It seems we're in the midst of a merger and acquisition party in the oil and gas industry. The rationale seems obvious -- if you're an energy company that wants to take advantage of today's high energy prices, you need fossil fuels to sell. Unfortunately, major energy companies are finding it increasingly difficult to increase production from their own fields.
Buyouts are nothing new in the energy sector, but today's motivations are a little different. In the past, relatively low energy prices led companies to pursue mergers to cut costs and boost efficiency. Nowadays, it's all about buying growth -- acquiring assets that are either productive today or that can be brought online or expanded relatively quickly.
With companies like PetroKazakhstan, Vintage Petroleum, and now Burlington Resources all agreeing to buyouts, it's time to take a quick look at who else might be catching the eye of large energy companies now flush with cash. Of course, it's also important to understand that we at The Motley Fool don't advocate buying stocks just because the company might get bought out. I tried to find companies that would be appealing to industry players, but would also have their own long-term investing merits.
I tend to look for several qualities in an appealing energy stock:
- First, efficiencies in finding and developing energy assets. The less you have to pay to find your energy, the more profitable you can be.
- Second, long-lived assets supported by a nice reserve replacement ratio -- the ratio between additional proven reserves and energy production. This can help to ensure years of good production.
- Third, good return on capital -- a strong ratio of the cash flow generated from each barrel versus the costs to find and produce it.
- Wrap it all up in a nice valuation, based upon cash flow and enterprise value-per-unit of proven reserves, and you're good to go.
Got all that? Good. Let's move on to the candidates.
Apache Corp
If you want to argue that Apache is one of the best independent energy companies out there, I won't disagree. Management here is top-notch, and that shows in the company's exceptional efficiencies in finding and lifting energy out of the ground. The company is also quite good at applying technology and know-how to garner very good returns from fields in apparent decline. Despite all that, the market doesn't assign an especially high premium to the company, valuing it at about $13 per barrel of proven reserves.
Chesapeake
Energy
It might be a little ironic to include Chesapeake on a list of possible takeover candidates, since the company has been pretty active as an acquirer in its own right. It now holds the third-largest natural gas reserves in the United States, yet it has a market capitalization of just over $11 billion, making it a viable target.
While the company engages in a lot of hedging, it has an attractive spread between the cash flow it generates from its energy and the costs of finding and replacing that energy. Although the company carries a fair bit of debt, it also has an enviable record of increasing reserves through exploration, not acquisition. Valuation on these shares has caught up a bit lately, but at under $17 per barrel, it still trades below the recent ConocoPhillips-Burlington Resources valuation.
Occidental Petroleum
Few large energy companies do better with investors' capital than Occidental. A return on invested capital of about 29% doesn't come by accident -- this company is exceptionally efficient at finding new reserves at attractive prices, and spends just over $7 per barrel of oil equivalent to do so. New projects in places like Libya would also offer an acquirer some attractively priced new production in the next few years.
Occidental recently announced an agreement to acquire Vintage Petroleum at an appealing price -- less than $9 per barrel of proven reserves. Not only will that boost overall production, but there should be operational synergies in Latin America and California. Occidental's current production profile isn't quite as attractive as others on this list, but the shares are being valued at less than $14 per barrel of reserves, excluding the Vintage purchase.
Ultra Petroleum
The smallest company on the list, Ultra Petroleum has seen torrid growth in earnings, cash flow, and production. The company produces natural gas very efficiently and keeps finding costs low. Add in very long reserve life and the potential to increase proven reserves several times over in the next decade or so, and you have a smallish but very appealing energy company. The downside? The stock already carries a generous valuation of nearly $36 per barrel of proven reserves.
XTO Energy
Like Apache, XTO is quite good at cost-effectively extracting energy from fields that other players no longer want. In my view, it's a triple threat -- it's quite efficient with energy production, it replaces its production at a good clip, and it generates an appealing amount of cash flow per barrel relative to its finding costs.
Finding costs of about $7.50 per barrel might be attractive to a major industry player, but given how the company has built itself by buying undesired assets from the likes of ExxonMobil
In conclusion
I honestly have no idea if any of these companies will attract the attention of suitors. It's possible that some of the aspects I find appealing in these companies -- great management and internal operating efficiencies -- might be wasted on multinational acquirers. After all, if you're simply on the prowl for productive resources and reserves, you might want to look for poorly run companies. There, you could probably pay less of a premium, boot management out the door, and simply add the reserves to your production base.
But I can't really recommend that sort of company in good conscience. As I said in the beginning, I tried to single out potential acquisitions that still excelled on their own merits.
Of course, Fools must do their own due diligence and remember that energy prices could easily slide back down at least a little. That's not terrible news for well-run companies such as these, but it highlights the importance of picking good companies. When the going gets tougher -- and believe me, it will -- you don't want to be holding hands with the weak sisters of the industry.
For more on the energy sector:
Valuations were based on the most recent information supplied by company sources.
Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares).
