E&P M&A Inevitability

A framework for Energy M&A, Post #1

I have written five deep dive posts on profitability (i.e., ROCE) and cost of capital. I would like to extend the discussion to the topic of risk taking via mergers and acquisitions (M&A) activity. I’ll start by focusing on traditional upstream oil & gas. Unlike most other businesses, a unique aspect of the E&P business is captured by the adage that if you aren’t growing, you are shrinking. Oil & gas is a depleting asset; once produced, the given barrel is gone forever (technically it is “gone forever” at the point a barrel is consumed when people drive cars, fly airplanes, or consume electricity, but I think the point holds from the perspective of the producer).

Most E&P companies today talk about inventory life and, just about to a company, discuss how they have plenty of low-cost resources that can allow current drilling programs to continue for many, many years into the future without having to engage in M&A. That is what they always say...publicly. Have you ever heard an E&P CEO state: "You know, we are doing well now, but, man, our high-quality inventory is running on fumes...not sure if we can lower costs on the Tier 2 or 3 stuff. Hopefully we can find something good to buy or get lucky with the drillbit." While perhaps it is true that some or even many companies have a large inventory of high-quality drill-able locations or projects, the immutable truth still holds that every barrel coming out of the ground today is a drawdown on the ultimate resource base.

Hence, the good Lord created exploration and M&A as the two means of adding resource. Currently, exploration is not a major focus of most companies. This leaves M&A as the remaining avenue by which most companies will replenish inventory in the next few years or consolidate into a better positioned survivor. I include in the M&A bucket resource development opportunities pursued in international areas where host governments contract with international oil companies.

In my ROCE Deep Dive series (here, here, here, here, and here), I have discussed the “right to spend”, the benefits of a fortress balance sheet, energy transition resilience, and a host of related issues. I won’t rehash those points. Instead I would like to hone in on the reality that upstream M&A is a fact of life for ALL upstream companies—it’s only a question of timing, execution, and the buy versus sell decision. There are two choices:

1. Every upstream company that seeks going concern status will be purchasing assets; or

2. Those not seeking going concern status will be selling assets or the entirety of the company to another entity that is striving for going concern status.

A third way of entering “blow down mode” is unheard of in the publicly-traded space to my knowledge (some analysts point to present day Marathon Oil as a company moving to blow down mode, but I am too distanced from it to confirm). The fourth way of simply being part of the living dead of long-term E&P mediocrity should be unacceptable to all. Super-Spiked will waste no time on "living dead" E&Ps.

The typical E&P CEO claim that “we have more than enough inventory than we can say Grace over” can only be true for a finite period of time. Once a barrel is produced, it is gone forever. E&P companies do not self perpetuate without M&A or exploration, and very few are pursuing any meaningful exploration these days. As such, investors and managements and boards ought to think about a risk/reward framework for M&A that increases the odds of long-term success. M&A denialism is not a productive strategy. Placing greater weight on the potential to sell assets or the entire company should be a bigger part of the decision tree for more companies than I believe has historically been the case.

A framework for impact E&P M&A

In this note, I will focus on impact M&A, which I believe broadly fall into two buckets: (1) Inflection M&A and (2) Diversification M&A. To be sure, there are plenty of run-of-the-mill bolt-on deals, smaller asset sales, and other moves companies regularly make. That is not my focus in this post. It is on the deals that move the needle and often signify a structural change is occurring in a company's outlook.

(1) Inflection M&A. A company is at a critical juncture where things have to change. The positive example catapults a company from dire straights back to health. The negative example is when a previously "good" company's upstream asset base is unfavorably maturing, with the Street likely not to have caught on yet.

(2) Diversification M&A. In the oil & gas business, I am not aware of very many (any?) companies that could be one-trick, one-basin ponies and ultimately perpetuate as a financially successful, going concern measured over decades. If any reader has an example, please let me know. Perhaps Pioneer Natural Resources as a Permian pure-play of decent size is going to give this a try? A Canadian oil sands company would theoretically have a shot, though all the large ones are now diversified. Maybe the Appalachia natural gas names would count, assuming a future US government figures out how to ensure pipeline export capacity out of the region isn't stymied by climate/environmental obstructionists? Investors often cringe at the thought of diversification ("I can do it myself by owning a basket of companies.") but I would argue that when done right, it can be favorable to ROCE, cost of capital, and long-term share price success.

M&A is a topic that will instinctively raise investor concerns about:

• Empire building

• Di-”worse”-ificaiton

• Overpaying due to over-optimism about commodity prices

• Overpaying due to over-optimism about the resource being acquired

• Overpaying for both of the previous reasons (the brutal double whammy)

• ROCE dilution

• Balance sheet impairment

• Increase in oil/gas price dependency

• Lack of deep knowledge about acquired assets

• Dilution of quality employees

• Cultural incompatibility

Key M&A considerations:

• Is a company ahead of or behind the curve on inventory replenishment?

• What are the warning signs that a company has flipped from strength to weakness?

• At what point in the long-term structural oil/gas cycle is M&A occurring? Toward the beginning, middle, or end of a super cycle? Or at the beginning or end of the bust period?

• Is the company currently in a position of strength or weakness in terms of its asset base health, investor confidence in management/strategy, and balance sheet strength?

• Is the company buying inventory that will be at the lower end of the future oil and gas cost curve excluding the acquisition cost (i.e., looking just at project cost or drilling economics)?

• How does the acquisition premium, if any, impact overall economics and what steps can be taken to the lower the risk of adverse commodity price movements vis-a-vis the acquisition premium paid?

I think the points I am trying to convey can best be made by looking at a variety of M&A deals that have occurred over the course of my career, which represent different elements of the aforementioned points. The examples are a bit over-indexed to ExxonMobil; truth to be told, there is no company I have more admired or enjoyed covering than Exxon, even as it went through a tougher period last decade.

Inflection M&A

There were fewer energy companies more dis-liked than Occidental Petroleum in the 1990s. There weren’t many energy companies more revered than ExxonMobil in the 1990s and 2000s. In both cases, high profile M&A transactions marked critical inflections in their respective fortunes; for the better for Oxy and for the worse for ExxonMobil.

Positive Inflection: Occidental Petroleum - Altura Energy (March 2000)

Starting point: Oxy was in a position of weakness with poor stock price performance, weak ROCE, a weak balance sheet, and a management team that was openly despised by most Street analysts and investors at the time. If a company could literally drop dead and be cheered by investors, this was it.

Structural oil cycle positioning: We were in Year 14 of the post 1986 Oil Bust era and just a few short years ahead of the next oil super-cycle, which essentially no one was forecasting in 2000 (my own bullish call was not until 2004).

Bold move: Oxy paid what then seemed like a staggering $3.6 billion to outbid others and secure Altura Energy, which was a joint venture between BP and Shell in the Permian Basin.

The result: Oxy was favorably transformed (along with a series of other moves). ROCE improved dramatically. A new super cycle ultimate kicked in. The share price was a home run.

Exhibit 1 shows the significant underperformance of OXY shares in the 1990s versus the S&P 500 and broader energy sector (S5ENRS is energy stocks in the S&P 500). Post Altura and turbo-charged by the Super-Spike era, OXY crushed the S&P 500 and beat other energy equities into the 2008 peak.

Exhibit 1 (Bloomberg)

Negative Inflection: Exxon Mobil - XTO Energy (March 2009)

Starting point: Exxon literally wrote the definition for ROCE and was broadly heralded as the most disciplined, highest returning, most likely to succeed management team with a fortress balance sheet and unquestioned commitment to putting shareholder interests first. The problem we didn’t know at the time was corporate excellence is not something you can decree to future management generations. It needs to be actively managed at all times. All companies need to evolve; ExxonMobil didn't.

Structural oil cycle positioning: We were mid-Super-Spike era, though rebounding from the Great Financial Crisis interruption. With hindsight, ROCE for the Super-Spike era peaked in 2006, a good 8 years prior to its ignominious November 2014 ending. Industry CAPEX and capital intensity had ramped dramatically over 2002-2009 and energy was at the time a must-own sector for investors.

Bold move: Exxon returns to onshore US with the $41 billion acquisition of XTO Energy, a successful “acquire and exploit” US E&P that had been uber-successful for its investors by focusing on onshore US assets at a time everyone “knew” the only opportunities were in deepwater or foreign lands. Few companies more successfully played the Super-Spike era than XTO.

The result: XTO marked the inflection point to Exxon’s decade-long decline that culminated in Engine No. 1 successfully winning three board seats against Exxon’s wishes near the trough of the structural oil cycle in 2021. I will take credit for instinctively dis-liking the XTO deal (from Exxon's perspective) at the time it happened when I was a covering analyst at Goldman. For the first time, Exxon talked about commodity prices being near a low (they weren’t), about expanding its metrics to include net income and cash flow per barrel and not just ROCE (terrible idea), and about capturing the best of XTO’s entrepreneurial culture (a clear sign its own culture was facing needed reform). XTO sold not only at what was near the peak of the Super-Spike era but also just before its core Barnett Shale acreage was about to be displaced by the much larger and significantly lower cost Appalachia natural gas basin. Exxon paid a peak price for yesterday's asset with a management team and corporate culture that was the antithesis of ExxonMobil's.

Exhibit 2 shows the relative performance of XOM shares versus the S&P 500. An upward sloping line indicates XOM is outperforming the S&P and a downward sloping line indicates it is lagging. For Exxon, this is a tale of two very different mergers: one great (Mobil) and one bad (XTO).

Exhibit 2 (Bloomberg)

Diversification

Diversification is one of those words many investors instinctively recoil at when considering a particular company's need for it. Pure-plays are all the rage. But pure-plays almost always come with expiration dates that are hard to discern in the moment. For companies that aspire to be S&P 500 leaders over multiple decades, there is almost always a need to expand to new areas. But, unsurprisingly, the need for diversification doesn't mean a good deal is guaranteed. Having picked on Exxon in the previous section, I will include a positive example on this front from the Lee Raymond era. On the negative side, I am going to repeat the XTO transaction as the analytics around my other choices, such as Suncor-PetroCanada (2009) and Range Resources-Memorial Resource Development (2016) are not as clear cut as I expected and would unnecessarily delay this post.

Good Diversification: Exxon - Mobil super major merger (November 1999)

Starting point: In the 1990s, Exxon under Lee Raymond had ascended to “greatest company in the history of the world” status.

Bold move: This deal was Exxon’s quick answer to the super major kickoff merger between BP and Amoco. Clearly, cost savings/synergies, size and scope, and balance sheet strength were all important drivers. But the deal also brought Exxon a meaningful ramp to its LNG business via Mobil’s then uncertain prospects with Qatar’s new LNG expansion effort. I will say that when two, large diversified companies merge, the diversification benefits (or lack thereof) by definition are going to be a key make or break driver, but the expansion of its LNG strategy was an important benefit to legacy Exxon.

Structural oil cycle positioning: We were in Year 13 of the post 1986 Oil Bust era and just a few short years ahead of the next oil super-cycle.

The result: In the case of Mobil, its previous company-maker Arun LNG venture in Indonesia was mature and many were skeptical Qatar LNG would be a worthy successor. Exxon took the risk that within the context of a super-sized Exxon-Mobil, Qatar LNG was a good risk to take. It was a home run.

Unfortunately, ExxonMobil management post Lee Raymond's 2005 retirement were not able to figure out the next, big thing or pivot, culminating in the disastrous XTO merger. Still, the subsequent mistakes and mis-steps do not take away from the brilliance of the Mobil merger.

Bad Diversification: Exxon-XTO

There is no need to repeat the background noted above from the negative inflection discussion. The intention to diversify into US shale was a good one, but not through this transaction. It was the wrong asset (non-Appalachia shale gas) at the wrong price with the wrong cultural fit. I believe this point is the greatest source of frustration among investors (referring to all companies, not just Exxon). There are strategic steps companies need to take, but you still have to get the mix of timing, asset, execution, and price right to be successful.

Key takeaways and themes

Based on the deals discussed, which clearly stand out in my memory as they were high profile and came at key cyclical inflections, here are some key themes:

• Transactions in the early days of a super cycle or at the end of the bust period worked out far better than those late- or even mid-super cycle.

• Perceived (by investors) management quality at the time of M&A was not a differentiator in good versus bad deals—an especially surprising observation.

• Company fortunes can change from bad-to-good and vice versa based on M&A; unexpected or higher profile M&A is an important signal about future fortunes that warrants the significant attention it receives.

• Diversification on its own is not inherently good or bad; to be a going concern, it is going to be be needed by most companies.

• All companies involved in upstream oil & gas need to add inventory or consider liquidation; no one should aspire to “living dead” status.

• It’s hard to remain patient when patience is needed and to show urgency when urgency is needed; there-in lies management and board judgement. There isn’t a black box to check in with; it is human judgement. A framework can help; but it won't give you the answer.

• Buying upstream assets in North America from European Oils concerned about the "End of the Oil Age" usually works out really well for the buyer.

How does inevitable E&P M&A reconcile with energy transition?

The depleting nature of oil & gas reserves is the most natural hedge the sector has to energy transition. In a nutshell, the inherent decline rate of supply is almost certainly higher than any conceivable decline rate in structural (i.e., assuming future trend global GDP growth) oil demand. If the world ever does transition away from fossil fuels, just about every company will by definition instantly be ready.

In the meantime in the world we actually live in, there are the lucky 1-2 billion people or so that have benefitted greatly from fossil fuel-enabled advances in living standards, health outcomes, and the environment. The 3-5 billion unlucky ones are deserving on humanitarian grounds to close the gap. As such, the oil & gas industry—publicly traded, privately owned, and state owned—around the world is critical to the continued advancement of the world we live in.

A framework for good M&A is critically needed to ensure we have viable companies, especially in geopolitically friendly areas like the United States and Canada.

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⚡️ On a personal note…

People in Oklahoma are nice. Really nice. Here is a tale of two experiences with TSA that occurred on back-to-back days earlier this month.

At Newark airport:

TSA agent (yelling at no one in particular): YOU MUST EMPTY YOUR POCKETS. IF YOU DON'T EMPTY YOUR POCKETS, I WILL TELL YOU TO STEP OUT OF THE LINE SO YOU CAN EMPTY YOUR POCKETS. IF YOU DON'T EMPTY YOUR POCKETS, YOU WILL NOT GET THROUGH THIS LINE. BLAH BLAH BLAH. YELL YELL YELL.

It was packed. It was hot. The line was long even in Clear TSA Pre-check. The TSA agents at Newark did everything in their power to make the experience as miserable as possible.

Meanwhile, on the return from Oklahoma City airport:

TSA agent (smiling): Sir, can I help you put your bags on the conveyor belt.

Me (looking around, answering with a NY analyst tone of voice): Are you talking to me?

TSA agent (still super polite, friendly tone of voice): Yes sir. I think we can fit your backpack and carry-on in this one trey. Let me help you fit it in.

Me (shifting to perplexed tone of voice): Umm, OK, thanks.

TSA agent (still smiling): There we go. The bags fit easily. I hope you have a great day and safe flight. Come visit us again.

It's beyond the scope of Super-Spiked to examine the underlying reasons for the divergent approaches taken by TSA agents in various locations. I am going to chalk it up to a +1 for the people of Oklahoma.

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⚖️ 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.

Regards,

Arjun