Could EOG Be A Potential Acquisition Target For Exxon Mobil?
Prolonged weakness in crude oil prices has pulled down the valuation of a majority of the oil and gas exploration and production (E&P) companies. As a result, the large integrated companies, who have been struggling to grow organically due to a number of reasons, are viewing the independent companies as a perfect acquisition target to augment their long-term growth. The $70 billion deal between Royal Dutch Shell (LON:RDSA) and BG Group, announced earlier this year, is one such example, and has set the tune for more merger and acquisition (M&A) activity in the industry. We had previously written an article – “3 Reasons Why Exxon Mobil Should Acquire EOG Resources,” describing how EOG Resources (NYSE:EOG) could be a potential acquisition target for the oil giant, Exxon Mobil (NYSE:XOM). In this article, we aim to explore the topic further, discussing the possibility of a deal between the two companies, and determining an appropriate target price that Exxon should be willing to pay to woo EOG shareholders.
See Our Complete Analysis For EOG Resources
Before delving deeper into the prospects of a potential deal, we will quickly outline the key reasons that make EOG Resources a suitable acquisition target for Exxon:
- Higher Production Growth
Due to its huge size and rising finding and development costs, Exxon has been unable to grow its upstream production over the past decade. On the contrary, EOG Resources has delivered almost a double digit growth in its hydrocarbon production over the past few years due to the increased use of horizontal drilling and hydraulic fracturing techniques in tapping tight oil reserves. Since, EOG has significant acreage in one of the world’s best shale plays such as Eagle Ford and Bakken, it can substantially increase its hydrocarbons production and remain profitable even at current low levels of oil prices. Though EOG’s production constitutes only a small portion (less than 15%) of Exxon’s production, a combination of the two has the potential to deliver notable production growth going forward.
- Better Volume Mix
Since liquids yield higher price realizations, it is typically more profitable for E&P companies to produce more liquids than to produce natural gas. However, due to constant acquisitions, the proportion of liquids in Exxon’s total production has declined from more than 60% in 2009 to 53% in 2014. This has weighed heavily on the company’s operating margins. On the other hand, the proportion of liquids in EOG Resources’ volume-mix has almost tripled to 62% in 2014. As EOG continues to focus on developing its liquid-rich acreage in the Eagle Ford play, this proportion is likely to increase further. Further, EOG generates industry leading operating margins. Thus, by acquiring EOG, Exxon can substantially enhance its upstream operating margins in the long term.
- Low Valuation Due To Weak Crude Oil Prices
While integrated oil companies, such as Exxon, have held up well due to the relatively stable cash flows from its downstream and chemicals divisions, independent oil companies have been severely impacted by the recent volatility in oil prices. EOG Resources’ stock price has dipped close to 35% since July 2014. Since EOG is trading at a much lower valuation than a year ago, Exxon will have a higher bargaining power while deciding the acquisition price.
Source: Google Finance
Now that we have established that EOG Resources would be a hypothetical suitable contender for acquisition by Exxon Mobil, we move to the specifics of the deal, if it comes true in the near future.
Revenue Synergies
If Exxon Mobil, one of the world’s largest integrated oil and gas company, decides to acquire EOG Resources, an independent oil and gas company, the deal would form the world’s largest integrated company with a market capitalization of more than $350 billion (at current market prices). Since both the companies have upstream operations, their production and revenues would be wholly additive. Based on our analysis, we expect Exxon’s 2015 revenue, which includes inter segment sales, to be around $405 billion, 25% lower on a year-on-year basis, while EOG’s consolidated hydrocarbon sales revenue is likely to be close to $8 billion in the current fiscal. Taking a conservative view, we estimate the combined entity’s consolidated revenue to be around $413 billion in 2015, 23% lower than Exxon’s total revenue in 2014. The chart below shows how the addition of EOG’s production will be a positive for Exxon’s production as well as top line growth in the long term.
Source: Trefis forecast
Cost Synergies
The objective of most of the M&A transactions is to bring about cost synergies for the combined entity. For the purpose of our analysis in this article, we estimate the maximum potential cost savings that can be achieved through this deal. Since we assume that Exxon will take over EOG’s entire production, all major costs that are driven by production, such as exploration, transportation, gathering and processing, and marketing costs, cannot be eliminated completely even if the deal comes through. However, EOG’s general and administrative costs (G&A) can be reduced due to the economies of scale obtained from Exxon’s large operations. So, to put things in perspective, EOG incurred G&A expenses to the tune of $402 million, while Exxon’s G&A expenses were almost $13 billion. Given the slowdown in production due to weak oil prices, we estimate EOG’s G&A costs to decline to $370 million in 2015 before rising to $400 million in 2016. Since these costs represent an insignificant proportion of Exxon’s G&A costs, we assume they can be completely eliminated if the two companies merge, leading to higher EBITDA margins for the combined entity going forward.
Source: Trefis forecast
Capex Savings
Next, we look at the capital spending of the two companies. Due to the depressed oil prices, oil and gas companies have been cutting down their upstream capital spending aggressively. EOG announced a more than 40% decline in its capital spending budget for 2015, while Exxon is likely to see a 20% dip in its overall capex for the year. However, if the two companies merge, there would be substantial capex savings for the combined entity due to the overlapping upstream business. Based on our understanding, we assume that Exxon will be able to cut down at least 20% of EOG’s capex expectations. Consequently, Exxon’s post merger capex will comprise of 80% of EOG’s and 100% of its own capex estimates. A 20% capex savings will notably escalate Exxon’s cash flows in the long term.
Source: Trefis forecast
Having discussed the key expected changes in the combined entities’ P&L summary, we will now determine an appropriate price target that Exxon would be willing to pay in return for the value derived from the deal, which is also acceptable to EOG’s shareholders.
Deal value
It is evident that the recent oil slump has washed away one-third of EOG’s valuation over the last one year. Consequently, if a potential suitor approaches EOG’s shareholders for an acquisition, they would not be willing to accept an offer which is less than the company’s all-time high of $116 per share, achieved in July of last year when the oil price had peaked out. So, to determine the target price, we calculate the present value of the net synergies gained from the deal and add it to our current price estimate for EOG Resources which stands at $93 per share. As elaborated earlier, the deal will result in cost synergies and capex savings over the long term. These would have a present value of almost 24 billion over the next 7 years (assuming a tax rate of 35%, discount rate of 10%, and terminal growth rate of 2%), translating into an incremental value of $44 per share to the EOG shareholders. Accordingly, we arrive at a deal price of $137 per share, representing a premium of 76% to EOG’s current market price of $78 per share.
While some may argue that this premium is unfairly high, in our view it is justified given the recent decline in EOG’s valuation due to depressed oil prices. It is important to note that this estimated target price is the maximum price that Exxon will be willing to pay and is determined based on our estimate of the maximum potential cost savings that can be achieved through this deal. The actual deal price, however, would be largely driven by the negotiating skills of Exxon’s management and how much confidence EOG’s shareholders and the board have on the fundamentals of the company in the current pricing environment.
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