The trade war with China has caused investors to overlook catalysts for firming oil prices and put another chill in oil stock prices. The trade war will end eventually. In the meantime, China is stimulating and the U.S. Federal Reserve is about to end QT - Quantitative Tightening.
Catalysts for rising and firming oil prices the next 12-18 months include:
- Iran sanctions enforcement
- Potential escalation of the Middle East conflict (as I discussed President Trump validating Iran conflict thesis)
- Venezuela and other oil production disruptions set to last at least a year
- Shale production growth slowing for financial and technical reasons
- Lack of EV penetration until the early-to-middle 2020s
When Occidental Petroleum (OXY) took Anadarko (APC) from Chevron (CVX) with a better bid, it should have woken investors up to a pair of facts. First, consolidation in the oil patch to create scale and costs synergies is kicking into overdrive. Second, the most desirable companies to purchase or merge with have significant Permian acreage.
Use this pullback to buy these 5 Permian "pure plays."
M&A Will Pivot On The Permian
The Permian Basin is the key oil shale field in America. It accounts for over 75% of American production growth overall (with Gulf of Mexico accounting for most of the remaining) and virtually all of shale production growth. The Permian is where the best assets are. Other shale assets are merely add-ons to Permian assets.
The STACK/SCOOP in Oklahoma, Powder River Basin, Eagle Ford and Bakken are secondary plays at this point. The Niobrara is a mixed bag, with Colorado assets potentially becoming lost reserves.
According to Baker Hughes, the Permian employs 463 of the 1045 rigs in America. Most of the wells are oil-seeking and horizontally drilled.
The magnitude of drilling in the Permian relative to all other plays is demonstrated by the rigs, a new set of pipelines completing construction in coming quarters and overall production of 4 million barrels per day (U.S. EIA) out of 12.2 mbd total U.S. production (U.S. EIA).
To make the Permian even more prolific and more profitable for producers, the ability to drill longer laterals is important. That means combining adjacent acreage is very important.
There are over 500 acreage holders in the Permian. Significant consolidation must occur in order for companies to pay down debts and return cash to shareholders. That is a point critics of the Occidental acquisition of Anadarko miss. Occidental and Anadarko acreage were adjacent in several areas in the Delaware Basin side of the Permian. Occidental, while outbidding Chevron, got the acreage for the same price it has traded for two years.
In my weekly webinar a couple weeks ago, I covered 8 Permian Oil Merger & Acquisition Candidates to describe how we could see deals develop.
Permian Pure Plays
Concho Resources (CXO), Diamondback Energy (FANG) and Parsley Energy (PE) are Permian pure plays that have valuable assets in both the Delaware Basin and Midland region of the Permian. All three are potential targets of Chevron, Exxon (XOM), Royal Dutch Shell (RDS.B) and, possibly, BP plc (BP), which entered the Permian last year with a purchase of BHP assets.
Centennial Resource Development (CDEV), run by industry legend Mark Papa, is a Delaware pure play. It is almost certain to be bought out due to its proximity to other operators, but also a need for scale. The company will be a bolt-on acquisition for another. It could even be acquired by Concho or Diamondback before they engage in another strategic transaction. Chevron could clearly gobble the company up as well.
Pioneer Natural Resources Company (PXD) is a Permian pure play now and would clearly be attractive as a takeover target by the Majors. A potential hang-up is that the CEO recently said the company is not a takeover target. Pioneer is also a merger candidate with Concho Resources, Parsley Energy or Diamondback Energy. I could actually see Pioneer acquire Parsley. In such a transaction, they company would keep the Midland assets and likely sell the Delaware assets.
Who Will Buy In The Permian?
The obvious candidates to buy in the Permian are majors Chevron, Exxon, Royal Dutch Shell and BP plc that already have Permian acreage. These companies also have the financial might right now to make purchases. They can use cash on hand, financing and, for the moment, money generated by divesting non-core assets.
There are also several shale U.S. shale players that could buy or merge with Permian producers, expanding their footprint in that basin.
ConocoPhillips (COP) is the largest of the independents and has divested significant other assets in recent years. The company is now flexible enough to make a major acquisition in the shale patch. It could seek a Permian pure play or a more diversified shale player with overlapping assets in multiple fields.
We already know that Devon Energy (DVN) is in merger talks, though we don’t know with whom. It could seek a Permian pure play or a company with overlapping assets in multiple shale fields.
Encana Corp. (ECA) has a similar profile to Devon in that it has valuable assets across several North American plays, including valuable Permian acreage. The company recently merged with Newfield Exploration. Encana is planning to sell the rest of its non-core assets to become very cash flow-rich now and in the future. It could be an outright takeover target by a major or a potential merger candidate with a company like Devon.
Marathon Oil Corp. (MRO) has assets across U.S. shale plays, including the Permian, Bakken, STACK/SCOOP and Eagle Ford. It could be a merger candidate with another mid-tier company to create a larger company with more scale and operations synergies. Marathon could also be a takeover play for the majors.
EOG Resources (EOG) could also be a sensible merger candidate for multiple companies. It is a potential takeover target for the majors, though I think the company grows through mergers.
Buy These Permian Oil Stocks
In general, I like the Permian pure plays best, as they can most easily be bought or merged. I rate Parsley Energy, Centennial Resource Development, Concho Resources, Pioneer Natural Resources and Diamondback Energy as Strong Buys.
The companies operating in multiple basins are takeover targets, though also very likely to engage in mergers of near equals. Mergers don't give as big of an immediate price boost but might provide better returns long term. I rate Devon Energy, Encana Corp. and Marathon Oil Corp. as Strong Buys, with ConocoPhillips and EOG Resources as Buys.
Remember to mind your asset allocation. Energy only makes up about 7% of the S&P 500 at this point. A double or triple weighting makes sense, to my mind, but further than that enhances your risks if the "end of the oil age" is closer than we think. A basket of a dozen or so of these stocks makes a lot of sense for those seeking some insulation from company-specific risk.
Margin of Safety Investing's 4-Step Process And Kirk Spano's Team Of Analysts Can Help You In A Rapidly Changing And More Dangerous World.
Right Now, Try Margin of Safety Investing Free For Two Weeks And 20% Off Your 1st Year.
Disclosure: I am/we are long CDEV, PXD, ECA, DVN, PE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.