Wednesday, December 16, 2009

Exxon/XTO: a Cartoon and a Song

I’ve spent the past couple of days reflecting on Exxon’s proposed acquisition of XTO Energy, and so much pops in my head. The first thing that I thought of was an old Far Side cartoon by Gary Larson where a dog dreams that he finally catches the car. He sits atop the flipped-over car howling. (Unfortunately I can’t find it online and my copy is in storage.)
It seemed like the perfect image to illustrate the situation where the big independents like XTO find themselves. By unlocking enormous reserves of shale gas, they’re the dog that has caught the car. But what are they going to do now? It will take mountains of cash to efficiently produce these reserves, but it will also require that the production companies have bullet-proof balance sheets able withstand the gyrations of the market in terms of volatility in demand and commodity price. That’s not possible at this stage – the big independents can have one or the other.

The big gas independents can raise billions of debt and equity, but will that be enough? Apparently not for some. I read in the front page Wall Street Journal article on the deal that Bob Simpson, Chairman and founder of XTO, approached Exxon, rather than the other way around. Simpson recognized that XTO didn’t have the financial resources or borrowing power to take advantage of the opportunity.

Chesapeake Energy has been very creative by setting up deals with major (mostly foreign) players to fund a portion of its drilling expenses, but the company has vast acreage to explore and produce. Will that strategy “scale?” At some point, will Chesapeake have to sell so much that it becomes a sharecropper on its own leases? Perhaps that language is a bit harsh, but it seems that CHK is moving towards being a contract producer where it gains first mover advantage by leasing land, starting drilling operations, and then bringing in a partner before really blowing it out. I suppose that once the company gets the leases held by production it can develop the leases in a methodical, capital efficient manner. But that doesn’t seem like Chesapeake’s style. Ultimately they might farm out the capital risk of the “factory operations” phase to another company and stay on to operate the production of the fields in a less financially risky capacity.  I don’t see CHK selling out, but I do see the company looking for creative ways to continue to shift the capital risk on the proverbial car they’ve caught. As I've mentioned before, CHK looks more like a private equity investment manager than an E&P company to me. 

But I digress.

The song that pops in my head is the Christian hymn “What a Friend We Have in Jesus.” Please don’t think me a heathen, but from the perspective of domestic natural gas, I’m singing, “What a Friend We Have in Exxon.” Exxon is no stranger to natural gas, but with this transaction it is going from ninth biggest U.S. gas producer to numero uno. Based on the WSJ’s chart below, in the first half of 2009, Exxon would have produced 3.53 Bcf/day of gas combined with XTO, 51% more than second place BP.

Suddenly, Exxon joins Aubrey McClendon (CHK) and Boone Pickens in becoming a big domestic natural gas advocate. Exxon has strong pull in Washington, and it’s nice to befriend the #1 Fortune 500 company.  It's one thing when Aubrey McClendon goes to Washington but something entirely different when it's Rex Tillerson sitting in front of a Congressional committee (nothing against Aubrey).

Another potential positive of this deal and others like it is that it could bring stabilization to gas commodity prices. One of the biggest issues natural gas has is price volatility, as witnessed by past 18 months. Without some price stability, many potential users will resist switching to gas. As an analyst interviewed for another WSJ article pointed out, “If the Exxon deal prompts other large, integrated oil and gas companies to enter the shale gas industry, the volatility in natural gas prices could subside five to 10 years from now…(t)he gas exploration-and-production sector would become better funded and dominated by fewer players.” The analyst in question sees long-term NG prices around $7/MMBtu.  The belief is that bigger players have longer-term time horizons and can fund exploration when commodity prices are low.  They are not as vulnerable to the whipsaw nature of commodity price fluctuations. 

I don’t know what will happen with the big independents. There are not a whole lot of companies that can pull of big acquisitions like XOM/XTO. What about consolidation among the big independents? Maybe for survival, but they’re called “independents” for a good reason. Most of the big gas players are still managed by their founders and long time employees and are not controlled by hired guns. Not to be a rumormonger, but I’ve always heard that Petrohawk is on the block for the right deal...

The next few months will be very interesting, so stay tuned.

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