ConocoPhillips' $9.5 billion all-cash deal to acquire oil and gas giant Royal Dutch Shell PLC's Permian basin acreage reinforced ConocoPhillips' recently announced 10-year strategy while also helping Shell to achieve greenhouse gas emissions reductions goals, according to executives.

Through the acquisition, ConocoPhillips aimed to achieve economies of scale in the Permian's Delaware basin, a position the company expanded in October 2020 with its acquisition of Concho Resources Inc. The new acreage would be positioned to compete for capital within ConocoPhillips' global portfolio as the company seeks to dispose of $4 billion-$5 billion of assets in a bid to position itself for the energy transition, executives said.

"We're adding some of the most economically viable resources in the world while enhancing our compelling multiyear plan and maintaining a strong balance sheet," ConocoPhillips Chairman and CEO Ryan Lance said on a Sept. 21 conference call.

ConocoPhillips in June outlined a 10-year strategy to increase output by roughly 3% per year and achieve an average cash flow breakeven of $30 per barrel. By driving down its cost of supply, the company will try to increase shareholder returns while positioning itself to compete for dwindling demand in a world transitioning away from oil and gas.

The strategy assumes a $50/b West Texas Intermediate crude price and an average reinvestment rate of 50%, lower than the historical trend, reflecting efficiency gains and shale drillers' shift from a growth-oriented mindset to a focus on shareholder returns.

ConocoPhillips aims to 'core up' in Delaware basin

Lance said the Shell transaction "handily" met three criteria for greenlighting a deal: It matched ConocoPhillips' strict cost of supply and financial framework; it presented the opportunity to improve the acquired properties' value by applying the company's commercial and technical skills; and it will enhance the 10-year plan.

Within the framework of this plan, the deal will increase cash flow from operations by $20 billion to $165 billion and boost free cash flow by $10 billion to $80 billion over 10 years, the company projected. That will allow ConocoPhillips to boost shareholder distributions by $10 billion over the previous 10-year plan to $75 billion, roughly equivalent to the company's market cap today, Lance noted. The company increased its quarterly dividend from 43 cents per share to 46 cents per share as part of the announcement.

The acquisition would add roughly 225,000 net acres and 600 miles of operated oil, gas and water pipelines and infrastructure to ConocoPhillips' Permian basin assets. The company expected the acreage to yield about 200,000 barrels of oil equivalent production per day in 2022, with a production mix of 50% oil, 25% gas, and 25% natural gas liquids. Shell operates about half of the production, while equity partners operate the other half.

Parsing up the Permian acreage with some of these partners will likely drive some of the $2 billion in potential additional divestments that ConocoPhillips announced as part of the deal, though the company also intends to work with partners to improve operations at nonoperated wells, executives said. High grading, or focusing production on a company's best assets, will be a major focus for ConocoPhillips, they said.

"We have more things to work with in the Permian Basin that others might be interested in — that should allow us to core up, make sure we can drill the longest laterals," Lance said, referring to the horizontal drilling that underpins shale production. "That acumen came to us in large degree from the Concho transaction. That's what they had been doing for years."

'Free cash flow machine'

At the corporate level, unconventional shale oil and gas production generates steady cash flow that ConocoPhillips can use to fund legacy conventional assets with low capital needs in places like Alaska, Norway and Qatar, executives said. These assets in turn yield long-term, steady output that offsets the sharp production decline rates in the unconventional business.

"We run that as a free cash flow machine," Lance said. "So we're running that in a different fashion for modest growth — focus on returns of capital on capital — and this transaction makes that even better for the company going forward."

The deal also would improve the greenhouse gas emissions intensity of ConocoPhillips' production mix, Lance said. The company revised its emissions intensity reduction target from 35-45% for gross operated production to 40-50% for both net equity and gross operated output against a 2016 baseline.

The market reacted positively to the announcement, with shares of ConocoPhillips jumping nearly 5% in afternoon trading and several analysts raising price targets on the stock.

In a Sept. 21 research note, Mizuho Securities USA LLC said the deal was positive for ConocoPhillips' ability to fund shareholder payouts and extended ConocoPhillips' Delaware basin production inventory to about 35-plus years.

MKM Partners LLC analyst John Gerdes said the acquisition created "upper echelon Permian Basin asset scale" by increasing ConocoPhillips' Delaware basin leasehold by about 50% to roughly 665,000 net acres.

Other Wall Street analysts were less enthused. Scotiabank analyst Paul Cheng called the deal positive for Shell, but a mixed bag for ConocoPhillips. In a Sept. 21 note, Cheng said, "despite a reasonable price tag, at least some COP investors would expect a more sweetheart deal given the limited number of potential buyers for such a transaction."