We are in the later stages of a consolidation phase in shale-oriented E&P’s that began in late 2020 and has continued since without much let up. Put simply, “big fish have eating smaller fish” to enhance their acreage profile to ensure long-term survival. Nearly every large shale E&P has gotten bigger, often repeatedly, by merging with or outright acquiring competitors whose assets complement their own. I discussed one company recently in an OilPrice article that followed this strategy. The company is Devon Energy, (NYSE:DVN). DVN’s made a number of accretive acquisitions since 2021 that had the core rationale of bringing top-tier acreage under its umbrella in key shale plays.
There’s more to this “Drill on Wall Street” strategy than just getting the best acreage before someone else beats you to it. Scaling up is at the heart of every commodity business. It drives Return-On-Invested-Capital-ROIC, which is what attracts investor dollars. So if ROIC matters, and it does, the companies that are the first movers scoop up the best assets early in the consolidation phase, leaving the dregs for those desperate to make a deal as their production nose-dives. This adds an element of urgency to this process as the more desirable partners are gobbled up in what later is a frenzy. In a blog post in May, energy analyst firm RBN characterized the M&A process in terms of a high school dance.
“Mergers and acquisitions (M&A) cycles often play out like a high-school dance. It starts with the Prom King and Queen, and then the most desirable dance partners are eventually taken. Ultimately, the last people to dance are the ones who were too slow to ask and now must react and accept those still left, or end up on the outside looking in.”
In this article, we will discuss some of the key drivers that have played into the M&A activity coming out of the down phase of the current oil price cycle. This is the first of a three-part series that will examine the impact of the shale E&P merger/consolidation phase now in process. In
Lessons from the boom
The application of horizontal drilling and fracking in shale set off the first boom in the early 2010s. Prior to oil and gas being extracted from shale, most U.S. production came from the Gulf of Mexico, Alaska, Texas, and California. The shale boom brought new tens of billions in capital into the oilfield as private equity firms backed startup companies and legacy companies with good strategies for growth toward an IPO. There was really only one watchword in this phase. Growth at any cost. This means to grow production as rapidly as possible, regardless of the cost. Rig counts rose as did production, but few companies had any positive cash flow despite generally good oil prices for much of this period. All cash flow was diverted to constantly adding rigs to generate more cash flow to generate an acceptable internal rate of Return. As a result, the balance sheets of many companies were bloated with debt, and investors began to get nervous about ever receiving a return on their investment.
The boom ended in a bust in 2019, as this Reuters article notes. Investor capital began to flee in search of better and quicker returns and no longer supplied the cash infusions that had kept the drilling “Merry-Go-Round” going around, and a severe downturn began. This downturn was only exacerbated by the Covid panic of 2020, with oil prices dropping well below the cost of production for an extended period of time before beginning a very gradual rebound. With little cash on many balance sheets and massive debt, these companies came within a quarter or two of default on bonds and other credit instruments and an asset sale on the “Courthouse Steps,” in bankruptcy. These companies, with their production declining, no Free Cash Flow or ability to meet their Cost of Capital, or deliver an acceptable ROIC, became the first victims of the consolidation phase.
Cutting costs during the bust
In the boom era, there was very little emphasis on controlling costs. As the bust deepened, there was only one focus for the management of the surviving companies. Ruthlessly cut costs in the merged entity through non-core asset sales, layoffs of personnel, closing facilities and offices, renegotiation of contracts, redesigning wells to be more capital efficient, and using technology to extract more resources than before.
Often, there were opportunities for merged companies to use their new scale within geographic areas to maximize contracting power and technology to improve logistics. Pad-style developments to optimize lateral section lengths and “Zipper-style” fracking are examples of companies pulling out all the stops to reap the benefits of scale. Areas that were determined to be “Non-core” to the future of the company and thus not be able to compete for capital were jettisoned in asset sales to entities better able to put these resources to work.
Drilled but Uncompleted Wells DUCs were also a way for companies to keep production higher while controlling costs. These wells were very accretive to balance sheets as the drilling costs had already been expensed, leaving only the (not insignificant) completion costs. From 2020 through mid-2022, the cumulative DUC count was reduced from around 9,000 to about 4,500 as per the Energy Information Agency-EIA.
By the mid-point of 2021, most companies had worked through much of the rationalization process- cutting costs, making significant progress in deleveraging balance sheets, and upgrading their drilling portfolios. Thanks to a rise in oil prices, they were now ready to begin a new expansion cycle with two key caveats. Capital discipline and shareholder rewards.
Shale E&P’s control costs and use excess cash to reward shareholders
In early 2021, many companies began to introduce revamped shareholder returns programs that included higher dividends and share repurchases. Noteworthy in these companies' newfound attention to shareholders was the introduction of the “Variable” dividend. When combined with a lower fixed dividend designed to be funded through oil price points as low as $40 per barrel, the Variable often allocated 50-75% of net free cash to investors.
One thing that shale drillers have made clear is that capital discipline is here to stay. Leading shale driller Pioneer Natural Exploration’s (NYSE:PXD) CEO Scott Sheffield noted in their Q-2, 2021 conference call-
“Pioneer Chief Executive Officer Scott Sheffield anticipates output in the Permian basin to grow roughly 5% - in line with his own company's planned production increases - over the coming years, while other basins will be flat or face declines, he said during a second-quarter conference call.
Irving, Texas-based Pioneer, is the largest producer in the Permian Basin. It grew its holdings there with the acquisitions of Double Point Energy and Parsley Energy this year.
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The M&A cycle is fairly mature at this point. Deals are getting larger and, therefore, harder to do. Some still get done, as the recent $7.6 bn Chevron, (NYSE:CVX) purchase of PDC Energy illustrates. Others fall, by the way, as the recent, rumored ExxonMobil (NYSE:XOM) purchase of PXD. This was a natural fit for both companies, as I discussed in this OilPrice article a few months ago. These things usually come down to price, and the $50-60 bn it would have taken to get this deal done probably sank it at the end.
However long the M&A cycle has to run, the result so far, combined with higher oil prices, is a revamped industry with relatively clean balance sheets and adequate cash flow to meet investor and single-digit growth objectives. In other words, shale drilling has become a stable business with reliable revenues and profits.
The recent sell-off in commodities has many trading at low cash flow multiples, and yield-seeking investors are beginning to bid up prices in the sector again. One company, ConocoPhillips, (NYSE:COP) has seen shares rally nearly 25% in the last 6-weeks as the market perception of oil-related equities has improved. I think many opportunities remain and will be discussed in future articles.
In the next installment in this series, we will look at how E&P’s reserve life factors into M&A decisions.
By David Messler for Oilprice.com
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