per cent from one year ago and crude remains under $50 a barrel. That means the contrast between the industry's haves and have-nots will remain stark and provide takeover opportunities for the former.

With the downturn now into its second painful year, investors have lost patience for energy producers whose future is predicated on a rebound in oil prices, and bidders will be welcomed.

Factors that may hold back deals in the next few weeks are the federal election on Oct. 19 and the Alberta budget eight days later, as buyers wait to gauge the political climate. But the rest of the table appears set.

"There is an increasing spread, from a valuation perspective, between the successful companies and companies with less success," Mr. Waterous says. "That gives the successful companies the firepower to make offers."