Why M&A Activity is Heating Up in the Oil Sector

By Markets Fool.com

When oil prices drop, the oil industry tends to see a flurry of M&A activity. The sector saw it in the '90s with mergers such as those of Exxonand Mobil -- and in the past few years, M&A activity is bubbling up again.

Continue Reading Below

In this week's episode of Industry Focus: Energy, Sean O'Reilly and Matt DiLallo look at some of the biggest M&A activity from the past few years, and a few companies that are pretty promising acquisition targets. Also, the hosts explain just what's so special about the Permian that every other company is buying land setting up camp in it.

A full transcript follows the video.

A secret billion-dollar stock opportunity
The world's biggest tech company forgot to show you something, but a few Wall Street analysts and the Fool didn't miss a beat: There's a small company that's powering their brand-new gadgets and the coming revolution in technology. And we think its stock price has nearly unlimited room to run for early in-the-know investors! To be one of them, just click here.

This podcast was recorded on Sept. 15, 2016.

Continue Reading Below

Sean O'Reilly: This episode of Industry Focus is supported by Wunder Capital, an investing service that allows individuals to invest in solar projects across the United States. Earn up 11% annually while diversifying your portfolio, curbing pollution, and combating global climate change. Create an account for free at wundercapital.com/fool. Wunder Capital: Do well and do good.

Welcome to Industry Focus,the podcast that dives into a different sector of the stock market every day. Today isThursday, Sept. 15, 2016, so we're talking about energy, materialsand industrials. I am joined today viaSkype by Motley Foolcontributor Matt DiLallo. Hi, Matt! How's your week going?

Matt DiLallo: Going really well. How's yours?

O'Reilly: It's still hot here in D.C.,as you might imagine. You're down there in South Carolina, so youprobably sympathize.

DiLallo: Oh, yeah, it's very, very hot here.

O'Reilly: I can't thank you enough for joining meon today's show. For our listeners that may not befamiliar with your work, you're one of our more prolific energy and materials writers. The space has been ...I think active is probably the right word,these past few weeks, in terms of M&A announcements. You hadApachewith that find. There's been lots ofnews coming out of the oil and gas sector. AndI could not wait to get your thoughts onwhat's been going on. Before we get into recent events, can you give us some context as to where the oil industry is today, and what we've seen in the past in terms of M&A,when these conditions last existed?

DiLallo: Sure. One of the things I really like about the oil and gas industry is that, M&A, it's just fun for some reason to see big deals go out. Any time oil prices go down,there seems to be this huge wave of M&A. Back inthe late 1990s, that's when all the big oil companies were created, and it was all due to this M&A boom after OPEC overshot with oil supplies,andBPboughtAmoco, andExxon boughtMobil,andChevronboughtTexaco, so you had all these big oil and gas mergers. It seems to me like we're getting ready for thatto happen again. We just had [Royal Dutch] Shellbuying BG, and midstream companies, pipeline companies, they're doingtons of mergers and acquisitions. Andthe Permian Basin --

O'Reilly: I still can't believeSpectra [Energy], by the way.

DiLallo: Yeah, I didn't see that one coming. And that's the thing, a lot of these,you're not going to see coming,but we can kind of tell, maybe, who's for sale and who's going to be buying. That's what's interesting. For example, both Canadian companiesTransCanadaandEnbridge, they just made deals. TransCanada bought Columbia Pipeline, and Enbridge bought Spectra. What'sinteresting about those is that they're both natural gas pipeline companies in the U.S., and those are oil pipeline companies in Canada. It kind of shows where they're looking, in the future.

And then,as far as U.S. companies, we just had Energy Transfer Partners(NYSE: ETP), they tried so hard to getWilliams [Companies] (NYSE: WMB), and that deal blew up, but their CEO, Kelcy Warren, he's like, "We're gearing back up for deals," they have an M&A strategy. So we know there's something coming down the pipeline with Energy Transfer. He said they wouldn't go hostile again, and that was one of the problems, he went against what Williams wanted, and forced them into a deal, and that didn't work. So they'll probably do friendly deals goingforward. It's definitely one to watch.

O'Reilly: I can't believe how long that dragged out. Really quick, taking a step back -- in your opinion, with what we've seen over the last 20-30 years, and it's funny you brought up the late '90s. My mom always talks about that summer, I think it was 1998, when gas was below $1 a gallon. She would always talk about that. Do you think all these mergers are the strong buying the weak when they're down? The whole sector is down, but the strong will survive, and they're just picking things up on the cheap? Or is it moretrying to squeeze efficiencies out of operations, whichoften means buying another playerwhere there's a complimentary nature to it?

DiLallo: I think it's both. Given that asset values are down,companies are out there lookingfor cheap valuations. For example, a pipelinethat they would have had to pay 12 or 14 times earnings for a couple years ago, they can get for 11 or 12. That's whatSouthern Companydid when they bought a pipeline -- they joint-ventured withKinder Morgan(NYSE: KMI). There are thesegreat deals out there because of valuations.

For example,Enterprise Products Partners, they just went after Williams, and their whole deal was, they wanted to get in on the cheap, but they saw a good way to link their pipelines together. Andthat's one of the things with pipeline companies, this network effect. For example, Williams has this greatpresence in the Marcellus Shale, and Enterprise has a pipeline that takes NGLs, ethane and propane, down to the Gulf Coast. If you can link those two, you can save money.

O'Reilly: Andit's a better value proposition for your customers; all kinds of good things happen.

DiLallo: Yeah. So there's going to be a lot of those,where company is going to look for a spot in their value chain that they're missing, andwho has that, and can I get a great deal on it? So,I think that's going to be one of the big drivers going forward. And then, there are companies out there that are known dealmakers.Kinder Morgan, half of the growth they've beenable to accomplish since they went public has been M&A. And theyhaven't done a deal since they bought themselves, they bought all their pipeline companies --

O'Reilly: [laughs] Since they bought themselves!

DiLallo: Yeah, 2014 or something like that. So they have to beout there looking. They've sold some assets lately,but a transformative deal couldaccomplish a lot for Kinder Morgan,and possibly restart dividend growth. So I definitely think they're out there looking.

O'Reilly: Gotcha. You'retalking a lot about Williams and Enterprise. What about poor Kinder Morgan?

DiLallo: Their problem right now is they had too much debt. They want to get their leverage metric below 5 times EBITDA. Right now it's at 5.3. It's on the higher end of even what most pipeline companies have. There aretwo ways of going about that. They can sell assets to get that number down, or they can buy a company that doesn't have as high debt, so a stock-for-stock deal, andthat could push their leverage metric down. I think that could be something they're looking at.

O'Reilly: They already did do that sale, what was it, a month ago? Was that with Williams? Oh, no, it was Southern Company. So,they're doing a little bit of that.

DiLallo: Andthat was big for them.

O'Reilly: What did they get? $2-3 billion?

DiLallo: I believe it was like $1.5 billion in cash, and then they handed over half of the debt. So it knocked their leverage metric down below ...

O'Reilly: So that's obviously good.

DiLallo: Yeah,it was a good deal.

O'Reilly: OK. Before we move on to talking about someattractive takeover targets,I wanted to take a moment to talk brieflyabout our sponsor. We're probably not going to be using oil forever. What if you could helpcombat global climate change, and make money at the same time?

Introducing Wunder Capital,the award-winning online investment platformthat allows individuals to invest in solar energyprojects across the U.S. Wunder'sonline investment platform allows youto earn up to 11% annually whilediversifying your portfolio, curbing pollution, and combating global climate change. Your investment in Wunder's fully managed solar investment funds goes directly to helping the U.S. small and medium sized businesses install solar panels. As those businesses repay their loans to Wunder,you receive monthly payments directlydeposited into your bank account. Individuals who have previouslyinvested in Wunder Capital havesupported the installation and long-term financing for a high-endstorage facility in Florida,a government office building in Minnesota,and many other projects across the country. Best of all, Wunder Capitaldoesn't take any fees for investing your money. Create an account for free at wundercapital.com/fool. That's Wunder. Wunder Capital: Do well and do good.

So, Matt,obviously there are a bunch of players in the oil and gas space,particularly pipelines, that have been pretty acquisitive lately. But, we are, of course, investors here at the Fool. So,more important,what do you see you around the bend in terms of potential takeover candidates?

DiLallo: First of all,it's hard to predict these. Like Spectra energy, that came out of nowhere. So, in one sense, your better bet is to buy a strong company and hold on to that. But there are some really good, strong companies thatI think would make good takeover targets. They're just strong companies in general.

O'Reilly: Either way, you'll win. That's the bottom line.

DiLallo: Yeah. Absolutely. Williams is one of those. It's beaten downbecause it had so many problems with the Energy Transfer merger. Now,we know that Enterprise Products Partners was interested in them. They just walked away. However, Williams said they weresurprised by that announcement, and that their boardwould always consider a strategic alternative like a merger,if that was a good way to create value. So, Idon't personally think that Williamsis going to be a standalone company forever.I really think it would fit wellwith a Kinder Morgan, possibly.

O'Reilly: They'reno longer the biggest. That was the big outcome of the Spectra deal, right?

DiLallo: Yeah.Spectra wasapparently considering Williams a couple months ago. AndKinder Morgan is always interested. Another one I like,and it's not very well known, isTarga Resources. They did a Kinder Morgan thing where they had an MLP and they brought it in-house. They've done a lot over thepast couple of months to lower their leverage. Wementioned earlier that Kinder Morgan's leverage is 5.3 times debt to EBITDA. Targa's is 3.6. A lot lower. So, if a Kinder Morgan bought them, and they paid all stock, it would lower their leverage metrics. And it also has greatpositions in the Bakken and the Permian Basin. So it would feel some gaps fora company like Kinder Morgan,or a company like Enterprise Products Partners, which lacks in those two areas. Targa was almost bought out by Energy Transfer in 2014. The deal just fell through. That's when Energy Transfer switched to Williams --

O'Reilly: Why do you think all these deals are falling through?

DiLallo: A lot of it had to do with oil prices. Companies werefreaking out about how low it was going to go. In Energy Transfer's case, they did a poor jobnegotiating. They wanted to do an all-equity deal,but Williams wanted some cash. In order to pay that cash, Energy Transfer needed to take on $6 billion in debt, and the market didn't like that, because debt in a falling market is a bad --

O'Reilly: Right, and that's why KMI had to cut theirdividend last year. They had that credit rating scare and everything.

DiLallo: Yeah. That's really what did in the Energy Transfer-Williams deal; it was debt. Companies that don't have a lot of debt,they're going to be highly valued.

O'Reilly: Gotcha. I'm looking at Targa here. They've beenfree cash flow-positive,and they've stayed that way this whole time. Yields arepretty darn attractive, are you pretty sure that's safe as well?

DiLallo: It looks like it. Like I said, they have low levels of debt,they don't have a whole lot of capital projects going forward, and they're primarily fee-based. Last I checked, it was 78% fee-based.

O'Reilly: So not the highest,but that's pretty good.

DiLallo: Yeah.

O'Reilly: Very good. Talk to meabout the Permian, because ...how do I put this ... thiswhole time, we've been talking about how if they'remerging, it's mostly stock. That's what the deal was with Spectra. Deals are falling through because of debt worries and all this stuff. And it seems like every day --it's not, but it definitely seems like it --I come into the office and I check my oil and gas news,and somebody did something in the Permian. And that's kind of been the story for a year now.

For ourlisteners who don't know --the Permian Basin is basicallythe huge geological formation in West Texasthat extends into Oklahoma. Every day. EOGjust had that $3 billion deal, or maybe $2.5 billion,they bought that private company therein the Delaware Basin,which is actually just a subsection of the Permian. Mr. DiLallo, why iseverybody cutting everywhere but the Permian?

DiLallo: Because it's economicat current prices. There'sso much oil. Just forsome history, the Permian Basin has been producing since 1929. It's this oldlegacy oil basin. However, they had beengoing down vertically to drill wells. So they would get a couple hundred barrels a day from these wells,and it was fine and good. However,once they switched over the horizontal drilling,it was like this a-ha moment, where they could pull out more oil in six months than they were getting out in decades.

O'Reilly: Andit's even better than the Eagle Forddown there in South Texas?

DiLallo: Yeah. It's not as oily as theEagle Ford or the Bakken,but it's the combination of how muchthey can pull out and the cost. Inthe Bakken, it might cost $10 million to drill a well, but they're going to get a million barrels of oil over the lifetime of the well, so theeconomics work out, at a certain oil price. Now,in the Permian, they can get, like, 2 million barrels of oil equivalent, it's oil, gas, and NGLs, for $6-7 million. So,the economics are just so much betterwhen you have that combination. So,that's drawing all these companies in,and they're buying up as much land as possible,because the economics or so goodat current prices that they can drill.

You have companies likePioneer Natural Resources(NYSE: PXD), they'restill growing production. Now,we have an oversupply of oil in the country,and yet they're growing production. At first it was 10%, then it was 12%, now it's 13% this year. Part of that isefficiency gains,and part of it is that it's just so good,they're able to get more oil than they initially thought, and that's what'sdrawing all these companies in. And like you mentioned, they're just buying things up,and they're paying a ton of money.

O'Reilly: Yeah,I can't believe some of these numbers. Do you want to share a few of them?

DiLallo: Pioneer Natural Resources, they just bought land from Devon [Energy]. It was 28,000 acres for $435 million. It's about $15,000 an acre. And that'spretty good, compared towhat some of its peers are paying. ThisPDC Energy, just last month, they bought 57,000 acres for $1.5 billion, which is about $26,000 an acre. That's $10,000 more an acre. And thenConcho Resources(NYSE: CXO), they paid $1.265 billion for 40,000 acres. That's $40,000 an acre. Theprices just keep going up.SM Energy, they just paid roughly $40,000 an acre for a deal. So you have these companies that are paying big dollars,because even with that initial investment, they'restill going to make a ton of money. And then you have EOG, they only paid like $7,000-8,000 an acre for great land,because they were able to negotiate an amazing deal. It just shows thatcompanies are willing to pay a ton of money for Permian land.

O'Reilly: Gotcha. Thenext question, obviously, then becomes,are there companies that you likethat are in the Permian right nowin a meaningful way?

DiLallo: Yeah. Whodoesn't like companies in the Permian these days? Pioneer Natural Resources, they'reone of the leaders in the Permian. But I did some math on them. It's a $32 billion company, and they have about 800,000 acres in the Permian.

O'Reilly: That'sthe enterprise value, right? That'sstock market value plus debt. So the whole kit and kaboodle?

DiLallo: Yeah. If you do the math on that, their acreage in the Permian is worth about $40,000, which ispretty high compared to some of the other metrics.And then I did some math and some of the other ones. One that stood out to me was Concho resources. They're worth about $20.5 billion, and they have almost 700,000 acres. If you do the math, that's just less than $30,000 an acre. If you're looking for a value compared to Pioneer Natural Resources, Concho stands out. And then, another one I saw that really stood out wasEnergen.They're about a $6 billion company, and they have 225,000 acres. If you do the math on that, it's about $26,000 an acre. So if I was a company that was looking for an acquisition, I would look at these and say, "I can get Energen for $26,000 an acre,that's much better than if I bought a private deal." Or, "Man, I can scoop up Concho and just get this whole ton of land out there."

O'Reilly: Before we head out here, for thedisparity, is Pioneer just more efficient than Concho or Energen, therefore theenterprise should be worth more, even thoughthe land itself is the same? Oris it that they have better acreage in the Permian?

DiLallo: There'sa little bit of that. Now, Pioneer does have some land in the Eagle Fordand some other places, so that wouldchange the value. They also have higher production. So there's a lot of factors. So this is just a back-of-the-envelope number. But Pioneeris also well known by investors, they're the leader with thethe Midland Basin, which is the eastern portion,so they're at a premium price these days. And then there'ssome others.Diamondback Energyisvery popular these days. Their valuation, from my math, is almost $80,000 an acre. That's because they'regrowing so fast, and investors really want that growth. But if you look in the middle,sometimes you can find some interesting targetsthat are doing the same thing. Pioneer isgrowing their production by about 15%. Concho, they believethey can grow their production by 20%. So you're still getting that really good growth, you're gettingpretty good economics. For investors,maybe they're never a takeover target,but they still look like a good long-term investment.

O'Reilly: Awesome. Well, Matt,thank you for your thoughts. I can't thank you enoughfor joining me on the show today.

DiLallo: No problem.

O'Reilly: Have a good one.

DiLallo: You, too.

O'Reilly: That's it for us, folks. We would like to give a special shout-out to our producer,Austin Morgan, who's behind the glass as we speakworking his video and audio magic. Ifyou're a loyal listener and have questions or comments,we would love to hear from you. Just email us at industryfocus@fool.com. Once again, that's industryfocus@fool.com. Asalways, people on this program may have interests in the stocks they talk about, and The Motley Foolmay have formal recommendations for or against those stocks,so don't buy or sell anything based solely on what you hear on this program. For Matt DiLallo, I am Sean O'Reilly. Thanks for listening, and Fool on!

Matt DiLallo owns shares of Enterprise Products Partners and Kinder Morgan. Matt DiLallo has the following options: short January 2018 $30 puts on Kinder Morgan and long January 2018 $30 calls on Kinder Morgan. Sean O'Reilly has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Kinder Morgan and Spectra Energy. The Motley Fool owns shares of Devon Energy, and EOG Resources. The Motley Fool recommends Chevron, Enterprise Products Partners, and Southern Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.