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Oil is dead. The oil-baron cowboys of Texas holding the title of “world elite” and running the world’s most powerful, profitable companies are no more relevant today than VCRs and fax machines. They’re simply a thing of the past. Or are they? There is one man, in Texas of all places, that sees things differently.

Ryan Lance, CEO of ConocoPhillips, shocked the commodities world when he announced late October that ConocoPhillips would acquire competitor Concho – a leading oil firm in Texas’s Permian Basin – for $9.7 billion. The deal will make ConocoPhillips, with relatively little prior assets or oil production in the Permian, into a leading producer that is set to establish itself as the dominant company in the area. The deal is to complete in early 2021.

This comes as quite the surprise after the world witnessed the oil and gas industry be beaten to a pulp and become replaced in the eyes of investors by green-energy stocks such as Canadian Solar and Jinko Solar, who have seen their market cap’s respectively double and triple this past year. To make matters worse, Joe Biden, who has vowed to end drilling in the U.S. and invest $2 trillion into renewable energy, has become the president-elect of the United States. Therefore, such an expensive acquisition at such a catastrophic time for the oil industry may seem like madness at first – but dig a little deeper and it becomes clear that this is indeed a brilliant wager. 

This strategic move signals a comeback for the U.S. oil industry, but one that makes the industry itself akin to the resource it’s based on – finite. In this new era for oil, the companies at the top will be players of a different game and ConocoPhillips, with their new acquisition, is setting their course for that position.

Industry Overview

The United States, reports say, had become the number one oil producing country in the world by 2018. This was a feat unimaginable six years before, but through a mixture of technological advances in drilling and fracking, as well as an expanding customer base that now includes South America, Europe and China, they managed to outproduce both Saudi Arabia and Russia.

That is, until 2020. COVID-19 left a mark on everyone with the oil industry being no exception. Demand for oil fell immediately when China, the world’s largest oil consumer, of approximately 10 billion barrels a day, locked down and ground their consumption to a halt. The rest of the world soon followed suit and everywhere people stopped driving, factories stopped producing, flights were grounded and the price of oil nosedived. Then came the price war between Russia and Saudi Arabia and the price of oil was beat down to its lowest level in history.

(Credit: U.S. Department of Energy)

ConocoPhillips’ stock price (COP) fell from a January high of $67.13 to a March low of $20.84 and Concho (CXO) plunged from $93.34 to $33.13 – approximately 69% and 65% falls, respectively. This meant multi-year lows for oil company valuations, leaving their market capitalizations at a fraction of what they were at only months before. To make matters worse, many U.S. shale companies have since struggled to raise new capital for debt restructuring. Therefore, companies that managed to come out cash-strong, those that don’t need external funding to manage existing debts, have been presented a rare opportunity for expansion through acquisitions.

It was not until late summer that oil prices stabilized around the $40 mark and the U.S. shale patch acquisitions began. Chevron was first to acquire Noble Energy, followed by Devon Energy announcing their purchase of WPX in September.

When deciding on acquisition, however, it is important to consider that American oilfields are not all equal. The Permian Basin, lying in both western Texas and southeastern New Mexico, has become an oilfield superstar the last few years. Advances in hydraulic fracturing have sent its production rate skyrocketing, making it the second highest producing oilfield in the world, second only to the Ghawar field of Saudi Arabia. Further, for an area that has been producing for over a hundred years, there is an estimated 30 billion barrels of crude oil and 75 trillion cubic feet of natural gas left to be extracted in the Texas region alone. In fact, even when oil crashed in 2015 and the rest of the American oilfields reduced their production, the Permian Basin continued to increase theirs. It’s believed that with the combination of its production rate and its enormous amount of resource left, the Permian Basin could soon become the most important oilfield in the world.

(Credit: U.S. Energy Information Administration)

So, it’s a pretty big deal – and one that producers are not blind to. Devon Energy’s acquisition of WPX was made specifically to strengthen their position into the Permian Basin, and, in 2019, Occidental Petroleum purchased Anadarko Petroleum to become the largest player in the oilfield itself.

ConocoPhillips

ConocoPhillips, with a December 1st market cap of near $42 billion, is the third largest oil producing company in the United States. While based in Houston, Texas and the majority of their profits coming from the United States, their operations span the globe and include sites on six continents.

In spite of this, Conoco, until now, has been a relatively small player in the Permian Basin, producing under 100,000 barrels per day in this region.

 Despite losing $30 billion in market value, and perhaps proving their repute as a high-performing producer true, they emerged from the worst of the price slump with nearly $7 billion in cash and cash equivalents. This put them at an advantage to their competitors in a strategically critical time – and they wasted little of it before moving on the Permian Basin and Concho.

Concho Resources

Concho Resources saw an equally devastating loss of value, as they dropped from $30 billion to a low of $8 billion in 2020. While much smaller than ConocoPhillips in size, they are a Permian Basin specialist, the fifth-largest producer by volume with “quality assets, sufficient scale and an inventory of rich areas to be drilled in the Permian” according to Ian Nieboer, head of oil research at Enverus. In fact, in the second quarter of 2020, Concho pumped over six times more barrels in the Permian Basin than ConocoPhillips.

Deal Structure and Financial Advisors

The deal, priced at $9.7 billion, or $13.3 billion when including debt, represents the largest merger and acquisition deal in the U.S. shale patch following the crash of the oil price this year. The deal will create a company with an enterprise value of $60 billion and the world’s largest independent oil producer (one that is not vertically integrated).

An all-share transaction, Concho’s shareholders are set to receive 1.46 ConocoPhillips shares for each of their own, or a 15% premium above their mid-October price. This means their 196.3 million Concho shares will become roughly 286.6 million ConocoPhillips shares. While the premium paid is greater than that received by Noble Energy shareholders in their Chevron deal, Concho’s current valuation is still around a meager half of its January valuation.

Credit Suisse and JP Morgan Chase acted as financial advisors to Concho, while the commodity-bullish Goldman Sachs advised ConocoPhillips.

ConocoPhillips headquarters in Houston (Credit: ConocoPhillips)

Motivation behind the deal

It’s safe to say that with how downtrodden the oil industry has become this year that some pretty strong motivation has to exist to spend $13.3 billion on increasing your stake in it. One would need to be convinced that the idea of the oil industry’s 2021 comeback is not just a possibility but a high probability – and ConocoPhillips’ CEO Ryan Lance is one of this theory’s strongest advocates.

Considered the personification of American Big Oil, Lance started as a rig-worker to pay for his university fees and later became a petroleum engineer in Alaska. From there he worked his way up to CEO of ConocoPhillips in 2012. Along the way, he became a well-connected and influential man in Washington, serving as chairman of the American Petroleum Institute that persuaded the Obama administration to lift the U.S. crude oil ban in 2015. He has also become known as something of a strategist.

Crude oil prices will see a comeback in 2021, according to Lance, but not before U.S. oil output falls further. Lance foresees times getting even worse for upstream oil producers (those focused on exploration, drilling and the extraction of oil) like ConocoPhillips before they get better. As well, the U.S. shale fields are notorious for quickly depleting their resource, and the recent slashing of capex, which includes a reduction of exploration, could mean the end for some firms.

This is where Lance’s strategy to invest in the Permian Basin comes in, and to acquire an area-leader – Concho.

The acquisition grants ConocoPhillips access to Concho’s 23 billion barrels of oil and gas and for a cheap production cost of $30 a barrel – allowing room for profits at an October crude price of $40 a barrel and the near $50 it has reached in December. “Together,” says Lance, the merged companies will have “unmatched scale and quality across important value drivers” of ConocoPhillips’ business. Further, Lance notes, Concho presents “an enviable low cost of supply asset base, a strong balance sheet, a disciplined capital allocation approach, ESG excellence and great people”. The low costs of production are expected to provide ConocoPhillips with strong cost synergies, saving $500 million a year on production by 2022.

Concho’s CEO, Tim Leach, who will now run the merged company’s U.S. production, cited Concho’s motivations as the shared vision held between the two companies, likely meaning smooth integration into the larger firm, as well as the increasing importance for “size, scope and scale” which ConocoPhillips offers. Lastly, he says the deal was the best available option in regards to their shareholders, who, according to a rough calculation, will own approximately 21% of the combined company.

As previously mentioned, many U.S. shale companies have been unable to arrange sufficient new capital to restructure their massive debt. With $3.9 billion in debt this represents a problem that has plagued Concho, who has not posted an annual profit since 2018.

And about the Biden-threat? In fact, Biden has eased his earlier aggression on U.S. shale – perhaps to win the favour of Pennsylvania – emphasizing the importance for fracking to continue during the planned energy transition. His pledge to stop drilling on federal lands remains a threat, however, but as only a quarter of oil-production exists on federal lands, it is a limited threat. Lance assured investors that the risk Biden presented was under control, as nearly all of Concho’s assets are located on non-federal land.

The left displays the major oilfields in the U.S., while the right indicates federal lands. Aside from Wyoming and part of Colorado, much of the major oilfields lie outside the government’s reach. (Credit: U.S. Energy Information Administration and Bureau of Land Management)

Market and analyst reaction

The deal is set to create the world’s largest independent oil and gas producer, with the ability to outproduce entire OPEC countries. Robert Clarke, analyst at Wood Mackenzie, noted that this would allow ConocoPhillips to “nip at the heels of ExxonMobil’s massive programme”.

Yet the market, upon announcement of the merger, hardly moved. Concho’s shares (CXO) rose 0.7% and ConocoPhillip’s (COP) fell 0.3%. This did not come as a surprise to analysts though, as Bloomberg had reported rumours of the acquisition in early October and saw both company’s shares rise in reaction.

Robert Clarke went on to praise the deal, noting the potential for synergies between the two companies. “Concho has a history of acquisitions in the region and brings a considerable amount of incumbent Permian knowledge. ConocoPhillips has proven itself as a leader in shale technology…The combination bodes well for the Permian’s longer-term outlook.” He said.

Andrew Dittmar, a senior M&A analyst at Enverus agreed: “This deal looks to be a natural fit on both sides… Buying Concho strategically fills a gap in Conoco’s portfolio”.

Tudor, Pickering, Holt & Co. stated their approval of the premium chosen by Conoco, as it allows for an apparently accretive deal for Conoco while allowing Concho’s shareholders to “comfortably rotate” into Conoco, “a name which continues to hold favor with the investor community”.

The future of American oil

A Conoco pumpjack in the Bakken oilfield (Credit: ConocoPhillips)

The deal is set to create the world’s largest independent oil and gas producer, with the ability to outproduce entire OPEC countries. Robert Clarke, analyst at Wood Mackenzie, noted that this would allow ConocoPhillips to “nip at the heels of ExxonMobil’s massive programme”.

Goldman Sachs, who, perhaps not surprisingly, acted as advisor to Conoco’s acquisition, shares in Lance’s sanguinity of the future of oil – forecasting WTI crude oil prices reaching $65 in 2021. Watching the price of crude oil grow over November and approach $50 a barrel now in December, it appears Lance’s bet is going according to plan.

Oil, therefore, may not be dead after all, but it certainly is dying. Even the optimistic Lance cannot deny this. In fact, his deal with Concho relates strongly to his awareness of the transition in energy taking place and that “eventually there will be a peak in demand [for oil and gas]”.

Deloitte, in its outlook for the industry, noted several gloomy aspects that will hamper the future of oil. They come with little to no surprise, citing changes such as a growing focus on clean energy, the rise of socially responsible investing and consolidations of the industry with a focus on low-prices. Their report points to the far right of the industry lifecycle chart for oil – that it’s undoubtedly in the “decline” phase.

Interestingly, Deloitte singles out U.S. shale, stating that its future likely relies on companies’ ability to “insert themselves into a greener future”.

Which is precisely Lance’s plan. He says he understands the world is pushing towards a greener future, “but we also understand that there’s [still] going to be a need for fossil fuels”. While he doesn’t believe the end has come for oil, he is confident that as it approaches, the “winners will be the cheapest and the cleanest”.

To be cheap, one could buy a low-cost producing competitor with assets that are untouchable by the changing government on land that has far more resource to extract. To be clean, ConocoPhillips has pledged to be the first American oil producer to reach zero carbon emissions (aside from that produced by burning oil) by 2050. With these moves, he has a battleplan laid out to align ConocoPhillips as the upstream oil and gas leader of tomorrow.

The transformation that the oil and gas industry is undergoing is nothing new. It began well before the pandemic. The crash in oil prices and the stronger demands for a greener future have only shifted that transformation into the next gear. Whether or not the industry is a shifting landscape is not being called into question. What is, rather, is to what extent does “green” mean “fossil fuel free”? And what role does oil and gas play in this environmentally-friendly future?

If the answer to this is murky, one Darwinian point seems clear – if the industry is here to stay, only the clever will survive.

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