WPX Energy Merges With Devon Energy
“Shale didn’t work because folks threw too much money at it to grow too quickly,” Pickering said. “It feels like we now have the play book.”
“This deal represents the form of shale company consolidation that many across the industry have been looking for,” said Andrew Dittmar, a mergers and acquisitions analyst at Enverus.”
Strategically, WPX and Devon were in approximately the same, difficult place. Both were generally well-regarded companies and both spent years creating the best portfolios they could from their gassy starting points. However, because their current portfolios were created through high cost M&A transactions, they were unable to break into the Have quadrant, despite excellent execution and generally thoughtful deal making. This deal is another step toward getting them there, but they aren’t there quite yet because neither their portfolio nor balance sheet is quite as good as their Have peers:
If one key to being a Have company is having a low-cost portfolio, then how does the pro-forma company compare?
Before the deal, the futures for both companies were almost entirely in the Permian. The merged company is no different. While many assets I’ve put into the disposition category may have been low cost assets, their go-forward options are both high cost. In option 1, the assets are capitalized, but because of limited to no low-cost inventory, continued investment drives up the pro-forma company’s corporate F&D while also reducing the Permian’s budget. In option 2, the assets receive no incremental capital, production declines, and operating costs increase. Either way, these assets will keep the pro-forma company’s cost structure higher than their Have company peers.
At the same time, a key element of the pro-forma company’s value proposition is this:
The “assets to sell” I listed above make up ~40% of the pro-forma company’s oil production. Given this, the balance sheet implications of selling them, particularly in today’s depressed A&D market, would be very negative. Instead, the pro-forma company will primarily capitalize the Permian, letting production decline from the other assets. As Permian production grows relative to the other assets, even if corporate production stays flat, it weakens the importance of the other assets. This sets the stage for their eventual sale. In the interim, they will receive a very small amount of capital to moderate their decline rates. This capital budgeting activity sets up the next part of the pro-forma company’s plan.
The pro-forma company hopes to eventually close the valuation gap highlighted below by increasing the size of their Permian production while selling their non-core assets. The one exception to this disposition plan is likely to be the Powder River Basin, which they will likely continue viewing as an exploration option.
So, the idea is to grow their Permian such that it completely dominates the cash flow of the company in order to achieve this multiple expansion, which is a material prize for shareholders. However, by the time their Permian production grows large enough to enable the sale of the other assets and therefore this multiple expansion, their go-forward Permian inventory story will be relatively weak, preventing multiple expansion. As such, they will need to do additional Permian deals to deepen their inventory.
And this endgame was the ultimate strategy behind the merger: get big today to position themselves as a key Permian consolidator tomorrow. The trick for them, in that case, will be doing subsequent deals at low enough prices that they are able to, at last, enter the Have quadrant.
Southwestern Energy Acquires Montage Resources
Southwestern acquired Montage in an all stock, no premium deal. To understand what happened, first we need to understand where both companies sat within the industry pre-merger:
- Southwestern was a high leverage, higher cost Have Not
- Montage was a high cost, low leverage Have Not
This, then, was a merger between a high leverage Have Not and a Low leverage Have Not.
I wrote about these kinds of mergers in Consolidating What:
“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.”
This is exactly what Southwestern accomplished acquiring Montage. To be clear, this deal is directionally positive, but is just the first step in a relatively long process. Southwestern’s assets are superior to Montage’s, but relative to other peers, Southwestern still needs to execute additional deals to improve their asset positioning. However, with a strengthened balance sheet, they improved their ability to do so.