Devon Energy An Unlikely Merger Partner in 2010

About a month ago I wrote about Devon Energy’s (DVN) plan to focus on North American on-shore energy exploration by disposing of its off-shore and international properties in 2010. Essentially the company has too many properties to drill for oil and natural gas and not enough capital resources to fund all of the potential projects. By selling off their international and off-shore properties Devon can reduce debt and focus its future exploration efforts on the very promising on-shore acreage they have, boosting shareholder value in the process.

Despite the restructuring plan announcement just last month, Devon’s name is being thrown around as a possible M&A partner now that XTO Energy has been gobbled up by Exxon. I find it unlikely that in light of the deal announced this week that Devon would all of the sudden scrap its 2010 asset disposition plan and instead entertain buyout offers from larger energy players.

Judging from Devon’s stated strategy it does seem that they share Exxon’s bullish stance on North American on-shore shale properties. After all, they are selling other assets to focus their company on those plays going forward. As a result, it seems to me that Devon already owns enough attractive assets that it prefers to go it alone and build a leading North American energy producer.

Now surely a larger company with less attractive assets may covet a company like Devon, but I do not believe given the firm’s recent strategy announcement that it feels like it needs to partner with a larger firm to create shareholder value from those assets. Of course the company would need to strongly consider any significant premium they may be offered for the entire company, but in terms of companies positioned to benefit from doing a larger M&A deal, Devon Energy does not seem to fit that mold.

Like Chesapeake, which I mentioned yesterday, Peridot Capital is also invested in Devon, but again not necessarily for the prospects of a takeover. Rather, the company already has plenty of assets (and after their asset disposition plan is complete, ample capital) to boost their stock price significantly long term. Unless a large energy company has both an interest in the assets that Devon is putting up for sale, as well as a desire to boost its on-shore shale exposure, I believe it is unlike that Devon agrees to a takeover anytime soon.

Full Disclosure: Peridot Capital was long both Chesapeake Energy and Devon Energy at the time of writing, but positions may change at any time.

Chesapeake Energy Unlikely Next Energy Merger Partner

On Monday I showed data on the mid-sized energy firms that could be next in line to be acquired on the heals of ExxonMobil’s (XOM) $31 billion buyout of XTO Energy (XTO). Today I wanted share my personal view that I do not believe natural giant Chesapeake Energy (CHK) will be next in line to be gobbled up if indeed the XTO deal sets off a domino effect in the industry.

For those who do not follow Chesapeake, they are one of the largest independent natural gas producers in the United States and the most gas-heavy exploration and production firm on the short list of possible buyouts going forward (about 90% of the present value of CHK’s reserves are natural gas).

A lot has changed for Chesapeake over the last 18 months. Back in July 2008 natural gas prices were a lot higher than today and Chesapeake, as the largest leaseholder of gas-producing acreage, was busy inking exploration partnerships for its massive shale properties. Big energy companies were eager to gain access to vast gas reserves and Chesapeake was interested in sharing some of the development costs to reduce their growth financing needs.

Shares of Chesapeake Energy peaked at $74 each in July 2008.  The company’s  co-founder and CEO, Aubrey McClendon, had been aggressively buying the stock on the way up, signaling his optimism over the company’s future prospects. At the peak, McClendon owned 5.2% of the company and those 34 million shares were worth a whopping $2.5 billion. Things could not have looked better.

Amazingly, within 5 months the tide had completely shifted. Natural gas prices began to decline as the financial crisis and subsequent recession began to rear their ugly heads. As the economy weakened demand for natural gas would drop and Chesapeake’s profits would take a hit. Then in December 2008 the stock started to drop a lot faster than its peer group. Rumors began to swirl that there was a large seller of the stock and that it might in fact be the company’s CEO. Chesapeake shares hit rock bottom around $10 each in December, down about 85% in just 5 months.

As rumors continued to run rampant about what was happening the company issued a press release informing investors that in fact McClendon had been issued a margin call by his brokerage firm and was forced to sell 93% of his holdings in the company. It turned out that McClendon had been using margin (borrowed money) to build up his stake over the years.

If that seemed reckless, despite his optimism about Chesapeake’s future, it turned out to be even more reckless given that he did not seem to hedge any of his massive margined stake even when the stock peaked and was worth billions of dollars.

Given the events that had transpired and how shocking they were, one can certainly understand why the stock began to lag the natural gas sector. After all, if McClendon could be so careless with his own money, who knew what he might do with shareholders’ capital. The stock did rebound from a panicked low of $10 to the 20’s in subsequent months, but it continued to lag behind its rivals; companies that carried a lot less baggage.

After such an embarrassment, McClendon vowed to slowly rebuild his stake over time, but he has yet to do so. He still owns 2.4 million shares of Chesapeake (a 0.4% stake) worth nearly $60 million but that has to feel like nothing compared to what he once had. And that is why I doubt Chesapeake will be the next natural gas company to be sold.

While it is pure speculation on my part, I do not believe that McClendon, who co-founded Chesapeake with Tom Ward (who now runs SandRidge Energy), would be extremely anxious to sell the company after he allowed $2.5 billion of equity to disappear within a matter of months. McClendon remains CEO and shows a lot of passion about continuing to grow the company himself.

In my view, the only motivation for him to sell at this point in the natural gas cycle would be to lessen his work load and cash out financially. While $60 million may seem like a lot to you and me, it may not be an attractive option for McClendon (or even $70 or $80 million if he accepted a premium) considering that he owned a 5%, $2.5 billion stake as recently as mid 2008. Furthermore, with natural gas prices in the tank lately it would be a reasonable argument to claim that it would not be in the best interests of shareholders to sell now either.

More likely I would bet that McClendon does in fact want to build up his stake again (maybe not back to 5% but somewhere above his current 0.4%), sell at a time when the natural gas market is a bit more favorable, and really cash in on the company he has built from nothing over the last two decades.

As a result, I really do not expect Chesapeake Energy to be sold in the near term (say the next 3-6 months at least). It just does not seem to be something McClendon would entertain given where we are right now in the natural gas cycle and what he has been through over the last couple of years.

McClendon is usually outspoken on quarterly conference calls, so perhaps he will even address the M&A landscape and his current thinking on the company’s fourth quarter earnings call in early February. If he does, I will be sure to keep you all posted.

All of that said, Peridot Capital continues to invest in the company. I believe it has excellent leverage to the future of the natural gas market, which will likely turn around sometime in the not-too-distant future as currently low prices discourage gas production. I am just not banking on a blockbuster merger anytime soon.

Full Disclosure: Peridot Capital was long shares of CHK at the time of writing, but positions may change at any time

Will ExxonMobil-XTO Spark Energy M&A Boom Like 1998-2001?

I have decided this will be “energy week” on the blog. I have a total four posts in mind including yesterday’s about Exxon’s decision to buy XTO Energy. I have reiterated what many people have said, that Exxon may have started a chain reaction of rather large energy mergers. Is there a precedent for such a run on quality energy assets? Absolutely.

Consider the period from 1998 to 2001, the last large energy consolidation. Large energy companies have a history of “me-too” transactions in order to avoid falling behind the competition in terms of size and scope of energy producing properties. Take a look at how many mega mergers were announced between 1998 and 2001:

  • Exxon buys Mobil
  • Conoco buys Phillips
  • BP buys Amoco
  • Chevron buys Texaco

Many energy industry insiders are thinking we could see a repeat of this now that Exxon Mobil, a conservative deal maker (they have not done a large deal since Mobil), has gotten the ball rolling.

So which targets are most likely to be gobbled up first? Interestingly, I have more of  a strong view on which firms likely will not be sold in the short term. More details on those later this week.

Exxon Buy of XTO Could Start Energy M&A Domino Effect

I love Monday mornings for the sole reason that they are often very exciting from a merger announcement prospective. Many have expected lots of merger and acquisition activity in the energy sector but until today there was very little going on there. With this morning’s announcement that ExxonMobil (XOM) is buying XTO Energy (XTO) it appears that the long anticipated trend of consolidation in mid-sized North American energy companies (most notably the unconventional natural gas producers) may be under way.

Exxon is paying a 25% premium for XTO Energy, one of the five companies always rumored to be on the short list of possible major oil company targets. Exxon is a conservative dealmaker so the fact that they are shelling out $31 billion ($41 billion including debt assumption) for XTO shows that they not only liked what they saw and the price they got. Other leading oil giants (think the likes of BP and Shell) are likely scrambling to draft their own plans to follow suit to ensure they do not get stuck with inferior growth properties. The majors are lacking an excess of replacement fields for the huge amounts of energy they produce each year, so a large acquisition is really the best way to secure future growth opportunities in a very competitive energy market.

So who might be next? I have compiled a list of the obvious targets, including valuations, to show you exactly why Exxon likely chose XTO (it was the cheapest company in the group), what other firms are likely going to have their tires kicked in coming months, and which of the remaining independent firms may be most attractive from a price tag perspective. Exxon is paying 6.6x trailing cash flow for XTO, so we can expect that to be the yardstick off of which future deal negotiations will be based.

xom-xto

Full Disclosure: Peridot Capital was long Chesapeake and Devon at the time of writing (yeah, unfortunately no XTO) but positions may change at any time.

Devon Energy Asset Disposition Plan Should Bode Well For Shareholders

Devon Energy (DVN), a leading oil and gas exploration and production company, announced yesterday an asset disposition strategy for 2010 that appears to be very accretive for equity holders should it be completed as planned. Devon announced that it plans to sell its Gulf of Mexico and international operations next year in order to focus on North American onshore energy properties. The sales are expected to bring in between $4.5 and $7.5 billion on an after-tax basis.

Devon’s stock rose $3 to $71 on the news as investors realized that Devon simply had too many properties to explore given its finite financial resources. By selling non-core assets and using the proceeds to focus on their strongest properties, Devon should be able to operate in the most efficient and shareholder friendly way.

A deeper look at the numbers shows a very attractive proposition for stockholders. Devon believes it can reap $6 billion from their gulf and international assets, which represents about 20% of the company’s current equity market value of ~$30 billion. These same assets only represent 7% of the firm’s energy reserves and 11% of current production. Since energy production companies are largely valued by investors based on reserves, selling these assets appears to be a very smart move for Devon. Clearly Wall Street is undervaluing these assets if indeed Devon can get $6 billion for only 7% of the company’s reserve base.

In addition, Devon will see its exploration expenses drop meaningfully after shedding these non-core assets. These non-core assets currently account for 29% of Devon’s annual capital expenditures. So, not only is Devon trying to unload assets that are undervaluing the company, but they are also the company’s most expensive assets to develop.

To recap, Devon currently spends 29% of its capital budget to develop only 7% of their reserves and it believes it can sell those assets for 20% of its current equity market value. This looks like a no-brainer for Devon and its shareholders.

As previously mentioned, Wall Street applauded the move, sending Devon shares up $3 to $71 after this strategic announcement. Since I am not fan of buying stocks after a big move up, now might not be the best time to scoop up the stock, but if it drops back to $65 or lower I will likely take a hard look at it based on recent developments.

Full Disclosure: Peridot Capital had a position in Devon at the time of writing, but positions may change at any time

U.S. Energy Department Paves Way for Nuclear Power Plants, Public Companies To Benefit

You may have heard that the U.S. Department of Energy is planning to offer $18.5 billion in loan guarantees for the construction of more nuclear power plants. Not only would additional nuclear capacity reduce greenhouse gas emissions, it would also help private energy companies boost their market positions. Federal loan guarantees will reduce the cost of capital and make expanded nuclear power an easier goal to attain.

This is good news for investors too, as four publicly traded companies will share the $18.5 billion raised. The companies include NRG Energy (NRG), Scana (SCG), The Southern Company (SO), and UniStar, a joint venture between France’s EDF and Constellation Energy (CEG). These utility stocks are already fairly inexpensive on a valuation basis, with high dividend yields, so new future growth opportunities will only make them even more attractive.

The growth will help some more than others (Southern, for example, is a huge power player already, so nuclear might not make a large dent in their business), but I believe ventures like these serve to identify the leaders in the energy transformation movement. As a result, investors may want to take a closer look.

Full Disclosure: Peridot Capital was long shares of Constellation Energy preferred stock at the time of writing, but positions may change at any time

Suncor/Petro-Canada Combo Could Be First Of Many Energy Deals

Today we learned that two of Canada’s largest oil producers, Suncor (SU) and Petro-Canada (PCZ), are merging in a $15.5 billion deal due to close in the third quarter. More large commodity-related deals, especially in the energy sector, could be coming. Despite the global recession, the long-term fundamentals for the commodities sector remain intact. Lower demand is clearly going to have a large effect on demand near-term (prices have already come down a lot in most cases), but unless you think the global economy will not recover, commodities will serve as an economic barometer going forward, in both directions.

When you couple temporary price declines (in the actual commodity as well as the stock prices of the large producers) with long term bullish industry trends and supply limitations (lack of credit availability limits exploration and drilling projects used to boost supply), mergers in the current environment are going to look attractive to CEOs who are anticipating the commodity markets will rebound when the economy does.

While I don’t have specific companies in mind that have a better chance of being acquired than others (I would have preferred Suncor to be a seller rather than a buyer, given Peridot’s long-term position in the company), but I would expect this energy deal to be just the first in a series of large deals in the next couple of years.

Full Disclosure: Peridot was long shares of Suncor at the time of writing, but positions may change at any time

El Paso Debt Deal Shows High Yield Market Isn’t Dead, Just Expensive

To get an idea of how bad the high yield debt market is right now, one need only look at what price El Paso (EP) had to pay this week to issue $500 million worth of senior notes. El Paso is a solid company and should not have trouble selling debt. Their hybrid business model; energy pipelines coupled with exploration and production, makes their cash flow more predictable than more narrowly focused energy companies.

Still, El Paso is paying 12% interest and even with such a coupon rate, could not sell the notes at par. Instead they discounted them to entice buyers, who will earn 15.25% by holding to maturity. Why did EP sell such expensive debt? They have more than $13 billion of debt, with more than $1 billion coming due in 2009, and wanted to refinance until 2013.

Hopefully deals like this will continue. While they do not represent bargains for issuing companies, an increase in corporate debt offerings will be crucial for getting improvement in the corporate debt market. Once it becomes more clear that companies can issue new debt (even at high prices), the pressure on common stock prices of highly leveraged firms will abate, removing one of the largest elements of fear in today’s equity market.

Full Disclosure: Peridot was long shares of El Paso preferred stock at the time of writing, but positions may change at any time

Insane Valuation Case Study: Valero Energy

It is pretty easy to find ridiculously low stock valuations in today’s market, but here’s an example of the value present in the current bear market. Valero Energy (VLO) this morning reported third quarter earnings of $1.86 per share, well above estimates. The stock closed yesterday at $15 per share, which gives it a P/E ratio of 8 based solely on one quarter’s worth of earnings! Insane.

Full Disclosure: Peridot was long VLO at the time of writing, but positions may change at any time

Yes, Oil Demand Should Keep Growing

A few months back we had people calling for $150 and $200 oil, but now many people are saying $50 or $60 is not only possible, but likely. What a difference hedge fund liquidations and a recession can make. Is the oil bull market over, or just put on hold due to an impending global recession? My best guess is the latter.

Consider the charts below. They show crude oil consumption for this decade, with current 2009 estimates included. The first one shows oil consumption in the U.S. which isn’t very impressive and screams lower prices. After all, we represent 5% of the world’s population but consume 25% of the world’s oil.

Not so fast though. Here is a chart of oil consumption worldwide. It shows a much different picture.

Will the current recession result in a reversal of this graph? Probably not to any large degree. The line will flatten surely, and perhaps even dip slightly, but by the time that happens any global recession will be mostly over and demand growth will be set to resume alongside economic growth. Long term I still think the oil bull market remains intact until we truly start replacing large amounts of oil consumption with alternative fuels.