“By now it should be abundantly clear that the current shale business model does not work – even for the very best companies in the industry…it is obvious that the shale oil industry needs to be restructured and the remaining companies need to pivot toward [a returns focused business model]…there should be only a handful of operators that use their scale to realize capitalize efficiencies, minimize cash costs (including G&A which remains way too high across the sector), and reduce their cost of capital. The advantaged companies should then use their lower cost of capital to consolidate the industry – not to push growth at their own demise.” -Sailingstone Capital
There are two related narratives in the US oil and gas industry today. The first that the industry should consolidate and the second that the industry should have a “returns focused” business model. One is an action, the other a result. The desired result, generating returns, comes from the broad observation that the last ten years of shale oil investment did not, in fact, generate any returns at the industry level. Too many companies, too much cheap capital, too much drilling, too much production, and too much G&A, all led to a multi-legged, 100-mile, bruising race to the bottom for the sector. The upshot to this race was energy underperforming nearly every other sector for nearly ten years.
Because part of this multi-legged race was acquiring land, another general observation is that most, if not all, prospective shale oil resource is now owned by some company actively drilling. In most cases, several companies drill for oil in almost the exact same area. The recommendation to consolidate the industry questions the logic of this arrangement: if one company can more efficiently develop the same acreage, why are several companies doing so? Investors in both companies would be better off, the argument goes, by merging to enable cost reductions across multiple fronts. Even more, without all the companies, competition and thus production growth should lessen, leading to less capital destruction and, hopefully, a more constructive price environment. Thus, consolidating the industry will lead to improved returns.
These arguments all seem true. The downside to this vagueness, unfortunately, is that it remains unclear whether this merger activity would indeed lead to increased returns. What kinds of companies, specifically, would benefit from merging? Is it all of them? Over what time frame would the merged entity accrue these benefits? And to whom would such benefits accrue? If prices did rise because of such activity, why would new entrants not drive production up again? Finally, and most importantly, would this activity lead not just to improved returns, but to returns that are competitive with other sectors of the economy?
Have’s, Have Not’s, and Corporate Strategy
Firm level performance is a function of industry structure and the firm’s position within that industry. Thus, a great industry can have firms that underperform, and a poor industry can have firms that outperform.
For now, let’s assume that the energy industry underperformed and that it underperformed largely due to its structure. In that way, we can focus, for now, only on firm level features that impact strategic position within the industry – why are some firms at the top and others at the bottom? In oil and gas, outperformance primarily means that a company produced oil for less than their peers, and that they were able to do this over time. This is no small feat because low cost production is not only a function of operational effectiveness (OE), but also of resource quality. The best oil companies have the best returns because they have the best resource, whose returns they enhanced through operational effectiveness, but never the other way around. Let’s call companies that are able to do this Have companies.
The trick for Have companies is sustaining industry leading returns over time. The reason this is challenging is for two reasons. First, because oil companies deplete, or produce, their existing resource, they constantly need to find more to replace what they produced. Second, as reservoirs are produced, costs increase. So if an oil company held one asset forever, it could certainly start as a low cost operator, but over time, would become high cost. Likewise, a company can have one low cost asset, but when it acquires or discovers a new resource, the new resource may be higher cost than its original asset.
The way Have companies maintain their low cost status over time is by constantly re-focusing their portfolios around low cost resources while shedding high cost resources. It is an exercise in vine pruning. But the better analogy for Have companies is that of a high wire circus act, always precariously balanced on edge. Have companies do not have pricing power nor unique technology nor any other sustainable competitive advantage other than their discipline, or luck, adhering to the fine line that is investing in only the best, and lowest cost, resource. One wrong acquisition, however, and suddenly they fall and fall until they, too, are a Have Not. Imagining a portfolio of assets, a Have company will ideally have multiple assets in the green region below while having few assets in the purple region. Moreover, Have companies will actively try to divest assets in the purple region.
Consider the pictures below. When some of Have’s assets become high cost, they sell them or otherwise compartmentalize them. The “Remainco,” post dispositions, is lower cost than it previously was. At the same time, Have companies find new, low cost resources to add to their portfolio over time. So for any given time period, Have is either in Chart 1, where it actively divests certain assets to high grade its portfolio, or is in Chart 2 where it has the low cost portfolio. Most Have companies in the sector today spent the last several years in Chart 1, actively high grading their portfolios. Today, Have companies arguably have the best asset portfolios they have had in the last ten years.
Have Not companies, for their part, have portfolios made of high cost assets. Perhaps they were once low cost producers, but didn’t replenish their portfolios with new, low cost resource. Perhaps they have always been high cost, as buyers of Have company disposals. Either way, we can think of Have companies as sitting in the low cost region while Have Not companies sit in the high cost region. In this way, Have Not companies are primarily made up of assets that Have companies don’t want. Since we have implicitly assumed price differences away for our discussion, Have Not companies, by definition, have lower returns than Have companies because they make less money for every barrel they produce.
Because we want to understand returns, another important consideration is the amount of debt a company has, its leverage. It can be shown, certainly, that some leverage improves returns for all stakeholders, but that having too much leverage is a problem. One of the dynamics in the US shale industry is that many companies increased their leverage when oil prices were substantially higher than today. Specific company performance aside, pricing debt at $100 oil and then operating in a $50 oil environment, much less a $35 oil environment, increases company leverage because this unavoidably decreases its asset value and cash flows. As the size of the asset value pie decreases, debt’s share of it grows. This creates return problems for both equity and debt holders as i) the company moves closer to insolvency and ii) there is less cash to go around. Ultimately, too much of a company’s cash flow goes to its debt vs portfolio renewal or shareholder friendly activities leading to relative underperformance, particularly over time. As such, the other important lens for defining Have and Have Not companies is leverage
So now we can formally, albeit qualitatively, strategically outline the US shale industry. There are Have companies, with low cost asset portfolios and low leverage, and there are three different types of Have Not companies. First, there are high cost, high leverage companies. These are companies most likely to go bankrupt. Examples of this include Whiting Petroleum and Denbury Resources. Second, there are high cost, low leverage companies. While unlikely to go bankrupt, their asset portfolios just aren’t as good as Have companies and so they still have poor relative returns. Bonanza Creek is an example of this kind of company, though it is worth noting that it only has low leverage due to a 2016 bankruptcy process. Finally, there are low cost, high leverage companies. There are very few of these companies. Were it not for their leverage, they would be Have companies. Reducing debt, not improving its business or returning capital to shareholders, is their number one priority. Occidental, post its Anadarko acquisition, is an example of these companies.
Consolidation Options
If an individual firm wishes to improve its returns, can it do so through merger activity? This question has two meanings. First, can it improve its returns relative to its pre-merger levels? Second, and most importantly, are those improved returns competitive with other industries?
Because we have defined exactly one high return quadrant in the US shale space, it is logical to ask how consolidation can help Have Not companies move closer toward the Have quadrant. If merging does not move them into that quadrant, even if their returns increase relative to pre-merger levels, then the consolidation activity will prove unsuccessful in making the merged company competitive with other sectors.
There are really three challenges to achieving this.
- Barriers to return enhancement
- Resource Quality
- Leverage
- Valuation
We won’t really discuss valuation explicitly here, but in the context of our discussion around consolidation improving returns, it is incredibly important. If Company A overpays for Company B, then competitive full cycle returns will be very difficult to achieve. As a general rule, if there is sound industrial logic to a variety of mergers occurring, but the companies can’t get a deal done, it is most likely due to differences of opinion on valuation and/or associated ‘social issues’ surrounding the subject.
High Cost Mergers
Let’s consider two companies with high cost resources, but low leverage. Will their merger improve returns? Advocates argue yes for the following reasons:
- High grading inventory – once merged, the MergeCo no longer needs to actively grow production and so can focus only on maintaining production. With this excess cash flow, it can return this to investors, pay down debt, and so on.
- Lower corporate costs – why have two companies doing the same activity, duplicating costs, if one can suffice?
The first point is largely irrelevant. Neither company has the asset base to be a low cost operator as standalone companies. Merging them doesn’t change this. Advocates of this approach assume that there exists within each Have Not company improved returns if only the assets were managed differently. In US shale, this broadly means “upspacing,” or drilling fewer wells in a given area. And no doubt, this is true, even in inferior rock quality. The difficulty with this position is that i) companies need not merge to realize these benefits, ii) these benefits are largely incremental given the low quality nature of their resource positions, and iii) upspacing generally leads to a fraction of drillable inventory available.
Much like high grading inventory, the second point can also occur without consolidation. If a firm wishes to lower its G&A costs, then it could have done so at any point in time. There are, today, low G&A companies at virtually every production scale. Merging can be a way accelerate this process, and for companies with significant geographic overlap, the savings could be higher than with less complementary assets. Still, for E&P companies with G&A/boe in the $3-4 range, there is little reason why these weren’t $1-2/boe in the first place.
Nevertheless, let’s assume that two high cost Have Not companies merge and successfully lower G&A by ~70% from, say, $3.5/boe to $1/boe and that they high grade and upspace their inventory. Assuming the same pricing, their margins do indeed improve. As such, they will generate more cash per barrel produced, leading to improved returns.
But the two questions we asked were did returns improve relative to pre-merger levels and did those returns become competitive with other sectors? Because their margin still falls short of the industry leaders, MergeCo did not achieve sector competitiveness. However, it did improve its returns relative to pre-merger levels.
Time is also critical here. As such, just as important as a return comparison immediately post-merger, we should consider what will happen to MergeCo over the next several years. Immediately prior to the merger, Have Not is at point 1 on the chart below. After the merger and its implied cost cutting and inventory high grading, MergeCo’s costs decline to point 2. However, after a relatively short period time, MergeCo’s costs increase to point 3 simply due to further depletion and the end of its high graded inventory. Without an additional acquisition or discovery of a new, lower cost resource base, MergeCo’s costs will continue to increase. Even worse, this increased cost of production will mostly erode any short terms gains created through the merger. If additional bad news were needed, MergeCo would still broadly fit into a Have’s definition for a divestiture candidate because its underlying asset quality remains poor.
Should two high cost companies merge? Merging should lead to a lower cost, and therefore, higher return company. However, this version of MergeCo is unable to move into the Have quadrant of the industry. If it can’t compete with the best firms in the underperforming sector, then it clearly will be unable to compete with the broader market. That being said, merging does appear to improve relative returns and therefore should be done.
Before moving on, it is worth discussing implementation for just a moment longer: any gains are only possible if the combined company in fact does rationalize its corporate costs and does high grade its inventory. As we have already discussed, these were options already available to both companies prior to merging. Why they did not take that option earlier is related to how the company became a Have Not in the first place –management. As such, there is the question of whether consolidation “could” improve returns for these companies and then there is the question of whether or not management teams “will” improve returns.
High Leverage Mergers
Two high cost, high leverage companies merging will lead to a larger, high cost, high leverage company. Like comparisons between other high cost companies above, this will do little to improve either company’s standing over time.
The interesting case is what happens if a low cost, high leverage company merges with a high cost, low leverage company. By merging, the low leverage company delevers the high leverage company while the low cost company provides high margin inventory for the high cost company, assuming the companies are similarly sized.
While not firmly in the Have quadrant, this merger moves MergeCo closer to the center of the sector graph. While MergeCo has both high and low cost assets, it will choose to allocate capital to the low cost assets, improving its full cycle margin and its overall value. Because the company is lower leverage, more surplus cash flow is available to shareholders. Both steps improve the company’s performance. Importantly, the company is now in Chart 1 of the Have company lifecycle chart discussed previously. Once MergeCo has grown its low cost production base high enough while letting its high cost production base decline, it could even dispose of Have Not’s assets in pursuit of an additional low cost asset. In this way, it can use the low leverage firm as a bridge back toward the Have quadrant of the industry.
Have’s Acquire Have’s
Remember that the biggest challenge to a Have’s returns isn’t its portfolio today, but how that portfolio looks over time. If it is unable to replenish its portfolio with additional low cost resource, it will become a Have Not company as it depletes its resource base. It cannot rely on operational efficiency because i) those gains are largely available to its competitors and ii) cost increases from declining resource quality more than offset gains from OE over time. For today, Have companies have the most surplus cash available for reinvestment or shareholder distributions because of their industry leading margins and industry leading leverage profiles. The most interesting value creation case is two Have companies merging. This scales their cash flow while lowering their overall cost structure. Moreover, the increase in scale should lower its cost of capital further while the combined inventory should allow for a long runway of high return activity. In this way, merging both delays the onset of its assets becoming high cost while further advancing additional opportunities for consolidation as its success snowballs forward.
The Future of US Shale
We started our conversation with a quote from an energy investor. They outlined what is today a commonplace vision for the energy industry: less companies that generate superior returns by and through consolidation. While they didn’t explicitly define it, what they were really referring to were the Have companies and the Have companies alone. Most of the US shale industry is too high cost, too levered, or both for consolidation to allow them compete with Have companies, let alone with other sectors of the economy. The increasing cost, depleting nature of oil reservoirs makes it impossible to take high cost assets and make them low cost, regardless of a company’s cost of capital or bargaining power.
If this is the case, then the industry will:
1. Shrink in general as investment at Have companies declines to something like maintenance capital or maintenance plus 5% growth and investment at Have Not companies approaches zero;
2. Further bifurcate the industry into a small number of Have companies and then everyone else. This dynamic already exists, but the gap between the Have’s and Have Not’s will only grow from here as the latter’s production declines and becomes more and more levered.
It’s likely that the Have’s of today will use their already relatively low cost of capital to take other Have assets off the board to secure their own low cost of supply for the coming years. The ones that do will still be Have’s in the future, while those that don’t will find themselves tumbling from the tight rope they walked so well to date.
Have Not companies, for their part, will further prioritize debt reduction, and some may even merge, fulfilling the consolidation narrative. This will certainly lead to improved returns and therefore should be done. But it is likely too little too late. If such mergers do happen, their inevitably disappointing absolute returns will shift the industry’s narrative from “consolidation” to “consolidate what?”