Three Best Ways to Play Oil’s Coming M&A Boom
The U.S. shale boom has created its fair share of millionaires. Now we’re seeing a historic shift in how the industry operates, one that presents us with new profit-making opportunities.
You see, pressure from lower oil prices and higher debt costs means that many shale oil companies will have to sell assets or be acquired, giving well-positioned investors the chance to see shares jump in price.
Now, the talking heads will tell you that this is the time to get out of the industry completely. But the trick during any consolidation wave is to invest in companies targeted for acquisition before the herd moves in, so that you can benefit from the bump in stock price as the acquisition is announced.
That’s why I’ve prepared this watch list of shale oil companies with choice drilling assets and leases in the best locations and with the best performance records, so that you too can benefit from the oil industry’s wave of mergers and acquisitions (M&As).
Why the Oil Sector is Consolidating
There are two main factors behind the wave of M&As about to hit shale oil in the fourth quarter of this year. First, the decrease in oil prices has, as you might imagine, decreased revenue streams.
Second, shale oil extraction companies have historically operated mostly on loans, not revenue. Because of this, they depend on the ability to roll over their debt to keep operating. In the past, this worked fine.
But as oil prices have decreased, so has the market value of the reserves that these companies have on their books. And as these decrease in value, creditors are left with less and less collateral in case the loan is defaulted on. And so they demand higher yields.
Even before the recent plunge in oil prices, energy debt traded on the upper end of the high-yield debt curve (i.e. junk bonds). But as you can see in this chart, recently the yield curve for high-yield (HY) energy bonds has exploded:
As junk bond yield rates increased, energy yields expanded even quicker. The annualized rates for high-yield energy bonds are now in double digits and rising.
Because shale oil extraction companies have historically operated mostly on loans, not revenue, they need to be able to roll over debt to stay afloat. But with debt financing increasing in cost at the same time revenues are declining, shale oil companies are finding it increasingly difficult to roll over their debt.
Now, oil prices will rise again, albeit in a ratcheting pattern, with an upward trend punctuated by downward volatility. With global oil demand expected to reach record levels this year, the survivors of this M&A wave in shale oil stand to create huge returns for investors in the future.
The increasing cost of finance will mean a wave of mergers and acquisitions toward the end of this year as stronger companies buy up their cash-poorer competitors. Well-positioned companies with the best assets will be the prime targets for acquisition during this M&A cycle.
This is about to hand us some great profit opportunities, as M&A targets will see a boost to their stock price as they are acquired, while the survivors emerge stronger.
The Three Shale Oil Companies to Watch
The prime targets in this M&A wave will be companies with prime wells and leases in the best shale plays and the lowest operating costs. The better the assets, the higher the premium commanded, which in turn will give investors the highest returns as the consolidation phase begins in earnest.
The Eagle Ford and Delaware Basin shales, especially, are plentiful enough in oil and gas to make breakeven prices approach $35 per barrel, making companies with leases there prime acquisition targets.
These are exactly the kind of companies I’ve been keeping tabs on with my watch list.
You see, when companies get acquired, a premium is paid on their stock price, giving a boost to shareholders. So investors who buy stock just before the companies are acquired stand to make hefty profits as the merger is announced and the stock jumps.
This process has already begun with shale producer WPX Energy Inc. (WPX) buying privately held RKI Exploration & Production LLC, with operations in the Permian basin, for $2.35 billion, and Marathon Petroleum Corp. (MPC) offering to buy MarkWest Energy Partners LP (MWE) for $15.8 billion.
That amounted to a 32% premium on MWE’s stock price at the time the offer was announced.
These are the kinds of gains well-positioned investors can expect as shale oil’s consolidation picks up speed toward the end of this year.
And more deals like these are coming. Here is my shale oil M&A watch list, with the three shale oil companies to watch as the industry consolidates:
Callon Petroleum Co.
Recent Price: $15.37*
YTD Change: 89.75%
*As of 1/2/2017
- Callon Petroleum Co. (CPE) is an oil and natural gas extraction company operating in the Permian Basin in Texas, the most prolific oil-producing region in the U.S., and one of the cheapest to extract oil from, with breakeven prices approaching $35 per barrel. Activist shareholder Jeff Eberwein, of Lone Star Value Management, who owns 4% of Callon Petroleum and has two board seats, has long been arguing that the company should be sold.
Strong assets and an activist investor make Callon Petroleum a prime acquisition target. Investors would do well to keep an eye on this company and any signs of a deal that would raise the stock price.
Contango Oil & Gas Co.
Recent Price: $9.34*
YTD Change: 45.94%
*As of 1/2/2017
- Contango Oil & Gas Co. (MCF) is a Houston-based oil and natural gas producer focused on shallow waters of the Gulf of Mexico and onshore finds in Texas and in the Rocky Mountain region. The Texas assets include wells in the Eagle Ford shale, which is one of the cheapest shale plays with breakeven prices approaching $35 per barrel. These assets make the company a prime target for acquisition, which would reward well-poised investors with nice returns.
Panhandle Oil & Gas Inc.
Recent Price: $23.55*
YTD Change: 40.68%
*As of 1/2/2017
- Panhandle Oil & Gas Inc. (PHX) is an oil and natural gas company with operations in Oklahoma, Arkansas, and Texas. The company does not operate any wells, but rather owns stakes in land and wells.
This business model makes it easy for Panhandle to sell individual assets as needed, and also a prime acquisition target as a whole. Either way, investors can expect a nice boost in stock price when such deals are made.
These three companies are the ones to watch as the shale oil industry moves into its consolidation phase.
Dr. Kent Moors
Editor, Oil & Energy Investor