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What's Behind the Recent Frenzy of U.S. Energy M&A Deals?

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U.S. shale producer Pioneer Natural Resources Company (PXD - Free Report) on Tuesday agreed to buy smaller rival Parsley Energy (PE - Free Report) in a $4.5 billion all-stock deal — the latest in a wave of consolidation in the oil patch. A day ago, ConocoPhillips (COP - Free Report) confirmed its decision to take over Concho Resources (CXO - Free Report) in another all-stock transaction, valued at $9.7 billion. In September, Devon Energy (DVN - Free Report) decided on a $2.6 billion merger agreement with WPX Energy (WPX - Free Report) , which followed Chevron’s (CVX - Free Report) deal to acquire Noble Energy for roughly $5 billion.

Let’s find out the reasons behind all the deal making in the Oil - Energy space.

4 Key Drivers of the Oil & Gas Dealmaking Flurry

Low Oil Driving Sector Consolidation

Oil’s horror show has seen black gold’s price falling below $30, $20, $10 and even going negative for a while. The commodity’s collapse has threatened the industry’s creditworthiness by hurting cash flows, drying up liquidity and narrowing profit margins.

While all crude-focused stocks stand to lose from plunging commodity prices, companies in the exploration and production (E&P) sector are some of the worst affected, as they get less value for their products. Consequently, they have resorted to pulling back activities and curtailing production in response to sharply lower commodity realization and demand.

In these trying circumstances, merger and acquisition deals are being forged by the upstream operators to cut their average costs and benefit from geographical overlapleading to per-share accretion. For example, ConocoPhillips’ acquisition of Concho Resources is likely to be able to save cost and capital of $500 million, annually, as estimated by both companies.

The New Normal E&P Environment

While E&P companies are looking for expansion and synergy derivations, investors are putting pressure on value creation and higher returns. They no longer support drilling programs and expansions in the absence of strong cash flows amid low commodity prices. Investors want these companies to reduce costs, improve internal efficiencies, boost share repurchases and increase returns.

In this context, consolidation is viewed as a key to deliver shareholder value. As capital access (both debt and equity) becomes increasingly difficult and expensive, smaller players are counting on willing buyers to revive and accelerate their growth plans. In a nutshell, a bigger entity is expected to have a lower cost of capital. For the acquirer, it leads to large-scale development opportunities.

As Pioneer’s President and CEO Scott D. Sheffield put it in the context of Parsley Energy’s acquisition, “Parsley’s high-quality portfolio in both the Midland and Delaware Basins, when added to Pioneer’s peer-leading asset base, will transform the investing landscape by creating a company of unique scale and quality that results in tangible and durable value for investors”. To put it simply, in this era of heightened shareholder scrutiny, the companies are ultimately responsible for returning capital to their stakeholders. An accretive acquisition is a way to position a company to deliver improved corporate level returns throughout the inherent boom and bust cycle of oil prices.

Permian Remains the M&A Hotspot

The Permian Basin in the West Texas and New Mexico was the hottest U.S. shale play before the coronavirus-induced downturn, and a slew of deals over the past few months with a combined value of more than $20 billion have cemented the view that assets in the region still remain attractive investment opportunities.

The buyout of Noble Energy’s assets is anticipated to add 92,000 acres to Chevron’s Permian Basin position, while Zacks Rank #3 (Hold) Pioneer Natural Resources’ Parsley acquisition would solidify the status of the former as one of the biggest operators in the most prolific basin in the United States. Further, Devon Energy and WPX Energy have decided to merge in a bid to strengthen their position in the premier unconventional play. Meanwhile, the largest energy deal since the outbreak of coronavirus is believed to have catapulted ConocoPhillips to Permian’s No.2 producer behind Occidental Petroleum (OXY - Free Report) .

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This once again points to Permian shale’s superior economics and viability even at the current oil prices. Experts say that it’s cheaper to drill and complete oil wells in the Permian Basin, as compared to most other major fields. The low operating cost stems from the region's extensive pipeline infrastructure, plentiful labor and supplies, and relatively warm winters that make year-round work possible. Most other domestic shale regions need far higher prices to support new developments and expansion.

Standalone Companies are Finding It Difficult to Compete

At the current energy environment, scale has become more necessary than ever. In these trying times, dealmaking is primarily seen as a way to achieve a widerreach and prune overhead, in the process improving the resulting company’s financial discipline. This is particularly applicable for the shale-focused companies.

Shale drilling by nature suffers from steep decline rates, meaning the wells deplete quickly. Consequently, the operators are required to go on drilling new wells to compensate for the lost barrels and forcing them into a capital-intensive situation just to maintain output level – one which some of them are unable to cope with. A potential solution is to merge into a larger firm and gain scale.  

Further, oil between $45 and $50 a barrel is considered the break-even point for most shale operators, which means that they need crude prices of at least $45 to balance their operating cash flows with capital expenditure. At the prevailing crude prices of under $40 per barrel, a number of firms are unlikely to hit cash flow breakeven. However, a series of consolidation activities in the oil patch has helped some of them to add to their size and see out the lower prices.

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