Does It Make Sense For Exxon Mobil To Acquire Permian Assets?

Only a couple of days after making a breakthrough oil discovery in offshore Guyana, Exxon Mobil (NYSE:XOM), the world’s largest integrated oil company, has announced its plans to acquire a bunch of companies owned by the Bass family of Fort Worth, Texas((Exxon Mobil To Acquire Companies Doubling Permian Basin Resource To 6 Billion Barrels, 17th January 2017, www.exxonmobil.com)). These companies have an estimated resource base of 3.4 billion barrels of oil equivalent (boe) in New Mexico’s Delaware Basin, which is considered to be a highly prolific, oil-prone section of the Permian Basin. The US-based energy company will pay a one time sum of $5.6 billion in the form of shares and a series of additional contingent cash of roughly $1 billion, to be paid between 2020 and 2032, depending upon the development of the resource.

The market seemed pleased with the deal, as Exxon Mobil’s stock price traded 1.2% higher at $87.36 per share on Monday, post the announcement. While the acquisition will add to the company’s already high quality asset base and augment its future growth, it is imperative to analyse the impact of the deal on the company’s cash flows and financial position.

Source: Google Finance

Deal Dynamics & Rationale

Before jumping to the economics of the deal, we briefly describe the terms and rationale of the deal. As mentioned earlier, Exxon Mobil will acquire the Bass family holdings, including BOPCO, a privately held exploration and production company. BOPCO holds about 275,000 acres of leasehold, currently producing more than 18,000 net boe per day, of which roughly 70% is liquids. Of the total acreage acquired, about 250,000 acres is on three large contiguous parcels in the Permian Basin, while the rest is on oil fields in Colorado and Louisiana. The Permian land is held-by-production units in the New Mexico Delaware Basin, with more than 60 billion boe estimated in place.

Source: Drilling Productivity Report, January 2017, US Energy Information Administration (EIA)

Given the technological improvements and rebound in oil prices over the last year, transactions in the Permian Basin have risen sharply. The region is known for the abundance of oil resources as well as the low cost of production, that enables oil producers to generate higher returns for its investors. This is Exxon Mobil’s seventh transaction in the Permian Basin in the last three years, and its biggest since its buyout of XTO Energy in 2010. In fact, Exxon’s XTO Energy is likely to manage the newly acquired assets in the region.

Exxon currently holds around 1.5 million acres in the region, and produces about 140,000 boe per day from its current holdings. At present, the energy company has 10 rigs working in the Permian region, and plans to add 15 or more after the acquisition closes in the first quarter of 2017. With the closure of the deal, Exxon’s estimated resources base in the basin will double to approximately 6 billion boe, further strengthening the company’s position in the region that is considered to be one of the largest and most economical oil plays in the US.

Economics Of The Deal

Having discussed the terms and rationale of the deal, now we analyze the impact of the deal on Exxon Mobil’s cash flows and financial position. Exxon will acquire a significant portion of acreage from BOPCO, which has an ongoing production of 18,000 boe per day in the Permian Basin. This implies that the company will not have to drill wells immediately to justify the deal. Moreover, the additional production will yield close to $260 million in revenue for the company, if the crude oil prices average at around $40 per barrel through 2017. Although, given that the oil prices averaged at around $43 per barrel in 2016, and are estimated to recover in the coming quarters, the revenues are likely to be much higher than this.

That said, the incremental revenue is only a small portion of the deal. The major value of the transaction will come in the later half of this decade, when Exxon will explore the acreage and drill more wells in the basin to ramp up its oil production. The assets in the region are believed to have abundant oil that can be drilled at a much lower cost. To add to this, with the use of advanced technology and expertise, Exxon has managed to increase the well recovery at lower development costs for its Permian assets. Thus, the company’s assets in the region are estimated to yield 35%-40% higher margins compared to its other assets. With a increased resource base in one of the most profitable oil plays in the country, the oil and gas company will have a huge upside potential, as and when the commodity markets bounce back.

Exxon Mobil’s Well Recovery & Development Cost In The Permian Basin

On the financial side, Exxon Mobil will have to issue 64.1 million shares worth $5.6 billion at its current market price, in order to finance the initial portion of the deal. This implies that the company will have to dilute only 1.5% of its total share base, in order to acquire high quality assets in one of the premium oil plays in the US. This will, in no way, hamper the company’s capital structure. On the contrary, the deal will result in a marginal reduction in Exxon’s leverage ratio that has increased sharply from around 10% in 2015 to roughly 14% at the end of the third quarter of 2016.

However, the only flip side to the deal in the short term is that the outflow of higher dividend payments due to an increase in the share count. The oil and gas major currently pays an annual dividend of $2.98 per share to its shareholders. Assuming a similar dividend pay out in the next year, the company’s dividend obligation will increase by roughly $190 million due to the incremental shares. Although this is a relatively small figure for a company of Exxon’s size, it could pinch the company’s cash flows in the current weak and uncertain oil price environment. Yet, when we compare this additional cost to the potential upside offered by the acreage acquired under the deal, this amount seems meager and manageable.

In addition to this, Exxon will have to make a contingent payment of about $1 billion to the Bass family post 2020. However, since this payment is contingent to the development of the resource, we estimate that the recovery from the resource, coupled with the rebound in commodity prices, will be sufficient to cover this cost.

Thus, we figure that Exxon Mobil has made a smart move by investing in the Permian assets through an all-stock deal. The assets in the region are of superior quality and have low production cost, which will enable the company to generate higher margins and returns in the long term.

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