Given the recent crash in oil prices this April, it may come as a surprise that on October 19th, ConocoPhillips — the world’s largest independent oil producer — decided to acquire Concho Resources, a US shale oil producer, in a deal worth $9.7bn. However, it could be argued that consolidation within the oil industry is precisely the best way for ConocoPhillips to position itself for a post-pandemic market recovery. The deal will make ConocoPhillips the largest independent oil and gas company in the world, and many proponents believe that this is a great strategic move. Critics, on the other hand, argue that the deal does little to address structural, political, and commercial threats facing the oil industry.
The $9.7bn deal is set to be an all-stock transaction, with Concho shareholders receiving 1.46 shares of Conoco stock for each share of Concho common stock. The acquisition, expected to close by Q1 2021, values Concho at a relatively modest premium of 15% over Concho’s closing price on October 13th. Considering Chevron’s acquisition of Noble Energy in July for $5bn, and Devon Energy’s decision to buy rival WPX for $2.6bn in September, the Conoco-Concho deal is the third and largest acquisition within the shale industry this year. Moreover, the deal signals a trend towards consolidation within the oil industry, in efforts to exploit low asset valuations driven by the pandemic-induced crash in oil prices (they have been hovering around $40 a barrel since June), so as to scale and capitalise on resource bases. Indeed, Conoco’s acquisition of Concho will place the combined company as one of the largest producers in the Permian Basin, a prime US oilfield, positioning it well to compete with its rival, ExxonMobil.
A key rationale for the deal is to leverage Concho’s production capacity in the Permian Basin of Texas and New Mexico. Conoco currently has assets ranging across the US, Australia, Canada, the Asia-Pacific region, Europe, the Middle-East, and North Africa. Yet, the firm only produced less than 100,000 barrels per day from the Permian Basin last year. Concho, on the other hand, has resources concentrated within the Permian Basin, pumping about 319,000 barrels of oil equivalent per day — making it the fifth-largest producer by volume in the region. The deal therefore enables Conoco to expand within the Permian Basin, creating a combined resource base of roughly 23 billion barrels of oil, and a production capacity of 1.5 million barrels of oil equivalent per day. ConocoPhillips CEO, Ryan Lance, believes that the deal will thus position the company to better manage their margins, and mitigate sharp levels of volatility in commodity prices. From Concho’s perspective, joining Conoco enables a greater diversification of assets, and an opportunity to scale at a size it could not have possibly done any time soon without the acquisition.
Furthermore, Conoco believes that the combined company will produce an enterprise value of $60bn, and $500mn in annual cost and capital savings by 2022. Most importantly, CEO Ryan Lance points out that the deal will enable Conoco to deliver greater shareholder value through lower decline rates (the rate at which production is expected to decline over the lifetime of available oil assets), greater operational efficiency, and, consequently, more attractive dividends.
The uncertain future of oil
Conoco has not been in a great position financially throughout the first half of 2020, having lost more than $30bn (almost 50%) in market capitalisation value since 2019. In Q2, Conoco reported an adjusted loss of $1bn. Given hits to global demand amid COVID-19 lockdowns, and as one of the first major producers to cut production this year following the drop in US oil prices in the midst of the Saudi-Russian market share struggle, analysts predict Conoco’s Q3 earnings will decline. Taking on $2.4bn in debt to finance this deal might therefore not seem like the best move in the short term, from a shareholder’s perspective. Concho has also seen its market capitalisation decline from a high of over $30bn in the second half of 2018 to roughly $8bn this October, before the deal announcement.
Such a drastic depreciation is, in part, the result of decreases in the equity valuations of their Permian Basin shale patch over the last few years, alongside the oil crash this year. Generally speaking, as Ed Hirs (Energy Fellow at University of Houston) suggests, shale is an expensive industry to operate in because shale wells do not produce the same returns as conventional wells do. Hence, it is worth questioning the extent to which this deal is as lucrative as it might seem initially.
More broadly, the shift towards renewable energy, geopolitical uncertainties, the upcoming US election, and changes in commuting habits following the COVID-19 pandemic calls into question the long-term value of oil. BP’s Energy Outlook 2020 predicts that demand for oil, even at modest estimates, will drop by 10% over the next 30 years. Yet, BP suggests, if governments and corporations take the action required to meet the net-zero target by 2050, oil demand could drop by an enormous 80%. The outcome of the US Presidential Election may also have a detrimental effect on the future of the oil industry, with the Democrat Party advocating regulations to restrict the US oil industry, and proposing a $1.7bn climate plan to transition the country towards net-zero emissions. Additionally, people working from home in greater numbers post-pandemic may reduce long-term demand in oil, if people decide to commute less.
Conoco may have to present a more robust and detailed strategy to navigate a number of these uncertainties in order to convince shareholders that this deal is worth betting on. Conoco and Concho have made clear in their recent press releases that both companies are wholly committed to ESG principles and sustainability. Perhaps expanding more aggressively into the green energy space, following the likes of BP, could be the best way for Conoco to ensure its longevity within the energy sector for decades to come.