It’s worth asking why an oil company would ever acquire a competitor. If the company has an existing resource base, they could, instead, drill and produce that. They could also explore for new resource, whether close to existing operations or in new frontiers. In either case, the choice is not for new resource per se, but for cheaper resource. So, most simply, a company acquires a competitor when it is cheaper than alternatives.
From this, we can reasonably conclude that ConocoPhillips (COP) acquired Concho Resources (CXO) because they thought it was the lowest-cost option for them.
But shale focused M&A is not low cost, even excluding typical integration problems. Exploring and developing your own resource organically is often less expensive because acquisition costs are relatively low, but development costs are either lower or comparable. Even if development costs are slightly more expensive, low acquisition costs often still tilt the advantage to exploration. Given this, COP’s relinquishment of their new venture program is because the development costs of the resource they are finding exceeds alternatives, namely, M&A. The read through is that global exploration opportunities, at least for COP, are expensive:
Now, COP stressed that they’ve not finished exploring in general, but are instead prioritizing brownfield over greenfield exploration. In the U.S., however, Conoco has yet to find a new, scalable U.S. oil play on its own, where it has relied on the development of legacy Bakken and Eagle Ford positions. The standard counterpoint to COP in this regard is, of course, EOG Resources.
A Have competitor, EOG has, to date in 2020, avoided large scale M&A. This is less a case of EOG losing out to Conoco than it is to a fundamentally different view of resource availability. For EOG, they can always find more low-cost resource through exploration.
But can they find additional low-cost oil in the U.S. anymore? Can anyone?
U.S. Shale and the Return of Resource Scarcity
In the middle of today’s criticism of shale companies, it’s easy to forget the historical context for their acquisitions. If the key critique is that companies overpaid for assets – this includes over-development, which was required to justify the acquisition prices– then it’s worth remembering why companies overpaid: resource scarcity.
During each phase of the shale boom, including the natural gas focused 2000s, the name brand play of the day was always the last one. If Marathon, for example, didn’t buy Hilcorp out of the Eagle Ford, Marathon would never find another play, and would get boxed out into irrelevance. While Marathon’s returns are in part still low from this acquisition, that Eagle Ford asset is nevertheless the second largest in the company today. Where would 2020 Marathon be without it? This dynamic even drove companies like Chevron to speculatively pay for Canadian resources like the Duvernay, under the belief that if they didn’t buy it, there would be no other opportunities.
This dynamic is also why, despite relatively low oil prices at the time, that the Permian acquisition boom began in earnest after 2014’s oil crash, in 2015. This happened because i) core of every major shale play was smaller than expected, and ii) their relative ownership concentration acted as a barrier to entry for new firms. This made the Permian sort of a last man’s stand for resource accumulation, even for companies like Marathon that had previously rushed into other basins.
But today, if you are a U.S. E&P looking to grow, or even enter the market to begin with, where in the U.S. would you look? Outside of long dated exploration in the Gulf of Mexico, the only place you can look is at other companies. There really isn’t anything else, at least not for oil. For anyone working in U.S. shale, from bankers to front line engineers to corporate acquisitions groups, this has been the case for several years now, but the reality of core inventory depletion is coming even faster than many expected. Acquisitions premised on “decades of inventory” have amounted to just a few years of low-cost inventory.
With this in mind, the Permian’s fabled stacked pay is less important than simply having a very large overall acreage position. Breadth rather than depth wins the day due to limited low-cost zones. Unfortunately, most companies, to justify their expensive acquisitions, drilled through the majority of their best inventory, with 2020 further exaggerating a high-grading trend that began in 2019.
In a broader sense, U.S. shale’s seemingly unending oil production growth from 2010 through 2019 came at the cost of drilling through the majority of its low-cost resource base. There is still tremendous resource remaining, but all at considerably higher costs. In this way, the U.S. is once again running out of low-cost oil.
Every commodity boom cycle unlocks a finite amount of new low-cost supply while every commodity bust cycle depletes that supply, setting the stage for the next commodity boom. If today’s oil market is in a bust cycle, after the 2000s commodity super-cycle, then the resource lot has been cast. For individual companies, it’s all about positioning for an inevitable recovery in oil prices. Because resources, and especially low-cost resources, are now explicitly finite, the only way to do that is through M&A. This is what I meant when I wrote:
“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.”
By accumulating the lowest-cost resource available, the acquirer boxes competitors out of this cycle’s best resources, all but guaranteeing who will still be in the Have quadrant during the next commodity cycle upswing. In this way, M&A in bust cycles can be strategically beneficial for companies, extending the duration of their low-cost resource bases.
ConocoPhillips Acquires Concho Resources, and The Chevron Test
In Chevron Acquires Noble, I wrote about Chevron’s differentiated Permian position. They could literally be the worst Permian basin operator, but still come out ahead because they generally don’t pay royalties and they didn’t use high cost M&A to create their position. In this way, they have a durable competitive advantage because no matter how hard their competitors work, they cannot replicate Chevron’s cost structure or relative returns. Because of their unique position, we can apply the Chevron Test, like we did in Chevron Acquires Noble, to benchmark shale projects.
Conoco’s acquisition of Concho is only similar to Chevron’s with respect to its size. Rather than cost structure, the advantage COP is targeting is simply resource ownership, the boxing out activity referenced above. Yes, Concho has a good position and yes, it is a large position, but because Concho generally does not own its minerals and it did do large, high cost M&A, even before the Conoco deal, their position compared unfavorably to Chevron’s Permian on a full-cycle cost basis:
Now, Conoco comes along and acquires Concho. While low relative to most Permian M&A and A&D deals the last several years, Conoco’s acquisition of Concho nevertheless moves them even farther away from Chevron:
Because of this, Conoco can never generate the same returns from the CXO position that Chevron generates with theirs. Even though Concho’s half-cycle development costs are low and in line with Conoco’s general cost of supply framework, the acquisition will still make their business more expensive. Conoco admitted this without admitting this, flagging an increase in their cashflow breakeven.
Defined as the oil price required to maintain production and pay their dividend, Conoco’s cash flow breakeven was in the “mid-30s” in April 2020:
Doug Leggate, Bank of America/Merrill Lynch: …where do you think your breakevens are right now, just to give us a kind of road map for how your cash flow capacity is coming out the other side of that? That’s my first question.
Don Wallette, ConocoPhillips, Executive VP and CFO: Yes, Doug, this is Don. I think on a recent call, we mentioned with – on a go-forward basis, if you’re looking at our spending for the remaining three quarters of the year, we said that our breakeven to cover CapEx was under $30 WTI.
Doug Leggate, Bank of America/Merrill Lynch: Does that include the dividend…?
Don Wallette, ConocoPhillips, Executive VP and CFO: It does not include the dividend. So to get to the dividend, you’d be in the mid-30’s WTI
However, after acquiring Concho, COP expects their cash flow + dividend breakeven to increase to the “mid-40’s”:
Why is that? It is partially due to the larger shareholder base and partially due to, in the CEO of Concho’s words, the high capital intensity of their business relative to Conoco’s:
Tim Leach, Concho Resources, Chairman of the Board and CEO: Yes, that’s a great question. I mean, Ryan and I started talking about the company of the future quite a while ago and discovered that we shared a lot of the same views. And Concho is running a great business and kind of hitting on all cylinders right now. But I think size and scale are the driving factors today, and at the size and scale that we are today with the underlying decline rate that approaches 40%, it’s hard to distribute cash back to shareholders as rapidly as we can in this new model. So that was really what drove the decision about – between go-it-alone and this combination.
Leach is saying that Concho, which is unquestionably a Have U.S. shale company, cannot hold its production flat and pay a competitive dividend because the capital intensity of their business is simply too high. Therefore, they need to merge into a less capital-intensive-business, like Conoco’s, to deliver compelling shareholder returns.
To say this differently, by acquiring Concho, COP is making their own business more capital intensive and expensive.
So why, then, did Conoco do this deal? By inference, they believe three things:
- There are no new low-cost shale oil plays remaining in the U.S.
- The full cycle cost of frontier exploration is too high to justify at current prices
- Oil prices will eventually go up and they want to maximize resource capture for best upswing positioning
Which brings us to EOG Resources.
EOG Resources
EOG Resources was wildly successful the last ten years in at least two ways. First, they became the gold standard U.S. shale company: low leverage, great well results, low costs, and general peer outperformance. Second, and more importantly, they branded those achievements. “EOG” is not just an oil company, but the best, most technically advanced company in the space. The “Apple Computer of shale.”
How did they achieve this relative outperformance? Like all Have companies, EOG has low full-cycle costs. Most fundamentally, they achieved this by generally avoiding the expensive shale M&A/A&D market. In the full cycle cost equation, finding + development + operational + corporate costs, they consistently had lower finding costs than peers. By spending less upfront, they generated superior full-cycle returns. Make it, don’t buy it.
Even their early claim to fame – being one of the first shale companies to pivot from gas to oil – came out of this strategy. Seeing how elevated asset prices were for natural gas assets, they simply avoided buying them, which they would have needed to do after having organically missed out on core gas play ownership in the major shale gas basins. Instead, they drilled wells in quite literally every tight play in North America, exploring for Have quality rock without the associated price tag. Eventually, they found the Eagle Ford, which became the company’s foundation.
Now, it could be that EOG really is a better operator than its competitors, but it also does not matter. Much like Chevron’s Permian position, EOG would still have materially lower full cycle costs than competitors simply by generally avoiding the U.S. A&D/M&A market. Executing their make-not-buy strategy, above all else, their historical source of peer outperformance.
As such, their view is that they have the best inventory position in the sector, and, if they need more, will find it themselves. More pointedly, why bother buying other companies when everyone else is invariably worse?
On their Q3 2020 conference call, Billy Helms, EOG’s COO, reiterated this perspective:
Billy Helms, EOG Resources, COO: Yeah. Paul, this is Billy. I’ll touch maybe on the M&A question. I think — certainly, I think the industry needed to go through some M&A some consolidation in the space. And I think we’re certainly supportive of what we’ve seen so far. For EOG, we’ve looked at just about every possible combination that’s out there.
And we certainly understand the financial uplift or the accretion that you might get from a corporate M&A, but we look at that more as a one-time event. And we’re really looking — for us to be entering that market, we would look at the longer-term impact that a possible M&A would have on our current inventory.
And so we look at the inventory that a company might have in comparison to the inventory, we already have or what we’re seeing in our exploration program, and we just don’t see anything that we’re — we need to allocate any funds to at this point in time.
There’s nothing that really meets our objectives. And I guess it just stems from the fact we have such a high level of confidence in our current exploration program, which is mainly aimed at improving the quality of our premium inventory.
I wrote about this in Consolidating What: just because a deal is financially beneficial in the short term doesn’t mean that it helps a company’s strategic position. EOG is keenly aware that oil companies cannot financially engineer superior returns. Industry winners own the lowest-cost resource, and they minimize their acquisition costs to own it. There is no other way to join, and remain in, the Have quadrant. This is why, like I wrote about in Recent North American M&A Deals, WPX hasn’t made it into the Have quadrant: the majority of their company was built through high cost M&A, leaving them with perpetually higher full-cycle costs than Have competitors like EOG.
EOG, then, takes the view that:
- They don’t need M&A because developing their existing portfolio has better returns
- Their organic exploration program has better full cycle returns than M&A
So, back to the broader U.S. market context in 2020. Basin cores are tightly held, and all have rapidly dwindling low-cost inventory. Peer companies like Conoco and Pioneer acquired competitors. What did EOG do? They announced a dry gas discovery in South Texas and a farm-in agreement to explore for oil shale in Oman. Both are behaviorally consistent decisions, and likely correct, but they also point to the broader scarcity of U.S. oil resources.
If one motivation behind COP’s acquisition of Concho is that there are no new shale oil plays in the U.S., then EOG is, in their own way, agreeing with the view that the opportunity set for finding additional low-cost oil in the U.S. is relatively sparse.
What Comes Next
To say it differently, shale brought new life to a declining U.S. industry. But the last ten years were sort of like seeing a magic show as a child. The magician comes out, and you, having seen wizards and magic in movies and read about them in books, imagined turning invisible or conjuring flames. You see smoke bellow from beneath drawn curtains, purple ones, with gold adorned in intricate patterns. You hear a low rumbling – is it a dragon? – as the curtains open and a man with a black cloak and top hat slowly emerges. Your heart is beating faster than it ever has, your mind is racing with possibility. You make eye contact with him and he starts to walk toward you. You can barely breathe you are so excited. Finally, he arrives to conjure something beyond imagination. His hands, cloaked in white gloves, flash before your eyes. His right hand suddenly reaches behind your ear and quickly shows you his discovery: a quarter. And that is not really what you expected, not really close at all.
So it is with shale. Because most of the low-cost shale resource has been developed, technological gains have materially slowed, and the sector’s cost of capital increased, it will be unable to repeat its 2016-2019 production performance. This isn’t to say that U.S. shale cannot grow again, but only that it will require higher prices than it historically needed.
For the U.S. sector as a whole, resource scarcity will become a barrier to entry for new firms. The emergence of shale dramatically lowered the barriers to entry for the industry because it was perceived as such a large opportunity. Price only governs the speed at which new firms enter, but it is resource availability is that governs whether new firms can enter the market in the first place. In Chevron Acquires Noble, I wrote about the fundamental problem with Exxon’s XTO acquisition. It wasn’t that they bet on high natural gas prices per se, but rather that they bet that there wouldn’t be new competitors. At the time, the view was XTO had the biggest and best positions in unconventional gas, something competitors, including Exxon, simply couldn’t replicate. The reason U.S. natural gas prices collapsed is because there were not only new competitors, but lower cost ones with superior resource bases to XTO.
Today, the oil shale resource base has not only stopped expanding, but is largely defined. Whereas companies like Concho emerged over the last decade, comparable new entrants that add new oil into the market are no longer feasible. By taking these companies off the board today, Conoco is capturing the last of the best shale resource. EOG, on the other hand, is starting what will be a long pivot away from its historical profit centers. For Conoco, the change is happening today. For EOG, it will take years, and in the meantime, they continue to develop their current portfolio of low-cost resource.
Given the world is currently oversupplied with oil, talking about resource scarcity may seem mistimed. However, at the individual firm level, resource scarcity drove the entirety of the shale boom, and continues to be the driving force behind the sector’s evolving industrial structure.