On April 1, Pioneer Natural Resources announced an acquisition of DoublePoint Energy:
“DoublePoint has amassed an impressive, high quality footprint in the Midland Basin, comprised of tier one acreage adjacent to Pioneer’s leading position. We are pleased with their decision to become long-term partners with Pioneer in a transaction that will complement our unmatched position in the core of the Permian Basin. Pioneer will incorporate these assets into our investment model, migrating the assets from significant production growth to a free cash flow model, moderating growth for the U.S. shale industry and generating significant value for our shareholders”
The deal was met with a general lack of enthusiasm by the market, with most analysts finding the deal unnecessary, overvalued, or strategically confusing. Investors broadly agreed, with Pioneer underperforming peers since the deal was announced:
The brief context on Pioneer: like all Have companies, Pioneer has a large, low-full cycle cost asset base and superior balance sheet. To become that kind of company, they spent 2009-2019 making their Midland Basin position the centerpiece of their company through non-core asset sales and increased capital allocation. And unlike many new entrants to the Permian region, Pioneer generally did not acquire their position through high-cost M&A/A&D. Like Chevron’s Permian or EOG’s asset base, this put their full-cycle cost structure lower than most of their competitors. With low full-cycle costs, non-Permian asset sales were used to position Pioneer’s balance sheet as best in class. And with low full-cycle costs and a strong balance sheet, Pioneer became a relative outperformer in the sector.
Buying DoublePoint, then, is a clear change in strategy. There is no way to hide that this purchase is expensive. Using the Chevron Permian test, this absolutely shifts Pioneer to the right from a full-cycle cost perspective:
So, why would Pioneer, one of the few Have companies in the shale sector, do a confounding, expensive deal?
Market Structure Problems
In the U.S., most industries are becoming increasingly concentrated. Along with increased concentration, most companies are becoming increasingly profitable. As a recent Review of Finance article described:
“Since the late 1990s, over 75% of US industries have experienced an increase in concentration levels. We find that firms in industries with the largest increases in product market concentration show higher profit margins and more profitable mergers and acquisitions deals. At the same time, we find no evidence for a significant increase in operational efficiency. Taken together, our results suggest that market power is becoming an important source of value…We also show that the higher the profit margins associated with an increase in concentration are reflected in higher returns to shareholders. Overall, our results suggest that the US product markets have undergone a shift that has potentially weakened competition across the majority of industries”
But not in U.S. upstream oil and gas! In fact, U.S. oil production is one of the few U.S. industries that became less concentrated, and materially so, over the last ten years. Not only is that unique with respect to other U.S. industries, but that is unique even within the global oil and gas industry, with the U.S. sector being the least concentrated:
The broad unevenness in market concentration throughout the global oil and gas sector shouldn’t actually be surprising. Despite oil producers large and small being global price takers, the industrial structure of oil producing sectors within and between countries varies significantly. This in turn impacts the full-cycle cost structure and margin for production firms in and between countries.
In some cases, competition is limited by the regulatory and institutional environments of a country. In other cases, it is due to the kind of resource the country has. In others still, it is a combination of both. Canada, as a useful comparison to the U.S., is most similar in terms of regulatory and institutional environment and yet its production sector is far more concentrated. One of the primary drivers for this difference is the kind of oil resource Canada has the most of: oil sands. The size of and capital requirements for oil sands projects act as natural barriers to entry for new firms. A group of five guys with friends and family money isn’t going to develop an oil sands project. On the other hand, Canada lacks shale/tight oil resource that is comparable in scale to what the U.S. has, though what it does have is indeed dominated by much smaller companies, even groups of five guys with friends and family money. The U.S. stands alone globally in the scale of its shale resource and, more importantly, in its general lack of barriers to entry for new firms. Remove the existence of large-scale shale resource and the U.S. sector would be more concentrated because its production would be dominated by high barrier to entry offshore projects; keep the large-scale shale resource but remove the infrastructure, information, regulatory environment, and so on and the U.S. sector would again be more concentrated.
So, the competitive structure of the U.S. shale industry ought to give potential investors pause. Without barriers to entry, new firms will enter and compete away each other’s profits, which happened in the U.S. shale sector.
But what I’ve found interesting in the seemingly endless critiques of the shale industry is that they seem to frame market structure problems as a choice made by individual firms rather than the other way around. If only shale producers showed more discipline, critics argue, returns would have been better, etc. These critics seem to believe that shale firms had unlimited free will and self-determined themselves to lose, rather than make, money. But framing the U.S. shale sector in that light – prioritizing the individual firm’s decisions above all else – neither explains nor predicts the sector particularly well. This is because market structure is not the choice of individual firms but is a function of whether or not barriers to entry exist.
Marginal Mergers
Because of low barriers to entry and lack of control and/or differentiated ownership along their value chains, shale firms primarily compete against one another on operational effectiveness (OE) dimensions – drilling faster, optimizing operating costs, etc. Even without mergers, shale companies drilled increasingly long laterals, decreased their input costs, and reduced their corporate costs. This form of competition is what drove the industry’s dramatic and seemingly unending gains in productivity and cost improvements. However, competition along these dimensions – trying to work harder than the next guys – does not represent a competitive advantage when those improvements are easily replicated. As Michael Porter wrote in an article called “Operational Effectiveness is Not a Strategy”:
“OE competition shifts the productivity frontier outward, effectively raising the bar for everyone. But although such competition produces absolute improvement in operational effectiveness, it leads to relative improvement for no one.”
Yet, shale sector consolidation advocates, such as Kimmeridge Energy, like mergers specifically for their ability to improve operational performance:
“There is significant industrial logic to being larger in the development of unconventional resources. The major reasons include better oilfield service pricing, negotiating leverage and more efficient use of services, the ability to drill longer laterals and lower per barrel and per foot completed costs, a reduced environmental footprint, and lower overhead and other fixed costs.”
Like I wrote about in Consolidating What, these types of gains are possible through mergers, but are relatively limited in magnitude and generally have expiration dates due to the depleting nature of oil assets. But strangely, Kimmeridge makes it seem as though shale firms have insufficiently improved their operational performance the past ten years, as though they weren’t competing on these parameters the entire time. In fact, shale companies have never operated better, at lower direct inputs costs, nor with longer laterals than they do today. Further, it would be a U.S. onshore oilfield first for larger companies to outperform smaller ones on input costs.
Kimmeridge is essentially arguing that companies should merge so they can continue to show improvement on the charts below, the holy trinity of shale company investor relations presentations. But again, this is already the form of competition pursued by shale companies, an approach that hasn’t historically been successful despite the sector realizing substantial performance improvements.
Here is Porter again:
“Constant improvement in operational effectiveness is necessary to achieve superior profitability. However, it is not usually sufficient. Few companies have competed successfully on the basis of operational effectiveness over an extended period, and staying ahead of rivals gets harder every day. The most obvious reason for that is the rapid diffusion of best practices. Competitors can quickly imitate management techniques, new technologies, input improvements, and superior ways of meeting customers’ needs. The more generic solutions – those that can be used in multiple settings – diffuse the fastest. Witness the proliferation of OE techniques accelerated by support from consultants.”
There was a point in time, for example, when EOG Resources really did operationally outperform many competitors. But that margin has closed significantly over the past several years, if one even exists at all. This is why my designation of Have and Have Not companies has little to do with whether they drill slightly longer laterals or have slightly lower G&A costs than the next guy. Resource quality, balance sheet strength and full-cycle cost structure lead to relative firm outperformance, which is enhanced through the pursuit of operational effectiveness.
Haggling over operational improvements, though, completely misses the point: by framing the benefits of mergers around operational improvements, Kimmeridge distracts from the more important question of whether mergers in the shale sector create sustainable competitive advantage. If the whole point of competitive advantage is that no matter how hard competitors work, they cannot replicate what you have, then how is a merger accomplishing that objective?
Oil Prices
To be clear, the principal source of U.S. E&P underperformance relative to the broader market is because oil prices declined. It was not because companies had $4/boe G&A rather than $1/boe G&A costs. Consider operational and, if it were even possible, full-cycle reserve add cost improvements relative to changes in oil price. Even the best in a best in class operator today would realize less than half the cash flow per barrel produced than they did at $100 oil. It would be great for companies to improve their performance – going from 12 to $18/boe is a massive improvement, but still pales in comparison to changes in oil price.
So, why did oil prices decline? Oil prices declined because U.S. oil production grew too fast. Why did U.S. oil production grow too fast? Low barriers to entry allowed endless new entrants into the market who then competed away profits by driving up M&A/A&D prices while executing identical business plans using identical technologies while continually replicating each other’s best practices. The byproduct of high acquisition costs and competition along operational effectiveness parameters was rapid production growth. Because every firm is a price taker with little ability to differentiate themselves along their value chains, production growth always maximized the value of each firm. The shale sector’s behavior is not only rationale under these constraints but is extremely predictable due to the sector’s market structure.
This is the same problem I highlighted in Chevron Acquires Noble with respect to ExxonMobil’s acquisition of XTO Energy:
“As Tillerson pointed out, the market could have gone the other way and the investment would have been more successful. That is true, but in offering his defense of the deal, he framed the problem around the output rather than around the input. Exxon’s bet on XTO wasn’t that prices would stay high, but that competition would stay low. The point isn’t to argue whether or not the deal was good, but simply that [competitive markets] offer no protection for incumbent producers. In regions where supply is rapidly increasing, little can be done to protect prices.”
In competitive markets with low barriers to entry, firms compete away each other’s profits. Blaming individual firms for doing so makes little sense. The question, again, is how can mergers create entry barriers to prevent this dynamic?
Merging for Differentiation
Merging for differentiation is why Chevron’s Noble acquisition was the best acquisition of 2020. Though not an exhaustive list, the below are would-be barriers. Can mergers create differentiation along any of these?
- 1. Technology
- 2. Information
- 3. Market access
- 4. Capital
- 5. Land/resource
Technology and information are ubiquitous in the E&P sector. Production technology is not owned by E&P firms and information is readily available through both formal and informal channels. Continuous job changing transfers labor specific knowledge, as do informal conversations. Industry organizations explicitly encourage the sharing of technical details and problem solving approaches, participation within which is generally encouraged by the E&P firms themselves. State and Federal regulations further encourage technology transfer and information availability. In upstream oil and gas, there is no equivalent of Google’s algorithm or a Pharmaceutical patent portfolio.
Regarding 3, can large U.S. oil producers use their size to limit competitor access to sales markets? Generally, no. The U.S. is an extremely consumer friendly jurisdiction and anti-competitive producer and midstream behavior is generally not tolerated. Even if it were, given the upstream sector is broadly disintegrated, it would likely be the E&P sector itself that suffers at the hands of the midstream and downstream market segments rather than E&P’s inflicting harm onto each other. Related, there likely would only be integrated producers were this institutional context the case. That the upstream sector is nearly entirely disintegrated from midstream and downstream components says a lot by itself about the regulatory and institutional environment in which U.S. shale firms operate. Other jurisdictions certainly differ from this. Chevron’s Noble acquisition, for example, gave Chevron access to natural gas markets with very high barriers to entry. By using gas sales and purchase agreements, Noble, and now Chevron, limits new entrants into regional gas markets in general and specifically for the volumes they contracted. This is why this was the best deal of 2020.
So, we are left to consider what can be done on 4 and 5.
Kimmeridge and other consolidation proponents talk about 4, access to capital, as a benefit to scale. Without access to capital, new entrants can’t exist. Even more, larger companies generally have a lower cost of capital than smaller ones. These are great points. It is impossible, as an example, for a small private equity backed oil producer to issue 10-year notes at 2%, yet Pioneer, in February, did just that. But is access to capital for small firms zero? Certainly not. Even more, several new private equity backed companies emerged in 2020 and 2021, in addition to the large “shadow banking” sector offering term loans, bridge loans, overriding royalty interests, volumetric production payments and more. The capital is there, but it is more expensive. That is just another way of saying that capital exists to finance high-cost oil supply.
At current or lower oil prices, however, U.S. production will decline because most of the sector is high cost. Have companies will stay flat, grow marginally, or drive merger activity, all of which is already happening. But what happens at higher prices? Marginal shale acreage at $55 WTI suddenly becomes wildly economic. The pull of production growth, for every company, becomes difficult to resist at high prices, and any capital constraints that may exist today, are unlikely to persist. In other words, under the right price conditions, capital is probably not going to prevent new firms from entering the market, nor is it today albeit the pace of new firms entering the market is certainly slower.
At $100 oil, however, what land, exactly, would new entrants purchase and develop? Like I wrote about in U.S. Oil Scarcity, there are no new, large oil plays in the U.S. for unconventional technology to exploit. The resource exploration and delineation phase is over. This is why EOG is exploring for oil plays internationally or spending time on relatively small ones in the U.S. like step outs in the San Juan Basin. As such, Number 5, land/resource availability, is most likely to become a true barrier to entry.
Even more, thanks to high information availability, the supply cost of shale and its size is relatively well known at this point:
This dynamic is why ConocoPhillips acquired Concho Resources in the first place. This dynamic is also why there can’t be a new of “Concho Resources” that emerges today to add new incremental barrels into the market. The resource lot is cast.
So, in the world of $100 oil, where would these new entrants find their land? It would not be through organic leasing programs, but through A&D transactions from much larger companies. The kinds of assets large companies would sell in this context are generally going to be mature, late-life or high cost assets. In this way, the largest companies would not only dominate production itself, but would begin to control the number of new entrants. Owning the land becomes the source of competitive advantage.
Pioneer Acquires DoublePoint
All of this context is where Pioneer’s acquisition of DoublePoint starts to become interesting. Why did Pioneer acquire DoublePoint?
Pioneer’s president, Richard Dealy, said this of the deal:
“The more we can bring some of these larger private players into public discipline, that’s very good.”
What does he mean? Pioneer thought that a competitor – DoublePoint – was growing too fast. To prevent DoublePoint from adding incremental barrels into the market, Pioneer bought them. This is not language used to describe the kinds of marginal operational benefits that consolidation advocates like Kimmeridge highlight, but is about market power and is explicitly anti-competitive.
To illustrate this, Pioneer shows the following slide in their acquisition deck:
This slide is atypical for shale company investor presentations because it highlights Pioneer’s gross production. Gross barrels are not the barrels Pioneer has an economic interest in, but are the barrels they control as an operator. This slide is making a strategic point: Pioneer controls the majority of barrels produced in the Midland basin. The implication is that if they don’t grow, the Midland Basin itself is unlikely to grow. Indeed, using a simple C4 concentration ratio, the Midland Basin itself, post PXD/DoublePoint deal, will look more like an oligopoly than anything else. Still, Pioneer has little to worry about regarding anti-trust violations because they will still be a small producer relative to overall U.S. production, and smaller still relative to global oil production.
The Real Goal of Consolidation
Acquisitions related to market power only work if they act as true entry barriers. DoublePoint itself demonstrates that M&A by itself is insufficient in this regard. DoublePoint is the third iteration of a company called Double Eagle combined with another serial entrepreneur’s company called FourPoint . So, simply buying companies isn’t enough to change the industrial structure of the sector.
Still, the structure of the U.S. shale sector is changing, but it is changing because supply side opportunities are increasingly limited. So when Pioneer acquires a company like DoublePoint, it is not only removing undisciplined production growth from the market today, to use Pioneer’s language, but once DoublePoint is out of the market, they won’t be able to return in a comparable, production growth oriented vehicle because the resource to do so is simply not available. Much like Conoco’s acquisition of Concho, Pioneer’s acquisition of Double Point is itself a source of competitive advantage because they now own an increasingly limited supply of low-cost U.S. resource. It is not a competitive advantage because of incremental improvements to lateral lengths or corporate cost reductions, but because a competitor is out of the market that cannot re-enter it due to lack of supply side resource opportunities.
This doesn’t mean the deal was “good,” necessarily. It absolutely increases Pioneer’s full-cycle cost structure, increasing the price at which the company can deliver the same returns to shareholders as they could prior to the deal. Related, because Pioneer is intentionally reducing DoublePoint’s activity level, they are reducing its value. The relatively large equity sell off of Pioneer post deal announcement, then, shouldn’t be particularly surprising as the deal absolutely makes Pioneer’s shareholders worse off today. But what about in 5 years?
The real hope of shale sector consolidation isn’t for marginal operational improvements but to change the industrial structure of the U.S. oil and gas market. Companies like Pioneer hope that the next time prices go up, the price increases is sustained for longer periods of time because new shale entrants won’t be able to crash prices. Higher future prices and a weakened ability for the U.S. shale sector to grow, then, is what shale sector consolidation today is all about.