When oil prices drop, the oil industry tends to see a flurry of M&A activity. The sector saw it in the '90s with mergers such as those of Exxon and Mobil -- and in the past few years, M&A activity is bubbling up again.
In this week's episode of Industry Focus: Energy, Sean O'Reilly and Matt DiLallo look at some of the biggest M&A activity from the past few years, and a few companies that are pretty promising acquisition targets. Also, the hosts explain just what's so special about the Permian that every other company is buying land setting up camp in it.
A full transcript follows the video.
This podcast was recorded on Sept. 15, 2016.
Sean O'Reilly: This episode of Industry Focus is supported by Wunder Capital, an investing service that allows individuals to invest in solar projects across the United States. Earn up 11% annually while diversifying your portfolio, curbing pollution, and combating global climate change. Create an account for free at wundercapital.com/fool. Wunder Capital: Do well and do good.
Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, Sept. 15, 2016, so we're talking about energy, materials and industrials. I am joined today via Skype by Motley Fool contributor Matt DiLallo. Hi, Matt! How's your week going?
Matt DiLallo: Going really well. How's yours?
O'Reilly: It's still hot here in D.C., as you might imagine. You're down there in South Carolina, so you probably sympathize.
DiLallo: Oh, yeah, it's very, very hot here.
O'Reilly: I can't thank you enough for joining me on today's show. For our listeners that may not be familiar with your work, you're one of our more prolific energy and materials writers. The space has been ... I think active is probably the right word, these past few weeks, in terms of M&A announcements. You had Apache with that find. There's been lots of news coming out of the oil and gas sector. And I could not wait to get your thoughts on what's been going on. Before we get into recent events, can you give us some context as to where the oil industry is today, and what we've seen in the past in terms of M&A, when these conditions last existed?
DiLallo: Sure. One of the things I really like about the oil and gas industry is that, M&A, it's just fun for some reason to see big deals go out. Any time oil prices go down, there seems to be this huge wave of M&A. Back in the late 1990s, that's when all the big oil companies were created, and it was all due to this M&A boom after OPEC overshot with oil supplies, and BP bought Amoco, and Exxon bought Mobil, and Chevron bought Texaco, so you had all these big oil and gas mergers. It seems to me like we're getting ready for that to happen again. We just had [Royal Dutch] Shell buying BG, and midstream companies, pipeline companies, they're doing tons of mergers and acquisitions. And the Permian Basin --
O'Reilly: I still can't believe Spectra [Energy], by the way.
DiLallo: Yeah, I didn't see that one coming. And that's the thing, a lot of these, you're not going to see coming, but we can kind of tell, maybe, who's for sale and who's going to be buying. That's what's interesting. For example, both Canadian companies TransCanada and Enbridge, they just made deals. TransCanada bought Columbia Pipeline, and Enbridge bought Spectra. What's interesting about those is that they're both natural gas pipeline companies in the U.S., and those are oil pipeline companies in Canada. It kind of shows where they're looking, in the future.
And then, as far as U.S. companies, we just had Energy Transfer Partners (NYSE:ETP), they tried so hard to get Williams [Companies] (NYSE:WMB), and that deal blew up, but their CEO, Kelcy Warren, he's like, "We're gearing back up for deals," they have an M&A strategy. So we know there's something coming down the pipeline with Energy Transfer. He said they wouldn't go hostile again, and that was one of the problems, he went against what Williams wanted, and forced them into a deal, and that didn't work. So they'll probably do friendly deals going forward. It's definitely one to watch.
O'Reilly: I can't believe how long that dragged out. Really quick, taking a step back -- in your opinion, with what we've seen over the last 20-30 years, and it's funny you brought up the late '90s. My mom always talks about that summer, I think it was 1998, when gas was below $1 a gallon. She would always talk about that. Do you think all these mergers are the strong buying the weak when they're down? The whole sector is down, but the strong will survive, and they're just picking things up on the cheap? Or is it more trying to squeeze efficiencies out of operations, which often means buying another player where there's a complimentary nature to it?
DiLallo: I think it's both. Given that asset values are down, companies are out there looking for cheap valuations. For example, a pipeline that they would have had to pay 12 or 14 times earnings for a couple years ago, they can get for 11 or 12. That's what Southern Company did when they bought a pipeline -- they joint-ventured with Kinder Morgan (NYSE:KMI). There are these great deals out there because of valuations.
For example, Enterprise Products Partners, they just went after Williams, and their whole deal was, they wanted to get in on the cheap, but they saw a good way to link their pipelines together. And that's one of the things with pipeline companies, this network effect. For example, Williams has this great presence in the Marcellus Shale, and Enterprise has a pipeline that takes NGLs, ethane and propane, down to the Gulf Coast. If you can link those two, you can save money.
O'Reilly: And it's a better value proposition for your customers; all kinds of good things happen.
DiLallo: Yeah. So there's going to be a lot of those, where company is going to look for a spot in their value chain that they're missing, and who has that, and can I get a great deal on it? So, I think that's going to be one of the big drivers going forward. And then, there are companies out there that are known dealmakers. Kinder Morgan, half of the growth they've been able to accomplish since they went public has been M&A. And they haven't done a deal since they bought themselves, they bought all their pipeline companies --
O'Reilly: [laughs] Since they bought themselves!
DiLallo: Yeah, 2014 or something like that. So they have to be out there looking. They've sold some assets lately, but a transformative deal could accomplish a lot for Kinder Morgan, and possibly restart dividend growth. So I definitely think they're out there looking.
O'Reilly: Gotcha. You're talking a lot about Williams and Enterprise. What about poor Kinder Morgan?
DiLallo: Their problem right now is they had too much debt. They want to get their leverage metric below 5 times EBITDA. Right now it's at 5.3. It's on the higher end of even what most pipeline companies have. There are two ways of going about that. They can sell assets to get that number down, or they can buy a company that doesn't have as high debt, so a stock-for-stock deal, and that could push their leverage metric down. I think that could be something they're looking at.
O'Reilly: They already did do that sale, what was it, a month ago? Was that with Williams? Oh, no, it was Southern Company. So, they're doing a little bit of that.
DiLallo: And that was big for them.
O'Reilly: What did they get? $2-3 billion?
DiLallo: I believe it was like $1.5 billion in cash, and then they handed over half of the debt. So it knocked their leverage metric down below ...
O'Reilly: So that's obviously good.
DiLallo: Yeah, it was a good deal.
O'Reilly: OK. Before we move on to talking about some attractive takeover targets, I wanted to take a moment to talk briefly about our sponsor. We're probably not going to be using oil forever. What if you could help combat global climate change, and make money at the same time?
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So, Matt, obviously there are a bunch of players in the oil and gas space, particularly pipelines, that have been pretty acquisitive lately. But, we are, of course, investors here at the Fool. So, more important, what do you see you around the bend in terms of potential takeover candidates?
DiLallo: First of all, it's hard to predict these. Like Spectra energy, that came out of nowhere. So, in one sense, your better bet is to buy a strong company and hold on to that. But there are some really good, strong companies that I think would make good takeover targets. They're just strong companies in general.
O'Reilly: Either way, you'll win. That's the bottom line.
DiLallo: Yeah. Absolutely. Williams is one of those. It's beaten down because it had so many problems with the Energy Transfer merger. Now, we know that Enterprise Products Partners was interested in them. They just walked away. However, Williams said they were surprised by that announcement, and that their board would always consider a strategic alternative like a merger, if that was a good way to create value. So, I don't personally think that Williams is going to be a standalone company forever. I really think it would fit well with a Kinder Morgan, possibly.
O'Reilly: They're no longer the biggest. That was the big outcome of the Spectra deal, right?
DiLallo: Yeah. Spectra was apparently considering Williams a couple months ago. And Kinder Morgan is always interested. Another one I like, and it's not very well known, is Targa Resources. They did a Kinder Morgan thing where they had an MLP and they brought it in-house. They've done a lot over the past couple of months to lower their leverage. We mentioned earlier that Kinder Morgan's leverage is 5.3 times debt to EBITDA. Targa's is 3.6. A lot lower. So, if a Kinder Morgan bought them, and they paid all stock, it would lower their leverage metrics. And it also has great positions in the Bakken and the Permian Basin. So it would feel some gaps for a company like Kinder Morgan, or a company like Enterprise Products Partners, which lacks in those two areas. Targa was almost bought out by Energy Transfer in 2014. The deal just fell through. That's when Energy Transfer switched to Williams --
O'Reilly: Why do you think all these deals are falling through?
DiLallo: A lot of it had to do with oil prices. Companies were freaking out about how low it was going to go. In Energy Transfer's case, they did a poor job negotiating. They wanted to do an all-equity deal, but Williams wanted some cash. In order to pay that cash, Energy Transfer needed to take on $6 billion in debt, and the market didn't like that, because debt in a falling market is a bad --
O'Reilly: Right, and that's why KMI had to cut their dividend last year. They had that credit rating scare and everything.
DiLallo: Yeah. That's really what did in the Energy Transfer-Williams deal; it was debt. Companies that don't have a lot of debt, they're going to be highly valued.
O'Reilly: Gotcha. I'm looking at Targa here. They've been free cash flow-positive, and they've stayed that way this whole time. Yields are pretty darn attractive, are you pretty sure that's safe as well?
DiLallo: It looks like it. Like I said, they have low levels of debt, they don't have a whole lot of capital projects going forward, and they're primarily fee-based. Last I checked, it was 78% fee-based.
O'Reilly: So not the highest, but that's pretty good.
O'Reilly: Very good. Talk to me about the Permian, because ... how do I put this ... this whole time, we've been talking about how if they're merging, it's mostly stock. That's what the deal was with Spectra. Deals are falling through because of debt worries and all this stuff. And it seems like every day -- it's not, but it definitely seems like it -- I come into the office and I check my oil and gas news, and somebody did something in the Permian. And that's kind of been the story for a year now.
For our listeners who don't know -- the Permian Basin is basically the huge geological formation in West Texas that extends into Oklahoma. Every day. EOG just had that $3 billion deal, or maybe $2.5 billion, they bought that private company there in the Delaware Basin, which is actually just a subsection of the Permian. Mr. DiLallo, why is everybody cutting everywhere but the Permian?
DiLallo: Because it's economic at current prices. There's so much oil. Just for some history, the Permian Basin has been producing since 1929. It's this old legacy oil basin. However, they had been going down vertically to drill wells. So they would get a couple hundred barrels a day from these wells, and it was fine and good. However, once they switched over the horizontal drilling, it was like this a-ha moment, where they could pull out more oil in six months than they were getting out in decades.
O'Reilly: And it's even better than the Eagle Ford down there in South Texas?
DiLallo: Yeah. It's not as oily as the Eagle Ford or the Bakken, but it's the combination of how much they can pull out and the cost. In the Bakken, it might cost $10 million to drill a well, but they're going to get a million barrels of oil over the lifetime of the well, so the economics work out, at a certain oil price. Now, in the Permian, they can get, like, 2 million barrels of oil equivalent, it's oil, gas, and NGLs, for $6-7 million. So, the economics are just so much better when you have that combination. So, that's drawing all these companies in, and they're buying up as much land as possible, because the economics or so good at current prices that they can drill.
You have companies like Pioneer Natural Resources (NYSE:PXD), they're still growing production. Now, we have an oversupply of oil in the country, and yet they're growing production. At first it was 10%, then it was 12%, now it's 13% this year. Part of that is efficiency gains, and part of it is that it's just so good, they're able to get more oil than they initially thought, and that's what's drawing all these companies in. And like you mentioned, they're just buying things up, and they're paying a ton of money.
O'Reilly: Yeah, I can't believe some of these numbers. Do you want to share a few of them?
DiLallo: Pioneer Natural Resources, they just bought land from Devon [Energy]. It was 28,000 acres for $435 million. It's about $15,000 an acre. And that's pretty good, compared to what some of its peers are paying. This PDC Energy, just last month, they bought 57,000 acres for $1.5 billion, which is about $26,000 an acre. That's $10,000 more an acre. And then Concho Resources (NYSE:CXO), they paid $1.265 billion for 40,000 acres. That's $40,000 an acre. The prices just keep going up. SM Energy, they just paid roughly $40,000 an acre for a deal. So you have these companies that are paying big dollars, because even with that initial investment, they're still going to make a ton of money. And then you have EOG, they only paid like $7,000-8,000 an acre for great land, because they were able to negotiate an amazing deal. It just shows that companies are willing to pay a ton of money for Permian land.
O'Reilly: Gotcha. The next question, obviously, then becomes, are there companies that you like that are in the Permian right now in a meaningful way?
DiLallo: Yeah. Who doesn't like companies in the Permian these days? Pioneer Natural Resources, they're one of the leaders in the Permian. But I did some math on them. It's a $32 billion company, and they have about 800,000 acres in the Permian.
O'Reilly: That's the enterprise value, right? That's stock market value plus debt. So the whole kit and kaboodle?
DiLallo: Yeah. If you do the math on that, their acreage in the Permian is worth about $40,000, which is pretty high compared to some of the other metrics. And then I did some math and some of the other ones. One that stood out to me was Concho resources. They're worth about $20.5 billion, and they have almost 700,000 acres. If you do the math, that's just less than $30,000 an acre. If you're looking for a value compared to Pioneer Natural Resources, Concho stands out. And then, another one I saw that really stood out was Energen. They're about a $6 billion company, and they have 225,000 acres. If you do the math on that, it's about $26,000 an acre. So if I was a company that was looking for an acquisition, I would look at these and say, "I can get Energen for $26,000 an acre, that's much better than if I bought a private deal." Or, "Man, I can scoop up Concho and just get this whole ton of land out there."
O'Reilly: Before we head out here, for the disparity, is Pioneer just more efficient than Concho or Energen, therefore the enterprise should be worth more, even though the land itself is the same? Or is it that they have better acreage in the Permian?
DiLallo: There's a little bit of that. Now, Pioneer does have some land in the Eagle Ford and some other places, so that would change the value. They also have higher production. So there's a lot of factors. So this is just a back-of-the-envelope number. But Pioneer is also well known by investors, they're the leader with the the Midland Basin, which is the eastern portion, so they're at a premium price these days. And then there's some others. Diamondback Energy is very popular these days. Their valuation, from my math, is almost $80,000 an acre. That's because they're growing so fast, and investors really want that growth. But if you look in the middle, sometimes you can find some interesting targets that are doing the same thing. Pioneer is growing their production by about 15%. Concho, they believe they can grow their production by 20%. So you're still getting that really good growth, you're getting pretty good economics. For investors, maybe they're never a takeover target, but they still look like a good long-term investment.
O'Reilly: Awesome. Well, Matt, thank you for your thoughts. I can't thank you enough for joining me on the show today.
DiLallo: No problem.
O'Reilly: Have a good one.
DiLallo: You, too.
O'Reilly: That's it for us, folks. We would like to give a special shout-out to our producer, Austin Morgan, who's behind the glass as we speak working his video and audio magic. If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at firstname.lastname@example.org. Once again, that's email@example.com. As always, people on this program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Matt DiLallo, I am Sean O'Reilly. Thanks for listening, and Fool on!