Oil Merger Mania: The Best Way to Make (and Lose) Money

By Markets Fool.com

On April 8th,Royal Dutch Shell announced it was buying BG Group for $70 billion. This shouldn't come as a surprise, as the most severe oil crash in six years is a great opportunity for stronger oil companies to acquire quality oil and gas assets on the cheap. However, with oil merger maniapotentially heating up, I feel the need to warn long-term investors about the dangers of short-term speculating regarding who may be bought out next, and suggest a much safer method of profiting from oil industry consolidation.

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Why short-term merger speculation can be dangerous
Whiting Petroleum Corp is a perfect example of how making a potential buyout the cornerstone of a short-term investment can be a big mistake.

On March 9th, The Wall Street Journal broke the news that the highly indebted independent oil producer was shopping around for a buyer -- news that sent the share price soaring as much as 13% that day. While the move by Whiting made sense because of its heavy debt load -- made worse by its $3.8 billion acquisition of Kodiak Oil & Gas in 2014 just before the oil crash -- investors hoping to "get in on the ground floor" of a major buyout ended up getting burned.

That's because on March 24th, Whiting announced a major convertible debt and stock offering that sent shares crashing 22%. The reason the market reacted so violently to the news was because the deal could supply Whiting with up to $2.5 billion in new liquidity -- meaning it likely won't need to sell itself after all.

What's worse, the deal could potentially dilute existing shareholders by a staggering 55% should Whiting shares be trading above $39 per share come 2020, which would likely trigger the conversion of its new convertible bonds into additional shares.

Thus, Whiting Petroleum shows the downside of speculating on a distressed oil producer being acquired. The very fact that a company needs to sell itself -- distress due to unmanageable debt levels -- means that, should an acquisition not occur, investors might end up getting the short end of the stick.

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For example, should oil prices remain low, or drop even lower, distressed oil companies may be forced to aggressively dilute existing shareholders, as Whiting recently did. Or worse yet, should credit markets dry up and no buyer appear, distressed oil companies may end up going bankrupt, causing investors to lose their entire investments.

A better, safer alternative to speculating on oil-crash mergers
The most important thing to remember about oil-crash mergers is that such consolidation is healthy for the industry in two ways. First, it can transfer assets from distressed and overly leveraged companies to stronger, more conservatively run ones. When oil prices finally recover, the acquiring company can boast a stronger market share and higher margins because of synergistic cost savings and higher production volumes.

Mergers between large, healthy companies allow blue-chip oil companies to increase their production and reserves cheaper than by investing billions into further drilling and exploration. Throw in potentially billions in cost savings, and it becomes clear why deals like the Shell-BG Group merger are so attractive.

For example, Royal Dutch Shell expects to be able to generate $2.5 billion in annual cost savings by 2018 via its BG Group acquisition, and it expects the merger to increase its oil and gas reserves and production -- compared to 2014 levels -- by 25% and 20%, respectively.

Thus, investors in Royal Dutch Shell -- which already pays a generous 4.9% dividend yield -- have reason to celebrate not only likely improved future sales and margin growth, but a growing payout as well, especially once oil prices recover.

Bottom line: The best way to profit from oil mergers is to not speculate on them at all
Buying distressed companies in the hopes that a stronger competitor will snap them up later is a speculative, short-term move that opens you up to many negative potential consequences, such as continued share price declines -- in which case even a possible merger may be for less than what you paid for the shares.

In addition -- as with the example of Whiting Petroleum -- a debt and equity offering might dilute your holdings and scuttle a buyout deal entirely. In a worst-case scenario, a possible bankruptcy could cost your entire investment.

The best way to profit from mergers -- in the oil industry, or in general -- is to not speculate on them at all. Just buy quality companies with the goal of holding them for the long term, and view any profits from a future merger as a "cherry on top."

The article Oil Merger Mania: The Best Way to Make (and Lose) Money originally appeared on Fool.com.

Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.