Will This Massive Oil Merger Pay Off?

There's nothing like a merger to really stir up controversy. Message boards are aflame with vitriol aimed at Energy XXI (NASDAQ: EXXI  ) and EPL Oil & Gas (NYSE: EPL  ) as the two agreed to tie the knot. Energy XXI is really the acquirer here, paying EPL shareholders $2.3 billion in total compensation after assumption of EPL's debt. Both sets of shareholders have their knickers in a knot over the same issue—the price.

Not surprisingly, EPL shareholders feel cheated and Energy XXI shareholders feel duped. While Energy XXI's offer of $39 per share is a sharp premium to EPL's recent trading range, it's significantly below EPL's recent historical high.

You sold me out!
Prices exceeded $42 last fall as excitement grew over EPL's latest acquisition from Hilcorp Energy. The half billion dollar prize brought an expected abundance of low-hanging fruit. Both Energy XXI and EPL have similar 'acquire-and-exploit' business models. They buy legacy production assets, wringing as much production from them as possible.

It's not a sexy business model. Especially not in the Gulf of Mexico, with North American shale dominating the landscape. Late last year, when a tropical storm and third-party pipeline shut-in caused EPL to miss its production forecast, shorts descended on shares like flies on—well, you get the picture.

The ensuing tailspin undid a year's worth of gains, setting shareholders back to square one. But the promise that the Hilcorp acquisition provided isn't gone. The potential for strong production growth is still there, and it's that very growth potential that has some shareholders underwhelmed by the price. After all the suffering, why sell out now when that potential is about to be realized?

You sold me down the river!
Some Energy XXI shareholders are hopping mad as well. It's been an unkind year. Desperately seeking to enhance shareholder interest, management extended beyond the company's core competence on a series of ill-advised high risk exploration projects that busted.

Their failure contrasts sharply with Energy XXI's developmental success. Through a series of large acquisitions, the company built an oil-rich portfolio that grew rapidly, flirting with a 50 MBOEd (thousand barrel of oil equivalent per day) production level.

Shareholders' restlessness and that unattainable 50 MBOEd glass ceiling led management down this exploratory rabbit hole, and those failures have punished everyone significantly. The response, however, was sensible. Energy XXI hunkered down, dialed back capex, and returned capital to shareholders.

The company canceled gas projects, reduced capex and cut back rigs, focusing on only its highest return oil projects. A small dividend was instated and a larger repurchase program put into place. Those repurchases were made at higher prices than current levels.

The price is right?
Energy XXI shareholders are used to pretty rigorous discipline in its acquisitions. CEO John Schiller scrounges up assets at bargain basement prices, and he's proud of that fact. Most deals fall below the $20 range on a proved barrel basis. Energy XXI never pays up—until now.

This deal is rich. EPL carries 77 MMBOE (million barrels of oil equivalent) of proved reserves on its books, pricing the $2.3 billion deal at just shy of $30 per BOE. That begs an obvious question. If Energy XXI thinks its shares are undervalued even at higher than current levels, how can management be comfortable with a stock-based dilutive deal?

Management's answer to analysts on its conference call centered around the compatibility of the companies' physical assets and personnel.

Three-quarters of a billion in synergy?
That's the mark-up over the typical deal: $750 million. Can the two fit together well enough to justify it? I think so. Both management teams made similar cases on independent calls. There will be the typical synergies.

The combined company becomes the third largest Gulf of Mexico shelf producer. With scale comes greater bargaining strength with suppliers and customers, providing opportunities to lower lease operating expenses and improve pricing differentials.

Importantly, the two company's assets are also virtually mirror images. During these times of challenged gas prices, being oily is an advantage. Together they'll own more of the largest legacy oil fields in the Gulf of Mexico than any other producer. Production is skewed heavily to oil. Ditto for reserves.

Operationally, however, the two companies have distinct and complementary skillsets. Energy XXI feels better equipped to maximize production from EPL's assets. Production is their expertise and Energy XXI's engineering staff far outnumbers EPL.

On the flip side, EPL's geoscience staff is superior. That's critical as these fields evolve. The next step on the Gulf of Mexico shelf is deeper. It's likely that considerable oil lurks subsalt on the shelf just as it does in deepwater. Both companies are acquiring new seismic data and EPL is much better equipped to analyze that data.

The two staffs dovetail well. Each brings a different strength to the table and both management teams seem optimistic about the potential for synergy. Realizing that potential will be important. Energy XXI paid a steep premium for that human capital, and management clearly hopes the deal will be transformational. Less certain shareholders are voting with their feet, and Energy XXI shares slumped badly on the news. Only time will tell whether or not the gamble pays off.

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