Domestic Oil Producers Ripe for Plucking

Regardless of whether oil is selling at $40 a barrel or $100, the United States does not have enough of it. The recent flare-up in the Middle East reminds us that far too much of this essential fuel is found in countries that are unstable, and unfriendly to boot. Lest we forget the stranglehold that energy providers can have over their clients, just tune into the nasty little catfight going on between Russia and the Ukraine.

All of which has prompted Bernard Picchi, veteran oil analyst and currently a consultant for Hollow Brook Associates, to predict an acquisition binge in the oil sector. He has expected for some time that larger U.S.-based "supermajors" like ExxonMobil (NYSE: XOM) or Chevron (NYSE: CVX) would seek to bolster their reserve positions by snapping up domestic companies like Anadarko (NYSE: APC) or Occidental Petroleum (NYSE: OXY). As Bolivia, Venezuela, Russia, and other countries became less hospitable to foreign oil companies, oil company management teams should and likely will be ready to pay a premium for so-called "secure" reserves. 

Over the past two years, booming oil and stock prices put such takeovers on hold. A further monkey wrench was thrown into the mix in late 2007 when the credit crisis throttled overall acquisition activity.

Today, though, with the prices of most energy stocks well below their 2008 highs and with huge 2008 earnings and cash flow plumping industry pocketbooks, consolidation in the oil patch seems inevitable. Picchi describes share valuations as being well below replacement value; in other words, it is cheaper today to buy oil through acquiring companies than through drilling.

Picchi says that a good rule of thumb is that buyers will pay one-third the long-term price of oil (which he says most old-timers like himself estimate at about $75 per barrel) for known reserves. If indeed oil companies were willing to pay $25 per barrel of oil equivalent, he says, the prices of most target companies' shares would nearly double from current levels.

For example, Picchi sums up the enterprise value (EV) of a company like Anadarko by adding its total equity (share price times outstanding shares) to its debt, and comes up with $28.4 billion. Then he looks at Anadarko's total SEC-defined reserves of oil and natural gas, which amounts to 2.43 billion barrels of oil equivalent (BOE). Combining the two, he comes up with enterprise value per barrel of equivalent oil of $11.68, or less than half what a buyer might be willing to spend.

Picchi says Anadarko and Apache (NYSE: APA) (EV per BOE of $12.72) look especially cheap using this approach. Occidental, with an EV per BOE of $17.50, looks more expensive. The difference stems from Oxy's large and profitable chemical operation, which probably inflates the overall valuation. 

Other names he regards as possible targets are Devon (NYSE: DVN), with an enterprise value per barrel of oil equivalent of $13.36 and Chesapeake (NYSE: CHK) (EV per BOE of $12.02). He notes that Chesapeake currently carries a heavy debt load, which might discourage would-be buyers but at the same time encourage the company to come to the table. Also, Chesapeake's production is heavily skewed toward natural gas, less attractive than oil to potential buyers.

Picchi has looked at the largest acquisitions in the oil patch over the past decade (including Exxon's purchase of Mobil and BP's acquisition of Amoco, both in the late 1990s) and points out that on average the purchasers paid an 18% premium over the prevailing stock price, and on average an enterprise value per BOE of $11.19. While the prices of oil stocks have moved higher over the past few weeks, the long-range outlook for oil prices, in Picchi's view, has moved up a notch as well, despite recent weakness.

To give him his due, Picchi predicted that oil prices would stabilize about where they are now, apparently, stabilizing. He was able to sort through this past summer's hysteria about rising oil prices and the more recent panic about falling prices, bracketing the upside and downside by analyzing long-term and intermediate-term supply and demand trends.

Limiting the downside, says Picchi, is the inability to supplant oil over the next decade as the primary transportation fuel. Also preventing all-out collapse is the modest amount of global excess production capacity, even given the downshift in demand due to high prices. He says that producers around the world have "financial staying power," and the West will require prices north of $40 to invest in any meaningful alternatives.

The upside in prices -- "no $200 oil" -- is limited by the natural economic response to higher energy costs. Conservation and slowing growth provide a damper to prices, while investments in alternatives loom over long-term price trends.

In other words, the marketplace for oil, which was temporarily rocked by hedge funds first gorging on and then spewing forth energy contracts, is finding its way back to normal. Henceforward, prices will bounce up or down depending on the economic outlook and an array of geopolitical events that will surprise us all.

However, oil companies will and must invest in the inevitable increase in consumption worldwide over the next 10 or 20 years and an equally reliable drawdown of known reserves. It is also hard to imagine that the oil industry will enjoy greater, rather than less, access to the resources of other nations.

Overall, then, Picchi's bet on a buying spree seems likely. Finally, some good news for investors ... and for Wall Street.