Oil Price Uncertainty and M&A Activity.

• Author: Barrows, Samuel D.
• Position: Mergers and acquisitions

1. INTRODUCTION

   What is the impact of uncertainty on firms' investment activities, more specifically mergers and acquisitions (M&A)? Recent studies highlight the impact of political (Nguyen and Phan, 2017; Bonaime et al., 2018; Chen et al., 2018; Lee, 2018; Cao et al., 2019), stock market (Bhagwat et al. 2016), regulatory (de Bodt et al. 2020), and cash flow uncertainty (Garfinkel and Hankins, 2011) on the level of M&A activity. In contrast to prior work, we investigate the impact of oil price uncertainty on M&A outcomes using the oil and gas sector as a laboratory. Studying oil price uncertainty in the oil and gas sector is appealing as the market price of inputs and outputs is fully observable and allows for a complete resolution of issues related to cross-industry heterogeneity. (1) The oil and gas sector is economically interesting to observe as the industry provides the foundation for investment decision-making under the conditions of risk and uncertainty (Macmillan, 2000; Kellogg, 2014). (2) Crude oil as a commodity is an output in upstream operations and an input in downstream operations. Consequently, this setting further allows us to examine the impact of both output and input price uncertainty on M&A activity.

   The general theories of irreversible investment under uncertainty and real options offer heterogeneous predictions. (3) Incentives of rational agents observed in the irreversible choice theory under uncertainty can lead to a decline in investment activity (Bernanke, 1983; Zeira, 1989; Dixit and Pindyck, 1994; Bloom, 2009; Lee et al., 2011; Carriero et al., 2018; Drobetz et al., 2018). On the contrary, uncertainty can lead to increasing levels of investment in perfect competition (Hartman, 1972; Abel, 1983; Caballero, 1991) and strategic competition (Kulatilaka and Perotti, 1998), for a class of low-risk, low-growth firms (Sarkar, 2000), and in individual industries (Mohn and Misund, 2009).

   In general, uncertainty impacts firm investments and, ultimately, M&A activity via the real options and risk management channels. The real options literature is composed of two strands. The first strand relates to the time value of the option. The value of waiting to exercise the option increases with uncertainty and leads to the deferral of investments until information becomes more complete, e.g., Pindyck (1991) and Dixit et al. (1994). The second strand of the real options literature relates to compound options and opines that conducting investments not only sacrifices the value of waiting options but also results in the acquisition of future investment options. (See, e.g., Kulatilaka and Perotti (1998) and Smit and Trigeorgis (2004)).

   The risk management motive emerges from two strands of literature. First, is the operational hedging literature (Hirshleifer, 1988; Penas and Unal, 2004), where firms hedge input price uncertainty by acquiring upstream producers. Second is the transaction cost literature (Williamson, 1971; Carlton, 1979), where firms can solve contracting problems that increase with uncertainty through vertical integration. Building on this, Garfinkel and Hankins (2011) document that increases in cash flow uncertainty induce vertical integration to hedge operational risk. Using M&A as a risk management tool can also explain the presence of diversifying acquisitions. Banal-Estanol and Ottaviani (2006) argue that firms in high uncertainty environments conduct diversifying transactions to share the risk. To conclude, the real options channel does not establish precise predictions. In contrast, the risk management channel postulates a positive relationship between uncertainty and M&A activity regarding vertical and diversifying transactions.

   Our main hypothesis is that oil price uncertainty impacts M&A activity. However, this link is theoretically ambiguous; the real options framework provides both negative and positive predictions of the relationship. The risk management framework predicts a positive relationship between uncertainty and M&A activity for vertical and diversifying transactions, but not for horizontal. Hence, to establish the link between oil price uncertainty and M&A activity, we need to study the issue empirically. We employ the implied volatility on West Texas Intermediate (WTI) crude oil options as our oil price uncertainty measure. The advantage of using implied volatility is that it is a forward-looking measure of uncertainty (Alquist et al. 2013). Furthermore, we assume that oil price uncertainty is exogenous with respect to M&A activity in the oil and gas sector. Initially, we test the oil price uncertainty and M&A relationship using aggregated oil and gas industry data. Further, to confirm our findings, we utilize firm-level data to rule out the unobserved sector and market-wide drivers of M&A activity.

   We test several additional hypotheses. First, we build a hypothesis on the asymmetric reaction to uncertainty between upstream and downstream participants. They differ primarily in one dimension; their sensitivity to crude oil prices (Kumar and Rabinovitch, 2013). Upstream producers engage in exploration and production, whereas downstream refiners focus on refining and marketing. Upstream producers sell their output on the physical market; thereby, their cash flows are highly correlated to the underlying commodity price. In contrast, downstream refiners see different dynamics since they can take advantage of the crack spread, which is the difference between the prices of refined products and the cost of crude oil as an input (Suenaga and Smith, 2011). This built-in margin allows downstream firms to transfer part of the price variation to their customers. Therefore, the economic impact of crude oil price uncertainty on M&A activity should differ between upstream and downstream firms. We repeat our analysis on a sample divided into upstream producers and downstream refiners to test for these differences. To further elaborate on the viability of the risk management motive, we partition our sample into horizontal, vertical, and diversifying transactions. In line with the risk management motive for M&A activity, we expect uncertainty to be positively related to the number of vertical and diversifying transactions but not for horizontal transactions.

   Our analysis complements a relatively non-developed strand of financial literature on how uncertainty in the product market affects M&A activity. The product market and M&A literature are connected through an empirical study by Hoberg and Phillips (2010), building based on the theoretical model of Rhodes-Kropf and Robinson (2008), which states product market competition creates incentives to merge, especially when the target is producing complementary products.

   The prior literature explores several sources of uncertainty on M&A activity yet neglects oil price uncertainty. Garfinkel and Hankins (2011) document that increases in cash flow uncertainty induce vertical integration and the start of merger waves. Duchin and Schmidt (2013) state that merger waves coincide with elevated uncertainty using expected stock return volatility as an uncertainty measure. Bhagwat et al. (2016) show that an increase in the market volatility index, The Chicago Board Options Exchange Volatility Index (VIX), decreases the deal activity and prolongs the time to deal completion. Nguyen and Phan (2017), Bonaime et al. (2018), Cao et al. (2019), and de Bodt et al. (2020), argue that either political or regulatory uncertainty decreases M&A activity.

   Although to the best of our knowledge, there is no prior study examining the impact of crude oil price uncertainty on M&A activity, Henriques and Sadorsky (2011), Aye et al. (2014), Hsu et al. (2017), Phan et al. (2019) and Maghyereh and Abdoh (2020), come close. Henriques and Sadorsky (2011) examine the effect of crude oil price volatility on strategic investment decisions of U.S. firms. They report a U-shaped relationship between crude oil price volatility and the level of firms' investments. Kellogg (2014), who studies upstream producers, finds a negative relation between implied oil price volatility and investments. Aye et al. (2014) finds that oil price uncertainty negatively impacts manufacturing output. Hsu et al. (2017) report that crude oil prices and production levels in the oil and gas sector are the most critical factors determining M&A activity. Phan et al. (2019) report that uncertainty, measured as the standard deviation of daily returns of oil prices, negatively impacts corporate investment, defined as CAPEX scaled by lagged assets. Maghyereh and Abdoh (2020) show that uncertainty also negatively impacts corporate investments, although the impact is asymmetric and more significant after the prior positive price changes. Our study extends the above literature, examining not only how the uncertainty impacts the overall investment/M&A activity but also introduces a novel forward-looking measure of uncertainty to the literature, namely the implied volatility of crude oil options contracts.

   Using a sample of firms in the U.S. oil and gas sector between 1994 and 2018, we report a negative relationship between oil price uncertainty and M&A activity. The economic effect is substantial; a one standard deviation decrease in the implied crude oil price volatility increases the sectors' quarterly deal count by 136%. Our results hold up after including other widely-used uncertainty measures, both at the industry and firm-level. This negative relationship between uncertainty and M&A activity rules out the risk management motive as the trigger for M&A transactions. Instead, our results are consistent with the view that uncertainty increases the value of the real option to wait (e.g., Pindyck, 1991; Dixit et al., 1994). In line with our expectations, upstream M&A activity is somewhat more sensitive to oil price uncertainty relative to downstream. The results are consistent with findings in Kellogg...