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Another Mega-Merger Is Brewing in the U.S. Shale Patch

The merger and acquisition deals are coming in the shale patch, at a rate almost too fast to document. Last week news broke about Devon Energy, (NYSE:DVN), and Canadian-based producer, Enerplus, (NYSE:ERF) opening merger talks. Enerplus has some choice acreage in the Bakken play that would be very attractive to Devon as it fills in a lot of gaps in its own prime Bakken acreage. They also hold some non-operated acreage in the Marcellus, that would likely be sold off as Devon has no other operation in that basin. The Bakken is home to some of the longest shale laterals, and the ERF "jigsaw puzzle" pieces would assist DVN greatly in maximizing the production from the play.

Details are sketchy at this point, and I wouldn't be surprised if ERF isn't holding out for a cash premium given the liquids-rich "dirt"- 68%, they own. That would be the smart play for their shareholders. DVN has reached for its checkbook in its last couple of deals, for RimRock, and Validus. The stocks of both companies are off from peaks set in Q-3 of last year, DVN about 30% and ERF about 15%. This is the time to be merging with companies that can contribute immediately to the bottom line, and synergistically make Newco potentially a better entity than the two were separately. That's what's supposed to happen anyway.

The question arises, should Devon be the one buying? Here's the problem with the moves Devon has made employing this fill-in-the-gaps, "bolt-on" strategy, from a shareholder perspective. They aren't getting paid for it by the investing community! Perhaps ERF should be buying Devon's Bakken acreage. The industrial logic works that way as well. We will table that thought for now, but return to it as we close out the article.

Put aside other factors, such as declines in oil and gas prices, and focus only on one thing. When Devon bought the RimRock acreage in June of 2022, the share price was $69. When they bought Validus in August of 2022, the stock price was $65. Since those halcyon days of 2022 when people talked glibly of $100 WTI going back to $120, DVN stock has nose-dived, along with WTI, to be fair, into the low $40's. $2.7 bn in cash later and investors have lost 40% of their capital. This is the sort of thing that attracts activist investors, and it wouldn't surprise me to see Engine #1 or Carl Icahn take a sizeable position to get board seats and start swinging a meat axe.

In this article, we will compare a couple the Devon/ERF potential merger with another M&A transaction now in process. There are some glaring differences that should put the proposed deal between Devon and Enerplus in the proper frame.

ExxonMobil and Pioneer Natural Resources

There is a limit to how far you can go comparing a Super Major like ExxonMobil, (NYSE:XOM) and even a large U.S.-focused shale producer like Devon Energy. That said, the "Industrial Logic" behind the XOM deal with Pioneer is evident if you look at the pro forma acreage footprint in the Midland basin, in the slide below. The difference between what ExxonMobil is doing with its merger with Pioneer and what Devon is proposing to do with Enerplus is that the former is enhancing its core acreage position in the most prolific shale basin in the country. It remains to be seen if XOM shareholders will reap any bounty, at least over the short term, from this deal. XOM stock was $112 in October, of 2023 when it was announced, and trades just above $100 today.

Devon, on the other hand, has been expanding into other shale plays, to take advantage of regional aspects of each. The problem with that approach is Devon has not performed in the top percentile in these other basins, nor have they delivered growth to their shareholders.

As noted, Devon's share price has collapsed with each additional deal, while the management of Pioneer has delivered growth to its shareholders by focusing on expanding its empire in the Permian. In 2021 PXD's $6.4 bn acquisition of Double Point Energy raised some eyebrows coming on the heels of its $7.6 bn (cash and debt assumption) acquisition of Parsley Energy. Nearly $14 bn in acquisitions in half a year, for a company Pioneer's size was a bold move by management.

Pioneer filings

Pioneer wasted no time in monetizing assets from the Parsley Energy pickup, selling the Delaware basin acreage to Continental Resources for $3.25 bn in late 2021. Shareholders of Pioneer received $21.68 in regular and special dividends in 2022, and capital growth from $140 per share in early 2021 to the final sales to XOM of $253 per share. By any measure, shareholders of Pioneer have benefited from the shrewd empire-building in the Midland basin.

Scott Sheffield, Pioneer's long-time CEO, and the architect of the empire in the Midland basin that drew ExxonMobil's eye, is retiring this year at the top of his game. Capping his career with the company sale to XOM, he is set to receive a payout of cash and stock of $151 mm, according to this Bloomberg article. I expect few PXD shareholders will begrudge him this magnificent payday.

Let's now look closer at what Devon hopes to achieve with the multi-billion dollar acquisition of Enerplus.

The DVN and ERF Industrial Logic

Here is what Devon management told us about the RimRock acreage pickup. The slide directly below discusses its "industrial logic." As you can see, the rationale was obvious as the RimRock acreage facilitated several aspects of shale development laterals, optimized well spacing, critical mass-higher output, in theory-lower production costs, and enhanced logistics. 

They ticked every box, and shareholders were promised that increased free cash flow generation would result and increased amounts of cash would be returned to them. As previously noted, Devon Energy's stock went from $69 to $65 per share in just a few months. What actually happened? Free cash declined from 60% of operational cash flow-OCF in 2021 to 40% of OCF in 2022. What about shareholder returns?

Dividends paid out to shareholders went from $1.97 in 2021 to $5.17 in 2022 but declined to $2.87 in 2023. If you add the value of share buybacks-$4.65, over this period, it gets better, but at a total of $12.67 all-in, Devon shareholders have fared much more poorly than PXD shareholders, with no capital appreciation to sweeten the medicine!

Now we come to the basics of what ERF might mean to DVN. Or what DVN's Bakken acreage might mean to Enerplus.

The fit between ERF's footprint in Dunn, and McKenzie counties becomes apparent when you transpose it against DVN's current footprint in the slide above. The Industrial Logic only gets better with the two combined, when you look at the blocky acreage in Willams County. The three counties mentioned here are in the top ten and top twenty shale-producing counties nationally, according to my industry sources.

There is another aspect to DVN's interest in ERF. Enerplus is killing it in productivity. If you look at the slide above the YoY growth rate from 2021 to 2022 is 13%. DVN's Williston output by comparison has been fairly flat during this period. Industry sources confirm to me that ERF is one of the top producers in this basin, landing in the top 15 nationally. In their last conference call, DVN management noted a decline in the Bakken and a shift of capital focus to the Delaware basin.

Finally, on LOE-lease operating costs. Company filings reveal that ERF is light years ahead of DVN, coming in at $10.75-11.00 in Q-3, vs $13.04 for DVN. DVN reports a cash margin in the Williston of $32.14 on realized pricing of $52.64. If they had ERF's numbers it would correlate to an 8% bump higher.

DVN last paid $23K per acreage to RimRock, so I expect that will be a starting point for ERF's consideration. An equivalent offer for their 236K acres would total in the neighborhood of $5.4 bn, making quite a windfall for ERF shareholders with the company's current capitalization of $3.15 bn.

I expect the cash side of this deal is the hard part. After shelling out ~$900 mm for RimRock and $1.8 bn for Validus in the last couple of years, DVN only has $1.3 bn in cash on the books. Just hypothesizing, if they were to put $1 bn in cash and use debt for 40% of it, leaving a share exchange for the other ~45%-say ~$2.0 BN, the cash flow would pay out the purchase pretty quickly. Figuring price realizations at $55, and a cash margin of $35, with ~160K BOEPD of combined production would pay out in a year. But that's been true of the other acquisitions well, and so far, there is nothing to show for it.

At that sale price, ERF would bring $5.4 bn in new capitalization, ~$1 bn in EBITDA and ~100K BOEPD to DVN, and almost no debt, moving DVN's EV/EBITDA metric incrementally a little higher (taking into account the new $2.0 bn in debt to close the deal) to around 3.4X from 3.0X. On a flowing barrel basis, it also moves up a bit to $52K from $46K per barrel. So the likelihood that shareholders will benefit from a deal where their basic financial metrics worsen defies logic.

The past is not necessarily a prologue. This deal could be the one that justifies itself with rewards to shareholders. Nothing in our review suggests this, quite the reverse, actually, but we have to allow for the possibility. The date for Devon's 2024 annual meeting hasn't been set yet. Typically it's in early June. If enough disgruntled shareholders show up, it could be a raucous affair. They have ample reason to be unhappy.

By David Messler for Oilprice.com 

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David Messler

Mr. Messler is an oilfield veteran, recently retired from a major service company. During his thirty-eight year career he worked on six-continents in field and… More