EOG Resources, Inc. Might Have Made the M&A Deal of the Year

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Leading shale driller EOG Resources' (EOG 0.55%) announcement earlier this month that it was paying $2.5 billion to acquire Yates Petroleum was a stunning surprise. It was a surprise not only because EOG Resources has traditionally avoided M&A, but because the company paid a very reasonable price for Yates' assets, relative to what its peers are paying for similar assets. That alone could make it the deal of the year.

Drilling down into the core of the deal

In Yates, EOG Resources acquired a company that has amassed 1.6 million net acres of drillable land across the western U.S. That said, EOG's primary interest in Yates is the company's 186,000 net acre position in the Delaware Basin portion of Texas' Permian Basin. That's because oil and gas saturate the rocks underneath that land, which, when combined with relatively low drilling costs, enable drillers to earn profitable returns even in the current environment.

Those returns are why producers are bidding up land in the region, paying top dollar to bolster their acreage positions:

Data sources: Diamondback Energy, Concho Energy, EOG Resources, SM Energy, PDC Energy, Pioneer Natural Resources, and Parsley Energy.

As that chart shows, producers spent billions of dollars to snap up land in the Permian Basin this year, paying upwards of $44,000 an acre for prime land in the Midland Basin, which is the eastern portion of the Permian. Several of these acquisitions marked transformational deals for the acquiring company. SM Energy (SM 1.58%), for example, not only doubled its land position in the Permian, but it transformed the company back into an oil growth story. Before the deal, analysts at KeyBanc expected SM Energy's production to grow by a mere 2% next year, with production projected to decline by 1% the following year. However, because of the Permian's rich economics, those analysts now believe SM Energy can grow its oil production by 15% next year and 20% in 2018. That said, at $39,500 an acre, it paid a hefty premium for that growth compared to the average transaction, which had ranged $25,000 to $35,000 an acre earlier in the year.

Concho Resources (CXO) likewise used its Permian Basin transactions as a platform to ramp up growth going forward. The company initially anticipated that its production would be flat to down 5% this year. However, its most recent deal will push its production up by 1% to 3%. Further, the deal sets Concho Resources up to deliver 20% oil production growth in 2017. That said, like SM Energy, Concho paid an enormous premium to return to growth mode.

A steal of a deal

The premium prices its rivals are paying for land are what make EOG Resources' recent transaction stand out. According to analysts, it paid somewhere in the neighborhood of $7,000 to $8,000 an acre for its Delaware Basin land after factoring in the market values of the other assets it's acquiring in the Yates transaction. That's remarkably below what rivals are paying for similar acreage in the region, and below the $13,000 an acre EOG Resources paid for land late last year.

That's noteworthy because this is not land along the fringes of the basin, but right within the core of the play. In fact, EOG Resources estimates that it can drill into three separate hydrocarbon-bearing formations: the Wolfcamp, Bone Spring, and Leonard. Overall, the company expects to drill at least 1,700 premium wells on this acreage, which are wells it defines as generating a 30% after-tax rate of return at flat $40 oil. Those compelling economics will not only reward investors in the current oil price environment, but could lead to substantial returns should oil prices begin to recover.

Investor takeaway

EOG Resources made what appears to be the best Permian Basin deal of the year. It paid a rock-bottom price for prime acreage at a time when its rivals were paying top dollar for similar acreage. That will allow the company to earn much higher returns than its rivals, which are paying a premium to grow.