A Puzzling Oil-Patch Pairing

Not so long ago, Bronco Drilling (Nasdaq: BRNC) accepted what major shareholder Third Avenue Management has since called a "woefully inadequate bid" from services company Allis-Chalmers Energy (NYSE: ALY). Buck this deal, said I.

Well, we're seeing a similar situation today, with the announced merger of Grey Wolf (AMEX: GW) and Basic Energy Services (NYSE: BAS). That's right -- another pairing of a land driller and an oilfield-services company. If this is a "merger of equals," why did Grey Wolf's share price tank yesterday?

As we've seen with the breakup of Rowan (NYSE: RDC), investors tend to like their energy businesses simple. Grey Wolf provides investors with nearly pure exposure to the onshore North American natural gas drilling market. That purity would be lost in exchange for more oil exposure, broader service offerings, and other supposed synergies.

Another cost of these synergies is higher indebtedness. Grey Wolf runs a pretty lean operation and has little to no net debt (debt minus cash on hand). But Basic Energy carries quite a bit of debt. What's more, as part of the merger proposal, the companies will be giving $600 million in cash to shareholders of both companies, and that payout will have to be financed with additional borrowings. Transocean (NYSE: RIG) and GlobalSantaFe did something similar, but they had enormous multiyear backlogs to monetize. The land market offers less to lean on.

Now, part of the appeal of these mergers is that size provides the capability to expand internationally. It's hard to blame these smaller outfits for wanting to take on Nabors Industries (NYSE: NBR), which has gone east to seek its fortune. International land-drilling markets are looking attractive, and investors are finally waking up to the Nabors story.

Scaling up internationally while paying down a significant debt load is going to be a challenge for the "new" Grey Wolf. There's never been much visibility in the contract-drilling market, so the combined companies will need a fair bit of luck to pull off the transformation. If shareholders approve the deal, that is.

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