Oil stocks have been terrible investments in recent years. Over the last three years, the average U.S. oil producer (as measured by the iShares US Oil & Gas E&P ETF) has produced a total return of negative 17%. That decline came even though the U.S. oil benchmark price has rebounded 5%.
Oil companies can't seem to do anything to get out of their funk of chronic underperformance. They've tried growing their oil production, selling assets to bolster their balance sheets, and returning cash to investors through dividends and buybacks. More recently, they've pursued consolidation in hopes that headline-grabbing deals would excite investors.
Of all those options, investors seem to dislike M&A the most. That's evident by the way they've been punishing producers that announce deals. However, despite investor disapproval, oil companies continue to pursue this strategy in hopes that they'll find a blueprint that investors will like.
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Merger mania without the excitement
The oil patch's current M&A wave started last year, with most of it centered around consolidation in the Permian Basin. Regional heavyweights Diamondback Energy and Concho Resources each spent more than $9 billion to acquire Permian-focused peers. Cimarex Energy (XEC), likewise, bulked up on its Permian position last year, buying a regional rival for $1.6 billion. In each case, the buyer gushed that it was making a perfectly aligned strategic transaction that would create value for shareholders. Cimarex, for example, said that its deal was "tailor-made" for the company, given the near-perfect strategic fit.
However, instead of enriching shareholders, these deals have destroyed value:
Despite that awful performance, oil companies have continued pairing up this year. The biggest deal came this spring when Occidental Petroleum (OXY 0.09%) outbid Chevron for control over Anadarko Petroleum. The acquisition was a real head-scratcher, given that Chevron had already offered a stunning 38.9% premium for Anadarko, valuing it at $33 billion. Occidental upped the ante by $5 billion while paying Chevron a $1 billion breakup fee. Investors, unsurprisingly, didn't like that hefty price. They've shown their disapproval by selling off shares of Occidental, which has plunged 40% from its peak this year even though oil prices have gained 14%.
Undaunted, the industry has continued to push ahead with more deals. In July, Callon Petroleum (CPE) agreed to buy fellow Texas-focused producer Carrizo Oil & Gas for $3.2 billion, including the assumption of debt. That value implied a hefty 25% premium to Carrizo's closing price the day before the announcement and 18% above its average in the previous 60 days. Callon's investors, unsurprisingly, didn't like this transfer of wealth, which is why its stock tumbled more than 15% on the news. Shares, however, bounced back last month after a major shareholder said they planned to vote against the proposed deal.
But this time it's different
Despite all the investor backlash to M&A, oil companies continue to pursue this strategy. Parsley Energy (PE) is the latest one to try to impress investors with a deal by agreeing to acquire Jagged Peak Energy (JAG). It's paying $2.27 billion for its Permian peer, including the assumption of $625 million in debt. While that deal price implied an 11.2% premium to Jagged Peak's value the day before the deal, it was only about 1.5% above its average trading price in the last 30 days. As such, Parsley Energy trumpeted its transaction as a low premium merger. Investors, however, weren't impressed, sending shares of Parsley down as much as 14% as a result of the announcement.
That sell-off came even though the deal would boost Parsley's cash flow per share, among other financial metrics. Further, it would enhance the company's position in the region and reduce costs. Investors, however, saw it as an expansion-related transaction as opposed to one that would boost their returns. That's because the company still paid a premium for Jagged Peak, even if it was a small one.
Oil stock investors want but one thing
Oil companies are trying a variety of strategies to win back investors who have been burned by the sector. M&A, however, has clearly not worked out as well as they'd hoped. Because of that, the energy sector needs to rethink its approach. It needs to give investors what they really want, which is for the industry to focus on returns and to create value instead of continuing to pursue strategies that destroy their capital.
