Permian M&A faces challenges
Expectations of a post-Anadarko flurry of merger and acquisition activity in the prolific shale basin may be wide of the mark
The hottest question in US energy M&A is whether the bidding war between Chevron and Occidental Petroleum for independent producer Anadarko Petroleum was a one-time event, specific to the assets and ambitions of the three players involved, or whether it will kickstart a flurry of Permian Basin-focused deal-making.
US independent Occidental trumped Chevron, which had agreed to buy Anadarko for $65/share — a 39pc premium on Anadarko's last closing price prior to the announcement — laying out $33bn plus the assumption of $17bn of debt, for a total cost of $50bn. Occidental, with a little help from billionaire investor Warren Buffett, upped the price to $38bn, leading Chevron to abandon the deal and pocket a $1bn termination fee.
While Anadarko's assets are certainly valuable, many analysts considered Chevron's move a wise one; they think Occidental overpaid.
For both Chevron and Occidental, Anadarko's appeal stems from production growth in the Permian (see table). For Chevron, picking up Anadarko would have connected several of its existing fields to create a 75-mile-wide corridor; connected acreage facilitates the drilling of longer laterals, allowing the extraction of more oil from a well and pushing down the cost per barrel.
Chevron is already one of the biggest landowners in the Permian and the Anadarko buyout would have increased its holdings by 240,000 net acres to over 1.4mn net acres in the Delaware Basin.
Chevron might be tempted to move on to an alternative to Anadarko, but expectations that it will move swiftly could be wide of the mark. The firm will not be in a rush, predicts Jason Gammel, senior oil analyst at investment bank Jefferies. "Where it sees reasonable valuations, it may be tempted. But there is no great urgency," he says.
A sell-side analyst event hosted by Chevron's CFO in New York reinforces this view. The messages that firmly emanated from the company were that Anadarko was very much an opportunistic move when particular circumstances aligned. The thought was that Chevron does not need to do a major acquisition, and that it is very comfortable on its organic growth trajectory.
Oil price concerns
Alongside logical geographical fits, a key factor in the appetite for further acquisitions is going to be valuations. "All the integrated [oil firms] have been fairly consistent, they are not going to do a deal just for the sake of doing something," says Gammel.
Shareholders in the majors have become accustomed to capital discipline, an emphasis on dividends and buybacks, and the divestment of non-core assets. They are unlikely to reward the writing of a big cheque for expensive production, regardless of the Permian's flashy production growth numbers.
Oil price gyrations could, though, offer some interesting opportunities. After WTI's late-2018 swoon to $42.50/bl recovered to top $65.50/bl in late April, the most bullish analysts predicted that it could rise as high as $80/bl. With inventories shrinking due to disruptions affecting major producers such as Iran and Venezuela, this did not seem entirely unreasonable.
But increasingly pessimistic forecasts for global economic growth in 2019, on the back of fears over tariffs and a potential US interest rate hike, led to growing concern over oil demand growth. At the same time, US storage data pointed to an unexpected surge in inventories. The benchmark WTI futures contract slumped to under $51.20/bl by mid-June, only for a ramp-up in tensions in the Mid-East Gulf, combined with slightly more conciliatory language over global trade, to assist it all the way back up towards $60/bl, from where it fell back to the mid-$50s.
If prices step lower again, or even if they remain volatile, oil and gas producers' equity value could slide further. This would potentially increase the attractiveness of long-term targets the relatively cash-rich big beasts have been eyeing. And, some of the Permian's largest independent producers already have share prices 30pc+ lower than a year ago.
When Occidental had its premium bid for Anadarko accepted, several other producers in the Permian enjoyed share price surges, as investors surmised that they could be potential acquisition targets. But the vast majority of these premia have since dissipated, suggesting a flurry of blockbuster deals is not imminent.
Nonetheless, several material players in the Permian could be in the frame to receive friendly — or hostile — acquisition bids. Beyond the majors, other producers of scale include US independents Apache, ConocoPhillips, Noble Energy and Devon Energy. Other smaller, but also potentially attractive Permian producers include WPX Energy, Parsley Energy and Cimarex Energy.
Diamondback Energy, Concho Resources, EOG Resources, Pioneer Natural Resources, Centennial Resource Development and the combined Occidental-Anadarko should be considered as the "Big Six" US independents in the Permian, according to Stuart Joyner, an analyst at London-based research firm Redburn.
Leaving aside acquisition targets that make sense for the buyer based on the geography of their respective holdings, the most attractive Permian takeover targets share three factors: robust balance sheets, lean operations and significant untapped production capacity.
Of the Big Six, Diamondback is one of the fastest-growing companies in the Permian. From its 2012 initial public offering to the end of 2017, the firm's shares ended each year higher than they started, even during the 2014-16 oil price plunge.
While the late-2018 collapse in oil and E&P firm share prices put an end to that run, other metrics have impressed over the past 12 months. The firm's 2018 full-year revenues and Ebitda racked up double-digit increases, while its annual oil production rose each quarter and has now increased by a factor of 10 in just four years.
EOG is a more diversified than Diamondback, with extensive operations throughout the North American mid-continent and internationally. While it is a material producer in the Permian, EOG is also active in other shale plays, including the Eagle Ford, Anadarko Basin and Williston Basin.
EOG was one of the fastest-growing US independents in the run up to the 2014 oil price crash, but since then it has focused on slashing costs. With a market cap of over $50bn, EOG sits on total estimated net proved reserves of almost 2.15bn bl oe. And it can also boast a robust inventory of non-drilled but proven leases that could quickly be deployed.
Free cash flow has increased for five straight years, giving EOG one of the strongest balance sheets of its peers, and its debt pile is comparatively low. It also earns plaudits for being among the most efficiently run producers in the shale fields.
Beyond the Big Six, Devon stands out as a prime candidate as its fracking programmes in Texas are bearing huge productivity gains. While some of its peers struggle with huge debts and shrinking revenues, Devon is reducing debt and its cost of operations, shedding underperforming assets and shoring up its balance sheet. The firm operates 19,000 producing wells across 1.3mn net acres in the Permian. Its cash flow is robust, and it has earnings momentum.
Reluctant to be wooed
Joyner is unconvinced, however, that any of the Permian's more sizeable independents are ripe for a takeover, and their relatively sluggish share price performance over the last eight months would appear to bear out his view.
"Most of the Big Six management teams are firmly of the view that they are about to reap the rewards of what they have been doing," he says. The possible exception is Pioneer, but even in this case returning CEO Scott Sheffield is likely to have a turnaround plan, rather than accepting a takeover bid, in mind. "Mid-2019 is not the time they will be open for an offer," says Joyner.
His view is that the short-term Permian M&A picture will remain similar to that seen over the past three to four years, with the majors doing relatively small consolidatory deals around their existing holdings, some private equity-held assets being sold and peer-to-peer transactions in the small to mid-cap sector.
The larger independents will seek better performance before they exit, he predicts, which would mean any deals for them would have to go hostile, further reducing their attractiveness. The length of time it took Anadarko to engage with Occidental is indicative of the lack of willingness to entertain unwanted interest, he says. "There is value in some of these companies — in accessing a position in a play that will be the marginal price-setting barrel for the global Brent benchmark," says Joyner. "But we are a long way from the 'Per-mania' days of 2014-16."
ExxonMobil is largely in the same position as Chevron in being happy to wait for the right opportunity at the right price, says Jefferies' Gammel, with the caveat that while ExxonMobil has a high-grade Permian portfolio its inventory is not as deep as Chevron's. "Based on its drilling rates, it has not got as long a runway," he says.
But Joyner is unconvinced, given that it is currently exceeding its productivity targets from its newer shale assets. He sees looming substantial capex commitments, e.g. in Guyana, as further obstacles against ExxonMobil doing another significant Permian transaction.
BP is another heavyweight that is unlikely to be involved in any large-scale Permian M&A. The firm only took over full operatorship of the shale assets it purchased last year from UK-Australian independent BHP in a $10.5bn deal in April and its focus is likely to be on improving performance there.
Total would like to get into shale, says Gammel, but it simply cannot make the economics work based on current valuations. It has a natural gas position in the Barnett shale but it is a very small element of its overall portfolio. Without its own Permian platform, Total cannot do bolt-on deals so would require an existing platform and need to secure it with a price tag acceptable to its shareholders.
Given veteran CFO Patrick de La Chevardiere's read-my-lips vehemence at Total's first quarter results presentation about not doing a US shale deal, Joyner does not expect the French firm to change its position before his next quarterly call at the end of July. But should that prove to be the retiring CFO's valedictory appearance, it could leave flexibility for a change in strategy, says Joyner.
Shell has been fairly open about its aspiration to increase its footprint, but again "at the right price", says Gammel. The fact that the firm has become less restrictive about including M&A within its overall spending cap, and instead giving it itself the flexibility to pursue attractive deals that fall within its overall financial framework, could give it greater headroom to splash the cash.
On the other hand, at its capital markets day in early June the firm denied that a major deal was imminent, and that message was "well-received" by the analysts, says Joyner. While that offers no cast-iron guarantees, Joyner struggles to see an obvious 'deal of the century'-style acquisition that would allow Shell to easily justify a screeching U-turn.
Norway's Equinor is not present in the Permian, but it does have positions in the Marcellus, Bakken and Eagle Ford basins. So, while it is unlikely to get involved in Permian M&A, it may well look to supplement those assets if it can find attractive options at a good price, says Gammel.
Possible targets outside the Permian include US independent Cabot Oil & Gas, one of the country's largest gas producers with operations in the Marcellus shale in northeast Pennsylvania and the Eagle Ford shale in south Texas. The firm routinely produces more free cash flow than its gas peers, one of only a handful to generate positive free cash flow.
Cabot benefits from its position as the lowest-cost producer in the Marcellus, with 2019 production costing only $0.11/'000ft³, less than half those incurred by competitor EQT, for example. The firm forecasts c.$2.5bn of cumulative Marcellus pre-tax free cash flow from 2018 to 2020, and production growth in the Marcellus averaging at least 20pc pa.
Predator, prey or neither?
The status of US independent ConocoPhillips within any further round of Permian M&A activity has been much discussed since the Chevron-Occidental-Anadarko battle. The firm looks like too big a meal to be swallowed by all but the largest fish. But, so the thinking goes, if ExxonMobil, Chevron, Shell and possibly even Total took to the waters, it could still be at risk — unless it decides to take the Occidental approach and bulk up to make itself even more difficult to swallow.
In its first quarter results call at the end of April, the firm's CEO Ryan Lance committed to continue doing deals in the first two of what he describes as the "three buckets" of M&A: incremental fence-line transactions that bring additional working or royalty interest or core up the firm's acreage; and larger-scale, high-return, bolt-on asset or acreage deals.
But he admits that what "the bucket people seem focused on now is the third one, bigger corporate transactions that require premiums". "Of course, we pay attention to what is out there. However, we have always said the bar is very high for these large transactions and that is still the case. We are focused on returns and we will not do transactions that are not in our shareholders' best interest," says Lance, stressing that any deal faced "a really, really high hurdle".
But ConocoPhillips is "throwing off an enormous amount of free cash now", Doug Leggate, managing director and head of US oil and gas at Bank of America Merrill Lynch, noted on the same call, wondering whether there is a risk that if the firm "does not do something, someone will see [its] cash flow as attractive" and it will itself become an acquisition target.
By early June, ConocoPhillips' share price had fallen back to $57/bl, as low as it was at the depths of the oil price slump in late December, performance Joyner describes as "pretty poor". "The management are not particularly well regarded," he says. "They need to do something."
His view is in sharp contrast to that of financial services firm Evercore ISI. In a late June note, it continues to favour ConocoPhillips, alongside BP, for what it sees as its focus on capital discipline and enhanced corporate governance.
Its currently depressed share price suggests the market is not expecting a premium bid imminently. Joyner is unsurprised; ConocoPhillips' overall global footprint is gas-heavy and worldwide gas prices are at their lowest level in years. While that could in theory encourage a countercyclical move, ConocoPhillips remains relatively expensive, says Joyner. Total, long linked as a suitor, was likely keener before the spin-out of the Phillips 66 refinery business, given the French major's enthusiasm for integration.
The theory that ConocoPhillips may need to buy in case it is bought is a difficult hypothesis to fully justify. And, without a looming existential threat, its management's hurdles to a major acquisition are unlikely to lower. For a catalyst to kick off more Permian corporate activities, as either purchaser or purchased, M&A bulls may need to look elsewhere.
Extent of principal wells and basins in the Permian Basin Source: Petroleum Economist