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US shale deal-making stirs to life

Domestic acquisitions gain momentum after woeful performance across the first three quarters of the year

US shale M&A activity is suddenly gathering pace from a lethargic first three quarters of the year as firms eye deal-making opportunities  Deal-making slumped to its lowest level in a decade in January-September on the back of Covid-19 uncertainty and no sign of anything but a moderate price recovery following the Q1 crash.

But heading into the final quarter of the year, US independent ConocoPhillips agreed to acquire Texas-based Concho Resources for $13.3bn, the largest upstream shale deal since Australian producer BHP completed a $15bn takeover of independent Petrohawk in 2011 (see Fig. 1). And fellow US indie Pioneer Natural Resources struck a deal for shale peer Parsley Energy for $7.6bn, the second-largest domestic deal of 2020.

“This is part of a historic winnowing of US-based independent E&P companies,” says Andrew Dittmar, senior M&A analyst at upstream researcher Enverus. “There has now been over $40bn in public-public corporate mergers year-to-date. In just two days, we have seen two of the top ten US-based E&P acquisitions of the last ten years.”

Taking advantage

The ConocoPhillips merger marks a decisive shift for the company. When others spent big to mop up domestic assets and expand their footprints into shale, the US firm took a more conservative approach. Rather than aggressively pushing into the Permian basin, ConocoPhillips instead focused on low-cost production in the Eagle Ford and Bakken.

“ConocoPhillips’ patience waiting for the right deal appears well rewarded as the company is picking up one of the premier positions in the Permian at a fraction of the cost” Dittmar, Enverus

But with commodity prices in the doldrums, the economic downturn has created valuable opportunities for large-cap firms to buy at budget costs. “Buying Concho strategically fills a gap in ConocoPhillips’ portfolio,” says Dittmar. “ConocoPhillips’ patience waiting for the right deal appears well rewarded as the company is picking up one of the premier positions in the Permian at a fraction of the cost of other large deals in the basin over the last few years on a dollar-per-acre basis.”

Concho’s Permian asset base and healthy balance sheet also played a decisive role in the merger. Net debt is down by 16pc since last year, partly through $1.3bn in asset divestments. And, unlike many independents in the shale patch, Concho faces no debt maturities until 2027. The pro forma business will have only $2bn due in debt maturities over the next five years, against $13bn in liquidity.

And Concho’s production costs have also fallen dramatically in 2020, despite, or perhaps because of, the economic crisis. Well costs in the Delaware and Midland basins have been slashed by 33pc and 22pc respectively. The Texas-based producer posted $532mn in net losses over the first half of the year, but the financial damage would have been much worse without the efficiency gains—positioning the portfolio well for any future oil price recovery. Going forward, the pro forma business expects to accelerate cost-cutting, targeting $500mn annually from unifying operations.

The new producer is also projecting an average cost of supply of less than $30/bl, offering balance sheet protection against a lower-for-longer oil price environment. The consolidation of acreage in the Lower 48 states ensures 50pc of output will be produced domestically. ConocoPhillips will gain around 550,000 net acres in the Permian from Concho, split between 350,000 in the Delaware and 200,000 in the Midland basins.

Added to that, only 20pc of its acreage in the Permian is on federal land. If the Democrats win the November presidential election and halt future drilling leases, the pro forma business still has wide scope to grow its production base. Elsewhere, halting new onshore leases will have significant impact in the Permian, Bakken, Niobrara and Anadarko basins. Consultancy Rapidan Energy estimates that 15-20pc of production in the Permian and Bakken was on federal land in Q1. 

Permian push

The Pioneer and Parsley merger also helps consolidate acreage in the Permian but is not the only motivating factor for the deal. “Unlike some corporate deals we have seen, for Pioneer adding inventory is not a particular concern given its massive runway that amounts to nearly 30 years of drilling at expected rig rates,” says Dittmar. “Instead, the company is looking to bolster free cash flow (FCF) metrics as it builds around a sustainable reinvestment rate of 65-75pc.”

Like ConocoPhillips, Pioneer did not imitate its Permian rivals and rush to make major shale acquisitions. Instead, the independent patiently focused on its high inventory of low-cost barrels in the Midland basin. Parsley’s adjacent acreage in the Midland was particularly tempting, though, as it is likely to require only a low capex spend to integrate into Pioneer’s Permian portfolio.

$20.9bn – Combined value of the two mergers

Likewise, Pioneer was able to take advantage of the subdued commodity prices to purchase at a significantly better price than other major deals over the past decade. “The acquisition price is at less than half the cost of prior big Permian deals on a dollar per acre basis,” says Dittmar.

Pioneer estimates that unitising operations will save the pro forma business $325mn annually and lift FCF above a 6pc yield into next year. Combining the two company’s assets will also make the business the largest producer in the Midland basin with 631,000bl/d in gross output. As a yardstick, US independent Diamondback produces just 205,000bl/d in second place. Across the entire Permian basin, the combined assets will make the pro forma business the fourth-largest producer, behind only EOG, ConocoPhillips and Occidental Petroleum.  

And similar to other major corporate combinations in 2020, the pro forma balance sheet of the business is robust. No debt maturities are due until 2023, and there is a $1.1bn credit facility the company can tap if necessary. The board has also set a corporate dividend based on a mid-$30s WTI oil price into next year and will target a variable dividend if economic conditions improve.

The addition of a variable dividend is becoming increasingly popular as the shale patch edges away from a growth model that has burdened much of the sector with unsustainable debt. While capital discipline is the new order of the day, the variable dividend is seen as a way of rewarding sustainable production growth, as long as it is accompanied by sufficient free cash flow. 

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