Mergers in the U.S. shale patch have continued through the course of 2023 as companies jockey for assets that will fill in gaps in their acreage base. Two key basins have been the focus of much of this activity. I refer to the Permian Basin and the Eagle Ford, each of which has attributes that draw the interested eyes of companies with strong balance sheets and cash to spend.
This article continues a series I started back in August, with this OilPrice article where the recent activity by Devon Energy (NYSE: DVN) in the Eagle Ford snapping up Validus Energy was discussed, among others. The theme of that article was “Big fish, eating little fish.” What we didn’t get into then in any detail, and will do in this article, is look at one of the primary metrics now driving this merger mania in the shale patch.
It shouldn’t come as any surprise to anyone that oil and gas companies need to make new discoveries at a rate greater than they are producing reserves as daily production. We call this Reserve Replacement-RR, and it is one of the primary drivers causing big operators to use some of their cash hoard in M&A activity. The challenge before these companies is it is becoming more difficult to replace production-which has been increasing monthly, as the most recent EIA-Drilling Productivity report notes, through new drilling alone.
One of the key problems inherent in this effort has been the shift producers have made in reallocating cash flow from new drilling to shareholder returns. These returns have been very popular with investors but have come at a price for reserves replacement even as Finding and Development-F&D costs for a broad cohort of shale E&Ps, have declined as the blue bars in the RBN Energy graph reveal. The sharp bump higher in RR from 2020-2021 came in part from companies reappraising reserves that had been previously written down in the oil price collapse. Once this was complete, we see the line flattening into 2022 as new drilling shoulders the burden for many operators.
One of the things that comes into focus is how some companies have done a better job than others at RR. We can start with Pioneer Natural Resources (NYSE:PXD), a company soon to be merged into ExxonMobil (NYSE:XOM). There are many reasons why XOM was determined to pay up for PXD, and we discussed some of them in an OilPrice article last April. There are other reasons, and we plan to detail them in a future article. That said, PXD’s success in replacing its reserves can’t have escaped XOM’s careful eye, at better than 300% over the three-year period, as this RBN Energy graphic notes.
For reference, XOM hasn’t been doing nearly as well on this metric, as this graphic from Energy Intelligence reveals. To be fair we must acknowledge the Law of Large numbers hobbles XOM in this regard. Even with the massive discoveries the last few years in Guyana XOM’s reserves are falling year over year. The purchase of PXD will buy XOM some time with its 2.2 bn barrels of P-2 reserves, and we should see a bump higher over the next couple of years.
It is worth noting that Pioneer is in the position it is precisely from this sort of M&A activity over several years. The company was one of the first movers in the shale M&A space with its purchase of Parsley Energy in early 2021 for $7 bn. That was followed a few months later with the acquisition of privately held Double Point Energy for $6.4 bn. Pioneer management is to be congratulated for having the vision to spend the money they did, at a time when the oilfield’s recovery from Covid lows was still nascent. It set the stage for them to become the leading Permian producer they became and ultimately draw ExxonMobil’s buyout offer at a 20% premium to recent share prices.
Pioneer wasn’t alone in building a shale empire to bolster reserve replacement rates on Wall Street when they couldn’t through drilling. Devon Energy (NYSE:DVN) is another price example of a company that has transformed itself through acquisitions and divestitures over the last few years.
Devon made its first big splash in the M&A theatre with its $5.3 bn takeout of Ocean Energy in 2003, gaining a significant shale footprint along with deepwater blocks in the Gulf of Mexico and international interests in a number of West African countries, Indonesia and Russia. In 2015, Devon bought the Anadarko assets of Felix Energy for $1.9 bn. The next big buy was Permian-Delaware-focused WPX Energy in 2021 for $5.8 bn. WPX brought acreage that now forms the cornerstone of much of DVN’s development plans in the Delaware. It followed up WPX with Parsley Energy later that year for another $4.5 bn. Devon has continued this torrid pace with bolt-on purchases of Validus Energy in 2022 for $1.9 bn, enhancing its Eagle Ford oil-weighted acreage in the process. Then came the Williston basin assets of Rimrock Oil and Gas in the sweet spot of the Bakken play.
All of that M&A activity builds a company with a portfolio that is top-tier in every shale play in which it participates. Devon itself is a powerhouse with nearly 700K BOEPD output that will generate nearly $12 bn of EBITDA in the full year 2024. It trades currently at 3X EV/EBITDA and $59K per flowing barrel. For reference, ExxonMobil just paid $66 bn or $254 per share for PXD, which prior to the deal, was trading at 5-6X EV/EBITDA and $88K per flowing barrel.
I think it’s just a matter of time before a Super Major like Chevron (NYSE:CVX)-which has the same reserves replacement problem that XOM does, does the math and puts an offer on the table for Devon.
An alternative scenario might be where Devon makes a merger deal with another shale operator that would give them the critical mass to stay independent. Marathon Oil (NYSE:MRO) has a similar acreage footprint to DVN’s and trades in the 3-4X EV/EBITDA sweet spot and at a very low-for these days, $40K per flowing barrel. Whether it’s Devon or someone else, MRO’s days as an independent operator are likely numbered.
Shale drilling has been refined to a high art since the mid-teens. Longer wells and increased efficiencies in fracturing treatments have enabled operators to grow production with fewer assets. This has resulted in helping to keep costs in line and for companies to grow production year over year and pad the coffers with record cash flows.
Shrewd operators have used their cash flow to fund aggressive acquisition campaigns that have enhanced their reserve replacement rates. In the case of PXD, this put a target squarely on the back, and in my view, an offer like the one XOM made was inevitable.
As I’ve discussed, there are other companies performing at a high level in terms of reserve replacements, and I think it is very likely we will see more M&A activity in the shale patch as we head into 2024.