• Tom Bradley & Atiyu Mehta

Consolidation in the US Energy Space

Updated: Nov 23, 2020

By Tom Bradley & Atiyu Mehta

The US oil & gas sector has seen a wave of consolidation in recent months, from supermajor firm Chevron’s acquisition of Noble in July to a recent flurry of deals that has involved another supermajor in ConocoPhillips as well as smaller Canadian and American shale producers. The rationale behind the deals appears similar in each case as the oil & gas sector faces challenges on multiple fronts.

The first major post-lockdown deal in the US energy space was supermajor group Chevron’s $5bn acquisition of Noble which was announced in July. At the time there was speculation this deal would trigger a wave of consolidation although doubts as to whether further deals would occur existed due to the lack of firms with Chevron’s financial strength – especially amidst record low oil prices caused by pandemic-induced falls in global demand and supply gluts fuelled by OPEC tensions. The deal allows Chevron to expand their position within US shale with the gain of assets in the Texan Permian basin as well as a new position in the Denver-Julesburg basin in Colorado. Chevron have also gained foreign diversification with positions in natural gas in the Eastern Mediterranean and off the coast of West Africa. The deal is forecast to bring lucrative financial benefits as a result of the strong strategic gains with a touted $300m of savings through synergies as well as an 18% expansion of Chevron’s proven oil reserves. These benefits have come at a cheap cost as well – with Chevron only paying a 7.6% premium on the July share price at the time of deal announcement. Noble shareholders will likely feel hard done by only owning 3% of the combined company in spite of the expectation that Noble’s assets will contribute 8% of the combined company’s EBITDA. The deal therefore appears as opportunistic as it is strategic as Chevron took advantage of a cut-price opportunity in an unstable period for the oil & gas sector. However, with many firms, particularly those in US shale, having increasing difficulty in dealing with debt burdens and the price outlook for remaining low for the foreseeable future there exists the incentive for M&A activity with cut-price targets becoming increasingly available. This has been seen with the deals that have followed more recently.

ConocoPhillips, another US ‘supermajor’ firm has also taken advantage of value acquisition targets in US Shale. Conoco are set to buy Concho resources in an all-stock deal worth $9.7bn, the deal will make the merged firm the largest independent oil & gas producer globally, with an estimated output of 1.5m barrels of oil equivalent per day (boepd) making them a larger producer than many OPEC nations. The most significant impact of the deal is the gains it will bring to Conoco in US Shale as the merged firm will become third biggest producer in the Permian which is often touted as the most productive oilfield in the world. Concho is considered to be a particularly strong firm in the Permian basin, producing over 330,000 boepd last year – and even with reduced 2020 output is expected the combined firm will produced 465,000 boepd in the Permian this year. There is long term potential in the Permian for Conoco as they add 550,000 acres to their holdings in the region, taking their overall position to 700,000 acres. These assets include those on both federal and non-federal acreage, which offers important diversity at a time with concerns that Biden may ban fracking permits on government land should he be elected in November. The deal also brings financial benefits with a projected $500m in annual savings through synergies and a material potential for profit with a free-cash flow break even price at just $34 a barrel – below the current price which appears to have stabilised at $40. As with the Chevron-Noble deal sound strategic rationale coincides with an opportunistic approach as Conoco have paid a meagre 15% premium on pre deal announcement share price for a group that can bring lucrative benefits.

In late September, two Oklahoma based shale producers Devon Energy and WPX Energy, announced a ‘merger of equals’. The deal sees Devon acquiring WPX in a like for like stock swap, with WPX share holders being given 43% of the new entity. Interestingly, Devon will only pay a 3% premium on WPX shares. This seems to be part of a developing trend in the shale industry, with competitors consolidating in a series of low premium deals to weather the current downswing in oil prices. The new combined entity has many selling points that set it apart. Firstly, the combined entity has a net debt to EBITDAX ratio of 1.6x, as well as $1.7 billion of cash on hand and $3 billion of undrawn credit. Further, the merger will increase the scale of the new combined entity and allow it to diversify across various sources of production. The combined entity will produce 277,000 barrels of oil per day from multiple basins across the US. The biggest holding of the combined entity is a 400,000 acre position in the Delaware basin that accounts for 60% of total oil production. Only 35% of this is federal land, which is particularly important with the prospect of a future Democratic administration taking power in the USA. Thirdly, the synergies and cost savings from the merger are like to increase annual cash flow by $575 million annually by the end of 2021. Finally, the new entity is switching to a business model that prioritises growth in free cash flow over growth in production. Devon has committed that only 70-80% of operating cash flow will be reinvested, with production growth being capped at 5% annually. This vision of an oil company that seeks reduce costs, increase free cash flow, is measured in its production growth is attractive to investors in a time where global oil demand is weak, and many see the industry in secular decline. This is evidenced by the fact that on the announcement of the deal Devon’s stock price surged 11% while WPX’s surged 16%.

A similar story is unfolding in Alberta, Canada. In October 2020 Cenovus Energy acquired Husky Energy. The $2.9 billion dollar all stock deal will see Husky shareholders being paid a 21% premium on their shares. The combined entity will be Canada’s third largest oil producer and second largest oil refiner. Total production capacity will be around 750,000 barrels per day, and total refining capacity will be 660,000 barrels per day, including 350,000 barrels of heavy oil conversion capacity. The combined entity will increase annual free funds by $1.2 billion, with half of the saving coming from operating cost synergies, and half coming from capital allocation synergies. One of the key aims of the merger was to reduce the companies exposure to Western Canada Select, a price index for Canadian heavy oil that trades at a discount to West Texas Intermediate. This reduction in exposure be achieved through the companies refining capacity and non-Canadian assets. The combined entity will target a break-even WTI price of $36 in 2021 and $33 by 2023. Another motivation for the merger is the potential improvement in the combined entity’s financial metrics. The new company aims to achieve a ned debt to EBITDA ratio of less than 2 by 2022, and to reduce their cost of borrowing by improving the funds-flow metrics. Additionally, the combined entity is likely to have ample liquidity with $8.5 billion in undrawn credit facilities, and no major debt repayments due till 2022. Overall, this seems like a strong move for 2 producers in the weakened Canadian oil industry to combine and improve financial standing, allowing them to weather the storm and forge a path towards reducing leverage and delivering returns to shareholders.

In conclusion, the early 2010s saw a massive expansion of Shale production in the United States. This expansion was predicated on high oil prices, strong oil demand, and easy access to financing. In the current market none of these things are true anymore, and shale producers that expanded aggressively in the boom years are struggling to deal with the new reality, where their business models are simply not sustainable. One response to this has been for major shale producers to consolidate in low premium deals and shift focus away from production growth and toward cost minimisation. This is in order to convince investors that are shying away from the sector that there is still value to be generated by harnessing cost synergies to increase free cash flow and returns in the form of dividends. Whether it will be successful or not remains to be seen, as energy stocks have still not returned to their pre-pandemic levels, and many in the market believe that the industry is in permanent secular decline.