Royal Dutch Shell (RDS.A) (RDS.B) would love to bulk up its position in the Permian Basin. Doing so would enable the oil giant to increase its scale so that it can better compete with rivals that boast leading land holdings in that fast-growing region.
However, Shell won't follow in Occidental Petroleum's (OXY -0.79%) footsteps and pay a huge premium to grow in the Permian. Instead, Shell plans to remain disciplined and wait for a compelling opportunity to arise.
Image source: Getty Images.
Sizzling hot M&A market
The Permian Basin has been a hotbed of M&A activity in recent years. In 2018, for example, Concho Resources and Diamondback Energy each paid more than $9 billion to buy a Permian rival and boost their scale in the region. Meanwhile, earlier this year Chevron (CVX -0.42%) initially offered a nearly 40% premium to acquire Anadarko Petroleum (APC) only to walk away from that deal after Occidental Petroleum bid $5 billion more for Anadarko.
The Chevron-Occidental bidding war for Anadarko has driven up the valuations of Permian Basin assets. Because of that, "most of the things we see tend to look overpriced," according to comments by Shell CFO Jessica Uhl, which is why "we have tried to maintain cool heads." Instead of overpaying to increase its position in the Permian, Shell plans to invest in its existing assets in that region and elsewhere to drive healthy organic growth over the next few years.
Shell isn't the only oil company that has cooled on M&A due to the enormous premium needed to make a deal. ConocoPhillips' (COP -0.06%) CEO Ryan Lance was one of many oil executives to recently address the topic of M&A. During the company's first-quarter conference call, he said that ConocoPhillips puts M&A into three buckets: small deals that increase its stake in existing assets, bolt-on assets and acreage deals, and corporate acquisitions. Lance then stated:
The bucket people seem focused on now is the third one, bigger corporate transactions that require premiums. Of course, we pay attention to what's out there. However, we've always said the bar is very high for these large transactions, and that's still the case. We're focused on returns, and we won't do transactions that are not in our shareholders' best interest.
The required premium for a corporate merger is a bit rich for most oil executives, especially given what Occidental agreed to pay to wrestle Anadarko away from Chevron. That's why Chevron opted to walk away from its deal. In commenting on that decision, CEO Michael Wirth stated: "Winning in any environment doesn't mean winning at any cost. Cost and capital discipline always matter, and we will not dilute our returns or erode value for our shareholders for the sake of doing a deal."
Image source: Getty Images.
Playing the waiting game
Instead of paying up to bulk up, Shell and many of its more conservative rivals plan to be patient. They intend on continuing to drill their existing acreage and making smaller deals around their current position when those make sense. In Shell's case, it plans to invest $3 billion to $4 billion per year to drill on its U.S. shale assets, including its position in the Permian. That investment level will enable Shell to roughly double its shale output by 2025 while generating increasing free cash flow that should reach $2 billion to $3 billion annually by 2025.
"But of course," stated Shell's Uhl, "if there are opportunities -- we are very pleased with the delivery capability we have established with that part of our business -- so we would have an appetite for expanding, but it would have to fit within the financial framework." Shell's patience could pay off, given how volatile oil prices have been over the past year. While valuations had soared due to M&A and rallying oil prices during the first few months of the year, both have come down over the past month. If oil continues to decline, it could further cool off valuations, potentially pushing them down to a more attractive level for Shell's tastes.
Patience could pay off
Occidental wanted to acquire Anadarko Petroleum so badly that it was willing to pay an absurd premium to outbid Chevron. That transaction, however, could weigh the company down for years, especially if oil prices remain volatile. That's a situation Shell would rather avoid, which is why it plans to stay patient and wait for valuations to come down to its target level. That decision could pay big dividends down the road, since the company will be able to pounce if a compelling opportunity arises during the next big slump in crude prices.
