What's Driving E&P Consolidation?

Shale's merry-go-round outspending began to break down toward the end of 2019 as investors lost their patience and the promise of free cash flow return never came to fruition. After the March 2020 oil and natural gas price collapse, shale's high decline rates, and dismal cash returns, we foresee high reinvestment risk. Companies are running out of tier 1 acreage, and their limited capital resources with investors have been burned one too many times. Moreover, improved synergies through lower overhead and cash costs look increasingly attractive as exploration and production (E&P) teams focus more on cost take-out.

Some companies have taken massive write-downs this year as they re-evaluate their long-term price outlooks. This increases the risks of stranded assets, lower proved reserves, and the long-term viability of certain basins should this price environment remain:

• Royal Dutch Shell PLC's impairment of $16.8 billion post-tax in the second quarter reduced average assets employed 6%.
• BP PLC announced an impairment of up to $17 billion post-tax on a reduction in the company's long-term oil price to $55 per barrel.
• Chevron Corp.'s impairments of $4.8 billion include a $2.6 billion write-off of its Venezuelan assets.
• Although Exxon Mobil Corp. has not taken any material impairments thus far, the company indicated it is reviewing development plans for its North American dry gas assets, putting up $25 million-$30 billion of asset value at risk of impairment.

While a longer-term factor, this comes during an inevitable transition to renewables as investors embrace environmental, social, and governance factors. The cost of renewables has meaningfully declined, policy developments will likely only increase after the COVID-19 pandemic. Largely a result of the EU's 2050 net-zero carbon emission policy, European players such as BP and Total are further along the renewable investment path. Given modest U.S. policies and incentives, U.S. integrated firms are much further behind in adopting renewable strategies--and in fact are positioning themselves to be the lowest-cost oil and gas producers rather than renewable energy providers.

A potential catalyst could be new government policies. U.S. President-elect Joe Biden has pledged $2 trillion in "carrot" policies to eliminate greenhouse gases from the electricity grid before 2035. Additional "stick" policies could include banning new permits on federal land as well as methane regulations. Therefore, much needed consolidation and cost reduction within the fragmented E&P wave has finally arrived as players feel the need to merge with peers or be acquired to survive the currents.

2020 Consolidation Results In Neutral To Positive Rating Actions

This year's deals are being done primarily with stock, at minimal premiums. Moreover, most are focused on high quality assets--with several in the prolific Permian Basin--as well as on those companies with clean balance sheets. It's clear risk appetite is at all-time lows as the industry looks to deleverage, leading to a modestly positive credit environment.

Larger, more diversified asset bases give management teams the option to select from better basins and high-grade wells, and they have stronger access to capital markets. As acquisitions are announced in the oil-rich Permian, they add high-quality inventory from the most prolific basin in the U.S., while those acquired gain access stronger financial companies with deeper access to resources suitable for the high decline and reinvestment rates of shale oil. Though not the driving factor, these deals produce underlying synergies and streamline management-related costs. It's difficult to rationalize the number of management teams in an industry that's far from expanding and may reach peak oil over the next decade. Therefore, lower break-evens help improve an ever-lower cost structure.

We do not believe this merger and acquisition (M&A) wave has reached its end, and wonder if the next crest includes distressed names post reorganization as midsize peers look to reduce leverage.

Key Mergers And Acquisitions

ConocoPhillips' acquisition of Concho Resources

ConocoPhillips announced an all-stock acquisition of Permian-focused peer Concho Resources Inc. for $9.7 billion, plus the assumption of $3.9 billion of debt. In our view, this will significantly improve credit measures given Concho's low leverage and ongoing capital discipline. Moreover, the acquisition will add nearly 25% to ConocoPhillips' total proved reserve base and production while boosting its presence in the Permian Basin, enhancing its business risk. Through a combination of direct costs, corporate costs, and reduced exploration costs, ConocoPhillips expects to achieve $500 million in annual cost and capital synergies by 2022. As a result, we affirmed our 'A' issuer credit rating on ConocoPhillips and revised the outlook to stable. We placed the rating on Concho Resources on CreditWatch with positive implications, reflecting the likelihood we will raise it to match our rating on ConocoPhillips following the acquisition.

Pioneer Natural Resources' acquisition of Parsley Energy

Pioneer Natural Resources Co.'s all-stock acquisition of Parsley Energy LLC will make the combined company the largest E&P independent player in the Permian Basin, with a massive acreage position of 930,000 net acres and pro forma oil and gas reserves of 1.7 billion barrels of oil equivalent as of year-end 2019. The companies expect to realize $325 million from operational synergies and lower general and administrative interest expenses. Moreover, given both companies' low leverage compared to peers and the all-stock deal, the ratings on Pioneer were unaffected, while we placed the ratings on Parsley on CreditWatch with positive implications. This reflects the likelihood we will raise our rating on Parsley to match our rating on Pioneer following the acquisition, which we expect will close in the first quarter of 2021.

Chevron's acquisition of Noble Energy

Chevron closed on its all-stock acquisition of Noble Energy Inc., expanding its strong position in the Delaware Basin of the Permian Basin while providing new assets in Israel and the Denver-Julesburg Basin in Colorado. In addition, the company expects to achieve annual run-rate operating and other cost synergies of $300 million before taxes by the end of the first year. We affirmed the ratings and outlook on Chevron, and raised the rating on Noble to that on Chevron at the close, given the all-equity deal. Chevron's assumption of Noble's debt will weaken its financial measures relative to our prior expectations, therefore the outlook remains negative.

Devon Energy's acquisition of WPX Energy

Devon Energy Corp.'s all-stock acquisition of WPX Energy Inc. will increase Devon's proved reserve base and production nearly 70%, bolster its acreage position in the Delaware Basin, and provide a new operating area in the Williston Basin. The acquisition would position Devon well relative to peers rated in the 'BBB-' category before incorporating potential asset sales, and reduce Devon's exposure to federal lands, where regulations could be increased on new drilling after the U.S. presidential election. Moreover, the acquisition will likely improve Devon's credit metrics and cash flows. It likely closes in early 2021. We affirmed the ratings on Devon and revised the outlook to stable from negative, and we put the ratings on WPX on CreditWatch positive.

Cenovus Energy's merger with Husky Energy

Cenovus Energy Inc. and Husky Energy Inc. announced their intention to combine in an all-stock deal, benefiting from an upstream and downstream vertical integration as upstream cash costs remain competitive. While the merged entity benefits from combined refining operations, it's somewhat tempered by the pro forma net long heavy oil exposure, as the consolidated refinery portfolio's processing capability is estimated at about 45% of total blended heavy oil production. We affirmed the ratings on Cenovus, and the outlook remains negative.

Southwestern Energy's acquisition of Montage Resources

This is expected to improve Southwestern Energy Co.'s production and reserve base while providing an expected $30 million of cost-saving synergies, improving efficiencies, reducing leverage, and increasing free cash flow in 2021 and beyond. Moreover, the transaction will increase Southwestern's acreage in both the Utica dry gas and Marcellus rich gas plays, enabling the company to become the third-largest producer in Appalachia. The ratings on Southwestern are unchanged, and we placed the ratings on Montage Resources Corp. on CreditWatch with positive implications.

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