Beautiful Big Oil: Takeaways From Super Major M&A

Corporate Strategy

Energy merger mania is back in force, with ExxonMobil announcing a merger with Pioneer Natural Resources, Chevron the acquisition of Hess, and speculation around various other combinations of traditional energy companies making the rounds in the media and among Street analysts. Beautiful Big Oil is back, and our "E&P M&A Inevitability" theme (here) is gaining traction. In this post, we provide some big picture takeaways and our perspectives on what this all means in a Q&A-styled note. 

Key points: 

• Recent Super Major M&A activity has both offensive and defensive elements. Defensive in that these are all-stock transactions of low-cost, free cash generating oil properties that would likely be "amongst the last barrels produced" for those with a more bearish oil demand outlook than we have. Offensive in that both transactions offer current and future resource upside and significant oil price torque in the event "Super Vol" transitions to "super-cycle" in coming years.  

• In our view, there is no message to be taken away about greater or lesser confidence in the viability of new energies versus what we (or likely any of the four companies) thought previously. The world is dependent on growing amounts of traditional energy and also needs new energy technologies to scale up without significant government subsidies. Investing in traditional energy does not preclude investments in new energies and vice versa. We desperately need it all if the significant energy needs of the other 7 (soon to be 9) billion people on Earth are to be met over the coming 50-100 years. 

• We are at a unique time where investors (and many management teams) continue to be cautious toward traditional energy and the new stuff is in the midst of a significant downward correction as the "hopes and dreams" phase is meeting with a harsher reality. Frankly, it is an excellent time for companies and investors to be evaluating all forms of energy given three mega risks: (1) geopolitical turmoil; (2) potentially structurally higher inflation; and (3) challenging rich-country government debt burdens.  

DISCLAIMER: Super-Spiked and Veriten do not provide company-specific investment recommendations. In this post, we are not commenting on the reasonableness of the transaction terms for any of the active deals mentioned. Rather, we are trying to provide readers with our perspectives on what the recent pickup in M&A activity means for the outlook for energy based on our 30-year history of analyzing the sector. We would note that in prior career stops at JP Morgan Investment Management (1995-1999) and Goldman Sachs (1999-2014), we were the lead equity research analyst covering ExxonMobil and Chevron. Our perspectives on both companies stem from that time period as well as our subsequent monitoring of each as an industry senior advisor and now at Veriten. 

100TH POST: This week's post is our 100th since creating Super-Spiked in November 2021, with 69 in written form plus 31 videos (all of the videos are also on our YouTube channel here). We would like to sincerely thank all of our readers for their support, comments, feedback, and overall well wishes. Your encouraging response to Super-Spiked was my motivation to un-retire and join Veriten, a firm whose name means "truth in energy."

Given sector profitability is currently above long-term averages, are these "peak of cycle" deals? 

We believe the answer is a hard no. Yes, sector profitability is above "100-year" averages that we agree are likely to persist over the next 30-50 years (we recommend subscribing to The Crude Chronicles (here) for access to unique analysis of the industry since its founding in the late 1800s). And these are of course not "trough of cycle" deals like we saw in 2020 and 2021. As we have noted in many prior posts, we believe we are in year three of what will be a decade-plus period of above-normal profitability. Capital spending remains closer to trough levels rather than peak. There is still considerable skepticism on the long-term viability of traditional energy. While we are indeed off trough, we believe we are far from peak conditions. 

We would also highlight that long-dated oil prices have barely budged over the past three years despite generally much higher spot oil, further supporting our view that these are nowhere near "peak oil cycle" deals (Exhibit 1). Resilient oil demand, a steepening oil cost curve, and rising geopolitical turmoil all point to a rally in long-dated oil at some point over the next several years. It may not be tomorrow and it certainly wasn't yesterday. The 2024-2027 window seems like a reasonable best guess on when back-end oil will re-rate higher. We view this as a major source of upside to doing M&A now or at any point prior to a potential future rally. 

Exhibit 1: Long-dated oil (CL60) has yet to move appreciable higher despite a lot of movement at the front end of the curve (CL1)

Source: Bloomberg 

Are these transactions a sign that the acquiring company is bullish oil demand long-term? 

Not necessarily. In the case of Pioneer's Midland Basin Permian acreage and Hess's Guyana position, both are near the lower end of the industry cost curve and likely to be "amongst the last barrels produced" whenever that is. As Super-Spiked readers are by now well aware, we believe it is not possible to predict the decade let alone year when oil and natural gas demand will peak, given the substantial energy needs of the other 7 (soon to be 9) billion people on Earth that are not among the lucky 1 billion of us that live in rich, fully developed countries. That said, even under the various downward sloping "net zero" scenarios, these are the type of assets that we think would fare well. 

In our view, it would be investment in long-term, greenfield projects or exploration that would signify an optimistic view of demand. An example would be the various LNG projects announced by many different companies in recent years, which require a bullish view of global gas demand. The assets owned by both Pioneer and Hess represent known barrels that have already entered full-scale development mode. While it is true that merger upside would come from developing additional resources above and beyond what is known today via improving recovery rates, field extension, or exploration, we do not see the logic for translating that potential into a specific global oil or natural gas demand outlook; even in a theoretical downward sloping demand scenario, we will need significant additional oil and gas resources to be developed. 

And to be clear, it is likely that the acquiring companies have an optimistic view of oil demand versus the "peak demand" pessimists. Our point is that the transactions we do not think require a bullish view of oil demand. 

Is M&A activity a sign of commodity price bullishness? 

Over the 30 years we have covered Big Oil companies, we would characterize their commodity price assumptions as usually being "conservative" for planning purposes. Classically, it was the E&P management teams that were more likely to bet on a bull market (this is far less true today). The basic idea has always been to invest in assets at the low end of the future cost curve that will allow favorable returns on capital over a full cycle. 

That said, there is likely a case to be made that consideration was given to the potential for commodity prices to overall remain above a conservative assessment of mid-cycle over the coming decade. We suspect this would have been characterized as a source of upside versus base case planning assumptions. 

Is this a repeat of the late 1990s "Super Major" wave? 

We see the drivers of the earlier era as very different than today's M&A activity. Back then, the expectation was that WTI was in a "permanent" sub-$20/bbl (nominal in the $ of that era) environment and cost cutting/synergies was the main avenue to improving corporate profitability (a good reminder to always be humble about what you "know" to be true). Neither the Pioneer nor Hess mergers appear to be based on a classic cost-cutting exercise. Instead, both fit our theme of "extending the runway" by which an upstream business can develop competitively advantaged resources for a longer period of time.  

The similarity with the earlier era is the recognition from both sides of the transactions that size and scale and balance sheet strength all matter. We believe this will be especially true if companies are to meet net zero scope 1 and 2 and near zero methane promises. The low-hanging fruit toward meeting those objectives will have been plucked by the time we finish this decade. The potentially significant expense of fully eliminating carbon/methane emissions (scope 1 and 2) may well require "Super Major" or at least "really large cap" status. Furthermore, the risks from diminished capital and insurance availability due to efforts from the likes of the Glasgow Financial Alliance For Net Zero (GFANZ) (see previous posts) suggest there probably is no such thing as having too strong of a balance sheet. 

What does this say about traditional energy interest in new energies? 

In our view, this does not say anything about new energies, either in terms of pace of development or any change in the interest level from traditional energy versus what we thought prior to recent M&A news. It is neither bullish nor bearish to the outlook for new energies. As has long been our view, the world is far better off with large, profitable, and healthy US, Canadian, and Western European oil and gas companies. No one needed Israel-Gaza to join Russia-Ukraine as a second area of conflict to know that the world is a better place when there is a counterbalance to Middle East and Russia oil and gas via home-country companies. 

Frankly, if there is a new energies area that is about to profitably scale without needing sizable government subsidies and is within the core competency of a western major oil company, the post-merger companies will be in incrementally stronger financial positions to theoretically pursue such opportunities. We have long favored the more measured approach ExxonMobil and Chevron have taken to new energies versus the more aggressive steps taken by various European counterparts, some of which are sensibly starting to scale back those efforts. We believe the significant criticism aimed at ExxonMobil and Chevron in particular regarding energy transition objectives from politicians and others that are especially passionate about climate is off base and ultimately damaging to the causes they purport to support. 

Should M&A capital have instead been directed at new energies opportunities? 

My apologies that this may come across to some as an "I told you so." But at the depths of COVID and maximum pessimism toward the traditional energy sector, which coincided with peak optimism toward various energy transition and ESG-oriented themes, there were many calls from those most passionate about climate in the academic, activist, and policy making communities for Big Oil to more aggressively transition into new energies. Exhibit 2 shows that investors (and company employees) can be thankful that Big Oil leadership teams, in particular those in the United States, showed their legendary patience and discipline. Senior management teams at US Super Majors stood their ground at a time they were in somewhat weakened positions and facing a full-on assault to "get with the times," "to be part of the solution," and "to be more forward looking."  

Exhibit 2: New Energies equities have been under significant selling pressure since peaking in early 2021

Source: Bloomberg 

While US Super Majors have increased spending in new energies areas over the past few years, the pace and strategies we believe have been appropriately prudent and in a manner consistent with the culture and capabilities of the respective companies. Said more simply, thank goodness neither purchased any number of the former highfliers or invested corresponding large sums in high CAPEX, fixed return projects in areas in which they had no competitive advantage. Turns out they were being forward looking by not being browbeaten into moving prematurely into immature areas at a point of irrational exuberance. And to be clear, just about all sectors go through periods of excessive optimism and pessimism. The correction in new energies is healthy and is not a critique of new energies as a concept. We are critiquing the idea that traditional energy must invest in new energies at any particular point in time. 

Given that many new technologies have not faced a prior investment cycle and most remain heavily dependent on government subsidies, it is not obvious at this time which might merit a value-investing approach in the future from the perspective of Big Oil diversification. We remain open-minded to all possibilities. It remains our view that the world desperately needs any number of new or future technologies and energy source to successfully ramp, at scale, and with economics not heavily dependent on government support in order to meet the substantial energy needs of everyone on Earth and to reduce dependence on energy from hostile nations. 

What about the European Majors? 

God Bless America! Seriously, the European Majors are in a really tough position given the very different political and societal backdrop that exists in many Western European countries vis-a-vis the USA. We believe the world would benefit from a Euro Super Major revival and the application of their extensive skills, knowledge, and financial power to help develop the oil and gas the world needs and to help US and Canadian oils counterbalance the Middle East and Russia. One question is whether European companies can find ways to relocate oil and gas business lines to regions outside of Europe and create more flexibility to pursue organic and inorganic investment strategies. How to escape from Europe is both a theme and a challenge to take on. There is likely a meaningful value uplift that could come from not being Europe-based (inclusive of UK). 

One aspect of the Euro Majors we find interesting is that they have all remained global in nature and have a history of exploration success. Most are not major US shale players, which was a missed opportunity over the past decade but might look better going forward as or if shale matures. One company that especially stands out is Shell under its new CEO Wael Sawan, which has taken some encouraging steps to re-emphasize areas of strength. We have not done the study, but we suspect Shell is at or near the top of the list for industry history in terms of the number of new oil and gas fields that it has discovered or other companies have found on acreage Shell once owned. 

TotalEnergies under CEO Patrick Pouyanné is the European oil that we have perhaps most admired from afar over the past decade during a very challenging time for industry. There are likely some pros to Total being France-based that might at least partially offset some of the cons from France being in the EU. 

Nothing in this section should be construed as a recommendation to buy, sell, or hold any specific European Major Oil. Our point is that most of the European Oils have had a long and important history in the oil and gas business and have helped provide the energy that citizens throughout the world have benefitted from. They are as well positioned as any US or Canadian oil to remain leading players going forward. The challenge is the very unique European demand that they must transition to "integrated energy companies" from integrated oils. We would hope that at least some of these companies will be able to escape from EU influence. The world would be a better place. 

Who's next?  

Since we are not in the business of publicly speculating about future combinations, we will instead offer commentary on how to think about it. Some comments: 

• For upstream companies that are confident in a decade (plus or minus) of advantaged resource running room, pressure to engage in M&A will be lower than those with shorter runways. 

• Engaging in M&A before long-dated oil has rallied and prior to a major ramp in industry CAPEX is typically better than investing later in the cycle. 

• We believe as companies gain in size, a diversified business model (in terms of basins and geographies) is usually inevitable and preferable, though there are exceptions. 

• We see appeal in evaluating long-cycle projects in the current "pre-growth" environment, which would come in the form of exploration acreage acquisition or via the purchase of companies with undeveloped, long-dated project opportunities.  

• We believe companies that retained "global" or exploration skillsets will gain in favor after being largely left-for-dead during the height of the US shale boom. 

ROCE and pooling versus purchase accounting 

One of the challenges in pursuing all-stock, large-scale mergers is the issue of dilution to return on capital employed (ROCE) metrics that comes from the write-up of the acquired company's book equity value to its market capitalization at the time of purchase. It's an esoteric subject to be sure. But it is highly relevant when analyzing large-cap M&A activity in particular. 

With apologies to actual certified public accountants (of which we are not), here is a simplified description of the issue. Prior to 2001, under certain conditions, usually with all-stock transactions, a company could choose to use "pooling of interests" accounting to value the capital stock of the acquired company. Under pooling accounting, the historic book value of the acquired company's equity is retained post-merger. The Financial Accounting Standards Board (FASB) banned "pooling" in 2001, with all deals having to now use the "purchase accounting" method. Under purchase accounting, the acquired company's shares are valued at the market capitalization at the time of purchase rather than its historic book (accounting) value. 

Intuitively, the idea that an acquired company's shares are valued using market capitalization at the time of purchase, rather than legacy book value, may seem logical to many reading this. We disagree when it comes to an all-stock transaction where the shares of both companies are trading at a premium to book value. We believe issuing premium price-to-book-value shares for another company's premium price-to-book-value shares should not result in a write-up of only the acquired company's equity value for book accounting purposes and ultimately the calculation of ROCE. If anything, some sort of netting to account for the difference in trading premiums might be warranted. 

This is a complicated issue and we suspect our written explanation will not be helpful to anyone that is not already deeply familiar with this issue. So perhaps another way to say this is that in an all-stock transaction, we believe an analysis of ROCE accretion/dilution should be done on a pooling-effective basis. We recognize most investors today are unlikely to do this. This is a point of principle even as it somewhat goes against our normal pragmatism and preference for reported GAAP results versus "adjusted" metrics. 

We also appreciate there are differences of view on this point. Some will say that it does not matter whether a transaction is all cash, all equity, or a mixture of the two. That is not our view; we recognize some will feel just as strongly in the other direction.

We would offer to write a stand-alone post on this, but this is already far too many words on a subject that we would guess only the 0.1% will care about. For those of you that do care, comments are welcomed. For those of you that work with Veriten, please call or email. 

⚡️On A Personal Note: John Hess 

One of my favorite CEO relationships during my Goldman years was with John Hess. I don't recall meeting with him when I was previously at JPMIM as to my recollection we never owned shares of Amerada Hess as it was then known. 

My first meaningful interaction with Mr. Hess came in the 2002 time frame. The company was riding high following a rally in oil prices and in the aftermath of the Triton Energy acquisition. I recall the stock being in the high $70s (not adjusted for any subsequent stock splits) after a big run from the $40s or $50s. On an earnings call, the company mentioned some production issues at acquired properties in Equatorial Guinea. We were bearish oil prices, concerned the E.G. production issues would take longer to address than investors at the time expected, and thought Amerada Hess shares had meaningful downside risk.  

I made the call to downgrade Hess shares to Market Underperfomer, the equivalent of a "Sell" rating, something that rarely existed in those days and even now is not widely used. Keep in mind, Goldman had been Hess's long-standing investment banker dating back to when original CEO Leon Hess ran the company (John's father). The idea of a relatively new and young analyst downgrading an investment banking client's shares to "Sell" was simply something that didn't happen on the Street in those days.  

Having moved to Goldman from a well-regarded buy-side position at JPMIM, I always tried to bring an investor's approach to my stock calls at Goldman. JPMIM also gave me a confidence that getting the stock or macro call right is all that matters; I simply did not find it relevant that Goldman had an investment banking relationship with Hess as far as my job to provide investment recommendations to my institutional investor clients was concerned.  

We were trained that when making a ratings change, it was appropriate after publication to give company management a courtesy phone call to alert them so they wouldn't be caught off guard by investors or the media (instant knowledge of everything didn't exist in 2002; reports were physically mailed out though email did exist by this time). I remember the call with John Hess like it was yesterday (paraphrasing): 

John Hess: Hello. This is John Hess. 

Me: Hi, Mr. Hess. Umm, John. I am calling to give you, uhhh, a courtesy heads up that we sort of just published a research report that kind of took our rating on Amerada Hess to Market Underperformer. Just, you know, wanted to give you a heads up. 

John (super pleasant, positive tone of voice): Arjun, it is very nice of you to call me. Thank you for the heads up. I know you have a lot of detailed models that look at the sector and our company. You do in-depth research. It is my job as CEO to prove your call wrong and to convince you through our performance that a higher rating is warranted.  

Me: Wow, umm, yes, thank you for your understanding. We will continue to follow the company closely. 

John (still super pleasant, friendly tone of voice): OK. Thank you. Have a great day. 

And that was it. In my view, even if John was not happy with our ratings downgrade, he never let on. I was able to ask questions on future conference calls without being relegated to last up, or excluded altogether as sometimes happens. I was able to visit 1:1 with the management team as is customary for covering analysts, especially at leading brokerage firms. It is how all CEOs should respond to the vast bulk of analyst calls, good, bad, or indifferent. John Hess was then and remains a class act. 

About a year later when the stock had fallen back to the $40s (our MU rating was our first big, good call at GS), we ended up double upgrading the stock to Market Outperformer when it became clear to us they were getting their arms around the E.G. production issues and weren't going to replace lost volumes with an ill-advised "plug the gap" acquisition as was so common in E&P land in those days. That "Buy" rating and a corresponding "Buy" on Murphy Oil were our next two big calls at GS before our career-defining Super-Spike report of March 2005. 

Over the subsequent years, John Hess became one of my favorite CEOs to interact with. I was with Mr. Hess, John O'Connor (then Head of E&P), and Jay Wilson (investor relations) visiting Hess shareholders on the West Coast in 2008 when AIG was nationalized. I recall John O'Connor turning to us in the SUV between meetings as the AIG news was released and saying "I never thought I would see America nationalize a company like that." It was a prescient comment. As a country, it's not clear we ever really worked through what became an extended "free money" era that really only ended in the past year or so. Coming out of the worst of the 2008-2009 crisis, Hess was a top pick of ours along with Petrobras and Suncor—all three rose sharply off Great Financial Crisis lows. 

On that same 2008 trip, John and I had a memorable dinner in L.A. near Staples Center where we discussed the pros and cons of an impact exploration program. At that time, the focus was Brazil's pre-salt, which didn't pan out for Hess. But it was a precursor to continuing the restructuring of the previously integrated Amerada Hess to the E&P bellwether Hess successfully morphed into. 

It is my great pleasure to see John Hess's vision for the company his father founded realized via the Guyana success, culminating in this week's sale to Chevron. In its nearly 90+ year history, Hess has had two CEOs: Leon Hess and John Hess. It is still headquartered in New York City! It is the end of an era.  

Congratulations and best wishes John!

⚖️ Disclaimer 

I certify that these are my personal, strongly held views at the time of this post. My views are my own and not attributable to any affiliation, past or present. This is not an investment newsletter and there is no financial advice explicitly or implicitly provided here. My views can and will change in the future as warranted by updated analyses and developments. Some of my comments are made in jest for entertainment purposes; I sincerely mean no offense to anyone that takes issue