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The oil and gas sector is booming with mergers and acquisitions. Exploration and production has led activity, with 26 deals in the second quarter. Seven of the top 10 deals by value were associated with shale plays, and that doesn't even include BHP Billiton's $12 billion acquisition of Petrohawk Energy announced in July. The deals are expected to continue, especially as Exxon has said it is looking for natural gas acquisitions. Read along, and I'll tell you the three stocks I believe are on acquirers' short list.
The short list
Acquirers have some key considerations in mind. First up: A play must be rich in liquids. Natural gas varies in its composition around the world, from about 80% to 95% methane with the rest composed of natural gas liquids propane, butane, and other hydrocarbons. NGLs are worth much more than natural gas, typically trading at roughly 60% of oil, and as such are much more profitable than natural gas, which is trading below many companies' cost of production. Liquids also refers to oil, which is still trading at a high $85 in the U.S. -- and could go much higher.
With prices for NGLs and oil high, the liquids-rich Eagle Ford shale in Texas is bringing the highest prices. However, Exxon's XTO Energy President Jack Williams believes you can still get good value in the U.S. That's because large amounts of reserves are unproven and not priced into exploration and production. Thus the second consideration is that an E&P company be undervalued relative to its potential production. So, what's on the short list?
EOG Resources (NYSE: EOG )
EOG Resources has significant holdings in the Eagle Ford with 535,000 acres, the Bakken with 600,000 acres, the Marcellus with 210,000 net acres, and many other large fields in the U.S. Consistently a top performer, from 1999 to 2009 the company averaged a return on equity of 25.6%. EOG's production had been 25% liquids and 75% natural gas. In 2009, the company began a transition from natural gas to oil, which hurt ROE, pushing it down to 1.6% in 2010 and 10% in 2011. Once its transition is complete in 2012, with a production profile of 75% oil and 25% natural gas, the firm expects to be able to hit an ROE of 17% in 2012 and beyond. With a liquids-rich production profile and assets across the U.S., EOG Resources should be on any large acquirer's short list. Another positive: EOG pays a small dividend of 0.7% that you can collect while you wait.
Add EOG Resources to your Watchlist.
Chesapeake Energy (NYSE: CHK )
As Fool Adam Crawford has speculated before, Chesapeake should be on the short list for a large acquirer. The company has been steadily increasing its exploration budget toward liquids from 10% in 2010 and 50% in 2011, to 75% in 2012. This increasing shift to liquids has been boosting revenue and will continue to do so going forward. Chesapeake has some of the largest assets in the business including the principal positions in the Anadarko Basin, the Utica Shale, the Marcellus, the Haynesville, and the Bossier shale. Chesapeake also has the second-largest positions in the Eagle Ford and Barnett shale.
Furthermore, Chesapeake is undervalued relative to its production potential. In February, BHP Billiton acquired Chesapeake's Fayetteville shale assets for $4.75 billion. Using the reserve value implied by the BHP Billiton purchase price, the value of Chesapeake's remaining proved reserves is near $40 billion. At today's prices, CEO Aubrey McClendon believes you are getting the unproved reserves for free.
Add Chesapeake Energy to your Watchlist.
Kodiak Oil & Gas (NYSE: KOG )
Kodiak is an E&P focusing on the Bakken in North Dakota and Montana. The company is sitting on 93,000 net acres and currently has 21 net wells producing oil. The firm has three drilling rigs operating, with one operated by a partner. By the end of the year, Kodiak expects to have seven total rigs operating, with five operated by itself and two by partners. The Bakken has an advantage over other formations in that it sits above the Three Forks-Sanish formation, which also produces oil. This means a company can use the same drill to reach two formations, with the potential to significantly increase oil production across the same acreage.
At market cap of $1.1 billion, Kodiak is much smaller than both EOG Resources and Chesapeake, making it a more digestible size for an acquirer.
Add Kodiak Oil & Gas to your Watchlist.
Foolish bottom line
While I believe these three could be the next oil and gas buyouts, intelligent investors demand more options for their hard-earned investing dollars. The Motley Fool has created a new, special oil report, and you can download it today at no cost to you. In this report, Fool analysts cover three outstanding oil companies, including the stock Fool analyst David Lee Smith calls the "energy king." To get instant access to the names of the three oil stocks, click here -- it's free.