There's been no shortage of mergers and acquisition among exploration and production (E&P) companies this year, particularly in the red-hot Permian Basin region.
Given the flurry of activity in recent months, how should investors play E&P stocks?
"I like almost every acquisition being done in the Permian these days," said Jim Collins, founding partner of Portfolio Guru and Real Money contributor.
There were 93 M&A announcements in the third quarter of 2016, totaling $16.6 billion, according to a recent report by the U.S. Energy Information Administration. So far, nine deals worth at least $1 billion or more were made in the third and fourth quarters of this year, and deals in the Permian Basin "accounted for more than half of the total deal value in the fourth quarter to date on only six of 28 deals," the EIA wrote.
Looking at some of the notable billion-dollar deals in the Permian, the most recent was Action Alerts PLUS holding Occidental Petroleum (OXY) . The company announced a $2 billion transaction -- to be fully funded by cash on hand -- on Oct. 31.
Collins thinks the deal is the "right thing strategically" because, as the EIA notes, the Permian Basin is the only region where oil production is expected to increase in November.
Meanwhile, Jim Cramer and Jack Mohr, portfolio managers for the Action Alerts PLUS (AAP) charitable trust, "approve" of Occidental deepening its resource inventory in the Permian. However, they question the cost of getting those premium assets.
"Although we do not believe the market will frown upon the idea behind the investment, the costs for the resources seem high at first glance," wrote Cramer and Mohr in a note to subscribers on Nov. 1.
Analysts at Jefferies estimate the cost at $35,000 per acre, before assigning any value of infrastructure. However, they also note that the company's "very moderate pace of drilling will burden its full cost economics including the acquisition costs," adding that Occidental will only be operating six rigs in its Permian resources in 2017. The analysts rated OXY shares Hold with a $69 price target.
Furthermore, the AAP portfolio managers said the increased investments in Permian growth areas "will drive an expected capex of $3.3 billion to $3.8 billion," which Cramer and Mohr believe raises questions about cash flow generation and dividend coverage obligations.
While Occidental made a positive move for its long-term growth strategy by adding assets in the Permian, AAP intends to hold the name throughout the cycle and "for at least the next 12 months, barring a structural or fundamental change in the company's story."
However, AAP just downgraded OXY shares to Three from Two, meaning it is a stock the portfolio would sell on strength.
Billion-Dollar Permian Deals
SM Energy (SM) , which has a $2.79 billion market cap, has also made a couple of moves in the Permian Basin. On Oct. 18, the company said it will sell $785 million in Williston Basin assets in the Bakken region and spend $1.6 billion in cash and stock to acquire 35,700 net Permian Basin acres from QStar. That acquisition follows its Aug. 8 agreement to purchase 24,783 acres of Permian Basin rights in Howard County, Texas, to expand its Midland Basin footprint.
The company anticipates Permian production growth to increase 165% in 2017 and 80% in 2018, with outspend projected at $175 million in 2017 and $300 million in 2018. But SM Energy is also expecting the non-operated Eagle Ford sale proceeds to exceed the estimated outspend in 2017 and 2018, with plans to align capex and cash flow in 2019.
"While we can easily get to the Permian production growth numbers that [management] provided, our 2017/2018 outspend is greater at $185 M/$445M," wrote analysts at KeyBanc Capital Markets on Nov. 2. They noted that the company looks to cover this cash flow deficit from its Eagle Ford sale, which the analysts estimate could receive $600 million to $800 million. They now look forward to delineation results from the recently acquired acreage in the Permian and official 2017 guidance. KeyBanc rated SM shares Overweight with a $47 price target.
Meanwhile, EOG Resources (EOG) had one of the more sizable Permian Basin acquisitions. On Sept. 6, EOG and Yates Petroleum agreed to combine. The move allowed EOG to double its acreage in the Delaware Basin, which is part of the Permian Basin.
"It is an aggressive move which indicates EOG's optimistic view of both oil prices and the Permian in particular," Real Money contributor Daniel Dicker said via email. Collins also thought EOG's Permian purchase "made sense."
Furthermore, one of Collins favorite Permian Plays is RSP Permian (RSPP) . RSPP announced in the middle of October that it would pay $2.4 billion for Silver Hill Energy Partners. Assets included 41,000 net acres in northeast Loving County and northwest Winkler County, both in Texas, with current net production of 15,000 barrels of oil per day from 58 producing wells and 3,200 undeveloped locations.
"We believe RSPP's acquisition bolsters the bull case going forward, despite paying what was on an acreage basis the highest price thus far in the Delaware," wrote Canaccord Genuity analyst Sam Burwell following the announcement. "The company now enters one of the best parts of the basin accretively while maintaining a relatively clean balance sheet and improving its debt-adjusted cash flow growth trajectory," Burwell added. He rated RSPP shares Buy with a price target of $50.
Other Permian Plays
Collins also likes Diamondback Energy (FANG) and PDC Energy (PDCE) for Permian plays. He believes all three names "offer attractive long-term returns if purchased at today's levels."
Investors shouldn't expect news out of the Permian to slow down. In fact, earlier this week Royal Dutch Shell (RDS.A) revealed more moves in the area. CFO Simon Henry said during a conference call with analysts that the company is selling "two smaller packages" of land in the Permian but will consider acquisitions in the area.
"[The Permian] is the crown jewel, not just in terms of the value and quality of the asset, but also the capability that is being developed there," Henry said.
