[Editor's note: A version of this story appears in the April 2020 edition of Oil and Gas Investor. Subscribe to the magazine here.]

Offering a 25% premium made sense at the time. Occidental Petroleum Corp. had just paid a hefty kicker for Anadarko Petroleum Corp.—nearly all in cash. Deals leading up to July 15, 2019, had come with premiums.

But times were changing—fast—as Callon Petroleum Co.’s offer for Carrizo Oil & Gas Inc. was in draft.

Dating back to July of 2018, the Callon board had Carrizo, a fellow Delaware Basin operator, on a short list of potential merger candidates when regularly discussing M&A prospects, particularly as Callon had shifted to the goal of generating free cash flow rather than growth.

The deal was announced before markets opened on July 15. An all-stock transaction, its value was $3.2 billion. The 2.05 Callon shares offered were worth $13.12 before markets opened.

Trading response was disappointing, though; Callon shares tumbled 16% that day, while the S&P E&P Index fell about 3%.

Until the deal was recast down to a 6.7% premium in November—based on the pre-deal share values; it was 1.1% based on Nov. 13 share prices—the journey was arduous.

And it was bruising, with a series of blows in rapid succession: a surprise punch from an activist shareholder that appeared from nowhere and disappeared before year-end, followed by cross punches by other major shareholders, finally closing with one-two uppercuts from Institutional Shareholder Services and Glass Lewis & Co.

In a summary of industry conditions last fall, a Seaport Global Securities LLC analyst reported, “Let’s get real about the state of the E&P space. Time to face the facts: The 2020 oil macro setup is a mess.

“Non-OPEC growth [in daily production] is pegged at 2.2 MMbbl by the [International Energy Agency], while oil-demand growth is expected [of] 1.3 MMbbl—and we’ll take the under on that.”

Additional observations included that share prices will be pressured until “operator pain is palpable” and a view that discounted

E&P stocks have a “scarlet letter hung around their neck.”

He concluded, “What’s the route for [these] names? MOE [merger of equals].”

Activism in E&P

Just days ahead of the Callon-Carrizo announcement in July, a group led by EQT Corp. shareholder Toby Rice won a vote to take over the EQT board. Earlier in the year, the Denbury Resources Inc. merger with Penn Virginia Corp. failed upon dissent by shareholder Mangrove Partners Master Fund Ltd.

After the Rice win at EQT, QEP Resources Inc. satt down with activist shareholder Elliott Management Corp., agreeing to add two independent board members. Texas Pacific Land Trust, owner of more than 900,000 West Texas acres, came to terms with Horizon Kinetics Asset Management LLC, reviewing and then deciding to convert to a C-corp.

Until then, shareholder activism in E&P was vocal but mostly unsuccessful. In May of 2019, Kimmeridge Energy Management Co. LLC failed in its bid to win three PDC Energy Inc. board seats. Kimmeridge had made a case beginning in 2018 for zero-premium mergers among E&Ps.

However, on Aug. 26, 2019, PDC announced a low-premium MOE with SRC Energy Inc. That day, PDC Energy Inc. shares rose 17%; the deal closed in January.

Meanwhile, other deals hadn’t closed due to the price of WTI. In December of 2018, Earthstone Energy Inc. had to cancel a purchase from Sabalo Energy Inc. as futures plummeted in a matter of weeks.

Soon after, Vantage Energy Acquisition Corp. was unable to close on a $1.65-billion deal struck pre-plummet for QEP’s Williston Basin portfolio. Vantage had to release from escrow back to shareholders its SPAC funding when a 24-month deadline to deploy expired in April of 2019.

As buyers of E&P assets became fewer, private-equity firms began talking publicly in 2019 of looking at intra-portfolio combinations and the even greater challenge of inter-portfolio deals.

Did the Rice-EQT outcome drive more boards to the table?

Leo Mariani, KeyBanc
Leo Mariani, managing director and equity analyst for KeyBanc Capital Markets Inc., concluded that, from the response to the Carrizo-Callon deal, “the lesson is that, in this type of market, investors don’t want to see any kind of significant premiums.”

Leo Mariani, managing director and equity analyst for KeyBanc Capital Markets Inc., told Investor in February, “In general, it’s always hard to know what any given management team or board of directors is thinking.

“But we have certainly seen some pretty significant successes on the activist side—maybe not in certainly in getting some agendas to bear.”

Icahn versus Oxy

He expects E&Ps “are going to be taking activists more seriously these days than they might have a few years back. Obviously, you’ve got the major one brewing right now between Carl Icahn and Oxy.

“It will be interesting to see how that plays out over the next few months.”

Icahn, taking issue with what Oxy bid for Anadarko last May and the lack of a shareholder vote on it, has called it the “OxyDarko Disaster.” He and the funds he manages held 32 million Oxy shares before the deal and 87 million at press time.

Gabe Daoud, managing director and equity analyst for Cowen & Co., told Investor that the Toby Rice-EQT situation was unique in that Rice had great familiarity with the EQT assets, having contributed to them in a corporate sale of Rice Energy Inc. in 2017.

With activist shareholder Paulson & Co. Inc. in the Callon-Carrizo deal, it was “an outsider who had no true inside knowledge of daily operations.”

But “there was some credence to what Paulson was arguing,” Daoud added. “I think investors would prefer to see deals executed at low- or no-premium terms versus Callon’s initial 25% premium for Carrizo.

“Callon did hear that message and ultimately revised the terms, making it more favorable,” he said.

It made for a better deal for Callon and Carrizo going forward, he said, in “ability to generate free cash flow over the next couple of years.”

MOEs for now

In late 2019, the WPX Energy Inc. deal for Felix Energy that closed in March “looked like a much cheaper price relative to what people were paying back in 2018,” KeyBanc’s Mariani said.

The WPX-Felix announcement has been “clearly the most successful E&P deal we’ve had in a number of years.” WPX shares rose after the news.

Another success has been the MOE of PDC and SCR that was announced after the Callon-Carrizo deal news as well as the Parsley Energy Inc.-Jagged Peak Energy Inc. combination announced in October, Mariani added. “In both of those, we saw minimum premiums.”

Seeing market reception of these three deals, “I would think other E&Ps that would potentially consolidate or sell themselves are likely going to be giving a lot of credence to the MOE framework.”

He added that he doesn’t think it will just be small and mid-caps (SMID) taking notes. “It’s possible we could see that in someone a little larger as well.”

Daoud said, “The E&P business has migrated to moderating growth and, ultimately, generating sustainable free cash flow that can pay down debt and be returned to shareholders.

“Perhaps the only way this can be achieved for some of the smaller-cap names is to merge with peers to enhance scale, take costs out of the equation, particularly on the G&A [general and administrative] side, and slow down operations to augment free cash generation.

“It’s likely one of the only ways most SMID-caps can create value at this point.”


Is more consolidation—and among the largest E&Ps as well—needed to make picking up an independent worth a major bothering with the paperwork?

Gabe Daoud
Mergers among smaller-cap E&Ps are “likely one of the only ways most [of these] can create value at this point,” said Gabe Daoud, managing director and equity analyst for Cowen & Co.

Daoud said, “You need to be pretty close to generating free cash flow if you’re not already. Majors are also quickly drilling through Permian inventory over the next several years; thus, one could argue they will need to replenish at some point.”

Mariani said, “If you’re a major, you certainly want a deal that’s really going to move the needle. You don’t want to spend tons of time and effort on some crumbs if you can go after the cake.”

There are some independents that could begin to move the needle.

“If you listen carefully to what Parsley management had to say about their Jagged Peak acquisition, it’s just that: They view Jagged Peak as a sort of interim setup [with] the right dance partner,” Mariani said.

Over time, “as they’ve gotten larger—and that deal was pure-play Delaware—that would make them more attractive as a take-out to a larger operator.”

Signing MOEs gets tricky, though, particularly the part about which management team will survive, he noted. Among SMID-caps, Mariani said, “some of the most natural fits have already happened, so there aren’t as many other really good fits out there.”

But if this downward investment environment persists, “it could force incremental consolidation in the next year or two.”

Daoud concurred that consolidation and free-cash-flow generation may reverse investor apathy toward the E&P space. “It’s a tough environment. That’s where we stand today.”

Mariani concluded that, from the response to the Carrizo-Callon deal, “the lesson is that, in this type of market, investors don’t want to see any kind of significant premiums.”

In February, as operators reported fourth-quarter earnings, Tudor, Pickering, Holt & Co. analysts wrote that production growth “isn’t wanted or needed.”

After an E&P’s earnings call in February, a SeekingAlpha member wrote in the comments, “With the release of these great numbers, combined with pursuing overall debt reduction, I don`t understand the reason for the exceptionally low [price-to-earnings] ratio.

“Can anyone explain this?”

One member replied: “Investors don’t want to be in oil anymore.”