Recent M&A Activity

The recent sell-off in oil prices has hit many companies hard. In some cases, bargains have been created, but in others it has merely made some overpriced companies less overpriced. The obvious bargains are often snapped up by larger companies, and since summer we have seen some significant mergers and acquisitions (M&A).

In July Growth Portfolio holding Whiting Petroleum (NYSE: WLL) said it would acquire Kodiak Oil and Gas (NYSE: KOG) in an all-stock transaction valued at $6 billion. The combined company should become the biggest oil producer in the Bakken formation, displacing Continental Resources (NYSE: CLR).

Also in July Breitburn Energy Partners (NASDAQ: BBEP) and QR Energy (NYSE: QRE) — two of the top five upstream master limited partnerships (MLPs) — announced a merger that would create the largest oil-weighted upstream MLP with an enterprise value of $7.8 billion.

Last month Canadian-based oil and (predominantly) gas company Encana (TSE: ECA, NYSE: TCA) unveiled a buyout of Athlon Energy (NYSE: ATHL) in a deal valued at $7.1 billion. Encana is Canada’s largest natural gas producer, but the company has been investing more in liquids production in recent years. This move into the Permian Basin is seen as another step in that direction. The buyout price was a 25% premium to Athlon’s share price immediately prior to the deal announcement.

Who’s Next?

Who might be the next to be acquired, or perhaps do the acquiring? The most likely targets for acquisitions would be small-cap and midcap companies in the most productive areas of US shale formations, especially those attractively priced relative to their peers. A recent report from USB identified six potential targets, three of which are in Energy Strategist portfolios. The six candidates were:

1. Growth Portfolio holding Cabot Oil & Gas (NYSE: COG) is a top natural gas producer and one of the lowest-cost gas producers in the Marcellus shale in northeast Pennsylvania. Cabot has been recently making a move into oil development in the Eagle Ford shale. Despite a very favorable outlook, the share price is down more than 10% in the past year. Nevertheless, the long-term fundamentals for Cabot appear to be excellent, and I believe patient shareholders will be rewarded. Cabot has an enterprise value (EV, representing the sum of its market capitalization and net debt) of $14.1 billion.

2. Concho Resources (NYSE: CXO) is an oil producer in the Permian Basin in West Texas, which is probably the hottest oil producing region in the US at present. Concho has an EV of $15.9 billion.

3. Aggressive Portfolio holding Oasis Petroleum (NYSE: OAS) is a pure play in the Bakken shale region that has sold off sharply with the decline in oil prices. Oasis is beginning to show up at the top of many stock screens for the oil and gas sector, as I will show below. Oasis has an EV of $6.1 billion, which is in the range of some of the recently announced acquisitions.  

4. Pioneer Natural Resources (NYSE: PXD) is a major producer in the Permian Basin and the Eagle Ford in Texas, and is one of the companies recently approved by the US Commerce Department to export natural gas condensate. Pioneer has an EV of $28.4 billion, and would therefore be a large bite to swallow for all but the largest E&P companies. On the other hand Pioneer has relatively low debt, and could easily acquire a smaller rival.

5. Range Resources (NYSE: RRC), which is primarily a natural gas producer in the Appalachian and Southwestern regions of the US. Range Resources has an EV of $13.5 billion now that its share price has slid more than 30% since early June.

6. Aforementioned Growth Portfolio holding Whiting Petroleum. Following the acquisition of Kodiak, the projected EV of the new company will be about $18 billion. In comparison, the new company’s production is expected to rival that of Continental Resources, which sports an EV of $28 billion.

Screening for M&A Targets

In order to highlight other upstream oil and gas companies with attractive valuations relative to competitors, I recently performed a series of stock screens. In this week’s Energy Letter (With Trusts, It Pays to Verify) I discussed the risks of relying too heavily on stock screeners for making investment decisions. However, properly designed stock screens can identify a pool of attractively priced companies. An investor should then apply another layer of due diligence before committing any capital.

I have yet to find a stock screener that contains all of the variables I am interested in evaluating, but I used Fidelity’s for this exercise. I first screened all of the publicly traded energy companies for those in the upper 40% of the sector on profit margin, return on equity and revenue growth. Total Debt/Equity is shown just to give a relative picture of the extent of the leverage employed by each company, but is not part of the screening criteria.

Do keep in mind that this screen used backward looking metrics, which may not be as relevant in the today’s rapidly shifting commodity price environment. In any case, upstream oil and gas producers dominated the top of the rankings:

Oasis Petroleum came out on top of this screen, while portfolio holdings Continental Resources (we advised investors to take some profits in this position in April 2014), EOG Resources (NYSE: EOG), Rice Energy (NYSE: RICE), Cabot Oil and Gas, Core Laboratories (NYSE: CLB), Occidental Petroleum (NYSE: OXY), Schlumberger (NYSE: SLB), and contract driller Helmerich & Payne (NYSE: HP) were also listed. Seadrill (NYSE: SDRL) a Hold in our Aggressive Portfolio, is also on the list, but we are concerned that a slowdown in offshore drilling will continue to weigh down the stock in the short term.   

One variable missing from the above screen (again, I have yet to find my “perfect” screener) is the EV/EBITDA value (easily calculated, but not often found in stock screeners). If one includes its cousin, the price/earnings (PE) ratio in the above screen (a variable that is available in this screen), then Oasis with a PE based on this year’s projected earnings of 12.4 drops to second place on the list, while Abraxas Petroleum (NASDAQ: AXAS) with a PE of 9.9 jumps to the top.

The high degree of leverage for Oasis (Total Debt/Equity of 175%) and Continental Resources (125%) is one reason they are in the Aggressive Portfolio. When oil prices are rising, leverage can certainly juice your returns, but investors must be prepared for the inverse when oil prices are falling, as they are now. In any case, with the recent pullback in the share price of Oasis, aggressive investors should take note, as it’s been about year and a half since Oasis’ shares were this cheaply priced. It could prove a tempting target soon — for aggressive investors or for a larger competitor.

Conclusions

There will likely be additional consolidation in the oil and gas industry, especially if low oil prices continue to weigh on the shale oil and gas producers. While all stock screens have their limitations, I have tried to identify companies that are trading at a value relative to competitors (albeit perhaps not yet as cheap as they will be given overall market sentiment), and are thus more likely to be acquired, or if they are large enough that may seek to acquire a smaller competitor to unlock additional shareholder value.  

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)