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.


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.

Airline CEOs: Hedge Your Fuel Costs Now

We have seen crude oil prices fall 50% from $150 to $75 per barrel. Aside from Southwest Airlines (LUV), my preferred air carrier for many years (for traveling, not investing), the other airlines missed the boat on hedging fuel costs and paid the price as the oil spike wiped away their profits after the last round of bankruptcies. If they were smart, they would begin hedging right now. Given the economic problems we are facing and the fear of a global economic recession, oil is on sale due to temporary factors and global demand is still growing (more on this in coming days).

Sure,oil could get even cheaper in 2009 as the economy weakens, but that would be the time to increase the hedges further as prices fall. Once the economy rebounds we will see $100 oil again and those who hedged will look very smart. Legacy carrier CEOs might not be used to being called smart, but they certainly should give it a try.

If any airline workers are reading this, pass along this advice to your bosses. Airline CEOs: start hedging your fuel costs now and increase them should oil prices continue to fall during the recession. Global oil demand is not going to start falling anytime soon, and falling gas prices today are just going to reaccelerate the demand growth that has fueled the commodity bull market.

Full Disclosure: No position in Southwest Airlines stock at the time of writing, but positions may change at any time. I do, however, have a Southwest Visa card in my wallet.

Don’t Borrow Money to Buy Stocks

Much of the recent market decline has been due to forced sellers like hedge fund and mutual fund managers that have had no choice but to sell stocks they own due to redemption notices from their panicked investors. In many cases, forced selling has also taken the form of margin calls.

Consider the shares of long time Peridot favorite Chesapeake Energy (CHK) which fell 50% in just the last 3 days of last week. The stock movement felt like panic selling and late Friday we learned that the company’s largest shareholder (the co-founder and CEO) was forced to sell most of his 5% stake in the company between Wednesday and Friday. Why? To meet brokerage margin calls that were triggered because he had bought the shares in part with borrowed money.

For the most part, I would never recommend that individual investors borrow money to buy stocks. Every so often there are arbitrage opportunities that can be completely hedged and therefore using margin can pay off if downside risk can be hedged away, but speculating on a stock price’s future movement based on fundamental bullishness (as was the case with CHK) with borrowed money is a recipe for potential disaster.

Aubrey McClendon, Chesapeake’s CEO, has paid the ultimate price by being forced to sell 94% of his stake in his own company in the middle of one of the most panicked weeks the market has ever seen. Don’t make the same mistake he did by speculating with borrowed money. Leverage has crushed the investment banks, but it can get individuals in deep trouble too.

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

With Oil Down 25%, Is The Bull Market Over?

After seeing the price of crude oil start the year around $100 per barrel, peak at nearly $150, and come nearly all of the way back, where does the oil market go from here? It is interesting to see how many people no longer think we see a range of $150 to $200 anymore. The Goldman Sachs year-end target of $149 is now considered overly bullish by most pundits. Is the bull market in oil over?

The sharpness of the recent decline lends some credence to the belief that much of the 2008 price spike was related to speculative trading activity. After all, the move from the 120’s to the 140’s came with nearly no new information that would lead one to think the supply/demand balance had changed materially. Daily price swings of $5+ became commonplace without significant events accompanying them. Now with oil down about 25% from its high, calls for $70 or $80 oil are easy to find.

Personally, I think it is important to note that the fundamentals of the oil bull market remain intact. Global demand is growing faster than global supply. It is true that we began to see demand destruction once crude passed $140 per barrel, but since that level was merely temporary, a price of $110 or $115 all of the sudden looks reasonable again. Should we expect gasoline demand to continue to drop at the same pace when gas drops from over $4.00 to under $3,50 per gallon? Probably not.

Even if demand growth drops in the United States and China and India see lower GDP growth levels, oil demand should still rise in coming years. Consider 2008 worldwide demand. Despite the price spike we saw this year, daily global consumption is estiamted to rise 1% to 86.3 million barrels per day. That comes on the heals of a 1% increase last year and another 1% increase forecasted for 2009.

In any bull market there are periods of sharp spikes higher and even sharper declines. Looking at the global economy, it is hard to argue that oil demand will not continue to grow. Sure, alternative energy sources can cut that growth rate noticeably, but with each and every price correction brings less pressure to really promote alternatives in a meaningful way.

A price correction moving toward $100 per barrel, without significant fundamental changes in the outlook for crude oil demand and supply and demand, makes me think triple digit oil prices are not going to become a thing of the past any time soon, for an extended period of time anyway.

From an investment perspective, leading oil producers have seen serious price per share declines, which now imply long term oil prices of far less than $100 per barrel (most are between $70 and $80 per barrel). If you think the next three to five years will see triple digit oil, as I do, then the stocks are going to prove to be excellent investments from here.