Permian consolidations set high standards

The prolific Permian basin has been central to the four major US oil and gas mergers this year — a catalyst role it will likely continue to play in the coming year.

While 2020's demand collapse has stopped producers from bragging about output growth and driven them to focus on free cash flow, large Permian positions are still seen as a long-term benefit. ConocoPhillips' deal to buy Concho Resources last month was motivated in part by the former's need for a significant foothold in the Permian that it has long been missing. The Pioneer Energy-Parsley Energy tie-up was about creating a Permian-centric company with enough financial heft and reserves for many years of profitable production, as was the September merger deal between Devon Energy and WPX. Even the early merger of the year, Chevron's acquisition of Noble Energy, had a strong Permian acreage position at its heart.

All four deals place those combined companies among the top eight producers in the Permian, each with nearly 250,000 b/d or more of output based on first quarter 2020 numbers (see chart). Rounding out that top eight are Occidental Petroleum and ExxonMobil — firms that are struggling with bigger issues than consolidating a Permian position right now — and EOG and Diamondback Energy.

EOG and Diamondback have expressed scepticism about mergers, but both are financially strong enough to take on a smaller competitor. Diamondback chief executive Travis Stice said in his second-quarter earnings call that debt issues encumber too many competitors to make deals work from a financial perspective, while the number of firms with top-tier acreage is limited. EOG has taken a similar stance, seeing better opportunities in its existing acreage. It is seen as the role model for the new US shale mantra of lower output growth and higher free cash flow generation that producers have been chanting since the spring.

A number of other producers linger with sizeable Permian footprints but mixed outlooks. Cimarex Energy appears to have made the shift to lower operating cost, higher free cash flow and more modest growth with prices around $40/bl, despite a $925mn loss in the second quarter. The company has 238,000 acres (965km²) in the Delaware basin of the Permian, in Texas and New Mexico, as well as 326,000 acres in the Woodford and Meramec formations in Oklahoma. With a market capitalisation of $2.4bn and enterprise value of $5bn, it falls below the $10bn threshold that many analysts say is needed to remain relevant to investors.

Ovintiv, led by former BP veteran Doug Suttles, is more diversified, with acreage in Canada's Montney fields, and the Anadarko and Permian basins. It has a similar market capitalisation of $2.6bn, but an enterprise value of $10.9bn thanks to much higher debt — a sizeable barrier to becoming an acquisition target. The firm also just reported a third-quarter loss of $1.5bn, largely on non-cash asset impairments. But it also appears to have successfully turned the corner into effective free cash flow generation, touting $1.7bn returned to shareholders in the last two years.

But mergers are still tricky in the current price environment and with mid-term crude demand recovery in doubt.

"We've been dancing on the head of a pin at $40 for the last 90 days or so," says Bryan Benoit, managing partner of Grant Thornton's energy advisory practice. That price is not strong enough to signal a significant boost in production or a consolidation wave, but not low enough to tip many companies into bankruptcy — notwithstanding the 17 exploration and production company bankruptcies in the third quarter.

Many banks have set $40/bl as their mark for this fall's redetermination process, Benoit said, so companies that looked to be in trouble in the second quarter are able to hang on a little longer.

So near and yet so far

Mergers among companies with overlappling assets in the Permian may seem like a sensible way to grow financial and production heft while lowering costs. But a study by consultancy Deloitte of US oil and gas mergers since 2014 found the end results rarely met expectations. Deals involving producers with contiguous acres did lead to some lower costs — about 15pc on average — but those savings did not fully offset the higher upfront spending to combine two operators.

The deals so far have been among firms that are some of the strongest financially and have the most productive assets. The remaining field has fewer strong players and many with significant debt burdens that are likely to complicate the theoretical logic of combining small firms with geographically overlapping assets.

By Tom Fowler

Permian basin oil output, 1Q20