HOUSTON—In 2016, Permian Basin A&D had an unmistakable rah-rah element: each successive, high-price deal built on the last, like storied baseball player Joe DiMaggio’s streak of 56 consecutive hits.
David Deckelbaum, senior E&P analyst at KeyBanc Capital Markets, said 2016 had the feel of the dot-com boom.
“Back in the 2000s, every Thursday or so there was a new tech IPO and you just played it because the last one worked the week before,” Deckelbaum said at the KeyBanc Capital Markets Breakfast in February.
Permian deals gained similar traction. “That was the logic going into it. You do it because it works,” he said.
Now that E&Ps are digesting their deals, it appears not every company fared equally well at the M&A feast. E&Ps that acquired acreage through Permian bolt-ons and other deals have generally been rewarded by the market. Companies that made in-basin transactions are up about 14%.
But companies that hoped to trade up by either diversifying or exiting a basin for the Delaware and Midland have been “universally punished,” Deckelbaum said. To date, those companies’ market performance is down roughly 6%.
“The companies that did it have not fared very well from an equity perspective,” Deckelbaum said.
Timing also matters. Permian acquirers in 2014 and 2015 have seen a 43% relative outperformance since 2015. In 2016, outperformance from most acquisitions was “non-existent” and has been negative in 2017.
Capital markets own feeding frenzy was equally impressive: $46 billion for A&D and restructuring between 2015 and 2016—essentially squeezing five years’ worth of combined activity into 18 months, Deckelbaum said.
To justify their A&D spending, companies are moving into overdrive, with E&Ps ready to spend more cash flow than they have—just as they did before the industry fell into commodity-price purgatory.
In 2017, E&P budgets are set to increase 45% year-over-year to more than $65 billion for U.S. E&Ps.
Scott Hanold, an analyst at RBC Capital Markets, said in a March 2 report that he was “a bit surprised at several [E&Ps] willing to outspend for more growth. Any incremental free cash flow likely gets spent.”
“We have entered the digestion phase in the Permian after 2016's M&A feast,” Hanold said. “Focus now turns to integration, execution and infrastructure build-out.”
E&Ps may not have any choice but to accelerate following expensive deals. David Tameron, a senior analyst at Wells Fargo Securities, noted that in the past six months more than $20 billion has been spent in the Permian Basin.
“In order to justify the lofty acreage prices that we’ve seen, spacing and timing of development were crucial,” Tameron said.
Acreage prices north of $30,000 per acre “become difficult to justify without tight well-spacing, rapid development pace and strong commodity prices all working in tandem,” Tameron said. “The takeaway here is that pulling cash flows forward through accelerated drilling is, in many cases, necessary to justify lofty acreage prices.”
That may seem counter-intuitive since public companies were supposed to realize an arbitrage value on deals with private companies. Generally, the idea that what a private company valued at $30,000 per acre was worth $50,000 or more per acre to a public company.
At the beginning, that was true, Deckelbaum said. In the early days of the Permian land rush, the upside for a public company buying private E&Ps’ assets was close to 70%. Now it’s shrunk to roughly 35%.
Making the math work on deals has become increasingly tricky, particularly as prices have inflated. Consider a company valued at $3 billion that buys an asset trading at a 30% premium to an asset it wants to buy. A $1 billion deal means the company will have to issue equity.
“There’s your 30% [arbitrage] that’s gone,” Deckelbaum said. “And now you’ve got to accelerate [drilling].”
SM Energy Co. (NYSE: SM) has so far purchased $2.3 billion in Permian assets and divested $2.7 billion in noncore assets as it moves into the Permian suite. The company issued $1.4 billion in equity and $700 million in debt.
Initially, the company outperformed its peers. Now the stock is down 3% compared to the E&P index, which in turn is up 14%.
In the midst of its horse trading, the company sold off 65,000 barrels of oil equivalent per day (boe/d) for 7,500 boe/d in the Permian.
In a long-term market, entering a new asset requires kicking up growth. But high-grading a portfolio comes with its fair share of friction.
“Here’s the rub, though. At the end of the day, all of this is inevitable. E&P is a very difficult inventory management game,” Deckelbaum said.
With oil still in the $50 to $55 range and service cost inflation up by perhaps 10% or more, the larger concern is that KeyBanc sees its coverage universe of companies with about 11 years of inventory that is economic at current strip prices.
Prices either must rise, new technology must be deployed or “everyone needs to buy stuff,” he said. “And you can’t accrete stuff like we’re starting to see on some of these bolt-ons.”
For some companies, that means scrambling for more inventory in the basin. Or it means heading outside of the Permian, to areas such as the Powder River Basin, the East Texas Eagle Ford and other seemingly forgotten regions.
But the market general frowns on buying outside the Permian.
“You get killed,” he said. “But you need to buy something non-Permian.”
Darren Barbee can be reached at email@example.com.
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