Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.
Instead of buying drillable land, Permian Basin producers could soon have the urge to merge.
*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.
Alert: Top Cash Back Card Now Offers 0% Intro APR Until Nearly 2027
Enjoy 0% intro APR on purchases and balance transfers for 15 months—plus up to 5% cash back in popular categories.
A couple of years ago, the Permian Basin in Texas was a hotbed of activity. Oil companies were snapping up drillable land as quickly as they could, spending billions to acquire acreage, mainly from privately held companies. However, the land grab started cooling off last year as investor sentiment shifted from rewarding companies that grew their size to those that increased shareholder value.
While that change slowed down M&A activity in the region, it could shift back into high gear after Concho Resources (CXO +0.00%) struck a deal to acquire Permian peer RSP Permian (NYSE: RSPP) in a pricey transaction that will create the largest shale producer in the region. That deal, which the company saw as a "road map" to consolidation, could spark a wave of M&A in the basin this year.
Image source: Getty Images.
Conoco Resources was one of the early leaders in the Permian land grab a few years ago, announcing a series of transactions in early 2016 to enhance its position in the region, including trading for some adjacent acreage as well as buying and selling some other properties. The company's wheeling and dealing continued throughout the year, making two more notable deals, spending $1.625 billion for 40,000 acres in the Midland Basin and then $430 million for land on the Delaware side of the Basin. The driller made another deal last year, spending $600 million for acreage in the Midland.
However, its $9.5 billion deal for RSP Permian takes things to another level by creating the largest producer in the region. The combined company will also have the biggest drilling program in the area, with plans to run 27 rigs across the nearly 640,000 acres they'll control.
However, in addition to increasing its scale, Concho sees its transaction having an even greater strategic importance, as it should serve as "a road map for in-basin consolidation," according to CEO Tim Leach. The company paid a hefty price to set this trend, not only in the 29% premium for RSP's stock but also in the implied value of more than $75,000 an acre for the land acquired, which is well above recent deals. However, Concho believes it can justify this high cost by using its larger scale to reduce costs and become even more efficient at drilling wells, especially larger ones that require vast tracks of adjacent land.
Analysts agree that the deal, while costly, "has the potential to spark an arms race in the region," according to industry consultant Wood Mackenzie. Diamondback Energy (FANG +0.01%) has already hinted to analysts that it's interested in merging with a Permian peer rather than just buying more undeveloped acreage. That's because it would allow Diamondback Energy to use its premium-priced stock to acquire a rival in a deal that would likely provide a significant boost to its per-share metrics even as it bolsters its scale in the region.
EOG Resources (EOG +0.01%) has also hinted that it's open to M&A. While EOG typically avoids mergers, it did make what was one of the best deals in 2016 when it bought Yates for a fraction of what others paid for similar companies that year. However, with the company on pace to generate $1.5 billion in excess cash this year, it "does position us to take advantage of opportunities for maybe an acquisition," according to EOG CEO Bill Thomas, who also noted that "we continue to look at those."
One potential target to keep an eye on is Energen (EGN +0.00%). The driller's resource size rivals that of Diamondback Energy, yet it sells for half its valuation. That discount has driven one of Energen's largest investors to push the company to take action and address "what we believe is a material discount to its underlying value," by potentially putting the company up for sale. In fact, in a recent agreement with those investors, Energen agreed to "conduct an in-depth review, assisted by financial advisors, of the company's business plan, competitive positioning, and potential strategic alternatives." Given the premium Concho paid for RSP Permian, a sale looks like it could be a compelling alternative.
Concho Resources believes that its purchase of RSP Permian will not only turn two great Permian companies into one even stronger entity but spark a consolidation wave across the region. Those mergers would enable drillers to cut costs and drill better wells, which should boost returns and profitability. While it's anyone's guess what company might be the next acquisition target, Energen certainly seems like a high probability option.