Crude Questions: Mergers and Rising Prices

Can you briefly detail what has transpired in the energy complex over the last few weeks?

Over the past two weeks, Exxon (XOM) agreed to spend $60 billion (all stock) to acquire Pioneer, a prominent player in the Permian basin known for having the largest shale inventory among the Permian majors, according to most reports. Meanwhile, Chevron (CVX) announced Monday (10.23.23)  a $53 billion stock-based acquisition of Hess, albeit at a relatively modest premium. I have to figure both deals were many months in the works and not reactionary to anything recent.

Hess stock had appreciated substantially in the last three years owing to their joint position with Exxon in Guyana, where Hess held a 30% interest in several exploration and production blocks slated to hold 11 billion+ barrels (bbls) of producible offshore oil. Guyana’s offshore oil is fairly similar to that of Brazil – massive pre-salt conventional offshore deposits. Hess also has a sizable inventory of Gulf of Mexico (GoM) production and exploration sites, and is one of the largest Bakken oil producers. The Bakken has been in decline for a few years now, and as a single-layer shale formation far from most refineries, it does not carry the more favorable economics of the Permian or even Colorado.

Hess produces about 350 kbpd currently, but their 30% stake in Guyana should translate to around 400 kbpd just from Guyana once that is fully producing in a few years (thus putting Hess close to 800k bpd had it remained independent). Our annual gift from Hess, as we were once shareholders a long time ago, has been a Hess truck – I’m assuming these go away as a cost save.

Chevron, on the other hand, has committed to an 8% div raise in 2024 and upped their annual buyback range to $15-$20 bn per year from $12.5-$17.5 bn per year post closure. That’s a lot of stock but at the moment they are issuing a fair amount of shares. Including the PDC Energy deal completed earlier this year, Chevron would get back to the 2022 share count in 2027 by my math, which is not what we are really looking for as shareholders but the deal math does compute.

What are Exxon and Chevron up to?

In two words: getting huge.

Both deals are all-stock and at small premiums, which is an interesting message in terms of capital market dynamics. Nobody is taking on leverage to buy others out, while the stock of the acquirers appears to be a happy currency for billionaire CEOs Sheffield and Hess to receive as payment. Both Sheffield and Hess happen to be about the same age (~70) and obviously have some interest in cashing out. It’s clear enough that XOM and CVX are interested in adding producible reserves with substantial reserve life in politically stable jurisdictions (Texas, Guyana, GoM states, Dakotas). One of the main reasons that we have not pursued pure shale producers is the reserve life is not all that long in most cases (Pioneer was an exception, Hess is mainly offshore) and required capex to sustain and grow production is notably higher than other more conventional forms of production.

Both CVX and XOM are large enough companies that they could do more deals – it’s hard to say if they are done or not.  For Exxon, they will become the kings of shale, and can ratchet production/capex up and down as needed depending on the environment.

Pro forma these deals and with current production-growth plans projected into the future (2025-2028 range), Exxon should produce about 5.0-5.2 mm boe per day, versus 3.8 mm boe per day at the end of 2022, while Chevron should push into the 4.0-4.2 mm boe per day range versus 3.0 mm boe per day.  The United States’ current overall crude oil production is around 13 mm bbls per day.  Most observers expect this figure to rise to 14 mm bbls per day in 2025, but beyond this it’s not at all clear whether U.S. shale producers (and now big integrateds) can grow more and continue to sustain capital discipline promises.  We are skeptical, with three of the five major North American shale basins in decline in 2023.

If production plateaus around this level, CVX and XOM would represent a stunning 65% of U.S.  production on their own!  Obviously both companies produce globally so that is not a technically correct statistic.  But the point for energy investors will be hard to miss. The capitalization of the U.S. energy sector will be so concentrated in just two stocks that energy investing will become almost a binary decision.  Assuming one is investing in the space, should PMs just buy Chevron and/or Exxon, or venture out elsewhere?

Is this a good idea?

I am not sure either company specifically needed these acquisitions, but both CEOs do sound as convinced as anyone could be, that the cumulative underinvestment in supply is going to be a big problem going forward. Locking in long-lasting reserves makes sense if you believe that.  I’d rather see them grow reserves via exploration.

For the last ~10 years CVX has been the better of the two stocks to own, though XOM closed the gap substantially in the last 20 months, largely on the back of the higher production growth potential it had vis a vis its own position in Guyana. The two stocks will be almost indistinguishable from each other now in terms of reserve and production growth profiles. XOM has a bit more refining. Chevron will have a somewhat larger profile in LNG production, which most energy investors agree has the least long-term risk among hydrocarbons to disruptive technology, such as electric cars.   That’s about it. CVX will have some production elsewhere in South America (Argentina, Venezuela) that XOM does not have. The earnings power of these two majors will be pretty unreal in terms of headline net income. We don’t have a precise oil price forecast, but net income well over $50 bn and possibly approaching $100 bn in a super spike scenario are not implausible for either company.

Here’s one provocative thought: what if these stocks, as consistent dividend-payors with an intent to grow dividends come rain or shine, are better TIPS securities than current TIPS securities?  TIPS (Treasury Inflation Protected Securities) have their principal due at maturity indexed to CPI inflation.  These currently yield 2.45% for 10 year TIPS.  Exxon and Chevron are both rated AA by the major credit rating agencies, versus a split rating average of AA+ for the United States government.  In other words, there is not much difference.  If Exxon and Chevron managements are generally correct that hydrocarbon usage is unlikely to head south in the visible future, and lack of upstream investment continues to compound supply availability, then oil prices should correlate with inflation.  Alongside some consistent dividend growth, these yields (3.45% for XOM in 2024, 4.10% for Chevron in 2024) are markedly better than TIPS.  Stocks are not bonds, no, but it’s an interesting point of comparison.

What are your latest thoughts on the current price of oil?

Oil has shot up close to $90 per barrel (rising about $7) since the October 7 Hamas invasion of Israel.  An enlarged Israeli army is now massed around Gaza, while Israel continues fielding inbound rockets from various directions.  The game theory clearly is to try to entice Israel into a multi-front war with multiple armies and cause a massive regional conflict. This is all stirred up by Iran, who ironically has grown its production nearly 700 k bpd in the last year or so, as sanctions enforcement has been lax.

Obviously, there is no oil coming from Gaza (while there is LNG coming from offshore Israel nowadays, courtesy of Chevron). The $7 oil price increase is small and suggests a low market-assigned probability of anything like a full-blown blockage of the strait of Hormuz and some sort of modern-day Arab oil embargo.  Net – the market has assigned a very small fear premium, and oil stocks reflect very little change in longer-term oil price assumptions. Inventories are tight and the U.S. Strategic Petroleum Reserve has not been refilled in any appreciable way since being drained in 2022 – meaning that if the strait of Hormuz was actually blocked, it’s going to get bad. But the market does not believe that right now.

Global oil supply fears can and should focus on Iranian oil exports. Sanctions may be reinforced; however, this is easily replaced by Saudi oil not currently being produced. I am not going to offer any forecasts for how the Israel-Hamas war proceeds, though I see little chance the Israelis are willing to live with these fanatics on their border or retaining something that resembles sovereignty after the October 7th massacres. That is part of the basic problem of a two-state solution – if one state is persistently determined to invade the other and launch rockets with regularity, this is not going to ever work. Israel’s intelligence failure around the Hamas invasion will probably lead to some major changes in their own government, but only after the war is reasonably concluded.

In a quiet announcement, the U.S. government relaxed some sanctions on Venezuela, which was once this hemisphere’s largest producer of the heavy oil our current refining complex is set up to refine. It won’t change Chevron’s earnings/share all that much, but they are the only Western major in Venezuela and are needed to get oil producing there again. This seems to be a tacit acknowledgment that heavy oil availability can/will be a problem in the foreseeable future.

For the time being, it seems an oil price >$70/bbl is necessary to sustain capex in shale, and did bring about material OPEC cuts. That’s just one small but important data point. Something in the $80s as a production-inducing price may be more necessary longer term.