This week was an interesting one for investors in Concho Resources (NYSE:CXO). The Permian Basin producer stunned the oil market by announcing that it had agreed to acquire fellow Permian driller RSP Permian (NYSE:RSPP) in a $9.5 billion deal. While that news sent its target up about 15%, Concho's stock went in the opposite direction, sinking more than 9% on the announcement. That sell-off, according to analysts, looks like a big mistake.
Price is what you pay
Investors shuddered at what Concho had to pay to seal the deal with RSP Permian. The transaction, which came at a 29% premium to RSP Permian's prior trading price, was even richer when considering how much it valued RSP's land in the oil-rich Permian. According to an analyst at Jefferies, Concho is effectively paying $76,000 per acre for RSP's holdings in the region, well above the value of other recent deals. Last August, for example, Concho spent $600 million for 12,400 acres of land, implying a $48,400 per-acre value. Before that, the company paid $1.625 billion for 40,000 acres, or roughly $40,500 apiece.
Meanwhile, this acquisition was also well above other notable third-party transactions. One of the most recent came last December when Oasis Petroleum (NYSE:OAS) paid roughly $46,600 an acre for land in the basin in a widely panned deal due to the price. The transaction is also well ahead of the $58,500 an acre RSP Permian paid to acquire privately held Silver Hills in 2016 as well as the roughly $45,000 an acre Noble Energy (NYSE:NBL) paid when it bought Clayton Williams Energy for $3.2 billion early last year.
Value is what you get
That high price, however, could be worth it in the long run because there are "a lot of synergies that make sense," according to an analyst at RBC Capital, who thought the 29% premium was "reasonable." In the immediate term, Concho expects to capture at least $60 million in annual corporate savings from the combination. However, future corporate and operational synergies could exceed $2 billion as the company uses its greater scale to optimize well designs to drill longer ones, which boost returns.
In addition, the companies can share infrastructure, which should reduce costs. That ability to capture greater value from the combined company's assets is why an analyst from Williams Capital also thought the deal made sense. Another noteworthy aspect of this combination is that Concho can leverage its larger scale to potentially get better pricing on equipment and services in the region, which have inflated in recent months due to rising demand.
That added scale has been a game-changer for Noble Energy in the Permian. The company was able to reduce its drilling and completion costs by a double-digit rate on a per-foot basis, which when combined with other factors, has yielded a 20% improvement in the underlying value of its acreage in the region. Contrast that with Oasis Petroleum's Permian land grab last year, which lacked any potential synergies. The company, which until that point had focused solely on North Dakota's Bakken Shale, wants to cash in on the higher returns drillers are earning in the Permian. However, it will take the company time to build out its operations in the region, including the necessary infrastructure to develop the field. That's why analysts gave its high-priced purchase the thumbs down.
The Concho-RSP Permian deal could have farther-reaching benefits beyond just those realized by the combined company. "Even if Concho ends up having overpaid with its stock, if a less-fragmented Permian yields a more efficient one, then it would take shale's competitive challenge to the likes of OPEC to another level," according to a writer with Bloomberg. That's because the deal could spark additional M&A in the region, leading adjacent producers to link up to improve development efficiency so they can lower costs and boost returns.
Taking the long view could earn a rich reward
There's no denying that Concho Resources paid a hefty premium to gain control of RSP Permian, which is why its stock tumbled this week. However, the deal has the potential to pay big dividends down the road as Concho works to maximize the value of the combined company's assets. If it's successful, and oil prices hold up, this week's sell-off could end up being an excellent starting point for investors with an ultra-long-term mindset.